Conventional wisdom has it that, as a government fiscalises the contingent liabilities of nationalised banks, the currency of the country in question should depreciate. More generally, banking crises are, very often, accompanied by balance of payments (or currency) crises. The
Popular Thesis on Nationalisation and the Dollar
The notion that nationalisation of banks should lead to currency weakness is popular mainly because it is intuitive. Since nationalisation of banks is ‘not good news’, and runs counter to the principles of capitalism and the free market, some have the visceral reaction to sell the currency in question.
Further, as highlighted by Kaminsky and Reinhart (K&R) (see Graciela Kaminsky and Carmen Reinhart (1999), “The Twin Crises: The Causes of Banking and Balance-of-Payments Problems”, The American Economic Review 89: 3, June), there are many historical examples of ‘twin crises’, whereby banking crises and currency crises occurred simultaneously. The more memorable examples include
This link between banking crises and currency crises is genuine, and the usual dynamics are well-summarised by ex-Governor of the Riksbank (
Moreover, nationalisation of banks will increase the fiscal burden of the government. For a country that already has a large fiscal deficit, this is clearly negative for the interest rate outlook. For one that also has an external deficit, a large public borrowing need, ceteris paribus, should translate into a weaker currency, so the logic goes. At the same time, the central bank may be tempted to ‘monetise’ the debt, or run a monetary stance that is easier than otherwise – again currency-negative.
The Inconvenient Historical Fact
While the arguments above may sound logical and compelling to many, the inconvenient fact is that the historical pattern of how currencies perform before and after nationalisation or bail-outs tells a very different story. Averaged across five episodes of prominent banking crises, the nominal exchange rate tended to fall before nationalisation, but rise thereafter.
The historical pattern suggests that financial markets tend to be forward-looking and try to price in the deterioration in the state of the banking system by selling down the currency and financial sector stocks, but the government is usually not compelled to act until conditions deteriorate significantly. As a result, more often than not, government interventions have coincided with the lows in currency values. In other words, even though K&R’s observation that currency crises often occur simultaneously with banking crises is correct, there is no strong proof that nationalisation leads to further currency weakness.
Other more visible examples are consistent with this link between banking crises and currency crises. The S&L Crisis and its bail-out spanned a protracted period of time. The dollar index did continue to fall from 1986 – the beginning of the S&L Crisis – until 1989 or so. (In 1986, the FSLIC (Federal Savings and Loan Insurance Corporation) – the deposit insurance scheme funded by the thrift industry but guaranteed by the government – first reported being insolvent (incidentally, the main reason why 1986 is remembered as the beginning of the S&L Crisis). The RTC (Resolution Trust Corporation) was established in 1989, and by 2003, the RTC had ‘resolved’ US$394 billion worth of non-performing assets of US savings and loans. (The total cost of the clean-up of the US S&L Crisis reached US$153 billion, in ‘current’ terms equivalent to some 2.6% of US GDP in 1991. This translates to US$375 billion in 2008 dollar terms.) The dollar index essentially moved sideways in the early 1990s. The dollar did falter in 1994/95, but that was attributed more to the inflation scare than to the S&L Crisis. Similarly,
The case of the
In sum, banking crises are unambiguously bad for currencies, but nationalisation per se does not make the situation worse for currencies. In fact, it often marks the low in the currencies.
Having said the above, the
The Congressional Budget Office (CBO) released its budget update last week, and predicted that the
Investors will likely see it as key for the next Administration to control spending. However, it is also important for investors to appreciate how sensitive
Banking crises are bad for currencies, but nationalisation per se does not necessarily make it worse for currencies. In fact, it often marks the low in the currencies. We believe this is the case for the dollar in the current episode. What remains a lingering risk for the dollar over the medium term is the