Credits, Crises, and Capital Controls: A Microeconomic Analysis

Abstract We analyze the behavior of foreign banks who sequentially provide credit to finance projects in an emerging market. The foreign banks are exposed to both project-risks and the macro-economic risk of a currency crisis, and there are no bailout guarantees. Nevertheless, we show that it is often the case that banks provide too much credit too easily and that this behavior may precipitate the onset of a currency crisis. We demonstrate how the imposition of capital controls in the form of taxes and subsidies on foreign investment may improve the situation. Whereas most of the literature on currency crises focuses its analysis on debtor countries and thus on the borrowers' side, our paper illustrates that the lenders' side also deserves attention.