Fundamentals, Contagion and Currency Crises: An Empirical Analysis

Abstract

The 1990s will be remembered in economic history as a decade of currency crises. In September 1992 the exchange-rate mechanism of the European Monetary System came under attack. This was followed by the Mexican currency crisis of December 1994 and, more recently, the Asian and Russian crises. 1 Concern about the possibility of these crises spreading to other countries and the implications this might have for the conduct of monetary policy rekindled interest amongst economists and policy-makers in the determinants of currency crises. There is no consensus in the theoretical literature regarding the causes of such crises. Traditional models suggest that currency crises are caused by deteriorating economic fundamentals, while more recent models link crises to self-fulfilling prophecies and contagion effects. Since different factors are identified as the causes, it is necessary to examine their determinants empirically.This article examines the determinants of currency crises in developing countries. It asks two basic questions: (a) are currency crises linked to economic fundamentals? and (b) is there any evidence of a contagion effect after controlling for the potential effects of economic fundamentals? Using a panel of annual data for 19 developing countries spanning the period 1977-97, it demonstrates that, among the macroeconomic fundamentals considered as predictors of currency crises, the current account deficit is the only variable that can be consistently linked to currency crises. Economic fundamentals such as the growth rate of domestic credit, lending booms, inflation, foreign debt, output growth and high fiscal deficits are generally not significant. In cases where a

Leading Indicators of Currency Crises: Are They the Same in Different Exchange Rate Regimes?

“…Several subsequent studies also use probit (or logit) models. For example, Kruger et al (2000) use annual data for 19 developing countries spanning the period 1977-1997. They report that the current account deficit is the only variable that can be consistently linked to currency crises.…”

Real and financial shocks, exchange rate regimes and the probability of a currency crisis

“…Studies have used a probit model to estimate the probability of currency crises or currency crashes (Eichengreen et al 1996: Frankel andBerg and Pattillo 1999;Kruger et al 2000;Komulainen and Lukkarila 2003;Frankel 2005;Licchetta 2011;Furceri et al 2012;Zhao et al 2014). 6 Before examining the empirical literature, it is worth distinguishing between "currency crises" and "currency crashes" because these are two different concepts that are frequently confused.…”

“…Using data for 20 developing countries, Kruger et al (2000) found that real exchange rate overvaluation and a dummy variable for a currency crisis in a foreign country had statistically significant effects on the probability of currency crises. Analyzing the data on 31 emerging market countries, Komulainen and Lukkarila (2003) found that the foreign debt of private companies and banks provides a good explanation of currency crises.…”

International Contagion Effects from the Russian Crisis and the LTCM Near-Collapse

“…This may be more likely in increasingly integrated international financial markets (International Monetary Fund (1999)). Kruger, Osakwe and Page (1998) consider that herd behavior leads to a concept they distinguish as unwarranted contagion, which occurs when a crisis spreads to another country that otherwise would not have experienced a speculative attack. This is consistent both with contagion as a residual (Masson (1999a,b,c)), and the definition used in this paper.…”