FRBSF Economic Letter
98-25; August 28, 1998
How Do Currency Crises Spread?
The world has experienced three waves of speculative attacks on fixed
exchange rate regimes recently: the European Monetary System (EMS) crisis
of 1992-93, the Mexican meltdown and "Tequila Hangover" of 1994-95,
and the "Asian Flu" of 1997-98. These currency crises generally
involved countries in the same region. Why?
One explanation is that currency crises tend to spread through a region
because countries are linked by trade, and trade tends to be regional.
Once Thailand floated the baht, its main trade competitors (Malaysia and
Indonesia) were suddenly at a competitive disadvantage, and so were themselves
likely to be attacked. Thus the spread of currency crises reflects
international trade patterns. Countries who trade and compete with
the targets of speculative attacks are themselves likely to be attacked
Our explanation of the regional nature of currency crises might seem
obvious. But most economists think about currency crises using macroeconomic
models. They think of crises as resulting from conflicts between incompatible
internal and external macroeconomic objectives. This apparently reasonable
view has a simple problem: macroeconomic phenomena do not tend to be regional.
So it is hard to understand why currency crises would be regional from
a strictly macroeconomic perspective.
In this Letter we summarize empirical evidence by Glick and
Rose (1998) that systematically assesses the role of trade linkages as
a channel for contagion. Using data for a number of different currency
crisis episodes, we show that currency crises affect clusters of countries
tied together by international trade. This linkage is important in understanding
the regional nature of speculative attacks. Currency crises spread along
the lines of trade linkages, even after accounting for the effects of
macroeconomic and financial factors.
Currency crises have been regional
This decade has witnessed three important currency crises. In the autumn
of 1992, a wave of speculative attacks hit the EMS and its periphery.
Before the end of the year, five countries (Finland, the U.K., Italy,
Sweden, and Norway) had floated their currencies. Despite attempts by
a number of other countries to remain in the EMS by devaluing their currencies
(Spain, Portugal, and Ireland), the old system was ultimately unsalvageable.
The bands of the EMS were widened from ± 2.25% to ± 15% in August
1993.
The Mexican peso was attacked in late 1994 and floated shortly after
an unsuccessful devaluation. A rash of speculative attacks broke out immediately.
The most prominent targets of the "Tequila Hangover" were Latin
American countries, especially Argentina and Brazil, but also including
Peru and Venezuela. Not all Latin countries were attacked -- Chile was
the most visible exception -- and not all economies attacked were in Latin
America (Thailand, Hong Kong, the Philippines, and Hungary suffered brief
speculative attacks). While few countries actually devalued, the Tequila
attacks were not without effect. Argentine macroeconomic policy in particular
tightened dramatically, precipitating a sharp recession.
The "Asian Flu" began with the flotation of the Thai baht
in July 1997. Within days speculators attacked Malaysia, the Philippines,
and Indonesia. Hong Kong and Korea were attacked somewhat later on; the
crisis then spread across the Pacific to Chile and Brazil, and "bahtulism"
effects still linger.
All three waves of attacks were largely regional. Once a country had
suffered a speculative attack - Thailand in 1997, Mexico in 1994, Finland
in 1992 - its trading partners and competitors were disproportionately
likely to be attacked themselves. Not all major trading partners devalued
- indeed, not all were even attacked. Macroeconomic and financial influences
were certainly not irrelevant. But neither was the trade channel irrelevant
as a means of transmitting speculative pressures across international
borders.
It should be noted that currency crises were regional long before the
1990s. The German decision in April 1971 to abandon its Bretton Woods
exchange rate obligations precipitated a rash of flotations by other European
countries. The same was true of the German decision to float out of the
Smithsonian Agreement in February 1973.
Explanations of currency crises
Most economists tend to think about currency crises using one of two
standard models of speculative attacks, both of which emphasize macroeconomic
fundamentals as determinants. "First generation" models direct
attention to inconsistencies between an exchange rate commitment and domestic
economic fundamentals. For example, excessive monetary expansion to monetize
fiscal deficits can deplete the central bank=s foreign exchange reserves
and weaken its ability to defend a peg. "Second generation"
models view currency crises as shifts between different monetary policy
equilibria in response to self-fulfilling speculative attacks. In these
models, market speculators initiate attacks based on their beliefs about
the willingness of policymakers to resist pressure on the exchange rate.
When markets perceive that conditions such as high unemployment or a weak
banking system compromise the central bank's willingness to defend
a currency peg by raising interest rates, speculative attacks are more
likely to succeed.
Both models suggest that currency crises will be regional if economic
conditions are regional, i.e., a crisis may spread among countries in
the same region if they exhibit similar macroeconomic and financial features.
But macroeconomic conditions do not tend to be regional. Thus, from the
perspective of most speculative attack models, it is hard to understand
why currency crises tend to be regional, at least without an extra ingredient
explaining the regional relationship of relevent macroeconomic fundamentals.
The "extra ingredient" may well be trade patterns, which are
regional: countries tend to export and import with countries in geographic
proximity. It is easy to imagine why the trade channel is important. If
prices tend to be sticky, a nominal devaluation delivers a real exchange
rate pricing advantage, at least in the short run. That is, countries
lose competitiveness when their trading partners devalue. They are therefore
more likely to be attacked -- and to devalue -- themselves.
Of course, this channel may not be important in practice. Nominal devaluations
need not result in real exchange rate changes for any long period of time.
Devaluations are costly and can be resisted. Making the case for the trade
channel is therefore primarily an empirical exercise.
Empirical methodology
To demonstrate that trade provides an important channel for contagion
above and beyond macroeconomic and financial similarities, we focus on
explaining the incidence of currency crises across countries
for five different currency crisis episodes: the breakdown of the Bretton
Woods system in 1971, the collapse of the Smithsonian Agreement in 1973,
the EMS Crisis of 1992-93, the Mexican meltdown and the Tequila Effect
of 1994-95, and the Asian Flu of 1997-98. We ask why some countries were
hit during each of these episodes of currency instability, while others
were not. Further details are provided in Glick and Rose (1998).
Our empirical strategy keys off the "first victim" in a given
crisis episode. Given the incidence of the initial speculative attack
(e.g., Thailand in 1997 and Mexico in 1994), we ask how the crisis spreads
from this first victim. Were the subsequent targets closely linked by
international trade to the first victim? Or did they share macroeconomic
similarities?
We answer this by estimating a cross-country relationship for each crisis
episode; we compare the incidence of crises with a measure of each other
country's trade linkage with the first crisis victim as well as relevant
macroeconomic variables. To estimate this relationship we must (1) define
the incidence of currency crises, (2) measure the trade linkage between
the first crisis victim and other countries, and (3) measure the relevant
macroeconomic and financial control variables.
We define our currency crisis measure as a simple binary variable indicator
of crisis victims (1 if a country is a victim, 0 if it is not) determined
from journalistic and academic histories of the various episodes. More
complex measures of currency crisis involvement that take into account
the extent of exchange rate pressure experienced by a country during a
crisis deliver similar results.
The magnitude of international trade links between the first victim
and other countries is constructed from a weighted average measure of
the extent to which the countries compete in foreign export markets. This
trade measure is computed for each episode using annual data for the relevant
crisis year taken from the IMF's Direction of Trade data set.
As an example, in 1997 all of Thailand's top 10 trade competitors and
16 of its top 20 trade competitors were located in Asia. (The top 10 ranked
in descending order were Malaysia, Korea, Indonesia, China, Japan, Taiwan,
the Philippines, India, Myanmar, and Singapore; Hong Kong was 17th.) Unsurprisingly,
these countries were also disproportionately likely to have suffered speculative
attacks. Perturbing the trade linkage measure in different ways makes
little difference to the results.
A variety of different macroeconomic variables are used to control for
the determinants of currency crises dictated by standard macroeconomic
models of speculative attacks. We do this so that the trade linkage variable
picks up the effects of currency crises that spill over simply because
of trade. That is, we take into account key aggregate and financial imbalances
that might lead to a currency crisis for macroeconomic reasons. The macroeconomic
variables we employ include the annual growth rate of domestic credit,
the government budget as a percentage of GDP, the current account as a
percentage of GDP, the growth rate of real GDP, the ratio of M2 to international
reserves, domestic CPI inflation, and the degree of currency under-valuation.
(We also tested other variables, and the thrust of the results was the
same.) The data set is annual and was extracted from the IMF's International
Financial Statistics.
Empirical results: trade links matter
The cross-country relationships between currency crisis involvement,
trade linkage, and other macroeconomic variables are estimated by bivariate
and multivariate probit analysis. The results are striking.
For all five episodes, the strength of trade linkage to the "first
victim" varies systematically between crisis and non-crisis countries.
In particular, it is systematically higher for crisis countries at all
reasonable levels of statistical significance, i.e., countries that become
"infected" by the crisis have closer trade linkages to the "first
victim" than countries that escape the disease.
In contrast, none of the macroeconomic variables typically varies systematically
across crisis and non-crisis countries. While some variables sometimes
have significantly different means, these results are not consistent across
episodes. And they are never as striking as the trade results. These findings
are consistent with the importance of the trade channel in contagion.
When macroeconomic and trade linkages are included simultaneously, the
results are unchanged. The trade channel for contagion remains consistently
important. While the economic size of the effect varies significantly
across episodes, it is consistently different from zero at conventional
levels of statistical significance. Its consistently positive sign indicates
that a stronger trade linkage is associated with a higher incidence of
a currency crisis.
On the other hand, the macroeconomic controls are small economically
and rarely of statistical importance. This is true both of individual
variables and of a host of macroeconomic factors taken simultaneously.
These results hold up with respect to a number of perturbations to the
basic empirical methodology.
The hypothesis of no significant trade channel for contagion seems wildly
inconsistent with the data, while macroeconomic conditions do not explain
the cross-country incidence of currency crises. That is, currency crises
seem to spread contagiously because of international trade patterns.
Conclusion
We have found strong evidence that currency crises tend to spread along
the regional lines suggested by international trade. Countries tend to
suffer speculative attacks after their foreign competitors are attacked.
This is true of five waves of speculative attacks since 1971. Accounting
for a variety of different macroeconomic effects does not change this
result. Indeed, macroeconomic factors do not consistently help much in
explaining the cross-country incidence of speculative attacks.
Our analysis implies that countries may be attacked because of the actions
(or inaction) of their neighbors who tend to be trading partners merely
because of geographic proximity. This externality has important implications
for policy. If speculative attacks spread through trade links, then enhanced
international monitoring on a regional basis is desirable. Moreover, If
countries are more at risk to the spread of currency crisis than is apparent
by looking just at domestic economic factors, a lower threshold for international
or regional assistance is also warranted in order to limit the spread
of speculative attacks.
Reuven Glick
Vice President and Director
Center for Pacific Basin
Monetary and Economic Studies, FRBSF
Andrew K. Rose
Visiting Scholar, FRBSF, and
Professor, Haas School of Business
University of California, Berkeley
Reference
Glick, Reuven, and Andrew K. Rose. 1998. "Contagion
and Trade: Why Are Currency Crises Regional?" U.C Berkeley Working
Paper and Pacific Basin Working Paper No. 98-03.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
|
