Regionality revisited: An examination of the direction of spread of currency crises

What determines the direction of spread of currency crises? We examine data on waves of currency crises in 1992, 1994, 1997, and 1998 to evaluate several hypotheses on the determinants of contagion. We simultaneously consider trade competition, financial links, and institutional similarity to the “ground zero” country as potential drivers of contagion. To overcome data limitations and account for model uncertainty, we utilize Bayesian methodologies hitherto unused in the empirical literature on contagion. In particular, we use the Bayesian averaging of binary models that allows us to take into account the uncertainty regarding the appropriate set of regressors.We find that institutional similarity to the ground zero country plays an important role in determining the direction of contagion in all the emerging market currency crises in our dataset. We thus provide persuasive evidence in favour of the “wake-up call” hypothesis for financial contagion. Trade and financial links may also play a role in determining the direction of contagion, but their importance varies amongst the crisis periods.     

The optimal currency basket under vertical trade

This paper explores the theory of optimal currency basket in a small open economy general equilibrium model with sticky prices. In contrast to existing literature, we focus on an economy with vertical trade, where the currencies in the basket may play different roles in invoicing trade flow. In a simple two-currency basket, one currency is used to invoice imported intermediate goods and is called “import currency”, while the other currency is used to invoice exported finished goods and is called “export currency”. We find that the optimal weights of the import currency and the export currency depends critically on the structure of vertical trade. Moreover, if a country decides to choose a single-currency peg, the choice of pegging currency also depends on how other competing economies respond to external exchange rate fluctuations.     

Bounds and prices of currency cross-rate options

This paper derives the pricing bounds of a currency cross-rate option using the option prices of two related dollar rates via a copula theory and presents the analytical properties of the bounds under the Gaussian framework. Our option pricing bounds are useful, because (1) they are general in the sense that they do not rely on the distribution assumptions of the state variables or on the selection of the copula function; (2) they are portfolios of the dollar-rate options and hence are potential hedging instruments for cross-rate options; and (3) they can be applied to generate bounds on deltas. The empirical tests suggest that there are persistent and stable relationships between the market prices and the estimated bounds of the cross-rate options and that our option pricing bounds (obtained from the market prices of options on two dollar rates) and the historical correlation of two dollar rates are highly informative for explaining the prices of the cross-rate options. Moreover, the empirical results are consistent with the predictions of the analytical properties under the Gaussian framework and are robust in various aspects.     

Government finance in the wake of currency crises

We address three questions: (i) Can classical models be reconciled with the fact that many crises are marked by high rates of depreciation and small increases in seignorage revenue? (ii) What are the implications of different financing methods for post-crisis rates of inflation and depreciation? (iii) How do governments pay for the fiscal costs associated with currency crises? To study these questions we use a general equilibrium model in which prospective government deficits trigger a currency crisis. We then use our model in conjunction with fiscal data to interpret government financing in the wake of three recent currency crises: Korea (1997), Mexico (1994) and Turkey (2001).     

Foreign currency debt,financial crises and economic growth: A long-run view

Foreign currency debt is widely believed to increase risks of financial crisis, especially after being implicated as a cause of the East Asian crisis in the late 1990s. In this paper, we study the effects of foreign currency debt on currency and debt crises and its indirect effects on short-term growth and long-run output effects in both 1880–1913 and 1973–2003 for 45 countries. Greater ratios of foreign currency debt to total debt are associated with increased risks of currency and debt crises, although the strength of the association depends crucially on the size of a country's reserve base and its policy credibility. We found that financial crises, driven by exposure to foreign currency, resulted in significant permanent output losses. We estimate some implications of our findings for the risks posed by currently high levels of foreign currency liabilities in eastern Europe.     

Discrete devaluations and multiple equilibria in a first generation model of currency crises

The first generation models of currency crises have often been criticized because they predict that, in the absence of very large triggering shocks, currency attacks should be predictable and lead to small devaluations. This paper shows that these features of first generation models are not robust to the inclusion of private information. In particular, this paper analyzes a generalization of the Krugman-Flood-Garber (KFG) model, which relaxes the assumption that all consumers are perfectly informed about the level of fundamentals. In this environment, the KFG equilibrium of zero devaluation is only one of many possible equilibria. In all the other equilibria, the lack of perfect information delays the attack on the currency past the point at which the shadow exchange rate equals the peg, giving rise to unpredictable and discrete devaluations.     

Banking crises: An equal opportunity menace

The historical frequency of banking crises is similar in advanced and developing countries, with quantitative parallels in both the run-ups and the aftermath. We establish these regularities using a dataset spanning from the early 1800s to the present. Banking crises weaken fiscal positions, with government revenues invariably contracting. Three years after a crisis central government debt increases by about 86%. The fiscal burden of banking crisis extends beyond the cost of the bailouts. We find that systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms, in rich and poor countries alike.     

The ADR shadow exchange rate as an early warning indicator for currency crises

We develop an indicator for currency crisis risk using price spreads between American Depositary Receipts (ADRs) and their underlyings. This risk measure represents the mean exchange rate ADR investors expect after a potential currency crisis or realignment. It makes crisis prediction possible on a daily basis as depreciation expectations are reflected in ADR market prices. Using daily data, we analyze the impact of several risk drivers related to standard currency crisis theories and find that ADR investors perceive higher currency crisis risk when export commodity prices fall, trading partners’ currencies depreciate, sovereign yield spreads increase, or interest rate spreads widen.     

Heavy tails and currency crises

In affine models of foreign exchange rate returns, the nature of cross sectional interdependence in crisis periods hinges on the tail properties of the fundamentals' distribution. If the fundamentals exhibit thin tails like the normal distribution, the dependence vanishes asymptotically; while the dependence remains in the case of heavy tailed fundamentals as in case of the Student-t distribution. The linearity of the monetary model and heavy tail distributed fundamentals are sufficient conditions for fundamentals-based repeated joint currency crises. An estimator for the extreme exchange rate interdependencies is obtained and applied to Western, Asian and Latin American currency block data.     

Risk and wealth in a model of self-fulfilling currency attacks

Market participants’ risk attitudes, wealth and portfolio composition influence their positions in a pegged foreign currency and, therefore, may have important effects on the sustainability of currency pegs. This paper analyzes such effects in a global game model of currency crises with continuous action choices, generating a rich set of theoretical comparative static predictions related to often discussed but rarely modelled accounts of currency attacks. The model can be solved in closed form and the methods could be used to study other economic issues in which coordination and risk aversion play important roles.     

Country risk and financial integration—A case study of South Africa

This paper examines the importance of economic factors in a time-varying beta model of country risk before and after the occurrence of financial integration for South Africa's stock market. We examine how fundamental economic factors impact the variation of South Africa's country risk over the period 1993-2008. We find that exchange rates and gold prices are significant economic variables that induce significant volatility in South Africa's beta during the pre-financial integration period through June 1998. Post-financial integration, South Africa's beta rises and fundamental economic factors cease to be significant in determining its variation, a result consistent with an integrated financial market.     

General equilibrium pricing of currency and currency options

This paper presents a consumption-based general equilibrium model for valuing foreign exchange contingent claims. The model identifies a novel economic mechanism by exploiting highly but imperfectly shared consumption disaster with variable intensities which are the concerns to the representative investor under recursive utility. When applied to the data, the model simultaneously replicates (i) the moderate option-implied volatilities; (ii) substantial variations in the risk-neutral skewness of currency returns; (iii) the uncovered interest rate parity puzzle; and (iv) the first two moments of carry trade returns. Furthermore, the model rationalizes salient features of the aggregate stock, government bonds, and equity index options.     

The size of banking crises in credible fixed exchange rate regimes

Since monetary policy is constrained in fixed exchange rate regimes, we should observe fewer banking crises due to moral hazard in countries with credible currency pegs. However, three countries with seemingly credible pegs in the nineteen-eighties and -nineties, namely China, Hong Kong and Argentina, still suffered crises in their domestic banking sectors. The present note illustrates that bank incentives to take on excess risk still exist in countries with currency peg credibility and that the size of that risk exposure (and thus the potential for crisis) may be positively related to the level of central bank foreign exchange reserves.     

Are twin currency and debt crises special?

In the literature on currency and banking crises it has become the standard procedure to distinguish pure currency crises, pure banking crises and combined (“twin”) currency and banking crises. We show theoretically and empirically that a similar differentiation should be chosen with regard to currency and debt crises. Twin currency and debt crises differ from both pure currency and pure debt crises in their determinants, course of events, and economic consequences. We find that each type of crises has a unique set of macroeconomic causes. We also identify internal contagion and selection bias effects, which may lead to biased empirical estimates if twin crises are not treated as a specific type of crises. Such a separation allows in significantly improving the efficiency of early warning systems especially for debt and twin crises.     

Currency bid-ask spread dynamics and the Asian crisis: Evidence across currency regimes

Using a sample of 21 emerging and developed country currencies, we evaluate the impact of the Asian crisis on bid-ask spreads. While the crisis had widespread and uniform volatility effects, the spread effects were not uniform across emerging and developed country currencies. For Asian emerging markets, spreads widened and spread volatility increased significantly during the crisis, while developed markets spreads narrowed and spread volatility decreased significantly. We investigate the impact of more flexible and less flexible exchange rate regimes on bid-ask spreads using panel data. In general, countries with tightly-managed regimes have significantly lower spreads than countries with more freely-floating regimes, while controlling for the influence of other factors such as volatility. Asian developing market spreads are higher than spreads of the other countries, again, after controlling for the influence of other factors.     

Uncertainty and currency crises: Evidence from survey data

How does uncertainty about fundamentals affect speculation in the foreign exchange markets? This paper studies empirically the role of uncertainty in currency crises. Uncertainty, which is measured using the dispersion of survey forecasts of key macroeconomic variables, is found to have a non-monotonic effect on exchange rate pressures: it heightens speculative pressures when expected fundamentals are good and eases them when they are bad. This prediction is consistent with a broad class of currency crisis theories, ranging from first-generation to global-game models. The proposed empirical strategy remains valid in the presence of forecasters with strategic objectives and addresses potential endogeneity bias by building a novel set of instrumental variables.     

Gross capital flows: Dynamics and crises

This paper analyzes the behavior of international capital flows by foreign and domestic agents, dubbed gross capital flows, over the business cycle and during financial crises. We show that gross capital flows are very large and volatile, especially relative to net capital flows. When foreigners invest in a country, domestic agents invest abroad, and vice versa. Gross capital flows are also pro-cyclical. During expansions, foreigners invest more domestically and domestic agents invest more abroad. During crises, total gross flows collapse and there is a retrenchment in both inflows by foreigners and outflows by domestic agents. These patterns hold for different types of capital flows and crises. This evidence sheds light on the sources of fluctuations driving capital flows and helps discriminate among existing theories. Our findings seem consistent with crises affecting domestic and foreign agents asymmetrically, as would be the case under the presence of sovereign risk or asymmetric information.     

Diversification at financial institutions and systemic crises

It is widely believed that diversification at financial institutions benefits the stability of the financial system. This paper shows that it also entails a cost: even though diversification reduces each institution’s individual probability of failure, it makes systemic crises more likely. When systemic crises induce additional costs (over and above individual failures), full diversification is no longer desirable as a result and the optimal degree of diversification may be arbitrarily low. We show that the analysis can be extended beyond diversification, such as to interbank insurance and financial integration.     

Volatile and persistent real exchange rates with or without sticky prices

The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Two methodologies are employed to explore this model's ability to generate volatile and persistent exchange rates. In the first, actual data is used for the exogenous driving processes. In the second, the model is simulated using estimated forcing processes. The theory, in both cases, is capable of explaining the high volatility and persistence of real and nominal exchange rates as well as the high correlation between real and nominal rates.     

A theory of optimal expropriation, mergers and industry competition

We model a competitive industry where managers choose quantities and costs to maximize a combination of firm profits and benefits from expropriation. Expropriation is possible because of corporate governance ‘slack’ permitted by the government. We show that corporate governance slack induces managers to choose levels of output and costs that are higher than would otherwise be optimal. This, in turn, benefits consumers - the equilibrium price is lower - and other stakeholders such as suppliers and employees. Depending on the government’s social welfare objective, less-than-perfect investor protection can be optimal. We show why some mechanisms suggested by the literature as improving investor protection - legal change, cross-listing, domestic mergers - may not be effective. We provide a theoretical argument showing the efficacy of cross-border mergers. The stronger corporate governance of a foreign acquirer, imposed on the domestic target firm, benefits merging shareholders and those of competing unmerged domestic firms.