Skip to main content

Why are currency crises contagious? A comparison of the Latin American Crisis of 1994–1995 and the Asian Crisis of 1997–1998

Abstract

Why Are Currency Crises Contagious? A Comparison of the Latin American Crisis of 1994–1995 and the Asian Crisis of 1997–1998.—This paper analyzes three channels through which currency crises are transmitted between countries: contagion based on unsustainable economic fundamentals; contagion resulting from herding behaviour in financial markets; contagion induced by close trade integration. The presented model that links currency crises with these three types of contagion is employed to analyze the transmission of the Mexican crisis in 1994–1995 and the Thai crisis in 1997 to other emerging economies. The empirical results show that, first, the most important contagion channels were based on close financial and trade integration rather than on the weakness of macroeconomic fundamentals. Second, the vulnerability to capital flow reversals and weak financial sectors made countries particularly prone to a currency crisis, while external imbalances and currency misalignments were much less important. JEL no. F30, E60, E65, E44

Zusammenfassung

Warum sind Währungskrisen ansteckend? Ein Vergleich der lateinamerikanischen Krise von 1994/95 mit der Asienkrise 1997/98.—Dieser Artikel untersucht die Frage, wie Währungskrisen zwischen Ländern übertragen werden. Es wird zwischen drei verschiedenen Übertragungskanälen unterschieden: Übertragungen, die auf unhaltbare makroökonomische Faktoren zurückzuführen sind; Übertragungen durch das Verhalten von Investoren auf Finanzmärkten; und Übertragungen, die durch enge Handelsverflechtungen verursacht werden. Es wird ein theoretisches Modell präsentiert, das den Zusammenhang von Währungskrisen und diesen drei Übertragungskanälen analysiert. Es wird dann eingesetzt, um die Ausbreitung der Währungskrisen in Lateinamerika 1994/95 und Asien 1997/98 auf andere aufstrebende Volkswirtschaften zu untersuchen. Die Ergebnisse der Analyse verdeutlichen, daß die beiden Währungskrisen hauptsächlich durch enge Finanzmarkt- und Handelsintegration übertragen wurden. Zudem waren es vor allem schwache Finanzsektoren und die Abhängigkeit von kurzfristigen Kapitalströmen und deren Umkehr, die die Länder für Krisen anfällig machten, während externe Ungleichgewichte und fehlerhafte Wechselkursanpassungen von geringerer Bedeutung waren.

This is a preview of subscription content, access via your institution.

References

  1. Agenor, P.-R., J. S. Bhandari, and R. P. Flood (1992). Speculative Attacks and Models of Balance of Payments Crises. International Monetary FundStaff Papers 39 (2): 357–394.

    Article  Google Scholar 

  2. Bhagwati, J. N. (1998). The Capital Myth: The Difference Between Trade in Widgets and Dollars.Foreign Affairs 77(3):7–12.

    Google Scholar 

  3. Bordo, M. D., B. Mizrach, and A. J. Schwartz (1995). Real Versus Pseudo-International Systemic Risk: Some Lessons from History. NBER Working Paper 5371. Cambridge, Mass.

  4. Calvo, G. A. (1995). Varieties of Capital Market Crises. University of Maryland, Working Paper 15. Center for International Economics, College Park.

    Google Scholar 

  5. Calvo, S., and C. Reinhart (1996). Capital Flows to Latin America: Is There Evidence of Contagion Effects? The World Bank Policy Research Working Paper 1619. Washington, D.C.

  6. Diehl, M., and R. Schweickert (1998). Currency Crises: Is Asia Different? Kiel Discussion Paper 309. Kiel Institute of World Economics.

  7. Dornbusch, R. (1998). Asian Crisis Themes. MIT, mimeo.

  8. Dornbusch, R., I. Goldfajn, and R. O. Valdes (1995). Currency Crises and Collapses.Brookings Papers on Economic Activity (2):219–295.

    Article  Google Scholar 

  9. Edin, P.-A. and A. Vredin (1993). Devaluation Risk in Target Zones: Evidence from the Nordic Countries.Economic Journal 103(January): 161–175.

    Article  Google Scholar 

  10. Edwards, S. and J. Santaella (1993). Devaluation Controversies in the Developing Countries: Lessons from the Bretton Woods Era. In M. D. Bordo and B. Eichengreen (eds.),A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform. Chicago: University of Chicago Press.

    Google Scholar 

  11. Eichengreen, B., and A. Rose (1998). Staying Afloat When the Wind Shifts: External Factors and Emerging-Market Banking Crises. NBER Working Paper 6370. Cambridge, Mass.

  12. Eichengreen, B., A. Rose, and C. Wyplosz (1995). Exchange Market Mayhem: The Antecedents and Aftermath of Speculative Attacks.Economic Policy 21 (October): 249–312.

    Article  Google Scholar 

  13. Eichengreen, B., A. Rose, and C. Wyplosz (1996). Contagious Currency Crises. EUI Working Paper EUF 96/2. San Domenico.

  14. Flood, R. P., and N. P. Marion (1996). Speculative Attacks: Fundamentals and Self-Fulfilling Prophecies. NBER Working Paper 5789. Cambridge, Mass.

  15. Folkerts-Landau, D., and T. Ito (1995).International Capital Markets: Developments, Prospects, and Policy Issues. Washington, D.C.: International Monetary Fund.

    Google Scholar 

  16. Frankel, J. A., and A. K. Rose (1996). Currency Crashes in Emerging Markets: An Empirical Treatment.Journal of International Economics 41 (3/4):351–366.

    Article  Google Scholar 

  17. Frankel, J., and S. Schmukler (1996). Crisis, Contagion, and Country Funds: Effects on East Asia and Latin America. Center for Pacific Basin Monetary and Economic Studies Working Paper Series PB96-04. San Francisco.

  18. Garber, P. M., and L. E. O. Svensson (1994). The Operation and Collapse of Fixed Exchange Rate Regimes. NBER Working Paper 4971. Cambridge, Mass.

  19. Gerlach, S., and F. Smets (1994). Contagious Speculative Attacks. CEPR Discussion Paper 1055. London.

  20. Goldfajn, I., and R. O. Valdes (1997). Capital Flows and the Twin Crises: The Role of Liquidity. International Monetary Fund Working Paper 87. Washington, D.C.

  21. Kaminsky, G., and C. M. Reinhart (1996). The Twin Crisis: The Causes of Banking and Balance-of-Payments Problems. International Finance Discussion Paper 544. Board of Governors of the Federal Reserve System, Washington, D.C.

    Google Scholar 

  22. Kaminsky, G., S. Lizondo, and C. M. Reinhart (1997). Leading Indicators of Currency Crises. International Monetary Fund Working Paper 79. Washington, D.C.

  23. Krugman, P. (1979). A Model of Balance of Payments Crises.Journal of Money, Credit, and Banking (11): 311–325.

    Article  Google Scholar 

  24. Krugman, P. (1998). What Happened to Asia? MIT, mimeo.

  25. Obstfeld, M. (1994). The Logic of Currency Crises. NBER Working Paper 4640. Cambridge, Mass.

  26. — (1996) Models of Currency Crises With Self-Fulfilling Features.European Economic Review 40 (3/4): 1037–1047.

    Article  Google Scholar 

  27. Rojas-Suarez, L., and S. R. Weisbrod (1995). Financial Fragilities in Latin America: The 1980s and 1990s. Occasional Paper 132. International Monetary Fund, Washington, D.C.

    Google Scholar 

  28. Sachs, J. (1997). The Wrong Medicine for Asia.The New York Times, Monday, November 3, 1997.

  29. Sachs, J., A. Tornell, and A. Velasco (1996). Financial Crises in Emerging Markets: The Lessons from 1995.Brookings Papers on Economic Activity (1): 147–215.

    Article  Google Scholar 

Download references

Authors

Additional information

Remark: I am grateful to Markus Diehl, an anonymous referee and the participants of the 1998 Annual Congress of the European Economic Association and an ASP seminar at the Kiel Institute of World Economics for helpful comments and suggestions. While working on this paper in 1997 and 1998, I was at the Kiel Institute of World Economics, Germany. I would also like to thank the office of the Harvard Institute of International Development (HIID) in Jakarta, Indonesia, for accommodating me while researching on this paper in November 1997 and April 1998.

About this article

Cite this article

Fratzscher, M. Why are currency crises contagious? A comparison of the Latin American Crisis of 1994–1995 and the Asian Crisis of 1997–1998. Weltwirtschaftliches Archiv 134, 664–691 (1998). https://doi.org/10.1007/BF02773292

Download citation

Keywords

  • Current Account
  • Real Exchange Rate
  • Exchange Rate Regime
  • Financial Integration
  • Currency Crisis