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130 Years of Fiscal Vulnerabilities and Currency Crashes in Advanced Economies


This paper investigates the empirical link between fiscal vulnerabilities and currency crashes in advanced economies over the last 130 years, building on a new data set of real effective exchange rates and fiscal balances for 21 countries since 1880. The paper finds evidence that crashes depend more on prospective fiscal deficits than on actual ones, and more on the composition of public debt (that is, rollover/sudden stop risk) than on its level. The paper also uncovers significant nonlinear effects at high levels of public debt as well as significantly negative risk premiums for major reserve currencies, which enjoy a lower probability of currency crash than other currencies ceteris paribus. Yet, the estimates indicate that such premiums remain small in size relative to the conditional probability of a currency crash if prospective fiscal deficits or rollover/sudden stop risk are high.

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  1. 1.

    The wealth of empirical literature on—or inspired by—currency crashes in emerging market economies is indeed simply enormous (see, for example, among many others, Obstfeld, 1986; Frankel and Rose, 1996; Corsetti, Pesenti, and Roubini, 1999; Kaminsky and Reinhart, 1999; Calvo and Reinhart, 2002), not to mention that on early-warning models designed to predict currency crisis in these economies (for example, Kaminsky, Lizondo, and Reinhart, 1998; Berg and Pattillo, 1999; Hemming, Kell, and Schimmelpfennig, 2003; Kumar, Moorthy, and Perraudin, 2003; Bussière and Fratzscher, 2006).

  2. 2.

    Other studies include Tudela (2004), who looks at various macroeconomic determinants—but not public finances—of the probability of entry into a currency crisis state in the OECD over the period 1970–97; and Wright and Gagnon (2006) who, in testing for the determinants of sharp depreciations of OECD countries’ exchange rates over 1970–2005, find that the current-account-to-GDP ratio plays an important role.

  3. 3.

    These studies find that raising public deficits may generate Keynesian or anti-Keynesian effects, depending on the government position. In this context, when public debt is high, cutting deficits may reduce the default probability of the public sector and enhance confidence, which may have implications for exchange rate (in)stability.

  4. 4.

    Some have arguably challenged the view that a high share of foreign debt is a source of financial vulnerability. For instance, Frankel and Schmukler (1996) found that domestic Mexican investors were the “front runners” in the peso crisis of December 1994, turning pessimistic before foreign investors. Different expectations about the economy, perhaps due to asymmetric information, prompted Mexican investors to be the first ones to pull out from the country.

  5. 5.

    Indeed, if F increases, for a constant B, ℓ decreases and S t /S increases.

  6. 6.

    We define the level of foreign yields as follows: for all countries (excluding the United Kingdom and the United States), the foreign yield is the U.K.'s yield before 1945 and the U.S.'s yield afterwards; for the United States, the foreign yield is the U.K.'s yield before 1945 and Germany's yield afterwards; for the United Kingdom, the foreign yield is the U.S.'s yield before and after 1945.

  7. 7.

    We include the United States as the foreign counterpart, rather than a weighted set of foreign countries, for data reasons but also as the United States assumed the role of the main international currency as early as the 1920s (see Eichengreen, 2010). For the United States itself, we use the United Kingdom before World War II and Germany thereafter as a counterpart.

  8. 8.

    For instance, Frankel and Rose (1996, p. 353) define currency crashes in emerging economies as a nominal bilateral depreciation vis-à-vis the U.S. dollar “of at least 25 percent.” Bussière and Fratzscher (2006, p. 959) define a currency crisis in emerging economies as the event when their exchange market pressure index is “two standard deviations or more above its country average.” Gagnon (2009a, p. 163) defines currency crashes in advanced economies as an exchange rate depreciation of “at least 8 percent in year t, followed by a cumulative depreciation in years t and t−1 of over 20 percent, with this two-year depreciation being at least 10 percentage points greater than the depreciation over year t−2.”

  9. 9.

    Effective rates allow us to identify currency collapses less ambiguously than simple bilateral rates. Since bilateral rates are by definition relative prices, movements in the latter are indeed not interpretable in an unambiguous way. For instance, an increase in the pound sterling-U.S. dollar exchange rate could reflect either an appreciation of the pound or a depreciation of the U.S. dollar or perhaps even both.

  10. 10.

    It is worth stressing that 10 percent is a very large magnitude indeed since we consider here real effective depreciations that occur over just one year. For instance, between August 2010—when Chairman Bernanke announced QE2—and May 2011, the U.S. dollar lost 7 percent in effective terms. This was sufficient to trigger a debate about “currency wars” and capital controls by emerging economies. A depreciation of such magnitude would yet be insufficient to qualify as a currency crash under our baseline definition. Those captured here are therefore really large—and potentially disruptive—ones.

  11. 11.

    Once controlling for other factors, they even find that the coefficient for the fiscal balance-to-GDP ratio becomes insignificant.

  12. 12.

    As a measure of fit of the baseline models, we report both their scaled resolution (as described in Galbraith and van Norden, 2011) and McKelvey and Zavoina's R2.

  13. 13.

    Mismanaged in the case of Bordo and Meissner (2005) implies that countries do not match their foreign currency liabilities with foreign currency reserves or take out such debt in proportion to their export earning potential.

  14. 14.

    It is useful to bear in mind that the probability is indeed predictive of a crash, since it is calculated using explanatory variables lagged by two years (that is, as of 1932, 1983, and 2001). One might also argue that the 1985 crash was a “controlled” one, since the aim of the G7's Plaza agreement was precisely to let the dollar depreciate. But the “controlled” nature of the crash is dubious: the dollar's fall was such that the G7 had to undertake concerted interventions (Louvre agreement of 1987) to put a floor to it.

  15. 15.

    The unconditional probability is the frequency of such crashes across all countries and all years in the sample.

  16. 16.

    Additional estimates (not reported here to save space but available upon request) might also tend to nuance the alleged special character of the U.S. dollar in the face of severely deteriorated public finances. When calculating indeed the conditional probability of a currency crash if fundamentals are set to (i) the sample's mean and (ii) U.S. mean values, we obtain essentially the same crash probabilities. This suggests that U.S. fundamentals are very similar to the average sample fundamentals and that, under similar conditions, the U.S. dollar would crash as frequently as the average currency.

  17. 17.

    In this context, see inter alia Feldstein (1982); Giavazzi and Pagano (1990); Blanchard (1990); Perotti (1999).

  18. 18.

    As a further robustness check, we repeat the exercise using the public debt data of Ali Abbas and others (2010). The results (not reported here to save space, but available upon request) confirm that the effects are stronger at very high levels of public debt both for the direct fiscal and foreign debt channels. There are also significant nonlinearities for the banking crisis channel, although the effects are found to be stronger at intermediate levels of public debt (60–90 percent of GDP) rather than high levels. We also find some evidence of nonlinearities in the level of fiscal deficits (not reported here to save space).


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Additional information

Supplementary Information accompanies the paper on IMF Economic Review website (

*Marcel Fratzscher is Head of Division in DG-International of the European Central Bank, where Arnaud Mehl and Isabel Vansteenkiste are also Principal Economists. The authors are grateful to the editor (Pierre-Olivier Gourinchas), the co-editor (Ayhan Kose), two anonymous referees, Olivier Blanchard, Bartosz Mackowiak, Simon van Norden, Carmen Reinhart, Albrecht Ritschl, Andreas Steiner, Frank Warnock for helpful comments and suggestions as well as seminar participants at the ECB; the IMF-EUI “Fiscal Policy, Stabilization and Sustainability” conference (Florence, June 6–7, 2011); the INFINITI Conference (Dublin, June 13–14, 2011); and the European Economic Association meetings (Oslo, August 25–29, 2011). The authors would also like to thank Moritz Schularick for kindly sharing with them his data set of long-run time series of credit growth in advanced economies. The views expressed in this paper are those of the authors and do not necessarily reflect those of the European Central Bank or the Eurosystem.

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Fratzscher, M., Mehl, A. & Vansteenkiste, I. 130 Years of Fiscal Vulnerabilities and Currency Crashes in Advanced Economies. IMF Econ Rev 59, 683–716 (2011).

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JEL Classifications

  • F30
  • F31
  • N20