• Currency crises tend to be regional: this fact seems obvious, but standard models do not predict that currency crises will be regional. Most economists think about currency crises using speculative attack models, which emphasise macroeconomic and financial fundamentals as determinants of currency crises. But macroeconomic phenomena do not tend to be regional. Thus it is hard to understand why currency crises tend to be regional, at least without an extra ingredient explaining why the relevant macro fundamentals are intra-regionally correlated.

 

• Currency crises tend to be ‘contagious’ because countries are linked by trade, and trade tends to be regional. Therefore 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.

 

• Rose presented persuasive empirical evidence (reported in CEPR Discussion Paper No. 1947) which confirmed that trade linkages are the primary channel through which currency crises spread. Using data from five recent waves of speculative attacks (in 1971, 1973, 1992, 1994–5, and 1997), Rose estimated equations which predicted the probability of a crisis and the strength of pressure on the exchange rate, as functions of trade variables and macroeconomic variables. The trade variables had a consistently stronger effect than the macroeconomic fundamentals. This evidence confirms that countries who trade and compete with the targets of speculative attacks are themselves likely to be attacked, whatever their economic fundamentals.

The world has experienced three recent waves of speculative attacks on fixed exchange rates. The attacks on the European Monetary System in 1992–3, forced a number of devaluations, flotations of the Finnish markka, the British pound, the Italian lira, and the Swedish krona, and, eventually, the widening of EMS bands to +/- 15%. The meltdown of the Mexican peso in late 1994 was followed by ‘Tequila hangover’ crises in Argentina and Brazil. The collapse of the Thai Baht in July 1997 was quickly followed by speculative attacks on Malaysia, the Philippines, Indonesia, Hong Kong and Korea.

Standard economic models do not predict that currency crises will be regional, at least not without auxiliary features. Most economists think about currency crises using one of two standard models of speculative attacks. ‘First generation’ models direct attention to inconsistencies between an exchange rate commitment and domestic economic fundamentals such as an underlying excess creation of domestic credit, typically prompted by a fiscal imbalance. ‘Second generation’ models view currency crises as shifts between different monetary policy equilibria in response to self-fulfilling speculative attacks. What is common to both classes of models is their emphasis on macroeconomic and financial fundamentals as determinants of currency crises. But macroeconomic phenomena 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 why the relevant macro fundamentals are intra-regionally correlated.

Unlike macroeconomic phenomena, trade patterns are regional. Countries tend to export and import with countries in geographic proximity. Prima facie then, trade linkages seem like an obvious place to look for a regional explanation of currency crises.

It is easy to imagine why the trade channel might potentially be 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 primarily an empirical exercise.

Rose presented empirical evidence that systematically assesses the role of trade linkages as a channel for contagion. Using data for a number of different currency crisis episodes, Rose demonstrated that currency crises affect clusters of countries tied together by international trade. This linkage is important in understanding the regional nature of speculative attacks. Perhaps more importantly, this linkage allows one to understand the order of speculative attacks. Once Finland had floated the markka in 1992, Sweden, as Finland’s most important trading partner, was next in line. And after Sweden was attacked, the crisis logically spread South in turn to Sweden’s competitors, Denmark . A similar pattern characterized the sequence of events after the Thai baht was floated in July 1997. The regression results are consistent with the hypothesis that currency crises spread because of trade linkages. That is, countries may be attacked because of the actions (or inaction) of their neighbours, who tend to be trading partners merely because of geographic proximity. This externality has important implications for policy. If this effect exists, it is a strong argument for international monitoring. A lower threshold for international and/or regional assistance is also warranted than would be the case if speculative attacks were solely the result of domestic factors.

In trying to model ‘contagion’ in currency crises, Rose did not rule out the possibility of (regional) shocks common to a number of countries, nor did he attempt to study the timing of currency crises. Instead, his research was designed to show that, given the occurrence of a currency crisis, the incidence of speculative attacks across countries is linked to the importance of international trade linkages. That is, currency crises spread along the lines of trade linkages, after accounting for the effects of macroeconomic and financial factors. Indeed macroeconomic factors do not consistently help much in explaining the cross-country incidence of speculative attacks.

CEPR is a network of over 450 Research Fellows based throughout Europe, who collaborate through the Centre in research and its dissemination. CEPR helps its Research Fellows to develop projects, obtain their funding, administer them and disseminate their results. The Centre’s research ranges from open economy macroeconomics to trade policy, from the economic transformation of Central and Eastern Europe to regionalism in the world economy. For further information about CEPR, please contact Rita Gilbert, External Relations Officer, Tel: 44 20 7878 2917 or email rgilbert@cepr.org.

Andrew Rose is Professor of Economic Analysis and Policy in the Haas School of Business at the University of California, Berkeley, and a Research Fellow in CEPR’s International Macroeconomics programme. His talk drew on research reported in CEPR Discussion Paper No. 1947, written jointly with Reuven Glick, Vice President and Director of the Center for Pacific Basin Studies, Economic Research Department, Federal Reserve Bank of San Francisco, acting director of the NBER International Finance and Macroeconomics programme.

The views expressed in this meeting are those of the speaker, speaking in his personal capacity. CEPR takes no responsibility for these views, and CEPR takes no institutional policy positions.

‘Contagion and Trade: Why are Currency Crises Regional’
Reuven Glick and Andrew K Rose

CEPR Discussion Paper No. 1947

Available for £5/$8/€8 plus a postage and packaging cost of 50p/$1/€1 (UK or Europe) or £1/$2/€2 (Rest of World) from

90-98 Goswell Road, London EC1V 7RR, UK
Tel: (+ 44 20) 7878 2900 Fax: (+ 44 20) 7878 2999 Email: orders@cepr.org

Understanding Exchange Rate Volatility Without the Contrivance of Macroeconomics’, Robert P Flood and Andrew K Rose. CEPR Discussion Paper No. 1944

‘Staying Afloat When the Wind Shifts: External Factors and Emerging-Market Banking Crises’, Barry Eichengreen and Andrew K Rose. CEPR Discussion Paper No. 1828

‘Contagious Currency Crisis’, Barry Eichengreen, Andrew K Rose and Charles Wyyplosz. CEPR Discussion Paper No 1453

‘Speculative Attacks on Pegged Exchange Rates: An Empirical Exploration with Special Reference to the European Monetary System’, Barry Eichengreen, Andrew K Rose and Charles Wyyplosz. CEPR Discussion Paper No. 1060

Available for £5/$8/€8 plus a postage and packaging cost of 50p/$1/€1 (UK or Europe) or £1/$2/€2 (Rest of World) from

90-98 Goswell Road, London EC1V 7RR, UK Tel: (+ 44 20) 7878 2900 Fax: (+ 44 20) 7878 2999 Email: orders@cepr.org

Financial Crisis and Asia, Robert Chote with Barry Eichengreen, Morris Goldstein, Manmohan Kumar, William Perraudin, Richard Portes, Joseph Stiglitz and Charles Wyplosz. ISBN 1 898 128 36 7 £10/$14.95/€15