CEPR Discussion Paper No.3759 - 'Common Vulnerabilities'
Authors: Ashoka Mody (International Monetary Fund) and Mark P Taylor (Warwick University and CEPR)
February 2003
The financial crises of the 1990s differed from those of the 1970s in a fundamental way: they tended to strike several countries simultaneously. The term ‘contagion’ was quickly coined but has since proved difficult to define. The domino effect that took place during the 1992-3 ERM crisis, the ‘Tequila’ Mexican crisis of 1994, the ‘Asian flu’ of 1997-98 and the turmoil that took place in global financial markets following the 1998 Russia crisis all illustrate the coincidence of crises that took place in the last decade of the 20th Century.
In CEPR Discussion Paper 3759, Mody and Taylor begin their analysis with the observation that crises have tended to be regional. They pursue the idea that a region presents a common ‘prospectus’ to investors and lenders. Specifically, they explore whether investors respond to regional developments, rather than to country-specific fundamentals. Such behaviour may be appropriate where regions are identified by common development strategies and economic policies, and investors’ need to economize on information gathering. This Paper examines the determinants of regional vulnerability to crises. The authors estimate a common regional component of the exchange market pressure index (EMPI) as a measure of regional vulnerability. The typical question asked in the ‘contagious crisis’ literature has been: ‘given that a crisis has occurred in one country, which is the next most likely victim?’ In contrast, the question the authors of this Paper ask is: ‘what factors raise the likelihood of a regional crisis?’ They do not attempt to identify mechanisms that transmit crises from on country to another but instead aim to identify a set of underlying variables that contribute to vulnerability of a region to exchange rate crisis. Thus, the ultimate aim has been to contribute to an understanding of how crises may be prevented, rather than an understanding of how they spread.
Focusing on East Asia, this research shows that a high level of regional external liabilities and exuberance in domestic stock and credit markets generates regional vulnerabilities, which are heightened when the US High Yield Index is also on the rise. Country-specific movements of the EMPI are also explained by the same regional indicators rather than by the country-specific components of these indicators. This research suggests that regions are characterized by a pre-existing degree of common vulnerability, so that the region may be susceptible to the spread of a disease. Issues such as who contracted the disease first or who transmitted the disease to whom, are less important than the fact that common health problems create common risks. The implications for policy-makers in any particular country are that they need to be concerned not only about their own level of vulnerability, but should also monitor and safeguard against financial imbalances in the rest of the region. For international institutions, multilateral surveillance takes on greater importance.
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