The world has experienced three waves of speculative attacks on fixed exchange rates in the 1990s: in Europe, Latin America and Asia. New CEPR research explains the regional nature of these currency crises.

Macroeconomic fundamentals are not enough to explain the currency crises of the 1990s, according to Reuven Glick and Andrew Rose. In a recent CEPR Discussion Paper, they show that currency crises tend to be regional because trade is regional, driven largely by geographical proximity. Currency crises, they find, tend to be ‘contagious’ as a result of international trade patterns, spreading first between countries with tight trade linkages.

Glick and Rose note that the world has experienced three recent waves of speculative attacks on fixed exchange rates. The attacks on the European Monetary System (EMS) 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 the EMS bands to plus and minus 15%. The meltdown of the Mexican peso in late 1994 was followed by the ‘tequila hangover’ crises in Argentina and Brazil. And the collapse of the Thai baht in July 1997 was quickly followed by speculative attacks on the currencies of Malaysia, the Philippines, Indonesia, Hong Kong and Korea.

But while currency crises clearly tend to be regional, standard economic models fail to predict this stylized fact. 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 generations 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 macroeconomic 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. And 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. In other words, countries lose competitiveness when their trading partners devalue, and 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 that last for long. What is more, devaluations are costly and can potentially be resisted. Hence, making the case for the trade channel is primarily an empirical exercise.

Glick and Rose demonstrate that currency crises affect clusters of countries tied together by international trade. This linkage is intuitive, economically significant, statistically robust and the key to

understanding the regional nature of speculative attacks. Using data from five recent waves of speculative attacks (in 1971, 1973, 1992, 1994-5 and 1997), they estimate equations that predict the probability of a crisis and the strength of pressure on the exchange rate as functions of both trade and macroeconomic variables. They find that the trade variables have a consistently stronger effect than the macroeconomic fundamentals, confirming that countries which trade and compete with the targets of speculative attacks are themselves likely to be attacked, whatever their economic fundamentals.

For example, 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 to Sweden’s competitor, Denmark. A similar pattern characterized the sequence of events after the Thai baht was floated in July 1997. Suddenly, Thailand’s main trade competitors - Malaysia and Indonesia - were at a competitive disadvantage, and so were themselves likely to be attacked.

In trying to model ‘contagion’ in currency crises, Glick and Rose do not rule out the possibility of (regional) shocks common to a number of countries, nor do they attempt to study the timing of currency crises. Instead, their research is 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 currency crises spread along the lines of trade linkages after accounting for macroeconomic and financial factors. Indeed, they find that macroeconomic factors do not consistently help much in explaining the cross-country incidence of speculative attacks.

The fact that currency crises spread because of trade linkages - that countries may be attacked because of the actions (or inaction) of their neighbours, which tend to be trading partners merely because of geographic proximity - has important implications for policy. For a start, 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.