Date of Award
Doctor of Philosophy
Currency crises, prior to the 1990s, were thought to be the result of inconsistencies between domestic macroeconomic policies and the exchange rate commitment. But the collapse of the European Exchange Rate Mechanism in 1992, the 1997 Asian crisis and the most recent crisis in Latin America have shifted the focus to models based on self-fulfilling expectations and on contagion. This has resulted in the development of different theoretical models suggesting different mechanisms by which contagion works. But there is still relatively little empirical consensus on how crises spread across countries. My dissertation is intended to fill in the void by testing for contagion and identifying the transmission channels for crises.
With this objective, I have estimated a panel probit model using quarterly data (1960-1998) from 37 advanced and emerging market economies. Two main points make my work different from other studies on contagion. First, crises are identified using a relatively more objective method based on extreme value theory. The main argument for this approach is that exchange rate changes during crisis periods (like the 1997 Asian crisis) are outliers, making the distribution of exchange rate changes "fat-tailed". Extreme value theory allows us to determine the tail mass or observations measured via the tail index, and hence we take all the extreme outliers as indicators of crisis. Since we do not know the specific parametric distribution to which the crisis index belongs, the threshold to determine the tail observations is determined using Monte Carlo simulation. Second, I have allowed for crises to spread on a broader basis among (a) major trade partners/competitors, (b) countries with strong financial linkages, (c) countries with similar macroeconomic fundamentals, and (d) neighbors.
Results from my estimations reveal that countries face currency crises because of unsustainable macroeconomic fundamentals and contagion. In all cases considered, contagion works via the trade linkages channel. The results also show that the probability of a crisis in a given country increases as the number of its neighboring countries in crisis increases implying the presence of the neighborhood effects in the contagious spread of crisis. Because countries with sound macroeconomic fundamentals are still vulnerable to currency crisis, to prevent contagion countries, mainly major trade partners, need to consider alternative policies such as fixing their exchange rates collectively in a more firm and credible way. At the extreme, major trade partners may adopt a regional currency, the scheme followed by some of the European countries in creating the euro , to prevent contagion among members.
Haile, Fasika Damte, "Contagious Currency Crises" (2003). Dissertations. 1230.