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This paper examines the role of financial linkages, especially through a common creditor, in the propagation of emerging market crises during the 1990s. Using panel probit regressions on 41 emerging market countries, it finds that financial linkages played a significant role in the spread of the Mexican, Asian, and Russian crises. The significance of financial linkages emerges after controlling for the role of domestic and external fundamentals, trade spillovers, and financial weaknesses in the affected countries. A strong financial linkage to the crisis country of origin not only substantially raises the probability of contagion, but also helps to explain the observed regional concentration of currency crises.

A prominent feature of the financial crises that have engulfed emerging market economies in recent years—the Mexican crisis of 1994–95, the Asian crisis of 1997, and the Russian crisis of 1998—was the spread of financial difficulties from one economy to others in the same region and beyond in a process that has come to be referred to as “contagion”. Policymakers and researchers have increasingly wondered about the nature of these crises, the factors responsible for their spread, and, particularly, whether a country with seemingly appropriate domestic and external fundamentals can experience a crisis because of contagion. This paper extends earlier work on indicators of currency crises by looking at factors that render a country vulnerable to contagion and enhance the risk that a crisis in one country will spill over to others. It focuses on the role of financial linkages, through common bank lenders, as an important channel of transmission of exchange market pressures from one country to another during the major crisis episodes of the 1990s. When countries have a common creditor, a financial crisis in one country (country 1) can lead to financial market pressures in some other country (country 2) if, owing to the need to adjust its loan portfolio, the creditor curtails her lending or recalls some of her loans to country 2. The contagion effects stemming from the portfolio adjustment by the common creditor will be stronger the larger the share is of the common creditor’s portfolio that is lent to country 2 and the larger the share is of country 2’s external liabilities to the common creditor. The results of panel probit regressions for 41 emerging market economies indicate that once domestic and external fundamentals as well as trade spillovers have been controlled for, financial linkages and weaknesses play a significant role in explaining the spread of crises.1 Notably, a strong financial linkage to the first crisis country through a common creditor is the most important, significant, and robust variable: it not only substantially raises the probability of a crisis but also provides an economic rationale for the apparent regional concentration of these crises. Section 2 briefly reviews the explanations of contemporaneous currency crises found in the literature, focusing on spillovers and contagion. Section 3 provides the empirical analysis, and Section 4 concludes.

This paper extends earlier work on indicators of vulnerability to currency crises by documenting the importance of financial linkages, especially through a common creditor (as suggested by Kaminsky and Reinhart, 2000), in the propagation of currency crises among emerging markets in the 1990s. In a panel probit estimation on 41 emerging market countries, financial linkages and weaknesses play a significant role in explaining the spread of emerging market crises, even when controlling for domestic and external fundamentals and trade spillovers. The common creditor variable is the most important, robust, and significant variable. This variable alone has half of the explanatory power of the benchmark regression and, jointly with slow output growth, provides the largest contribution to the probability of a crisis. Moreover, it appears to explain why there is a regional pattern specific to each crisis episode and thus indicates that this pattern can be explained by economic factors and not by referring, for example, to irrational herd behavior of agents who assess financial stability on the basis of geographical proximity. The role of the common creditor variable is not significantly different across regions and crisis episodes. The benchmark model appears to be very robust to the inclusion of many potential macroeconomic determinants of crises. Interestingly, the pattern of crises in emerging market economies does not appear to be different across crisis episodes (Mexican, Asian, and Russian) and across geographic regions, once the relevant explanatory variables common to the crises are taken into account. Among the fundamentals, weak output growth appears to play a larger role than external imbalances in increasing the probability of a crisis, while the indicators of financial fragility (reserves adequacy and maturity of bank liabilities) are highly significant.