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Using quarterly data (1960–1998) for a set of 37 advanced and emerging market economies we find that countries face currency crises because of unsustainable macroeconomics fundamentals and contagion. In most cases considered, contagion works via the trade channel. In addition, the estimation results reveal 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 neighborhood effects in the contagious spread of crisis. Our results also lend limited support to the notion that there is some contagion through capital markets

The main objective of this paper is to test whether currency crises are contagious and to identify the channels through which crises are transmitted across countries. Many economists have now realized that a role was played by contagion in propagating the currency crises of emerging market economies in the 1990s. Different theoretical models have been recently developed suggesting different mechanisms by which crises have been transmitted across countries. But there is relatively little empirical consensus on how crises spillover across countries while the frequency and intensity of crises points to the urgency of additional empirical works to come up with solutions for crisis prevention, crisis management and crisis resolution1. Currency crises prior to 1990s did not appear to spread across countries with the virulence and speed observed recently. The earlier literature tried to explain the crises as the result of inconsistencies between fiscal and monetary policies and the existing exchange rate commitment (so called first generation models of currency crisis such as Krugman, 1979). The collapse of the European Exchange Rate Mechanism (ERM) in 1992/93, the Mexican Peso crisis in 1994 and the Asian crisis in 1997 have, however, shifted the focus to models based on self-fulfilling expectations (Obstfeld, 1995) and on contagion (see Dornbusch et al., 2000, Pericoli and Sbracia, 2003 and Wolf, 1999 for a comprehensive survey of models of contagion). The Asian financial crisis, for example, began in July 1997 with the Thai baht devaluation. It then spread to Malaysia, the Philippines, and Indonesia in the third quarter of 1997. Prior to the 1997 crisis, all these countries had a few common characteristics: an appreciating real exchange rate, large current account deficits and financial sector squeezes linked to overexposure to a property market whose prices had fallen sharply (see Krugman, 1998, Masson, 2004 and Masson, 1999). But the currency pressures also quickly spread to Hong Kong, Singapore and Korea, economies with strong current account and fiscal positions. The crisis even jumped surprisingly to several emerging markets outside the region, notably to Brazil and Russia (see IMF, 1998 and IMF, 2001). This experience coupled with the earlier crises in 1992/1993 and 1994/1995 led economists to suspect that crises in the 1990s were contagious. In response to these events, several different theoretical models have been developed showing how crises end up spreading across countries. Some of the major models of contagion are based on trade linkage and macroeconomic similarities (Eichengreen et al., 1996, Gerlach and Smets, 1995 and Goldstein, 1998), while other models are based on financial linkage, neighborhood effects, and exogenous shifts in investors' beliefs (herd behavior) (Calvo, 2005, Calvo and Mendoza, 2000, Kaminsky and Reinhart, 2000, Masson, 2004 and Masson, 1999). Despite the explosion of models of contagion, there still lacks a general consensus on empirical findings on the relevant contagion channels. Existence of contagion has important implications. Because no open economy can insulate itself from what is happening in the rest of the world, to prevent contagious financial crises countries may need to adopt regionally or globally coordinated measures. But the specific measures that should be taken to prevent the spread of financial crisis presuppose knowledge of the relevant contagion channels. If the trade contagion channel is relevant, countries may need to diversify their trade and/or fix their exchange rates collectively in order to avoid speculative attacks following loss of international competitiveness. At the extreme, international cooperation of the countries may lead to the creation of a common currency. If, on the other hand, the financial contagion channel is relevant, countries may need to impose capital controls. Others suggest that a lender of last resort, such as the World Bank or the IMF, would need to be instituted to neutralize the financial contagion channel by providing liquidity support. As the foregoing discussion points out, the intensity and time clustering of the crises has now forced both policy makers and academics to focus on contagion as a principal culprit in the ensuing discussion. A number of questions have been raised in the literature. Why do currency and financial crises hit selected countries within a very close time period? Are those countries simultaneously under crisis hit by common shocks? Or do they have unsustainable fiscal and monetary policies or unsustainable current account positions to the extent that both countries face crises simultaneously? If each of these is not the case, why and how does a crisis in one country transmit to other selected countries that have sound macroeconomic fundamentals? This paper is motivated by some of the above questions. More specifically, the paper addresses two interrelated questions (i) does a currency crisis in one country spread to other selected countries? (ii) What are the channels through which crisis spreads across countries? To address these questions, the paper estimates a panel probit model as in Eichengreen et al. (1996). A probit model is estimated because it allows us to test for the existence of contagion while also empirically identifying the transmission channels. However, this paper is different from the Eichengreen et al. (1996) approach in at least two ways. First, the test for contagion is undertaken using crises identified by the extreme value theory. This represents a significant deviation from prior works in this area that employ ad hoc procedures to define crisis periods. The “standard” approach is to set a threshold constructed from the mean and standard deviations of an index measuring speculative pressures. Values of the index above this threshold are taken as indicators of crises. But there appears to be no consensus on the specification of the threshold applied (e.g., global mean plus 1.5 standard deviations as in Eichengreen et al., 1996 vs. country specific mean plus 3 standard deviations as in Kaminsky & Reinhart, 2000). We employ a more objective method by defining currency crisis periods using the extreme value theory. This paper differs from Eichengreen et al. (1996) in a second way, as well. We add countries from Asia and Latin America to the OECD sample of Eichengreen et al. (1996) to form an expanded data set representing many different regions of the world. This allows for testing contagion on a broader basis while also allowing for contagion to operate through a fourth channel — the neighborhood channel. Using the objectively identified crises, the paper, therefore, tests whether there is contagion among i) major trade partners/competitors, ii) countries with strong financial linkages such as among those having common creditors, iii) countries with similar macroeconomic fundamentals, and iv) neighbors. Overall, the estimation results from different model specifications indicate that currency crises are contagious. In almost all cases considered, contagion works through the trade channel. The macroeconomic channel turns out significant in none of the estimations. Moreover, the estimation results reveal that the probability of a crisis in a given country increases as the number of neighboring countries in crisis increases. While the evidence for contagion through common bank lenders is not strong, the estimation results point towards the need for more empirical tests for the workings of contagion through capital markets at least for emerging economies in line with the Calvo (2005) argument for contagion. The main conclusion of the paper is that currency crises are contagious. Contagion is regional and more specifically it operates through the trade channel. The main implication of this result is that countries could prevent contagion either by diversifying their trade base or fixing exchange rates collectively among major trade partners in order to avoid speculative attacks following loss of international competitiveness. At the extreme, countries may adopt a regional currency, which is the track followed by some of the European countries in creating the Euro, to prevent contagion among members. The remainder of the paper is divided into four sections. A review of the theoretical and empirical literature is provided in Section 2. Section 3 discusses the method of study and data sources. Section 4 provides analysis of the empirical findings. The last section is devoted to conclusions and a discussion of implications of the results.

This paper estimates a panel probit model for a set of 37 countries using quarterly data from 1960 to 1998 to test whether currency crises are contagious and to identify the channels through which crises spread across countries. The paper has made two major contributions. First, it identifies crises using a relatively more objective method based on the extreme value theory. As discussed earlier, the results of the test for the relevant contagion channel(s) are sensitive to the level of the commonly applied threshold used to identify crises. Second, it considers all four contagion-channels simultaneously instead of only trade and macroeconomic similarities (as tested by Eichengreen et al., 1996 and Glick and Rose, 1999) or only trade and finance (as tested by Kaminsky & Reinhart, 2000). In addition to the trade, finance and macro similarity channels, we also include the neighborhood effects channel. Our paper has also attempted to overcome some of the shortcomings of previous studies. The trade linkage weights are computed based on countries trade relations in both their respective bilateral and third party export markets instead of based only on bilateral imports and exports as applied in Eichengreen et al. (1996). In Glick and Rose (1999) and Van Rijckeghem and Weder (2001), crisis spreads only from “ground zero countries” (the countries where the crisis begins) to others. In practice, there is a possibility of cascading in that a crisis spreads to a second country causing a third country to receive pressure from both the first and second victims. Crises in this paper are allowed to spread from any country, allowing for the possibility of cascading effects. A number of different model specifications are estimated for a panel of 37 advanced and emerging countries. For comparability purpose, we also estimate the model for a subset of 20 OECD countries. According to the estimation results from different model specifications, the probability of a currency crisis in a given country is significantly increased by a crisis elsewhere. The results also reveal that increases in the domestic credit expansion, government budget deficits (absolute value), unemployment rate and inflation (in a few cases) do also significantly increase the probability of a currency crisis. These results are consistent with many of the major crises around the world. One example is the 1997 Asian financial crisis. Countries with unsustainable macroeconomic fundamentals such as Thailand, Malaysia, the Philippines, and Indonesia were the first victims in the Asian crisis. All these countries were believed to have experienced appreciating real exchange rates, large current account deficits and financial sector squeezes linked to overexposure to property markets whose prices had fallen sharply prior to July 1997 (see Masson, 1999 and Krugman, 1998). But the pressures also spread to Hong Kong, Singapore and Korea, countries with strong current account and fiscal positions. The crisis even jumped surprisingly to several emerging markets outside the region, notably to Brazil and Russia (see IMF, 1998 and IMF, 2001). Though countries can prevent the initiation of a currency crisis by pursuing polices that result in sound internal and external macroeconomic balances, currency crisis can still spread to such countries. The prevention, resolution and management of the contagious spread of the crises may require coordinated actions among different countries in the world. The appropriate specific measures to contain contagion, be they regional or global, depend on knowledge of the contagion channels. Among the four possible contagion channels considered, the test results in our paper reveal the importance of trade linkages as a relevant contagion channel. The macroeconomic similarity channel turns out significant in none of the estimations. But the estimation does point out that the probability of crisis increases as the number of neighboring countries in crisis increases suggesting that contagion begets contagion. The neighborhood variable may also be capturing the working of contagion via capital markets in line with Calvo's argument. However, the importance of financial linkages via common bank lenders and also other capital markets need further empirical tests. Overall, contagion is regional and more specifically it operates through the trade channel. What policies can be pursued to prevent contagion? One possibility is that countries could prevent contagion by diversifying their trade base. This would weaken the impact of one country in crisis on its trading partners. Another possibility is for countries to fix their exchange rates with major trade partners collectively in order to avoid speculative attacks following loss of international competitiveness. Such a policy, however, may lead to destabilizing speculation if the collective agreement is not firm and credible. At the extreme, countries may adopt a regional currency, which is the track followed by some of the European countries in creating the Euro, to prevent contagion among members through competitive devaluation