Working Paper Series

Congressional Budget Office

Washington, DC

IMPLICATIONS OF PAST CURRENCY CRISES

FOR THE U.S. CURRENT ACCOUNT ADJUSTMENT

Juann H. Hung

Macroeconomic Analysis Division

Congressional Budget Office

Young Jin Kim*

Department of Economics

Pennsylvania State University

June 2006

2006-07

Working papers in this series are preliminary and are circulated to stimulate discussion and critical

comment. These papers are not subject to CBO’s formal review and editing processes. The analysis

and conclusions expressed in them are those of the authors and should not be interpreted as those of

the Congressional Budget Office. References in publications should be cleared with the authors.

Papers in this series can be obtained at www.cbo.gov (select Publications and then Working Papers).

* Young Jim Kim was a summer associate at the Congressional Budget Office in 2005. We thank Menzie

Chinn of University of Wisconsin, and colleagues at the Congressional Budget Office, especially Bruce

Arnold, Thomas DeLeire, Bob Dennis, Naomi Griffin, Doug Hamilton, Kim Kowalewski, and John

Peterson for valuable input. Adam Weber’s valuable research assistance is much appreciated.
i

Abstract

This paper examines past currency crises to shed light on the likelihood that the

adjustment of the U.S. current account deficit will involve a dollar crisis. A currency

crisis is narrowly defined to be a depreciation that exceeds a critical threshold, regardless

of whether it has an adverse effect on the real economy. The literature suggests that one

should not infer from the experience of emerging economies what will happen to the

dollar. This paper’s empirical findings lend support to that view. Everything else being

equal, currencies are more likely to collapse in emerging economies than in industrial

countries. The collapse of a currency in industrial countries actually helped to revive

economic growth in some instances, even though it tended to cause severe output loss in

emerging economies with a pegged currency.

The estimated probability of a dollar crisis, which contains a significant upward bias, has

risen significantly from 2003 (about five percent) to 2006 (about 10 percent), a period

during which both the current account deficit and the oil price rose substantially. That

rise in the estimated probability, though in part due to the oil price hike, signals that the

probability would keep increasing if the U.S. current account deficit continues to grow

faster than GDP. Nevertheless, a more thorough analysis taking into account of many

factors beyond the regressions suggests that the adjustment of the U.S. current account

deficit is likely to be gradual rather than involving a dollar crisis; and, in the unlikely

event of a dollar crisis, the U.S. economy should be able to withstand it without suffering

a severe recession.
1

1. Introduction

Currency upheavals have been a recurring phenomenon since the end of the

classical gold standard in 1914. The inter-war period witnessed numerous currency

crises. Hopes for an international monetary system free of currency crises were raised by

the creation of the Bretton Woods system in 1945, only to be dashed by that system’s

demise in early 1973. Currency crashes have occurred frequently since then, sometimes

with devastating real consequences. In the 10-year period between 1992 and 2002, the

world again witnessed several currency collapses in quick succession: the crisis of the

European Exchange Rate Mechanism (ERM) in 1992-93; the Mexican crisis in 1994-95;

the Asian crisis in 1997-98; the Russian crisis of 1998; the Brazilian peso crisis of 1999;

and Argentina’s crisis of 2002. Those developments have rekindled research interest in

improving the understanding and management of currency crises and have spawned a

large literature.

Against this backdrop, the large and growing global trade imbalances of recent

years have raised the possibility of another sharp and sudden realignment of exchange

rates. What insight can we draw from past currency crises to help assess the risk of a

dollar crisis posed by the large U.S. current account deficit (6.5 percent of GDP in 2005)?

Whether that large deficit may result in a hard-landing for the dollar has been a subject of

much debate. Some analysts worry that if policies are not adopted to bring down the U.S.

current account deficit, there is a high risk that a dollar crisis will ensue.1 At some point,

investors may not want to continue holding dollar assets. If that scenario were to occur

1 For example, see Bergsten (2004), Martin Wolf (2004), Roubini and Setser (2004, 2005) and

Obstfeld and Rogoff (2005).
2

suddenly, according to those analysts, the dollar could crash and cause serious

consequences for the U.S. and the global economy.

Some analysts, however, argue that the risk of a hard landing for the dollar is

small. They point out that precedents of high current account deficits leading to currency

crises are mostly those of developing countries with inflexible exchange rate systems,

hardly applicable to the United States, which is an advanced country with a freely

floating exchange rate. Some argue that the large U.S. current account deficit is an

endogenous result of some emerging economies’ attempt to avoid future currency crises

in an international monetary system in which the dollar is the major reserve currency, not

an imbalance that threatens an impending dollar crisis.2 Still others believe that the

United States, in fact, does not have a problem of large external imbalances, once the

value of “dark matter” is included in the measurement of U.S.-owned assets abroad.3

This paper looks to the experience of past crises in both emerging and industrial

economies to shed light on these issues. We begin by identifying crisis events from a

sample of 51 countries over the years from 1970 through 2004, pointing out stylized

patterns displayed by those crisis events. Next, we briefly summarize prominent theories

advanced in the literature to explain why and how currency crises occur and what factors

make some crises more severe (in output loss) than others. We then conduct empirical

2 See Dooley, Folkerts-Landau, and Garber (2003, 2004, and 2005) for the so-called Bretton

Woods II theory. 3 Inferring from the fact that the United States has been earning more income from its assets

abroad than paying foreign investors for assets they own in this country, Hausmann and Stuzenegger

(2005) argue that the United States owns valuable “dark matter”—assets that must exist because they

generate revenue but cannot be seen or measured, such as U.S. firms’ superior know-how, the liquidity

service provided the U.S. dollar, and the lower risk of U.S. assets than emerging-country assets—that are

not included in the official measurement of U.S. international assets. Counting their rough measure of

“dark matter” as a part of U.S.-owned assets, the authors estimated the U.S. net international investment

position to be about $600 billion, not -$2.5 trillion, at the end of 2004.
3

analyses to estimate the influence of economic fundamentals on the probability and the

severity of a currency crisis, drawing explanatory variables from those theories.

Thus, rather than attempting to test some individual theories, we aim to bring the

leading theories together to sort out the common fundamental factors that trigger a

currency crisis as well as pre-crisis conditions that tend to deepen the severity a currency

crisis. This approach is grounded in our view that, even though each crisis episode is

unique in some way and may be better explained by one theory than by others, the factors

focused on by each theory are not necessarily mutually exclusive. We also hope to find

out whether some fundamental economic factors, if any, deserve particular attention

because of their dominant role in causing the most severe crises.

Following Frankel and Rose (1996), we define a currency crisis as a currency’s

depreciation that exceeds a critical threshold, regardless of whether there is a collapse of

the currency regime, a large drop in foreign exchange reserves, or an adverse effect on

economic activity. This approach allows us to investigate the influence of exchange-rate

regimes and the development status of an economy, among other factors, on the

probability and economic effect of a currency crisis. With this definition, we identify 133

episodes of currency crisis in our sample. We then conduct probit regressions to estimate

the effect of some commonly-cited fundamental variables on the probability of a currency

crisis. Separately, we also conduct OLS and tobit regressions to estimate the effect of

fundamental variables on the severity (in terms of output loss) of a currency crisis. The

list of those fundamental variables includes the exchange rate regime, the current account

balance, the budget balance, the origin of legal rules, inflation, trade openness, whether a

country is industrialized, among others.
4

Our findings include the following. First, a rise in the current account deficit/GDP

ratio indeed increases the probability of a crisis, as well as the severity of output losses

resulting from a crisis. An increase in some other indicators of economic imbalances, such

as fiscal deficit or inflation, also leads to a higher probability of a crisis. Second,

exchange-rate regimes have a significant effect, statistically and quantitatively, on both the

probability and severity of a currency crisis. Countries with a currency-peg regime are less

prone to a currency crisis than those with an intermediate regime (such as a crawling-peg or

target-zone regime); however, once those countries are hit by a crisis they tend to suffer a

larger output loss than those adopting either an intermediate regime or a free-floating

regime. Third, countries with a higher degree of openness to international trade and capital

flows are less prone to currency crises. Finally, industrial countries are less likely to

experience currency crises and, in the event of a currency crisis, the impact of that crisis on

the real economy tends to be less severe or even positive.

Our empirical results and overall analyses thus give rise to three broad-stroke

implications. First, the large U.S. current account deficit cannot keep rising relative to

GDP without triggering some kind of adjustment process some time down the road.

Second, in the absence of policy blunders or other shocks, the U.S. current account

adjustment is likely to evolve gradually rather than to entail a dollar crisis.4 Third, in the

unlikely event of a dollar crisis, the U.S. economy should be able to withstand the crisis

without suffering a severe recession in the absence of policy errors.

The remainder of this paper consists of six sections. Section 2 describes how we

identify a crisis and measure the severity of its impact on output, and observes the

4 A recent paper by Edwards (2006) lends some support to this conclusion.
5

stylized patterns of the frequency and severity of currency crises since 1970. Section 3

synthesizes the most prominent theories in the literature regarding the causes and effects

of currency crises. Section 4 reports the methods and results of our quantitative analyses.

Section 5 discusses the implications of what we have learned from past currency crises

for the U.S. current account adjustment. Section 6 concludes.

2. Measuring a Crisis: Definition, Frequency, and Severity

We follow Frankel and Rose (1996) and define a currency crisis as a nominal

depreciation of a currency that meets two criteria: (1) it is at least a 25 percent

depreciation from a year ago, and (2) it represents an increase in the rate of depreciation

from the previous year by a margin of at least 10 percentage points.5 This definition

differs from those which regard a currency crisis as a balance-of-payments crisis, either

successfully or unsuccessfully defended.6 By this definition, a sufficiently large

depreciation of a currency in a flexible exchange rate regime is counted as a crisis,

allowing us to estimate the influence of exchange rate regimes on the probability and

consequence of a currency crisis. By not including a successfully defended balance-of5 The requirement of a margin of 10 percentage points is to ensure that a 25 percent or more

nominal currency depreciation in a country with high inflation rates (and correspondingly high rates of

depreciation) is not automatically considered as an independent currency crisis; it is only counted as one if

it also represents a sufficiently large increase in the rate of depreciation. 6 Generally, other methods in the literature identify a currency crisis when an index of exchange

market pressure exceeds a critical threshold. The index is typically calculated as a weighted average of the

exchange rate change, short-term interest rate change, and reserve change relative to the center country,

usually the United States. For example, this type of method was used in Eichengreen et al. (1996a, 1996b),

in Kaminsky, Lizondo, and Reinhart (1998), in Kaminsky and Reinhart (1999). In Bordo et al. (2001), the

definition of a currency crisis is even broader, including a forced change in exchange rate parity, an

abandonment of a pegged exchange rate, an international rescue, or when their index of exchange market

pressure exceeds a critical threshold.
6

payments crisis in our sample, this definition also enables us to gauge the economic

effects of allowing a currency to succumb to market forces.

We apply our definition of a currency crisis to 51 industrial and emerging

economies over the period of 1970-2004. (See Appendix 1 for a list of those countries.)

As in Frankel and Rose (1996), we use a three-year exclusion “window” to avoid

counting the same crisis more than once. Any event occurring within three years of the

first crisis is defined to be an extension of that crisis. Crises are counted by country and

by period: if there are n currencies whose depreciation exceeds the threshold in period t,

there would be n crises identified for period t. With this method, we identify a total of

133 crisis episodes in 48 countries over the entire sample period. Three countries---

Canada, Singapore, and the United States---never experienced a currency crisis within the

sample period. (See Appendix 1 for details of these crises and their pre-conditions.)

The economic effect of a crisis can be measured in several different ways,

including the changes in jobs, output, or consumption. Because of data limitations, we

choose to measure severity by output changes. We use two alternative measures:

(1) One-sided measure. This measure follows that used in Bordo et al. (2001),

defining severity as the cumulative sum of the differences between the actual and trend

growth rates of real GDP over the duration of the crisis. The trend rate is calculated as

the average growth rate over the five years preceding the crisis event. Thus, one flaw of

this measure is that it overstates (understates) severity if the average pre-crisis growth

rate is higher (lower) than the true trend rate. The duration of a crisis is defined as the

number of years from the onset of the crisis until the actual growth rate returns to the

trend rate. When the growth rate in a crisis year is above the trend rate, output loss is
7

defined to be zero. Thus, by construction, this severity measure is censored to be less

than or equal to zero, and the minimum duration is one year.

(2) Two-sided measure. In this measure, severity is defined as the cumulative

sum of the difference between the actual rate of growth in each year during the (3-year)

crisis period and the average growth rate in the (3-year) pre-crisis period. (To be

consistent with our using a three-year exclusion “window” to avoid multiple-counting the

same crisis, each period is defined to be three years.) This measure of severity is not

bounded below zero as in the one-sided measure. Instead, it can be positive (indicating

an increase in the growth rate following the crisis event) or negative (indicating a

reduction in the growth rate). When there was not enough data to calculate the three-year

averages, we exclude the observation. As in the one-sided measure, this measure

overstates (understates) severity if the average pre-crisis growth rate is higher (lower)

than the true trend rate.

Several other notable observations regarding the frequency and severity of

currency crisis emerge from an overview of the 133 currency crises that we have

identified over the 1970-2004 period:

• Crises occurred with high frequency throughout the post-1973 period (Figure 1).

• Crises were more concentrated in the 1980s than in the 1990s. There were 60

crises in the 1980s, compared to 25 in the 1970s and 39 in the 1990s (Figure 1 and

Table 1).

• The number of crises that were followed by growth recoveries has been rising.

(During 1990-2004, the number of crises resulting in economic revivals has risen

to rival those resulting in contraction. See Figures 2 and 3.)

• The number of crises in emerging economies during the 1970-2004 period was

almost double that in industrial economies. There were 86 crises in emerging

economies, as compared to 47 crises in industrial countries (Table 3).
8

• Crises in emerging economies were considerably more severe than those in

industrial countries.

• More crises occurred, over the sample period, in an intermediate currency regime

than in either a pure-peg or a free-floating regime. This pattern fits into the bipolar view, which argues that either a hard peg (such as a currency board system)

or a free-floating exchange rate regime is more sustainable than an intermediate

regime, which is more prone to speculative attacks, for countries open to private

capital flows.7

o By the de jure classification of regimes, which is based on the regimes

declared by countries, the number of crises in an intermediate regime

totaled 58 during 1970-1999, compared to 36 in a pegged regime and 27 in

a floating regime (Table 1).

o By the de facto classification, which is based on the Natural Classification

proposed in Rogoff et al. (2003), 89 crises occurred in an intermediate

regime (either limited flexibility or managed float), compared to 16 in a

pegged regime and 17 in a free-float regime (Table 2).8

• Crises in a pegged regime were more severe and lasted longer than those in an

intermediate regime, and even more so when compared to those in a floating

regime (Tables 1 and 2).

• Twin (banking plus currency) crises were more severe than single (currency)

crises in emerging economies, but this was not the case in industrial countries

(Table 3).

• Crises in Asia were fewer in number, but had more severe aftereffects on the

economies, than those in Latin America and Europe (Table 4).

7 The bipolar view gained much currency following the quick succession of currency crisis in the

1990s. See Summers (2000) and Fischer (2001). 8 The IMF classifies de jure exchange rate regimes based on the regimes declared by countries.

However, it has been noted that many countries actually do not follow their declared exchange rate

arrangement. Many countries that say they float actually do not and many intermediate regimes, in fact,

have de facto pegs. Thus, Reinhart and Rogoff (2004) classify countries’ de facto regimes based on the

Natural Classification proposed in Rogoff et al. (2003). See Appendix 1 for detail.
9

3. Causes and Effects of Currency Crises: A Synthesis of Theories

Why have crises occurred so frequently in the post-1973 period? 9 Why are some

countries hit by crises more frequently than others? Why did some crises have more

severe effects on the real economy than others? Many hypotheses have been proposed in

the literature. While the factors stressed by each theory differ, they tend to complement

rather than compete with each other. Some factors may explain some crises better than

others; however, in many cases those factors actually reinforce each other in triggering,

spreading and/or deepening a crisis. In this section, we synthesize the most prominent

theories in the literature, grouping them into six categories.

Fundamental Imbalances. The first-generation models of speculative attacks,

pioneered by Krugman (1979) and developed by Flood and Garber (1984), stress the role

of fundamental imbalances in causing a balance-of-payments crisis. These models

typically attribute those imbalances to overly expansionary macroeconomic policies---

most notably those manifested in large fiscal deficits or high inflation rates---that are

incompatible with a country’s commitment to a currency peg. In a currency-peg regime,

the government needs to hold a comfortable level of foreign exchange (FX) reserves in

order to have the ability to prevent its currency from depreciating. If that country runs a

large budget deficit and finances it by borrowing from abroad or by monetization, its

currency will be under increasing pressure to depreciate. As long as the country

continues to maintain its currency at the pegged value by selling its foreign exchange

reserves, those reserves will continue to dwindle. Eventually, the country will run out of

9 Bordo et al. (2001), which defined a crisis differently from this paper and analyzed a database

spanning 120 years, also noted that crises have become more frequent since 1973 (doubling the number of

the Bretton Woods and classical gold standard periods and rivaling those of the crisis-ridden 1920s and

1930s), and that currency crises were actually more prevalent between 1973 and 1987 than subsequently.
10

foreign exchange reserves and be forced to devalue its currency. As soon as speculators

are confident that a devaluation of its currency is inevitable, they would begin to shift

money out of the country before those reserves run out. The government’s initial attempt

to defend its currency will only deplete its FX reserves even more quickly, moving the

time of the crisis forward.

Overall, such models have captured the basic elements of what typically triggers a

balance-of-payments crisis. The Latin-American debt crisis of the 1980s is an important

example of crises caused by large budget deficits, currency overvaluations and external

debt accumulation. However, these models have fallen short of explaining why crises with

similar degrees of fundamental imbalances can have vastly different degrees of severity.

Herding Behavior and Self-Fulfilling Expectations. Second-generation models,

first advanced by Obstfeld (1986, 1994), emphasize the effect of self-fulfilling

expectations of a currency crisis. These effects arise from herding behavior, namely

cases where investors act in response to what other investors do, not on the basis of

fundamental analysis. For whatever reason, if the devaluation of a country’s currency is

expected to be inevitable at some future date, then speculators would surely try to get out

of the currency ahead of time. In so doing, they would lead to an earlier devaluation of

that currency. When everyone tries to unload the currency before others do, the currency

will plunge. Such herding behavior means a currency crisis can occur so long as a

critical mass of investors has decided to sell a country’s currency, even if that country’s

economic fundamentals are basically sound.

Many recent studies have lent support to this theory, even though they disagree on

whether self-fulfilling behavior plays a dominant or supplemental role in triggering and
11

spreading currency crises.10 A prime example of crises better explained by the secondgeneration model than the first-generation model is the 1992-93 ERM crisis (see

Appendix 2).

Herding behavior also helps to explain the so-called “contagion effect”: a domino

effect among those countries that have anything less than immaculate fundamentals.

Calvo and Reinhart (1996) present evidence of contagion in capital flows to Latin

American countries, while Eichengreen et al. (1996a) find evidence that knowing there is

a crisis elsewhere increases the probability of a domestic currency crisis.

Radelet and Sachs (1998) argue that international financial markets are even more

prone to self-fulfilling crises than domestic markets because there is no international lender

of last resort. They argue that the lender of last resort helps prevent crises in two ways.

First, it prevents outright default by providing liquidity on an elastic basis.11 Second, and

perhaps more important, it can eliminate a self-fulfilling panic if investors believe that the

lender of last resort will provide the credit needed to forestall the collapse of a solvent

debtor. When the loans are denominated in a foreign currency, a country’s central bank is

unable to fulfill its role as lender of last resort because it cannot create foreign money. The

lack of an international lender of last resort means that, even though individual creditors

may act rationally, market forces can produce capital-flow reversals that are sharper and

10 For example, see Calvo and Mendoza (1996); Eichengreen, Rose, and Wyplosz (1996b); and

Kaminsky and Reinhart (1999).

11 In an illiquidity-insolvency model, a liquidity crisis occurs if a solvent but illiquid borrower is

unable to borrow fresh funds from capital markets to remain current on debt-servicing obligations.

Asymmetric information among creditors is a main cause of market instability: each individual creditor

may rationally respond more to the action of other creditors---now taken as signals---than to private

information. See Banerjee (1992); Mishkin (1991); Stiglitz and Weiss (1981).
12

more costly than necessary to restore equilibrium.12 This theory helps to explain why the

frequency of currency crises nearly doubled after the demise of the Bretton Woods system,

which provided a semblance of an international lender of last resort.

Extra Vulnerability of Poor Countries. A currency crash tends to cause

economic hardship in an emerging economy, even though it has often helped to revive

growth in an advanced country.13 Everything else being equal, an emerging economy is

more prone to costly currency crises than an advanced economy because of two “curses.”

The first is the original sin problem, namely a country’s inability to borrow abroad in its

own currency.14 An emerging country’s external debt is typically denominated in foreign

currency to avoid paying the exorbitant premium demanded by international investors to

compensate for its currency risk. This situation means it is much harder for that country

to pay off or service that debt through a real depreciation of its currency: even though a

real depreciation will help improve its trade balance, it will also raise the domesticcurrency values of that debt and interest payments on that debt. Recognizing that reality,

foreigners are even less willing to roll over the existing debt or to provide new loans to

that country than otherwise.

12 To support their view, the authors presented evidence that each of the three major currency

crises in the 1990s---Mexico in 1994-95, Argentina in 1995, and East Asia in 1997---displays elements of a

self-fulfilling crisis, in which capital withdrawals by creditors cascade into a financial panic and result in an

unnecessarily deep contraction. 13 Some currency crises are followed by a severe recession, but they need not be: a currency’s

depreciation by itself is expansionary because it stimulates net exports. Take some crises in the 1990s as

examples. Both the Mexican peso crisis of 1994-95 and the Asian currency crisis of 1997-1998 led to

severe contractions of real GDP in the crisis countries. But the ERM crisis of 1992, which resulted in the

withdrawal of the United Kingdom and Italy from the exchange rate mechanism, actually helped boost

output growth for those two countries. Indeed, of all 47 crisis events that occurred in industrial countries

over the sample period, 19 were followed by economic expansion, while 28 were followed by contraction.

See Table A1.a of Appendix 1. 14 The term “original sin” was coined by Eichengreen, Hausmann and Panizza (2003a).
13

The second curse is the debt intolerance problem--- the inability of emerging

countries to manage levels of external debt that are manageable for advanced countries.15

A level of debt that would not necessarily seem high by the standards of rich countries

can get some “debt-intolerant” developing countries into repeated troubles. When an

emerging country runs into difficulty, international institutions/investors tend to make

demands that actually make the problem worse. For example, when crisis countries’

budgets turned into deficit (from roughly in balance) in response to economic contraction

induced by the 1997-98 Asian crisis, the initial response of international community was

to ask those governments to cut their budget deficits, making economic recession even

more severe in the those countries. In contrast, investors tend to be more tolerant when

advanced countries need to run larger deficits to combat recession.

These two “curses” also feed on each other. Emerging economies are more prone to

the original sin problem because foreign investors tend to be reluctant to lend to a country in

its own currency if that country has underdeveloped institutions and/or its government has

low credibility. Moreover, Reinhart et al. (2003) find that a country’s credit ratings fall more

rapidly when an emerging-market economy increases its debt than in the case of an advanced

country, as though the former have less debt-management capacity. They attributed this

“debt intolerance” to original sin, among several other factors.16

Premature Capital-Account Liberalization Amidst Domestic Financial

Fragility. Third-generation theories emphasize the central role of premature capital15 The term“ debt intolerance” was coined by Reinhart, Rogoff and Savastano (2003) 16 The authors also show that countries that defaulted in the past and have histories of high inflation

have lower credit ratings in the present. They conjecture that default on external debt may weaken a country’s

financial system and that a weaker financial system increases the likelihood of subsequent default because

countries with weaker financial systems suffer larger output losses when access to external finance is

interrupted. Default on external debt may also weaken a country’s tax system by encouraging capital flight

and tax avoidance, in turn making it harder to raise the revenues needed to service public debts.
14

account liberalization and domestic financial fragility in the deepening of a currency

crisis. Even though those factors were common to a substantial number of crises before

the Asian crisis, those third-generation theories mainly arose to help make sense of the

Asian crises of 1997-98, an episode characterized by the severity of twin crises in many

Asian economies that did not appear to have large fundamental imbalances.17 The

interaction of capital-account liberalization, a fixed-exchange rate system, and an

underdeveloped financial structure (including the prevalence of crony capitalism)

allowed hot money to first inundate and overheat many Asian economies, and then to flee

and collapse those economies. (See Appendix 2 for a detailed discussion.) Authors

subscribing to this view include Radelet and Sachs (1998), Kaminsky and Reinhart

(1999), and Stiglitz (2000).

Nevertheless, empirical evidence appears mixed on whether capital controls protect

governments and investors against currency crises. This conflict may be because

governments in countries with capital controls tend to run riskier policies and markets view

their presence as unfavorable signals of official resolves, while a country more open to

capital mobility sends a positive signal that its government is confident of its ability to

withstand potential financial disciplines that are part and parcel of being open to foreign

investment. Moreover, countries with weaker financial indicators, such as a low external

debt/exports ratio, a low foreign exchange reserves/GDP ratio, and/or a high short-term

debt/foreign reserves ratio, are more likely to suffer rather than benefit from capital mobility

17 For example, Kaminsky and Reinhart (1999) write: “Consider an economy that had

successfully stabilized inflation, enjoyed an economic boom, and was running fiscal surpluses. However,

this economy had liberalized its capital account and its domestic financial sector amidst an environment of

weak regulation and poor banking supervision. Banking-sector problems emerged and intensified,

eventually undermining the ability of the central bank to maintain its exchange-rate commitment. While

this profile fits Asia rather well, this was Diaz-Alejandro’s description of the antecedents to the fierce

Chilean crisis of 1982. At the roots of the meltdown of the Thai baht, Korean Won, and Indonesian rupiah

lay systemic banking problems.”
15

because they are more exposed to the risk of sudden changes in investors sentiment. In

contrast, those with stronger financial indictors are more likely reap net benefits from capital

mobility by lowering the risk of speculative attacks or herding behavior.

Abrupt and Large Changes in External Conditions. Adverse and large changes

in external conditions can hurt emerging economies that are linked with the world

economy through international trade and capital movements. For example, a sharp rise in

oil prices could push the budget deficit and/or the current account deficit of many oilimporting countries beyond a level tolerated by international investors. Conversely, an

abrupt fall in oil (or other commodity) prices could enlarge those deficits of countries

heavily dependent on revenues from oil (or commodity) exports to levels that spook

investors. Moreover, to the extent that some emerging countries export similar products,

a currency crisis in one emerging country could spread to others because that first crisis

constitutes an abrupt shift in external conditions to those other countries.

A sharp rise in U.S. interest rates could undermine the ability of countries with

large external debts to service and/or repay outstanding loans. Financial crises were

heavily bunched in the early 1980s, when real interest rates in the United States were at

their highest level since the 1930s. This situation suggests that external factors (such as

U.S. interest rates) matter a great deal, as argued in Calvo et al. (1993). Jeffrey Frankel

and Rose (1996) also find that foreign interest rates play a significant role in predicting

currency crashes.

Generally speaking, a country that is more open to international trade would be

more vulnerable to external shocks such as a large shift in commodity prices or a crisis in

another country, while a country more open to capital mobility would be more vulnerable
16

to a large increase in the U.S. interest rate or other changes in world financial conditions,

as well herding behavior of international investors. However, an increase in trade

openness may also enhance creditors’ confidence in receiving real transfers for their

financial claims on the debtor country, thereby reducing the probability of sudden

reversals in capital flows and currency crashes in the debtor country.

Problems with a Currency-Peg Regime. Emerging economies tend to adopt a

currency-peg regime for several reasons, such as providing a stable exchange rate to

facilitate international trade and investment or using it as a guarantor of credibility on

controlling inflation.18 However, a currency-peg regime also breeds its own problems.

First and foremost, the inability of the country’s exchange rate to adjust in response to

external shocks may be very costly, especially for those that depend on export revenues

or capital inflows heavily. For example, when an adverse shock---such as a plunge in the

prices of commodities it exports, or an increase in U.S. interest rates---hits a country with

a pegged currency, that country’s foreign exchange reserves are likely to keep falling

until they dwindle to a level that is insufficient to fend off speculators. By not allowing

the currency to depreciate in response to negative shocks, the eventual devaluation tends

to occur in a more devastating fashion: a plunge of the currency that is much steeper than

needed to restore equilibrium after the initial shock.

Second, a currency-peg regime constrains the array of policy tools at a

government’s disposal; consequently, fundamental imbalances tend to grow until they

make it impossible for the country to keep that peg. Take Thailand and Argentina as

examples. Large capital inflows kept pouring into Thailand for years prior to the 1997-98

18 See Hausmann, et al. (1999) for a comprehensive discussion of the potential benefits that fixed

exchange rates could offer to developing economies.
17

crisis, resulted in rising inflation and current-account deficit; but that country’s currencypeg system constrained its central bank’s ability to put a lid on its economy’s unsustainable

growth. Argentina’s currency-board system also rendered its monetary authority powerless

in combating that country’s deep recession that began in 1999, a recession that did not end

until 2003, a year after Argentina abandoned the currency-board regime and allowed its

currency to float.19 Unless the government is able to successfully impose capital controls,

its commitment to a currency peg would deprive it of the option of conducting monetary

policy to fight inflation or combat recession. Moreover, crises also could be more costly in

a currency-peg regime because that regime encourages the accumulation of unhedged

exposures to currency risk (that was falsely assumed to be nonexistent) while frustrating

the (domestic) lender of last resort function of its central bank by assigning monetary

policy to goals other than the provision of liquidity.20

For the above reasons, the commitment to a currency peg appears to lower the

frequency of currency crises in a country, but increase the severity of a crisis once it

occurs. This result indeed is the broad-stroke picture we observed in the previous

section: the number of crises is higher in the intermediate regimes, as predicted by the bipolar view, but crises occurring in pegged regimes are the most severe and have the

longest duration. Both the severity and the duration of crises decrease as crisis countries

19 Argentina entered a deep recession in 1999 in large part because the Asian crisis and

(especially) the collapse of the Brazilian real adversely affected capital inflows to Argentina, while

rendering its exports less price-competitive internationally.

20 Friedman and Schwartz (1963) and Wigmore (1987) argue convincingly that during the Great

Depression, the Federal Reserve System refused its role as lender of last resort in part for fear of pushing

the United States off the Gold Standard. More recently, a consensus view is that Argentina’s vulnerability

to financial panic in 1995 in part came from its government’s limited capacity to act as a lender of last

resort because of the currency board arrangement, which fixed the Argentine peso at one-to-one with the

US dollar, and limited the government’s ability to issue credits that are not backed by dollar reserves.
18

move to a more flexible exchange rate regime; those results stay unchanged when data

are sorted by de facto exchange rate regime.

4. Quantitative Analysis

The preceding synthesis suggests that a currency crisis is more likely to occur in

an emerging economy with an intermediate exchange rate system that has weak economic

fundamentals (such as a high current account deficit, high budget deficit, high inflation,

etc.), and less likely to occur in an advanced economy with a flexible exchange rate that

has strong economic fundamentals. Moreover, it suggests that the impact of a currency

crisis is much more devastating for an emerging economy with a fixed exchange rate

system and weak economic institutions than for an advanced economy with a more

flexible exchange rate and stronger economic institutions; if anything, the crisis may even

revive GDP growth in an advanced economy rather than cause a recession.

This section conducts an empirical analysis to see whether the above view

receives discernable support from data. Our analysis consists of two parts. Part one uses

probit regressions to estimates the impact of a country’s economic fundamentals---

including its exchange rate system and whether it is an advanced economy---on the

probability of a currency crisis. Part two uses OLS and tobit regressions to estimate the

impact of an economy’s fundamentals on the severity of output loss following a crisis.

4a. The Probit Regression

We use a panel data of 49 countries over the period of 1970-2004 to estimate the

impact of fundamental economic variables on the probability of a currency crisis. We do
19

so by estimating a probit regression equation that postulates the probability of a crisis (P)

is a function of the variables listed in Box 1.

The dependent variable is the crisis indicator (P), which is a dummy variable. For

each country i, Pit = 0 if no crisis occurred in period t, and Pit =1 if a crisis occurred. We

also construct dummy variables for each different exchange rate system. For example,

the dummy variable representing the floating exchange rate system takes the value of 1

when a country is, and 0 when a country is not, under that system. The industrial country

indicator is also a dummy variable which takes the value of 1 for industrial countries, and

0 for emerging countries.

We estimate the probit regression equation using three alternative samples: (1) the

full sample (including both advanced and emerging economies); (2) the advancedeconomy sample; and (3) the emerging-economy sample. For each sample, we conduct

two sets of regressions. In the first set, the exchange-rate regime dummy is set to equal 1

when the de jure regime is not a currency-peg regime. The results of this set of

regressions are reported in Table 5a.

In the second set of regressions, the exchange-rate regime dummy is set to equal 1

when the de facto regime is not a currency peg; the results are reported in Table 5b. In

both Tables 5a and 5b, the coefficient estimate on variable X is its probit slope

derivatives (at the mean of X) in percent terms, or (100)*dF(x)/dx, which can be

interpreted as the change in probability of a crisis caused by a one unit change in X

around the mid-point of X.

The main results reported in Table 5a and Table 5b do not differ significantly, and

most variables are estimated to have the expected effect on the probability of a crisis. An
20

increase in the current account balance/GDP is estimated to have a negative and

significant effect on the probability of a currency crisis in the full-sample regression as

well as in both sub-sample regressions.21 In Table 5a (Table 5b), a one percentage-point

increase in the current account /GDP ratio is estimated to reduce the probability of a

currency crisis by about 0.85 (0.75) percentage points in the full-sample regression, and

by 0.87 (0.85) percentage points in the industrial-country regression. In the emergingeconomy sample, a one percentage-point increase in the current account/GDP ratio is

estimated to reduce the probability of a crisis by about 0.6 percentage points in both

Tables 5a and 5b. (The difference between the coefficients in the two sub-sample

regressions may in part arise from the fact that a one percentage-point increase in the

ratio represents a larger percent increase in industrial countries than in emerging

countries.) Clearly, the current account matters.

21 We also tested whether the effect of a current account deficit on the probability of a crisis jumps

up when it exceeds a threshold. We did so by including a constant dummy for episodes in which the

current account deficit was greater than 4, 5, or 6 percent of GDP. But we found no threshold effects.
21

Box 1. Explanatory Variables in Probit Regressions

Variable Expected Effect

Exchange Rate Regime According to the bi-polar view, an intermediate regime is more prone to crisis than

either a pegged or a floating regime.

Current Account

Balance/GDP

A higher current account balance should reduce the probability of a crisis: a higher

current account deficit subjects a country to a greater risk of sudden stop of foreign

financing, raising the probability of a crisis.

Fiscal Balance/GDP A higher fiscal deficit either leads to a higher current account deficit or undermines

investor's confidence in the country’s price stability, thus raising the probability of

crisis.

Non-FDI Inflows/GDP This variable serves as a proxy for capital account openness. A lower level of nonFDI inflows, indicating a higher level of capital restrictions, may reduce the

probability of a crisis by avoiding the large swings in hot moneys. However, it may

also increase the risk of crisis by shielding the country’s financial system from

benefits of healthy financial disciplines. Investors may also regard it as an adverse

signal of the country’s poor economic fundamentals. The net effect of capital

account openness on the crisis indicator is thus ambiguous ex ante.

Inflation Rate A sustained increase in the inflation rate can raise the probability of a crisis for two

reasons: (1) It results in the overvaluation of currencies under a pegged exchange

rate system; (2) It indicates macroeconomic mismanagement, thereby hurting

investors’ confidence and economic growth.

Real Oil Price High oil prices hurt economic growth and generally increase inflation in oilimporting countries, raising the risk of a financial crisis. But they benefit the

economic conditions of oil-exporting countries, lowering the risk of financial crisis.

Real U.S. interest rate An increase in the real U.S. interest rates hurt debtor countries’ economy by raising

the interest burden of their external debt and lowering net capital inflows to those

countries, thus increasing the probability of crisis.

Trade Openness An increase in trade openness may enhance creditors’ confidence in receiving real

transfers for their financial claims on the debtor country, thereby reducing the

probability of sudden reversals in capital flows and currency crashes in the debtor

country.

Total External

Debt/Exports

Higher indebtedness is expected to raise vulnerability to a reversal in capital flows

and hence to raise the probability of a crisis.

Foreign Exchange

Reserves/GDP

Higher ratios are assumed to lower vulnerability to liquidity problems and hence

lower the probability of a financial crisis.

Industrial Country

Dummy

Industrial countries have a lower probability of a crisis than emerging economies

because of stronger fundamentals, less debt intolerance, and more free of original

sin.

Note: See Appendix 1 for data source and constructions.
22

An increase in the fiscal balance/GDP ratio has the expected effect of lowering

the probability of a crisis, but that effect is smaller (and estimated with a lower degree of

statistical significance) than that of the current account. In full-sample regressions, a one

percentage-point increase in the fiscal balance/GDP ratio lowers the probability by about

0.4 percentage points in both tables. In the advanced-economy sample, that effect is

statistically significant in Table 5a, but not in Table 5b. In the emerging-economy

sample, that effect is not statistically significant in either table. These results may in part

reflect the fact that the correlation between the current account and the fiscal balance in

emerging economies is higher than that in industrial economies.22

An increase in the non-FDI inflows/GDP ratio (a proxy for capital-account

openness) helps to reduce the probability of a currency crisis for industrial countries, but

does not have a significant net effect on the probability of a crisis for emerging

countries.23 (A one percentage-point increase in non-FDI inflows/GDP reduces the

probability by 0.8 percentage points in industrial economies.) This difference between

the coefficients on non-FDI inflows/GDP in the two sub-sample regressions may arise

because those inflows tend to be better channeled to truly productive uses in industrial

economies (because of better-established financial institutions), while they are more

likely to lead to overinvestment and overpricing in financial and real-estate assets in

emerging economies.

22 Our simple regressions of the current account on the fiscal account (and a constant term) show

that the two variables are positively correlated, with a partial correlation coefficient of 0.27 for industrial

economies and 0.37 for emerging economies. 23 We also tried to test the effect of capital-account openness by including the index of capitalaccount liberalization constructed by Chinn and Ito (2002). However, regressions including that index

result in less reasonable coefficient estimates on many explanatory variables, including that index itself. A

possible reason for these puzzling results may be that capital controls are correlated with the error term

because countries more prone to crises are more likely to put on capital controls.
23

An increase in inflation has the expected effect of increasing the probability of a

crisis, but that effect is bigger in advanced economies than in emerging economies. A

one percentage-point increase in the inflation rate increases the probability about by 0.19

percentage points for advanced economies, but only by 0.003 percentage points for

emerging economies (Table 5a). This result could be because, on average, a one

percentage-point increase in the inflation rate amounts to a much smaller percent increase

in the inflation rate for emerging economies, many of which experienced hyperinflation

for many years in the sample period, than for industrial economies.

An increase in the real oil price (i.e., oil prices deflated by the U.S. consumer

price index) increases somewhat the probability of a currency crisis for all- and advanced

economies (a one-dollar increase in the real oil price increases the probability by about

0.2 percentage points) but not for emerging countries. This result may be because there

are more oil-exporting countries in the emerging-country group, and those countries’

economies tend to do better as the price of oil rises.24

An increase in the real U.S. interest rate raises the probability of a crisis for

emerging economies significantly, both quantitatively and statistically. A one

percentage-point increase in the real U.S. interest rate is estimated to raise the probability

of a crisis in an emerging economy by about 2.6 percentage points. Comparing this

coefficient with those of other regressors suggests that an increase in the real US interest

rate may be the single most critical factor, besides a currency regime, that could cause a

currency crisis in an emerging economy. In comparison, an increase in the real U.S.

24 There are 34 crises in our sample that occurred in emerging economies (Argentina, Columbia,

Egypt, China, Indonesia, Malaysia, Mexico, Peru, Russia, and Venezuela) when they are net oil-exporters.

There are only 5 crises that took place in advanced economies (Denmark, Norway, and the United

Kingdom) when they are net oil-exporters.
24

interest rate does not have a significant effect on the probability of a crisis in industrial

economies. This difference may be in part because many emerging economies’

currencies are pegged to the dollar, while most industrial countries have a flexible

exchange rate vis-à-vis the dollar. An increase in the real U.S. interest thus tends to

attract immediate and large capital outflows from emerging countries by raising the

expected rate-of-return differential in favor of dollar assets relative to those countries’

assets, but it will not necessarily increase the expected rate of return on dollar assets

relative to assets of other industrial countries. (In general, the expected rate-of-return

differential between U.S. assets and other countries’ assets equals the interest-rate

differential plus the expected rate of dollar depreciation. If an emerging country’s dollarpeg regime is credible, the expected rate of dollar depreciation against its currency is

zero; if that regime is not credible, the expected rate of dollar depreciation against its

currency is positive, further enhancing the expected return differential on dollar assets.)

The coefficient estimates on the dummies for exchange rate regimes suggest

that, everything else being equal, a country under an intermediate regime is more prone to

a currency crisis than that under currency-peg regime; but it is less clear whether a

country is more prone to crisis in a free-floating regime than in a currency-peg regime.

The coefficient estimate on the intermediate exchange-rate regime is positive (4.14, at

five percent significant level) in the full sample, while that on the floating exchange rate

regime is statistically insignificant (Table 5a). The coefficient estimates on the

managed-floating regime and on the freely-floating/free-falling regime in the full sample
25

in Table 5b suggest that these results do not change when we replace dummies of de jure

exchange-rate regimes with dummies of de facto regimes in the regressions.25

Neither a decrease in the foreign exchange reserves/GDP ratio, nor an increase

in the gross external debt/exports ratio, is estimated to increase the probability of a

crisis in emerging economies.26 In Table 5b, the coefficient estimate on the external

debt/exports ratio is statistically significant but has a “wrong” sign: a one percentagepoint increase in that ratio lowers the probability of a crisis by 0.009 percentage points.

These results suggest that the importance of these two variables are not unconditional; if

the overall external condition---such as the oil price, the U.S. interest rate---is benign, and

other economic fundamentals are sound, a low foreign reserves/GDP ratio or a low

external debt/exports ratio is not likely to trigger a crisis by itself.

Finally, the coefficient estimate on the industrial-country dummy is negative

(-3.92) and statistically significant at the 95 percent confidence level (in Table 5a),

suggesting that being an industrial country by itself helps to lower the probability of a

currency crisis. (The coefficient on that industrial-country dummy is also negative in

Table 5b, but is statistically significant only at an 80 percent confidence level.)

It is important to note that the Pseudo-R2’s of the regressions reported in Tables 5a

and 5b are quite low, suggesting that the origin of currency crises remains largely

unexplained by the included explanatory variables. This result is not surprising given

that many factors cited in the literature---such as herding behavior, weak financial

25 The free-floating/free-falling regime includes both the free-floating regime and the free-falling

regime. Free-falling regimes are regimes that are managed-floating regimes based on the de jure

classification but are forced (for example, by hyperinflation) to allow the exchange rate to freely plunge. 26 This variable is not included in the full- and industrial-country samples because many industrial

countries only reported their external debt in a few selected years during the sample period.
26

institutions, capital openness, and crony capitalism, etc.---are either poorly measured (by

use of proxy) or excluded (due to lack of data) all together.

Nevertheless, those regression results make a useful contribution by confirming

the core of the theories we synthesized in the previous section:

• Countries under an intermediate exchange rate regime are more prone to currency

crises than those under a fixed or free-float regime.

• Being an advanced country by itself appears to help reduce the probability of a

currency crisis.

• Countries with stronger economic fundamentals (especially, the current account,

the fiscal balance, and inflation) are less prone to currency crises.

• The effect of a shift in some fundamental variables on the probability of a crisis in

an advanced economy could be quite different from than that in an emerging

economy.

4b. The Severity Regressions

We run two alternative regressions to estimate the impact of selected fundamental

variables on the severity of a currency crisis. The first is an OLS regression which uses

the two-sided measure of severity as the dependent variable. The second is a tobit

regression which uses the one-sided measure of severity as the dependent variable. A list

of explanatory variables and why they are included are provided in Box 2. Since the

difference made by using either de jure or and de facto exchange-rate regime in the probit

regressions is not significant enough to cause concern, we use only de jure exchange rate

dummies in all severity regressions to streamline the analysis.
27

Box 2. Explanatory Variables in the Severity Regressions

Variable Expected Effect

Current

Account/GDP;

Fiscal

Balance/GDP

A higher level of current account deficit or budget deficit may increase the severity

of a crisis because it signals that the crisis country has poorer fiscal discipline,

discouraging the speedy return of capital needed to revive economic growth.

Inflation Higher inflation before the crisis may deepen the severity of a crisis because (1) it

undermines the credibility and effectiveness of monetary authorities, and (2) it places

a constraint on using monetary policies to counter the contractionary effect of a

crisis.

Real GDP per

capita

A higher real GDP per capita is expected to lower the severity of a crisis because it

serves as a proxy for soundness of economic fundamentals not captured by other

explanatory variables.

Real Oil Prices Higher oil prices may deepen the severity of a crisis by making it harder to use

expansionary fiscal/monetary policies to counter the contractionary effect of a crisis.

Real U.S.

Interest rate

The higher the real U.S. interest rate, the more difficult emerging economies have in

attracting net capital inflows to help revive its economy following a crisis.

Real GDP

Growth in G7

Crisis in emerging economies may have more severe output loss if import demand of

industrial economies is weak due to cyclical downturn.

Trade Openness The more an economy is open to trade, the more should a currency crisis help revive

its net exports and real GDP after a 2-3 year lag.

Twin Crisis v A twin crisis (a combination of currency and banking crises) will tend to result in

more severe output loss than a currency crisis alone. A steep currency depreciation,

by itself, is expansionary after some time lag by boosting net exports. In contrast, a

banking crisis drastically reduces liquidity needed for investment and consumption,

thereby hampering economic recovery.

Origins of Legal

rules

A currency crisis is less likely to trigger a banking crisis in countries with better

legal and financial infrastructures Thus, origins of legal rules---serving as a proxy for

market capitalization and the efficiency of financial institutions---could matter for

the severity of a currency crisis. La Porta, Shleifer, Lopez-de-Silanes, and Vishny

(1997) found that countries with poorer investor protections, measured by both the

character of legal rules and the quality of law enforcement, have smaller and

narrower equity and debt markets.

Note: See Appendix 1 for data source and constructions.
28

The results of OLS regressions are reported in Table 6, and those of tobit

regressions are in Table 7. In both tables, the first two columns report the results of

regressions using the full sample, and columns (3) and (4) those of the two sub-samples.

Column (1) excludes the industrial-country dummy, while column (2) excludes the twincrisis dummy.27

The coefficient estimates (and statistical significance) change somewhat from

Table 6 to Table 7. Nevertheless, the qualitative results of both OLS and tobit

regressions are roughly similar and provide a solid support to the collective theory that

we synthesized. First, countries having a more flexible exchange rate system tend to

suffer less output loss once a currency crisis has occurred than those with a currency-peg

system. The difference made by the free-floating regime is both quantitatively and

statistically significant in regressions using the full-sample, and strikingly large for

emerging countries alone. In table 6, for emerging countries, the cumulative growth rate

of a floating-exchange-rate country during the 3-year crisis period (beyond that during

the pre-crisis period) is estimated to be about 15 percentage points higher than that of a

pegged-currency country. In Table 7, that difference is even bigger: the cumulative

growth rate over the duration of the crisis in an emerging country adopting a floating

regime is about 27 percentage points higher than that with a pegged-currency regime.

For industrial countries, the difference made by the floating regime is not as striking.

The cumulative growth rate in an industrial country with a floating exchange regime is

about nine percentage points higher than that with a pegged-currency regime in Table 7

27 Twin crises occurred much more frequently in emerging-market countries than in industrial

countries. We circumvent the problem of multi-collinearity by not including both (twin-crisis and

industrial-country) dummies in the same regression.
29

but not statistically significant in Table 6. These results, however, could be due to the

fact that very few industrial countries had a floating exchange rate system in the pre-crisis

period (Appendix 1).

Second, being an industrial economy helps. The significant and positive

coefficient estimate on the industrial-country dummy in Table 6 could have resulted from

the fact that industrial economies tend to have stronger economic, financial, and legal

infrastructures that are not sufficiently controlled by other variables included in the

regression. It could also be because of the power of “brand name,” which affords added

credibility to a country. (Foreign investors are less likely to panic at some unfavorable

events and withdraw en masse funds that are critical to help a country stabilize the

negative impact of a currency crisis.) If we believe that the real GDP per capita and the

legal origin are sufficient as a proxy for the soundness of legal and economic

infrastructure, then we can probably attribute the estimated effect of the advancedeconomy dummy (in Table 6) to that of “brand name” alone.

It is true that the coefficient estimate in column (2) of the tobit regressions (Table

7) indicates that being labeled an “advanced economy” by itself does not make a

significant difference. However, by using the one-sided measure of severity as the

dependent variable, that result very likely underestimates the effect of being labeled an

advanced economy. In several crisis episodes among advanced economies, the economic

growth rate is higher in the crisis period than in a pre-crisis period, largely because the

large depreciation of their currencies helped to boost exports (an economic activity) by

more than its depressive effect on the economy. But the one-sided measures of severity
30

in those episodes are set to be zero, rather than a positive number as in a two-sided

measure.

Third, the severity of a twin crisis is much greater than that of a currency crisis

alone. Both tobit and OLS regressions estimate a negative and significant coefficient on

the twin-crisis dummy in the full sample and in the emerging-economy sample. For

industrial countries, the coefficient estimate on the twin crisis dummy is negative and

significant in the tobit regression but insignificant in the OLS regression. Again, this

difference could be because the one-sided measures of severity in episodes with abovetrend growth rates are set to be zero, artificially amplifying the degree of output losses in

twin crises for industrial countries.28

Finally, macroeconomic conditions in the pre-crisis period matter, but they tend to

matter differently for industrial versus emerging countries. First, countries with a larger

current account deficit suffer a larger output loss during the crisis period, but that

relationship is more pronounced among emerging economies than among industrial

countries. (In Table 6, the full-sample OLS regression estimates that a one percentagepoint increase in a country’s current account balance/GDP ratio during the pre-crisis

period is estimated to increase (decrease) that country’s cumulative output growth (loss)

over the crisis period by about one percentage point; that effect rises to nearly two

percentage points for emerging countries and lowers to a statistically insignificant level

for industrial countries.) In Table 7, the coefficients on the current account/GDP ratio

estimated by the full-sample tobit regressions are nearly double those in the OLS

28 There are only three episodes of twin crises in the industrial countries, as indicated in Table 3. The

average two-sided measure of severity in those three episodes was 9.2 percentage points, but the average

one-sided measure was -1.3 percentage points (Tables 3 and 4).
31

regressions. The coefficients estimated by the two sub-sample regressions are also much

larger than those estimated in the OLS regressions.

The effect the fiscal balance on the severity of a crisis in industrial countries also

appears to be different than that in emerging countries. In both the OLS and tobit

regressions, the coefficient estimates on the fiscal balance/GDP ratio are statistically

insignificant for all countries and for emerging economies. (Again, this result could be in

part due to the correlation between the fiscal deficit and the current account deficit,

especially in emerging economies.) For industrial economies, the coefficient estimate is

negative and significant in the OLS regression, indicating that a larger fiscal surplus

(deficit) in the pre-crisis period helps to lower output growth (loss) in a crisis. The

seemingly perverse relationship may stem from the likelihood that a currency crisis in an

advanced country tends to occur after economic growth has weakened, a time in which

the fiscal deficit tend to rise; the crisis then revive growth by boosting net exports.

A higher inflation rate in the pre-crisis period is followed by a more severe crisis

in industrial economies, but not so in emerging economies. This result may be because a

higher inflation rate makes it more difficult for industrial countries to lower interest rates

to combat output loss during the crisis, thus making the crisis more severe than otherwise.

In comparison, this policy constraint may be less relevant for emerging economies where

hyper-inflation and double-digit interest rates tend to be a common phenomenon.

Moreover, a one-percentage increase in inflation in countries that have persistent doubledigit inflation is likely to matter less than the same increase in countries where inflation is

generally kept around a low single-digit rate.
32

Origin of legal rules, which is included in the regressions as a proxy for the

soundness and efficiency of financial institutions, matter significantly for industrial

countries both statistically and quantitatively, but not for emerging countries. Crises in

industrial countries having the French civil law are estimated to suffer more severe output

loss than those having the British common law or other legal origins.29 However, the

legal origin dummy does not have a statistically significant coefficient in the regressions

using the emerging-country samples.

Overall, the results indicate that the exchange rate regime is the most critical

factors influencing the severity of a currency crisis, followed the current account, whether

the country is labeled an “advanced economy,” and whether the country’s crisis is also

accompanied by a banking crisis.30 For example, the current account/GDP ratio would

need to increase 10 percentage points for it to have the same effect on severity as a

currency-peg regime has (in comparison to a free-floating regime).

29 La Porta, Shleifer, Lopez-de-Silanes, and Vishny (1997) found that French civil law countries

had weaker investor protections, and less developed capital markets, than the other three types of legal

origins (i.e., the British common law, German civil law, and Scandinavian civil law). Common law

countries provide companies with better access to equity finance than civil law countries, and particularly

French civil law countries. They also found that the creditor-rights index is the highest in common law

countries, intermediate in German and Scandinavian civil law countries, and the lowest in the French civil

law countries.

30 The coefficient estimates on other explanatory variables---namely, real GDP per capita, real

GDP growth in the G7 countries, real oil prices, the real U.S. interest rate, trade openness, the foreign

exchange reserve/GDP ratio, and the external debt/exports ratio---are all statistically insignificant in the

OLS regressions. In the tobit regressions, a higher real U.S. interest rate is estimated to increase the

severity of a crisis (as expected) in the full-sample regression, but not in the sub-sample regression. An

increase in real oil prices is estimated to reduce the severity of a crisis in emerging economies (most of

them are net oil-exporters), but have no significant effect on the severity in industrial countries. An

increase in the trade openness has the puzzling effect of increasing the severity in industrial countries,

while having no effect on the severity in emerging economies.
33

5. Implications for the U.S. Current Account Adjustment

Overall, the literature and our empirical findings have three broad implications for

how the U.S. current account adjustment might unfold. First, the large U.S. current

account deficit cannot keep rising relative to GDP without triggering some kind of

adjustment process some time down the road. Second, it is not very likely that the

downward adjustment will involve massive capital outflows and a dollar crisis. Third, in

the (unlikely) event of a dollar crisis, this country is not likely to be thrown into the type

of recession that tends to be associated with a currency crisis in emerging economies.

Our regression results indicates that a sharp fall of the dollar is a possible scenario

of the U.S. current account adjustment, but they also confirm the collective insight of the

literature that investors are more willing to allow the self-adjusting market mechanism to

work out imbalances in industrial countries with sound financial and legal institutions

than in emerging economies with weaker institutions. The average of the full-sample

estimates of probit regressions (in both Tables 5a and 5b) indicates that the probability of

a dollar crisis has grown to about 11 percent in 2006, up from the six percent estimated

for 2003. The average estimates based on the industrial-country sample also indicate a

large rise in the probability, from three percent in 2003 to nine percent in 2006 (Figure 4).

If other factors remain the same, that probability will rise further if the U.S. current

account deficit climbs higher. However, that probability rises only very modestly in

response to an increase in that deficit: the estimated probability only rose to 11 percent in

2006 even though both the current account deficit and the oil prices surged to record

levels.31 At 11 percent, the risk of a dollar crisis appears to be much lower than it was

31 The hike in oil prices no doubt also contributed significantly to the rise in the estimated

probability. From 2002 to 2005, oil prices rose from $25/barrel to $53/barrel, while the current account
34

back in 1981, when high oil prices and inflation were the scourges. The estimated

probability of a dollar crisis was about 19 percent in 1981. However, at that time, the

dollar actually rose rapidly until it peaked in late 1985 (Figure 4).

Considerable uncertainty surrounds the estimated probability of currency crises.

Some emerging economies have experienced serious currency crises when the estimated

probabilities of those crises were around or even below 11 percent (Figure 5). However,

for the reasons discussed in section 3, emerging countries’ experiences are simply not

applicable for forecasting what may happen to the U.S. dollar. Moreover, our probit

regressions, which are designed to assess the relative importance of economic

fundamentals in the making and unfolding of a currency crisis, are grossly inadequate to

serve as forecast models. Those regressions have a very low pseudo-R2

, indicating that

the included explanatory variables together explain only a very small part of the variation

in the probability of a crisis. For example, Thailand did not have a currency crisis in

1981 when the probability of a baht crisis was about 23 percent in that year, but had one

in 1997 when that probability was only six percent. This result is not surprising in light

of the widely-shared view that it is inherently difficult to predict a currency crisis by

using regression estimations. That inherent difficulty mainly arises from the fact that

many potentially important contributors to a currency crisis---such as herding behavior,

crony capitalism, weak financial institutions, financial-account openness---either can only

be included in regressions with large measurement errors, by inadequate proxies, or are

omitted from regression analyses altogether. We thus take into account factors in

addition to those included in the regressions to assess the likely paths of U.S. currentdeficit/GDP ratio rose from 4.5 percent to 6.3 percent. In the full-sample regressions, the coefficient

estimate on lagged oil prices is about 0.2, while that on the lagged current account/GDP ratio ranges is

about 0.8.
35

account adjustment. With such an approach, we find that the literature and our empirical

findings, together, suggest a rather centrist view for the U.S. current account adjustment:

the dollar will need to depreciate substantially down the road to help narrow the U.S.

current account deficit, but the downward adjustment is more likely to be gradual than

involving a dollar crisis.

Some readers of Freund (2000) are inclined to think that a dollar crisis is

imminent because that deficit has exceeded five percent of GDP for over two years.32

Our results indicate that it would take a much larger current account deficit/GDP ratio, by

itself, to trigger a currency crisis. Our findings, in fact, do not contradict those of Freund,

which do not imply a compelling case for an imminent dollar crisis even though some

readers have come to that conclusion. The author used 25 industrial countries data from

1980 to 1997 to identify 25 episodes of current account reversal. It is true that the

average current account/GDP ratio for those countries (at the peak of their respective

deficits during those 25 episodes) was about five percent. However, the distribution of

the current account ratios that triggered a crisis ranged from 2.2 percent in France (1982)

to 16.8 percent in Portugal (1981). The triggering ratio was above 10 percent in three

countries, and was below three percent in three countries. Clearly, there is no undisputed

32 As early as in 2002, the press and even some analysts began to voice their concern that there

may be a problem because the U.S. current account deficit was reaching five percent of GDP. Many of

them cite a paper by Freund (2000), then an economist at the Federal Reserve Board. For example, in

reaction to the paper, an article in The Economist (April 27, 2002) writes: “A study by the Federal Reserve

of large current-account deficits in developed economies found that deficits usually began to reverse when

they exceeded five percent of GDP. And this adjustment was accompanied by an average fall in the

nominal exchange rate of 40 percent, along with a sharp slowdown in GDP growth. America is likely to

move into this danger-zone by the end of this year.”
36

evidence that five percent current account/GDP is the magic number that will trigger a

currency crisis.33

Shouldn’t we nevertheless be worried about the size of net U.S. external

liabilities? Given our finding that the external debt/exports ratio by itself does not have a

quantitatively significant effect on the probability of a currency crisis for emerging

economies, it would seem that the effect of that ratio on industrial economies would be

even more easily blunted by other factors. Moreover, the fact is that U.S. net

international investment position (NIIP) is not yet large relative to GDP. That net

position amounted to about -21 percent of GDP at the end of 2004, a ratio lower than that

in many emerging countries. The experiences of Australia and Canada also suggest that

the U.S. position is far from an alarming level. (Australia’s NIIP fell to -80 percent of

GDP in 1990; Canada’s NIIP fell to -43 percent of GDP in 1993. In both countries, net

international liabilities were brought down without incurring excessive hardship in their

economies.) Neither does the U.S. net external investment position look particularly bad

now when compared with its own experience in the late 19th century.34

Moreover, the case for a gradual U.S. external adjustment, as opposed to a hardlanding scenario for the dollar, is bolstered by the U.S. possession of many factors that

would help to deter a sudden reversal of capital:

33 Freund (2000) uses the Frankel and Rose (1996) method to identify a currency crisis, as we do

in this paper, and finds that 10 out of 20 episodes of current account reversal in industrial countries were

associated with currency crisis. However, none of those 10 crises occurred in countries under a floating

exchange-rate regime (Table 4 of the paper). Thus, it is possible that managed currency regimes were as

likely to blame as large current account deficits for causing those crises. 34 The U.S. net external debt (measured by NIIP) relative to GDP in 2004 is still a bit below where

it was during 1894-1895 when that ratio was about -24 percent. As its borrowing from abroad was put to

productive use, the United States did not crumble under the weight of that high level of international debt.

Instead, its rapid development enabled it to become a net lender after 1914, when World War I changed the

warring European countries from net lenders to net debtors.
37

• The exchange value of the dollar is market-driven, not pegged to another currency

or a commodity. This means that to a large extent its high value, despite the large

current account deficit, reflects high investors’ demand for dollar assets.

Moreover, a strong case can be made that the high demand was driven mainly by

economic fundamentals, not irrational exuberance.35 Thus, the dollar is more

likely to adjust downward gradually along with economic fundamentals rather

than burst like a bubble.36 At the very least, a free-floating dollar exchange rate

makes it less likely for “one-way” bets to rule the day.

• The United States has even stronger financial institutions than other advanced

countries. This strength, by itself, would help reduce the probability of a dollar

crisis by avoiding extra risks associated with “debt intolerance.”

• Most U.S. international liabilities are denominated in dollars, virtually eliminating

the problems of “lack of lender of last resort” and “original sin.” Moreover, it also

means that foreign countries and investors with large holdings of dollardenominated assets will hurt the value of their portfolio sharply if they dump their

dollar holdings en masse, making it less likely that a dollar crisis would be

triggered by massive foreign dumping.

• The dollar is the international reserve currency and is used as a medium of

international transactions. This provides a basic level of precautionary and

transaction demand for the dollar, providing a stabilizing cushion to the dollar’s

35 For example, see CBO (2004, 2005) and papers on the revived Bretton Woods system. 36 The sharp rise in the share of dollar assets in international investors’ portfolios over the past

decade means that the growth in demand for dollar assets is more likely to taper off than keep rising. At

the same time, the supply of dollar assets will continue to rise as long as the current account is still in

deficit, exerting downward pressure on the dollar.
38

exchange value. (Indeed, many Asian governments have accelerated their

accumulation foreign reserves, and thus dollar-denominated assets, after the Asian

crisis of 1997-98, in part to help prevent another crisis from occurring.)

Finally, it is quite likely that the U.S. net international investment position is

significantly underestimated in the official data reported by the Bureau of Economic Analysis

(BEA), as forcefully argued by Hausmann and Sturzenegger (2005). In their view, the

United States owns valuable assets (dark matter)---such as U.S. firms’ know-how, the

liquidity provided by the U.S. dollar, and the insurance premium the world pays for

exchanging safer U.S. assets for riskier assets---that are not included in the official

measurement. In all likelihood, the authors have grossly overestimated the value of dark

matter.37 Nevertheless, given the fact that much is still unknown regarding why there has

been a persistent return gap favoring U.S. investments abroad, their view deserves some

recognition.38

37 According to the authors’ estimate, the United States has a net international asset position worth

about $600 billion, not a net liability position of $2.5 trillion. We judge that the value of dark matter is

significantly overestimated by the authors for three reasons. First, even when we use the market-value

measures of FDI assets and liabilities---which already reflect, though imperfectly, the market’s valuation of

“dark matter”--- to derive the rate of returns on them, we still find the persistent return gap favoring U.S.-

owned FDI assets. Second, given that foreign holdings of U.S. currency has accounted for less than five

percent of total foreign holdings of U.S. assets since 1982, the value of liquidity service provided by the

U.S. dollar can only contribute to a very small portion of the return gap favoring U.S. investments abroad.

38 Hung and Mascaro (2004) also look into this issue and find that the return gap favoring U.S.

investments abroad can be attributed, at least in part, to two factors. First, U.S. subsidiaries abroad have

generally been in business longer than foreign-owned subsidiaries in this country; experience and other

age-related factors thus helped to increase the aggregate profitability of U.S. investments abroad. Second,

investors may have required higher return on U.S. subsidiaries abroad than foreign subsidiaries in this

country because the former face greater (political or economic) risks than the latter. A third possible factor

is that U.S.-owned subsidiaries abroad may have overstated their profits—and foreign-owned subsidiaries

in the US understate their profits—for tax reasons. However, empirical evidence on the extent to which

such misstatements affect the gap in returns is sketchy.
39

Even if a dollar crisis does occur, it is unlikely to wreak havoc on the U.S.

economy as a crisis typically does for an emerging economy. First, a dollar crisis is not

likely to spread into a devastating twin crisis as what often occurs in emerging

economies. To be sure, the U.S. financial sector will take a hit as a large sum of capital

leaves the country, and the sharp drop in liquidity will hurt the economy in the short run.

Nevertheless, a full-scale financial crisis is unlikely to be triggered as a result. The U.S.

financial system is much stronger and better diversified than that of emerging economies.

Moreover, U.S. banks’ international assets (loans to foreigners) and liabilities

(foreigners’ deposits) are almost all denominated in dollars; thus, U.S. banks will not see

their net liabilities soar as the dollar plunge, a critical development that often pushes

banks in emerging economies over the brink once a currency crisis erupted.

The fact that the United States is an advanced economy and has a floating

exchange rate system will also help mitigate any negative impact of a dollar’s sharp fall

may have on the economy. While a sharp fall of the dollar may hurt consumption,

investment, and employment in the United States (by increasing import prices, inflation,

and interest rates), it also helps to revive investment and employment by boosting net

exports. A large exit of capital flows from the United States is also more likely to occur

when foreign economies are booming, a condition that will also help boost U.S. net

exports. The net impact on the economy of a sharp dollar depreciation thus may even be

positive. That almost all foreign claims on the United States (both private and official)

are denominated in dollars also allows the redeeming aspect of a sharp depreciation to

work its way without enlarging the dollar burden of external debt at the same time. This

prospect, in turn, will also help limit the degree to which capital flows are reversed.
40

Indeed, the past four episodes of sharp dollar declines since 1970 did not cause

severe harm to the U.S. economy. Inflation did rise in all four episodes. However, the

unemployment rate also fell in all four episodes, and GDP growth accelerated in all but

the episode from 1971 to 1973. This result is perhaps not surprising given that the 1971-

73 episode is also the only one (among those four) that occurred as a collapse of a fixed

exchange rate regime.39 Overall, those post-1970 experiences testify to the healing

ability of the self-adjusting mechanism offered by the floating exchange rate and a free

market economy.

The preceding observations, of course, do not amount to arguing that a gradual

decline of the dollar does not have negative consequences for the United States in the

long run. A steady decline of the dollar’s exchange value will lower U.S. residents’

welfare by lowering the dollar’s purchasing power of foreign goods. It also erodes the

dollar’s position as an international reserve currency over time, thereby reducing the

many benefits accruing to an international reserve currency (such as seigniorage from

foreign holdings of U.S. currency, etc.)

6. Conclusion

This paper draws from the existing literature on currency crises and conducts new

empirical analyses, to shed light on how likely it is that the adjustment of the U.S. current

account deficit will involve a dollar crisis. The literature suggests that one should not

39 The dollar upheaval in 1971-72 was the collapse of a unsustainable exchange-rate peg: the

dollar was becoming increasingly overvalued (relative to gold), and the balance-of-payment deficit of the

United States was rising to a level perceived to be unsustainable. Even though the United States was not

running a significant current account deficit, its large capital outflows meant it was running a large balance

of payments deficit.
41

casually infer from emerging-economies’ experiences to predict what will happen to the

dollar. Our findings lend support to that view, suggesting that a dollar crisis is not likely

in the near future. This conclusion appears to be supported by the fact that the dollar’s

downward adjustment since the early 2002 has proceeded in a gradual and orderly

fashion. Our findings also suggest that, in the unlikely event of a dollar crisis, the U.S.

economy should be able to withstand it without suffering a severe recession. To be sure,

the negative impact of a (unlikely) dollar crisis could be much greater on the rest of the

world. Analyzing that prospect, however, is beyond the scope of this paper.
42

Figure 1. Number of Currency Crises: 1970 - 2004

0

2

4

6

8

10

12

14

16

18

20

22

24

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

EMS Crisis

Asian Crisis

Number of Currency Crises

Year

0

2

4

6

8

10

12

14

16

18

20

22

24

26

28

30

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

EMS Crisis

Mexico

Crisis

Asian Crisis

Figure 2. Severity of Currency Crises (one-sided measure): 1970 - 2004

Cumulative Output Loss (%)

Year
43

-30

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Year

Asian Crisis

Mexico Crisis

EMS Crisis

Cumulative Output Changes (%)

Figure 3. Severity of Currency Crises (two-sided measure), 1970 - 2004
44

Figure 4. Estimated Probability of a Dollar Currency Crisis, 1970-2006

(Percent)

Note: Estimates are based on the coefficient estimates of the full-sample regressions in Table 5a.

1970 1975 1980 1985 1990 1995 2000 2005

30

25

20

15

10

5

0

1970 1975 1980 1985 1990 1995 2000 2005

30

25

20

15

10

5

0

1970 1975 1980 1985 1990 1995 2000 2005

30

25

20

15

10

5

0

1970 1975 1980 1985 1990 1995 2000 2005

30

25

20

15

10

5

0

De Jure (Full Sample) De Jure (Industrial-Countries Sample)

De Facto (Full Sample) De Facto (Industrial-Countries Sample)
45

Figure 5. Estimated Probability of a Currency Crisis in Selected Countries, 1975-2000

(Percent)

Notes: Estimations are based on the coefficient estimates of the full-sample regressions in Table 5a.

Shaded regions indicate the beginning year of actual crises.

1975 1980 1985 1990 1995 2000

50

40

30

20

10

0 1975 1980 1985 1990 1995 2000

50

40

30

20

10

0

1975 1980 1985 1990 1995 2000

50

40

30

20

10

0 1975 1980 1985 1990 1995 2000

50

40

30

20

10

0

1975 1980 1985 1990 1995 2000

50

40

30

20

10

0 1975 1980 1985 1990 1995 2000

50

40

30

20

10

0

1975 1980 1985 1990 1995 2000

50

40

30

20

10

0 1975 1980 1985 1990 1995 2000

50

40

30

20

10

0

Argentina Brazil

Korea Mexico

Thailand Turkey

Italy New Zealand
46

Table 1. Currency Crises and De Jure Exchange Rate Regimes

(Period: 1970 – 1999)

Exchange Rate

Regime

Total Number of

Crises

Average Severity

(two-sided

measure) (1) (2)

Average Severity

(one-sided

measure) (1)

Average

Recovery Time

(Years)

Pegged 36 -8.69 -14.52 3.71

Intermediate 58 -4.18 -9.14 3.47

Floating 27 2.29 -2.53 1.70

Notes: (1) The average severity of crises in an exchange rate regime is obtained by taking the

simple average of severities of all crises occurred in that exchange rate regime. (2) Episodes that

do not have sufficient data to calculate the three-year averages are excluded from the computation

of the average.

Table 2. Currency Crises and De Facto Exchange Rate Regimes

(Period: 1970 – 2001)

Exchange Rate

Regime

Total Number of

Crises

Severity (twosided measure) (1)Severity (onesided measure)

Average

Recovery Time

(Years)

Pegged 16 -7.60 -11.34 3.50

Limited

Flexibility 43 -5.32 -12.92 3.90

Managed

Floating 48 -2.62 -6.57 2.62

Freely Floating 17 1.04 -4.58 2.00

Note: See notes in Table 1.
47

Table 3. Currency Crises in Industrial Countries vs. Emerging Markets

Severity of Crisis (one-sided measure) Severity of Crisis (two-sided measure)

Period Industrialized

Countries

Emerging

Economies Period IndustrializedCountries

Emerging

Economies

1970 – 1979 -5.48 -12.99 1970 – 1979 -2.52 -7.73

1980 – 1989 -10.25 -9.48 1980 – 1989 -4.31 -4.97

1990 – 1999 -3.05 -9.87 1990 – 1999 2.84 -3.80

2000 – 2004 -8.99 -4.55 2000 – 2004 -9.21 8.99

1970 – 2004 -7.42 -9.77 1970 – 2004 -2.13 -4.40

Twin Crises -1.28 -14.12 Twin Crises 9.20 -6.91

Average Recovery Time (Years) Number of Crises

Period Industrialized

Countries

Emerging

Economies Period IndustrializedCountries

Emerging

Economies

1970 – 1979 2.38 3.47 1970 – 1979 8 17

1980 – 1989 4.60 2.56 1980 – 1989 25 35

1990 – 1999 2.54 2.80 1990 – 1999 13 26

2000 – 2004 4.00 1.50 2000 – 2004 1 8

1970 – 2004 3.64 2.70 1970 – 2004 47 86

Twin Crises 1.67 2.96 Twin Crises 3 28

Note: A crisis episode is defined to be a twin crisis if a banking crisis occurred 2 years before, during or

after that currency crisis.
48

Table 4. Currency Crises across Regions

Severity of Crises (one-sided measure) Severity of Crises (two-sided measure)

Period Latin

America

East

Asia Europe Other Period LatinAmerica

East

Asia Europe Other

1970 - 1979 -13.69 -0.58 -2.12 -16.13 1970 - 1979 -5.99 1.97 0.99 -13.01

1980 - 1989 -11.98 -7.31 -9.76 -8.74 1980 - 1989 -4.90 -5.53 -4.48 -4.40

1990 - 1999 -5.79 -22.22 -3.59 -3.57 1990 - 1999 1.61 -16.29 3.86 0.23

2000 - 2004 -8.67 0.00 -8.99 -0.58 2000 - 2004 15.51 19.70 -9.21 0.38

1970 - 2004 -10.35 -12.53 -6.91 -8.02 1970 - 2004 -2.67 -7.72 -1.55 -4.50

Twin Crises -11.44 -29.47 -1.28 -6.32 Twin Crisis -3.96 -22.50 9.20 0.55

Average Recovery Time (Years) Number of Crises

Period Latin

America

East

Asia Europe Other Period LatinAmerica

East

Asia Europe Other

1970 - 1979 3.14 1.50 1.67 4.50 1970 - 1979 7 2 6 10

1980 - 1989 2.80 2.50 4.90 2.47 1980 - 1989 15 6 21 18

1990 - 1999 2.56 4.14 2.90 1.83 1990 - 1999 9 7 10 13

2000 - 2004 1.75 1.00 4.00 1.33 2000 - 2004 4 1 1 3

1970 - 2004 2.69 3.00 3.84 2.61 1970 - 2004 35 16 38 44

Twin Crises 2.36 5.17 1.67 2.29 Twin Crises 14 6 3 8

Note: See notes in Tables 1 and 3.
49

Table 5a. Probit Regression Results (De Jure Exchange Rate Regime)

Dependent Variable: Crisis Indicator (1 = Crisis, 0 = Otherwise)

All Countries Industrial Countries Emerging Economies

(1) (2) (3)

Current Account/GDP (L) -0.845 -0.871 -0.563

(-4.41)*** (-3.33)*** (-1.89)**

Fiscal Balance/GDP (L) -0.442 -0.356 -0.448

(-2.99)*** (-1.65)* (-1.36)

Non-FDI Inflows/GDP (L) -0.352 -0.834 0.246

(-1.39) (-2.64)*** (0.73)

Inflation (L) 0.003 0.186 0.003

(2.66)*** (2.75)*** (2.27)**

Real Oil Price (L) 0.202 0.242 -0.178

(2.63)*** (3.98)*** (-1.29)

Real U.S. Interest Rate 0.591 0.078 2.619

(1.91)* (0.32) (4.03)***

Trade Openness (L) -0.038 -0.016 -0.039

(-1.79)* (-0.65) (-0.90)

Foreign Exchange Reserve / GDP (L) -0.288

(-1.06)

Total External Debt / Exports (L) -0.006

(-1.32)

DUMMY VARIABLES

Intermediate Ex. Rate Regime (L) 4.135 1.302 5.281

(2.24)** (0.66) (1.30)

Floating Ex. Rate Regime (L) 3.913 3.524 3.530

(1.42) (0.93) (0.87)

Industrial Country -3.92

(-2.29)**

Number of Observations 1010 540 409

Pseudo R2 0.09 0.13 0.09

Notes:

2. Values of z-statistics in parentheses; * significant at 10%; * * significant at 5%; *** significant at 1%

3. (L) means that the variable is lagged one year.

4. Coefficient on an exchange-rate regime indicates the effect of that regime relative to a fixed exchange-rate regime.

1. Coefficient estimates are probit slope derivatives,dF(x)/dx, in percent terms, and thus can be interpreted as the change in

probability of a crisis casued by a one-unit change in the explanatory variable.

5. The cluster option in STATA is used to correct for heteroskedasticy and serial correlation within each country.
50

Table 5b. Probit Regression Results (De Facto Exchange Rate Regime)

Dependent Variable: Crisis Indicator (1 = Crisis, 0 = Otherwise)

All Countries Industrial Countries Emerging Economies

(1) (2) (3)

Current Account / GDP (L) -0.747 -0.845 -0.579

(-4.29)*** (-3.49)*** (-2.09)**

Fiscal Balance/GDP (L) -0.405 -0.318 -0.333

(-2.48)** (-1.26) (-1.12)

Non-FDI Inflows/GDP (L) -0.248 -0.636 0.124

(-0.96) (-1.50) (0.40)

Inflation (L) 0.003 0.098 0.002

(2.33)** (1.66)* (1.12)

Real Oil Price (L) 0.172 0.231 -0.163

(2.24)** (3.03)*** (-1.21)

Real U.S. Interest Rate 0.769 0.165 2.294

(2.53)** (0.58) (3.86)***

Trade Openness (L) -0.049 -0.028 -0.038

(-2.09)** (-0.90) (-0.89)

Foreign Exchange Reserve/GDP (L) -0.364

(-1.48)

Total External Debt/Exports (L) -0.009

(-2.17)**

DUMMY VARIABLES

1.962 2.608 -0.371

(0.87) (1.05) (-0.09)

5.611 5.754 4.869

(2.27)** (1.84)* (1.28)

Free Floating/Falling Regime (L) 3.791 0.508 9.477

(1.15) (0.10) (2.47)**

Industrialized Country -2.233

(-1.27)

Number of Observations 1036 520 461

Pseudo R2 0.09 0.12 0.10

Note: see Table 5a.

Limited-Flexibility Regime (L)

Managed-Floating Regime (L)
51

Table 6. Severity of Currency Crises (OLS Regression)

Dependent Variable: Output Loss (two-sided measurment; "+" indicates gain and "-" loss)

Industrial Emerging

(1) (2) (3) (4)

Current Account / GDP (L) 0.948 1.034 0.705 1.961

(2.15)** (2.23)** (1.35) (2.40)**

Fiscal Balance / GDP (L) -0.120 -0.175 -0.557 0.819

(-0.50) (-0.71) (-1.46) (1.62)

Inflation (L) 0.004 0.004 -0.108 0.005

(6.83)*** (6.46)*** (-1.00) (6.20)***

Real GDP Per Capita (L) -0.014 -0.312 -0.261 -0.441

(-0.08) (-1.35) (-0.84) (-0.44)

G7 Real GDP Growth 1.621

(0.57)

Real Oil Price 0.032 0.020 -0.254 0.582

(0.20) (0.13) (-1.07) (1.62)

Real U.S. Interest Rate -0.559 -0.419 0.141 -0.402

(-1.11) (-0.88) (0.18) (-0.25)

Trade Openness (L) -0.025 -0.034 -0.047 -0.072

(-0.60) (-0.78) (-1.34) (-0.57)

Foreign Exchange Reserve / GDP (L) 0.450

(0.91)

External Debt / Exports (L) 0.010

(0.77)

DUMMY VARIABLES

French Civil Law -1.270 -2.524 -8.271 -4.919

(-0.43) (-0.91) (-2.61)** (-0.81)

Intermediate Ex. Rate Regime (L) 5.983 5.312 7.292 10.670

(1.67)* (1.44) (1.49) (1.94)*

Floating Ex. Rate Regime (L) 10.021 9.485 5.614 15.237

(2.73)*** (2.53)** (1.45) (2.10)**

Twin Crisis -5.875 2.817 -9.725

(-1.78)* (0.64) (-1.99)*

Industrial Country 6.437

(2.10)**

Constant -0.798 -1.449 8.539 -11.174

(-0.18) (-0.33) (1.16) (-0.84)

Number of Observations 101 101 41 51

Adjusted R2 0.227 0.210 0.293 0.270

NOTES:

1. Values of t-statistics in parentheses; * significant at 10%; * * significant at 5%; *** significant at 1%.

3. (L) means that the variable is lagged one year.

4. Coefficient on French Civil Law indicate the effect of that legal origin relative to that of British common law.

5. Coefficient on an exchange-rate regime indicates the effect of that regime relative to a fixed exchange-rate regime.

2. White's correction is used to correct for heteroscedasticity.

All Countries
52

Table 7. Severity of Currency Crises (Tobit Regression)

Dependent Variable: Output Loss (one-sided measures, censored to be less or equal zero)

Industrial

Countries

Emerging

Economies

(1) (2) (3) (4)

Current Account / GDP (L) 1.873 1.930 1.675 2.979

(3.57)*** (3.57)*** (3.38)*** (2.67)**

Fiscal Balance / GDP (L) 0.322 0.275 -1.303 1.669

(0.90) (0.75) (-2.82)*** (1.51)

Inflation (L) 0.002 0.002 -0.486 0.008

(0.58) (0.63) (-2.84)*** (0.54)

Real GDP Per Capita (L) -0.305 -0.201 0.538 -1.034

(-1.03) (-0.45) (1.49) (-0.59)

G7 Real GDP Growth 4.582

(1.23)

Real Oil Prices 0.224 0.269 0.016 0.962

(0.96) (1.11) (0.06) (2.00)*

Real U.S. Interest Rate -1.430 -1.428 -0.932 -1.008

(-1.66)* (-1.60) (-1.14) (-0.38)

Trade Openness (L) -0.075 -0.084 -0.261 -0.193

(-1.15) (-1.24) (-3.30)*** (-1.10)

Foreign Exchange Reserve/GDP(L) 1.289

(1.38)

External Debt / Exports (L) 0.023

(0.86)

DUMMY VARIABLES

French Civil Law -5.069 -5.871 -16.650 -7.812

(-1.12) (-1.26) (-3.20)*** (-0.82)

Intermediate Ex. Rate Regime (L) 8.100 8.393 18.278 11.093

(1.79)* (1.78)* (3.39)*** (1.51)

Floating Ex. Rate Regime (L) 19.104 18.211 9.214 26.808

(3.39)*** (3.18)*** (1.81)* (2.21)**

Twin Crisis -8.557 -17.165 -13.836

(-2.16)** (-2.31)** (-2.11)**

Industrial Country -0.237

(-0.04)

Constant 11.529 8.504 8.443 -13.505

(1.48) (1.07) (0.81) (-0.58)

Number of Observations 101 101 41 51

Pseudo R2 0.066 0.058 0.179 0.077

Note: See notes in Table 6.

All Countries
53

Table 8. Economic Indicators in the Post-1970 Episodes of Steep Dollar Declines

1971Q2- 1973Q3 1977Q2-1978Q3 1985Q1-1988Q2 2002Q1-2004Q4

Dollar

Depreciation

Total: 14%

Annual: 6.2%

Total: 11%

Annual: 8.8%

Total: 22%

Annual: 6.8%

Total: 22%

Annual: 8.0%

Unemployment

Rate

Average:5.5%

Change: 5.9 to

4.8%

Average: 6.5%

Change: 6.7 to

5.9%

Average: 6.6%

Change: 7.2 to 5.5%

Average: 5.9%

Change: 5.7 to

5.4%

Annual Real

GDP Growth

Average: 4.7%

Change: 2.3 to

-2.1%

Average: 5.1%

Change: 5.0 to

6.7%

Average: 3.8%

Change: 3.7 to

5.3%

Average: 3.6%

Change: 3.4 to

3.9%

Yield on 10-

year TreasuryNote

Average: 6.4%

Change: 6.2 to

7.2%

Average: 7.9%

Change: 7.6 to

8.8%

Average: 8.9%

Change: 11.6 to

8.8%

Average: 4.3%

Change: 5.1 to

4.2%

Annual CPI

Inflation

Average: 4.8%

Change: 5.7 to

8.5%

Average: 6.5%

Change: 6.3 to

7.8%

Average: 3.2%

Change: 3.7 to

4.7%

Average 2.2%

Change: 1.3 to

3.5%

Note: “Change” indicates the levels of economic indicators at the beginning and at the end of the period of

a large dollar depreciation.
54

Appendix 1. Data Descriptions

1. Selection of Countries

We include 51 countries, including industrial and emerging countries, in the

study. Advanced countries are defined using the definition from World Economic

Outlook (WEO) published by the International Monetary Fund (IMF). Emerging markets

are defined using the Morgan Stanley Capital International (MSCI) classification. This

index classifies a country as an emerging market using a number of different criteria:

GDP per capita, local government regulations, perceived investment risk, foreign

ownership limits, capital controls and other factors. (For detailed information on the

method of MSCI’s classification, see http://www.msci.com/equity/index.html.) Israel,

Korea and Taiwan are classified as advanced countries by WEO, but they are also

included in the MSCI emerging market index. We classify them as emerging economies.

Taiwan is included in the original MSCI classification but is excluded in our sample due

to the lack of data.

2. Dependent Variables

The Crisis Indicator We use the Frankel and Rose (1996) method, which focuses only

on the successful speculative attacks. They define a currency crash as a depreciation of

the nominal exchange rate of at least 25 percent that is also at least a 10 percentage-point

increase in the rate of nominal depreciation. The original paper used annual data, but we

use monthly data. We first measure the twelve-month log difference in the exchange

rate ( , , , 12 (%) log( ) log( ) it it it exr exr exr Δ= − − ); we then identify a crisis with the rule below:

, , , 12 1 if (%) 25% and (%) (%)>10% Crisis

0 otherwise

it it it exr exr exr Δ > Δ −Δ − = 


55

Exchange rate data are obtained from the International Financial Statistics published by

the IMF (line ae.zf).

Frankel and Rose (1996) use a three-year exclusion “window” to avoid counting

the same crash twice. Any crisis occurring within three years of the first crash is defined

to be an extension of the first identified crisis. With this method, we identify the crisis

dates and find a total of 133 crisis episodes in 48 countries over the sample period of

1970-2004. Canada, Singapore and the United States did not have any crises during this

period.

Two-sided Measure of Severity This measure of output effect of a currency crisis in

country i in period t (Si,t ) is the difference between the total real GDP growth rate in the

crisis period (t) and that on the pre-crisis period (t-1). That is,

Si,t = 3*(g i,t – g i t-1)

Where g i,t is the average real GDP growth rate during the three-year period that begins

in the year when the crisis occurred and ends two years afterwards, and g i,t-1 is the

average growth rate during the three years prior to the crisis year. The severity, Si,t can

be positive or negative. A positive Si,t indicates an expansionary episode and a negative

Si,t indicates a contractionary episode.
56

One-Sided Measure of Severity The construction of the one-sided measure of severity

follows that used by Bordo et al. (2001). In this measure, severity is the cumulative sum

of the differences, over the duration of the crisis, between the rates of real GDP growth in

each year following the crisis and the trend growth rate that prevailed before the crisis.

The trend rate is calculated as the average growth rate of the five years preceding the

crisis event. The duration of a crisis is defined as the number of years from the onset of

the crisis until the actual growth rate returns to the trend rate. When the growth rate in a

crisis year is above the trend rate, output loss is defined to be 0. Thus, by construction,

this severity measure is censored to be less than or equal to 0, and the minimum duration

is one year; in other words, no currency crisis is allowed to be expansionary. Real GDP

data of all countries are obtained from the IMF’s data base for World Economic Outlook.

Characteristics of Crises Episodes The characteristics of crises identified in the sample

are reported in the table below.

Table A1. Time, Severity, and Pre-conditions of the Crisis Episodes

Country

(E:emerging;

A:advanced)

Time of

Crisis

Twin

Crisis

Severity

(Onesided

Measure)

Severity

(Two-sided

Measure)

Average

Duration

(Years)

De Jure

Exchange

Rate Regime

De Facto

Exchange Rate

Regime

Argentina**

(E) Mar-75 -9.52 -5.09 3 Pegged Freely Floating

Apr-81 X -16.56 -16.64 3 Intermediate Limited Flexibility

Jul-84 0.00 9.27 1 Intermediate Freely Floating

Aug-87 X 0.00 -9.64 1 Intermediate Freely Floating

Jan-02 X -11.57 15.51 2 #N/A Pegged

Australia (A) Feb-85 0.00 4.36 1 Floating Freely Floating

Aug-98 0.00 -1.35 1 Floating Freely Floating

Austria (A) May-81 -11.67 -2.14 8 Pegged Limited Flexibility

Belgium** (A) May-81 -13.44 -9.03 8 Intermediate Pegged

Brazil** (E) Jun-76 -56.24 -10.60 8 Pegged Limited Flexibility

Jul-79 0.00 -6.14 1 Intermediate Managed Floating

Feb-83 -6.47 4.51 2 Intermediate Managed Floating

Jun-87 -18.77 -14.43 7 Intermediate Pegged

Jul-90 X -17.13 -10.28 4 Intermediate Freely Floating
57

Country

(E:emerging;

A:advanced)

Time of

Crisis

Twin

Crisis

Severity

(Onesided

Measure)

Severity

(Two-sided

Measure)

Average

Duration

(Years)

De Jure

Exchange

Rate Regime

De Facto

Exchange Rate

Regime

Aug-93 X 0.00 18.50 1 Floating Freely Floating

Jan-99 -2.44 0.40 2 Intermediate Limited Flexibility

Nov-02 -2.26 2* #N/A Managed Floating

Chile** (E) Jul-71 0.00 -6.09 1 Pegged Managed Floating

May-75 X -12.94 4.01 2 Pegged Managed Floating

Aug-82 X -29.20 -27.70 3 Pegged Pegged

Sep-85 0.00 25.45 1 Intermediate Managed Floating

China (E) Sep-84 0.00 12.30 1 Pegged Managed Floating

Nov-90 -6.72 0.20 3 Pegged Managed Floating

Jan-94 0.00 -4.20 1 Intermediate Limited Flexibility

Columbia**

(E) Jun-85 X 0.00 8.41 1 Intermediate Managed Floating

Nov-97 -18.92 -13.30 8* Intermediate Managed Floating

Jan-03 0.00 1 #N/A #N/A

Cyprus (A) Jul-81 -48.93 -9.32 8 Pegged Limited Flexibility

Czech Rep.

(E) Jul-97 -7.79 -12.99 4 Pegged Managed Floating

Denmark (A) May-81 -4.44 -1.97 2 Intermediate Limited Flexibility

Egypt** (E) Jan-79 X -2.89 -13.44 2 Pegged Managed Floating

Aug-89 0.00 1.29 1 Pegged Managed Floating

Apr-03 -1.74 2* #N/A #N/A

Finland (A) Mar-93 X -1.05 16.67 2 Floating Limited Flexibility

France** (A) May-81 -8.65 -2.93 8 Intermediate Limited Flexibility

Germany (A) May-81 -13.27 -7.55 8 Intermediate Managed Floating

Greece** (A) Feb-81 -30.38 -14.97 8 Intermediate Limited Flexibility

Feb-85 0.00 0.97 1 Intermediate Managed Floating

Jul-93 -4.65 -1.30 5 Intermediate Pegged

Hong Kong

(A) Sep-83 -2.28 -6.10 2 Floating Limited Flexibility

Hungary (E) May-89 X -26.22 -20.17 6 Pegged Managed Floating

Jan-96 0.00 6.89 1 Intermediate Limited Flexibility

Oct-00 0.00 -1.03 1 Intermediate Managed Floating

Iceland (A) Sep-74 -9.21 -13.73 4 Intermediate Limited Flexibility

Feb-78 0.00 1.20 1 Intermediate Managed Floating

Mar-81 -19.73 -12.36 7 Intermediate Managed Floating

May-85 0.00 13.98 1 Intermediate Managed Floating

Dec-88 -25.18 -16.77 7 Pegged Limited Flexibility

Jun-93 0.00 6.94 1 Pegged Limited Flexibility

May-01 -8.99 -9.21 4 #N/A Limited Flexibility

India (E) Jul-91 -7.68 -11.06 4 Intermediate Limited Flexibility

Indonesia**

(E) Nov-78 0.00 4.22 1 Pegged Managed Floating

Apr-83 0.00 1.12 1 Intermediate Limited Flexibility

Sep-86 0.00 -1.48 1 Intermediate Limited Flexibility

Aug-97 X -44.75 -31.21 7* Intermediate Limited Flexibility

Jun-00 0.00 19.70 1 Floating Freely Floating

Ireland (A) May-76 -3.52 2.15 2 Pegged Pegged
58

Country

(E:emerging;

A:advanced)

Time of

Crisis

Twin

Crisis

Severity

(Onesided

Measure)

Severity

(Two-sided

Measure)

Average

Duration

(Years)

De Jure

Exchange

Rate Regime

De Facto

Exchange Rate

Regime

May-81 -15.16 -7.97 7 Intermediate Limited Flexibility

Jul-93 -2.26 4.57 2 Intermediate Limited Flexibility

Israel (A) Nov-74 -43.97 -16.75 8* Pegged Managed Floating

Dec-77 X -6.58 -0.38 3 Pegged Managed Floating

Jan-81 0.00 -7.51 1 Floating Managed Floating

Feb-84 -5.10 -1.32 3 Floating Managed Floating

Italy** (A) Mar-76 0.00 2.76 1 Intermediate Limited Flexibility

Apr-81 -16.64 -10.01 8* Intermediate Managed Floating

Feb-93 -3.07 0.12 2 Floating Limited Flexibility

Japan (A) Oct-79 0.00 -2.40 1 Intermediate Managed Floating

May-96 0.00 0.86 1 Floating Managed Floating

Jordan** (E) Oct-88 -31.70 -27.70 5 Pegged Pegged

Korea (A) Sep-80 -13.56 -14.07 4 Pegged Pegged

Nov-97 X -16.89 -17.42 3 Intermediate Limited Flexibility

Luxembourg**

(A) May-81 -3.97 -3.69 3 Intermediate Pegged

Malaysia (E) Oct-97 X -42.22 -22.94 7* Intermediate Limited Flexibility

Mexico** (E) Sep-76 -4.74 -2.62 3 Pegged Pegged

Feb-82 X -59.16 -28.92 8* Intermediate Limited Flexibility

Jul-85 -11.49 1.91 5 Intermediate Managed Floating

Dec-94 X 0.00 -6.41 1 Intermediate Pegged

Aug-98 0.00 9.49 1 Floating Managed Floating

Morocco**

(E) Apr-81 -8.27 -4.37 2 Intermediate Limited Flexibility

May-84 0.00 12.66 1 Intermediate Limited Flexibility

Netherlands**

(A) May-81 -7.84 -6.04 4 Intermediate Limited Flexibility

New Zealand

(A) Aug-75 -31.08 -23.65 8 Pegged Limited Flexibility

Jul-84 0.00 -2.51 1 Pegged Limited Flexibility

May-98 -3.78 -1.21 2 Floating Managed Floating

Norway (A) Aug-93 X 0.00 3.38 1 Floating Managed Floating

Pakistan (E) May-72 -5.18 -5.91 2 Pegged #N/A

Oct-82 -0.24 -3.51 2 Pegged Pegged

Peru** (E) Jun-76 -12.40 -15.38 4 Pegged #N/A

Feb-81 X 0.00 -14.38 1 Intermediate Freely Floating

Jan-85 X 0.00 28.00 1 Intermediate Freely Floating

Feb-88 -38.01 -46.34 6 Pegged Freely Floating

Mar-91 0.00 32.04 1 Floating Freely Floating

Philippines**

(E) Jan-71 -1.16 -0.28 2 Pegged Managed Floating

Jun-83 X -28.03 -24.95 6 Floating Managed Floating

Sep-97 X 0.00 -6.91 1 Floating Pegged

Poland (E) Dec-78 #N/A #N/A

Jan-82 #N/A #N/A

Feb-85 #N/A #N/A
59

Country

(E:emerging;

A:advanced)

Time of

Crisis

Twin

Crisis

Severity

(Onesided

Measure)

Severity

(Two-sided

Measure)

Average

Duration

(Years)

De Jure

Exchange

Rate Regime

De Facto

Exchange Rate

Regime

Mar-88 #N/A #N/A

Feb-92 X Intermediate Limited Flexibility

Portugal** (A) Feb-77 0.00 10.36 1 Intermediate Managed Floating

Jun-81 -22.01 -9.46 7 Intermediate Managed Floating

Jul-93 -14.87 -6.20 8* Intermediate Limited Flexibility

Russia (E) Jun-95 X 0.00 29.43 1 #N/A #N/A

Aug-98 X 0.00 17.44 1 Intermediate Limited Flexibility

South Africa

(E) Feb-76 -15.25 -18.95 5 Pegged Managed Floating

Oct-81 0.00 -13.48 1 Intermediate Managed Floating

Nov-84 0.00 1.28 1 Floating Managed Floating

Oct-96 0.00 0.13 1 Floating Managed Floating

Dec-01 0.00 1.80 1 #N/A Managed Floating

Spain** (A) Feb-81 -3.22 -0.83 5 Intermediate Limited Flexibility

Jun-93 -7.20 -3.15 5 Intermediate Limited Flexibility

Sweden (A) Sep-81 -1.64 -4.33 3 Pegged Limited Flexibility

Feb-93 X -2.80 7.56 2 Floating Limited Flexibility

Switzerland

(A) Jul-81 -4.47 -6.86 4 Floating Managed Floating

Feb-85 0.00 3.69 1 Floating Limited Flexibility

Thailand (E) Aug-97 X -44.95 -31.56 7* Pegged Pegged

Turkey** (E) Jan-71 Pegged Managed Floating

Mar-78 -24.06 -22.61 7 Intermediate Limited Flexibility

Jan-82 X 0.00 13.46 1 Intermediate Managed Floating

Jan-88 -10.60 -9.11 3 Intermediate Managed Floating

Feb-91 -4.70 3.33 2 Floating Managed Floating

Mar-94 -10.35 -6.21 2 Intermediate Managed Floating

Dec-99 X -8.58 -22.47 2 Intermediate Managed Floating

U.K. (A) May-76 0.00 3.19 1 Floating Managed Floating

Aug-81 -3.25 0.08 2 Floating Managed Floating

Feb-85 0.00 4.05 1 Floating Managed Floating

Jul-93 0.00 10.00 1 Floating Pegged

Venezuela**

(E) Feb-84 0.00 14.34 1 Pegged Managed Floating

Mar-87 0.00 -7.31 1 Pegged Managed Floating

Jan-93 X -9.88 -20.38 3 Floating Managed Floating

Feb-96 X -3.73 4.47 2 Pegged Limited Flexibility

Feb-02 -20.84 2* #N/A Limited Flexibility

Notes: (1) * indicates crisis episodes that are still ongoing or where the output loss measure was

truncated at 8 years because real GDP growth did not return to trend after 8 years.

(2) ** indicates French civil law countries.
60

3. Data Sources and Constructions of Explanatory Variables

Explanatory

Variables

Description Source

Current

Account/GDP

Current account deficit (-) or surplus (+) as a

percent of GDP.

World Bank: World Development

Indicators (WDI)

De Facto Freely

Floating

Exchange Rate

Regime

Equals 1 if the country’s exchange rate regime is

a freely floating or freely falling regime

according to the coarse classification of the

Natural Classification proposed by Reinhart and

Rogoff (2004) and 0 otherwise.

Reinhart and Rogoff (2004).

Available online at

De Facto

Limited

Flexibility

Exchange Rate

Regime

Equals 1 if the country’s exchange rate regime is

a limited flexibility (mostly crawling band)

regime according to the coarse classification of

the Natural Classification proposed by Reinhart

and Rogoff (2004) 0 otherwise.

Reinhart and Rogoff (2004).

De Facto

Managed

Floating

Exchange Rate

Regime

Equals 1 if the country’s exchange rate regime is

a managed floating regime according to the

coarse classification of the Natural

Classification proposed by Reinhart and Rogoff

(2004) and 0 otherwise.

Reinhart and Rogoff (2004).

De Facto Peg

Exchange Rate

Regime

Equals 1 if the country’s exchange rate regime is

a hard pegged regime according to the coarse

classification of the Natural Classification

proposed by Reinhart and Rogoff (2004) and 0

otherwise.

Reinhart and Rogoff (2004).

Available online at

http://www.wam.umd.edu/~creinhar

/Links.html

De Jure

Floating

Exchange Rate

Regime

Equals 1 if the country’s exchange rate regime is

a managed or free floating regime according to

the IMF’s classification and 0 otherwise.

IMF’s Annual Report on Exchange

Arrangements and Exchange

Restrictions.

De Jure

Intermediate

Exchange Rate

Regime

Equals 1 if the country’s exchange rate regime is

a limited flexibility (mostly crawling band)

regime according to the IMF’s classification and

0 otherwise.

IMF’s Annual Report on Exchange

Arrangements and Exchange

Restrictions

De Jure Pegged

Exchange Rate

Regime

Equals 1 if the country’s exchange rate regime is

a hard pegged regime according to the IMF’s

classification and 0 otherwise.

IMF’s Annual Report on Exchange

Arrangements and Exchange

Restrictions

External

Debt/Exports

Total external debt in current U.S. dollars as a

percent of exports in current U.S. dollars. Total

external debt is the sum of public, publicly

guaranteed, and private nonguaranteed longterm debt, use of IMF credit, and short-term

debt.

World Bank: WDI

IMF, International Financial

Statistics (IFS)

Fiscal

Balance/GDP

Central government deficit (-) or surplus (+) as a

percent of GDP.

IMF, International Financial

Statistics (IFS)
61

Foreign

Exchange

Reserve/GDP

Total foreign exchange reserve minus gold in

current U.S. dollars as a percent of GDP in

current U.S. dollars.

World Bank: WDI

G7 Real GDP

Growth

G7 Real GDP Growth is the GDP weighted

average of real GDP growth of the G7 countries

(Canada, France, Germany, Italy, Japan, United

Kingdom, and the United States).

IMF: World Economic Outlook

Industrialized

Country

Dummy

Equals 1 if country is classified as an

industrialized country and 0 otherwise.

Inflation Annual inflation rate based on annual CPI data.

(CPIt – CPIt-1)/CPIt-1 x 100%.

World Bank: WDI

Non-FDI

Inflows/GDP

(Financial-Account Balance– Net Foreign

Direct Investment) as a percent of GDP.

IMF: IFS; IMF: Balance of

Payments Statistics (BOPS)

Origins of legal

rules

A dummy variable is set to equal 1 if a country’s

legal origin is not English Common Law. (The

legal origins are: English common law, French

civil law, German civil law, Socialist law, and

Scandinavian civil law.)

La Porta, Lopez-de-Silanes,

Schleifer, and Vishny (1998); CIA

World Factbook; also available at

http://www.nationmaster.com/graph

-T/gov_leg_ori

Real GDP per

capita

GDP per capita is gross domestic product

divided by midyear population. Data are in

constant 2000 U.S. dollars.

World Bank: WDI

Real U.S.

Interest Rate

The prime rate adjusted for inflation as

measured by the GDP deflator. (in Percentage)

Board of Governors of the Federal

Reserve System: "Selected Interest

Rates." H.15 (415); Bureau of

Economic Analysis: GDP Press

Release. Tables 4 & 6.

Trade Openness (Exports + Imports) as a percent of GDP. World Bank: WDI

Twin Crisis

Indicator

A currency crisis was defined to be a twin crisis

if a banking crisis occurred within a 2 year

“window” around the currency crisis date. The

twin crisis indicator equals 1 if there was a twin

crisis and 0 otherwise.

Banking crisis indicator is obtained

from Caprio and Klingebiel (2003).

Also available online at

http://econ.worldbank.org/WBSITE/

EXTERNAL/EXTDEC/EXTRESE

ARCH/0,,contentMDK:20349050~p

agePK:64165401~piPK:64165026~t

heSitePK:469382,00.html

World Real Oil

Price

Spot world oil price (U.S. dollar per barrel)

deflated by the U.S. consumer price index (=1

over 1982-1984).

IMF: IFS
62

Appendix 2. A Brief History of Major Currency Crises in the 1990s

Almost all major currency crises in the 1990s occurred to countries with a fixed or

intermediate exchange rate regime and weak fundamentals, and triggered by a sudden

exit of massive capital flows. Some crises were made more severe than necessary by

herding behavior, counter-productive policy responses, or both. As an illustration, this

appendix gives a brief description of three major crises in the 1990s.

(1) The ERM crises of 1992-1993.

In the fall of 1992, massive capital flows led to the exit of Britain, Italy, and Spain

from the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS),

even though they remained with the EMS itself. In the summer of 1993, a second wave

of attacks led to a decision by the members to widen the exchange rate bands of ERM,

from a margin of 2.25 percent to 15 percent, essentially to allow the French franc to

depreciate without any formal exit.

The ERM crises are clear examples of the effect of speculative attacks, even

though the question of whether those attacks are reactions to fundamentals remains a

matter of debate. In all cases, the governments of attacked countries retained full access

to domestic and international capital markets. This meant they had no need to monetize

their budget deficits; and indeed the growth of domestic credit was not exceptionally

rapid (see Eichengreen, Rose, and Wyplosze [1995]). It also meant that they were not

suffering from any ironclad limitation on foreign exchange reserves. The target countries
63

did not run a large current account deficit (Table A2). Finally, all of the target economies

had low and stable inflation both before and after the crisis.

However, many member countries of the ERM did have a fundamental problem of high

unemployment. Authorities in member countries could not pursue expansionary policies to

help alleviate high unemployment rates as long as they remained committed to a fixed

exchange rate. Essentially, European countries with currencies pegged to the Deutsche mark

found themselves importing tight monetary policies from Germany which were unsuitable for

their weak economic conditions. High unemployment thus was the fundamental pressure on

the narrow band of the ERM, providing the essential fuel for the crises.

A remarkable fact about the ERM crises is that the “crisis” countries---those forced

to abandon their currency pegs---did better by almost any measure in the following period

than those that succeeded in defending their currencies. The United Kingdom, in

particular, experienced a rapid drop in its unemployment rate without any corresponding

rise in inflation. This underscores the harm to the domestic economy that can be caused by

forgoing exchange rate flexibility and the ability to conduct independent monetary policy,

and the good that can come from relaxing those constraints.

(2) The Mexican crisis of 1994-95.

The causes of the Mexican peso crisis in 1994-95 have been a topic of much

debate. For example, Dornbusch et al. (1995) assign heavy responsibility for the

Mexican crisis to poor macroeconomic management within the country, underscored by

the overvaluation of the peso exchange rate. In an alternative interpretation, Sachs et al.
64

(1996a, 1996b) argue that the overvaluation of the exchange rate played only an indirect

role; more important was creditor panic.

Underlying the debate is the fact that, prior to the crisis, international financial

conditions were generally stable and U.S. interest rates were moderate. Economic

reforms in Mexico and euphoria about the potential benefits of Mexico’s entering the

North American Free Trade Agreement (NAFTA) with Canada and the United States had

led to widespread enthusiasm for its economy, and attracted large capital inflows to the

country. However, Dornbusch et al. (1995) maintain that the peso was overvalued and

due for a large correction, citing the fact that the combination of a double-digit inflation

and the inflexible nominal exchange rate had resulted in a real appreciation of 36 percent

from 1988 to 1993 and the widening of the current account deficit to a staggering seven

percent of GDP by 1994.

Mexico’s fall from grace came suddenly in the second quarter of 1994, as

election-year instability rattled investors and capital inflows dropped sharply.40 The

sudden capital-flow reversals posed a serious threat to the economy, and the Bank of

Mexico expanded domestic credit in response. It also continued to peg the exchange rate,

after an initial modest depreciation. The result was a steady decline in reserves. After

the change of government in early December, investors’ fear of a plummeting peso led to

further capital outflows, and reserves dwindled further in mid-December, reaching

around $6 billion at their nadir (compared to $28 billion in February 1994). The currency

was devalued from December 19 to 22, and then allowed to float.

40 First, there was an armed rebellion in the state of Chiapas. Second, the presidential candidate of

the PRI was assassinated, there were accusations that the then president’s brother had something to do with it.
65

Immediately after the devaluation, international and domestic creditors started to

realize that the Mexican government was scheduled to repay around $28 billion of shortterm dollar-denominated debts (tesobonos) within the following few months, but had

only around $6 billion of reserves. Suddenly, Mexico was unable to borrow fresh funds

to service this debt. The government found itself illiquid, though not insolvent. (Its

solvency was reflected by the fact that $28 billion represented only around 10 percent of

Mexico’s pre-crisis GDP, a high but not crushing debt burden. Moreover, the budget was

roughly in balance.)

Thus, the Mexican government was pushed to the edge of default in early 1995.

To prevent that, the U.S. and the IMF led an emergency international loan to Mexico.

The Mexican government used the loan to retire tesobonos and was able to repay the loan

ahead of schedule in 1996. Mexican GDP growth collapsed in 1995 but recovered

strongly in 1996 and 1997.

Mexico was vulnerable to crises because of substantial economic imbalances, as

well as illiquidity (in the sense that short-term liabilities to foreigners exceeded shortterm assets.) That it is a developing economy (with problems of original sin and debt

intolerance) also contributed to its fragility.

(3) The Asian Crisis of 1997-1998.

Following years of stellar performances, the crisis countries in East Asia

(Thailand, Malaysia, Indonesia, the Philippines, and South Korea) experienced a plunge

in the exchange values of their currencies and a sudden reversal of private capital flows

from June 1997 onward. Investors had poured massive amounts of funds into the Asian

countries until the first half of 1997, before they drastically reversed the pattern in the
66

summer. The ensuing $100 billion net capital outflow---accounting for 10 percent of the

combined GDP of the five crisis-hit countries---exerted severe economic costs to those

countries.

East Asia was hit by several international macroeconomic shocks during 1994-96,

including a dramatic surge in the (price) competitiveness of rival economies such as

China and Mexico, and the abrupt reversal of the long-term trend of the yen’s

appreciation relative to the dollar. These shocks interacted with weaknesses in East Asian

financial systems to provoke the crisis. Each of the five crisis economies had initiated,

but had not completed, financial sector liberalization and reform. The partial reforms had

led to increasingly fragile financial systems, characterized by growing short-term foreign

debt, rapidly expanding bank credit, inadequate regulation and supervision of financial

institutions, and crony capitalism. These weaknesses, in turn, left the Asian economies

vulnerable to a rapid reversal of capital flows, even though other domestic factors that

tend to cause severe currency crises did not seem to apply here. (The crisis countries’

real exchange rates were, arguably, only mildly overvalued. Their overall debt-carrying

capacities did not seem to present imminent risks of default. Their government budgets

were basically in balance.) Once the capital withdrawals were underway, mistakes by

both Asian governments and the IMF further contributed to the panic and unnecessarily

deepened the crisis.

As in the case of the Mexico crisis of 1994-95, those five crisis countries were

vulnerable in part because of the weakness of their financial infrastructures, and in part

because their short-term liabilities to foreigners exceeded short-term assets. The still

incomplete reforms led to dramatic growth in the number of banks and their linkages to
67

the international economy, which in turn, increased the exposure of these economies to

international financial shocks by allowing a rapid buildup of short-term external debt into

weak financial systems. Large amount of foreign capital flowed into the region both

because East Asia’s successful track records attracted foreign credits, and because partial

financial market liberalization in the region made it easier for the entry of foreign capital.

The inflows rapidly appreciated the real exchange rates, expanded bank lending, and

increased vulnerability to a reversal in capital flows. When capital inflows did wane late

1996 and early 1997, a series of missteps by Asian governments, market participants and

the IMF resulted in a financial panic. The resulting crisis was much deeper than was

either necessary or inevitable.

Almost all of the major factors highlighted in section 3 of this paper played a role

in causing and spreading the Asian crisis. In particular, external shocks rendered

currency-peg regimes unsustainable, while precipitous capital-account liberalization

overwhelmed flawed (and weak) domestic financial regulation.41 The crisis countries

were also vulnerable because of problems of original sin and debt intolerance. On top of

all that, the initial conditions demanded by the IMF in exchange for providing bail-out

loans were wrong prescriptions for the sick, further exacerbating the situation. For

example, the IMF initially demanded that crisis countries cut the budget deficit (resulted

from the crisis-induced contraction), a contractionary policy response to the already hardhit economies, even though those countries did not have the problem of a large budget

deficit at the outset of the crisis (Table A2).

41 For example, see Radelet and Sachs (1998), Furman and Stiglitz (1998), Goldstein (1998),

Mishkin (1999).
68

Table A2. Severity and Fundamental Variables at the Onset of Some Crises

Crisis

Episodes

Severity

(two-sided

measure)

Current

Account /

GDP (%)

Fiscal

Balance /

GDP (%)

Total

External Debt

/ GDP (%) 1/

Non-FDI

Flow / GDP

(%)

Latin

American

Debt Crisis

(1979 - 1983)

-12.07 -6.09 -1.43 37.84 5.01

EMS Crisis

(1993) 3.86 -1.62 -5.99 -20.32 -0.44

Mexico

"Tequila"

Crisis (1994)

-6.41 -5.80 0.51 32.37 6.99

Asian Crisis

(1997) -22.01 -4.96 0.64 52.82 6.59

Brazil and

Russian

Crisis (1998 -

1999)

8.92 -2.16 -7.09 31.06 1.24

1/. “-” indicates external assets; “+” indicates external debt.
69

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