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Can Open Capital Markets Help Avoid Currency Crises?

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Author Info
Gus Garita
Chen Zhou
Abstract

By proposing a measure for cross-market rebalancing effects, we provide new insights into the different sources of currency crises. We address three interrelated questions: (i) How can we best capture contagion; (ii) Is the contagion of currency crisis a regional or global phenomenon?; and (iii) By controlling for “cross-market rebalancing” do other mechanisms like "financial openness" increase the probability of a currency crisis? We introduce the concept of conditional probability of joint failure (CPJF) to measure the linkages of currency crisis intra- and inter-regionally. From estimating this measure, we test for contagion and conclude that contagion only exists regionally. Furthermore, we construct a “cross-market rebalancing” variable based on the regional CPJF. By employing a probit model to compare our new variable with a regular contagion variable often used in literature, we conclude that our new variable captures contagion better; moreover, it also captures cross-market rebalancing effects. When we properly account for these effects, then financial openness helps to diminish the probability of a currency crisis even after controlling for the onset of a banking crisis. We also show that monetary policy geared towards price stability reduces the probability of a currency crisis.

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Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 205.

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Date of creation: Feb 2009
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Handle: RePEc:dnb:dnbwpp:205

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Related research
Keywords: Crisis; Contagion; Cross-Market Rebalancing; Exchange Market Pressure; Extreme Value Theory; Financial Integration.;

Find related papers by JEL classification:
C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - General
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
F15 - International Economics - - Trade - - - Economic Integration
F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation

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