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Can Open Capital Markets Help Avoid Currency Crises?

  • Gus Garita
  • Chen Zhou

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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