Why Are Currency Crises Contagious? A Comparison of the Latin American Crisis of 1994-1995 and the Asian Crisis of 1997-1998

Abstract

This paper analyzes three channels through which currency crises are transmitted between countries: contagion based on unsustainable economic fundamentals; contagion resulting from herding behaviour in financial markets; contagion induced by close trade integration. The presented model that links currency crises with these three types of contagion is employed to analyze the transmission of the Mexican crisis in 1994-1995 and the Thai crisis in 1997 to other emerging economies. The empirical results show that, first, the most important contagion channels were based on close financial and trade integration rather than on the weakness of macroeconomic fundamentals. Second, the vulnerability to capital flow reversals and weak financial sectors made countries particularly prone to a currency crisis, while external imbalances and currency misalignments were much less important. JEL no. F30, E60, E65, E44.