The contribution of economic and institutional factors to currency crises: Additional evidence from Asia, Europe and the western hemisphere

Many countries worldwide have experienced serious financial crises in recent years with high costs in terms of reduced income and increased unemployment to their own countries as well as others. Financial crises have taken three main forms, which are currency crises, banking crises, or both. Recent examples of financial crises include the European currency crises of 1992--1993, the Mexican crisis of 1994--1995, the Asian crisis of 1997--1998, the Russian crisis of 1998--1999, the Brazilian crisis of 1998--1999, and the Argentine crisis of 2001--2002.; The objective of this paper is to re-evaluate the causes of currency crises by focusing on the contribution of both economic and institutional factors to crises. Institutional factors are broadly conceived and range from activities like corruption, government stability, ethnic tension, and adherence to the rule of law to whether a country has capital controls, deposit insurance, or an independent central bank. A growing body of literature already recognizes the role played by institutions to economic growth and financial development. Because currency crises are closely linked with economic growth and financial development, it seems sensible to extend this work to currency crises.; The experience of Asia, Europe, and the western hemisphere between 1972 and 2002 will be investigated. A graphical event study and several multivariate probit models are used to identify the contributions of economic and institutional variables to the probability of a currency crisis. The relationship between the depth of a currency crisis and economic and institutional factors are also explored using panel OLS, seemingly unrelated regression, and fixed, random, and between effects estimation. Lastly, I explore differences in the average values of institutional factors based on the size of the contraction in real GDP.; The event study shows that for the most part, institutions such as government stability and law and order are weaker in the lead up to and following a currency crisis. Corruption, ethnic tensions, external conflict, and internal conflict also tend to be worse around the time of a crisis. My results generally confirm the hypotheses and to some extent support the anecdotal evidence from the event study that weak institutions may set the stage for currency crises. In multivariate probit regressions of currency crises, I find that institutional factors play a role both in the probability of a currency crisis and in the depth of the contraction in output over the crisis period. My results show that corruption, deposit insurance, a fixed exchange rate regime, low levels of government stability, and low levels of law and order increase the likelihood of a currency crisis. These factors are also key factors in the depth of a crisis, as measured by the decline in real GDP per capita relative to trend. Finally, I find evidence that countries with more corruption, ethnic tensions, external conflict, and internal conflict have bigger contractions in output, and those countries with lower bureaucratic quality, government stability, and law and order have larger contractions in output.