Working Paper No. 366
By Mirko Licchetta
This paper investigates the role of external balance sheet variables as determinants of currency crises in emerging market (EME) and advanced economies. A random effect probit model is used in a panel of 40 countries with monthly data over the January 1980–December 2004 period. The main results of the paper are as follows. First, size and, particularly, the composition of a country’s external balance sheet are found to play an important role in the onset of crises. Second, EMEs seem to be more sensitive to external balance sheet variables than developed countries, and so too do economies with fixed or quasi-fixed exchange rate regimes. Third, further support is provided to standard theoretical explanations of currency crises. The likelihood of a crisis is found to increase with: the extent to which the real exchange rate rises above its trend; faster growth in broad money (relative to the level of international reserves); larger current account and budget balance deficits; lower GDP growth; and, if a neighbouring country already has a crisis. Economic fundamentals are also found to be a more important explanation of the onset of currency crises during the 1980s than during the 1990s, suggesting that more recent crises are less ‘fundamentally’ driven.