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Currency Crises and Output Dynamics

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Abstract

Output effects of currency crises are often estimated to be negative and persistent. A new banking crisis database allows us to construct pure currency collapses that are not associated with banking crises. The estimates show that countries facing a pure currency crisis have full recovery of output in the long-run while twin crisis leads to larger output losses. Allowing for long lags is a critical element in understanding the recovery dynamics. Further analysis reveals that there is a similar lag in the association between export growth and recovery dynamics.

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Notes

  1. Studies on currency crisis use a variety of definitions to measure crisis episodes that includes exchange rate depreciations/devaluations, foreign reserve losses and interest rate changes as outlined in Flood et al. (2010). Given the focus of our study, we mostly follow the Frankel and Rose (1996) method of using exchange rate depreciation to define the crises episodes. In this paper, we use the terms ‘large depreciation’, ‘large devaluation’, ‘currency crises’ and ‘currency collapse’ interchangeably.

  2. Lizondo and Montiel (1989) stress that it is hard to analytically argue that devaluations are always costly.

  3. Kaminsky (2008) provides an overview of the types of currency crises and intuition behind the models. Hutchison and Glick (2001) show that the banking crisis often leads currency crisis in financially liberalized emerging economies.

  4. A related study by Radelet and Sachs (1998) distinguishes between U shaped and V shaped recoveries. Lee and Park (2002) argue that real GDP growth in South Korea following the Asian crisis represents a V shaped recovery. However, as stressed by Hong and Tornell (2005), the recovery in just the growth rates will still result in a permanent output loss.

  5. Out of the 159 countries, 41 countries never experienced any currency crisis thereby forming our ‘control group’.

  6. Some studies like Hong and Tornell (2005), Cerra and Saxena (2008) also incorporate reserve losses in their definition of currency crisis. That definition also includes no devaluation episodes which will not affect the net exports through the expenditure switching channel.

  7. This specification is based on panel unit root test on real GDP data The Im et al. (2003) W statistics that relaxes the assumption of common unit root was 9.13. This implies we cannot reject the null hypothesis of unit root for GDP. Based on these results, we use growth rates of GDP when estimating our Eq. (1) and use cumulative impulse responses to examine dynamic level effects.

  8. This approach assumes that there is no anticipation of currency crisis effect on real GDP. However, in the tax and government spending context, Yang (2005) and Ramey (2011) show significant anticipation effect. Theoretically, anticipation effect in the currency crisis context can have positive or negative effects depending on the channel of transmission. However, as Krugman (1979) elaborates, arbitrage opportunities should limit the difference in timing between anticipation and actual event.

  9. We also estimated models with wider definitions of pure currency crisis by isolating banking crisis dates within 1 year of large depreciations. The results are very similar. The results are also robust to using private GDP as our output indicator as used in King et al. (1991). These estimates are available upon request.

  10. We have also experimented with a limited sample based on timing restriction of currency crisis episodes. We selected 49 currency crisis episodes that happened in either January or February. The possibility of reverse causality in these episodes were smaller since most of the current year growth in data happened after these episodes. The results are very similar to the full sample no contemporaneous feedback results. Cerra and Saxena (2008) also examined the role of endogeneity in detail using Probit models and bivariate equations. They found lower current growth can increase the chance of a crisis in the same year. This should make the possibility of upward bias in our results unlikely.

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Acknowledgments

The authors would like to thank the two anonymous referees, the editor George S. Tavlas, Ronald Balvers, Stratford Douglas and Andrew Young for comments and suggestions. Usual disclaimers apply.

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Authors and Affiliations

  1. Department of Economics, College of Business and Economics, West Virginia University, Box 6025, Morgantown, WV, 26506, USA

    Arabinda Basistha

  2. University of Wisconsin, La Crosse, La Crosse, WI, USA

    Sheida Teimouri

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  1. Arabinda Basistha
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  2. Sheida Teimouri
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Correspondence to Arabinda Basistha.

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Basistha, A., Teimouri, S. Currency Crises and Output Dynamics. Open Econ Rev 26, 139–153 (2015). https://doi.org/10.1007/s11079-014-9323-y

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