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On Determinants of the Depth of Currency Crisis: Fundamentals, Contagion, and Financial Liberalization

September 2002
Masazumi HATTORI

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This paper contains an empirical analysis of the "depth" of the Mexican Currency Crisis (1994-1995) and the East Asian Currency Crisis (1997). The purpose is to attempt to gauge the degree of impact of 1) deterioration in economic fundamentals and 2) the function of contagion channels on the above two crises.

Below is a summary of the main conclusions reached from this empirical analysis.

  • 1) The significance of economic statistics hitherto emphasized as important in currency crisis theory to explain the depth of a currency crisis differs from crisis to crisis. Just because a certain economic statistic has a high degree of explanatory power for one crisis does not necessarily mean that it will be significant to explain another.
  • 2) The hypothesis that "deterioration in fundamentals will exacerbate the depth of currency crisis only in those cases in which fundamentals are extremely poor and, at the same time, there is a high likelihood of liquidity drying up" can not be accepted for the East Asian Currency Crisis sample, but can be for the Mexican Currency Crisis.
  • 3) Contagion channels have been confirmed to have explanatory power. In particular, the addition of contagion channels for the East Asian Currency Crisis, where fundamentals have little explanatory power, substantially improves the explanatory power of the regression analysis.
  • 4) Economic fundamentals and contagion channels alone can not satisfactorily explain the depth of the currency crises experienced. We gave initial consideration to the potential correlation between financial liberalization and depth of currency crisis for several leading East Asian countries. Our findings indicate the possible existence of a relationship in which the crisis is deeper the greater the liberalization of international capital transactions.

These findings indicate that the way to minimize the impact of a currency crisis is to maintain sound domestic economic policies (IS balance, sound bank lending etc.) and strong external liquidity positions. The analysis in this paper also indicates the importance of the relationship between liberalization of international capital transactions and depth of currency crisis, although this has not yet been sufficiently analyzed.