Contagion Effects, Informational Effects, and Economic Fundamentals: An Analysis of Exchange Rate Dynamics during the Asian Currency Crisis

Abstract

This paper develops an empirical framework to determine if the Asian currency crisis was contagious, and if so, whether the contagion was warranted or unwarranted. By applying a monetary-portfolio model to monthly data for 1991-1998, our results show that short-run variations in exchange rates were largely unexplained by macroeconomic fundamentals. The regime shift in our model suggests that informational effects had a major impact. For example, the collapse of the Thai baht released information for economic agents to reassess the stability of other currencies. Moreover, there were excessive correlations between exchange rates, even after controlling for the influence of fundamentals. All these indicate that the Asian currency crisis was contagious. However, further analysis of the residuals and classification of economies based on cluster analysis together indicate that the Thai baht crisis spread to economies with similar economic conditions. This finding supports the hypothesis of warranted contagion, i.e. the spread of a crisis is not entirely random and dependent on fundamentals.