Exchange Rate Regimes and Currency Crises: an Evaluation using Extreme Value Theory

Abstract

Abstract We test whether the exchange regime in place has an impact on the vulnerability of countries to currencycrises. Our paper is distinguishable from others (i) in its use of extreme value theory to identify currencycrisis periods and (ii) in using two separate designations for the exchange regime in place. The first is theself-reported or announced exchange rate system. The second classification scheme, by Levy-Yeyati andSturzenegger, is based on the relative movements of international reserves and exchange rates. The Levy-Yeyati and Sturzenegger procedure is intended to reveal the actual as distinct from the “legal” exchangearrangement. We find, interestingly, that the announced exchange regime has an impact on the likelihoodof currency crises, while the “true” or observed regime does not. Announced pegged exchange regimesincrease the risk of currency crisis even if, in reality, the exchange rate system in place is not pegged. 1. Introduction The 1990s saw a large number of currency crises in both developed and emergingmarket economies. The most notable ones include the 1992/93 European ExchangeRate Mechanism (ERM) crisis, the 1994 Mexican Tequila crisis, the 1997 Asian crisisand the more recent crises in Russia, Brazil, and Argentina.These financial crises havehad devastating economic, social, and political consequences, mainly in emergingmarket economies. As a result, scholars and policymakers have re-intensified theirefforts to understand the causes and early symptoms of financial crises.Fischer (1999) and Krueger (1999), among others, blame fixed exchange rates forthe financial meltdowns observed over time. Fixed exchange regimes often lack cred-ibility and invite speculation against the pegged rate, in particular when unfavorableconditions arise. While short-term increases in real exchange rate volatility are likelyto result from a flexible monetary system, these scholars claim that the costs associ-ated with increases in exchange rate variability are lower when compared with thecosts incurred when speculators attack a pegged exchange rate system. As a mechan-ism to prevent crisis, adherents of this view advise countries to allow their currenciesto freely float.But the case has also been made that flexible exchange rates are the culprit forincreasing nations’ vulnerability to currency crises. McKinnon (2002) blames flexibleexchange rates for increasing risk premiums through increased volatility in theexchange rate. This gives rise to moral hazard problems for poorly regulated bankingsystems as bankers ignore those risks and succumb to the temptation to borrow in whatappears to be cheap foreign currency. McKinnon’s preference for well-managed fixedexchange regimes derives from his belief that as long as there is little concern of anexchange regime change, fixed exchange rates will result in lower risk premiums andbankers will face less temptation to increase their dollar liabilities.