How Much Does Trade and Financial Contagion Contribute to Currency Crises? The Case of Korea

Abstract

The prime task of modelling cross-market is to predict the imminence of a pestilent currency crisis. Empirical models are developed here to study the roles and channels of contagion in exchange rate volatilities, in ways in which are as economically sound and econometrically simple as possible. Korea is used as the susceptible and eight adjacent economies as the potential infective. Two channels of contagion are investigated ? trade linkage and financial market linkage. Two key features of the latter channel are carefully specified ? the changing degrees of infectiveness of a neighbouring economy due to its changing capital mobility, and the changing intensity of currency speculation in response to the changing vulnerability of the susceptible. By using monthly data prior to the 1997 Korean won crisis, the models predict a looming currency collapse. Since the respective roles of major internal and external factors which propagate shocks to the won rate are carefully identified in the models, it is thus manifest that contagion indeed played a major role in the won collapse, that financial contagion was the main culprit whereas trade contagion played only a minor part, and that the susceptible is especially prone to shocks from economies which are structurally similar to or weaker than it.