Identifying the Role of Contagion in Currency Crises with Markov-Switching Models

Abstract

This paper analyzes the role of contagion in the currency crises in emerging markets during the 1990s. It employs a Markov-switching model to conduct a systematic comparison of three distinct causes of currency crises: contagion, weak economic fundamentals, and sunspots, i.e. unobservable shifts in agents’ beliefs. Testing this model empirically reveals that contagion, i.e. a high degree of real integration and financial interdependence among countries, is a core explanation for recent emerging market crises. The model has a remarkably good predictive power for the 1997–98 Asian crisis. The findings suggest that in particular the degree of financial interdependence and real integration among emerging markets are crucial not only in explaining past crises but also in predicting the transmission of future financial crises.