## The Changing Nature of Currency Crises

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---

### Globalization and the changing nature of crises
- Net private capital flows to developing countries rose steeply in the first half of the 1990s, with the largest capital flows in the 1990s being in equity and portfolio investments rather than bank lending; just ten countries received about 80 percent of total net private capital flows to developing countries.
- Globalization increased the role of the capital account in crises: changes in expectations or investor sentiment can induce sudden, sharp reversals in capital flows that precipitate currency crises.
- With larger capital flows, crises can occur more rapidly, tend to be more severe, less predictable, come in waves, and be regional.
- Global financial integration can reduce incentives for information gathering and strengthen herd behavior in contexts of imperfect and asymmetric information.
- Herd behavior and fads in mature markets have expanded in scope with increased international integration.

### Channels and mechanisms of contagion
- Common shocks:
  - Examples: steep rise in world interest rates; sharp slowdown in world aggregate demand; decline in commodity prices; large changes in exchange rates between major currencies.
  - Interaction of a common shock with domestic fundamentals can induce simultaneous pressures on multiple currencies.
- Trade spillovers:
  - A significant depreciation in one country can improve its price competitiveness, causing trade diversion and income effects that depress exports of trade partners.
  - Effects operate through direct bilateral trade, price competition, and income repercussions in third markets.
- Financial linkages (portfolio rebalancing and liquidity effects):
  - Investors rebalance portfolios for risk management or liquidity, selling assets correlated with those in the crisis country or selling liquid assets to meet margin calls.
  - Assets highly represented in portfolios may be sold disproportionately, producing outflows from otherwise sound economies.
- Shifts in investor sentiment:
  - A crisis can be a “wake-up call,” prompting a reassessment of fundamentals and increased risk aversion.
  - Speculative attacks can arise when investors expect others to sell; risks are greater with large shares of short-term obligations and maturity mismatches.
  - Low international reserves relative to short-term external debt or banking sector liabilities signal vulnerability.

### Incidence and characteristics of crises in the 1990s
- Currency crises in emerging markets were about double the incidence of industrial countries during the past two decades, but crisis frequency in emerging markets shows no marked trend; the nature, however, changed.
- Crisis identification method:
  - An index of speculative market pressure = weighted average of (detrended) monthly exchange rate changes and reserve changes (weights chosen so conditional variances equal).
  - Threshold set at 1.645 times pooled standard deviation plus pooled mean (so 5 percent of monthly index values exceed threshold if normally distributed).
  - Countries with index values exceeding threshold within six months of episode starts were classified as experiencing crises.
- Crisis episodes and counts (period: 1990–98; sample: over 60 industrial and emerging market economies):
  - ERM episode (September 1992–February 1993): 16 economies experienced substantial currency pressures.
  - Mexican episode (December 1994–May 1995): 9 economies.
  - Asian episode (July–December 1997): 10 economies.
  - Russian episode (August–November 1998): 13 economies.
- Average incidence:
  - In other six-month windows in the 1990s, on average under six countries (about 10 percent of the sample) suffered significant currency market pressures.
  - During ERM and Russian crises about 30 percent of sample countries experienced currency pressures; during Mexican and Asian crises 15–20 percent were affected.
- Financial market indicators during crises:
  - Short-term interest rates:
    - Sweden was raised to over 80 percent (on average) during September 1992.
    - Indonesian short-term rate peaked at 81 percent in August 1998.
    - The Russian three-month interbank rate reached 140 percent in September 1998.
  - Equity markets:
    - Italy and Sweden stock prices fell about 10 percent in September 1992.
    - Peruvian stock prices declined by over 30 percent after the Mexican crisis onset.
    - Hong Kong stock market fell by about 20 percent after Mexican crisis.
    - During the Asian crisis, Brazil and Hong Kong SAR stock markets declined by over 30 percent.
    - Indian stock market dropped about 17 percent.
    - Korean, Indonesian, Malaysian, and Thai stock prices fell by over 40 percent in many cases.
    - In the aftermath of the Russian crisis, stock prices in all but six countries in the sample fell by at least 10 percent, while Russian stocks declined by over 30 percent in August 1998 but rallied thereafter (in ruble terms).
  - Emerging market sovereign bond yield spreads:
    - Spreads jumped by about 10 percentage points after the Mexican and Russian crises.
    - Spreads rose by about 3 percentage points during the ERM and Asian crises.
    - After floating of the Thai baht, spreads rose by more than 5 percentage points during the second half of 1997 in some afflicted Asian economies.

### Characteristics of countries vulnerable to contagion (key variables and empirical differences)
- External position indicators:
  - Three-year real exchange rate appreciation: crisis emerging market economies exhibited almost 15 percentage points larger appreciation on average than noncrisis emerging market economies.
  - Current account deficit in year before crisis: over 2 percentage points of GDP larger on average in crisis countries for both industrial and emerging market economies.
  - Short-term external debt ratios (emerging markets):
    - Short-term external debt as percent of total external debt: 6 percentage points higher in crisis economies.
    - Ratio of short-term debt to reserves in year before crisis: almost 200 percentage points higher in crisis economies compared with noncrisis economies.
- Domestic macroeconomic indicators:
  - Ratio of broad money (M2) to international reserves: in emerging market crisis economies, this ratio in the year before the crisis was 30 percentage points higher on average than in noncrisis economies.
  - Real short-term interest rate in the year before the crisis: 4 percentage points higher in crisis countries than noncrisis countries.
  - GDP growth in year before crisis:
    - Industrial crisis countries: output growth was over 1 percentage point lower on average than in noncrisis industrial countries; before ERM crisis the difference was 2 percentage points.
    - Emerging market differences in growth were smaller.
  - Unemployment: for industrial countries before ERM crisis, unemployment rates were 4 percentage points higher on average in crisis countries.
  - Banking crises:
    - "All of the industrial countries and two-thirds of the Latin American countries that had a banking crisis in the year prior to a global currency crisis suffered currency market pressure."
    - For other emerging market economies, banking crises were less predictive—only 11 percent of countries with a banking crisis the prior year suffered currency market pressure the following year.
- Trade spillovers and competitiveness:
  - Implied appreciation of real exchange rate and implied slowdown of export market growth were larger, on average, for crisis countries; especially relevant during the Asian crisis for emerging markets and for industrial countries during several crises.
- Financial market linkages (common creditor effects):
  - Common creditor variables were significantly higher in crisis emerging market economies.
  - On average, common creditor held a 10 percentage point higher share of external bank liabilities of crisis countries than of noncrisis countries; average crisis country held a 5 percentage point higher share of the external loan portfolio of the common creditor than the average noncrisis country.
  - Mutual-importance variable (product of shares) almost always higher for crisis emerging market economies.
  - Interpretation: primary creditors to initial crisis countries tend to reassess and rebalance portfolios, causing withdrawals from other borrowing countries—helping explain regional bunching of crises.
- Composite indicators (method and results):
  - Composite indicators constructed to conserve degrees of freedom: external imbalances, domestic macroeconomic imbalances, trade spillovers, portfolio-management spillovers (common creditor variable + short-term as % of BIS bank debt), and reserve adequacy (M2/reserves and short-term external debt/reserves).
  - Findings (differences measured in standard deviations between crisis and noncrisis countries):
    - Indicators of external imbalances, reserve adequacy, portfolio-management spillovers, and trade spillovers were higher on average for crisis countries than noncrisis ones.
    - The domestic macroeconomic imbalances indicator, when examined in isolation, was not significantly different on average between crisis and noncrisis countries; however, domestic imbalances became important when combined with slow GDP growth and other indicators.
  - Econometric pooled probit analysis (emerging markets, Mexican/Asian/Russian crises):
    - Domestic macroeconomic imbalances mattered in identifying crisis-susceptible countries when associated with slow GDP growth.
    - External imbalances were particularly important for emerging markets and during the Asian and Russian crises.
    - Reserve adequacy and portfolio-management spillovers were strong indicators of currency market pressure for emerging market economies; trade spillovers were particularly important for the Asian crisis.

### Why some pressures lead to crashes and others do not
- Determinants of whether contagion leads to a currency crash:
  - Strength of economic fundamentals.
  - Firmness and credibility of market sentiment about government ability and willingness to defend the exchange rate.
  - Policy response and its perceived credibility given current and prospective economic conditions.
- Case study implication: Brazil
  - Brazil successfully repelled contagion during October 1997 (Asian crisis) by credible interest-rate defense while growth was strong.
  - Later in 1998, with slowing growth and unresolved fiscal weaknesses, markets judged defenses insufficient; contagion led to a crisis.
- Conclusion: contagion need not result in a crash; success in countering contagion depends on economic/financial strength, policy responses, and market perceptions.

### Policy implications and recommendations (derived from empirical findings)
- Strengthen domestic fundamentals:
  - Avoid significant exchange rate overvaluation; pursue fiscal and monetary policies consistent with exchange rate commitments.
  - Address external imbalances that can make economies vulnerable to sudden reversals in capital flows.
- Financial sector resilience:
  - Strengthen banking and financial systems to reduce fragility.
  - Monitor and manage maturity structure and currency composition of debt (public and private).
  - Consider prudential standards to limit short-term borrowing by domestic banks; monitor maturity structure of public debt.
- Reserves and short-term debt management:
  - Focus on the ratio of short-term debt to international reserves (not just levels of short-term debt).
  - Limit accumulation of short-term external debt and consider maintaining adequate international reserves—recognizing costs of reserve accumulation.
  - Need international arrangements to provide sufficient international liquidity to help countries manage large-scale crises from sudden investor sentiment shifts.
- Exchange rate regime considerations:
  - Freely floating exchange rates may be attractive, but not suitable for all countries (issues: excessive volatility; nominal anchor benefits of a peg).
  - Important to have a strategy to adjust a peg in an orderly fashion as part of an overall adjustment policy package.
  - Currency boards can be attractive in some cases but are demanding and not universally appropriate.
  - Intermediate approaches: wider bands around central parities with active intervention within the band.
- Capital controls:
  - Some tentative evidence that capital controls reduced the probability of suffering a crisis during the Mexican and Asian crises, but they were less effective during the global withdrawal following the Russian crisis.
  - Evidence is tentative due to measurement limitations (presence/absence indicator, no distinction between inflow vs outflow controls, data limitations after 1995).
- Systemic and international measures:
  - Improve international lender-of-last-resort mechanisms, mechanisms for private sector involvement in crisis resolution, adoption of international standards (banking, accounting, securities markets, bankruptcy), appropriate exchange rate arrangements, improved multilateral surveillance, and data dissemination.

### Box 3.1. Recent Experience with Exchange-Rate-Based Stabilizations

- Overview and theoretical background:
  - Exchange-rate-based stabilization programs have been widely studied; a recent review is Calvo and Végh, “Inflation Stabilization and BOP Crises in Developing Countries,” NBER Working Paper 6925 (February 1999).
  - Expansionary effects of exchange-rate-based stabilization programs have been attributed to:
    - demand effects resulting from inflation inertia, lack of credibility, and timing of purchases of consumer durables;
    - supply effects stemming from responses of labor supply and investment.
  - Many theoretical and empirical studies focus on stabilizations undertaken until the mid-1980s; see also “The Rise and Fall of Inflation—Lessons from the Postwar Experience,” Chapter VI in the October 1996 World Economic Outlook.

- Recent experiences and risks:
  - Common pattern during the first three years of programs:
    - marked tendency for the domestic currency to appreciate in real terms;
    - concomitant increase in the external current account deficit.
  - Financing and vulnerability:
    - The external current account deficits were generally financed by substantial capital inflows, which often permitted international reserves to be maintained or even increased.
    - These inflows implied a considerable buildup in external liabilities, increasing dependence on international capital markets and vulnerability to sudden reversals in capital flows.
  - Currency crises linked to policy inconsistencies:
    - Severe currency crises occurred where economic policies were inconsistent with the exchange rate regime: Mexico (collapse of the peso, December 1994), Russia (collapse of the ruble, August 1998), and Brazil (collapse of the real, January 1999).
    - Policy slippages played an important role in each case:
      - Mexico: crisis followed accommodating monetary policy and a strong expansion of credit inconsistent with the exchange rate anchor.
      - Russia: long-standing failure to bring the fiscal situation under control led to unsustainable levels of public debt and debt-service payments.
      - Brazil: efforts to cut the public sector deficit and reduce public debt encountered opposition and delays in Congress.
    - These crises were costly for credibility and were followed by rising inflation and plummeting output.
  - Many programs did not end in currency crashes:
    - In half of the non-crash cases, consistency was ensured by currency board arrangements (Argentina, Estonia, Lithuania, and Bulgaria). Currency boards fix the exchange rate and limit issuance of domestic currency to central bank foreign exchange holdings, eliminating independent monetary policy after stabilization.
    - In the other half, policy consistency was partly achieved by accepting some exchange rate flexibility (examples: Poland, Uruguay, Nicaragua, Croatia). However, without supporting economic policies, allowing some exchange rate flexibility was often insufficient to prevent a crash.
    - Prior to collapse, Mexico, Russia, and Brazil had moved to more flexible regimes but not sufficiently to avoid crisis given other policy shortcomings.

- Major exchange-rate-based stabilization programs since the late 1980s — selected country statistics:
  - Table entries (preserve all numeric values exactly):
    - Mexico — December 1987 — Peg, crawling peg, widening band — 143.7 — 29.9 — 18.6 — Yes (December 1994)
    - Poland — January 1990 — Peg, crawling peg, crawling band — 639.6 — 39.9 — 8.6 — No
    - Uruguay — December 1990 — Crawling band — 129.8 — 52.9 — 8.6 — No
    - Nicaragua — March 1991 — Peg, crawling peg — 20,234.3 — 3.4. . . — No
    - Argentina — April 1991 — Currency board — 267.0 — 4.3 — 0.7 — No
    - Estonia — June 1992 — Currency board — 1,085.7 — 29.2 — 4.4 — No
    - Croatia — October 1993 — Asymmetric peg, managed float — 1,869.5 — 4.0 — 5.3 — No
    - Lithuania — April 1994 — Currency board — 188.8 — 8.4 — 2.4 — No
    - Brazil — July 1994 — Peg, crawling peg — 4,922.6 — 6.1 — 0.4 — Yes (January 1999)
    - Russia — July 1995 — Band, crawling band — 226.0 — 5.5 — 66.8 — Yes (August 1998)
    - Bulgaria — July 1997 — Currency board — 1,471.9 — . . . — 3.2 — No
  - Notes from the table:
    - "In countries where the 12-month inflation rate was above 100 percent at the beginning of the stabilization program."
    - "Where more than one arrangement is listed, the sequence of arrangements is indicated."
    - For Russia, the 12-month inflation figure "In 1998" uses November 1997–November 1998.
    - Definition of "currency crash" used here: a nominal depreciation of the domestic currency of at least 25 percent in a year, along with a 10 percent increase from the previous year in the rate of depreciation. This excludes a priori instances where a currency came under severe pressure but the authorities were able to defend it.

- Aggregate indicators around stabilization (selected patterns):
  - Typical directional patterns observed in averages (with two-standard-error bands) included:
    - Sharp declines in inflation percent a year after stabilization launch.
    - Initial real effective exchange rate appreciation (stabilization year = 100 baseline).
    - Increases in international reserves (months of imports) in many cases, though heterogeneity exists.
    - Builds in total external debt (percent of GDP) and in the ratio of external debt to international reserves in some countries.
    - Mixed real output growth (percent a year) outcomes across countries.
    - Worsening current account balance (percent of GDP) in the first years for many programs.
    - Fiscal balance (percent of GDP) and short-term external debt (percent of total external debt) exhibited varied trajectories.
    - Ratio of M2 to international reserves showed increases in several cases, indicating potential reserve adequacy concerns.

- Policy implications and recommendations:
  - Disciplined macroeconomic policies are essential to support an exchange rate anchor and ensure program success.
  - Two strategic choices after stabilization:
    - Make a long-term binding commitment to a fixed exchange rate (e.g., currency board), accepting the loss of independent monetary policy; or
    - Allow for some degree of exchange rate flexibility later, but ensure the degree of flexibility is sufficient to be consistent with fiscal and monetary policies being implemented.
  - Financial sector strength:
    - Effective supervision and regulation of financial systems is crucial to reduce crisis risk.
    - Open capital markets provide substantial benefits but can constrain national policies and facilitate excessive borrowing.
    - In some instances, limiting short-term capital inflows via taxes on capital imports, foreign deposit reserve requirements, or similar measures can be considered.
  - Exchange rate flexibility can help deter excessive buildup of uncovered foreign currency debt by making exchange rate risk a two-way bet, potentially reducing some short-term capital inflows and lessening the need for abrupt corrections.
  - Countries with weak fundamentals or financial vulnerabilities in one or more dimensions are more likely to be susceptible to contagion and intensive foreign exchange market pressures.

*Source: IMF chapter “The Changing Nature of Currency Crises” (excerpt provided).*

### 3.6  percent  of  developing  country  GDP.  The  largest

### The Changing Nature of Currency Crises

### Globalization and the changing nature of crises
- Net private capital flows to developing countries rose steeply in the first half of the 1990s, with the largest capital flows in the 1990s being in equity and portfolio investments rather than bank lending; just ten countries received about 80 percent of total net private capital flows to developing countries.
- Globalization increased the role of the capital account in crises: changes in expectations or investor sentiment can induce sudden, sharp reversals in capital flows that precipitate currency crises.
- With larger capital flows, crises can occur more rapidly, tend to be more severe, less predictable, come in waves, and be regional.
- Global financial integration can reduce incentives for information gathering and strengthen herd behavior in contexts of imperfect and asymmetric information.
- Herd behavior and fads in mature markets have expanded in scope with increased international integration.

### Channels and mechanisms of contagion
- Common shocks:
  - Examples: steep rise in world interest rates; sharp slowdown in world aggregate demand; decline in commodity prices; large changes in exchange rates between major currencies.
  - Interaction of a common shock with domestic fundamentals can induce simultaneous pressures on multiple currencies.
- Trade spillovers:
  - A significant depreciation in one country can improve its price competitiveness, causing trade diversion and income effects that depress exports of trade partners.
  - Effects operate through direct bilateral trade, price competition, and income repercussions in third markets.
- Financial linkages (portfolio rebalancing and liquidity effects):
  - Investors rebalance portfolios for risk management or liquidity, selling assets correlated with those in the crisis country or selling liquid assets to meet margin calls.
  - Assets highly represented in portfolios may be sold disproportionately, producing outflows from otherwise sound economies.
- Shifts in investor sentiment:
  - A crisis can be a “wake-up call,” prompting a reassessment of fundamentals and increased risk aversion.
  - Speculative attacks can arise when investors expect others to sell; risks are greater with large shares of short-term obligations and maturity mismatches.
  - Low international reserves relative to short-term external debt or banking sector liabilities signal vulnerability.

### Incidence and characteristics of crises in the 1990s
- Currency crises in emerging markets were about double the incidence of industrial countries during the past two decades, but crisis frequency in emerging markets shows no marked trend; the nature, however, changed.
- Crisis identification method:
  - An index of speculative market pressure = weighted average of (detrended) monthly exchange rate changes and reserve changes (weights chosen so conditional variances equal).
  - Threshold set at 1.645 times pooled standard deviation plus pooled mean (so 5 percent of monthly index values exceed threshold if normally distributed).
  - Countries with index values exceeding threshold within six months of episode starts were classified as experiencing crises.
- Crisis episodes and counts (period: 1990–98; sample: over 60 industrial and emerging market economies):
  - ERM episode (September 1992–February 1993): 16 economies experienced substantial currency pressures.
  - Mexican episode (December 1994–May 1995): 9 economies.
  - Asian episode (July–December 1997): 10 economies.
  - Russian episode (August–November 1998): 13 economies.
- Average incidence:
  - In other six-month windows in the 1990s, on average under six countries (about 10 percent of the sample) suffered significant currency market pressures.
  - During ERM and Russian crises about 30 percent of sample countries experienced currency pressures; during Mexican and Asian crises 15–20 percent were affected.
- Financial market indicators during crises:
  - Short-term interest rates: example—Sweden was raised to over 80 percent (on average) during September 1992; Indonesian short-term rate peaked at 81 percent in August 1998; the Russian three-month interbank rate reached 140 percent in September 1998.
  - Equity markets: Italy and Sweden stock prices fell about 10 percent in September 1992; Peruvian stock prices declined by over 30 percent after the Mexican crisis onset; Hong Kong stock market fell by about 20 percent after Mexican crisis; during the Asian crisis, Brazil and Hong Kong SAR stock markets declined by over 30 percent; Indian stock market dropped about 17 percent; Korean, Indonesian, Malaysian, and Thai stock prices fell by over 40 percent in many cases; in the aftermath of the Russian crisis, stock prices in all but six countries in the sample fell by at least 10 percent, while Russian stocks declined by over 30 percent in August 1998 but rallied thereafter (in ruble terms).
  - Emerging market sovereign bond yield spreads:
    - Spreads jumped by about 10 percentage points after the Mexican and Russian crises.
    - Spreads rose by about 3 percentage points during the ERM and Asian crises.
    - After floating of the Thai baht, spreads rose by more than 5 percentage points during the second half of 1997 in some afflicted Asian economies.

### Characteristics of countries vulnerable to contagion (key variables and empirical differences)
- External position indicators:
  - Three-year real exchange rate appreciation: crisis emerging market economies exhibited almost 15 percentage points larger appreciation on average than noncrisis emerging market economies.
  - Current account deficit in year before crisis: over 2 percentage points of GDP larger on average in crisis countries for both industrial and emerging market economies.
  - Short-term external debt ratios (emerging markets):
    - Short-term external debt as percent of total external debt: 6 percentage points higher in crisis economies.
    - Ratio of short-term debt to reserves in year before crisis: almost 200 percentage points higher in crisis economies compared with noncrisis economies.
- Domestic macroeconomic indicators:
  - Ratio of broad money (M2) to international reserves: in emerging market crisis economies, this ratio in the year before the crisis was 30 percentage points higher on average than in noncrisis economies.
  - Real short-term interest rate in the year before the crisis: 4 percentage points higher in crisis countries than noncrisis countries.
  - GDP growth in year before crisis:
    - Industrial crisis countries: output growth was over 1 percentage point lower on average than in noncrisis industrial countries; before ERM crisis the difference was 2 percentage points.
    - Emerging market differences in growth were smaller.
  - Unemployment: for industrial countries before ERM crisis, unemployment rates were 4 percentage points higher on average in crisis countries.
  - Banking crises: for industrial countries and Latin America, a banking crisis in the year before a global currency crisis indicated vulnerability—“All of the industrial countries and two-thirds of the Latin American countries that had a banking crisis in the year prior to a global currency crisis suffered currency market pressure.” For other emerging market economies, banking crises were less predictive—only 11 percent of countries with a banking crisis the prior year suffered currency market pressure the following year.
- Trade spillovers and competitiveness:
  - Implied appreciation of real exchange rate and implied slowdown of export market growth were larger, on average, for crisis countries; especially relevant during the Asian crisis for emerging markets and for industrial countries during several crises.
- Financial market linkages (common creditor effects):
  - Common creditor variables were significantly higher in crisis emerging market economies.
  - On average, common creditor held a 10 percentage point higher share of external bank liabilities of crisis countries than of noncrisis countries; average crisis country held a 5 percentage point higher share of the external loan portfolio of the common creditor than the average noncrisis country.
  - Mutual-importance variable (product of shares) almost always higher for crisis emerging market economies.
  - Interpretation: primary creditors to initial crisis countries tend to reassess and rebalance portfolios, causing withdrawals from other borrowing countries—helping explain regional bunching of crises.
- Composite indicators (method and results):
  - Composite indicators constructed to conserve degrees of freedom: external imbalances, domestic macroeconomic imbalances, trade spillovers, portfolio-management spillovers (common creditor variable + short-term as % of BIS bank debt), and reserve adequacy (M2/reserves and short-term external debt/reserves).
  - Findings (differences measured in standard deviations between crisis and noncrisis countries):
    - Indicators of external imbalances, reserve adequacy, portfolio-management spillovers, and trade spillovers were higher on average for crisis countries than noncrisis ones.
    - The domestic macroeconomic imbalances indicator, when examined in isolation, was not significantly different on average between crisis and noncrisis countries; however, domestic imbalances became important when combined with slow GDP growth and other indicators.
  - Econometric pooled probit analysis (emerging markets, Mexican/Asian/Russian crises):
    - Domestic macroeconomic imbalances mattered in identifying crisis-susceptible countries when associated with slow GDP growth.
    - External imbalances were particularly important for emerging markets and during the Asian and Russian crises.
  - Reserve adequacy and portfolio-management spillovers were strong indicators of currency market pressure for emerging market economies; trade spillovers were particularly important for the Asian crisis.

### Why some pressures lead to crashes and others do not
- Determinants of whether contagion leads to a currency crash:
  - Strength of economic fundamentals.
  - Firmness and credibility of market sentiment about government ability and willingness to defend the exchange rate.
  - Policy response and its perceived credibility given current and prospective economic conditions.
- Case study implication: Brazil
  - Brazil successfully repelled contagion during October 1997 (Asian crisis) by credible interest-rate defense while growth was strong.
  - Later in 1998, with slowing growth and unresolved fiscal weaknesses, markets judged defenses insufficient; contagion led to a crisis.
- Conclusion: contagion need not result in a crash; success in countering contagion depends on economic/financial strength, policy responses, and market perceptions.

### Policy implications and recommendations (derived from empirical findings)
- Strengthen domestic fundamentals:
  - Avoid significant exchange rate overvaluation; pursue fiscal and monetary policies consistent with exchange rate commitments.
  - Address external imbalances that can make economies vulnerable to sudden reversals in capital flows.
- Financial sector resilience:
  - Strengthen banking and financial systems to reduce fragility.
  - Monitor and manage maturity structure and currency composition of debt (public and private).
  - Consider prudential standards to limit short-term borrowing by domestic banks; monitor maturity structure of public debt.
- Reserves and short-term debt management:
  - Focus on the ratio of short-term debt to international reserves (not just levels of short-term debt).
  - Limit accumulation of short-term external debt and consider maintaining adequate international reserves—recognizing costs of reserve accumulation.
  - Need international arrangements to provide sufficient international liquidity to help countries manage large-scale crises from sudden investor sentiment shifts.
- Exchange rate regime considerations:
  - Freely floating exchange rates may be attractive, but not suitable for all countries (issues: excessive volatility; nominal anchor benefits of a peg).
  - Important to have a strategy to adjust a peg in an orderly fashion as part of an overall adjustment policy package.
  - Currency boards can be attractive in some cases but are demanding and not universally appropriate.
  - Intermediate approaches: wider bands around central parities with active intervention within the band.
- Capital controls:
  - Some tentative evidence that capital controls reduced the probability of suffering a crisis during the Mexican and Asian crises, but they were less effective during the global withdrawal following the Russian crisis.
  - Evidence is tentative due to measurement limitations (presence/absence indicator, no distinction between inflow vs outflow controls, data limitations after 1995).
- Systemic and international measures:
  - Improve international lender-of-last-resort mechanisms, mechanisms for private sector involvement in crisis resolution, adoption of international standards (banking, accounting, securities markets, bankruptcy), appropriate exchange rate arrangements, improved multilateral surveillance, and data dissemination.

*Source: IMF chapter “The Changing Nature of Currency Crises” (excerpt provided).*

### Box 3.1.Recent Experience with Exchange-

### Box 3.1.Recent Experience with Exchange-Rate-Based Stabilizations

### Overview and theoretical background
- Exchange-rate-based stabilization programs have been widely studied; a recent review is Calvo and Végh, “Inflation Stabilization and BOP Crises in Developing Countries,” NBER Working Paper 6925 (February 1999).  
- Expansionary effects of exchange-rate-based stabilization programs have been attributed to:
  - demand effects resulting from inflation inertia, lack of credibility, and timing of purchases of consumer durables;
  - supply effects stemming from responses of labor supply and investment.
- Many theoretical and empirical studies focus on stabilizations undertaken until the mid-1980s; see also “The Rise and Fall of Inflation—Lessons from the Postwar Experience,” Chapter VI in the October 1996 World Economic Outlook.

### Recent experiences and risks
- Common pattern during the first three years of programs:
  - marked tendency for the domestic currency to appreciate in real terms;
  - concomitant increase in the external current account deficit.
- Financing and vulnerability:
  - The external current account deficits were generally financed by substantial capital inflows, which often permitted international reserves to be maintained or even increased.
  - These inflows implied a considerable buildup in external liabilities, increasing dependence on international capital markets and vulnerability to sudden reversals in capital flows.
- Currency crises linked to policy inconsistencies:
  - Severe currency crises occurred where economic policies were inconsistent with the exchange rate regime: Mexico (collapse of the peso, December 1994), Russia (collapse of the ruble, August 1998), and Brazil (collapse of the real, January 1999).
  - Policy slippages played an important role in each case:
    - Mexico: crisis followed accommodating monetary policy and a strong expansion of credit inconsistent with the exchange rate anchor.
    - Russia: long-standing failure to bring the fiscal situation under control led to unsustainable levels of public debt and debt-service payments.
    - Brazil: efforts to cut the public sector deficit and reduce public debt encountered opposition and delays in Congress.
  - These crises were costly for credibility and were followed by rising inflation and plummeting output.
- Many programs did not end in currency crashes:
  - In half of the non-crash cases, consistency was ensured by currency board arrangements (Argentina, Estonia, Lithuania, and Bulgaria). Currency boards fix the exchange rate and limit issuance of domestic currency to central bank foreign exchange holdings, eliminating independent monetary policy after stabilization.
  - In the other half, policy consistency was partly achieved by accepting some exchange rate flexibility (examples: Poland, Uruguay, Nicaragua, Croatia). However, without supporting economic policies, allowing some exchange rate flexibility was often insufficient to prevent a crash.
  - Prior to collapse, Mexico, Russia, and Brazil had moved to more flexible regimes but not sufficiently to avoid crisis given other policy shortcomings.

### Major exchange-rate-based stabilization programs since the late 1980s — selected country statistics
- Table fields: Country | Beginning Date | Exchange Rate Arrangement | 12-Month Inflation At start of program | 12-Month Inflation Third year of program | 12-Month Inflation In 1998 | Did the Program End in a Currency Crash?
- Country-level entries (preserve all numeric values exactly):
  - Mexico — December 1987 — Peg, crawling peg, widening band — 143.7 — 29.9 — 18.6 — Yes (December 1994)
  - Poland — January 1990 — Peg, crawling peg, crawling band — 639.6 — 39.9 — 8.6 — No
  - Uruguay — December 1990 — Crawling band — 129.8 — 52.9 — 8.6 — No
  - Nicaragua — March 1991 — Peg, crawling peg — 20,234.3 — 3.4. . . — No
  - Argentina — April 1991 — Currency board — 267.0 — 4.3 — 0.7 — No
  - Estonia — June 1992 — Currency board — 1,085.7 — 29.2 — 4.4 — No
  - Croatia — October 1993 — Asymmetric peg, managed float — 1,869.5 — 4.0 — 5.3 — No
  - Lithuania — April 1994 — Currency board — 188.8 — 8.4 — 2.4 — No
  - Brazil — July 1994 — Peg, crawling peg — 4,922.6 — 6.1 — 0.4 — Yes (January 1999)
  - Russia — July 1995 — Band, crawling band — 226.0 — 5.5 — 66.8 — Yes (August 1998)
  - Bulgaria — July 1997 — Currency board — 1,471.9 — . . . — 3.2 — No
- Notes from the table:
  - "In countries where the 12-month inflation rate was above 100 percent at the beginning of the stabilization program."
  - "Where more than one arrangement is listed, the sequence of arrangements is indicated."
  - For Russia, the 12-month inflation figure "In 1998" uses November 1997–November 1998.
  - Definition of "currency crash" used here: a nominal depreciation of the domestic currency of at least 25 percent in a year, along with a 10 percent increase from the previous year in the rate of depreciation. This excludes a priori instances where a currency came under severe pressure but the authorities were able to defend it.

### Aggregate indicators around stabilization (selected patterns)
- Recent exchange-rate-based stabilizations (sample: Mexico (1987), Poland (1990), Argentina (1991), Croatia (1993), Lithuania (1994), Brazil (1994), Russia (1995)) — centered on year of stabilization:
  - Typical directional patterns observed in averages (with two-standard-error bands) included:
    - Sharp declines in inflation percent a year after stabilization launch.
    - Initial real effective exchange rate appreciation (stabilization year = 100 baseline).
    - Increases in international reserves (months of imports) in many cases, though heterogeneity exists.
    - Builds in total external debt (percent of GDP) and in the ratio of external debt to international reserves in some countries.
    - Mixed real output growth (percent a year) outcomes across countries.
    - Worsening current account balance (percent of GDP) in the first years for many programs.
    - Fiscal balance (percent of GDP) and short-term external debt (percent of total external debt) exhibited varied trajectories.
    - Ratio of M2 to international reserves showed increases in several cases, indicating potential reserve adequacy concerns.

### Policy implications and recommendations
- Disciplined macroeconomic policies are essential to support an exchange rate anchor and ensure program success.
- Two strategic choices after stabilization:
  - Make a long-term binding commitment to a fixed exchange rate (e.g., currency board), accepting the loss of independent monetary policy; or
  - Allow for some degree of exchange rate flexibility later, but ensure the degree of flexibility is sufficient to be consistent with fiscal and monetary policies being implemented.
- Financial sector strength:
  - Effective supervision and regulation of financial systems is crucial to reduce crisis risk.
  - Open capital markets provide substantial benefits but can constrain national policies and facilitate excessive borrowing.
  - In some instances, limiting short-term capital inflows via taxes on capital imports, foreign deposit reserve requirements, or similar measures can be considered.
- Exchange rate flexibility can help deter excessive buildup of uncovered foreign currency debt by making exchange rate risk a two-way bet, potentially reducing some short-term capital inflows and lessening the need for abrupt corrections.
- Countries with weak fundamentals or financial vulnerabilities in one or more dimensions are more likely to be susceptible to contagion and intensive foreign exchange market pressures.

*Source: https://www.imf.org/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/weo/1999/01/_0599ch3pdf.pdf*

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_Source: https://www.imf.org/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/weo/1999/01/_0599ch3pdf.pdf_