Currency Crises in Transition Economies: Some Further Evidence
Liargovas, Panagiotis, Dapontas, Dimitrios, Journal of Economic Issues
One of the biggest desires of policy makers around the world is to develop a warning system of currency crisis. Such a task requires their ability to analyze potential causes and symptoms of currency crises. Since the 1970s there have been numerous theoretical and empirical efforts to accomplish this task. Most of the empirical research focuses either on the developing Latin American and Asian countries or on the developed economies of the European Monetary System.
The recent transformation of communist economies to market economies coincided, in many of them (e.g., in Central and Eastern Europe, in the Commonwealth of Independent States and in the Baltic states), with the occurrence of currency crisis. But there is not much research of currency crises within the unusual environment of transition economies. Therefore, the predictive power of first, second or third generation models is questionable in the case of transition economies. The present work tries to cover this gap by concentrating on a subgroup of eight transition economies: Albania, Belarus, Bulgaria, Croatia, Macedonia, Moldova, Romania and Ukraine. A better understanding of the interrelationships between macroeconomic and other institutional, political and external factors provides transition economies with better understanding and guidance as to the type of policy needed to avoid currency crises.
The paper is constructed as following: the next section reviews previous theoretical and empirical research. This is followed by a discussion of the main macroeconomic problems and policy outcomes in the countries concerned. A description of the data and the variables used is provided in the fourth section. Section five presents the set of models and the results. Finally, in the last section we offer some concluding remarks.
Previous Theoretical and Empirical Research
The models of currency crises were built based on real events. The first generation models were developed after the balance of payments crisis in Mexico (1973-82), Argentina (1978-81), and Chile (1983). The second generation models were developed after speculative attacks in Europe and Mexico in the 1990s. Finally, the third generation models started after the Asian crisis in 1997-98. Transition economies in Central and Eastern Europe and the former Soviet Union offer additional empirical input that allows for re-examination of the existing theoretical models and accumulated empirical observations and verification of policy conclusions and recommendations proposed by other authors.
The research on currency crises first emerged in the economic literature in the late 1970s pioneered by Krugman (1979). According to him, under a fixed exchange rate system domestic credit creation in excess of money demand growth leads to a gradual but persistent loss of international reserves and, ultimately, to a speculative attack on the currency. The process ends with an attack because economic agents understand that the fixed exchange rate regime will ultimately collapse, and that in the absence of an attack they would suffer a capital loss of their holdings of domestic assets. Therefore, the first generation crisis occurs as a result of an expansionary macroeconomic policy incompatible with a pegged exchange rate. The collapse may happen when the "shadow floating exchange rate" becomes equal to the exchange rate peg. This is the equilibrium exchange rate prevailing after the full depletion of foreign reserves and forced abandoning of the peg.
A number of papers have extended Krugman's basic model in various directions (see, for example, Agenor, Bhandari and Flood 1991; Eichengreen, Rose and Wyplosz 1995; Blackburn and Sola 1993; Garber and Svenson 1994; Flood and Marion 1999; Edwards 1989; Grilli 1990; Cumby and Wijnbergen 1988; Harris and Raviv 1989; and Kamisky, Lizondo and Reinhart 1998). Some of these extensions concern active governmental involvement in crisis management and sterilization of reserve losses (Flood, Garber and Kramer 1996). …