Emerging Markets Crises: Causes and Possible Remedies

Many emerging countries experience frequent and violent external crises, featuring large currency devaluations. Since these crises are often associated with recession and other dislocations, it is important to understand what causes currency crises. A very popular view among economists is that currency crises are an example of self-fulfilling expectations: they occur when individual market participants become worried that other market participants may be expecting a devaluation. When sufficiently many share this worry, a sell-off begins, leading market participants to make their own fears true.

CEP macro program member Bernardo Guimaraes casts serious doubts on this common wisdom. He shows that features of the data that are usually taken to support the self-fulfilling expectations view could also be explained by an alternative interpretation of currency crises. In this alternative interpretation, market participants expect the government to abandon the defence of the exchange rate when the rate reaches a certain threshold, and gradually learn about what this threshold is. But the learning interpretation also yields distinctive predictions about the behaviour of the probability and the expected magnitude of a currency devaluation. Using data on exchange rate options in the case of the end of the Brazilian pegged exchange rate regime, Bernardo finds empirical results that are consistent with his alternative theory of currency crises.

Another important question raised by the experience of emerging markets undergoing frequent crises is whether international financial institutions can be designed to attenuate some of the most adverse aspects of such episodes. A very frequent feature of emerging-market crises is debt default: countries declare a unilateral moratorium on their external debt. These debt defaults are usually extremely messy and often associated with severe recession. Some of Bernardo's work suggests that significant improvements to the global financial architecture are available. In particular, debtors and lenders should agree ex-ante to make the size of the debt contingent on the value of macroeconomic variables, such as world interest rates or domestic productivity.

To read more about Bernardo Guimaraes's research on emerging-market crises see:

• "US Real Interest Rates and Default Risk in Emerging Economies" [Full document in Adobe PDF] (Nathan Foley-Fisher and Bernardo Guimaraes), CEP Discussion Papers 0952, October 2009
  
  
• "Vulnerability of Currency Pegs: Evidence from Brazil" [Full document in Adobe PDF] (Bernardo Guimaraes), CEP Discussion Papers 0871, June 2008
  
  
• "Volatility and Development" [Full document in Adobe PDF] (Bernardo Guimaraes), CEP Discussion Papers 0847, February 2008