Common Elements in Financial Crises

A crisis is most likely to spread to countries with the following flaws: little in the way of cash reserves to defend their currency, weak banks, and a recent history of sharp currency appreciation.

The two big financial meltdowns of the 1990s--the Mexico or "Tequila" crisis of 1995 and the Asian crisis of 1997--brought with them the notion that in today's global economy, countries can be severely punished merely for the crime of proximity. But in Common Fundamentals in the Tequila and Asian Crises (NBER Working Paper No. 7139), NBER Research Associate Aaron Tornell argues instead that if one studies the historic record, a pattern emerges: while it's hard to predict which country will be the next Mexico -- or, in the case of Asia, the next Thailand -- it is possible to forecast which countries are most likely to be targeted when a crisis erupts. He asserts that a crisis is most likely to spread to countries with the following flaws: little in the way of cash reserves to defend their currency, weak banks, and a recent history of sharp currency appreciation. Conversely, Tornell finds that countries with high reserves or with strong banks and only mild currency appreciation are likely to be spared.

Tornell concludes "that the Tequila and Asian crises did not spread across emerging markets in a purely random way... a crisis will spread to countries that are vulnerable. A country is vulnerable to an attack if it has had an appreciated real exchange rate for the past few years, or it has experienced a lending boom, thus increasing the likelihood that its banking system is laden with bad loans."

Tornell does not completely discount an emotional element to the currency attacks. He sees the initial crisis as something that makes investors generally pessimistic, prompting them to be more suspicious of other countries' weaknesses. He also believes that investors exhibit a certain amount of herd behavior, with individual money managers initiating an attack in part because they expect their colleagues around the world to do the same.

But while investors may be somewhat motivated by fear, their attacks are rational events, Tornell believes. As a crisis unfolds, money managers merely look at the same economic data and reach identical--and sound--conclusions. In certain countries, the banks are so weak, reserves so low, and the exchange rate so high that a run on the currency would leave the government with almost no choice but to devalue.

For example, Tornell observes that in the four years preceding the Tequila crisis, Peru experienced a similar appreciation and a greater lending boom than Mexico. But it suffered far less during the crisis because it had the currency reserves required to deter an attack.

-- Matthew Davis