BOFIT Discussion Papers, Institute for Economies in Transition, Bank of Finland
No 10/2001:
Currency Crises in Emerging Markets: Capital Flows and Herding Behaviour
Tuomas Komulainen ()
Abstract: This study shows that due to herding behaviour and
possible capital outflows, emerging market countries are vulnerable to
multiple equilibria situations and currency crises. It uses a model by
Jeanne (1997), where currency crises can be formed by multiple equilibria
and self-fulfilling expectations. We determine the country fundamentals
according to balance of payments approach. In this study we introduce
capital flows, which depend from crisis probability, into the model. The
capital flows are further assumed to follow herding behaviour, which
produces a reason and mechanism for the large capital outflows witnessed
during the recent crises. The range of country fundamentals, where
self-fulfilling crises are possible, is now larger than without capital
flows and herding behaviour. Consequently, the country fundamentals have to
be better, if the country wants to stay totally out of crises. The model
further points out lender interdependence as one shortcoming in the current
structure of international capital markets. An empirical application of the
model to the Mexican and Asian crises shows that when the possible capital
outflows are included, the fundamentals of most emerging market countries
were inside the range of multiple equilibria in 1994 and 1996, and so
self-fulfilling crises were possible.
61 pages, October 25, 2001
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