Working Paper: CEPR ID: DP8612
Authors: Marcel Fratzscher; Arnaud Mehl; Isabel Vansteenkiste
Abstract: This paper investigates the empirical link between fiscal vulnerabilities and currency crashes in advanced economies over the last 130 years, building on a new dataset of real effective exchange rates and fiscal balances for 21 countries since 1880. We find evidence that crashes depend more on prospective fiscal deficits than on actual ones, and more on the composition of public debt (i.e. rollover/sudden stop risk) than on its level per se. We also uncover significant nonlinear effects at high levels of public debt as well as significantly negative risk premia for major reserve currencies, which enjoy a lower probability of currency crash than other currencies ceteris paribus. Yet, our estimates indicate that such premia remain small in size relative to the conditional probability of a currency crash if prospective fiscal deficits or rollover/sudden stop risk are high. This suggests that a currency?s international status is not necessarily sufficient to shelter it from collapse.
Keywords: advanced economies; banking crises; currency crashes; exchange rates; fiscal vulnerability; foreign debt; reserve currencies; total debt level
JEL Codes: F30; F31; N20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| actual fiscal deficits (H68) | increased probability of currency crashes (F31) |
| prospective fiscal deficits + banking crises (F65) | increased probability of currency crashes (F31) |
| rollover/sudden stop risk from foreign debt (F65) | increased likelihood of currency crashes (F31) |
| high levels of public debt (above 90% of GDP) (H69) | increased impact of fiscal deficits on crash probabilities (E62) |
| major reserve currencies (e.g., US dollar) (F31) | lower probability of crash (R48) |