DP8612 130 years of fiscal vulnerabilities and currency crashes in advanced economies

Author(s): Marcel Fratzscher, Arnaud Mehl, Isabel Vansteenkiste
Publication Date: October 2011
Keyword(s): advanced economies, banking crises, currency crashes, exchange rates, fiscal vulnerability, foreign debt, reserve currencies, total debt level
JEL(s): F30, F31, N20
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8612

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.