The Contribution of Domestic and External Factors to Emerging Market Devaluation Crises: An Early Warning Systems Approach

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Abstract
In this paper, a modified "early warning system" (EWS) approach is developed to identify the roles of domestic and external factors in emerging market crises. Several probit models of financial crises were estimated for 26 emerging market countries. These models were used to identify the separate contributions to the probabilities of crisis of domestic and external variables. We found that, relative to domestic factors, adverse external shocks and large external imbalances contributed little to the average estimated probability of crisis in emerging market countries, but accounted for much more of the spikes in the probability of crisis estimated to occur during actual crisis years. We interpret these results to suggest that while, on average over time, domestic factors have tended to contribute to much of the underlying vulnerability of emerging market countries,adverse swings in external factors may have been important in pushing economies "over the edge" and into financial crisis. In consequence, the costs of giving up exchange rate flexibility through adoption of strongly fixed exchange rate regimes-e.g., currency boards or dollarization-may be quite high for some countries.