Is there a causal link between currency and debt crises?

Abstract

Though currency and debt crises quite often occur simultaneously, the links between these two types of crises are not well understood. We review how currency and debt crises could be related due to (1) common causes, (2) internal contagion effects from one crisis to the other, and (3) complementary budget financing aspects. The relationship between currency and debt crises is illustrated with a small theoretical model. Using panel data for 80 countries over the period 1975-2000, we analyze the relationship between currency and debt crises empirically in two steps. First, we investigate the determinants of each crisis separately. Second, we estimate links between both crises employing instrumental variables techniques. We find that, while there is a negative lagged influence of currency crises on debt crises, the occurrence of a currency crisis significantly increases the risk of a contemporaneous debt crisis and vice versa. Both types of crises are significantly more likely if the debt burden is higher.