The Asian Currency Crises: Vulnerability, Contagion, or Unsustainability André Cartapanis, Vincent Dropsy, and Sophie Mametz* Abstract The Asian currency crises have been introduced by many economists as evidence that almost any country could be vulnerable to speculative attacks and to contagion effects, even with apparently good economic fundamentals.These financial crises have also been interpreted by other economists as rational market reac- tions to the unsustainability of domestic macroeconomic policies or structural weaknesses. The objective of this paper is to evaluate the relative importance of macroeconomic unsustainability, financial vulnerability, and crisis contagion in a model that explains and predicts the Asian currency crises. Out-of-sample forecasts based on two-stage panel and logit regressions provide evidence of a pure contagion effect, which signifi- cantly worsened the crises. They also show that Indonesia was the only one of the six Asian nations exam- ined (India, Indonesia, Malaysia, Philippines, South Korea,Thailand) that was in an unsustainable economic situation, and that the other five nations were only vulnerable to a currency crisis. 1. Introduction The financial crisis in East Asia has demonstrated the vulnerability of countries to spec- ulative attacks, despite their strong economic performance over the last three decades. While first-generation models of speculative attacks could describe most of the cur- rency crises of the 1980s, second-generation models focused on self-fulfilling expecta- tions and multiple equilibria in financial markets to explain the origins of the currency crises of the 1990s. The recent crisis is subject to the same choice of interpretations. Some economists argue that the collapse in international investor confidence in 1997 can be justified by news related to the unsustainability in economic fundamentals, first in Thailand, and by spillover effects for the rest of Asia. Others contend that the sever- ity of the financial and economic crisis cannot be rationalized by deteriorating macro- economic factors, but that the vulnerability of countries to speculative attacks and the contagion effects can explain why a currency crisis could erupt and spread in the fast- growing and apparently healthy Asian economies. Previous theoretical 1 and empirical 2 studies have distinguished between first- and second-generation models to explain currency crises. In contrast, we propose an em- pirical model of currency crisis, which differentiates between the notions of unsus- tainability, vulnerability, and contagion. By definition, a macroeconomic policy or situation is unsustainable if its indefinite continuation in the future renders the country (or its government) insolvent; i.e., if the present discounted value of its trade (or budget) surpluses is less than the current value of its external (or fiscal) debt. On the other hand, a country is rendered vulnerable to a financial crisis if a change in its macroeconomic policy or situation makes speculative attacks potentially successful. In this sense, the concepts of unsustainability and vulnerability are respectively related to the notion of stock and flow. This distinction is the basis for the specification of a Review of International Economics, 10(1), 79–91, 2002 © Blackwell Publishers 2002, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA *Cartapanis, Mametz: Centre d’Economie et de Finances Internationales, Université de la Méditerranée, Aix-Marseille II, Château La Farge, Route des Milles, 13290 Les Milles, France. Dropsy: California State University, Fullerton, CA 92834, USA.Tel/Fax: 1-714-278-3307; E-mail: dropsy@fullerton.edu.