Double Contagion: The Impact of Globalization and Exchange Rate Regime on Financial Fragility

We study the impact on financial fragility of globalization and a switch from managed to freely floating exchange rate regime in the context of a two-country multi-region model a la Allen and Gale (Journal of Political Economy, 2000) with open-economy monetary features of Chang and Velasco (Journal of Economic Theory, 2000). In this economy, both banking and exchange rate crises may develop. In contrast to Allen and Gale, we find that increased globalization, i.e. a more complete structure of links among regions, can increase financial fragility, if the smaller country maintains a floating exchange rate regime. Furthermore, in a globalized world a higher level of financial fragility may result from a switch to the floating exchange rate regime in the smaller country. The intuition behind these results is that the smaller economy with floating exchange rate regime ‘re-exports’ negative shocks to the neighboring region(s) of the larger economy via the exchange rate depreciation rather than absorbs them. These regions cannot follow suit, and so are more likely to suffer from the financial meltdown. These findings rationalize the phenomenon of ‘fear of floating’ in many emerging market economies in 1990s and 2000s.