A Large Speculator in Contagious Currency Crises

Abstract

This paper studies the implications of the presence of a large speculator like George Soros during a contagious currency crisis. The model proposes a new contagion channel and shows how a currency crisis can spread from one country to another even when these countries are totally unrelated in terms of economic fundamentals. This model enables us to distinguish between whether a crisis is a coincidence or due to contagion when it happens in two countries. It finds that the better the economic fundamentals in the originating crisis country, the more severe the contagion under certain conditions. The large speculator is more aggressive in attacking the currency peg than he would be if his size were small. Furthermore, the mere presence of the large speculator makes other small speculators more aggressive in attacking the currency peg, which in turn makes countries more vulnerable to currency crises. But surprisingly, the presence of the large speculator mitigates contagion of crises across countries. The model presents policy implications as to financial disclosure and size regulation of speculators such as hedge funds, which recently have been hot topics among policy makers. First, financial disclosure by speculators eliminates contagion, but may make countries more vulnerable to crises. Second, regulating the size of speculators (e.g., prohibiting hedge funds from high-leverage and thereby limiting the amount of short-selling) makes countries less vulnerable to crises, but makes contagion more severeContagion; Currency Crises; George Soros; Global Game