Banking Crises, External Turmoil and the Role of Gross Foreign Investment Reversals

Financial crises are linked to large output declines, but the potential links between different types of crises remains unclear. To enhance understanding we study the interdependencies between domestic banking crises, on one hand, and external financial crises, including currency and sudden stop crises, on the other in a quarterly global panel. We further ask how the different crises relate to gross foreign investment reversals (GIR), that is, foreign disinvestment in the home economy. Our main findings are the following. First, like previous work we find that banking crises predict currency crises while the converse is false. Second, banking crises predict sudden stop crises and again the converse is false. Third, currency and sudden stop crisis predict each other. Fourth, GIR predict banking crises, but neither currency nor sudden stop crises conditional on banking crisis. Fifth, using GIR to instrument for banking crises supports a causal effect of banking on external crises in emerging markets. We further find that it is FDI reversals rather than foreign portfolio or other reversals which are linked to banking crises. This suggests that GIR may ‘hit’ banks from the asset side more than the liability side emphasized in bank run models. However, any kind of GIR prolongs banking crises. Finally, we relate our findings to theories of financial crises and present a simple model consistent with the main findings.