How integrated are the exchange markets of the Baltic Sea Region? An examination of market pressure and its contagion

In the two decades since independence, the Baltic nations’ re-integration with Western Europe has resulted in close linkages to the Euro. While only Estonia has as of yet joined the common currency, Latvia and Lithuania maintain currency pegs in preparation for membership. But although the Eurozone’s pull is unmistakable, it is possible that the Nordic countries on the Baltic Sea—with which the Baltics have enjoyed economic ties for centuries—might also have an important influence on the region’s exchange markets. In particular, currency crises might more easily spread through the Baltic Sea region than to and from the Eurozone. This study investigates this relationship by generating indices of Exchange Market Pressure (EMP) for the three Baltic countries, Denmark, Sweden, and the Eurozone, before testing for contagion using Vector Autoregressive (VAR) methods. Granger causality tests and impulse-response functions show that pressure on the Scandinavian currency markets, as well as stock price declines, lead to increased Baltic EMP more than do events in the Eurozone.