We propose exploiting the term structure of relative interest rates to obtain estimates of changes in the timing of a currency crisis as perceived by market participants. Our indicator can be used to evaluate the relative probability of a crisis occurring in one week as compared to a crisis happening after one week but in less than a month. We give empirical evidence that the indicator performs well for two important currency crises in Eastern Europe: the crisis in the Czech Republic in 1997 and the Russian crisis in 1998.
The indicator looks for a downward sloping yield curve using a 7 day vs 30 day interbank interest rate.
- Fixed and crawling pegs or fluctuation bands are most prone to speculative attack
- Current early warning systems use Fundamental data
- Current account Balances
- Exchange rate overvaluation
- Export growth
- HistorySquared notes that Carmen and Reinhart and others have found many other Leading Indicators such as
- Jumps in FDI
- Credit Growth Surges
- Money Supply Spikes
- Debt Spikes
- Global Banking Crises
- Commodity price collapses
- Housing Bubbles
- Problem with current Early Warning Systems is limited availability and attempt to predict up to 2 years out
- Early Warning System indicator by Kaminsky, Lizondo, and Reinhart
- Failed to warn of thai crises until ex poste, more explanatory than predictive
- Uses economic indicators
- Weighted factors by relevance
- Incorporates deviations and thresholds
- Early Warning Systems by Collins approach
- Based on the Uncovered Interest Rate Parity theorum (UIP)
- Looks at the Term Structure of Interest rates
- Forecasts 1 week out
- Based on the Collins approach, this paper uses the daily interbank rates with maturity one week (it;7and it;7) and one month (it;30 and it;30) looking for a downward sloping yield curve
- Example :
- 1997 Czech Republic crisis
- Tight peg against DM and USD with bands of +0.5% to 7.5% until crises in May 1997
- Trade Balance turned negative in 1996
- Economic growth slowed
- Upward Trend in currency from 1992-1997
- Heavy central bank intervention in week before crises kept it within the band
- Indicator was positive since early January 1997, accelerating in the week before the crises
- Compared 1 week to 1 month interest rates
- Alternative is the forward rate
- Simple rate of change performed well to determine the threshold
- Leading indicator in Tranquil times
- Performed ok 5 days out for the Czech Republic but not for DM
- Conclusion:
- “To sum up, our indicator is able to identify both speculative pressures that were successfully combated by the central bank in the pre-crisis period, and starts signaling the impending crisis six days before the official announcement of the devaluation.”
- Jesús Crespo Cuares
Predictable Changes in Yields and Forward Rates
Popularity: 5% [?]
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