Currency Crises and Leading Indicators

December 13, 2011

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Leading Indicators of Currency Crises

GRACIELA KAMINSKY, SAUL LIZONDO, and CARMEN M. REINHART*

“This paper examines the empirical evidence on currency crises and proposes a specific early warning system. This system involves monitoring the evolution of several indicators that tend to exhibit an unusual behavior in the periods preceding a crisis. When an indicator exceeds a certain thresh old value, this is interpreted as a warning “signal” that a currency crisis may take place within the following 24 months.”

"Variables that receive ample support as useful indicators of currency crises include international reserves, the real exchange rate, credit growth, credit to the public sector, and domestic inflation. The results also provide support for the trade balance, export performance, money growth, M2/international reserves, real GDP growth, and the fiscal deficit."

The variables with the best track record within this approach include exports, deviations of the real exchange rate from trend, the ratio of broad money to gross international reserves, output, and equity prices.

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"Krugman’s (1979) model shows that, under a fixed exchange rate, domestic credit expansion in excess of money demand growth leads to a gradual but persistent loss of international reserves, and ultimately, to a speculative attack on the currency. This attack immediately depletes reserves and forces the authorities to abandon the parity. This model suggests that the period preceding a currency crises would be characterized by a gradual but persistent decline in international reserves and a rapid growth of domestic credit relative to the demand for money. “

“Also to the extent money creation may result from the need to finance the public sector, fiscal imbalances and credit to the public sector could also serve as indicators of a looming crises. For that matter, central bank credit to troubled domestic financial institutions would bplay the same role.”

Others have extended the Krugman model by observing that expansionary policies drives up higher wages and demand for goods, resulting in a loss of competitiveness.

  • 72 crises examined
  • Variables associated with external debt and the current account balance did not fare well.
  • Exchange rate rate expectations and interest rate differentials do not do well in predicting currency crises.
  • Forecasting problems in the domestic banking sector are prescient
  • Crises may develop without a significant change in fundamentals due to external shocks
  • Periods where the exchange rate is 3 standard deviations below it’s mean is defined as a crises
  • Indicators defined by a percentage change from over 12 months

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Source : Leading Indicators of Currency Crises
 
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