CURRENCY CRISESCURRENCY CRISES

POP IULIAPOP IULIA

Introduction Introduction

Importance and objectives of Importance and objectives of currency crises modelscurrency crises models

Empirical results: an effective Empirical results: an effective warning system should warning system should consider a broad variety of consider a broad variety of indicatorsindicators

SOURCES OF SOURCES OF SPECULATIVE ATTACKSSPECULATIVE ATTACKS

The First-Generation Models - The First-Generation Models - Latin American crises in the Latin American crises in the 1980s 1980s

Krugman (1979) and Flood and Krugman (1979) and Flood and Garber (1984)Garber (1984)

The approach: inconsistency The approach: inconsistency between a fixed exchange rate between a fixed exchange rate rule and the pursuit of domestic rule and the pursuit of domestic policies such as monetising policies such as monetising large fiscal and current account large fiscal and current account deficits deficits

The sudden speculative attacks The sudden speculative attacks on currencies are rationalon currencies are rational

SOURCES OF SOURCES OF SPECULATIVE ATTACKSSPECULATIVE ATTACKS

The Second-Generation The Second-Generation Models - European Exchange Models - European Exchange Rate Mechanism crises 1992-Rate Mechanism crises 1992-19931993

Obstfeld (1994,1996)Obstfeld (1994,1996) The approach: dynamic The approach: dynamic

interactions of market interactions of market expectations and the expectations and the conflicting objectives of the conflicting objectives of the government => self-fulfilling government => self-fulfilling run on the domestic currencyrun on the domestic currency

Multiple equilibria and herding Multiple equilibria and herding behavior by investors behavior by investors

How do these models How do these models perform empirically?perform empirically?

The empirical literature has The empirical literature has not been able to determine not been able to determine whether first or second-whether first or second-generation models are better generation models are better explaining currency crashesexplaining currency crashes

Indicators such as the real Indicators such as the real exchange rate, foreign exchange rate, foreign reserves and a weak banking reserves and a weak banking system are useful in system are useful in predicting crisespredicting crises

SOURCES OF SOURCES OF SPECULATIVE ATTACKSSPECULATIVE ATTACKS

The Third-Generation Models: Asian The Third-Generation Models: Asian Crisis 1997-1998Crisis 1997-1998

Eichengreen, Rose and Wyplosz Eichengreen, Rose and Wyplosz (1995), Sachs, Tornell and Velasco (1995), Sachs, Tornell and Velasco (1996), Kaminsky, Lizondo and (1996), Kaminsky, Lizondo and Reinhart (1997, 1998)Reinhart (1997, 1998)

Focus on a broader set of Focus on a broader set of fundamentals: political, fundamentals: political, institutional, financial variablesinstitutional, financial variables

What indicators worked best:What indicators worked best:• international reservesinternational reserves• real exchange ratereal exchange rate• credit growthcredit growth• export performanceexport performance• domestic inflationdomestic inflation

THE NONPARAMETRICAL THE NONPARAMETRICAL “SIGNALS” APPROACH “SIGNALS” APPROACH

It involves monitoring the evolution It involves monitoring the evolution of a number of economic variables; of a number of economic variables; when one of these variables when one of these variables deviates from its “normal” level deviates from its “normal” level beyond a “threshold”, this is taken beyond a “threshold”, this is taken as a warning signal about a as a warning signal about a possible currency crisis within a possible currency crisis within a specified period of timespecified period of time

The definition of a currency crisis: a The definition of a currency crisis: a situation in which an attack on the situation in which an attack on the currency leads to a sharp currency leads to a sharp depreciation of the currency, a depreciation of the currency, a large decline in international large decline in international reserves, or a combination of the reserves, or a combination of the two.two.

THE METHODTHE METHOD

The countries:The countries:

HungaryHungary AustriaAustria

RomaniaRomania GermanyGermany

PolandPoland GreeceGreece

Slovak RepublicSlovak Republic ItalyItaly

TurkeyTurkey SpainSpain

Russian FederationRussian Federation The sample length: 1994-The sample length: 1994-

20002000 The signaling horizon: 24 The signaling horizon: 24

monthsmonths

THE EXCHANGE MARKET THE EXCHANGE MARKET PRESSURE INDEXPRESSURE INDEX

For each country, crisis is identified ex For each country, crisis is identified ex post by the behavior of an index:post by the behavior of an index:

where T (threshold level) is set at three where T (threshold level) is set at three standard deviations from the mean standard deviations from the mean

where = monthly percentage where = monthly percentage changes in the exchange rate changes in the exchange rate

where = monthly percentage where = monthly percentage changes in the international reserveschanges in the international reserves

The weights are chosen so that the two The weights are chosen so that the two components of the index have the components of the index have the same variance. same variance.

TrtwstwK tifCrisis )Δ(2Δ1:

stΔ

r tΔ

THE EXCHANGE MARKET THE EXCHANGE MARKET PRESSURE INDEXPRESSURE INDEX

- results -- results -

Country Number of Crises Period Hungary 0 - Romania 2 January 1997

February 1997 Poland 1 August 1996 Slovakia 2 March 1999 May 1999 Turkey 1 January 1997 Russia 2 August 1998 September 1998

Austria 0 - Germany 0 - Greece 0 - Italy 1 February 1998

Spain 0 -

THE EXCHANGE MARKET THE EXCHANGE MARKET PRESSURE INDEXPRESSURE INDEX

RomaniaRomania

The results are consistent with the IMF The results are consistent with the IMF Country Report 01/16 forCountry Report 01/16 for Romania.Romania.

The evolution of the index does not The evolution of the index does not reflect the 1998 contagion effects of reflect the 1998 contagion effects of the Russian financial crisis and the the Russian financial crisis and the 1999 pessimistic expectations of the 1999 pessimistic expectations of the market .market .

ROMANIA: exchange market pressure index, 1994-2000

-0.10

-0.05

0.00

0.05

0.10

0.15

Jan-

94

Jul-9

4

Jan-

95

Jul-9

5

Jan-

96

Jul-9

6

Jan-

97

Jul-9

7

Jan-

98

Jul-9

8

Jan-

99

Jul-9

9

Jan-

00

Jul-0

0

inde

x K

LR (

%)

THE INDICATORSTHE INDICATORS

The choice of indicators was dictated The choice of indicators was dictated by theoretical considerations and by theoretical considerations and by the availability of information on by the availability of information on a monthly data. They are:a monthly data. They are:

exports (in U.S. dollars)exports (in U.S. dollars) imports (in U.S. dollars)imports (in U.S. dollars) monetary aggregate M1 monetary aggregate M1 real exchange ratereal exchange rate gross international reservesgross international reservesFor all these variables the indicator on a given For all these variables the indicator on a given

month was defined as the percentage month was defined as the percentage change in the level of the variable with change in the level of the variable with respect to its level a year earlier => the respect to its level a year earlier => the comparability of units across countries, it comparability of units across countries, it eliminates the seasonality effectseliminates the seasonality effects

DEFINITIONSDEFINITIONS

Signaling horizon = the period within Signaling horizon = the period within which the indicator would be expected which the indicator would be expected to have an ability for anticipating crises, to have an ability for anticipating crises, and is defined a priori as 24 months.and is defined a priori as 24 months.

Signals: an indicator is said to issue a Signals: an indicator is said to issue a signal whenever it departs from its signal whenever it departs from its mean beyond a given threshold level. mean beyond a given threshold level.

Thresholds: are defined in relation to Thresholds: are defined in relation to percentiles of the distribution of percentiles of the distribution of observations for each indicator. While observations for each indicator. While the percentile used as reference (20%) the percentile used as reference (20%) is uniform across countries, the is uniform across countries, the corresponding indicator-specific corresponding indicator-specific thresholds are different.thresholds are different.

DEFINITIONSDEFINITIONS

The performance of each indicator is The performance of each indicator is examined in terms of the following examined in terms of the following matrix:matrix: Crisis No crisis

(within 24 months)Signal was issued A A BNo signal was issued C DD

A = A = no. of months in which the indicator issued a no. of months in which the indicator issued a “good” signal“good” signal

B = B = no. of months in which the indicator issued a no. of months in which the indicator issued a “bad” signal or “noise”“bad” signal or “noise”

C = C = no. of months in which the indicator failed to no. of months in which the indicator failed to issue a signalissue a signal

D = D = no. of months in which the indicator refrained no. of months in which the indicator refrained from issuing a signalfrom issuing a signal

EMPIRICAL RESULTSEMPIRICAL RESULTS- information on the performance of - information on the performance of

individual indicators is presented in the individual indicators is presented in the next table - next table -

Final Results:Final Results:

- tendency of indicator to issue good - tendency of indicator to issue good signals: signals:

RERRER

ImportsImports

ExportsExports

ReserveReserve

- tendency of indicators to issue bad - tendency of indicators to issue bad signals: signals:

ImportsImports

ExportsExports

- noise/signal ratio: - noise/signal ratio:

ReservesReserves

RERRER

ROMANIA - EMPIRICAL ROMANIA - EMPIRICAL RESULTSRESULTS

1. The outcome of the analysis 1. The outcome of the analysis is consistent with the is consistent with the theoretical and empirical theoretical and empirical currency crises literaturecurrency crises literature

2. The real exchange rate and 2. The real exchange rate and international reserves are the international reserves are the indicators with the highest indicators with the highest power of anticipating a crisis power of anticipating a crisis situation on the foreign situation on the foreign exchange marketexchange market