Determinants of Currency crises in Emerging economies in 1996-2005 An Early Warning System Approach

This study incorporates 5 variables from Berg and Pattillo 1999b model Real exchange rate overvaluation, Foreign reserves loss, Export growth, Current account deficit, Short-term externa

VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

Determinants of currency crises in

emerging economies in 1996-2005:

An Early Warning System approach

A thesis submitted in partial fulfillment of the requirements

for the degree of Master of Arts in Development Economics

By

Trtrang Hong Tuan

Thesis supervisor:

Dr Vii Thanh Ttr Anh •

• BQ GIAO DVC FJAO TAO TRUONG HQC KINH TE TP.HCM

THliVIEN • r-

Ho Chi Minh city, October 2009

Certification

I declare that the thesis hereby submitted for the Master degree at the Vietnam-Netherlands Programme for M.A in Development Economics is my own work and has not been previously submitted by me at another university for any degree I cede copyright of the thesis in favor of the Vietnam- Netherlands project for M.A programme in Development Economics

Ho Chi Minh City, October 2009

Truong H6ng TuAn

Abstract

Theories of currency crisis consisted of 4 generations of models suggest that economic and institutional variables can be employed in early warning system models to predict currency crisis for the purpose of prevention policy This study incorporates 5 variables from Berg and Pattillo (1999b) model (Real exchange rate overvaluation, Foreign reserves loss, Export growth, Current account deficit, Short-term external debt/Foreign reserves) and additional Domestic credit growth, 6 institutional variables adopted from Worldwide Governance Indicators (Kaumann et al., 2008) (Voice and Accountability, Political Stability and Absence

of Violence, Government Effectiveness, Regulatory Quality, Rule of Law, Control of Corruption) into a simple logit model with dataset of 15 emerging market economies in the period 1996:01-2005:09 The new finding is the high statistical significance of the variable 'Voice and Accountability' (represents freedom of speech, free media and ability to participate in selecting government of a country citizen) on reducing probability of currency crisis 'Regulatory Quality' (measures government ability to implement efficient policies promoting private sector development) also shows its statistical significance at a lower level

in the model This study also reconfirms other studies that Domestic credit growth and Current account deficit precede currency crisis

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A brief review of the literature 18 Chapter 4 Methodological issues - Empirical framework 27

Chapter 6 Policy implications and conclusion 40

Appendix 1 Specification of 05 empirical currency crisis models 45 , Appendix 2 Logit regression results by Eviews (Probability of currency crisis) 4 7 Appendix 3 Robustness test of the result by running logit regression on regions 50

Chapter 1

Introduction

1.1 Statement of the Problem

On the way to development, currency crises are very costly for emerging economies Currency crises can lead to banking crises, loss of GDP, high unemployment rate and loss of development momentum In the Asian crisis in 1997-98, Thailand lost 10.5% of GDP, Indonesia 13.1% & Malaysia 7.4%

In May 2008, Morgan Stanley issued a report on Vietnam named "Beyond the tipping point", comparing Vietnam then with Thailand in 1997 and warning a 38% -55% depreciation of VND against USD in the next 12 months

In June 2008, State bank of Vietnam widened trading band for foreign exchange (USD) from 1% to 2% In November 2008, it raised the band to 3% and in March 2009 to 5% Domestic credit growth rate is 50% in 2007, 34% in 2008 and estimated 30% in 2009 by Economist Intelligence Unit

After the booming in stock and real estate market in 2007 with capital inflow mainly for portfolio investment, a crash of more than 70% in stock market broke out in 2008 against its peak in October 2007 Capital inflow and export shrink, larger current account deficit (13.6%

in 2008) is putting pressure on the peg regime of VND to USD It seems that the scenario of Asian crisis repeats in Vietnam

Unlike Asian crisis countries of crony capitalism, Vietnam's relationship-based system has even weaker institutions So do institutions play any role in setting stage for a currency crisis?

Now is October 2009 Fortunately, the Morgan Stanley's forecast failed, but whether the Vietnam currency crisis is coming soon? Thus, currency crisis is a burning issue in Vietnam for the time being

1.2 Objective of the Research

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Vietnam is an emerging market economy Understanding what caused currency crises in other emerging market economies in recent years would be a good reference for further comprehensive researches on what Vietnam should do to prevent its own currency crisis

1.3 Research Questions

This study aims to answer the following questions:

1 What are the key determinants of currency crises in emerging economies in the period 1996-2005 in the light of early warning system approach? (especially, current account deficit, domestic credit growth and institutional factors)

2 What are the policy implications to prevent a currency crisis?

1.4 Research Methodology

Based on theories, empirical models of currency crises and available variables/data, regression with logit model is carried out to recognize the determinants of currency crisis The statistic software Eview 4.1 is employed in this study

1.5 Scope of the Research

Based on availability of data of institutions and review of recent history of currency crises in emerging market economies, 15 economies are selected and the period of study is limited in 1996-2005 15 economies are: Argentina, Brazil, Colombia, Czech, Ecuador, India, Indonesia, Korea, Malaysia, Philippines, Russia, Slovakia, South Africa, Thailand and Turkey

1.6 Organization of the Research

The first chapter of this study hereby presents introduction of the issue The second chapter will look through theories of currency crisis The third introduces some typical early warning systems (EWS) and empirical currency crisis models employed at IMF, Goldman Sachs and

in a few academic studies The fourth mentions methodology for designing a EWS model including variables of domestic credit growth and institutions The fifth represents merits of the focused variables in the model and the sixth delivers policy implications and concludes

Chapter 2

Theories of currency crises - A brief review of the literature

In the literature of financial crises, there are banking crises, (sovereign) debt crisis and currency crises Banking crises are recognized as the insolvency of the banking system that occurs with high ratio of non-performing loan to assets Demirguc-Kunt and Detragiache (1997) considered one of event or combination of the following as banking crisis: (1) nonperforming assets/total assets ratio in the banking system exceeds 1 0%; (2) the cost of rescue at least 2% of GDP; (3) large scale nationalization of banks; and (4) extensive bank runs or other emergency measures executed by the government Debt crisis is defined as a national government fails to meet a principal or interest payment on the due date (Reinhart and Rogoff, 2008) This study focuses on currency crises only

This chapter consists of 2 parts Part 1 presents the identification of a currency crisis, part 2 reviews 4 generations of currency crisis models

What cause a currency crisis? It is an exciting question since the collapse to the Breton Wood system Especially, the heavy costs of currency crisis in Mexico, Asia, Russia, Argentina provoke attention of several economists

2.1 Identifying currency crises

An abrupt drop in a country currency value is regarded as currency crisis It is called 'crisis' because it bring about negative economic effects They includes shrink in GDP, investment and job loss, banking and business failures, inflation Currency crisis can be brought about by currency speculators or government action, or a mix of both

The ideal way to define a currency crisis is as Bussiere and Fratzscher (2002) that incorporate moves in exchange rate, interest rate and foreign reserves (initially set out by Girton and Roper, 1977) They identified a crisis as the exchange market pressure (EMP) of a specific country exceeds its mean by 2 standard deviations EMP is constructed as a weighted average

of the change of the real effective exchange rate (RER), the change in the real interest rate (r) and the change in foreign exchange reserves (res) Real values are considered to avoid different inflation rate across countries Interest rate is involved in case the central bank defends the domestic currency by increasing its interest rate

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The EMPi,t for defining a currency crisis for each country i and period t in formula is as follows:

_ ( RERi.t - RERi.t-'i) ( _ , ) _ ( resi.r- resi,1-l J

- mRER +mr li.r lu-1

In another simple way, Frankel and Rose (1996) defined a currency crisis as a depreciation of the nominal exchange rate by at least 25% that also exceeds the previous year's depreciation

by at least 1 0% Thus, they did not consider speculative attacks failed by government intervention via selling foreign reserves as a currency crisis

The theories of currency crisis have developed over the time It seems that after a series of currency crises occurred, a new-generation crisis model emerges A brief review of currency crisis literature can trace out 4 generations of currency crisis model

2.2 Four generations of currency crisis models

The first generation crisis models

The first generation crisis model is firstly presented by Krugman (1979) In a small open economy, government would defend the fixed exchange rate regime with limited foreign reserves Perfect foresight private investors hold asset portfolio in two kinds of assets: domestic and foreign currency In an attempt to maintain the fixed rate, government has to sell out reserves until it is exhausted Government finances its budget deficit by printing money that increases money supply

The model derives that as long as there is budget deficit and inflation, investors change the composition of their asset portfolio by increasing the proportion of foreign exchange, reducing the proportion of domestic currency Government has to run down its reserves to retain the fixed rate on the way to finance its budget deficit Exhaustion of reserves pushes government to abandon the pegging Such expectation makes investors advance the date of their speculative attacks, the leading speculators sell domestic money even earlier and so on, reserves run out faster and currency crisis breaks out

The model seems to have highly simplified assumptions on two asset portfolio holding, the tools government uses to intervene in foreign exchange market, only selling reserves, perfect foresight speculators, the time of crisis is unclearly identified

Flood and Garber (1984) refined Krugman (1979) model by developing it into 2 models The first one is a perfect-foresight, continuous-time model that relaxes two-asset portfolio to 4-asset portfolio (included domestic and foreign bond) and adding domestic credit into the model They found out the exact timing of the peg collapse, and timing has a positive relationship with the size of reserves and a negative one with the domestic credit growth rate The first model also shows that currency crisis can emerge under arbitrary speculative behavior of investors but they assumed that this effect is zero for simplifying analysis The second model is a discrete time, stochastic one (relax assumption of perfect foresight) that incorporate uncertainty to study the forward exchange rate of a peg regime as a response to reality that forward rate may exceed the fixed rate for long period of time Using the concept the shadow exchange rate, the rate that would prevail after the speculative attack, the second model yields an endogenous probability distribution over the crisis time and produces a forward exchange rate that is greater than the fixed rate (capture the real world)

The policy conflict in above-mentioned models is the financing fiscal deficit and retaining fixed exchange rate regime Dooley (1997) proposed an insurance model, in which the policy conflict is the desire of a credit-constrained government to hold reserve assets as a form of self-insurance against shocks to national consumption and the government's desire to insure financial liabilities of residents The first objective is pursued by accumulation of foreign reserves while the second objective depletes it Once the domestic yield is greater relative to international returns, it generates a private gross capital inflow Capital inflow increases to an extent that there is not enough foreign reserves to insure deposits, extra deposits have risk exposure This gap will ignite a speculative attack to minimize loss that runs up to crisis

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Dooley model offers a capital inflow/currency crisis follow view, that not budget deficit, money supply or higher international interest rate is blamed for currency crisis

The first generation models explained well the crisis of Latin America countries in the 1980s that have macroeconomic fundamental problems such as fiscal deficit, hyperinflation, foreign loan, current account deficit, capital flight

The first generation models suggest that macroeconomic fundamentals are the causes of currency crises Variables used in early warning systems could be budget deficit, money supply, domestic credit, current account deficit, international interest rates, capital inflow/outflow (capital control)

In the early 1990s, there were several currency crises, such as the European Monetary System crisis of 1992-93, that could not be explained by the first generation models Europe countries

at that time had sound macroeconomic fundamentals, but currency crises still occurred The currency crisis model then evolved to confront the new reality The second generation came out

The second generation crisis models

The second generation crisis models, initially developed by Obstfeld (1994, 1996):

self-fulfilling and contagious crises

The first generation models constrained government's tools in intervening foreign exchange market to selling limited reserves only The second· generation models relax this point, let foreign reserves can be freely borrowed in the world capital market, subject only to the government's intertemporal budget constraint

In a setting of purposeful reaction by the government, self-fulfilling crisis is taken into account Speculative anticipations depend on government responses, which subject to how price changes, that in turn are driven by expectations This dynamic circle suggests a potential for crises that would not have occurred, but that do because the market players expect them

to They are self-fulfilling crises

Obstfeld (1994) raised a question: Why does the government like to abandon the fixed rate?

He described 2 models in the paper to answer It is because government debt denominated in

domestic currency and unemployment problem In one model, he mentioned the role of

nominal interest rate Devaluation expectations feed into high nominal interest rate that pushes government further to give up the peg would have been viable under reverse private expectations Maturity structure of the government's domestic obligations and the currency composition of the overall public debt would decide the effect of interest rate in devaluation Large portion of debt burden denominated in domestic currency, higher nominal interest rate will lead to higher devaluation to lessen the government debt burden Perfect foresighted speculators would try to get out of the domestic currency ahead of that devaluation In another model, expectations feed into wages and competitiveness, raising unemployment The country suffers from unemployment/competitiveness problem due to demand shock and/or pre-set nominal wage, would like to abandon the fixed rate Negative expectation of government's willingness to tolerate unemployment can trigger a devaluation that would not have occurred under opposite expectations In contrast to the first generation models, the loss of reserves is not the factor triggering currency crisis

The models propose that a speculative attack can occur even with the absence of poor macroeconomic conditions in the pre-crisis time Currency crisis can result from self-fulfilling attack in which speculative anticipations and herding behavior play a role

Once unemployment rate is on upward trend and government policy is to maintain a fixed exchange rate Speculators can perceive that high political cost of the maintaining of the fixed exchange rate facing the future rising unemployment They recognize the devaluation is likely Even they don't know when, they start selling domestic currency now Herding behavior sets in and full-scale speculative attack breaks out even before unemployment becomes a problem

Eichengreen et al (1996) show that contagion takes its effect once the devaluation of a country's currency may reduce its trading partners' competitiveness enough to make their currencies subject to devaluation too They pose hypothesis that there are 2 channels for contagion taking effect Trade linkage between 2 countries can motivate one country to devalue its currency to increase its international competitiveness one the other country devalued previously Based on the current and prospective international competitiveness of the countries concerned, speculators ignite attacks The similar macroeconomic conditions across countries also are foundations for advancing speculative attacks Using a panel of quarterly data for 20 industrial countries for the period 1959-1993 to test for contagious currency crises, they find evidence of contagion Contagion appears to spread to countries which have close international trade linkages rather than to countries in similar macroeconomic conditions

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Calvo (1995) suggest that the basic cause of a currency crisis may be investors' behavior Risk averse investors invest in several countries Financial diversification and lender's information have an interesting relationship Investors with highly diversified portfolio have lower incentives to learn about individual countries than investors with few diversification opportunities Diversification encourages ignorance and, in that context, rumors could result

in massive capital flows from a country So investment into or away from a country is highly sensitive to news in a world of highly diversified investors Diversification magnifies herding behavior by making investors more sensitive to rumors If the composition of portfolio is mainly short-term capital, the capital flight may be quick, causing an abrupt crisis

If self-fulfilling crises are a real possibility, what stimulates them? The answer is that anything could in principle be the driver They would be expected unemployment, public debt, international competitiveness in trade, political factors This rationale gives a spacy room for empirical early warning system models in predicting crises

Second-generation models can explain the European Exchange Rate Mechanism (ERM) crisis

in the 1990s These crises didn't emerge by the poor macroeconomic fundamentals but by inconsistent policy and political events In Europe, the crises occurred in Britain, Italy, France because of the inconsistent policy with their committed peg to the German mark Retaining peg to German mark, they have to maintain high interest rate on local currency and face slow growth, gloomy export and increasing unemployment Speculators such as Soros recognized the tradeoff government confronts and expected the government under political pressure will give up the peg Their speculative attacks succeeded

In fact, behind the scene of claimed sound macroeconomic fundamentals, potential economic instability laying aside in Europe incites speculative attacks Macroeconomic fundamentals actually still play their role to a certain extent in the second generation model of crisis

In 1997-1998, new reality of crisis emerged again that requires currency crisis model to continue to evolve to deal with new generation of crisis

The third generation crisis models

The Asian crisis of 1997-98 led to the third generation models: twin crisis, a mix of banking

and currency crisis In fact, Velasco ( 1987) proposed models of interaction between banking problems and currency crisis Credit boom, bad debt, government spending on bail out

(budget shrinks) and stop of capital inflow all lead the way to abandonment of fixed exchange rate regime Velasco (1987) represented experiences in South America with these features Their models received little attention until the Asian crisis in 1997 broke out

What Velasco did is to extend Krugman model to a situation where foreign assets pay interest, including the presence of banks to find out the dynamics of banking crisis and currency crisis There is an asymmetry in the liquidity and riskiness of bank assets and liabilities A bank usually guarantees the nominal value of the deposits it accepts while allocating the money to investments with a variable return Normally, bank deposits are highly liquid, while bank investments are low liquid and long-term It takes time and cost to liquidate bank investments There is an assumption that all bank deposits are implicitly or explicitly guaranteed by the government Domestic and foreign depositors/lenders believe in the government umbrella, still put money into the banking system in spite of banking operation loss Banks play the Ponzi game until the problem become serious Government steps in to help, depletes its budget and foreign reserves Currency crisis of Krugman type eventually arrived here

Using monthly data of 20 countries for the period 1970-mid1995, Kaminsky & Reinhart (1999) also found that problems in the banking sector typically emerge before a currency crisis The currency crisis then worsens the banking crisis, making a vicious spiral Financial liberalization often precedes banking crises The progression of these events suggests that crises occur as the economy starts to enter a recession, following a boom in economic activity that is fueled by credit, capital inflows, associated with an overvalued currency

Compared to first and second generation models, Asian crisis appears to be differently Macroeconomic fundamentals are sound with· high GDP growth rates, low unemployment rate, low inflation, low budget deficits, manageable current account deficits, strong capital inflows and prevailed political stability However, inside the bright picture, there are problems in the banking sector - bad loans from domestic borrowers and unhedged, short-term borrowing from foreign banks The bad loan accumulation is the consequence of over lending Krugman (1998) described a moral hazard/asset bubble view There was a boom-bust cycle in the asset markets preceding the Asian currency crisis Prices of stock and land were soaring and plunging before the crisis Besides, moral hazard involved as strong political relations between government and finance companies/banks/corporations (crony capitalism) suggested implicit guarantees from government for lenders and depositors The lenders become much less prudent in lending to inefficient investment projects because of expectation

on government bailout

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Third generation model implies an additional set of variables related to financial liberalization and banking problem for early warning system Name a few as: Real interest rate, lending-deposit rate ratio, M2/reserves, bank deposit, non-performing loan

Recently, we faced the re-emergence of institutional economics (economics Nobel prize 2009

is an award for institutional economics) that pays more attention to the foundations for market functioning that shed new light on currency crises

The fourth generation crisis models

Behind the scene of phenomena like government budget and current account deficits, hyperinflation, self-fulfilling attacks, herding behavior, excessive lending, deeper questions should be raised What institutional factors set conditions for these pictures? In these models, institutional factors are incorporated and emphasized with a wide range: law framework, property right, enforcement of contract, financial regulations, bureaucratic quality, government stability, democracy and corruption Breuer (2004) coined these models as the fourth generation

This institutional focus has foundations on the theory of relationship between institutions and economic growth/crisis presented by Acemoglu et al (2002), Rodrik et al (2002), Fukuyama (1995), Sen (1999), Johnson et al (2000) and asymmetric information problem in financial market by and Mishkin (1996, 2001) as typical ones among several other authors

A defmition of institutions is helpful here What are institutions? By words ofDouglass North (1993) in his Nobel prize lecture:

"Institutions are the humanly devised constraints that structure human interaction They are made up of formal constraints (rules, laws, constitutions), informal constraints (norms of behavior, conventions, and self imposed codes of conduct), and their enforcement characteristics Together they define the incentive structure of societies and specifically economies."

Incentives and expectations play a vital role in the financial world that is infamous for uncertainty Institutions form the foundations and facilitate a well-functioning currency and banking system That's reason why the fourth generation models of currency crisis incorporate institutional variables

Fukuyama (1995) proposed the role of trust in society that lowers administration cost, increases institutional reliability and promotes large and efficient organizations Low trust society usually has corruption and trade with influences and tends to maintain small and inefficient organizations Trust should promote economic development It is vital for financial market whether investors have trust or loss of confidence in them

Sen (1999) presented concisely some of his best-known work on famines They are usually occurred by a lack of purchasing power or entitlements, not by food shortage He claimed that large-scale famines never happened in a democracy They can only happen in authoritarian regimes lacking openness of information and transparency His analysis inspired similar approach to the Asian crisis in 1997

Johnson et al (2000) proved that the effectiveness of protection for minority shareholders explain the extent of declines in exchange rate depreciation and stock market better than standard macroeconomic measures do They modelized the conflict of interest between insiders (managers) and outsiders (equity owners) Weaker corporate governance rules and a weaker legal system reduce the cost of stealing (expropriation) of managers The manager compares the marginal cost and marginal benefit of stealing for their reaction For a given rate

of return, if the manager invests less their own money, they have more incentives to steal However, if the manager has more shares in the firm, an increase in the return on investment persuades himto invest more into the project and, therefore, to steal less On the other hand, if the manager owns more of the firm, but the return on investment reduces, then he steals more The stealing of manager shrinks value of firm Less value of the firm, less confidence of foreign and domestic investors stays in the stock market Loss of confidence in the stock market triggers capital outflow or stop of capital inflow The capital outflow affects foreign exchange market, ignites currency crisis In order to study 27 emerging markets in the end of

1996 to January 1999, Johnson et al employed data measure institutional variable such as: shareholder protection, credit right, accounting standards, enforceability of contracts Gudicial efficiency, corruption, rule of law, corporate governance); economic variable like: fiscal and monetary policy, current account and reserves Running linear regression of these institutional and economic variables on exchange rate and then stock price, they found that the regression results support their theory Lower quality of shareholder protection and enforceability of contract have high statistical significance and influence in explaining the depreciation of domestic currency and decrease in stock price in emerging markets

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Acemoglu et al (2002) observed that countries pursuing poor macroeconomic policies also have weak institutions, including political institutions that do not constrain politicians, weak property rights for investors, widespread corruption, and a high degree of political instability They proposed that macroeconomic policies are more likely to be symptoms of underlying institutional problems rather than the main causes of economic volatility, weak institutions can cause volatility through a number of macroeconomic and microeconomic channels

Mishkin ( 1996, 200 1) approached financial crises in the light of asymmetric information with the moral hazard problem Emerging market economies such as Mexico, Ecuador, East Asian crisis countries and Russian are well-known for weak financial regulations and supervision When financial liberalization facilitate international capital inflow and opportunities to take more risky lending, these weak regulatory/supervisory system could not limit the moral hazard problem created by the government safety net Once government has signals offering bailouts to protect banks & corporations, excessive risk taking is one result, increasing the probability of financial crisis embracing banking crisis and currency crisis Mishkin also proposed 12 areas of policy to prevent financial crisis: 1 Prudential supervision, 2 Accounting and disclosures requirements, 3 Legal and judicial systems, 4 Market based disciplines, 5 Entry of foreign banks, 6 Capital control, 7 Reduction of control of state-owned financial institutions, 8 Restrictions on foreign-dominated debts, 9 Elimination of too-big-too-fail in the corporate sectors, 10 Sequencing of the financial liberalization, 11 Monetary policy and price stability, 12 Exchange rate regimes and foreign exchange reserves From this list, we can see some institutional factors that cause financial crisis

Rajan, R G and Zingales, L (1998) looked through the Asian crisis, pointed out that relationship-based systems (that are inefficient and corrupt) tend to attract short-term external capital inflows that make them excessively prone to shocks A relationship-based system distorts the price system and the signals it provides As a result, it can misallocate capital Majority of external capital inflow is typically from foreign investors that have little contractual rights or power in a relationship system They understand the potential for misallocation and keep their claims short term for easy withdrawing

Due to the definition of institutions, they may include factors of law system, legal practices, financial regulations, politics, customs, culture Thus the fourth generation crisis models spare large room for the choice of variables usable in early warning system for currency crises

The US crisis 2008: a new crisis generation or an old story?

The existing crisis in the US is in fact a banking crisis caused by excessive lending on prime mortgages (Ellis, 2008) The sub-prime mortgages are cut into pieces in securitization process and the risk become opaque, then are sold out, spread in the US and over the world Like the scenario is described in the third crisis generation (twin crisis), banking crisis come first, government implements giant bailouts of banks/corporations and then currency crisis follows There are holes in financial regulations in the US financial system that promotes such excessive risk lending (no job-no problem housing loans) Thus, the fourth generation factors can also be used to explain the US crisis Although FED's newly-issued treasury bonds (for bailouts) are supported by huge international reserves from China, the US dollar is being depreciated against other main currencies (EUR, GBP, AUD) So we can consider the US crisis is kind of third and fourth generation combination

sub-Theories on the causes of currency crises set foundation for several early warning system and empirical currency crisis models coming out The four generations of currency crisis models suggest what variables should be employed in empirical early warning system and currency crisis models While the first and the third generation models point out the specific economic variable such as budget deficit, current account deficit, money supply, capital flow, bad debts

as indicators of currency crisis, the second and the fourth generation give more room for choices ofvariables It is because expectations can be based on a wide range of indicators and institutions involve a lot of factors related to laws, politics, culture

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Several early warning systems (EWS) empirical currency crisis models have been designed and some of them are being used by IMF and private financial institutions like Goldman Sachs for policy and speculative purposes The Table 1 hereunder summarizes the main features of typical EWSs, including EWSs used in IMF like Kaminsky et al ( 1998), Berg and Pattillo (1999b), in Goldman Sach like GS-WATCH (Ades et al., 1998), and EWSs presented

in other academic studies like Peltonen (2006), Shimpalee and Breuer (2006), Leblang and Satyanath (2008)

3.1 Signal approach

Kaminsky et al ( 1998) (KLR) proposed observation of 15 indicators that give warning signals prior to a crisis KLR's crisis definition is previously mentioned in chapter 2 of this study (Theories of currency crisis) KLR selected 15 indicators based on prior theories and on the monthly data available 15 variables are listed below:

1 Real exchange rate deviation

12 Terms of trade

13 [Real interest differential

14 Imports

15 Bank deposits

16 Lending rate/deposit rate]

An indicator gives out a signal whenever it moves beyond a specific threshold Thresholds are defmed in relation to percentiles of the distribution· of observations of the indicator An

optimal threshold for a given predictor, such as export loss, might be 70, for example, that is uniform across countries, the corresponding country-specific thresholds would likely differ (for example 20% in a country, 30% in another) The performance of each indicator is considered in the following matrix:

Table 3.1: Matrix of measuring performance of indicators

Crisis No crisis

Signal was issued

No signal was issued

Source: (Kaminsky et al., 1998)

In this matrix, A represents the number of months in which the indicator issued a good signal,

B is the number of months in which the indicator issued a bad signal or

'noise,' C is the number of months in which the indicator failed to issue a signal which would have been a good signal, and D is the number of months in which the indicator did not issue a signal that would· have been a bad signal The optimal percentile threshold is the one that minimizes the bad signal to good signal ratio [(B/(B+D)]/[A/(A+C)] Four indicators (Real interest differential, Imports, Bank deposits, Lending rate/deposit rate) that produce excessive noise are eliminated from the KLR model

As described by Berg and Pattillo (1999a), Kaminsky 1 later developed a single composite indicator of crisis that is computed as weighted sum of the indicators, where each indicator is weighted by the inverse of its bad signal/good signal ratio

Then a probability of crisis for each value of the composite index is calculated by the number

of months having a given value of the index is followed by a crisis within 24 months

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Because of the shortcoming of signal approach in testing statistical significance of each indicator, most of the EWSs are probit/logit based models

3.2 Probit/Logit approach

Berg and Pattillo (1999a) modified and carried out out-of-sample test for the KLR model to predict Asian crisis 1997 Berg and Pattillo added 2 additional variables (Current account deficit/GDP ratio, level ofM2/Reserves) also replaced 5 developed countries in the sample by

8 emerging market countries Then they transformed KLR's signal approach to probit based model with 05 variables only (Reserves growth rate, Export growth rate, Real exchange rate deviation, Current account deficit/GDP and M2/Reserves) Probit and modified KLR performed well in predicting Asian crisis 1997 However, probit model with 5 variables can test the statistical significant of individual indicators with ease while the KLR model (with 17 variables) can not do it (Table 3.2)

Berge and Pattillo (1999b) (BP model) presented a simple probit model over a panel of developing countries through 1995 to predict Asian crisis 1997 They found that 5 variables (Reserves growth rate, Export growth rate, Real exchange rate deviation, Current account deficit/GDP & Short-term debt/Reserves)-measured in percentile- performed well in forecasting the crisis 1997 They regarded the first 4 variables as first generation ones and short-term external debt/reserves as second generation one Short-term external debt/Reserves ratio is used to measure vulnerability to panic, suggested by Radelet and Sachs (1998) Once foreign lenders become convinced that other lenders would not roll over their loan, there are not enough reserves to cover the mature loans Panics tum into self-fulfilling (Table 3.2)

Goldman Sach's GS-WATCH model, designed by Ades et al (1998), is the logit model employing 09 variables (Table 3.2) included 01 political risk indicator Like BP model, their definition of crisis involves reserves loss and nominal exchange rate move, but they have specific thresholds for specific countries by using Self Exciting Threshold Autoregression technique (also used to identifY recession in business cycle literature) Different from BP model, GS-WATCH incorporates stock prices, real interest rate in G7 economies, contagion, credit (to private sector) growth and political risk - a fourth generation variable For their purpose of private institutional investor, the predicting horizon is 3 months only Their in-sample test proved their model worked well in predicting currency crisis in developing countries (Table 3.2)

Peltonen (2006) model identified a currency crisis similarly to BP model but he used the threshold of 2 standard deviations beyond the mean of the specific country's crisis index His choice of variables falls in a range of 3 generations, from budget deficit, contagion to, stock price, real interest rate (Table 3.2) He also used several dummy variables for the world's regions and for different exchange rate regimes After testing in-sample and out-of-sample, Peltonen also claimed that his model did a good predicting work

3.3 Incorporating institutional variables

Shimpalee and Breuer (2006) extended EWS by adding institutional variables to previous economic EWSs in the literature They selected 3 models of Eichengreen et al (1995), Kaminsky and Reinhart (1999), Frankel and Rose (1996) and incorporated 13 institutional variables into these 3 models Most oftheinstitutional variables are measured by International Country Risk Guide The additional variables are briefly described as follows:

1 Bureaucratic quality: measures the strength and quality of civil service and bureaucrats and their ability to manage political problems without interruption of services

2 Government stability: captures the government ability to continue its announced programs and to stay in office

3 Absence of corruption: higher index means less corruption

4 Law and order (quality): measures the strength and impartiality of the legal system and popular observance of the law

5 Absence of ethnic Tensions: rooted from racial, nationality, or language division and gauge The index measures how intolerant groups might be to compromise Higher number indicates lower ethnic tensions

6 Absence of external conflict: ranges from trade restrictions and embargoes to geopolitical disputes to incursions, insurgencies, and warfare

7 Absence of internal conflict: reflects the extent of political violence

8 Exchange rate regime: dummy variable Code 1 with fixed exchange rate, and 0 otherwise

9 Capital controls: controls on capital account transactions, or restrictions on capital movements, especially inflows with a 1, and 0 otherwise

10 Central bank independence: level of freedom from political pressure It is measured

on a scale between 0 and 1 where 0 stands for the minimum level of independence and 1 for the maximum level

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11 Deposit insurance: dummy, 1 with explicit deposit insurance protection systems, 0 otherwise

12 Financial liberalization: real interest rates are used as a proxy for financial liberalization because real interest rates are usually lower, or negative, in repressed financial systems

13 Legal origin: dummy Civil law system are coded as 1 and common law countries as

In the similar approach of Shimpalee and Breuer (2006), Leblang and Satyanath (2008) employed 3 EWS models of Frankel and Rose (1996) (FR model), Kamin et al (2001) (KSS model), Bussiere and Fratzscher (2002) (BF model) and associated additional political variables into them Most of the political variables are measured by the World bank's Database of Political Institutions (Beck et al., 2003), except for the Democracy indicator measured by Adam Przeworski and his colleagues (Alvarez et al., 2000) The following are the extra political variables: (Table 3.2)

1 Government turnover: extent of turnover of a government's key decision makers in any one year

2 Unified/Divided government: A divided government is defined as the party of the chief executive does not control the legislative, then this dummy take the value of 1, otherwise, 0

3 Democracy: a dummy represents the absence/presence of a government actually relinquishing office following an election

4 Number of checks and balance: the number of actors whose permission is required to change policy from the status quo

5 Political polarization: captures the polarization level of zero as elections are not competitive, or if the chief executive's party has an absolute majority in the legislature

Leblang and Satyanath (2008) added 2 variables (Government turnover, Unified/Divided government) into FR model, KSS and BF models first, then Democracy, Checks and balance, Polarization

For the FR model, Turnover and Unified government proved their correct signs and statistical significance A shift from unified to divided government or an increase in government turnover does increase the probability of currency crisis

In KSS and BF models, coefficients for unified government and government turnover are correctly signed Out of which, government turnover is statistically significant in KSS model and vice versa in BF model For the out-of-sample test, all 3 modified models claim its improvement over 3 original models in predicting crises

The FR model with additional Turnover and Unified government is considered as 'core FR model' Robustness tests are done on the core FR model by adding in turn each of 3 other variables (Democracy, Checks and balance, Polarization) and Country and decade dummies Turnover and Unified government still proves correct sign and high statistical significance Democracy, Checks and balance and Polarization show low significance although Democracy

& Checks have correct sign

(Refer to the Appendix 1 for specification of 05 currency crisis models of Eichengreen et al (1995), Frankel and Rose (1996), Kaminsky and Reinhart (1999), Kamin et al (2001) and Bussiere and Fratzscher (2002).)

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one-24 months Signal approach

An indicator gives out a signal whenever it moves beyond a specific threshold

Output 'Excess' real M1 balances International reserves M2 multiplier

Domestic credit/GDP Real interest rate Terms oftrade (Real interest differential Imports

Bank deposits Lending rate/deposit rate)

Same as KRL (1998)

24 months Probit regression on pooled data measured in percentiles

Table 1 (cont.)

Specification of typical Early Warning Systems and empirical currency crisis models

Ades et al (1998) (Goldman Sachs) Peltonen (2006)

changes in the trade-weighted real exchange rate minus one-month changes in exchange rate minus three-month changes reserves that exceed country specific mean and 2

in reserves that exceed country specific standard deviations

Autoregression, a technique used in the business cycle literature to identify recession)

Logit regression with variables measured Probit regression on pooled data

as 0/1 indicators based on threshold found

in autoregression and dummies (SET AR:

Self Exciting Threshold Autoregression) and as continuous value

1983-1998

27 developing countries Real exchange rate deviation Export growth

Credit growth Reserves/M2 (level) Financing requirement (current account deficit plus gross external amortization payments)

Stock market price Global liquidity (real interest rate in G-7 economies)

Contagion

Political risk

1980-2001

24 developing countries Government budget balance/GDP Current account/GDP

Under/Overvalue of Real Effective

Exchange Rate Real interest rate

RealGDP Real domestic credit grow Broad money/Foreign reserves Stock market index

Dummy for hyperinflation Dummy for contagion Dummy for de facto pegged FX regime Dummy for de facto crawling pegged FX regime Dummy for de facto managed float FX regime Dummy for de facto floating FX regime Dummy for de facto freely falling FX regime Dummy for Latin America

Dummy for Europe Dummy for Asia; Dummy for Africa

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Table 1 (cont.)

Specification of typical Early Warning Systems and empirical currency crisis models

Crisis

definition

Shimpalee and Breuer (2006) Leblang and Satyanath (2008)

3 models: Eichengreen et al (1995); 3 models: Frankel and Rose (1996); Kaminsky and Reinhart (1999);

Frankel and Rose (1996)

Kamin et al (200 1 ); Bussiere and Fratzscher (2002)

Predict time t-1 (quarterly, annual, monthly) 0; 24 months; 12 months

20 OECD countries; 15 developing

and 5 industrial countries; 105

developing countries Economic variables of each of 3 models above-mentioned, and

Bureaucratic quality Government stability Absence of corruption Law and order

Absence of ethnic Tensions Absence of external conflict Absence of internal conflict Exchange rate regime Capital controls Central bank independence Deposit insurance

Financial liberalization Legal origin

Logit regression on pooled data 1971-1992, 1981-1999, 1993-2001

105 developing countries; 26 emerging countries; 32 emerging countries

Economic variables of each of 3 models above-mentioned, and

Government turnover Unified government Democracy

Number of checks and balance Political polarization