Determinants of currency crises in emerging economies in 1996 2005 an early warning system approach

Recently,wefacedthere-emergenceofinstitutionaleconomicseconomicsNobelprize2009isanaward forinstitutionaleconomicsthatpaysmoreattentiontothefoundationsformarketfunctioningthatshednew ligh

UNIVERSITYOFECONOMICS

INSTITUTEOFSOCIALSTUDIESHOCHIMINHCITY

THEHAGUE VIETNAM THENETHERLANDS

VIETNAM-NETHERLANDS PROGRAMMEFORM.AINDEVELOPMENTECONOMICS

Determinantsofcurrencycrisesinem ergingeconomiesin1996-

2005:AnEarly

WarningSystemapproach

Athesissubmittedi n p artial fu lfillmen t o f therequirem

entsforthedegreeof MasterofArtsinDevelopmentEcono mics

By

TruongH4ngTufin

Thesiss u p e r v i s o r : Dr.VfiThfinhTpAnh

HoChiMinhcity,October2009

Ideclarethatthethesisherebys u b m i t t e d f o r theMasterde gr e e

attheVietnam-NetherlandsProgrammeforM.AinDevelopmentEconomicsismyownworkandhasnotbeenpreviouslysubmittedbymeatanotheruniversityfor

Theoriesof currencyc r i s i s consistedo f 4generationso f modelss u g g e s t thateconomic

a n d institutionalv a r i a b l e s c a n beempl oyed i nearlywarningsyste m m o d e l s topredictc

u r r e n c y crisisforthepurposeofpreventionpolicy.Thisstudyincorporates5variablesfromBergandPattillo(1999b)m o d e l (Reale x c h a n g e r a t e overvaluation,Foreignreservesloss,E x

p o r t growth,C u r r e n t a c c o u n t d e f i c i t , S h o r t - t e r m e x t e r n a l d e b t /

F o r e i g n r e s e r v e s ) a n d a d d i t i o n a l Domesticcreditgrowth,6institutionalvariablesadopt ed fromWorldwideG o v e r n a n c e Indicators(Kaumannetal.,2008)

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Chapter1 Int

roduction

1.1 StatementoftheProblem

Onthewaytodevelopment,currencycrisesareverycostlyforemergingeconomies.Currencycrisescanleadto

5 5 % d e p r e c i a t i o n o f VNDagainstUSDinthenext12months

InJune

2008,StatebankofVietnamwidenedtradingbandforforeignexchange(USD)from1%to2%.InNovember2 00 8, it raisedthebandto3%andinMarch2009to5%.Domestic

creditgrowthr a t e i s 50%in2007, 3 4 % in2008a nde st i m a t e d 3 0 % i n 2009b y EconomistIntelligenceUnit

Aftert h e b o o m i n g i n s t o c k a n d r e a l e s t a t e m a r k e t i n 2 0 0 7 w i t h c a p i t a l i n f l o w m

a i n l y f o r portfolioinvestm ent, acrashofmorethan70%instockmarketbrokeoutin2008againstitspeakinOctober2007.Capitalinflowandexportshrink,largercurrentaccountdeficit(13.6%in2008)isputtingpressureonthepegregimeofVNDtoUSD.ItseemsthatthescenarioofAsiancrisisrepeatsinVietnam

UnlikeAsianc r i s i s c o unt r i e s o f cronycapitalism,Vi e t n a m ’ s r e l a t i o n s h i p - b a s e d

s y s t e m h a s evenweakerinstitutions.Sodoinstitutions playanyroleinsettingstageforacurrencycrisis?

Nowi s O c t o b e r 2 0 0 9 F o r t u n a t e l y , t h e M o r g a n Stanley’sf o r e c a s t f a i l e d , b u t

w h e t h e r t h e Vietnamc ur r e nc y crisisiscomingsoon?

Thus,currencycrisisisaburningissueinVietnamforthetimebeing

1.2 ObjectiveoftheResearch

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Vietnamisanemergingmarketeconomy.Understandingwhatcausedcurrencycrisesinotheremergingm a r k e t e c o n o m i e s i n r e c e n t y e a r s w o u l d b e a g oo d r e f e r e n c e f o r f u r t h e r comprehensiveresearchesonwhatVietnamshoulddotopreventitsowncurrency crisis.

1.3 ResearchQuestions

Thisstudyaimstoanswerthefollowingquestions:

1 Whatarethekeydeterminantsofcurrencycrisesin 2005inthelightofearlywarningsystemapproach?(especially,current

1.5ScopeoftheResearch

Basedonavailabilityofdataofinstitutionsandreviewofrecenthistoryofcurrencycrisesinemergingmarketeconomies,1 5 economiesareselectedandtheperiodo f studyislimitedin1996-

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Theorieso f currencyc r i s e s -Abriefreviewo f theliterature

Int h e l i t e r a t u r e off i n a n c i a l crises,t h e r e areb a n k i n g crises,

( s o v e r e i g n ) debtc r i s i s a n d currencycrises.Bankingcri ses arerecognizeda s theinsol ve ncy o f thebankings y s t e m t ha t occursw i t h h i g h r a t i o o f n o n -

p e r f o r m i n g loant o a s s e t s D e m i r g u c - K u n t

a n d D e t r a g i a c h e (1997)consideredoneofe v e n t orcombinationof t h e followingasbankingcrisis:(1)nonperforminga s s e t s /

t o t a l a s s e t s r a t i o i n t h e b a n k i n g s y s t e m e x c e e d s 1 0 % ;

(2)thec o s t o f rescueat least2%o f GDP;

(3)largesc a l e nationalizationo f banks;a n d (4) extensiveba nk runso r ot he r e m e r g e nc

y m e a s u r e s e x e c u t e d b y thegove r nm e nt D e b t c r i s i s i s defineda s anationalg o v e r

n m e n t f a i l s tomeeta principalo r interestpa ym e nt o n thedue date( Rei nha rt andRogoff,2008).Thisstudyfocusesoncurrencycrisesonly

Thischapterconsistsof2parts.Part1 presentsthe identificationo f acurrencyc r i s i s, part2reviews4generationsofcurrency crisismodels

defineacurrencycrisisisasBussiereandFratzscher(2002)thatincorporatemovesi n e x c h a n g e r

a t e , i n t e r e s t r a t e a n d f o r e i g n r e s e r v e s ( i n i t i a l l y s e t o u t b y G i r t o n a n d Roper,

1 9 7 7 ) Theyi d e n t i f i e d a crisisastheexchangem a r k e t p r e s s u r e ( E M P ) ofaspecificcountryexceedsitsmeanby2standarddeviations.EMPisconstructedasaweightedaverageofthechangeoftherealeffectiveexchangerate(RER),thechangeintherealinterestrate(r)andt h e changeinf o r e i g n exchange reserves(res).R e a l

v a l u e s arec o n s i d e r e d toa v o i d differenti n f l a t i o n r a t e a c r o s s c o u n t r i e s I n t

e r e s t r a t e i s i n v o l v e d inc a s e t h e c e n t r a l b a n k defendsthedomesticcurrencybyincreasingitsinterestrate.

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s t 10% T h u s , t h e y didnotconsiderspeculativeattacksfailedbygovernmentinterventionviasellingforeignreservesasacurrencycrisis.

Thetheorieso f currencyc r i s i s havede ve l ope d o v e r thetime.It s e e m s thata ft e r aseriesofcurrencycrisesoccurred,anewgenerationcrisismodelemerges.Abriefreviewofcurrencycrisisliteraturecantraceout4generationsofcurrencycrisismodel

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Themodeld e r i v e s thata s longastherei s budgetd e f i c i t a n d i n f l a t i o n, i n v e s t o r s changethecompositiono f theirassetportfoliobyincreasingtheproportiono f foreignexchange,reducingt h e p r o p o r t i o n o f domesticc u r r e n c y G o v e r n m e n t h a s torund o w n i t s reservest o retaint h e fixedrateont h e waytofinanceitsbudgetd e f i c i t Exhaustiono f reservesp us he s governmentt o abandont h e pegging.S u c h expectationm a k e s i n v e s t o r s a d v

a n c e thedateoftheirspeculativeattacks,theleadingspeculatorsse l l domesticmoneyevenearlierandsoon,reservesrunoutfasterandcurrency crisisbreaksout

Themodelse e m s tohavehighlys i m p l i f i e d a s s u m p t i o n s o n twoassetportfolioh ol di n

g, t h e toolsgovernmentusestointerveneinforeignexchangemarket,onlysellingreserves,perfectforesightspeculators,thetimeofcrisisisunclearlyidentified

firstmodelalsoshowst h a t currencycrisisc a n emerge

underarbitraryspeculativebehavioro f investorsb ut theya ss um e d t hat thiseffecti s zeroforsimplifyinga n a l y s i s T he secondm o d e l i s adiscretet i m e , s t o c h a s t i c o n e (relaxassumptiono f perfectf o r e s i g h t ) t h a t incorporateuncertaintyt o studytheforwarde xc

ha nge rateofapegregimea s aresponset orealitythatforwardratemayexceedthefixedrateforlongperiodoftime.Usingtheconcepttheshadowexchangerate,theratethatwouldprevailafterthespeculativeattack,thesecondmodely i e l d s ane n d o g e n o u s p r o b a b i l i t y distributionovert h e c r i s i s t i m e a n d p r o d u c e s aforwardexchangeratethatisgreaterthanthefixe

aformofself-entt ha t therei s note n o u g h f o r e i g n r e s e r v e s t o i n s u r e de pos i t s, e x t r a de pos i t s h a v

e r i s k exposure.T h i s g a p willi g n i t e a s pe c u l a t i v e a t t a c k t o m i n i m i z e l o s s tha t r u n

s u p t o c r i s i s

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Dooleym o d e l o f f e r s a c a p i t a l i n f l o w /

c u r r e n c y crisisf o l l o w v i e w , t h a t n o t b u d g e t d e f i c i t , moneysupplyorhigherinternationalinterestrateisblamedforcurrencycrisis

ThefirstgenerationmodelsexplainedwellthecrisisofLatinAmericacountriesinthe19 80 s thathavemacroeconomicfundamentalproblemssuchasfiscaldeficit,hyperinflation,foreignloan,currentaccountdeficit,capitalflight

Thef i r s t g e n e r a t i o n

m o d e l s suggestt h a t m a c r o e c o n o m i c fundamentalsaret h e c a u s e s o f currencyc r

i s e s V a r i a b l e s u s e d i n e a r l y w a r n i n g s y s t e m s c o u l d b e b u d g e t d e f i c i t , m

o n e y supply,domesticcredit,currentaccountdeficit,internationalinterestrates,capitalinflow/outflow(capitalcontrol)

Intheearly1990s,therewereseveralcurrencycrises,suchastheEuropeanMonetarySystemcrisisof1992-93,thatcouldnotbeexplainedbythefirst

generationmodels.Europecountriesatthattimehadso un d macroeconomicf u n d a m e n t a l

s , b u t currencycrisesstilloccurred.Thecurrencycrisismodelthenevolvedtoconfrontthenewreality.Thesecondgenerationcame out

Obstfeld(1994)raisedaquestion:W hydoesthegovernmentl i k e toabandonthefixedrate?Hedescribed2

modelsinthepapertoanswer.Itisbecausegovernmentdebtdenominatedi n domesticc u r r e n c

y a n d u n e m p l o y m e n t problem.Ino n e m o d e l , h e m e n t i o n e d ther o l e o f

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rate.D e v a l u a t i o n expectationsfeedintoh i g h nominalinterestr a t e t h a t pushesgove r

nm e nt f u r t h e r togiveupthepegwouldhavebeenv i a bl e underreverseprivateexpectations.M a t u r i t y s t r u c t u r e o f theg ov e r nm e nt 's d o m e s t i c o b l i g a t i o n s a n d t he c ur r e n

c y compositiono f theoverallpublicdebtwoulddecidetheeffectofinterestrateindevaluation.Largeportionof

debtburdendenominatedindomesticcurrency,highernominalinterestratewilll e a d t o h i

g h e r d e v a l u a t i o n t o l e s s e n t h e g o v e r n m e n t d e b t b u r d e n P e r f e c t f o r e s i g h

t e d speculatorswouldtrytogetoutofthedomesticcurrencyaheadofthatdevaluation.Inanothermodel,

Them o d e l s proposethata s p e c u l a t i v e attackcano c c u r e v e n withthea b s e n c e

o f p o o r macroeconomicconditionsinthepre-crisistime fulfillingattackinwhichspeculativeanticipationsandherdingbehaviorplayarole

Currencycrisiscanresultfromself-Onceunemployment r a t e i s onupwardt r e n d a n d g o v e r n m e n t p o l i c y i s tomaintainafixedexchangerate.Speculatorscanperceivethathighpoliticalcostofthemaintainingofthefixedexchanger a t e f a c i n g t h e f u t u r e r i s i n g u n e m p l o y m e n t Theyr e c o g n i z e t h e d

e v a l u a t i o n islikely.Eventheydon’tk n o w when,theystartsellingd o m e s t i c currencynow.Herdingbehaviorsetsi n a n d f u l l - s c a l e speculativeattack breaksoute v e n

b e f o r e unemploymentbecomesaproblem

Eichengreeneta I

( 1 9 9 6 ) s h o w t h a t c o n t a g i o n t a k e s itse f f e c t o n c e t h e d e v a l u a t i o n o f a country’sc u r r e n c y m a y r e d u c e i t s tradi ng p a r t n e r s ’ c o m p e t i t i v e n e s s e n o u g h t o m

a k e t h e i r currenciess u b j e c t t o d e v a l u a t i o n t o o T h e y p o s e h y p o t h e s i s t h a t t h

e r e a r e 2 c h a n n e l s f o r contagiont a k i n g e f f e c t T r a d e l i n k a g e b e t w e e n 2c o u

n t r i e s canm o t i v a t e onec o u n t r y t o devalueitsc u r r e n c y toincreaseitsinternationalcompetitivenesso ne t h e othercountrydevaluedpr e vi ousl y B a s e d o n thecurrenta n d prospe ctivei n t e r n a t i o n a l c o m p e t i t i v e n e s s o f thec o u n t r i e s c o n c e r n e d , s p e c u l

a t o r s i g n i t e a t t a c k s T h e s i m i l a r m a c r o e c o n o m i c c o n d i t i o n s acrossc o u n t r i e

s a l s o a r e f o u n d a t i o n s fora d v a n c i n g s p e c u l a t i v e a t t a c k s U s i n g a p a n e l o fquarterlyd a t a f o r 2 0 i n d u s t r i a l c o u n t r i e s f o r t h e p e r i o d 1959-

1993 t o t e s t f o r c o n t a g i o u s currencyc r i s e s , t he y f i n d e v i d e n c e o f contagion C o n

t a g i o n a p p e a r s t o s p r e a d t o c o u n t r i e s whichhavecloseinternationaltradelinkagesratherthantocountriesinsimilarmacroeconomicc o n d i t i o n s

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Calvo( 1 9 9 5 ) s u g g e s t t h a t t he b a s i c c a u s e o f a currencyc r i s i s m a y b e i n v e s t o r s ’ b e

h a v i o r Riskaverseinvestorsinvestinseveralcountries.Financialdiversif icati on andlender’sinformationhaveaninterestingrelationship.I n v e s t o r s withhighlydiversifiedportfoliohaveloweri n c e n t i v e s t o l e a r n a b o u t i n d i v i d u a l c o u n t r i e s t h a n i n v e s t o r s w i

t h f e w diversification opportunities.Diversification e n c o u r a g e s ignorance and,inthatcontext,rumorscouldresultinmassivecapitalflowsfromacountry.So

S p e c u l a t o r s suchasSorosrecognizedthetradeoffgovernmentconfrontsandexpectedthegovernmentunder politicalpressurewillgiveupthepeg Theirspeculativeattackssucceeded

Infact,behindthesceneofclaimedsoundmacroeconomicfundamentals,potentialeconomicinstabilityl a y i n g asidei n Europei n c i t e s s p e c u l a t i v e a t t a c k s Ma croec onomic f u n

d a m e n t a l s actuallystillplaytheirroletoacertainextent inthe secondgenerationmodelofcrisis

987)proposedm o d e l s ofinteractionbetweenba nki ng problemsand

currencycrisis.C r e d i t b o o m , baddebt,g o v e r n m e n t spendingo n b a i l o u t

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tofindoutthedynamicsofbankingcrisisandcurrencycrisis.Thereisanasymmetryintheliquidityandriskinessofbankassetsandliabilities.A b a n k usuallyguaranteesthen o m i n a l valueoft h e d e p o

s i t s i t a c c e p t s w h i l e allocatingt h e moneyt o investmentsw i t h a v a r i a b l e r e t u r n

N o r m a l l y , term.Ittakestime

bankdepositsarehighlyliquid,whilebankinvestmentsarelowliquidandlong-andcosttoliquidatebankinvestments.Thereisanassumptiont h a t a l l b a n k depositsa r e i m p l i c

i t l y or

explicitlyguaranteedb y t h e g o v e r n m e n t Domesticandforeigndepositors/lendersbelieveinthegovernmentumbrella,stillputmoneyintothebankingsystemin

spiteofbankingoperationloss.BanksplaythePonzigameuntiltheproblembecomeserious.Governmentstepsintohelp,depletesitsbudgetandforeignreserves.CurrencycrisisofKrugmantypeeventuallyarrivedhere

Usingm o n t h l y d a t a o f 2 0 c o u n t r i e s f o r t h e p e r i o d

1970-mid1995,K a m i n s k y &R e i n h a r t (1999)a l s o f o u n d t h a t p r o b l e m s i n t h e b a n k i n g s

e c t o r t ypi c a ll y e m e r g e b e f o r e a c u r r e n c y crisis.Thecurrencycrisisthenworsensthebankingcrisis,makingaviciousspiral.Financialliberalizationo f t e n p r e c e d e s b a n k i n g c r

i s e s T h e p r o g r e s s i o n o f t h e s e e v e n t s s u g g e s t s t h a t crisesoccur astheeconomystartstoenter arecession,followingaboomin economicactivitythatisfueledbycredit,capitalinflows,associated withanovervaluedcurrency

Comparedtof i r s t a n d s e c o n d g e n e r a t i o n models,A s i a n crisisa p p e a r s t o b e d i

f f e r e n t l y Macroeconomicf u n d a m e n t a l s a r e s o u n d w i t h h i g h G D P g r o w t h r a t

e s , l o w u n e m p l o y m e n t rate,l o w i n f l a t i o n , l o w budgetd e f i c i t s , m a n a g e a b l e c u r

r e n t a c c o u n t d e f i c i t s , s t r o n g ca pi ta l inflowsandprevailedp o l i t i c a l s t a b i l i t y However,i n s i d e thebrightpi ctur e, t her e areproblemsi n thebankings e c t o r —

b a d l oa ns fromdomesticborrowers a n d unhedged, s h o r t

-termbor rowi ng f r o m foreignbanks.Th e badl o a n ac c um ul a ti on i s theconsequenceofoverlending.Krugman(1998)describedamoralhazard/assetbubbleview.Therewasaboom-

bustcycleintheassetmarketsprecedingtheAsiancurrencycrisis.Pricesofstockandlandweresoaringa n d p l u n g i n g b e f o r e t h e c r i s i s B e s i d e s, m o r a l h a z a r d i n v o l v e d a s s t

r o n g p o l i t i c a l relationsbet we e n g o v e r n m e n t a n d financecompanies/banks/

corporations( c r o n y capitalism)suggestedimplicitguaranteesfromgovernmentforlende

rsanddepositors.Thel e n d e r s becomemuchlessprudentinlendingtoinefficientinvestmentprojectsbecauseofexpectationongovernmentbailout.

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Thirdgenerationmodelimpliesanadditionalsetofvariablesrelatedtofinancialliberalizationandbankingp r o b l e m f o r earlywarnings y s t e m Namea fewas:Reali n t e r e s t rate,l e n di n g-depositrateratio,M2/reserves,bank deposit,non-performingloan.

Recently,wefacedthere-emergenceofinstitutionaleconomics(economicsNobelprize2009isanaward

forinstitutionaleconomics)thatpaysmoreattentiontothefoundationsformarketfunctioningthatshednew lightoncurrencycrises

Thefourthgenerationcrisismodels

Behindthesceneofphenomenal i k e governmentb u d g e t a n d currentaccountdeficits,hyperinflation,se l f -

f u l f i l l i ng a t t a c k s , he r di n g b e h a v i o r , e x c e s s i v e l e n d i n g , deeperq ue s t i o ns shouldberaised.Whatinstitutionalfactorssetconditionsforthesepictures?In

thesemodels,institutionalf a c t o r s a r e i n c o r p o r a t e d a n d e m p h a s i z e d w i t h a w i d

e r a n g e : l a w f r a m e w o r k , propertyr i ght , enforcementof contract,financialregulations,bur e a uc r a t i c q u a l i t y , governments t a b i l i t y , democracyandcorruption Breuer(2004)coinedthesemodelsasthefourthgeneration.

Thisinstitutionalfocushasfoundationsonthetheoryofrelationshipbetweeninstitutionsandeconomicgrowth/crisispresentedbyAcemogluetal.(2002),Rodriketal

(2002),Fukuyama(1995),S e n (1999),Johnsone t al

(2000)anda symm e tr i c i n f o r m a t i o n p r o b l e m i n financialmarketbyandMishkin(1996,2001) astypicalonesamongseveralotherauthors

ofconduct),andtheire n f o r c e m e n t characteristics.Togethert h e y definet h e incentivestructureofsocietiesandspecificallyeconomies.”

Incentivesande x p e c t a t i o n s p l a y a v i t a l rolei n t h e f i n a n c i a l w o r l d t h a t

i s i n f a m o u s f o r uncertainty.I n s t i t u t i o n s form thefoundationsa n d f a ci li t at e

awell-functioningc u r r e n c y andbankings y s t e m T h a t ’ s r e a s o n w h y t h e f o u r t h g e n e r a t

i o n m o d e l s o f c u r r e n c y c r i s i s incorporateinstitutionalvariables

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Fukuyama(1995)proposedther o l e oft r u s t insocietythatlowersadministrationcost,increasesi n s t i t u t i o n a l r e l i a b i l i t y a n d p r o m o t e s l a r g e a n d e f f i c i e n t o r g a n i z a t i o n s L o w t r u s t societyu s u a l l y h a s c o r r u p t i o n a n d t r a d e w i t h i n f l u e n c e s a n d t e n d

s t o m a i n t a i n s m a l l a n d inefficientorganizations.Trustshouldpromoteeconomicdevelopment.Itisvitalforfinancialmarketwhetherinvestors havetrustorlossofconfidence inthem

Sen(1999)presentedc o n c i s e l y s o m e

ofhisbest-knownw o r k o n famines.Theyareusuallyoccurredbyalackofpurchasingpowerorentitlements,notbyfoodshortage.Heclaimedthatlarge-

scalefaminesneverha ppe ne d i n ademocracy.T h e y canonlyhappeni n authoritarianregimeslackingo p e n n e s s o f i n f o r m a t i o n andt r a n s p a r e n c y Hisa n a l y s i s inspiredsimilarapproachtotheAsiancrisisin1997

Johnsone t a l

( 2 0 0 0 ) p r o v e d t h a t t h e e f f e c t i v e n e s s o f pr ote ctionf o r m i n o r i t y s h a r e h o l d e r sexplaint h e e x t e n t o f d e c l i n e s i n e x c h a n g e r a t e d e p r e c i a t i o n a n d s t o c k m a r k e t

b e t t e r t h a n standardmacroeconomicmeasuresdo.T h e y modelizedtheconflictofi n t e r e s

t betweeninsiders(managers)andoutsiders(equityowners).Weakercorporategovernancerulesandaweakerl e g a l s y s t e m r e d u c e t h e c os t of st e a l i n g ( e x p r o p r i a t i o n ) o f managers.T h e m a na ge r comparesthemarginalcostandmarginalbenefitofstealingfortheirreaction.Foragivenrateofreturn,i f themanageri n v e s t s l e s s theiro wn mone y,t h e y h a v e m o r e i

n c e n t i v e s t o s t e a l However,ifthemanagerhasmoresharesinthefirm,anincreaseinthereturnoninvestmentpersuadeshim toinvestmoreintotheprojectand,therefore,tostealless.Ontheotherhand,ifthemanagerownsmoreofthefirm,butthereturnoninvestmentreduces,thenhestealsmore.Thes t e a l i n g o f m a n a g e r s h r i n k s v a l u e o f f i r m L e s s v a l u e o f t h e f i r

m , l e s s c o n f i d e n c e o f foreigna n d d o m e s t i c i n v e s t o r s s t a y s i n t h e s t o c k m a r k e t L o s s o f c o n f i d e n c e i n t h e s t o c k markettriggerscapital outfloworstopofcapitali n f l

o w Thecapitalo ut f l ow aff ect sforeignexchangemarket,ignitescurrencycrisis.Inordertostudy27emergingmarketsintheendof1996toJanuary1 9 9 9 , Johnsone t al.employedd a t

a measurei n s t i t u t i o n a l v a r i a b l e s u c h as:shareholderprotection,creditright,accountingstandards,enforceabilityofcontracts(judicialefficiency,corruption,ruleoflaw,corporategovernance);economicvariablel i k e : fiscalandmonetarypolicy,currentaccountandreserves.Runninglinearregressionofthese

institutionalandeconomicvariablesonexchangerateandthenstockprice,theyfoundthattheregressionresultss u p p o r t t h e i r t h e o r y L o w e r q u a l i t y o f s h a r e h o l d e r p r o t e c t i o n a n

d e n f o r c e a b i l i t y o f contracth a v e h i g h s t a t i s t i c a l s i g n i f i c a n c e a n d i n f l u e

n c e i n e x p l a i n i n g t h e d e p r e c i a t i o n o f domesticcurrencyanddecreaseinstockpriceinemergingmarkets

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Acemoglue t a1.

(2002)observedthatcountriespursuingpoor macr oec onomic p o l i c i e s a l s o havewea

ki n st i t u t i o ns , i nc l u d i n g politicali nst i t ut i ons thatdonotconstrainpoliticians,weakpropertyrightsforinvestors,widespreadc or r upti on, andahighdegreeofpoliticalinstability.Theyproposedt h a t macroeconomicp o l i c i e s a r e morel i k e l yt o bes y m p t o m s o f underlyinginstitutionalp r o b l e m s r a t h e r t h a n themainc a u s e s of economicv o l a t i l i t y , w e a k

i n s t i t u t i o n s cancausevolatilitythroughanumberofmacroeconomicandmicroeconomicchannels

Mishkin(1996,2001) approachedfinancialcrisesinthelightofasymmetricinformationwiththemoralhazardproblem.EmergingmarketeconomiessuchasMexico,Ecuador,EastAsiancrisiscountriesa nd Russiana r e well-knownf o r weakfi nancial regulationsa n d supervision Whenfinancialliber aliz ation f a c i l i t a t e i nt e r nat i onal c a p i t a l inflowandopportunitiest otakemorer i s k y lending,t h e s e w e a k regulatory/

supervisorys y s t e m c o u l d n o t limitt h e m o r a l hazardproblemcreatedbythegovernmentsa f e t y net.Oncegovernmenthassignalsofferingbailoutst o protect b a n k s & corporations,e x c e s s i v e ri sk taki ng i s oneresult,i n c r e a s i n g t h e probabilityoff i n a n c i a l c r i s i

s e m b r a c i n g b a n k i n g c r i s i s a n d c u r r e n c y c r i s i s M i s h k i n a l s o proposed12areaso f policyt o preventf i n a n c i a l c r i s i s : 1 P r u d e n t i a l s u p e r v i s i o n , 2 Accountinga n d d i s c l o s u r e s r e q u i r e m e n t s , 3.Legala n d judicialsystems,4 M a r k e t b a

s e d disciplines,5 Entryo f f o r e i g n b a n k s , 6 C a p i t a l c o n t r o l , 7 Reducti on o f c o n t r

o l o f s t a t e ownedf i n a n c i a l i n s t i t u t i o n s , 8 Re stric tions o n f o r e i g n

-d o m i n a t e -d -d e b t s , 9 Elimi nati on o f

too-big-too-failint h e c o r p o r a t e s e c t o r s , 1 0 Sequencingo f thef i n a n c i a l l i b e r a l i z a t i o n , 11.Monetarypolicya nd pricesta bility, 1 2 E x c h a n g e rateregimesa n d foreignexc ha ngereserves.Fromthis list,wecanseesomeinstitutionalfactorsthatcausefinancialcrisis

Pape 16 of 52

TheexistingcrisisintheUSi s infactabankingcrisi scausedb y exc essive l e n d i n g primemortgages( El li s, 2008).Thesub-

onsub-primemortgagesar e cutintopiecesi nsecuritizationprocessandtheriskbecomeopaque,thenaresoldout,spreadintheUSandovertheworld.Likethescenarioisdescribedinthethirdcrisisgeneration( t w i n crisis),bankingcrisiscomefirst,gover nme nt i m p l e m e n t s g i a n t b a

i l o u t s o f ba nks/

c or por at i ons andthe n c u r r e n c y c r i s i s follows.ThereareholesinfinancialregulationsintheUSfinancialsystemthatpromotessuchexcessiverisklending(nojob-

nop r o b l e m housingloans).Thus,thefourthgenerationfactorscanalsobeusedtoexplaintheUScrisis.AlthoughF E D ’ s newly-

issuedt r e a s u r y b o n d s (forbailouts)a r e s u p p o r t e d b y h u g e i n t e r n a t i o n a l r e s e r v

e s f r o m C h i n a , t h e U S d o l l a r i s b e i n g depreciateda g a i n s t o t h e r m a i n c u r r e n c i e s (

E U R , G B P , A U D ) S o wec a n c o n s i d e r t h e U S crisisiskindofthirdandfourthgenerationcombination

Theoriesonthecausesofcurrencycrisessetfoundationforseveralearlywarningsystemandempiricalc ur r e n c y crisismodelscomingout.Thefourgenerationsofcurrencycrisismodelssuggestwhatvariables s h o ul d beemployedi n empiricale a r l y warningsystemandcurrencycrisismodels.Whilethefirstandthethirdgenerationmodelspointoutthespecificeconomicvariablesuchasbudgetdeficit,currentaccountdeficit,moneysupply,capitalflow,

baddebtsasi n d i c a t o r s o f c u r r e n c y c r i s i s , t h e s e c o n d a n d t h e f o u r t h g e n e r a t i o n

g i v e m o r e r o o m f o r choicesofvariables.Itisbecauseexpectationscanbebasedonawiderangeofindicatorsandinstitutionsinvolvealotoffactorsrelatedtolaws, politics,culture

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Typicalearlyw a r n i n g systemsande m p i r i c a l currencycris is

models- Abrief rev iew o f theliterature

TheMexicana n d Asianc r i s e s tookt h e internationalc o m m u n i t y s o m e w h a t b ys u r p r

i s e andsincethenraisedtheattentiononmethodsthatcouldforecastcrisesofhighlyvulnerablecountriesinthetimelymanner

Severalearlywarnings y s t e m s (EWS)empiricalcurr ency cr i si s modelshavebeend e s i

g n e d ands o m e o f t h e m a r e b e i n g u s e d b y I M F a n d p r i v a t e f i n a n c i a l i n s t i t u t i o

n s l i k e G o l d m a n Sachsf o r p o l i c y ands p e c u l a t i v e p u r p o s e s TheT a b l e 1h e r e

u n d e r summarizest h e m a i n featuresoftypicalEWSs,includingEWSsusedinIMFlikeKaminskyeta1.(1998), BergandPattillo(1999b),inGoldmanSachlikeGS-WATCH(Adesetal.,1998),andEWSspresentedinotheracademic s t u d i e s like Peltonen( 2 0 0 6 ) , S h i m p

a l e e a n d Breuer( 2 0 0 6 ) , L e b l a n g a n d Satyanath(2008)

3.1Signalapproach

Kaminskyeta 1 ( 1 9 9 8 )

( K L R ) p r o p o s e d observationof15i n d i c a t o r s t h a t g i v e w a r n i n g signalspriortoacrisis.KLR’scrisisdefinitioni s previouslym e n t i o n e d i n chapter2.ofthisstudy(Theoriesofcurrencycrisis).KLRselected15indicatorsbasedonpriortheoriesandonthemonthly

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notissueasignalthatwouldhavebeena bads i g n a l Theoptimalpercentile t h r e s h ol d i s theone—thatminimizest h e ba d s i g n a l togo od s i g n a l ratio[ ( B / ( B + D ) ] / [ A /

( A + C ) ] F o u r i n d i c a t o r s ( R e a l interestdifferential,Imports,Bankdeposits,Lendingrate/depositrate) thatproduceexcessivenoiseareeliminatedfromtheKLRmodel

AsdescribedbyBergand

Pattillo(1999a),Kaminsky'laterdevelopedasinglecompositeindicatorof

crisisthatiscomputedasweightedsumoftheindicators,whereeachindicatorisweightedbytheinverseofitsbadsignal/goodsignalratio

Thenaprobabilityof crisisforeach valueofthecompositeindexiscalculatedbythenumberofmonthshavingagivenvalueoftheindexisfollowedbyacrisiswithin24months

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Becauseoft h e s h o r t c o m i n g o f s i g n a l a p p r o a c h int e s t i n g statisticalsignificanceo

i c i t / G D P a n d M2/

Re se r ve s ) P r o b i t a n d modi fi e d K L R performedw e l l inpredictingAsiancrisis1 9 9 7 However,probitmodelwith5variablesca n testthestatisticalsignificantofindividualindicatorswitheasewhiletheKLR model(with1 7 variables)cannotdoit.(Table3.2)

Bergea n d P a t t i l l o ( 1 9 9 9 b )

( B P m o d e l ) p r e s e n t e d as i m p l e p r o b i t m o d e l o v e r a p a n e l o f developingcountriesthrough1 9 9 5 topredictAsiancr i si s 1 9 9 7 Theyfoundthat5variables(Reservesg r o

w t h r a t e , E x p o r t g r o w t h r a t e , R e a l e x c h a n g e r a t e d e v i a t i o n , C u r r e n t a c c o u

n t deficit/GDP&S h o r t - t e r m d e b t / R e s e r v e s ) m e a s u r e d inp e r c e n t i l e

-p e r f o r m e d welli n forecastingt h e c r i si s 1 9 9 7 Theyr e g a r d e d t h e f i r s t 4va r i a bl e s a sfirstge ne r a ti on o n e s a n d short-termexternaldebt/reservesassecond generationone Short-termexternaldebt/Reservesratioisusedtomeasurevulnerabilityt o panic,suggestedbyRadeletandSachs(1998).Onceforeignlendersbecomeconvincedthatotherlenderswouldnotrollovertheirloan,therearenotenoughreservestocoverthematureloans.Panicsturnintoself-fulfilling.(Table3.2)

GoldmanSach’sG S - W A T C H m o d e l , d e s i g n e d b y A d e s e t a l

( 1 9 9 8 ) , i s t h e l o g i t m o d e l employing09variables(Table3.2)included0 1 politicalriskindicator.LikeBPmodel,theirdefinitiono f c r i s i s i n v o l v e s r e s e r v e s l o s s a n d n o m i n a l

e x c h a n g e r a t e m o v e , b u t t h e y h a v e specifict h r e s h o l d s f o r s p e c i f i c c o u n t r i e s b

y u s i n g S e l f ExcitingT h r e s h o l d A u t o r e g r e s s i o n technique( a l s o u s e d t o i d e n t i

f y r e c e s s i o n inb u s i n e s s c y c l e l i t e r a t u r e ) D i f f e r e n t f r o m B P

model,GS-WATCHincorporatesstockprices,realinterestrateinG7economies,contagion,credit( t o privates e c t o r ) gr o wt h a n d p ol i t i c a l r i s k —

a fourthge ne r a t i o n v a r i a b l e F o r theirpurposeo f privatei n s t i t u t i o n a l i n v e s t o r , t

he predictingh o r i z o n i s 3monthso n l y Theiri n - samplet e s t p r o v e d their

modelworkedwellinp r e d i c t i n g currency crisisi n d e v e l o p i n g countries.(Table3.2)

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Peltonen( 2 0 0 6 ) m o d e l i d e n t i f i e d a c u r r e n c y c r i s i s s i m i l a r l y t o B P m o d e l b u t h

e u s e d t h e thresholdof2standarddeviationsbeyondthemeanofthespecificcountry’scrisisindex.Hischoiceofvariablesf a l l s inarangeof3generations,f r om budgetdeficit,contagionto,stockprice,r e a l i n t e r e s t r a t e ( T a b l e 3 2 ) He a l s o use d s e v e r a l d u m m y v a r i a b l e

s f o r thew or l d’ s regionsa n d for differente x c h a n g e rateregimes.Aft ert e s t i n g i n

-s a m p l e a n d out-of sample,Peltonenal-soclaimedthathi-smodeldidagoodpredictingwork

3.3Incorporatinginstitutionalvariables

Shimpaleea n d B r e u e r ( 2 0 0 6 ) e x t e n d e d E W S b y a d d i n g i n s t i t u t i o n a l v a r i a b l e

s t o p r e v i o u s economic

EWSsi n t h e l i t e r a t u r e Theyselected3m o d e l s ofE i c h e n g r e e n eta l

( 1 9 9 5 ) , Kaminskya n d Rei nha rt ( 1 9 9 9 ) , F r a n k e l a n d R o s e ( 1 9 9 6 ) a n d i n c o r p o r a t

e d 13institutionalvariablesintothese3models.MostoftheinstitutionalvariablesaremeasuredbyInternationalCountryRiskGuide.Theadditionalvariablesarebrieflydescribedasfollows:

Bureaucratic

quality:m e a s u r e s t h e s t r e n g t h a n d q u a l i t y o f c i v i l s e r v i c e a n d bureaucratsandt h e i r a b i l i t y t o m a n a g e p o l i t i c a l p r o b l e m s w i t h o u t i n t e r r u p

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11 Depositi n s u r a n c e : d u m m y , 1 withe x p l i c i t d e p o s i t i n s u r a n c e p r o t e c t i o n

s y s t e m s , 0 otherwise

12 Financialliberalization:r e a l i n t e r e s t r a t e s a r e u s e d a s a p r o x y f o r f i n a n c i a lliberalizationb e c a u s e r e a l i n t e r e s t ratesareusuallylowe r , ornegative,i n repressedfinancialsystems

13 Legalorigin:dummy.Civillawsystemarecodedas1andcommonlawcountriesas0

Therationaletoincludetheinstitutionalvariablesint otheEWSmodelcanbetracedbacktotheoriesofthefourgenerationmodelofcurrencycrisis

Thet r i a l anderrorp r o c e s s , bydroppingaf e w institutionalvariablesint h e 3models,suggestedt h a t , i n m o s t o f the c a s e s , g o v e r n m e n t s t a b i l i t y , a b s e n c e o f c o r r u p t i o n , l

a w a n d order(quality),central ba nk i n d e p e n d e n c e p l a y ani mpor t a nt roleincurrencycrises (Table3.2)

Int h e s i m i l a r a p p r o a c h ofS h i m p a l e e a n d B r e u e r (2006),L e b l a n g a n d Satyanath(2008)employed3 EWSmodelsofFrankelandRose(1996)(FRmodel),Kamineta1.(2001)(KSSmodel),BussiereandFratzscher(2002)

(BFmodel)andassociateda dditi onal politicalvariablesintot h e m Mostoft h e p o l i t i c

3 Democracy:ad u m m y representsthea b s e n c e /

p r e s e n c e ofa g o v e r n m e n t actuallyrelinquishingofficefollowinganelection

4 Numberofchecksandbalance:thenumberofactorswhosepermissionisrequiredtochangepolicyfromthestatusquo

5 Politicalpolarization:capturest h e p o l a r i z a t i o n levelo f z e r o a s e l e c t i o n s a

r e n o t competitive,o r ifthechiefexecutive’s p a r t y has anabsolutemajorityi n thelegislature

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