Range of Indicators May Provide Warning System for Currency Crises

• Pages: 257-260

Page 257

Recent turmoil in the Southeast Asian currency markets, as well as the earlier Mexican crisis and collapse of the European exchange rate mechanism in 1992-93, has heightened interest in the causes and symptoms of currency crises. Can early detection of symptoms allow governments to adopt pre-emptive measures? While an accurate forecast of currency crises is likely to remain elusive, a warning system would be valuable. In a new IMF Working Paper, Leading Indicators of Currency Crises, Graciela Kaminsky, Saúl Lizondo, and Carmen M. Reinhart examine empirical literature on currency crises and propose an early warning system. Since multiple problems usually precede currency crises, the authors suggest a "signals" approach, which involves monitoring a broad variety of indicators.

Traditionally, theoretical literature on balance of payments crises stressed that weak economic fundamentals-such as excessively expansionary fiscal and monetary policies-resulted in a persistent loss of international reserves, ultimately forcing the authorities to abandon the fixed exchange rate parity. More recently, however, some economists have argued that the authorities may decide to abandon the parity for reasons other than a depletion of official international reserves. They may, for example, be concerned about the adverse consequences of policies needed to maintain the parity (such as higher interest rates) on other key economic variables (such as the level of employment). Other models have shown that a crisis may develop without a significant change in the fundamentals.

Traditional Explanations for Crises

In 1979, Paul Krugman of Stanford University, in a seminal paper, concludedPage 258 that under a fixed exchange rate, domestic credit expansion in excess of money demand growth leads to a gradual but persistent loss of international reserves and, finally, to a speculative attack on the currency. This attack immediately depletes reserves and forces the authorities to abandon the parity. The process ends with an attack, because economic agents know that the fixed exchange rate regime will ultimately collapse and that in the absence of an attack, they would suffer a capital loss on their holdings of domestic money. The period preceding a currency crisis would thus be characterized by a gradual but persistent decline in international reserves and rapid growth of domestic credit relative to the demand for money. To the extent that excessive money growth may result from the need to finance the public sector, fiscal imbalances and credit to the public sector could also serve as indicators of a looming crisis.

A number of studies since 1979...