Leading Indicators of a Currency Crisis: From Fundamentals to Contagion Edward Mongon, Syed Zillur Rehman, and Divya Yerraguntla International Capital Markets 11/25/08
Currency Crisis Defined
Three main models of Currency Crises
Set of Leading Indicators
Deterioration of the Capital Account
Weakening Current Account
Forecasting Future Crises
This presentation has two main goals:
Determine what drives currency crises.
Develop a set of leading indicators that enable a sovereign nation – either industrial or developing, to understand whether or not they may be vulnerable to a currency crisis in the near future.
Forecast three major countries that are likely headed towards crisis.
Definition: A situation in which an attack on the currency leads to substantial reserve losses, or to a sharp depreciation of the currency – if the speculative attack is ultimately successful – or to both.
In the long run, a currencies value mirrors the fundamental strength of the underlying economy.
In the short run, investor sentiment plays an important role.
As long as international markets remain stable, investors may be willing to finance the economic growth of developing nations.
When fundamental conditions worsen flight of short-term portfolio capital likely to ensue.
The result of such a situation can be can be devastating:
Decline in foreign credit
Contraction in output
Increase in unemployment
Even collapse of banks
Credit crunch spillover to nearby nations
First Generation Models (Krugman, 1979)
Macroeconomic fundamentals and fiscal/monetary policy
Recurrent loss of international reserves
Political/legal instabilities act to augment risk.
Second Generation Models (1992)
Relationship between expectations and actual results
Shift in expectations toward the devaluation outcome
Long-term macroeconomic movements
Third Generation Models (1992)
Point to the role of contagion
Links in trade and finance
Leading Indicators – Capital Account
Level of International Reserves
Most predictable indicator of a currency crisis over time.
As seen with many countries trying to maintain exchange rate parity, the persistent loss of reserves in the attempt to maintain such parity eventually causes policy makers to abandon the peg and allow the currency to float
Real Interest Rate Differential
Ceteris Paribus, a rise in the level of interest rates in one nation will cause investors to flock to that nation in order to take advantage of the higher rates of return.
The capital inflow will help foreign investors diversify their holdings.
However, it interest rate differentials that lead to a capital outflow weakens a country’s balance of payments and require a net payment to be made to foreign nations.
This causes a rundown in official reserve assets.
Capital Account Continued
Foreign Debt / GDP
The more foreign debt that is needed to produce promote economic growth within a country, the more vulnerable that country is to adverse financial shocks.
Increase in ratio results in reduced capital mobility.
Also, higher debt level leads to a currency devaluation.
Nations with liberalized capital controls are more apt to the flight of short-term portfolio capital.
When tight restrictions are placed, currency runs are less likely to occur.
ex) China and India
Leading Indicators – Current Account
Current Account Balance
Deteriorating current account balance indicates possible currency crises.
Determinants of current account are exports, imports, real exchange rate, terms of trade.
Current account surplus if
Export > Imports
Exports goods based on comparative advantage.
Current account deficit exists if
Imports > Export
Import growth can be attributed to currency crisis, although weak indicator.
Current Account (Contd..)
Real Exchange Rate
Overvalued (Argentina) – protect capital outflow, loss of reserves to maintain parity, matter of pride.