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Currency Crises Notes

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Pip Reeve IEMT10W8T7 "Currency crises are predictable, but governments and currency speculators choose to close their eyes." Is this correct?
In this essay I will begin with a discussion of some of the various models used to predict currency crises, and the success of these models. It seems that there are a number of indicators which are necessary but perhaps not sufficient in predicting currency crises. I will then move on to discuss some of the reasons why governments and currency speculators might not act as we would expect them to. In terms of creating an effective model for predicting currency crises, Kaminsky, Lizondo and Reinhart, suggest that the variables associated with the external debt profile did not fare well, and the current account balance did not receive much support as a useful indicator of crises. However, they also claim that market variables do not do well in predicting currency crises. In addition, 'the possible endogeneity of policy to the risk of crisis may also limit the predictability of crises.'1For example, if authorities react to signals to avoid a crisis. Indeed, it should be remembered that 'an effective warning system should consider a broad variety of indicators.'2One approach to creating a model to predict currency crises is the signals approach, which ranks the indicators by three metrics; the probability of a crisis conditional on a signal from that indicator; the average number of months prior to the crisis in which the first signal is issued and the persistence of signals ahead of crises. In this approach, 'when one of these values deviates from its 'normal' level beyond a certain 'threshold' value, this is taken as a warning signal about a possible currency crisis.' 3Kaminsky, Lizondo and Reinhart find that, on average, the various indicators called correctly 70% of the crises. Indeed, 'from the vantage point of an early warning system, the results are encouraging in that the signalling, on average, occurs sufficiently early to allow for pre-emptive policy actions.' 4 There is also a probit based alternative model, presented by Berg and Pattilo. In this model, the independent variable takes a value of one if there is a crisis within 24 months, zero if not. There are three main advantages of this type of model; it can test the usefulness of the threshold concept; it can aggregate predictive variables more satisfactorily into a composite index and it can easily test for statistical significance. There is a jump in probability of crises at the threshold which is often statistically significant although the underlying percentile variable is usually also important. However, very importantly, it 'largely ignored the problem that data on predictive variables are in many cases available only with a large lag.' 5 The predictability, and indeed preventability, of a crisis will depend fundamentally on which type of crisis it is. Radelet and Sachs suggest five main types of crisis. Firstly, a macroeconomic policy induced crisis. Secondly, a financial panic where there is an 'adverse equilibrium outcome in which short term creditors suddenly withdraw their loans from a solvent borrower.' Thirdly, a bubble collapse in which 'speculators purchase a financial asset at a price above its fundamental value in the expectation of a subsequent capital gain.' 1 'Predicting currency crises' Berg & Pattilo 2 'Leading indicators of currency crises' Kaminsky,Lizondo & Reinhart 1998 3 'Leading indicators of currency crises' Kaminsky,Lizondo & Reinhart 1998 4 'Leading indicators of currency crises' Kaminsky,Lizondo & Reinhart 1998 5 'Predicting currency crises' Berg & Pattilo

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