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Do indicators of financial crises work? An evaluation of an early warning system

  • Hali J. Edison

    (Research Department, International Monetary Fund, USA)

The object of this paper is to develop an operational early warning system (EWS) that can detect financial crises. To achieve this goal the paper analyses and extends the early warning system developed by Kaminsky, Lizondo and Reinhart (1998) and Kaminsky and Reinhart (1999) that is based on the 'signal' approach. This system monitors several indicators that tend to exhibit an unusual behaviour in the periods preceding a crisis. When an indicator exceeds (or falls below) a threshold, then it is said to issue a 'signal' that a currency crisis may occur within a given period. The model does a fairly good job of anticipating some of the crises in 1997|1998, but several weaknesses to the approach are identified. The paper also evaluates how this system can be applied to an individual country. On balance, the results in this paper are mixed, but the results suggest that an early warning system should be thought of as a useful diagnostic tool. Copyright © 2002 John Wiley & Sons, Ltd.

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Article provided by John Wiley & Sons, Ltd. in its journal International Journal of Finance & Economics.

Volume (Year): 8 (2003)
Issue (Month): 1 ()
Pages: 11-53

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Handle: RePEc:ijf:ijfiec:v:8:y:2003:i:1:p:11-53
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  1. Reuven Glick & Andrew K. Rose, 1998. "Contagion and Trade: Why Are Currency Crises Regional?," NBER Working Papers 6806, National Bureau of Economic Research, Inc.
  2. Carmen M. Reinhart & Graciela L. Kaminsky, 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, American Economic Association, vol. 89(3), pages 473-500, June.
  3. Graciela Laura Kaminsky, 1997. "Leading Indicators of Currency Crises," IMF Working Papers 97/79, International Monetary Fund.
  4. Barry Eichengreen, Andrew K. Rose, and Charles Wyplosz., 1995. "Speculative Attacks on Pegged Exchange Rates: An Empirical Exploration with Special Reference to the European Monetary System," Center for International and Development Economics Research (CIDER) Working Papers C95-046, University of California at Berkeley.
  5. Barry Eichengreen & Andrew K. Rose & Charles Wyplosz, 1996. "Contagious Currency Crises," NBER Working Papers 5681, National Bureau of Economic Research, Inc.
  6. Andrew Berg & Catherine Pattillo, 1999. "Are Currency Crises Predictable? A Test," IMF Staff Papers, Palgrave Macmillan, vol. 46(2), pages 1.
  7. Graciela Laura Kaminsky, 1999. "Currency and Banking Crises: The Early Warnings of Distress," IMF Working Papers 99/178, International Monetary Fund.
  8. Steven B. Kamin, 1999. "The current international financial crisis: how much is new?," International Finance Discussion Papers 636, Board of Governors of the Federal Reserve System (U.S.).
  9. Kamin, Steven B., 1999. "The current international financial crisis:: how much is new?," Journal of International Money and Finance, Elsevier, vol. 18(4), pages 501-514, August.
  10. Frankel, Jeffrey A. & Rose, Andrew K., 1996. "Currency crashes in emerging markets: An empirical treatment," Journal of International Economics, Elsevier, vol. 41(3-4), pages 351-366, November.
  11. A. Berg & C. Pattillo, 1999. "What Caused the Asian Crises: An Early Warning System Approach," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 28(3), pages 285-334, November.
  12. Girton, Lance & Roper, Don, 1977. "A Monetary Model of Exchange Market Pressure Applied to the Postwar Canadian Experience," American Economic Review, American Economic Association, vol. 67(4), pages 537-48, September.
  13. Aaron Tornell, 1999. "Common Fundamentals in the Tequila and Asian Crises," NBER Working Papers 7139, National Bureau of Economic Research, Inc.
  14. Reinhart, Carmen & Goldstein, Morris & Kaminsky, Graciela, 2000. "Assessing financial vulnerability, an early warning system for emerging markets: Introduction," MPRA Paper 13629, University Library of Munich, Germany.
  15. Berg, Andrew & Pattillo, Catherine, 1999. "Predicting currency crises:: The indicators approach and an alternative," Journal of International Money and Finance, Elsevier, vol. 18(4), pages 561-586, August.
  16. Catherine A. Pattillo & Andrew Berg & Gian-Maria Milesi-Ferretti & Eduardo Borensztein, 2000. "Anticipating Balance of Payments Crises--The Role of Early Warning Systems: The Role of Early Warning Systems," IMF Occasional Papers 186, International Monetary Fund.
  17. Steven B. Kamin & Oliver D. Babson, 1999. "The contributions of domestic and external factors to Latin American devaluation crises: an early warning systems approach," International Finance Discussion Papers 645, Board of Governors of the Federal Reserve System (U.S.).
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