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Early warning for currency crises: what is the role of financial openness?

  • Jon Frost
  • Ayako Saiki

We explore the role of financial openness - capital account openness and gross capital inflows - and a newly constructed gravity-based contagion index to assess the importance of these factors in the run-up to currency crises. Using a quarterly data set of 46 advanced and emerging market economies (EMEs) during the period 1975Q1-2011Q4, we estimate a multi-variable probit model including in the post-Lehman period. Our key findings are as follows. First, capital account openness is a robust indicator, reducing the probability of currency crisis for advanced economies, but less so for EMEs. Second, surges in gross (but not net) capital inflows in general increase the risk of a currency crisis, but looking at a disaggregated level, gross portfolio flows increase the risk of a currency crisis for advanced economies, whereas gross FDI inflows decrease the risk of a crisis for EMEs. Third, contagion has a very strong impact, consistent with the past literature, especially during the post-Lehman shock episode. Last, our model performs well out-of-sample, confirming that early warning models were helpful in judging relative vulnerability of countries during and since the Lehman crisis.

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Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 373.

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Date of creation: Mar 2013
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Handle: RePEc:dnb:dnbwpp:373
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  1. Rose, Andrew K & Spiegel, Mark, 2009. "Cross-Country Causes and Consequences of the 2008 Crisis: International Linkages and American Exposure," CEPR Discussion Papers 7466, C.E.P.R. Discussion Papers.
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  12. Reinhart, Carmen & Goldstein, Morris & Kaminsky, Graciela, 2000. "Methodology for an Early Warning System: The Signals Approach," MPRA Paper 24576, University Library of Munich, Germany.
  13. Carmen M. Reinhart & Kenneth S. Rogoff, 2002. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," NBER Working Papers 8963, National Bureau of Economic Research, Inc.
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  15. Babecký, Jan & Havránek, Tomáš & Matějů, Jakub & Rusnák, Marek & Šmídková, Kateřina & Vašíček, Bořek, 2014. "Banking, debt, and currency crises in developed countries: Stylized facts and early warning indicators," Journal of Financial Stability, Elsevier, vol. 15(C), pages 1-17.
  16. Fabio Comelli, 2013. "Comparing Parametric and Non-parametric Early Warning Systems for Currency Crises in Emerging Market Economies," IMF Working Papers 13/134, International Monetary Fund.
  17. Goldfajn, Ilan & Valdes, Rodrigo O., 1998. "Are currency crises predictable?," European Economic Review, Elsevier, vol. 42(3-5), pages 873-885, May.
  18. Mirko Licchetta, 2011. "Common determinants of currency crises: the role of external balance sheet variables," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 16(3), pages 237-255, 07.
  19. Jeffrey A. Frankel & George Saravelos, 2010. "Are Leading Indicators of Financial Crises Useful for Assessing Country Vulnerability? Evidence from the 2008-09 Global Crisis," NBER Working Papers 16047, National Bureau of Economic Research, Inc.
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