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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. Claudio Borio & Mathias Drehmann, 2009. "Towards an Operational Framework for Financial Stability: "Fuzzy" Measurement and its Consequences," Working Papers Central Bank of Chile 544, Central Bank of Chile.
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  3. Glick, Reuven & Guo, Xueyan & Hutchison, Michael M., 2004. "Currency Crises, Capital Account Liberalization, and Selection Bias," Santa Cruz Center for International Economics, Working Paper Series qt12t6x2ht, Center for International Economics, UC Santa Cruz.
  4. Patricia Alvarez-Plata & Mechthild Schrooten, 2003. "The Argentinean Currency Crisis: A Markov-Switching Model Estimation," Discussion Papers of DIW Berlin 348, DIW Berlin, German Institute for Economic Research.
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  8. Andrew Berg & Eduardo Borensztein & Catherine Pattillo, 2005. "Assessing Early Warning Systems: How Have They Worked in Practice?," IMF Staff Papers, Palgrave Macmillan, vol. 52(3), pages 5.
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  10. 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.
  11. Cardarelli, Roberto & Elekdag, Selim & Kose, M. Ayhan, 2010. "Capital inflows: Macroeconomic implications and policy responses," Economic Systems, Elsevier, vol. 34(4), pages 333-356, December.
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  13. 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.
  14. Goldfajn, Ilan & Valdes, Rodrigo O., 1998. "Are currency crises predictable?," European Economic Review, Elsevier, vol. 42(3-5), pages 873-885, May.
  15. Sebastian Edwards, 1987. "Exchange Rate Misalignment in Developing Countries," UCLA Economics Working Papers 442, UCLA Department of Economics.
  16. Arduini, Tiziano & De Arcangelis, Giuseppe & Del Bello, Carlo Leone, 2011. "Currency Crises During the Great Recession: Is This Time Different?," MPRA Paper 36528, University Library of Munich, Germany.
  17. 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.
  18. 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.
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