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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. Jan Babecký & Tomáš Havránek & Jakub Mateju & Marek Rusnák & Katerina Šmídková & Borek Vašícek, 2012. "Banking, Debt, and Currency Crises: Early Warning Indicators for Developed Countries," Working Papers IES 2012/20, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised Jul 2012.
  2. Andrew K. Rose & Mark M. Spiegel, . "Cross-Country Causes and Consequences of the 2008 Crisis: Early Warning," Working Papers 6, Department of the Treasury, Ministry of the Economy and of Finance.
  3. Reinhart, Carmen & Goldstein, Morris & Kaminsky, Graciela, 2000. "Early Warning System: Empirical Results from The Signals Approach," MPRA Paper 24577, University Library of Munich, Germany.
  4. 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.
  5. 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.
  6. 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.
  7. Reuven Glick & Xueyan Guo & Michael Hutchison, 2006. "Currency Crises, Capital-Account Liberalization, and Selection Bias," The Review of Economics and Statistics, MIT Press, vol. 88(4), pages 698-714, November.
  8. 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.
  9. Reinhart, Carmen & Kaminsky, Graciela & Lizondo, Saul, 1998. "Leading Indicators of Currency Crises," MPRA Paper 6981, University Library of Munich, Germany.
  10. Carmen M. Reinhart & Kenneth S. Rogoff, 2004. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," The Quarterly Journal of Economics, Oxford University Press, vol. 119(1), pages 1-48.
  11. 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.
  12. 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.
  13. Edwards, Sebastian, 1989. "Exchange Rate Misalignment in Developing Countries," World Bank Research Observer, World Bank Group, vol. 4(1), pages 3-21, January.
  14. Rodrigo O. Valdes & Ilan Goldfajn, 1997. "Are Currency Crises Predictable?," IMF Working Papers 97/159, International Monetary Fund.
  15. Tiziano Arduini & Giuseppe De Arcangelis & Carlo L. Del Bello, 2011. "Currency Crises During the Great Recession: Is This Time Different?," Working Papers 1/11, Sapienza University of Rome, DISS.
  16. Andrew K. Rose & Mark M. Spiegel, 2009. "Cross-country causes and consequences of the 2008 crisis: international linkages and American exposure," Working Paper Series 2009-18, Federal Reserve Bank of San Francisco.
  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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