CU RRENCY CRIS IS RE P ORT Early warning system for the Czech Republic by Seidu Issah & Joanna Nestorowicz February 2008
Currency crises appear a! around the world. The risk may be inevitable as it requires many factors to function properly in order to avoid a situation of a large depreciation of a national currency. The policies governments implement in order to insure themselves #om the output loss connected with a potential crisis may seem rational. They are if one considers a! the different non-economic factors involved in being the costs of a crisis. The social costs seem to be a underestimated value, yet mentioned in papers by other authors. But if one considers purely economic repercussions it appears that the output loss of a crisis would have to consume a much greater portion of the GDP then it would possibly do, in order for the outlay on preventing the crisis #om happening actua!y be equivalent to the loss in GDP due to the situation. That is why predicting currency crisis is so important. Since we can measure with some probability that the crisis may happen, we may also be able to take appropriate measures in order to minimize it’s consequences. Taking into consideration different variables, describing different aspects of the microeconomic landscape of a country’s profile, we may derive conclusions on the nature of the economy and on the factors, which can drive it’s currency down, what in a long-run should a!ow us to take appropriate preventive action in order to choose the optimal rate of protection in terms of eg foreign reserves in relation to imports or short-terms foreign debt.
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State of the art review
Based on the work by IMF economists (Kaminsky, Lizondo and Reinhart), we can derive three types of studies on occurrence of currency crisis: Descriptive. Such an approach takes advantage of tables and graphs depicting some patterns, which then may be identified as “stylized facts” in terms of currency crisis occurrence, giving some estimation of whether a crisis will appear or not. Yet this method may be very arbitrarily used. Logit/probit model. These models estimate a probability relationship with a discrete dependent variable - dummy indicating whether a crisis did, or did not happen. Both of the functions take value between zero and one. The outcome of the dummy allocation is regressed on many other explanatory variables describing certain microeconomic conditions. The output of such a regression may show us which of the variables has highest predictive power in terms of currency crisis occurrence. Signals approach. This method is eventually used by the authors and reproduced by this brief study of the Czech Republic. This approach give a more complex measure then the logit/probit modelling, as it does not assign merely a dummy variable depending in the occurrence of crisis or not, but it looks at different explanatory variables disjointly. The variables can then be ranked according to their prediciting power of a crisis.
Economic background
In the Czech Republic a fixed exchange rate regime was introduced on January 1st 1991. It was maintained for more than six years. It was seen by some policy makers and by part of the public as a symbol of the Czech success. Yet a worsening of the macroeconomic situation in the second half of the 1990s, combined with political instability at the beginning of 1997 and with contagious effect from the Asian crisis led to the abandonment of the peg. After 10 days of heavy pressure on the Czech koruna, the currency was set at a managed float regime. Currency crisis report - Czech Republic
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The impact of the Asian crisi though seems quite questionable, as - as it is mentioned in further in the paper - no crisis indicator correlated with market openness of the Czech Republic issue a signal prior to the crisis. A model used by a group of researchers quoted later in the text shows, that the majority of crises in countries such as the Czech Republic can be explained by
inconsistencies in the domestic policy mix and by the deterioration of macroeconomic fundamentals, as emphasised by first-generation crises models.
Research methodology In the signal approach, an indicator is said to issue a signal, if the value of the indicator rises above a certain threshold level. The threshold is defined in terms of the percentiles of the country-specific distribution of the indicator. The PERCENTILE function is exerted in this case. The major issue as reported by econometric papers on currency crisis, is choosing the proper horizon for recognizing good signals. Signals that are sent too early, just as signals that are sent too late, should be avoided. They may imply serious policy implications at a suboptimal (in case of too early signals) level. The signals issued to late may on the other hand imply no enough time for a reaction, not to mention the signals issued post-crisis.
The currency crisis in the Czech Republic was preceded by numerous signals as it is sated in a paper by Amina Ahec-Sonje published in Economic Trends and Economic Policy (Privredna kretanja i ekonomska politika), 1999, No. 75, 31-85. In the case of the Czech Republic almost 80 percent of indicators sent signals within 18 months before the crisis. About 40 percent of the indicators sent signals half a year before and 56 percent four months before the crisis.
It seems that the crisis occurred because of worsened domestic economic conditions and not, for example, because of the influence of the Asian crisis.
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Such a conclusion has been driven by the fact that because such indicators as: - imports, - foreign debt, - real interest rates - capital flight did not send any signals in the pre-crisis period. After the currency crisis in May 1997, the majority of the variables observed returned within normal bounds. The exception was bank deposits, which stayed in the critical area.
Therefore we did not consider them an option for our calculations. The variables, which were found to be significant explicitly for the Czech Republic are: - deviation of real exchange rate from trend, - current account balance as a GDP share, - the growth rate of the industrial production - the FDI decreased by current account deficit on GDP.
These findings come from a paper by Kittelmann, Kristina Tirpak, Marcel Schweickert, Rainer De Souza and Lucio Vinhas published in Comparative Economic Studies in September 2006.
Certainly the most comprehensive and influential paper on EWS indicators is one by Lizondo, Kaminsky and Reinhart from 1997, where the predicting power of certain microeconomic measures is said to be as follows: % good signals
% false signals
noise-to-signal ratio [B/(B+D)/A/(A+C)]
lead-time
persistence of signal*
A/(A+C)
B/(B+D)
Real exchange rate
57
25
5
0.19
17
5.14
Exports
85
17
7
0.42
15
2.37
Share prices
64
17
8
0.47
14
2.15
M2/international reserves
80
21
10
0.48
13
2.07
Index of production
77
16
8
0.52
16
1.93 1.92
Monetary equilibrium
61
16
8
0.52
15
International reserves
75
22
12
0.55
15
1.82
Money multiplier (M2)
73
20
12
0.61
16
1.64
Credit/GDP
56
14
9
0.62
12
1.62
Real interest rates
89
15
11
0.77
17
1.30
79
19
15
0.77
15
1.29
86
11
11
0.99
14
1.01
Imports
54
9
11
1.16
16
0.86
Deposits
49
16
19
1.20
15
0.84
Lending/deposit interest rates
67
13
22
1.69
13
0.59
Source: Kaminsky, Lizondo and Reinhart (1997). * Percentage crisis predicted by at least one signal in the 24 months preceding the crisis. 24 month timeofhorizon
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Terms of trade Real interest differential
$33)'4&5(6
% of crises*
THE PERFORMANCE OF INDICATORS - THE "SIGNALS" APPROACH
INDICATOR
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In the light of such previous research we have decided to use other variables, then the listed above in order to test their predicting power for the Czech economy. We have considered the following variables in order to test the Early Warning System for the Czech Republic:
- M2/reserves This measure indicates both of reserve adequacy and of domestic credit expansion. Rapid rise indicates dangerously rapid credit growth and/or falling reserves. Yields best result at alfa=0.25
- Foreign exchange This measure in terms of the balance of payments is an important indicator of the condition of the country’s exchange rate, and so the value of it’s currency (in relation to other currencies involved in bilateral and multilateral transactions). Yields best result at alfa=0.25
- International reserves The assets of the central bank held in different reserve currencies, such as dollar, eur oand yen are used to back its liabilities. Such an indicator allows to proxy for the safty net of the national economy in terms of crisis prevention. Yields best result at alfa=0.25
- Imports (CIF) This measure indicates the amount of goods simply being transported through a country (goods in transit) or temporarily admitted (except for goods for inward processing) do not add to the stock of material resources of a country and are not included in the international merchandise trade statistics. In many cases, a country’s economic territory largely coincides with its customs territory, which is the territory in which the customs law of a country applies in full. The c.i.f. price (i.e. cost, insurance and freight price) is the price of a good delivered at the frontier of the importing country, including any insurance and freight charges incurred to that point, or the price of a service delivered to a resident, before the payment of any import duties or other taxes on imports or trade and transport margins within the country. Yields best result at alfa=0.25
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- NEER The nominal effective exchange rate is the exchange rate of the domestic currency-related to other currencies weighted by their share in either the country’s international trade or payments. Yields best results at alfa=0.55
- Real effective exchange rate This measure is used due to provide reliable indication that a currency crisis is likely, as loss of competitiveness eventually forces currency adjustment. Apart from the above the real exchange rate of the Czech Republic belongs to the most important economic variables, as this is very small open economy dependent to considerable extent on international trade. The rate value informs us about the development of competitiveness on foreign markets and about changes in purchasing power. Real effective exchange rates take account of price level differences between trading partners. Movements in real effective exchange rates provide an indication of the evolution of a country’s aggregate external price competitiveness. Yields best results at alfa=0.13
- Industrial production Defining this variable allows us to capture the fact that an economy suffering from low or negative growth is more prone to a currency decline, though enjoying strong growth. Yields best result at alfa=0.75
- Foreign debt
This type of debt is that part of the total debt in a country that is owed to creditors outside the country. The debtors can be the government, corporations or private households. The debt includes money owed to private commercial banks, other governments, or international financial institutions such as the IMF and WB. Such a measure could be valuable for currency crisis predictions due to it’s signaling effect for foreign entities. Indicator could not be calculated, due to lack of data during the first 11 months under analysis.
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Other indicators, which might be also considered for the Czech Republic are:
- Current account deficit (as percentage of GDP) Application of this indicator allows to capture signals of lack of competitiveness and venerability to decline in external financing.
- Short term debt/reserves This indicator, used commonly in policy making in terms of currency crisis prevention measures the countries liquidity and so indicates the chances to stand against speculative pressures.
Conclusions As we have shown in the beginning of the paper, there were other methods of currency crisis prediction used in the past. Why then should the signaling approach be the optimal one? There are certain drawbacks of he method, what does not directly imply of course, that we have some better measure at the moment. When considering the findings of Lizondo, Kaminsky and Reinhart presented in the table above, one might have derived a conclusion, that here we have the most powerful indicators of his method in general. Yet it is not a one-size-fits-all solution. As presented in the analysis of literature on currency crisis specifically in the Czech Republic there are factors, which due to the economic setting of the country ata certain point in time, might matter more or les. If we consider the effects of the East Asian crisis at that time, it has been showed that it might not be the most significant issue, and so considering the explanatory/predictability power of such variables as imports or foreign debt, despite their relatively high position in the table from Lizondo, Kaminsky and Reinhart, these variables should not be taken to seriously in the case of the Czech Republic at that time. Currency crisis differ, just as economies differ. The signals approach captures an average tendency, which might not be sufficient to capture an extraordinary crisis in time. Statistically speaking out-of-sample predictability is usually lower than an in-sample fit. Such an argument can be brought forward though in the case of any statistical predictions, as we are trying to predict the future based on some trends from the past, and we can never be quite sure, whether these patterns would not suddenly change. Another issue arises when we consider a more and more inclusive and integrated world economy. The impacts of situation elsewhere in the world may affect a country, which has relatively sound
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macroeconomic conditions. More of a gravity-type approach would surely give more insight in terms of the different constellations of countries, which are interdependent on each other in terms of foreign debt, exports, capital flows, FDI and other international economic relations.
Bibliography 1.
Amado Nestor Adrian, Cerro Ana MarÌa, Meloni Osvaldo, Crisis costs: Argentina 1823-2003.
2. Dąbrowski Marek, Currency Crisis in Emerging Markets - Selected comparative studies, Center for Social and Economic Research, Warsaw 2001. 3. Flood, Robert, and Nancy Marion, Perspectives on the Recent Currency Crisis Literature, NBER Working Paper no. 6360, January 1998. 4. Kaminsky, Garciela, Saul Lizondo, and Carmen M. Reinhart, Leading Indicators of Currency Crisis, IMF Staff Papers 45:1, March 1998, pp.1-48. (IMF Working Paper version: 1997). 5. Obstfeld Maurice, The logic of currency crisis, National Bureau of Economic, Research Working paper No. 4640. 6. Sławiński A, Dusza M., Kryzysy walutowe w krajach otwierającyh się na wymianę, Materiałt i studia nr 70, NBP, Warszawa 1998. 7. World Bank, Private Capital Flows to Developing Countries: The Road to Financial Integration, Oxford University Press, 1997.
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