Balance‐of‐Payments Crises During the Great Recession: Is this Time Different?
18 Pages Posted: 18 Jul 2012
Date Written: August 2012
During the 2007–09 financial crisis large volatility and wide currency swings characterized the foreign exchange market. This paper utilizes the early‐warning framework to evaluate whether during the period of the Great Recession there has been a structural break in the relationship between fundamentals and exchange rates. This is done by extending an original data set from 1999 and including not only the most recent period, but also 17 new countries. The analysis considers two variations of the original early‐warning system. First, two new methods are proposed to obtain the probability distribution of the early‐warning indicator (conditional on the occurrence of a crisis) - one fully parametric and one based on a novel distribution‐free semi‐parametric approach. Second, the original early‐warning indicator is compared with a core indicator that includes only “pseudo‐financial variables” (domestic credit/GDP, the real exchange rate, international reserves and the real interest‐rate differential) and their performance is evaluated not only for currency crises during the Great Recession, but also for the Asian Crisis. The conclusion from all tests is that “this time is different”, i.e. early‐warning systems based on traditional macroeconomic variables have not only failed to forecast currency crises during the Great Recession, but have also significantly worsened with respect to the period of the Asian crisis.
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