Early Warning for Currency Crises: What is the Role of Financial Openness?

36 Pages Posted: 14 Mar 2013

See all articles by Jon Frost

Jon Frost

Bank for International Settlements; De Nederlandsche Bank; University of Cambridge - Cambridge Centre for Alternative Finance

Ayako Saiki

University of London - School of Oriental and African Studies (SOAS); De Nederlandsche Bank - Monetary and Economic Policy Department

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Date Written: March 12, 2013

Abstract

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.

Keywords: Currency crisis, early warning, financial stability, capital account openness, capital flows, contagion, exchange rate regime

JEL Classification: F31, F32, F33, F41, G10, G15

Suggested Citation

Frost, Jon and Saiki, Ayako, Early Warning for Currency Crises: What is the Role of Financial Openness? (March 12, 2013). De Nederlandsche Bank Working Paper No. 373, Available at SSRN: https://ssrn.com/abstract=2232014 or http://dx.doi.org/10.2139/ssrn.2232014

Jon Frost (Contact Author)

Bank for International Settlements ( email )

Basel
Switzerland

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

University of Cambridge - Cambridge Centre for Alternative Finance ( email )

10 Trumpington Street
Cambridge, CB21QA
United Kingdom

Ayako Saiki

University of London - School of Oriental and African Studies (SOAS)

10 Thornhaugh Street
Russell Square
London, WC1H 0XG
United Kingdom

De Nederlandsche Bank - Monetary and Economic Policy Department

POBox 98
Amsterdam, 1000AB
Netherlands

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