The challenge of predicting currency crises: how do definition and probability threshold choice make a difference?

Abstract

In order to analyze the definition effect on prediction powers of Early Warning Systems (EWS), we construct an EWS model with 20 different crisis definitions. Furthermore, to analyze the probability threshold effect, we identify 11 different threshold levels and forecast the different versions of our model for each of those threshold levels. Our results show that crisis definitions and threshold choices significantly affect the prediction powers of the EWS models. To put it more explicitly, Exchange Market Pressure (EMP) Index based definition is shown to be a better predictor compared to depreciation based definition. Furthermore, EMP Index is found to give better results with higher standard deviation multiplier. Last but not least, it is empirically proven that 50 % threshold is the optimal level for EWS analyses as until that level the prediction powers of the models significantly increase but keep constant above it.

Appendix

1.1 A1. Currency crisis definitions in selected literature

	Currency crisis definition	Time period	Country set
Eichengreen et al. (1995)	Eichengreen et al. (1995) Their exchange market pressure is based on change in exchange rate, change in reserves and the change in interest rate. The define currency crisis if this index exceeds its mean by 1.5 standard deviations.	1959–1993	20 developed countries
Frankel and Rose (1996)	They define currency crisis as a nominal depreciation of 25 % or greater, which is at least 10 percent greater than the depreciation in the preceding year.	1971–1992	105 developing countries
Sachs et al. (1996)	They construct a crisis index as a weighted avarage of the devaluation rate with respect to US dollar and percentage change in foreign exchange reserves	1989–1994	20 emerging countries
Kaminsky et al. (1998)	Crisis are identified by EMP index. This index is weighted avarage of monthly percentage changes in the exchange rate (units of domestic currency per US dollar or per deutshe mark, depending on which is relevant) and the negative of monthly percentage changes in gross international reserves (in dollars). Periods where index is above its mean more than three standard deviations are defined as crisis.	1970–1995	15 developing, 5 developed countries
Kruger et al. (1998)	They define EMP as a weighted avarage of percentage changes in the nominal exchange rate and negative of percentage changes in international reserves. They define crisis if this index is 1.5 standard deviations above the mean.	1977–1993	19 developing countries
Esquivel and Larraín (1998)	They consider that currency crisis exists when there is an abrupt change in the nominal exchange rate. First, they say there exist a currency crisis if the accumulated 3 month real exchange rate changes is 15 % or more. Second, they say there is a currency crisis if 1 month change in the real exchange rate is higher than 2.54 times the country specific standard deviation of the real exchange rate monthly growth rate, provided that it also exceeds four percent.	1975–1996	30 countries
Milessi-Ferretti and Razin (1998)	Milesi-Ferretti and Razin (1998) use a definition that requires, in addition to 25 % depreciation, at least a doubling in the rate of depreciation with respect to the previous year and a rate of depreciation the previous year below 40 %. To restrict the sample to episodes in which the exchange rate was relatively stable the previous year, another definition they employ requires a 15 percent minimum rate of depreciation, a minimum 10 % increase in the rate of depreciation with respect to the previous year, and a rate of depreciation of below 10 % points in the previous year.	1970–1996	105 low and middle income countries
Berg and Pattillo (1999)	They use currency crisis definitions of KLR, Frankel Rose and STV	1970–1995	20 countries
Aziz et al. (2000)	They construct FEMP index as a weighted average of monthly exchange rate changes and reserve changes. Currency crisis occurs if this index exceed a specified threshold which is 1,5 times the pooled standard deviation of the calculated index plus the pooled mean of the index.	1975–1997	50 countries
Edison (2000)	The index is calculated as the weighted average of percent changes in the bilateral nominal exchange rate and the percent change in foreign reserves. If this index exceeds the mean by 2.5 standard deviations, then currency crisis occurs.	1970–1995	Signal approach
Bussiere and Fratzscher (2002)	EMP is a weighted average of the change of the real effective exchange rate, the change in the interest rate and the change in foreign exchange reserves. Currency crisis occurs if this index is above the mean by 2 standard deviations.	1993–2001	32 countries
Reinhart and Rogoff (2009)	An annual depreciation versus US dollar (or the relevant anchor currency) of 15 % or more	1800–2006	70 countries
Candelon et al. (2013)	EMP index is comprised of change in exchange rate, interest rate and foreign reserves. Currency crisis occurs if this index is more than 2 standard deviation plus mean of the index.	1985-2008	15 Emerging Countries.

1.2 A2. Definitions of explanatory variables

Definitions are directly taken from World Bank, World Development Indicators Data.

1.2.1 Capital account variables

The Ratio of Foreign Direct Investment to GDP. Foreign direct investments are the net inflows of investment to acquire a lasting management interest (10 % or more of voting stock) in an enterprise operating in an economy other than that of the investor. It is the sum of equity capital, reinvestment of earnings, other long-term capital, and short-term capital as shown in the balance of payments. This series shows net inflows (new investment inflows less disinvestment) in the reporting economy from foreign investors, and is divided by GDP.

Portfolio equity, net inflows (BoP, current US$). Portfolio equity includes net inflows from equity securities other than those recorded as direct investment and including shares, stocks, depository receipts (American or global), and direct purchases of shares in local stock markets by foreign investors. Data are in current US dollars.

1.2.2 Debt profile variables

Public and publicly guaranteed debt service (% of GNI). Public and publicly guaranteed debt service is the sum of principal repayments and interest actually paid in currency, goods, or services on long-term obligations of public debtors and long-term private obligations guaranteed by a public entity.

External debt stocks (% of GNI). Total external debt is debt owed to nonresidents repayable in currency, goods, or services. Total external debt is the sum of public, publicly guaranteed, and private nonguaranteed long-term debt, use of IMF credit, and short-term debt. Short-term debt includes all debt having an original maturity of 1 year or less and interest in arrears on long-term debt. GNI (formerly GNP) is the sum of value added by all resident producers plus any product taxes (less subsidies) not included in the valuation of output plus net receipts of primary income (compensation of employees and property income) from abroad.

Domestic credit to private sector by banks (% of GDP). Domestic credit to private sector by banks refers to financial resources provided to the private sector by other depository corporations (deposit taking corporations except central banks), such as through loans, purchases of nonequity securities, and trade credits and other accounts receivable, that establish a claim for repayment. For some countries these claims include credit to public enterprises.

Total reserves (% of total external debt). International reserves to total external debt stocks.

1.2.3 Current account variables

Real effective exchange rate. Real effective exchange rate is the nominal effective exchange rate (a measure of the value of a currency against a weighted average of several foreign currencies) divided by a price deflator or index of costs.

Current account balance (% of GDP). Current account balance is the sum of net exports of goods and services, net primary income, and net secondary income.

1.2.4 Financial liberalization variables

Deposit interest rate (%). Deposit interest rate is the rate paid by commercial or similar banks for demand, time, or savings deposits. The terms and conditions attached to these rates differ by country, however, limiting their comparability.

1.2.5 Other financial variables

Money and quasi money (M2) to total reserves ratio. Money and quasi money comprise the sum of currency outside banks, demand deposits other than those of the central government, and the time, savings, and foreign currency deposits of resident sectors other than the central government.

1.2.6 Real sector variables

Inflation, consumer prices (annual  %). Inflation as measured by the consumer price index reflects the annual percentage change in the cost to the average consumer of acquiring a basket of goods and services that may be fixed or changed at specified intervals, such as yearly. The Laspeyres formula is generally used.

GDP per capita growth (annual  %). Annual percentage growth rate of GDP per capita based on constant local currency. Aggregates are based on constant 2005 US dollars. GDP per capita is gross domestic product divided by midyear population. GDP at purchaser’s prices is the sum of gross value added by all resident producers in the economy plus any product taxes and minus any subsidies not included in the value of the products. It is calculated without making deductions for depreciation of fabricated assets or for depletion and degradation of natural resources.

1.2.7 Net national savings (% of GNI)

Net national savings are equal to gross national savings less the value of consumption of fixed capital.

Unemployment, total (% of total labor force) (modeled ILO estimate). Unemployment refers to the share of the labor force that is without work but available for and seeking employment.

1.2.8 International variables

Use of IMF credit (DOD, current US$). Use of IMF credit denotes members’ drawings on the IMF other than amounts drawn against the country’s reserve tranche position. Use of IMF credit includes purchases and drawings under Stand-By, Extended, Structural Adjustment, Enhanced Structural Adjustment, and Systemic Transformation Facility Arrangements as well as Trust Fund loans. SDR allocations are also included in this category.