Determinants of Currency crises in Emerging economies in 1996-2005 An Early Warning System Approach

UNIVERSITY OF ECONOMICS HO CHI MINH CITY VIETNAM INSTITUTE OF SOCIAL STUDIES THE HAGUE THE NETHERLANDS VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS Determinants of currency crises in emerging economies in 1996-2005: An Early Warning System approach A thesis submitted in partial fulfillment of the requirements for the degree of Master of Arts in Development Economics By . ' , Trtrang Hong Tuan Thesis supervisor: Dr. Vii Thanh Ttr Anh • • BQ GIAO DVC FJAO TAO TRUONG HQC KINH TE TP.HCM THliVIEN • r- Ho Chi Minh city, October 2009 Certification I declare that the thesis hereby submitted for the Master degree at the Vietnam-Netherlands Programme for M.A in Development Economics is my own work and has not been previously submitted by me at another university for any degree. I cede copyright of the thesis in favor of the Vietnam- Netherlands project for M.A programme in Development Economics. Ho Chi Minh City, October 2009 Truong H6ng TuAn. Page 2 of 52 Abstract Theories of currency crisis consisted of 4 generations of models suggest that economic and institutional variables can be employed in early warning system models to predict currency crisis for the purpose of prevention policy. This study incorporates 5 variables from Berg and Pattillo (1999b) model (Real exchange rate overvaluation, Foreign reserves loss, Export growth, Current account deficit, Short-term external debt/Foreign reserves) and additional Domestic credit growth, 6 institutional variables adopted from Worldwide Governance Indicators (Kaumann et al., 2008) (Voice and Accountability, Political Stability and Absence of Violence, Government Effectiveness, Regulatory Quality, Rule of Law, Control of Corruption) into a simple logit model with dataset of 15 emerging market economies in the period 1996:01-2005:09. The new finding is the high statistical significance of the variable 'Voice and Accountability' (represents freedom of speech, free media and ability to participate in selecting government of a country citizen) on reducing probability of currency crisis. 'Regulatory Quality' (measures government ability to implement efficient policies promoting private sector development) also shows its statistical significance at a lower level in the model. This study also reconfirms other studies that Domestic credit growth and Current account deficit precede currency crisis. Page 3 of 52 TABLE OF CONTENTS Certification Abstract Table of Contents Chapter 1 Introduction Chapter 2 Theories of currency crises - A brief review of the literature 2 3 4 5 7 Chapter 3 Typical early warning systems and empirical currency crisis models - A brief review of the literature 18 Chapter 4 Methodological issues - Empirical framework 27 Chapter 5 Empirical results 36 Chapter 6 Policy implications and conclusion 40 Notes 42 References 42 Appendix 1 Specification of 05 empirical currency crisis models 45 , Appendix 2 Logit regression results by Eviews (Probability of currency crisis) 4 7 Appendix 3 Robustness test of the result by running logit regression on regions 50 Page 4 of 52 Chapter 1 Introduction 1.1 Statement of the Problem On the way to development, currency crises are very costly for emerging economies. Currency crises can lead to banking crises, loss of GDP, high unemployment rate and loss of development momentum. In the Asian crisis in 1997-98, Thailand lost 10.5% of GDP, Indonesia 13.1% & Malaysia 7.4%. In May 2008, Morgan Stanley issued a report on Vietnam named "Beyond the tipping point", comparing Vietnam then with Thailand in 1997 and warning a 38% -55% depreciation of VND against USD in the next 12 months. In June 2008, State bank of Vietnam widened trading band for foreign exchange (USD) from 1% to 2%. In November 2008, it raised the band to 3% and in March 2009 to 5%. Domestic credit growth rate is 50% in 2007, 34% in 2008 and estimated 30% in 2009 by Economist Intelligence Unit. After the booming in stock and real estate market in 2007 with capital inflow mainly for portfolio investment, a crash of more than 70% in stock market broke out in 2008 against its peak in October 2007. Capital inflow and export shrink, larger current account deficit (13.6% in 2008) is putting pressure on the peg regime of VND to USD. It seems that the scenario of Asian crisis repeats in Vietnam. Unlike Asian crisis countries of crony capitalism, Vietnam's relationship-based system has even weaker institutions. So do institutions play any role in setting stage for a currency crisis? Now is October 2009. Fortunately, the Morgan Stanley's forecast failed, but whether the Vietnam currency crisis is coming soon? Thus, currency crisis is a burning issue in Vietnam for the time being. 1.2 Objective of the Research Page 5 of 52 Vietnam is an emerging market economy. Understanding what caused currency crises in other emerging market economies in recent years would be a good reference for further comprehensive researches on what Vietnam should do to prevent its own currency crisis. 1.3 Research Questions This study aims to answer the following questions: 1. What are the key determinants of currency crises in emerging economies in the period 1996-2005 in the light of early warning system approach? (especially, current account deficit, domestic credit growth and institutional factors) 2. What are the policy implications to prevent a currency crisis? 1.4 Research Methodology Based on theories, empirical models of currency crises and available variables/data, regression with logit model is carried out to recognize the determinants of currency crisis. The statistic software Eview 4.1 is employed in this study. 1.5 Scope of the Research Based on availability of data of institutions and review of recent history of currency crises in emerging market economies, 15 economies are selected and the period of study is limited in 1996-2005. 15 economies are: Argentina, Brazil, Colombia, Czech, Ecuador, India, Indonesia, Korea, Malaysia, Philippines, Russia, Slovakia, South Africa, Thailand and Turkey. 1.6 Organization of the Research The first chapter of this study hereby presents introduction of the issue. The second chapter will look through theories of currency crisis. The third introduces some typical early warning systems (EWS) and empirical currency crisis models employed at IMF, Goldman Sachs and in a few academic studies. The fourth mentions methodology for designing a EWS model including variables of domestic credit growth and institutions. The fifth represents merits of the focused variables in the model and the sixth delivers policy implications and concludes. Page 6 of 52 Chapter 2 Theories of currency crises - A brief review of the literature In the literature of financial crises, there are banking crises, (sovereign) debt crisis and currency crises. Banking crises are recognized as the insolvency of the banking system that occurs with high ratio of non-performing loan to assets. Demirguc-Kunt and Detragiache (1997) considered one of event or combination of the following as banking crisis: (1) nonperforming assets/total assets ratio in the banking system exceeds 1 0%; (2) the cost of rescue at least 2% of GDP; (3) large scale nationalization of banks; and (4) extensive bank runs or other emergency measures executed by the government. Debt crisis is defined as a national government fails to meet a principal or interest payment on the due date (Reinhart and Rogoff, 2008). This study focuses on currency crises only. This chapter consists of 2 parts. Part 1 presents the identification of a currency crisis, part 2 reviews 4 generations of currency crisis models. What cause a currency crisis? It is an exciting question since the collapse to the Breton Wood system. Especially, the heavy costs of currency crisis in Mexico, Asia, Russia, Argentina provoke attention of several economists. 2.1 Identifying currency crises An abrupt drop in a country currency value is regarded as currency crisis. It is called 'crisis' because it bring about negative economic effects. They includes shrink in GDP, investment and job loss, banking and business failures, inflation. Currency crisis can be brought about by currency speculators or government action, or a mix of both. The ideal way to define a currency crisis is as Bussiere and Fratzscher (2002) that incorporate moves in exchange rate, interest rate and foreign reserves (initially set out by Girton and Roper, 1977). They identified a crisis as the exchange market pressure (EMP) of a specific country exceeds its mean by 2 standard deviations. EMP is constructed as a weighted average of the change of the real effective exchange rate (RER), the change in the real interest rate (r) and the change in foreign exchange reserves (res). Real values are considered to avoid different inflation rate across countries. Interest rate is involved in case the central bank defends the domestic currency by increasing its interest rate. Page 7 of 52 The EMPi,t for defining a currency crisis for each country i and period t in formula is as follows: _ . ( RERi.t RERi.t-'i) (. _ , ) _ ( resi.r- resi,1-l J - mRER +mr li.r lu-1 RE/1. t- 1 · res. _, "'"i. . !.} • The weights ffiRER, ffir and ffires are computed as the inverse of the variance of each variable for itself so as to give a larger weight to the variables with less volatility. Due to lack of data, most of the cases currency crisis is defined with changes in exchange rate and foreign reserves only like Kaminsky et al. ( 1998) (KLR) with a little bit difference in the threshold of number of standard deviations. KLR model recognized a crisis as EMP goes beyond its mean by 3 standard deviations. In another simple way, Frankel and Rose (1996) defined a currency crisis as a depreciation of the nominal exchange rate by at least 25% that also exceeds the previous year's depreciation by at least 1 0%. Thus, they did not consider speculative attacks failed by government intervention via selling foreign reserves as a currency crisis. The theories of currency crisis have developed over the time. It seems that after a series of currency crises occurred, a new-generation crisis model emerges. A brief review of currency crisis literature can trace out 4 generations of currency crisis model. 2.2 Four generations of currency crisis models The first generation crisis models The first generation crisis model is firstly presented by Krugman (1979). In a small open economy, government would defend the fixed exchange rate regime with limited foreign reserves. Perfect foresight private investors hold asset portfolio in two kinds of assets: domestic and foreign currency. In an attempt to maintain the fixed rate, government has to sell out reserves until it is exhausted. Government finances its budget deficit by printing money that increases money supply. Page 8 of 52 The model derives that as long as there is budget deficit and inflation, investors change the composition of their asset portfolio by increasing the proportion of foreign exchange, reducing the proportion of domestic currency. Government has to run down its reserves to retain the fixed rate on the way to finance its budget deficit. Exhaustion of reserves pushes government to abandon the pegging. Such expectation makes investors advance the date of their speculative attacks, the leading speculators sell domestic money even earlier and so on, reserves run out faster and currency crisis breaks out. The model seems to have highly simplified assumptions on two asset portfolio holding, the tools government uses to intervene in foreign exchange market, only selling reserves, perfect foresight speculators, the time of crisis is unclearly identified. Flood and Garber (1984) refined Krugman (1979) model by developing it into 2 models. The first one is a perfect-foresight, continuous-time model that relaxes two-asset portfolio to 4- asset portfolio (included domestic and foreign bond) and adding domestic credit into the model. They found out the exact timing of the peg collapse, and timing has a positive relationship with the size of reserves and a negative one with the domestic credit growth rate. The first model also shows that currency crisis can emerge under arbitrary speculative behavior of investors but they assumed that this effect is zero for simplifying analysis. The second model is a discrete time, stochastic one (relax assumption of perfect foresight) that incorporate uncertainty to study the forward exchange rate of a peg regime as a response to reality that forward rate may exceed the fixed rate for long period of time. Using the concept the shadow exchange rate, the rate that would prevail after the speculative attack, the second model yields an endogenous probability distribution over the crisis time and produces a forward exchange rate that is greater than the fixed rate (capture the real world). The policy conflict in above-mentioned models is the financing fiscal deficit and retaining fixed exchange rate regime. Dooley (1997) proposed an insurance model, in which the policy conflict is the desire of a credit-constrained government to hold reserve assets as a form of self-insurance against shocks to national consumption and the government's desire to insure financial liabilities of residents. The first objective is pursued by accumulation of foreign reserves while the second objective depletes it. Once the domestic yield is greater relative to international returns, it generates a private gross capital inflow. Capital inflow increases to an extent that there is not enough foreign reserves to insure deposits, extra deposits have risk exposure. This gap will ignite a speculative attack to minimize loss that runs up to crisis. Page 9 of 52 Dooley model offers a capital inflow/currency crisis follow view, that not budget deficit, money supply or higher international interest rate is blamed for currency crisis. The first generation models explained well the crisis of Latin America countries in the 1980s that have macroeconomic fundamental problems such as fiscal deficit, hyperinflation, foreign loan, current account deficit, capital flight. The first generation models suggest that macroeconomic fundamentals are the causes of currency crises. Variables used in early warning systems could be budget deficit, money supply, domestic credit, current account deficit, international interest rates, capital inflow/outflow (capital control). In the early 1990s, there were several currency crises, such as the European Monetary System crisis of 1992-93, that could not be explained by the first generation models. Europe countries at that time had sound macroeconomic fundamentals, but currency crises still occurred. The currency crisis model then evolved to confront the new reality. The second generation came out. The second generation crisis models The second generation crisis models, initially developed by Obstfeld (1994, 1996): self- fulfilling and contagious crises. The first generation models constrained government's tools in intervening foreign exchange market to selling limited reserves only. The second· generation models relax this point, let foreign reserves can be freely borrowed in the world capital market, subject only to the government's intertemporal budget constraint. In a setting of purposeful reaction by the government, self-fulfilling crisis is taken into account. Speculative anticipations depend on government responses, which subject to how price changes, that in turn are driven by expectations. This dynamic circle suggests a potential for crises that would not have occurred, but that do because the market players expect them to. They are self-fulfilling crises. Obstfeld (1994) raised a question: Why does the government like to abandon the fixed rate? He described 2 models in the paper to answer. It is because government debt denominated in domestic currency and unemployment problem. In one model, he mentioned the role of Page 10 of 52 [...]... including the presence of banks to find out the dynamics of banking crisis and currency crisis There is an asymmetry in the liquidity and riskiness of bank assets and liabilities A bank usually guarantees the nominal value of the deposits it accepts while allocating the money to investments with a variable return Normally, bank deposits are highly liquid, while bank investments are low liquid and long-term... symptoms of underlying institutional problems rather than the main causes of economic volatility, weak institutions can cause volatility through a number of macroeconomic and microeconomic channels Mishkin ( 1996, 200 1) approached financial crises in the light of asymmetric information with the moral hazard problem Emerging market economies such as Mexico, Ecuador, East Asian crisis countries and Russian... probability of financial crisis embracing banking crisis and currency crisis Mishkin also proposed 12 areas of policy to prevent financial crisis: 1 Prudential supervision, 2 Accounting and disclosures requirements, 3 Legal and judicial systems, 4 Market based disciplines, 5 Entry of foreign banks, 6 Capital control, 7 Reduction of control of stateowned financial institutions, 8 Restrictions on foreign-dominated... being depreciated against other main currencies (EUR, GBP, AUD) So we can consider the US crisis is kind of third and fourth generation combination Theories on the causes of currency crises set foundation for several early warning system and empirical currency crisis models coming out The four generations of currency crisis models suggest what variables should be employed in empirical early warning system. .. theories of the four generation model of currency crisis The trial and error process, by dropping a few institutional variables in the 3 models, suggested that, in most of the cases, government stability, absence of corruption, law and order (quality), central bank independence play an important role in currency crises (Table 3.2) In the similar approach of Shimpalee and Breuer (2006), Leblang and Satyanath... constitutions), informal constraints (norms of behavior, conventions, and self imposed codes of conduct), and their enforcement characteristics Together they define the incentive structure of societies and specifically economies. " Incentives and expectations play a vital role in the financial world that is infamous for uncertainty Institutions form the foundations and facilitate a well-functioning currency and banking... authoritarian regimes lacking openness of information and transparency His analysis inspired similar approach to the Asian crisis in 1997 Johnson et al (2000) proved that the effectiveness of protection for minority shareholders explain the extent of declines in exchange rate depreciation and stock market better than standard macroeconomic measures do They modelized the conflict of interest between insiders... lot of factors related to laws, politics, culture Page 17 of 52 Chapter 3 Typical early warning systems and empirical currency crisis models - A brief review of the literature The Mexican and Asian crises took the international community somewhat by surprise and since then raised the attention on methods that could forecast crises of highly vulnerable countries in the timely manner Several early warning. .. firm, an increase in the return on investment persuades himto invest more into the project and, therefore, to steal less On the other hand, if the manager owns more of the firm, but the return on investment reduces, then he steals more The stealing of manager shrinks value of firm Less value of the firm, less confidence of foreign and domestic investors stays in the stock market Loss of confidence in. .. of typical Early Warning Systems and empirical currency crisis models Ades et al (1998) (Goldman Sachs) Crisis defmition Weighted changes average in the of three-month Weighted average of one-month changes in real exchange rate minus one-month changes in exchange rate minus three-month changes reserves that exceed country specific mean and 2 in reserves that exceed country specific standard deviations . currency crises in emerging economies in 1996-2005: An Early Warning System approach A thesis submitted in partial fulfillment of the requirements for the degree of Master of. costly for emerging economies. Currency crises can lead to banking crises, loss of GDP, high unemployment rate and loss of development momentum. In the Asian crisis in 1997-98, Thailand lost. own currency crisis. 1.3 Research Questions This study aims to answer the following questions: 1. What are the key determinants of currency crises in emerging economies in the period 1996-2005