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ANDREW BERG and CATHERINE PATTILLO

This paper evaluates three models for predicting currency crises that were proposed before 1997. The idea is to answer the question: if we had been using these models in late 1996, how well armed would we have been to predict the Asian crisis? The results are mixed. Two of the models fail to provide useful forecasts. One model provides forecasts that are somewhat informative though still not reliable. Plausible modifications to this model improve its performance, providing some hope that future models may do better. This exercise suggests, though, that while forecasting models may help indicate vulnerability to crisis, the predictive power of even the best of them may be limited.

ANDREA PESCATORI and AMADOU N.R. SY

Crises on external sovereign debt are typically defined as defaults. Such a definition adequately captures debt-servicing difficulties in the 1980s, a period of numerous defaults on bank loans. However, defining defaults as debt crises is problematic for the 1990s, when sovereign bond markets emerged. Not only were there very few defaults in the 1990s, but liquidity indicators do not play any role in explaining defaults in this period. In order to overcome the resulting dearth of data on defaults and capture the evolution of debt markets in the 1990s, we define debt crises as events occurring when either a country defaults or its bond spreads are above a critical threshold. We find that, when information from bond markets is included, standard indicators—solvency and liquidity measures, as well as macroeconomic control variables—are significant.

Mr. Andrew Berg, Mr. Eduardo Borensztein, and Ms. Catherine A Pattillo

Since 1999, IMF staff have been tracking several early warning system (EWS) models of currency crisis. The results have been mixed. One of the long-horizon models has performed well relative to pure guesswork and to available non-model-based forecasts, such as agency ratings and private analysts' currency crisis risk scores. The data do not speak clearly on the other long-horizon EWS model. The two short-horizon private sector models generally performed poorly.

KENNETH ROGOFF and JEROMIN ZETTELMEYER

This paper describes the evolution of ideas to apply bankruptcy reorganization principles to sovereign debt crises. Our focus is on policy proposals between the late 1970s and Anne Krueger’s (2001) proposed “Sovereign Debt Restructuring Mechanism,” with brief reference to the economics literature on sovereign debt. We describe the perceived inefficiencies that motivate proposals, and how proposals seek to change debtor and creditor incentives. We find that there has been a moving consensus on what constitutes the underlying problem, but not on how to fix it. The range of proposed approaches remains broad and only recently shows some signs of narrowing. [JEL B290, B300, F020]

ASSAF RAZIN and EFRAIM SADKA

This first issue of Volume 51 for 2004 includes a new paper by Peter B. Clark and Jacques J. Polak, along with a tribute from the Editor to Mr. Polak in honor of his 90th birthday. This issue also launches a new featured section, "Data Issues," which will be devoted in future issues to on-going discussions of the latest in econometric and statistical tools for economists, data puzzles, and other related topics of interest to researchers.

MAY KHAMIS and ALFREDO M. LEONE

The paper finds strong evidence that real currency demand in Mexico remained stable throughout and after the financial crisis in Mexico. Cointegration analysis using the Johansen-Juselius technique indicates a strong cointegration relationship between real currency balances, real private consumption expenditures, and the interest rate. The dynamic model for real currency demand exhibits significant parameter constancy even after the financial crisis as indicated by a number of statistical tests. The paper concludes that the significant reduction in real currency demand under the financial crisis in Mexico could be appropriately explained by the change in the variables that historically explained the demand for real cash balances in Mexico. This result supports the Bank of Mexico’s use of a reserve money program to implement monetary policy under the financial crisis.

MARCOS CHAMON PAOLO MANASSE and ALESSANDRO PRAT

This paper uses binary classification trees (BCTs) to predict capital account crises. BCTs successively compare candidate variables and thresholds to split the data into two subsamples, allowing for a large number of indicators to be considered and complex interactions to emerge in a way that standard regressions cannot easily replicate. We identify a robust leading indicator role for three variables (international reserves, current account balance, and short-term external debt) as well as a reserve cover measure that combines them. External indebtedness and domestic GDP growth forecasts are also important predictors of vulnerability. Out of sample, we were able to capture some of the main emerging market crises with relatively few false alarms but the overall out-of-sample performance of our forecasts was mixed. Global cyclical variables help explain vulnerability to crises but they are difficult to predict and, therefore, are of limited use for forecasting purposes.

Mr. Robert P Flood

The paper discusses a model in which growth is a negative function of fiscal burden. Moreover, growth discontinuously switches from high to low as the fiscal burden reaches a critical level. The paper provides an overview of key elements of corporate bankruptcy codes and practice around the world that are relevant to the debate on sovereign debt restructuring. It also describes the broad trends in international financial integration for a sample of industrial countries and explains the cross-country and time-series variation in the size of international balance sheets.

PIERRE-RICHARD AGENOR and JOSHUA AIZENMAN

This paper interprets contagion effects as an increase in the volatility of shocks impinging on the economy. The implications of this approach are analyzed in a model in which domestic banks borrow at a premium on world capital markets, and domestic producers borrow at a premium from domestic banks. Financial spreads depend on a markup that compensates lenders, in particular for the expected cost of contract enforcement. Higher volatility increases financial spreads and the producers’ cost of capital, resulting in lower employment and higher incidence of default. Welfare effects are nonlinearly related to the degree of international financial integration.