The sudden collapse of exchange rate pegs in the absence of an immediate major change in economic fundamentals can seem a clear proof of irrationality in foreign exchange markets. An important contribution of the academic literature on this topic was to dispel that notion, showing that a sudden run on foreign exchange reserves that forces the abandonment of a peg can be, for example, the natural outcome of an inconsistency between monetary and exchange rate policy or the rational response by investors to a shift in expectations regarding macroeconomic policies. The Appendix provides a selective review of the causes of currency crises that have been identified in the, by now extensive, theoretical literature. This section examines the features of the main crisis episodes over the past 20 years and what they suggest about the origins and symptoms of approaching crises.
Different Episodes, Different Determinants?
The survey of the literature on currency crises in the Appendix suggests the distinction between crises that are caused by a deterioration in fundamentals and those that result from self-fulfilling speculative attacks. But even for the latter, it is often the case that some weakness in the fundamentals of the economy makes the country vulnerable to the speculative attack and the authorities less inclined to defend an exchange rate parity. Thus, a critical step in designing an early warning system for balance of payments crises is to identify those weak or inconsistent fundamentals. The problem is that the relevant fundamentals may be different in each episode. They may reflect disequilibria in the trade account or in the capital account. They may respond to private sector imbalances or to public sector deficits. They may be related to shocks affecting the real sector of the economy or the financial sector. The challenge in designing a unified approach is then to take into account all the relevant factors that are potential indicators of approaching crises.
Indeed, the changes in global financial markets and in emerging market economies have had an important effect on the genesis of crises. In “traditional” (first generation) balance of payments crises the fundamental disequilibrium typically involves some macroeconomic imbalance, such as a fiscal deficit financed through money creation that at some point becomes incompatible with an exchange rate peg. By contrast, in “modern” balance of payments crises issues such as self-fulfilling speculative attacks, contagion, and weaknesses in domestic financial markets appear to be the most relevant proximate causes, in the context of less restricted capital movements. Naturally, the two types of determinants of crises are not mutually exclusive, and indeed, in some of the recent crises the traditional macroeconomic imbalances were clearly perceptible. But it is obvious that the development and globalization of financial markets have had a major impact on the nature of currency attacks and balance of payments crises.
A look at the major international crises of the past two decades exemplifies the evolution in the pattern of crises. The debt crisis of the 1980s, which started with the suspension of payments by Mexico in August 1982 and continued for almost a decade, reflected a mix of external shocks and domestic macroeconomic imbalances that had developed behind the screen of the strong capital inflows of the previous years. Most observers identified the reasons for the debt crisis as a combination of negative external shocks—such as a deterioration in the terms of trade, the sharp rise in U.S. dollar interest rates, and the global economic slowdown—and the internal macroeconomic imbalances that affected many of the debtor countries—such as fiscal deficits and currency overvaluation. To these factors, Dorn-busch, Goldfajn, and Valdes (1995) add the mismanagement of capital inflows, especially through the provision of implicit or explicit exchange rate guarantees to private and state enterprise borrowers, in the context of pegged or predetermined exchange rates. The data in Table 1 are indicative of the unfavorable shift in external and internal fundamentals in the period immediately preceding the debt crisis.
Fifteen Heavily Indebted Countries: Summary Indicators1
The 15 countries are Argentina, Bolivia, Brazil, Chile, Colombia, Cote d'lvoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.
Fifteen Heavily Indebted Countries: Summary Indicators1
| Average | |||||
|---|---|---|---|---|---|
| 1977–80 | 1981 | 1982 | 1983 | ||
| Terms of trade | |||||
| (1977= 100) | 100 | 103 | 83 | 85 | |
| U.S. interest rate | |||||
| (federal funds rate, | |||||
| in percent) | 9.5 | 16.4 | 12.3 | 9.1 | |
| Real exchange rate | |||||
| (1977 = 100) | 109 | 129 | 107 | 98 | |
| Fiscal deficit | |||||
| (in percent | |||||
| of GDP) | 2.9 | 5.6 | 6.6 | 6.1 | |
| GDP growth | 4.8 | 0.4 | 0.5 | –2.6 | |
The 15 countries are Argentina, Bolivia, Brazil, Chile, Colombia, Cote d'lvoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.
Fifteen Heavily Indebted Countries: Summary Indicators1
| Average | |||||
|---|---|---|---|---|---|
| 1977–80 | 1981 | 1982 | 1983 | ||
| Terms of trade | |||||
| (1977= 100) | 100 | 103 | 83 | 85 | |
| U.S. interest rate | |||||
| (federal funds rate, | |||||
| in percent) | 9.5 | 16.4 | 12.3 | 9.1 | |
| Real exchange rate | |||||
| (1977 = 100) | 109 | 129 | 107 | 98 | |
| Fiscal deficit | |||||
| (in percent | |||||
| of GDP) | 2.9 | 5.6 | 6.6 | 6.1 | |
| GDP growth | 4.8 | 0.4 | 0.5 | –2.6 | |
The 15 countries are Argentina, Bolivia, Brazil, Chile, Colombia, Cote d'lvoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.
It is therefore not surprising that most observers drawing lessons from the debt crisis of the 1980s referred to the need for appropriate domestic macro-economic policies and structural reforms that would make economies more resilient to external shocks. For example, in his postmortem of the debt crisis, Cline (1995) emphasizes two policy prescriptions: to launch far-reaching structural reforms (especially trade liberalization and privatization) and to pursue sound macroeconomic policies (especially with reference to fiscal deficits but also keeping an eye on current account deficits that were the counterpart of excessive spending by the private sector).8 It is note-worthy that problems related to domestic banking systems did not receive a prominent place in the analyses of the debt crisis of the 1980s. While some debtor countries, particularly in the Southern Cone, suffered severe banking crises, the reasons were generally interpreted as having to do with the after-math of the external crisis in poorly regulated banking systems. That is, problems in the banking systems were not viewed as one of the deficiencies that had caused the external debt defaults.9
The Mexican crisis of 1994/95 suggested different explanations and different fundamentals. In this case, many observers pointed to self-fulfilling prophecies by market participants as being largely responsible for the collapse of the peso. But it was also recognized that an underlying vulnerability in the economy made the speculative attacks possible. In Mexico, large current account deficits (which resulted from an overvalued currency after a difficult inflation stabilization process) as well as the debt management policy followed just before the crisis had caused the accumulation of sizable short-term U.S. dollar-denominated debt; furthermore, the rapid expansion in the domestic financial sector had created a situation of poor quality loan portfolios and heavy exposure to an exchange rate devaluation. Calvo and Mendoza (1996) present two measures to summarize the vulnerability of the peso to a speculative attack. They are the adequacy of international reserves relative to M2 (which measures domestic liabilities of both the central bank and the banking system) and the adequacy of international reserves relative to the external short-term debt (both of the government and the private sector). As can be seen in Figure 2 the gap between international reserves and both types of liabilities widened significantly prior to the peso crisis.
Mexico, 1994: Indicators of Vulnerability
(In billions of U.S. dollars)
Sources: IMF, International Financial Statistics; and Bank of Mexico.Once again, economists, policymakers, and market participants made an effort to draw conclusions as to the reasons for the crisis and the best course to prevent recurrences. Summers (1995) presented ten lessons to be learned from the Mexican crisis, which differed in some significant ways from the conclusions that had been drawn after the debt crisis. Although the soundness and sustainability of domestic policies still figure at the top of the list, the new emphasis is on ways to deal with volatile financial markets, such as increasing transparency in economic data and creating new mechanisms to provide rapid financial support by the international community. Another recommendation is to maintain the current account balance within moderate bounds (deficits not exceeding 5 percent of GDP) to reduce vulnerability to speculative attacks, which is heightened when the deficits are financed by short-term debt or other easily reversible financial instruments. Again, it is interesting to note that banking sector problems were not mentioned in Summers's analysis, despite their noticeable role in the unfolding of the Mexican crisis.
The Asian crisis put financial markets in the fore-front of attention. In the affected Asian countries, traditional sources of fundamental imbalances were largely absent. The fiscal position was quite robust for all countries, and inflation had been moderate or low for a number of years.10 With the exception of Thailand, real exchange rates had not displayed any significant appreciation in the years leading to the crises, and although a slowdown in export growth had been recorded in some of the economies of the region since 1996, it had come after several years of very strong expansion. The loan portfolios of financial institutions, by contrast, had deteriorated significantly, and the corporate sector was excessively indebted and financially fragile, which resulted from years of poor lending and investment decisions. Indeed, weaknesses in the financial and corporate sectors seem to be the only common thread among all the affected countries in the region11 though of course other countries also share those same problems.
There is a strong presumption that contagion, somehow defined, also played a major role, to the degree that some of the affected economies might not have had a crisis at all were it not for the negative market reaction triggered by Thailand. Although contagion had been strong after the 1994 Mexican crisis (the “tequila” effect), Latin American countries were mostly able to preserve currency stability, though certainly not without costs. Spillovers originating in financial markets, as well as herding behavior by investors (not only in terms of joining in the stampede out of a currency but also in their propensity to flee from other countries in the same region), appear to have played an important role in the Asian “contagion,” in addition to more traditional channels related to trade.
SeaRching for Common Symptoms
Even if the ultimate causes of balance of payments crises may differ to some extent from case to case, it might be possible to identify a common pattern in the development of crises that becomes detectable as the process starts to unfold. For example, international reserves may become dangerously low at some point in the development of a currency crisis, or the level of external debt commitments may become too high relative to the relevant available resources. Alternatively, movements in asset prices may also follow a common pattern in anticipation of currency crises. For example, as markets identify a number of perhaps subtle signs of distress, this would be reflected in asset prices, such as increased risk premiums on the vulnerable currencies.
It should be evident that the vulnerability of an economy to a balance of payments crisis increases significantly when the level of international reserves is inadequate. While excessively low reserves must be the most universal sign of an approaching crisis, determining what constitutes an adequate level of reserves in particular cases is difficult. In principle, the relevant comparator should be the level of liabilities that may imply claims on reserves. The level of liquid monetary assets (say, M2) is a natural measure of potential demand for foreign assets from domestic sources. Even if the currency is not fully convertible or purchases of foreign exchange are severely restricted, the money supply could fuel the demand for foreign exchange through parallel markets or some indirect external transactions. To the extent that flight by external creditors is likely to be at the heart of the crisis, the volume of foreign debt payments coming due in the short term is an appropriate yard-stick to judge whether the level of reserves is adequate. In other cases, the relevant comparison for the level of reserves would be domestic debt payments coming due, as these may become a source of capital outflows (such as Tesobonos in Mexico or GKOs in Russia). In fact, with both domestic and foreign investors holding the “domestic” debt (bonds issued in the domestic markets) and with part of the domestic debt sometimes denominated in foreign currency or linked to the exchange rate, the distinction between domestic and foreign debt becomes blurred.12
It is clear, however, that indicators such as those above are not meaningful if they are not considered in conjunction with “fundamentals,” that is, the external balance position and the domestic macroeconomic situation of the country. Furthermore, the level of vulnerability implied by a given international reserves coverage would vary at times when investors display a generally more or less favorable sentiment toward emerging economies, or a higher or lower propensity toward contagion. For example, a country may have a large volume of payments coming due in a given year for purely coincidental reasons, but this would not be a meaningful indicator of vulnerability if the country displays strong fundamentals and the mood in international financial markets is favorable to emerging markets. Conversely, a relatively high level of international reserves could be short-lived in the presence of large deficits and negative investor sentiment.
Another relevant set of symptoms may be found in international financial markets themselves. After controlling for other factors, the evolution of prices in financial markets may provide indications of increased risk. The expectation of a devaluation of the domestic currency, for example, would widen interest differentials between assets denominated in domestic and foreign currencies. If economic difficulties are envisioned, investors would also pull out of sovereign debt instruments, and possibly the domestic stock markets, and this would be reflected in widening spreads on instruments such as Brady bonds and declining equity prices. Yet these different asset prices may provide apparently conflicting signals, because they are affected by different risks. For example, Brady bond spreads reflect the risk of default by the country on those bond payments. This risk is related to the risk of a currency collapse, as a balance of payments crisis may trigger both, but it is conceivable that in other situations the two risks may not be perceived as concomitant. For example, the exchange rate of a country may be considered to be overvalued and likely to be significantly devalued but the servicing of foreign bonds may be considered safe. In fact, in the Mexican and Asian crises it appeared that the risk of nonpayment on external bonds of the affected countries—as perceived by markets—rose after rather than before the currency devaluations.
In sum, the economic literature and the analysis of the broad trends in the major currency crises of the past years suggest a general strategy for the identification of the variables that may play an important role in the design of an early warning system. First, an early warning system should consider the evolution of economic fundamentals. The role of economic fundamentals is of prime importance both in the “traditional” (or first-generation) balance of payments crises and in the “modern” (or second-generation) crises. The former focuses on inconsistencies between the policy stance and the exchange rate, while the latter acknowledges that some weakness in the fundamentals is required for a currency attack to persuade the government to abandon the defense of the currency. It is true, however, that the range of fundamentals that are relevant has broadened with the changes in international financial markets. In particular, signals of stress in the banking sector should receive more attention and should be considered along with more traditional fundamentals such as those related to the external position of the economy, including the level of the real exchange rate or the current account balance, and those describing the domestic macroeconomic situation, such as fiscal balances and credit growth.
Second, an early warning system should also consider indicators of the likelihood of a successful defense of the currency in case of an attack, as a less vulnerable currency is not likely to suffer serious attacks. In particular, the coverage offered by the level of international reserves relative to possible shortrun liabilities of external and domestic origin has been identified as a measure of the vulnerability of the domestic currency to an attack. These variables could be supplemented by other data, such as the forward position of the central bank and other official or private institutions, and available lines of credit or other contingency financing, although these data may be harder to obtain.
It is important to note that these two types of variables—fundamentals and vulnerability indicators—play essentially a complementary role. Countries with weak fundamentals but good liquidity would not stay in a strong position for long, and conversely, countries with relatively bad liquidity but sound fundamentals, while not immune to attacks from “uninformed” investors, are less likely to be attacked and more likely to be successful in defending an attack.
Finally, indicators of market sentiment may also have a role in an early warning system, for example, indicators that can be extracted from asset prices or from developments in other countries that may trigger contagion. Market sentiment is a powerful force but is difficult to measure, and related indicators may also be relatively uninformative because they tend to provide signals only very late in the gestation of a crisis. Yet it is obvious that any analyst should be watching signs of market sentiment and thus their incorporation in an early warning system deserves to be explored.
