Early warning systems of financial crises: implementation of a currency crisis model for Uganda

The objective of this paper is to implement a prototype of a currency crisis model as part of an early warning system framework for Uganda. The financial systems of developing countries like Uganda are especially vulnerable and therefore robust instruments to predict crises are needed. Our model is based on the signals approach developed by Kaminsky, Lizondo and Reinhart (1998) and Kaminsky and Reinhart (1999). The basic idea of the signals approach is to monitor several indicators that tend to exhibit an unusual behaviour in the periods preceding a crisis. When an indicator crosses a threshold, then it is said to issue a signal that a currency crisis may occur within a given period. We implemented this signals approach for Uganda. One of the main challenges in this connection is that Uganda during the analyzed periods had no currency crisis. Therefore, we modified the model in a way that it estimates some of the performance measures based on empirical studies to obtain usable results. The outcomes of our calculations performed well and were economically validated. --Currency crises,Uganda,early warning systems,balance of payment crises,crisis prediction,vulnerability indicators,signals approach

CURRENCY CRISES IN GEORGIA: A MULTIVARIATE LOGIT MODEL

After the collapse of the Bretton Woods system, developing countries, including Georgia, experienced several currency crises followed by severe recessions and deteriorated macroeconomic stability. This creates incentives for policymakers to predict currency crises in a timely manner, and avoid them or mitigate their negative consequences. This paper aims to identify episodes of the currency crisis in a panel of the Post-Soviet countries (to create evidence for Georgia), and access predicting power of the various economic, structural and institutional variables. Based on the different versions of the foreign exchange market pressure indices and their critical values, we identified three periods of the currency crisis: 2008-2009, 2015-2017 and 2020 years (with multiple episodes of the crisis). Among the reasons behind these episodes of currency crises, we can highlight: global financial crisis, monetary expansion of the United States, reduced crude oil and commodity prices, armed conflicts between countries in the region, political instability and imposed sanctions, and COVID-19 pandemic. Early warning indicators were chosen based on desk research of the theoretical models, and meta-analysis of the empirical papers. The optimal forecast horizon is 1 year and predicting ability of indicators are assessed employing multivariate logit model. One-year lag of the annual export growth, crude oil price and credit to GDP ratio are significantly correlated with the probability of currency crisis. These early warning indicators have an ability to collectively predict currency crises one year prior. The results of the multivariate logit model are robust under different specifications of the model. In contrast to the theoretical foundation, the lag value of the crude oil prices is positively correlated with the probability of the currency crisis, but narrowing the predicting corridor changes the sign of the correlation coefficient from positive to negative. The most reliable specification of the models successfully predicts 34% of the crisis episodes. Moreover, the model has low Quadratic Probability Score (QPS) and Logarithmic Probability Score (LPS), indicating high level of reliability of the model’s outcomes

Predicting Financial Crisis in Developing Economies: Astronomy or Astrology?

In the aftermath of the European currency crisis of 1992-3, the Mexican financial crisis of 1994-5 and the Asian financial crisis of 1997-8, neoclassical economists in the academy and policy community have been engaged in a project to develop predictors or indicators of currency, banking and generalized financial crises in developing economies. This paper critically examines the efforts of the economics profession in this regard on both empirical and theoretical grounds. The paper argues that these predictors perform poorly on empirical grounds--indeed, the predictors developed after each of these crises failed to predict the next major crisis. These predictors are also rejected on theoretical grounds. From a post-Keynesian perspective, there is no reason to expect that the mere provision of information will prevent crises by changing agents' behaviors. The paper will also propose several indicators that are consonant with post-Keynesian economic theory, although it will be argued that these indicators do not represent a sufficient means to prevent financial crisis. Ironically, as agents develop confidence in the predictive capacity of crisis indicators, they may engage in actions that increase the economy's vulnerability to crisis. Far more important to the project of preventing financial crisis in developing economies is the implementation of constraints on those investor behaviors that render liberalized, internationally integrated financial systems inherently prone to instability and crisis. Hence, intellectual capital would be more productively expended on devising appropriate changes in the overall regime in which investors operate (such as measures that compel changes in financing strategies) rather than in searching for new predictors of crisis.Financial Crisis

A Review of the Literature on Early Warning Systems for Banking Crises

This paper presents a review of alternative methodologies for early detection of banking distress. The methodologies proposed are aimed to the early identification of financial distress for countries without an important recent history of bank failure, but facing an unstable international environment. We evaluate several indicators and methodologies to measure financial distress such as qualitative indicators, the signal extraction approach, limited dependent estimation and finally duration models.

Currency crises

A currency crisis is a speculative attack on the foreign exchange value of a currency, resulting in a sharp depreciation or forcing the authorities to sell foreign exchange reserves and raise domestic interest rates to defend the currency. This article discusses analytical models of the causes of currency and associated crises, presents basic measures of the incidence of crises, evaluates the accuracy of empirical models in predicting crises, and reviews work measuring the consequences of crises on the real economy. Currency crises have large measurable costs on the economy, but our ability to predict the timing and magnitude of crises is limited by our theoretical understanding of the complex interactions between macroeconomic fundamentals, investor expectations and government policy.Capital movements ; Foreign exchange

Assessing Early Warning Systems: How Have They Worked in Practice?

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. Copyright 2005, International Monetary Fund

A review of early warning system models

Financial crises have not declined in number, frequency or severity over the last two decades, rather the contrary. Each crisis causes enormous costs in the countries concerned. Thus, international financial institutions invest in researching early warning systems (EWS). The Early Warning System models can be made most useful to help sustain global growth and maintain financial stability, especially in light of the lessons learned from the current and past crises.Early Warning System models, financial crises

How to restructure the international financial architecture

To lower the likelihood of financial crises: Securitisation should be regulated to restore proper incentives for banks. The euro area should adopt a regulatory system based on objectives. The short-comings of the Basel II accord should be addressed. While difficult, ways must be found to incentivise financial firms to change the way they compensate employees. The euro area should have a single supervisor and regulator charged with ensuring financial stability. To prevent liquidity crises: There should be good systems of deposit insurance. Countries without important reserve currencies should not have large internationally exposed banking systems. To decrease the likelihood of exchange rate crises, the powers in Brussels and Frankfurt should allow potential future members of the euro area to unilaterally adopt the euro without jeopardising their chances of future membership in the euro area. should not enforce the exchange rate criterion of the Maastricht Treaty. Early warning of a financial crisis is unlikely to be best provided by the IMF might be provided by an independent committee of experts and individual market participants International cooperation in developing crisis management measures and disseminating this knowledge is desirable; funding these measures must be left to the national governments. Managing a crisis Requires writing off bad assets: Central banks should learn how use auctions to value non-traded securities. Requires short-term liquidity provision to and recapitalisation of viable financial firms: Countries should not have banking sectors that are to big to rescue. International coordination to avoid beggar-thy-neighbour regulatory anpolicies and exchange rate policies

TRIP WIRES AND SPEED BUMPS: MANAGING FINANCIAL RISKS AND REDUCING THE POTENTIAL FOR FINANCIAL CRISES IN DEVELOPING ECONOMIES

This paper investigates the shortcomings of the “early warning systems” (EWS) that are currently being promoted with such vigour in the multilateral and academic community. It then advocates an integrated “trip wire-speed bump” regime to reduce financial risk and, as a consequence, to reduce the frequency and depth of financial crises in developing countries. Specifically, this paper achieves four objectives. First, it demonstrates that efforts to develop EWS for banking, currency and generalized financial crises in developing countries have largely failed. It argues that EWS have failed because they are based on faulty theoretical assumptions, not least that the mere provision of information can reduce financial turbulence in developing countries. Second, the paper advances an approach to managing financial risks through trip wires and speed bumps. Trip wires are indicators of vulnerability that can illuminate the specific risks to which developing economies are exposed. Among the most significant of these vulnerabilities are the risk of large-scale currency depreciations, the risk that domestic and foreign investors and lenders may suddenly withdraw capital, the risk that locational and/or maturity mismatches will induce debt distress, the risk that non-transparent financial transactions will induce financial fragility, and the risk that a country will suffer the contagion effects of financial crises that originate elsewhere in the world or within particular sectors of their own economies. It argues that trip wires must be linked to policy responses that alter the context in which investors operate. In this connection, policymakers should link specific speed bumps that change behaviours to each type of trip wire. Third, the paper argues that the proposal for a trip wire-speed bump regime is not intended as a means to prevent all financial instability and crises in developing countries. Indeed, such a goal is fanciful. But insofar as developing countries remain highly vulnerable to financial instability, it is critical that policymakers vigorously pursue avenues for reducing the financial risks to which their economies are exposed and for curtailing the destabilizing effects of unpredictable changes in international private capital flows. Fourth, the paper responds to likely concerns about the response of investors, the IMF and powerful governments to the trip wire-speed bump approach. The paper also considers the issue of technical/institutional capacity to pursue this approach to policy. The paper concludes by arguing that the obstacles confronting the trip wire-speed bump approach are not insurmountable.