Currency Crises During the Great Recession: Is This Time Different?

Arduini, Tiziano and De Arcangelis, Giuseppe and Del Bello, Carlo Leone (2011): Currency Crises During the Great Recession: Is This Time Different?

Abstract

During the 2007-2009 financial crisis the foreign exchange market was characterized by large volatility and wide currency swings. In this paper we evaluate whether during the period of the Great Recession there has been a structural break in the relationship between fundamentals and exchange rates within an early-warning framework. This is done by extending the original data set by Kaminsky and Reinhart (1999) and including not only the most recent period, but also 17 new countries. Our analysis considers two variations of the original early-warning system. First, we propose two new methods to obtain the probability distribution of the early-warning indicator (conditional on the occurrence of a crisis) – one fully parametric and one based on a novel distribution-free semi-parametric approach. Second, we compare the original early-warning indicator with a core indicator that includes only “pseudo-financial variables” (domestic credit/GDP, the real exchange rate, international reserves and the real interest-rate differential) and we evaluate their performance not only for currency crises during the Great Recession, but also for the Asian Crisis. All tests make us conclude that “this time is different”, i.e. early-warning systems based on traditional macroeconomic variables have not only failed to forecast currency crises during the Great Recession, but have also significantly worsened with respect to the period of the Asian crisis.

• Item Type: MPRA Paper
• Language: English
• Keywords: Early Warning Systems; Exchange Rates; Semi-parametric Meth- ods
• Subjects: F - International Economics > F3 - International Finance > F30 - General; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C14 - Semiparametric and Nonparametric Methods: General; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F47 - Forecasting and Simulation: Models and Applications; F - International Economics > F3 - International Finance > F31 - Foreign Exchange

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