UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY THE HAGUE VIETNAM THE NETHERLANDS VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS DEVELOPING AN EARLY WARNING SYSTEM TO PREDICT CURRENCY CRISES IN EMERGING MARKETS MASTER OF ARTS IN DEVELOPMENT ECONOMICS By HOANG THUY HONG NHUNG Academic Supervisor Assoc. NGUYEN VAN NGAI Ho Chi Minh City, December 2014 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com CERTIFICATION “I certify that the substance of this thesis has not already been submitted for any degree and has not been currently submitted for any other degree. I certify that to the best of my knowledge and help received in preparing this thesis and all used sources have acknowledged in this dissertation”. HOANG THUY HONG NHUNG Date: 27th December 2014 i LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com ACKNOWLEDGEMENTS Upon completing this thesis, I have received a great deal of encouragement and support from many people.
First of all, I would like to express my deep gratitude to Assoc. Nguyen Van Ngai, my academic supervisor, for his patient guidance, enthusiasm and encouragement. I would also like to thank Dr. Truong Dang Thuy for his professional advices, and Mr.
Truong Hong Tuan and Mr. Luong Duy Quang, former students, for their valuable comments. My gratefulness is also extended to all of my lecturers and staff of the Vietnam- Netherlands Program, particularly, Assoc. Nguyen Trong Hoai and Dr.
Pham Khanh Nam for their assistance during the first days when I started this program. I wish to thank my family for their encouragement and support during my study as well. Without them, I would not have a chance to finish the thesis. Finally, I would like to thank all my friends and other people who have had any help and support for my thesis but are not above-mentioned.
ii LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com ABSTRACT This thesis develops a new early warning system (EWS) model to predict the currency crises in emerging markets by using the logit regression. According to the results, the macroeconomic variables and the institution variables are valuable indicators which play important roles in EWS model for predicting the currency crises. It shows that the real exchange rate, export growth, import growth, current account surplus/GDP, short-term debt/reserves have correct sign and are statistically significant at 5% level. It also shows that the law and order, external conflict have correct sign and are statistically significant at 1%.
In addition, this thesis also applies credit-scoring method to get the optimal cut-off threshold in order to have a more accurate probability of predicting currency crises. Since then, the policy- makers can consider taking the effective pre-emptive actions to prevent the currency crises occurring in the future. Key words: currency crisis, early warning system, emerging market, logit model TABLE OF CONTENTS iii LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com CHAPTER 1: INTRODUCTION. The scope of the thesis.
The structure of the thesis .5 CHAPTER 2: LITERATURE REVIEWS. Definition of currency crisis. Theoretical literatures of currency crises. First generation models of currency crises.
Second generation currency crisis theoretical model. Third generation currency crisis theoretical model. “Fourth generation” currency crisis theoretical model. Empirical studies of currency crises.
Indicators of currency crisis. Existing methods approach in EWS model of currency crisis. Summary of recent empirical findings .26 CHAPTER 3: RESEARCH METHODOLOGY AND DATA. The EWS model specification.
Dating the currency crisis and define the dependent variable. Explanation variables choice and hypothesis testing. How to choose the optimal cut-off threshold. Estimation strategy and statistical tests of the model .43 CHAPTER 4: RESEARCH RESULTS.
45 iv LUAN VAN CHAT LUONG download : add luanvanchat@agmail. The descriptive statistic of the sample. Effected by macroeconomics factors. Effected by institution factors.
Choosing the optimal cut-off threshold. Predicting the currency crisis. Turkey crisis in 1994 and 2001. Out-of-sample test of Latin America case.
Choosing optimal cut-off threshold of EWS model in Latin American. Compare results with other empirical studies .65 CHAPTER 5: CONCLUSIONS AND RECOMMENDATIONS. Suggestions for future researches. 73 APPENDIX A: LITERATURE WORKSHEET AND DATA SOURCES.
77 APPENDIX B: RESULTS OF CHOOSING CUT-OFF THRESHOLDS AND PREDICTING VALUE OF EWS MODEL IN ASIA. 90 APPENDIX C: RESULTS OF ROBUSTNESS TEST. 93 APPENDIX D: DISCRIPTIVE STATISTIC. 96 APPENDIX E: COMPARISON OF TWO MODELS: MACROECONOMIC VARIABLES ONLY AND INCLUDING INSTITUTIONS VARIABLES.
108 v LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com LIST OF FIGURES Figure 2.1: The flowchart of developing an EWS model to predict currency crises .1: Logit and probit cumulative distributions .2: The optimal cut-off identification .1: Optimal cut-off threshold of 12-months EWS model in Asian countries .1: The fitted and predicted value of EWS model in Asian countries .1: Optimal cut-off threshold of 12-months EWS model in Latin America .2: The fitted and predicted value of EWS model in Latin America countries .4: Short-term debt/Reserves .6: Current account/GDP .7: Real exchange rate growth .10: Law and order. 107 vi LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com LIST OF TABLES Table 3.1: Summary expected sign of explanation variables .1: The summary of sample used in the regressions .2: The multicollinearity between independent variables .3: The correlation between independent variables .4: The empirical results of logit regression of 12-month EWS model .5: Specification error test .6: Probability of predictability of 12-months EWS model (cut-off =13.7: EWS model performance with different cut-off point .8: Robustness test of Asian countries in 1994, 1997, 2001, 2007 .9: Performance of EWS model in Asian countries when cut-off = 13.10: The results of EWS model in Latin American countries .11: Results of explanation variables compare with other empirical studies .1: The summary references of explanatory variables of the model .2: Summary data, sources and period time of explanation variables .3: The literature worksheets of empirical studies .1: Identify optimal cut-off in Asian countries by Credit-scoring approach .1: Probability of predictability of 12-months EWS model (cut-off =12.2: Performance of EWS model in Latin American countries, cut-off = 12.1: Comparing 12-month EWS predicting of 02 models in Asia: 1992 - 2011 .2: Nested model test .3: Specification test of macroeconomic model .4: Specification test of full model. 110 vii LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com CHAPTER 1: INTRODUCTION 1. Problem statement There were a lot of financial crises which occurred during the 1990s: the crises of European in 1992-1993, Mexico in 1994-1995, the crises of Asia in 1997-1998, Brazil in 1999, Turkey in 2001, Argentina in 2002 and the economic crises over the world in 2008-2009.
These financial crises have strong influences on economy, politics and society. They caused the economic uncertainty which suffered from high inflation, slow growth, high unemployment and poverty. It made the GDP growth rate is negative, the abrupt changes in nominal exchange rate with over 50% devaluation. In Argentina, it lost 20% of GDP growth and the real wages decrease match with it percentage.
The policy-makers were all under the pressure of implementing new policies in order to recover the affected economy. Moreover, the cost of crises was very high, which led to an increase in the number of empirical studies with the aim of constructing the monitoring tools to predict the crisis occurrence. These studies were often called early warning system (EWS). There are three common types of financial crises: currency crisis, banking crisis and debt crisis.
However, The EWS model in this thesis only focuses on the currency crises like most of EWS models in previous empirical studies. EWS models for currency crises were first built by Krugman (1979) and enhanced by Flood and Garber (1984). They proved that reserve loss is an important indicator to predict crises. Obstfeld (1994, 1996) has proposed a different model for predicting currency crises.
He stated that the currency crises occurred due to the expectation of speculators. However, the model failed to take time matter into account therefore it could not predict the time when crises occurred. After Asian crisis in 1997, it has created the foundation to develop a new model for currency crises. Kaminsky and Reinhart (1999) built the models of the EWS for twin crises that combine banking crises and currency crises.
They also stated that, banking 1 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com crisis often occurred prior to currency crisis, when the currency crisis occurred, this deepened the banking crisis; as the result the economy is in twin crises. In the general, these studies used the macroeconomic and financial indicators to predict the currency crises such as foreign reserves, export and import, real interest rate, real exchange rate, M2/reserves, M2 multiplier, current account deficit (or surplus) to GDP ratio, short-term debt/reserve (Kaminsky et al.,1998, Frankel and Rose, 1996, Berg and Pattilo, 1999). In the recent years, some economists concerned about institutional factors such as bureaucratic quality, government stability, government effectiveness, voice and accountability, rules of law, democracy, election, control of corruption and so on (Block, 2003, Shimpalee and Breuer, 2006, Leblang and Satyanath, 2008) that were used to predict the probability of imminent crises. Besides selecting the potential indicators, several methods have been suggested.
The most popular and suitable one is logit models that were applied by Frankel and Rose (1996), Berg and Pattillo (1999). And the second is the signal approaches that were proposed by Kaminsky et al. Some alternative approaches are cross-country regression models which proposed by Sachs et al. Nevertheless, most of the EWS models only focus on identifying the indicators, which are statistically and economically significant, that should be included in the models to predict the currency crises, the problem raised is that the ability to predict of those EWS models were unexamined.
In order to solve the problem, the optimal cut-off threshold is chosen to evaluate the EWS model and minimizing the crisis risk. If the chosen cut-off point is low, it will give more signals of crises, therefore 2 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com more crises will be detected, however, resulting in false alarms (having the signals but no crises happen – type 2 error) increase. Conversely, if the chosen cut-off point is high, the fewer correct crises will be detected; thus, the missing signals (the crises occur but no preceding alarm – type 1 error) will decrease. Kaminsky et al.
(1998) developed the method named the noise-signal-ratio (NSR) to choose the optimal threshold that minimized the ratio of false signals to good signals. Berg and Pattilo (1999) used the Quadratic probability score (QPS) and the Log probability score (LPS) to prove that their EWS models have better forecasting ability than the Kaminsky et al. Bussiere and Fratcher (2002) based on the Damirguc-Kunt and Detragiache (1999) idea to build the loss function for policy-maker to predict the currency crises. They said that the choice of optimal cut-off thresholds and the predictive periods were based on the risk-aversion degree.
In the recent years, Candelon et al. (2012) who were the first ones to summarize many methods to choose the absolute optimal cut-off points that highly contributes to evaluate the EWS forecast performance. They concluded that Credit Scoring approach and Accuracy measure are better than given cut-off point method or the noise-to-signal ratio of Kaminsky et al. Following the trend of this development and enhancement of EWS models, this thesis will use seven macroeconomic variables that suggested by many previous studies such as Kaminsky et al (1998), Berg and Pattillo (1999), Bussiere and Fratzscher (2002) combine with five institutional indicators used by Shimpalee and Breuer (2006); simultaneously, use the logit approach to develop EWS models in terms of predicting the probability of currency crisis occurrence in emerging markets.
In order to evaluate the predictability of EWS models, this thesis will apply the Credit-scoring approach according to Candelon et al. This is also one of earlier paper studies applied Credit-scoring approach to evaluate the EWS models performance to predict the currency crises.