Currency Crisis: Theory and Practice with Application to Croatia

Published: 24/2/2004
Publication Working Papers
Issue W - 12
Author Ivo Krznar
Date August 2004
ISSN 1334-0131

Keywords

currency crisis, early warning system, signalling method, probit model

Summary

Following an initial overview of theoretical and empirical currency crisis models, the paper presents an early warning system of a currency crisis in Croatia, based on two standard empirical methods of researching and forecasting a currency crisis: the signalling method and the probit model. Measuring the index of exchange market pressure has so far indicated two currency crises in Croatia: one in September 1998 and the other in August 2001. The signalling method was used for the purpose of selecting the determinants of a currency crisis (in the period from January 1996 to March 2003) from a wide range of variables that are considered the best predictors of currency crises in the period of 12 months preceding them: the share of public finances in GDP, the share of the current account balance of the balance of payments in GDP, inflation, the share of freely available bank reserves in total bank assets, the rate of external debt growth, the rate of growth of the m2 multiplier, the deviation of the real exchange rate from the trend, the share of the foreign exchange assets of CNB in M4, and the growth of domestic credit. The currency crisis composite index, expressed as a weighted average of all the previously listed currency crisis indicators, shows a considerable predicting power of currency crisis in the sample. The statistically more rigorous probit model method exposes five variables among the indicators of vulnerability, of various forms of functional specification, that best empirically describe the characteristics of the periods preceding the two currency crises in Croatia. Thus there is a real exchange rate appreciation that is below the trend, a decrease in the share of the balance of public finances in GDP, a decrease in the share of the current account balance of the balance of payments in GDP, an increase in inflation and an increase in external debt, which increase the probability of a speculative attack on the kuna. As is the case with the composite indicator, the various goodness-of-fit measures of the customised probit model used in the Croatian example indicate a very high level of predicting power regarding the currency crisis in the sample. A more detailed analysis of each of the currency crisis indicators leads to the conclusion that the two currency crises in Croatia were not of the same nature. The indicators of the first crisis can be found in the literature on the third generation currency crises which describes the correlation between banking system difficulties and the currency crisis, while the signalling variables of the second crisis can be linked to the self-fulfilling characteristics of the second generation models of currency crises.