Global Economic Observer (Dec 2019)
Early Warning Systems for Currency Crises
Abstract
Currency crises may appear and propagate under many forms, a fact which led to their analysis through various methods. In a meta-analysis, a couple of authors (Frankel and Saravelos) review more than 80 papers of the literature on early warning systems for currency crises in which they found out that low central banks' reserves is the most reliable warning indicator. There are indicators such as “Exchange Market Pressure Index (EMPI) developed by Girton and Roper which is used to quantify pressures on a currency. This indicator is relevant whether the exchange rate is flexible, fixed, or intermediate”. In case of currency risk in Africa, “the EMPI is calculated monthly as a weighted sum of both the annual change in the exchange rate against the US dollar, and the change in reserves. As such, it can be either positive or negative. A higher EMPI - indicating a depreciation and/or depletion of reserves- reflects increased tensions in the foreign exchange market”. The need to predict systemic crises has led to the creation of a monitoring instrument known as the early warning system - EWS. The early warning system used for currency crises makes it possible to predict the appearance of a crisis within a well-defined period of time. Such a method may be applied both for currency crises, as well as for banking or fiscal ones. This method consists in the analysis of economic and financial indicators that facilitate the collection of information related to the potential vulnerability of the payment balance or to the non-sustainability of the exchange rate.
