An Early Warning System for Contagious Currency Crisis

Abstract

Despite widespread skepticism concerning the feasibility of building an EWS for the currency crisis, our empirical evidence suggests that the prudent monitoring of the contagion effect as well as key macroeconomic and financial variables is an essential measure to guard against the fragile nature of creditor panic, which can easily trigger a crisis phenomenon. While fundamentals matter for determining the vulnerability of an economy against various shocks, the contagion proved to be important in precipitating crises dynamics through various links. As such, the degree of vulnerability and the relative importance of various channels suggested for contagion are important to understand the shock-propagation mechanism in the Asian region. In this paper, we investigate the role of contagion in explaining currency crises in terms of the contagion vulnerability index. Incorporating this additional piece of information would allow us to expect improvements in the predictability of an EWS. Predicting exogenous shocks would be an impossible task, but measuring vulnerability to contagious currency crises can be done with reasonable accuracy.