Early Warning for Currency Crises: What is the Role of Financial Openness?

Abstract

We explore the role of financial openness – capital account openness and gross capital inflows – and a newly constructed gravity-based contagion index to assess the importance of these factors in the run-up to currency crises. Using a quarterly data set of 46 advanced and emerging market economies (EMEs) during the period 1975Q1-2011Q4, we estimate a multi-variable probit model including in the post-Lehman period. Our key findings are as follows. First, capital account openness is a robust indicator, reducing the probability of currency crisis for advanced economies, but less so for EMEs. Second, surges in gross (but not net) capital inflows in general increase the risk of a currency crisis, but looking at a disaggregated level, gross portfolio flows increase the risk of a currency crisis for advanced economies, whereas gross FDI inflows decrease the risk of a crisis for EMEs. Third, contagion has a very strong impact, consistent with the past literature, especially during the post-Lehman shock episode. Last, our model performs well out-of-sample, confirming that early warning models were helpful in judging relative vulnerability of countries during and since the Lehman crisis.