Measurement of International Currency Crises: A Panel Data Approach using Composite Indices

Abstract

The literature on crisis has often developed indices for measurement of crisis. The indices that have been developed in the earlier studies suffer from three problems: Conceptually, they include only exchange related variables and not other relevant variables that are crucial for international trade and international finance. The extant studies do not use a causal framework as a methodology for the selection of variable. Empirically, they do not use more evolved statistical tools such as Principal Component Analysis for constructing a composite index. This paper seeks to measure the international currency crisis of 1997 in Asia. It has taken the case of the A5 countries in 1997 and has developed a methodology meant to measure and explain currency crisis. The study has constructed composite indices for capturing the causes — macro-economic and financial — as well as an index of crisis. It uses Jha & Murthy's (2006) approach for constructing composite indices. It combines continuous and discrete approaches for defining and measuring crises and uses India as a ‘control’ which enables international and inter-temporal comparisons during crisis. An attempt to explain a widespread and complex phenomenon in terms of a single dependent variable would be incomplete and partial, where the dependent variables which represents the crisis are themselves a conglomerate of many factors. Since it is a complex phenomenon, it cannot be represented by one single variable. Moreover, these variables tend to be correlated. With the help of two composite indices — one for financial variables and another for macro variables, a fixed effects panel regression model is developed for explaining the crisis. The paper measures the decomposition effects of causal financial and macro variables on the crises. It has been found that Index of crises consists of exports, exchange rate, and interest rate. The financial index contains risk rating, domestic financing, and stock traded. The index of macro variables is based on GDP, capital formation, and budget balance. Macro index negatively influences crisis while financial index influences crisis positively. India as the base country clearly brings out the contrast between crises affected countries and neutral countries with the help of this methodology. The crisis window shows up very clearly, as it combines a discrete and continuous definition. Finally, the differences amongst the five Asian countries during crises are also brought out by this methodology.