Predicting Currency Crises, the Ultimate Significance of Macroeconomic Fundamentals in Linear Specifications with Nonlinear Extensions

Abstract

Informative content of macroeconomic fundamentals with respect to currency crisis prediction is reassessed for the period of 1990s on the panel of 46 developed and emerging economies. In the first part the paper develops a model for currency crisis prediction. The distinction is made between variables emphasized by 'first generation' and 'second generation' models. Special attention is directed towards multiple equilibria and contagion phenomena. Considerable amount of predictability is found, particularly on behalf of standard leading crisis indicators, such as overvaluation of the real exchange rate and the level of foreign exchange reserves. Multiple equilibria don't get much support from the data while contagion effect is obviously working –apparently through various channels. In the second part the relationship between model specification and the significance of coefficients is investigated in the attempt to ultimately evaluate what can be expected from empirical implementation of crisis prediction. An average predictive power of such models and employed variables is assessed.