The Nonlinear Dynamics of Foreign Reserves and Currency Crises

Abstract

A new early-warning system for international currency crises is developed in this paper. Theexisting crisis indicators in the literature are essentially static. We examine the relationship be-tween the dynamics of foreign reserves and currency crises. It is shown that rapid reserve deple-tion is a prominent feature before the collapse of the exchange rate system. The results from ourthreshold autoregressive model suggest that when the Reserves-to-Short-Term External Debt fallsby more than 29.1%, or if the Reserves-to-M2 ratio drops by more than 24.3% within six months,the likelihood of a crisis increases. Our model provides clear warning signals for policy makers totakeactionsbeforethereserveshavereachedacriticalvaluethatheraldsthearrivalofafull-blowncrisis.