Leading indicators of currency crises

Currency crises are difficult to predict but certain pressures in the economy can tell us if there are conditions for a crisis.

A large budget deficit financed by printing money. The creation of money causes inflation and the loss of international competitiveness. The country will starts running trade deficits that have to be financed by foreign investment. At some point the foreign investment may stop and the currency devalues.

A large trade deficit. As explained above, the trade deficit raises the likelihood of a crisis if foreign investment stops.

Real exchange rate appreciation. The real exchange rate is a measure of domestic prices compared to international prices. Its appreciation signals that the country is losing trade competitiveness.

Recession and high unemployment. The high unemployment puts pressure on the authorities to lower interest rates on credits, to spend more money, and to depreciate the currency as these measures could stimulate the economy.

Large foreign debt relative to foreign exchange reserves. Then, the country would not be able to pay its international obligations if its creditors demand repayment.

A typical statistical model on currency crises would include the variables outlined above. These models are fairly precise in revealing the factors that caused a past crisis. They are less successful in predicting crises but still offer very useful insights.

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