Ms. Catherine A Pattillo, Mr. Andrew Berg, Mr. Gian M Milesi-Ferretti, and Mr. Eduardo Borensztein
Recent years have witnessed an increase in the frequency of currency and balance of payments crises in developing countries. More important, the crises have become more virulent, have caused widespread disruption to other developing countries, and have even had repercussions on advanced economies. To predict crises, their causes must be clearly understood. Two competing strands of theories are reviewed in this paper. The first focuses on the consequences of such policies as excessive credit growth in provoking depletion of foreign exchange reserves and making a devaluation enevitable. The second emphasizes the trade-offs between internal and external balance that the policymaker faces in defending a peg.
are considered together. The results in Table 2 , third row of each panel show that overvaluation is no longer significantly different from zero, although the expected sign is kept. This is most likely a multicollinearity problem that arises because, as shown in Section 3 , expectations are correlated to misalignment.
One could argue that although forecasters cannot predict the exact timingofcrisis, they may have a good assessment of the possibility of a crisis within the next year. The paper repeats the exercise using the 12-month horizon one period before
probability in 1997. This suggests the model may be useful in identifying which countries are vulnerable in a period following a global financial shock. Still, the overall explanatory power is fairly low. In addition, the overall goodness-of-fit for the out-of-sample predictions illustrate the low predictive power of the weighted-sum-based probabilities in predicting the timingofcrisis. Although the model does significantly better than guesses based on the unconditional probability of crisis, most crisis are still missed and most alarms are false.
3. A PROBIT
This paper studies whether exchange rate expectations and overvaluations are predictors of currency crises. The results suggest that overvaluation has predictive power in explaining crises. However, although expected depreciation obtained from survey data partially takes different measures of exchange rate misalignment into consideration, expectations fail to anticipate currency crises.
, such crises emerged when some set of fundamental factors (typically the level of reserves) fell below a critical level. Obstfeld ( 1994 ) argued that in second-generation models, by contrast, the timingofcrisis was indeed arbitrary; in fact, a currency crisis could occur to a country whose fixed exchange rate might otherwise have survived indefinitely. I argued in reply ( Krugman, 1996 ) that this was a misleading point: the reason that the timingofcrisis seemed determinate in first-generation models was not because of the difference in the mechanism of crisis
three groups of countries in our sample undergoing no restructuring, a reprofiling only, or a face value cut. All four indices are normalized to the first observation of the reprofiling index, which is the youngest index, starting in November 1996 (see also Table 1 for the timingofcrisis episodes in the three subgroups). Note that the EMBIG is a market-value weighted index, while the other indices uses outstanding principal weighting .
Three stylized insights can be derived from the data. First, investors in countries experiencing sovereign debt crises have
Sovereign debt restructurings are perceived as inflicting large losses to bondholders. However, many bonds feature high coupons and often exhibit strong post-crisis recoveries. To account for these aspects, we analyze the long-term returns of sovereign bonds during 32 crises since 1998, taking into account losses from bond exchanges as well as profits before and after such events. We show that the average excess return over risk-free rates in crises with debt restructuring is not significantly lower than the return on bonds in crises without restructuring. Returns differ considerably depending on the investment strategy: Investors who sell during crises fare much worse than buy-and-hold investors or investors entering the market upon signs of distress
This paper proposes that international rescue financing should not be provided to a country where a crisis first occurs, but rather to any country that suffers a subsequent crisis. Such a timing-based lending facility can be Pareto-superior to both laissez-faire and existing international crisis lending facilities, when domestic governments have more information on their own economies than does the international lender of last resort. The new facility mitigates moral hazard owing to information asymmetry by not rescuing the first-hit country. At the same time, it limits crisis contagion by rescuing countries in subsequent crises. Even in the presence of common shocks, the timing-based facility can reduce global risks of crisis because it induces countries to undertake greater crisis-prevention efforts so as not to become the first country hit.
-based lending facility can resolve a coordination problem that arises under both laissez-faire and existing lending facilities. In the presence of common vulnerabilities, the risk of global crisis could be substantially lowered only when all the countries put crisis prevention efforts at the same time. From the standpoint of an individual country, however, its crisis prevention efforts can little affect the chance of its having a crisis, but only delay the timingofcrisis. Under both laissez-faire and existing facilities, however, borrower countries do not have any incentive
the remaining 30 crisis episodes, there are only 17 cases where the timingofcrisis is the same.
The appendix describes the crisis indexes.
Kaminsky and Reinhart (1999) in their well-known study on twin banking and currency crises do record a crisis in 1979. Moreover, the 1980 International Monetary Fund Article IV Mission in Thailand reports a credit crunch, a rapid deterioration of the financial position of financial institutions, and the collapse of a major finance company. It also mentions that the Central Bank reacted aggressively by