Assessing external vulnerability of a country: Causes of currency crises

Chapter one addresses problems present in Kaminsky and Reinhart (1999) and proposes an aggregate leading indicator of currency crises. This indicator performs better than a composite index based on Kaminsky and Reinhart, and represents an unified version of the currency crises approach that emphasizes the role of inconsistent macroeconomic policies as an explanation of currency crises, and the approach that emphasizes the role of tradeoffs among policymakers decisions as the main cause if this type of crises. The second chapter provides evidence about how much real exchange adjustment has occurred during periods where the nominal exchange rate has been fixed, and characterizes how this adjustment has been. Also, in this chapter we evaluate how good the crisis index developed in the first chapter is as predictor of the end of episodes of fixed nominal exchange rate. It concludes that there has been significant real exchange rate adjustment during periods of stable nominal exchange rate. In most cases (72%) there is an appreciation trend throughout the entire period where the nominal exchange rate is fixed. Also, evidence confirms that it is very unlikely to get a successful adjustment of the real exchange rate when a decline of the domestic price level is required to reach equilibrium. Economic authorities prefer to abandon the defense of the parity before letting the real exchange rate depreciate through deflation and recession. Also, the crisis index proposed in the first chapter predicts 87% of major devaluation episodes. Therefore, in the months leading up to major devaluations at least one of two problems is present: macro policies not consistent with fixed exchange rate regimes and overvaluation of real exchange rate, represented by recent appreciation of the real exchange rate during a period of economic slowdown. The third chapter analysis the Chilean experience of recovery of credit after the banking crisis of the early eighties, and also presents the Mexican experience of 1994--95. Both cases confirm the importance of getting rid of bad loans to get a healthy recovery of credit after a banking crisis. This is relevant for currency crises since banking crises often portend currency crises.