Journal
JOURNAL OF INTERNATIONAL MONEY AND FINANCE
Volume 25, Issue 6, Pages 953-973Publisher
ELSEVIER SCI LTD
DOI: 10.1016/j.jimonfin.2006.07.007
Keywords
currency crises; early warning system; crisis prediction; financial stability; emerging markets
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This paper develops a new early warning system (EWS) model, based on a multinomial logit model, for predicting financial crises. It is shown that commonly used EWS approaches, which use binomial discrete-dependent-variable models, are subject to what we call a post-crisis bias. This bias arises when no distinction is made between tranquil periods, when economic fundamentals are largely sound and sustainable, and crisis/post-crisis periods, when economic variables go through an adjustment process before reaching a more sustainable level or growth path. We show that applying a multinomial logit model, which allows distinguishing between more than two states, is a valid way of solving this problem and constitutes a substantial improvement in the ability to forecast financial crises. The empirical results reveal that, for a set of 20 open emerging markets for the period 1993-2001, the model would have correctly predicted a large majority of crises in emerging markets. (c) 2006 Elsevier Ltd. All rights reserved.
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