An Early Warning System of Currency Crisis in Iran: A TVTP Markov Switching Approach

A currency crisis occurs when there is a speculative attack to the currency value of an economy. This attack can result in devaluation of the currency and force monetary authorities to defend the value of the currency through selling foreign reserves or increasing domestic interest rate. High costs of currency crisis and the big shocks that it has had on output of many countries, have forced economists to forecast this phenomenon. Early Warning Systems (EWSs) has been designed to priory forecast thecurrency crisis, using some signals that appear in the economy, namely leading indicators. Accordingly, the purpose of this study is to design an early warningsystem for currency crisis in Iran. To this end, using the growth rate of spot exchange rate, the currency crisis during 1988-2010 has been identified and classified. Then, early warning indictors are identified which can be classified in 3 major groups: 1. foreign trade and currency flows, 2. real section and macroeconomic stances and 3. monetary and fiscal section, specifically government budget and central bank balance sheet. Before occurring a currency crisis, usually these indicators have odd movements which probably can be used to forecast the occurrence of the crisis. Using a Time-Varying Transition Probability (TVTP) Markov switching and above early warning indicators we have forecasted the currency crisis in Iran and the forecasts well fit the realities which are observed in Iran. The early warning indicators whith best performance in forecasting the crisis are growth rate of real GDP, budget deficit to GDP ratio, log deviation of real effective exchange rate from its trend, current accountdeficit to GDP ratio, growth rate of oil revenues in US dollar and first difference of M2 to first difference of central bank foreign reserves ratio. The model results show that there has been currency crisis during second half of 1988, first 3 quarters of 1989, second half of 1993, 1994, first half of 1995, third quarter of 1996, 1998 and 1999 which fit to the stylized crisis in Iran.

Keywords:

Currency Crisis , TVTP Markov Switching , Early Warning System