Developed on the arguments presented in Aslant and Henderson [ 1 | on speculative attacks on government- controlled price of gold, Grumman [2] introduced his model which assumed inevitable speculative attack in a fixed exchange rate regime when agents change composition f their portfolios from domestic to foreign currency, for instance, because of suspecting devaluation due to rolling fiscal deficit.
Crisis, then, may be triggered as a natural consequence as in that situation central reserve will be no longer enough to defend its currency (Chided and Owning [3]). Flood and Gerber [4] later developed a linear version of the Grumman [2] model for small economy. Though their model forecasted lower bounds for post-collapse exchange rates In a stochastic framework in access to predicting the timing and the probability of endogenous attack, likewise there deterministic models it considered attacks are predictable.
First Generation Models dealt with a wide array of occasions. These models demonstrated that crisis not necessarily occurs due to Irrationality of market participants, Instead It arises due to their very rational expectations (Jeanne For instance, if reserve does not flee, speculators could forecast the period of devaluation and thus could be able to make sure profits. The core of this speculative-attack approach claims that reserve flight occurs during a currency crisis due to rational arbitrage.
In general, these models coin their arguments on weak economic and financial fundamentals of a certain country which can make that country very suitable for speculative attack by international short term financial investors. Thus these models try to identify Indicators of currency crisis. However, they are reluctant to Identify underlying causes behind the crisis (Jeanne [5]). Moreover, they could not explain the rationale behind the spillover effect of crisis to other countries (Chided and Owning [3]).
Exchange Rate Mechanism (ERM) crisis of European Monetary System (MESS) in 992-93 in Western Europe and crisis in Mexico in 1994-95 nullified the strength of First Generation Models as despite having sound fundamentals In terms of adequate international reserves, manageable domestic credit growth and non-monitored fiscal deficits, and good economic policies, some countries enormously failed to build protective shield against speculative attacks.
Therefore, a broader and more holistic definition of determinants of currency credibility was required. As a result, a continuous argument was raised that the speculation did not entirely rely on economic fundamentals, rather it was also self-fulfilling. Features of self-fulfilling prophecies were entailed for developing Second Generation Models as per Obsolete [6, 7], Obsolete and Oregon [8], Bendable and Jeanne [9], and Evolves [10].
These models Incorporated the role of “expectations” of economic agents In predicting currency crisis and allowed for “multiple equilibrium” while assuming monetary and the foreign exchange reserves at central bank, the core of speculative attack in the models of Grumman [2] and Flood and Gerber [4], to the decision exercising ability of an optimizing policymaker so as to devalue domestic currency. The momentum of runners movement is exposed to the degree at which private agents coordinate and hence multiple equilibrium occur.
Second Generation of Models, termed as “the escape clause” models, views fixed exchange rate arrangements as conditional commitment devices of a country which is often dependent on the will of policymakers. A currency crisis, in this scenario, may arise if private agents perceive government’s propensity to exercise the escape clause given the existing conditions, and their beliefs about the policymakers’ objective.
In contrast to the economic fundamental driven first enervation models, escape-clause model has more rational approach over the speculative-attack models by introducing any variable that catalysts the policymakers’ decision to defend the fixed peg. Furthermore, it includes soft fundamentals such as, foreign exchange market participants’ perception of fixed exchange rate arrangement or policymakers’ reputation capital. Furthermore, self- fulfilling speculation and multiple equilibrium are significant contribution of these models as they aid in considering circular causality between fundamentals and market speculation Anyone, [5]).
Conflict on numerous competing objectives of look-alikes, was indeed a feature of the escape-clause model, but it can be thought aside of multiple equilibrium. Multiple equilibrium are not a spontaneous suggestive development of these models; rather it is favored due to multifaceted nature of economic factors. Economic fundamentals, however, may accompany the crisis as per Obsolete [7] and Jeanne [1 1], but to the extent that their deterioration relates vulnerability of fixed exchange rate system to self-fulfilling speculation.
In retrospect, if speculation is said to be self-fulfilling, speculators would be the scapegoat allowing policymakers to exercise the escape clause. The escape-clause model, nonetheless, approaches that self-fulfilling and fundamentalist views are not mutually exclusive. At first fundamentals must be in fragile state to initiate self-fulfilling speculation and then both exacerbate currency vulnerability. The Third Generation Models evolved with the Asian and the Tequila crisis during the mid 1990 in order to step out from traditional realm of theory by shifting interest from sound economic fundamentals to incompetent financial structure.
In this regard, Raddled and Cash [12] asserted the notion of Second Generation Models by suggesting that self-fulfilling panics at first it the financial intermediaries, then confirm the panic by forcing liquidation of long run assets. In addition, Manson [1 3] based on the notion of the “contagion” ascribed that mere occurrence of a crisis increases the likelihood of a similar crisis elsewhere. Furthermore, he projected three related scenarios to represent the contagion: monsoonal effects, spillover effects and pure contagion effects.
Change and Evolves [14] ascribed herding effect as “information cascade” and proposed that a correlation between currency crisis and banking crisis may prevail if local bank have debts denominated in foreign currency. Conversely, Burnside, Ichneumon, and Rebels [1 5, 16] argued that government may provoke vulnerability in both currency and banking system if it guarantees banking system and thus gives incentive to take foreign debt. Besides, according to Chided and Owning [3] rising interest rate can introduce moral wealth.
Increase in domestic interest rate in turn increases the perceived default risk and forces bank to restrict lending. According to Third Generation Models it is evident that external liquidity is a crucial factor in financial and currency crises (Munchkin and Pill, [1 7]; Change and Evolves, [18]). Moreover, these models mainly examine the role of monetary policy in a currency crisis. These models argue that fragility in the banking and financial sector reduces credit availability and increases the likelihood of a crisis.
On a whole, a notorious combination of high debt, low foreign reserves, falling government revenue, rising expectations of devaluation, and domestic borrowing constraints could lead to currency crisis. On a whole, three generations of models imply four influential factors are able to manifest the onset and magnitude of currency crisis: domestic and private debt, expectations, financial arrest’s vulnerability to pegged exchange rate and magnitude and success of speculative attack.
Third Generation Models was developed later on as it included the financial sector indicators derived from aggregate balance sheets of banks; Karma [19] however singled out the inconsistencies of using different determinants as major drawbacks in offering consensus on causes of financial crises. After attaining coherence in identifying determinants of financial crisis, mainly three significant approaches are proven to be beneficial in developing Early Warning Models: I. The linear-dependent variable approach; ii.
The Econometric approach (discrete-dependent variable approach); and iii. The signals approach (leading indicator approach). Cash, Torrent and Valance’s [20] attempting to analyze the Mexican Crisis in 1994-95 along with its aftermath, commenced the Linear-Dependent variable Approach. This approach introduced a dependent variable equivalent to a crisis index, which was essentially a weighted average of the devaluation of exchange rate against US Dollar and the percentage change in foreign exchange reserves.
The Econometric Approach incorporates limited dependent probability models (such as a profit or Logic model) o estimate a probability relationship with a discrete dependent variable (one or zero, or a crisis occurs or does not occur). This approach can suggest predictive power of different explanatory variables, and thus is able to demonstrate the probability of future crisis. One of the forerunners to adopt a profit model for predicting currency crisis, Exchanging, Rose, and Hypos [21] revealed the speculative attacks on fixed exchange rate as a major concern to predict the incidence of currency crisis.
In addition, employing profit model, Click and Hutchison [22] revealed a strong and bust correlation between banking and currency crises in the emerging markets; but inclusion of developing countries restricted the casual relationship between banking and currency crisis. Whereas, Sacristans, Dropsy, and Mate [23] using panel and Logic regressions found that both currency overvaluation and pure contagion effects were the leading indicators of the Asian crisis. This method was also used by Falsetto and Tuttle [24], Bucksaw [25] among others.
In contrast to Economic Approaches summary of the probability of crisis in one number between zero and one, Signals Approach as a distinct non parametric method was pioneered y Skinny and Reinhardt [26] who observed the macroeconomic behavior in 20 economies from 1970 to 1995. For a preferred signaling window, the behavior of 16 to measure the degree of financial openness, balance of payment conditions, and real and financial sector conditions. Later, Skinny, Liaison, and Reinhardt [27] proposed an extended the analysis based upon the persistence of the signals.
Edison [28], nonetheless, extended the work of Skinny, Liaison and Reinhardt [27] by using wider range of countries, adding explanatory variables, testing for regional differences; but the model performed mixed as it portrayed numerous false alarms. Signals approach, utilizing information from both crisis and non-crisis phase, explicitly considers occurrence of a crisis. It allows the policymaker to issue prompt action based on the ranking of the vulnerabilities of the indicators in accordance with their predictive power.
