Early Warning Signals for Currency Crisis in India

Abstract

This paper is an attempt to identify robust lead indicators to serve as early warning signals for a currency crisis in India. The Signals approach of Kaminsky, Lizondo, and Reinhart (KLR) 1998 is used to identify the lead indicators, and Logistic Regression is used to verify for their statistical significance. Monthly data for the period Apr’90-Dec’14 is considered for the analysis. Export Weighted REER, Domestic Price of Gold, Broad Money, Interest Rate Differential (between US and India), Money Market Pressure Index, and Forex Reserves emerge as robust lead indicators (in ascending order of noise-to-signal ratio) with noise to signal ratios of less than 0.5. Index of Industrial Production and Net FII flows follow in order, with noise to signal ratios of greater than 0.5 but less than 1. Interest Rate Differential, Terms of Trade, Domestic Price of Gold, and Export Weighted REER are statistically significant at 5% level with correct signs. The logistic regression model calls 74% of the 6 crisis points. The significant Lead Indicators warn 12-16 months ahead of crisis, with a KLR’s Conditional Probability of 84%. Time varying behavior of lead indicators and central bank’s intervention in pre-empting crisis may vitiate the signal approach. There is no study on India using KLR, 1998, Signals Approach for an early warning system on currency crisis. For the first time Gold Price is included to verify its power to signal a currency crisis and it displays robust signaling power. Crude Oil price lacks the power to signal a currency crisis.

Keywords: Currency Crisis, Exchange Rate Pressure Index, Money Market Pressure Index, Signaling Approach, Noise-to-Signal Ratio, Banking Crisis, Early Warning System

JEL Classification: F31, F47, F37, G01, G15