Scandinavian Working Papers in Economics

Working Papers,
Lund University, Department of Economics

No 2004:11: Regime switching as an alternative early warning system of currency crises - an application to South-East Asia

Guillaume Arias () and Ulf Erlandsson
Additional contact information
Guillaume Arias: Centre d’Economie et de Finances Internationales (CEFI), Université de la Méditerranée Aix-Marseille II, Postal: Centre d’Economie et de Finances Internationales (CEFI), Université de la Méditerranée Aix-Marseille II, Château Lafarge, Route des Milles,13400 Les Milles, France
Ulf Erlandsson: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden

Abstract: In this paper we develop an early warning system of currency crises based on the Markov switching methodology. Constructed data on speculative pressure from six Asian countries indicate that currency crises are mainly captured through volatility effects. Based on an extensive survey, we test potential determinants of exiting the tranquil state and find a number of variables with significant medians across the panel. Using these candidates, we obtain final specifications using a recently proposed penalized maximum likelihood methodology. The method enables us to extract smoother transition probabilities than in the standard case, reflecting the need of policy makers to have advance warning in the medium to long term ratherthan the short term. Our forecasting results indicate that the approach is useful in the early warning of currency crises setting.

Keywords: Currency crisis; Early Warning System; Markov Switching

JEL-codes: C22; C53; F47

37 pages, March 15, 2004

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WP04_11.pdf PDF-file 

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