The East Asian currency crises: lessons for an early warning system

Is it possible to devise a functioning early warning system for currency crises, and is there a role for the analysis of indicators beyond economic fundamentals? In light of the East Asian crisis, the issue is examined both theoretically and empirically. An analytical framework to detect macroeconomic and structural vulnerability as well as changes in the perception of fundamentals is developed, and a range of leading indicators explored. An exemplary early warning system which includes investors' sentiments is applied retrospectively in case studies of the crises in Indonesia and Thailand in 1997, Mexico 1994 and three other Latin American episodes. The paper argues that the monitoring of market sentiments has a place along with the analysis of economic fundamentals, structural and political factors. Particularly in the recent East Asian experience, a sudden and dramatic change in the perception of economic fundamentals and expectations regarding future developments was the driving force behind the crisis. A range of promising indicators are identified, some using readily available quantitative data. The challenge lies in the exploration of relevant information outside the traditional realm of economics and the construction of quantifiable indices. The importance of sudden changes in expectations, however, is the very fact that ultimately defeats any attempt to predict currency crises under perfect international capital mobility. Applying the framework suggested in this paper shows that in most cases alarm bells would have gone off some time before the crash; but this result is ultimately due to the benefit of hindsight. The next crisis will always be different. The best any early warning system can do is to give policymakers a clearer indication that problems are brewing