Prediction of Currency Crises: Case of Turkey

This paper explores the issue of constructing an economic predictive model of financial vulnerability through an alternative econometric methodology that addresses drawbacks in existing approaches. The methodology entails estimating a Markov regime switching model of exchange rate movements, with time-varying transition probabilities. Experiments with monthly and weekly models indicate that real exchange rate, foreign exchange reserves and domestic credit/deposit ratio are the most important determinants of financial vulnerability. These variables should be observed very closely by researchers and policy makers in order to determine if the country is heading for financially difficult times.