5. Monetary Policy in the SEMCs pre- and post-crisis
5.2 Rethinking macroeconomic policies: Towards a new early warning
5.2.1 Construction and implementation of an Early Warning
The leading international monetary and financial monitoring indicator (IVMF) or continuous macroeconomic vulnerability index (IVM)52 is the dependent variable in our model to build an Early Warning System (EWS).
It is based on the same approach as used by Cartapanis et al. (1998, 2002) and Ari & Dagtekin (2007, 2008) in the construction of an indicator of
50 Eichengreen & Hausmann (1999).
51 Monetary crises are defined as currency crises, banking crises or twin crises, i.e. a combination of banking and currency crises.
52 In the literature on early warning signals, two types of alternative indicators are used: the Speculative Pressure Index (SPI) and the Effective Crisis Index (ECI).
currency crisis, and consists of the average monthly variations of fragility and unsustainability indicators that form the credit to the economy (CREDEC), the real effective exchange rate (ITCER), the nominal interest rate (TIN) and the current deficit ratio with respect to international reserves (DEFCRES), weighted by the inverse of their respective standard deviations to standardise volatile components of the index.53 The data used covered the period from January 1999 to December 2009, on a monthly basis.
The vulnerability indicator is higher in the following cases:
when excesses in banking credit generate inflationary pressures ,
when the domestic currency appreciates sharply in real terms or the interest rate depreciates in nominal terms or
when the ratio of current account deficit to foreign exchange reserves is increasing :
(1)
In fact, the choice of indicators is justified by similar experiences in recent currency crises as well in emerging and developed countries, and attempts to detect early signs that meet the following observations:54
A decline in credit triggers a financial accelerator mechanism that spreads to different markets (real estate, stock market and foreign exchange).
Major fundamental imbalances and risks of macroeconomic overheating generally reflect excess credit, the overvaluation of the real exchange rate (and thus the misalignment), dwindling foreign-exchange reserves, excessive monetary growth leading to a sharp decline in interest rates and current-account deficits.
53 The nominal interest rate is defined as the average money market rate. The real effective exchange rate is calculated using the methodology developed by Mouley (2011).
54 With reference to theories of currency crises of the first and second generations.
1 .( ) A country permanently recording a current-account deficit cannot fund it with foreign capital inflows. If international financial markets believe that the deficit is unsustainable, the country becomes insolvent, which increases the probability of a crisis. In the same vein, the imbalances are also the result of unsustainable macroeconomic policies (expansionary monetary and fiscal policies that stimulate a strong credit growth, the accumulation of debt and over-investment in real assets).
Subsequently, a policy tightening to maintain inflation and adjusting foreign positions led to a slowdown in economic activity, difficulties in servicing debt and increasing bad loans threatened the capital position of banks.
The graph above shows that the index detected three peaks of currency crises in the Tunisian economy. The unit root tests (Augmented Dickey-Fuller, ADF) show that the index is stationary I (0) at both absolute level and at the first derivative at 1% level (Table 5.3).55
55 In addition, normality tests show that the index follows a normal distribution.
-0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
99 00 01 02 03 04 05 06 07 08 09 IVFM
Table 5.3 ADF unit root test of the continued crisis index
Level First derivative
Model with constant
ADF test statistic -10.7650 -18.4734 VC (1%)*
VC (5%) VC (10%)
-3.4815 -2.8837 -2.5784
-3.4819 -2.8838 -2.5785 Order of integration
Model with constant and trend
ADF Test Statistic -10.7323 -18.4036 VC (1%)*
VC (5%) VC (10%)
-4.0309 -3.4447 -3.1469
-4.0314 -3.4450 -3.1471 Order of integration I (0) I (0)
* MacKinnon's Critical Values for rejecting the null hypothesis of unit root.
Table 5.4 Descriptive statistics of the continued crisis index
Average 0.013223
Median -0.003431
Maximum 0.979374
Minimum -0.339959 Standard deviation 0.154172
Skewness 3.448642
Kurtosis 21.30695
Jarque-Bera 2088.997
Probability 0.000000
No. of observations 131
In addition, although the determination of the crises periods for Tunisia is insensitive to changes in definition of the term of crisis,56 there might be differences in terms of standard deviations. Setting a high threshold minimises the likelihood of predicting a crisis where there is none, while the probability of not predicting an actual crisis decreases. To avoid these biases, dating crisis is identified when IVMF index exceeds a threshold equal to three standard deviations ( ), plus the average for the entire reporting period ( ):57
(2)
This method appears optimal to detect the precise dates of crises and to minimise the probability of identifying crisis wrongly.
56 The same graphical results are indeed obtained with two different alternative definitions:
57 This threshold seems optimal with respect to three other crisis levels in terms of standard deviations, namely 1,5. IVFM , 2. IVFM and 2,5. IVFM , estimated for the sensitivity analysis of the datation on arbitrary crisis levels.
IVMF
During the reporting period, three periods of currency crises seem to have hurt the Tunisian economy, as follows:
The first in 2000, due to a significant increase in the current-account deficit during this year, partly due to the sharp rise in imported energy prices and the dollar appreciation, accompanied by an unprecedented growth in outstanding loans of around 13.1%.
The second in 2007 as a result of excess liquidity in the banking system due to an autonomous expansion of liquidity, as well as a credit growth of 9.8% compared to an average of 6.1% during the period 2004-06 with gross NPLs (% of total loans) of about 17.6%.
Meanwhile, and in view of the macroeconomic-balance approach used by the repository CGER (Consultative Group on Exchange Rate Issues) of the IMF, the real effective exchange rate of the dinar was over-valued by 2.7% during this year.
The third in 2009 as a logical consequence of the contagion effects related to the recent international financial and economic crisis and what it involved in the deterioration of the current-account deficit and dwindling foreign exchange reserves.
This analysis completes other attempts to analyse the financial crisis by academics and international organisations, presented in the table below.
Nature of the financial crisis Crisis periods References
Sovereign debt crisis 1991-92 Roubini et al. (2003) Banking crisis 1988-89
1991-95
Caisse des dépôts et consignations (1998) Systemic banking crisis 1991-94 Laeven & Valencia (2008)
1991 Boyd et al. (2009)