The (not-so-trivial) definition of currency crises

3.2 The (not-so-trivial) definition of currency crises

In the following we use a stylized version of the monetary model of the exchange rate to define the different types of currency crises (see, e. g., Eichengreen et al., 1994;

Klaassen and Jager,2011). Money supply equals the sum of domestic credit,D_t, and international reserves measured in domestic currency, R_t:

M_t=D_t+R_t. (3.1)

Equation (3.1) can be approximated by

∆mt ≈ ∆M_t Mt−1

= ∆dt+ ∆rt, (3.2)

with∆d_t = ∆D_t/Mt−1 and∆r_t= ∆R_t/Mt−1where low letter variables denote logs.

We assume standard money demand functions for two countries – home and for-eign, with asterisks denoting foreign country variables

m_t−p_t =βy_t−αi_t, (3.3)

m^∗_t −p^∗_t =βy^∗_t −αi^∗_t, (3.4)

where m_t denotes the money supply, p_t the price level, y_t the real income, i_t the nominal interest rate, α the interest rate semi-elasticity andβ the income elasticity of money demand. Further assuming purchasing power parity,

s_t=p_t−p^∗_t, (3.5)

with s_t as the nominal exchange rate yields

s_t =m_t−m^∗_t −β(y_t−y_t^∗) +α(i_t−i^∗_t). (3.6)

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Chapter 3 To Intervene, or Not to Intervene: Monetary Policy & Currency Crises

Taking first differences, and using equation (3.2) leads to

∆s_t+ ∆i_t−∆r_t= ∆d_t−∆m^∗_t + ∆i^∗_t −β(∆y_t−∆y^∗_t) + (1 +α)(∆i_t−∆i^∗_t). (3.7)

The left-hand side of equation (3.7) comprises the central elements of the crisis definitions in a straightforward way. In case of a speculative attack the central bank can either adjust interest rates (∆i_t) and/or intervene in the foreign exchange market (∆r_t) and/or let the currency depreciate (∆s_t).⁴ We characterize the three types of crises, namely immediate depreciations, successful interventions, and unsuccessful interventions, along two dimensions. On the one hand we use changes of the exchange rate (∆s_t) and on the other hand we use an intervention index (INTX) in order to describe the central bank behavior (see Bauer and Herz, 2010). The intervention index is defined as the standard deviations weighted sum of interest rate changes and percentage changes in reserves (INTX = ∆i_t/σ_∆it −∆r_t/σ_∆rt). To identify specific crisis events we apply the subsequent set of rules which follows the stylized time structure of a speculative attack (see figure 3.2):

1.a A depreciation is significant if it is larger than the average of the exchange rate changes during the previous 12 months plus two times the standard deviation of these changes. Additionally, the exchange rate change has to be greater than 5 %.⁵ All means and standard deviations in this study are calculated time and country specific.

4In practice, a central bank clearly has more policy tools than equation (3.7) suggests. For sim-plicity, we do not discuss in detail, for example, realignments and changes in exchange rate bands as monetary tools, since they could be subsumed under changes of the exchange rate. Analogously, ex-change rate orientated open market operations should be accounted for by interest rate adjustments (seeKlaassen and Jager,2011, p. 77).

5Increases of the exchange rate of less than 5 % are not classified as significant depreciations even if they exceed the standard deviation threshold, e. g. in a strictly managed exchange rate regime (see Bauer and Herz,2010). In fact, a managed exchange rate regime is typically announced with a respective exchange rate band (see, for example,Ilzetzki et al.,2008).

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3.2 The (not-so-trivial) definition of currency crises

1.b Analogously, an intervention is considered to be significant if the INTX exceeds the average value during the previous 12 months plus three standard devia-tions.⁶

2.a A successful defense in yearT is defined as a significant intervention in months of year T without a significant depreciation during the subsequent 12 months.

2.b An unsuccessful defense in year T is defined as a significant intervention in month s of yearT followed by a significant depreciation during the subsequent 12 months.

2.c An immediate depreciation in year T is defined as a significant depreciation without a significant intervention during the preceding 12 months.

Given our definition an unsuccessful defense might also be characterized as a de-layed depreciation. Once a central bank has started to intervene in the foreign ex-change market she could end the intervention and let the currency depreciate for basically two reasons: either she is no longer able to intervene, e. g. the reserves are depleted, or she is not willing to further intervene, e. g. the expected benefits of the intervention policy no longer exceed the expected costs. As we cannot differenti-ate between these two situations we use the terms unsuccessful defense and delayed depreciation interchangeably.

Our empirical analysis is in principle based on annual data due to data limitations.

However, as the data relevant for the timing of currency crises, namely interest rates, exchange rates and reserves, are typically available at higher frequencies, we deter-mine the crisis events on the basis of monthly data and assign them to the respective years (see, e. g., Bussière et al.,2010). A major problem in identifying crisis events is to appropriately differentiate whether subsequent crises are individual events or part

6We apply a more restrictive threshold than in the case of depreciations to account for central banks’ adjustments of reserve holdings that are due to portfolio alignment only and are not due to intentional intervention in the foreign exchange market.

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Chapter 3 To Intervene, or Not to Intervene: Monetary Policy & Currency Crises

of an ongoing currency crisis. After determining currency crisis events we apply a one-year window and drop all crises with overlapping time windows, i. e. crises have to be at least two years apart to be considered as distinct currency crises.⁷ By doing so we ensure that the effects of a specific crisis type in year T are not biased by other nearby currency crises. If, for instance, a successful defense occurs in year T and an unsuccessful defense in year T + 1, the post-crisis effects of the successful defense could be influenced by the effects of the unsuccessful defense. Therefore, to avoid possible interferences in such a situation, these two crisis events are dropped from our analysis.