Monitoring and Forecasting Currency Crises†

Can we improve forecasts of currency crises by using a large number of predictors? Which economic variables are most important to predict currency crises? This paper evaluates the performance of traditional Leading Indicators and a new Diffusion Index (DI) method as Early Warning Systems to monitor the risk and forecast the likelihood of the recent currency crises in East-Asia. We find that, relative to traditional Leading Indicators (such as money multipliers, terms of trade, etc.), the Diffusion Index performs quite well in real-time, with a higher probability of providing correct signals. We also find that the economic variables that help in forecasting future crises are output growth, the Balance of Payments, interest rates and money growth, and that their relative importance changes dramatically around the time of the crises.