Balance Sheet analysis of the country has become a very popular method of analysing a crisis. It tells you the source and nature of the problem in a crisis economy.
Mirko Licchetta of BoE in a new paper looks at 40 countries monthly data over 1980-2004 period to understand currency crisis. Findings:
First, size and, particularly, the composition of a country’s external balance sheet are found to play an important role in the onset of crises.
Second, EMEs seem to be more sensitive to external balance sheet variables than developed countries, and so too do economies with fixed or quasi-fixed exchange rate regimes.
Third, further support is provided to standard theoretical explanations of currency crises. The likelihood of a crisis is found to increase with: the extent to which the real exchange rate rises above its trend; faster growth in broad money (relative to the level of international reserves); larger current account and budget balance deficits; lower GDP growth; and, if a neighbouring country already has a crisis.
Economic fundamentals are also found to be a more important explanation of the onset of currency crises during the 1980s than during the 1990s, suggesting that more recent crises are less ‘fundamentally’ driven.
The last finding is pretty interesting (this is what Velasco has said in his excellent paper). However, not much is written in the paper on it.
Licchetta has also written an excellent short lit survey on currency crisis economics:
Several theoretical explanations have been provided for currency crises, which have subsequently been tested empirically. First-generation models explain the timing of speculative attacks as the result of inconsistencies between a fixed exchange rate and government policies. They focus on the interlinkages between macroeconomic fundamentals and the likelihood of currency crises. For example, researchers have found variables such as a strong real exchange rate, current account and fiscal deficits, strong credit growth and low foreign exchange reserves as important explanations of currency crises.
While some of the predictions based on first-generation models have been confirmed empirically during the 1970s and the 1980s, more recent speculative attacks have taken place without large apparent external or fiscal imbalances (eg in Europe in 1992 and in Mexico in 1994). Second-generation models highlight the strategic complementarities between agents that could lead to multiple equilibria. A major contribution of this second class of models is that a crisis can be the result of self-fulfilling expectations; for example, market expectations of the government ability to defend the peg are an important element of the costs of defending it.7
However, as shown in Sachs et al (1996), macroeconomic fundamentals are still important because they determine the range of possible equilibria. Therefore, variables such as GDP growth, interest rates, the inflation rate and unemployment can provide useful insights into a country’s degree of vulnerability to currency crises.
Neither first nor second-generation models of currency crises are good at explaining the East Asia crisis in 1997-98. This has led to the emergence of a third generation of models that concentrates on the degree of liquidity of the banking system. These more recent models of currency crises concentrate on the existence of government guarantees and adequate methods of supervision as well as on the potential for currency mismatches in credit-constrained economies. In these models, high short-term external liabilities (relative to reserves), weak banking supervision, government guarantees and a high share of non-performing loans (in total loans) are likely to increase the likelihood of a crisis. On the other hand, large FDI inflows and high levels of bank deposits are likely to reduce the vulnerability of the system to currency crises.
Also the potential for a currency crisis to propagate from one country (group of countries) to another country (group of countries) and their interaction with banking crisis have be extensively investigated. And several empirical studies have provided evidence that certain economic fundamentals such as current account, budget balance, real GDP growth and others provide useful information on the onset of a crisis.