an early warning system for currency crisis in mongolia

Hangyong Lee

An Early Warning System for Currency Crisis in Mongolia

Global Development Co-operation Think Tank

Table of Contents

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I. KSP with Mongolia 2010-2013: Overview

II. An Early Warning System for Currency Crisis in Mongolia

II-1. Motivation

II-2. Methodology & Results

II-4. Policy Recommendations

III. Implications on the Mongolian Economy

I. KSP with Mongolia 2010-2013

: Overview

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I. KSP with Mongolia

The KSP with Mongolia began in 2010 when the Ministry of

Finance (MOF) and National Development and Innovation

Committee(NDIC) of Mongolia agreed upon sharing of Koreas

development knowledge and experience through the program.

The 2012 KSP with Mongolia marked the third year of

cooperation, as well as the second year that Mongolia and Korea

forge the Strategic Development Partner Country(SDPC).

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KSP 2010 Mongolia

Public-Private Infrastructure Investment and Deposit Insurance in Mongolia

Improvement in Legal and Procedural PPP System

Improvement on the PFS System

A Study on the Foundation for Introducing Limited Deposit Protection Scheme

KSP 2011 Mongolia

Macro Policy Framework for Sustainable Development in Mongolia

Macroeconomic Policy Mix under the Environment of Volatile Capital Flows

Foreign Exchange Policy and Capital Controls

Fiscal Policy Reform by Upgrading Budgeting Process

Toward a Viable Scheme of Non-Performing Loans Resolution in Mongolia

Developing Standard Financial Model for Road PPP Project in Mongolia

5



KSP 2012 Mongolia

Selective Policy Recommendations for sustainable economic growth of

Mongolia: Trade, Macroeconomic and Public Policy Areas

Export policy and trade development of Mongolia

Mechanism for Allocating/Managing the Financial Resources from Foreign Loans

Implementation of Deposit Insurance Scheme in Mongolia

Establishing a National Early Warning System for currency crisis

Schemes to Improve Professional Training System for the Enhancement of

Capacity-building in Public Procurement

PPP Risk Management

KSP 2013 Mongolia (Ongoing)

Capacity Building of Human Resources in the Ministry of Economic

Development of Mongolia

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II. An Early Warning System for

Currency Crisis in Mongolia

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II-1. Motivation

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Rapid recovery since 2009.

Growth rate slowed down in 2012


II-1. Motivation

9

But, high inflationary pressure


II-1. Motivation

10

Large current account deficits and large capital inflows


II-1. Motivation The recent global financial crisis rekindles interest in developing

early crisis warning system.

One of the G20s first reactions to the global financial crisis

was to task the IMF and FSB with establishing a joint Early

Warning Exercise

EWS models provide a useful framework for identifying risks and

vulnerabilities that could lead to further systemic shocks, and thus

help policymakers coordinate an early policy response.

If the symptoms of crisis can be detected in advance,

government can adopt preemptive measures to prevent the

crisis or at least to reduce the adverse impacts of the crisis on

the domestic economy.

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Signaling approach developed by Kaminsky and Reinhart

(1999) and Kaminsky, Lizondo, and Reinhart (1998)

An EWS for currency crisis uses time series data to detect

an early "signal" of the crisis.

The basic premise of the signaling approach is that the

economy behaves differently on the eve of crisis and that

this aberrant behavior has a recurrent systematic pattern.



Three steps:

1) Dating historical crisis periods by constructing an

Exchange Markets Pressure Index (EMPI).

Interest rates, sovereign spread, stock returns, and return

volatility can be used to construct a more general financial

market pressure index (but the results do not change)

2) Selecting leading indicators and performing statistical

analysis for the forecasting power of the leading indicators.

3) Constructing a composite index using a group of leading

indicators that have the best track records in anticipating

crises

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Step 1: Exchange Market Pressure Index

A currency crisis is often characterized by substantial losses

in international reserves and/or a sharp depreciation of the

local currency.

Most early warning systems for currency crisis identify the

crisis periods in a statistical way that exchange rate and

foreign exchange reserve show abnormal values.

EMPI = -

Crisis if EMPI > EMPI + k EMPI

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15

Exchange Rate and International Reserves



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EMPI (Exchange Market Pressure Index)



Step 2: Selecting Leading Indicators

Given the identified crisis periods and signaling time horizon,

an indicator is said to issue a signal whenever it goes

beyond a given threshold level.

A signal, which is followed by a crisis, is called a good

signal, while a signal not followed by a crisis is called a false

signal or noise.

Thus, for a given threshold, each indicator of signaling

model produces one of the four cases at each point of time

in the following matrix.

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A/(A+C) : Good Signals as percentages of Possible Good Signals

B/(B+D) : Bad Signals as percentages of Possible Bad Signals

[B/(B+D)] / [A/(A+C)] : Noise to Signal Ratio (NSR)

Kaminsky, Lizondo, and Reinhart (1998) proposed setting the

threshold to minimize the noise-to-signal ratio

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Realizations

Crisis within 12 months No Crisis within 12 months

Signal issued A B (Type II error)

False Alarms

No signal issued C (Type I error)

Missed Calls D



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Indicator Threshold Type I Error

Type II Error

NSR

Inflation Rate 16.06 0.13 0.02 0.02

Interest Rate 0.45 0.6 0.17 0.43

Lending-Deposit Rate Differential 18.46 1 0.34 -

Domestic Credit 67.45 0.27 0.17 0.23

M2 47.61 0.8 0.12 0.61

Exports 6.24 0.73 0.14 0.51

Imports 85.69 0.6 0.1 0.26

Trade Balance 0.22 0.67 0.14 0.43

Capital Account 0.1 0.4 0.08 0.14

Real Effective Exchange Rate 21.27 0.73 0.04 0.17

Oil Price Index 59.47 0.47 0.05 0.09

Copper Price Index 20.23 0.67 0.07 0.22

Nominal Broad Dollar Index 6.71 0.67 0.09 0.27

OECD Leading Indicator -0.32 0.47 0.07 0.14

Chinese Industrial Production -8.78 0.8 0.09 0.45



Step 3: Composite Index

We combine the information of all the indicators by

constructing a single composite crisis signal index

The composite index is a weighted sum of the signaling

indicators.

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n

i

itit SwCI1

where Sit is equal to one if indicator i crosses the threshold and zero otherwise and wit is the inverse of noise-to-signal ratio of indicator i.

We can refine the composite index with more data and

other weights.



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Composite Index



Operation of the EWS

Contingency crisis planning

CI level can be classified to normal, caution, warning,

quasi-emergency, emergency

Then contingency policy actions need to be prepared for

each level.

For a better EWS,

Incorporate changing risk factors

Improve the quality of the data

Construct other type of model such as micro-prudential

surveillance system for banking industry.

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Qualitative Monitoring

No quantitative model is perfect.

Early warning system

= quantitative model + qualitative monitoring

Qualitative monitoring on foreign exchange market and

international markets on a real time basis and analyzing

information should be strengthened.

In Korea, KCIF(Korea Center for International Finance) was

established to assist the government in heading off financial

crises through real-time monitoring of foreign exchange

markets and operating early warning models.

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Crisis Prevention Policy 1: Foreign Exchange Policy

FX flexibility is very important.

Holding adequate amount of international reserves is very

important (as a self-insurance)

The amount of international reserves should depend on

trade volume, external debts, exchange rate regime, and the

past crisis experiences.

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Crisis Prevention Policy 2: Prudential Policy

Prudential regulations are intended to strengthen the ability of

financial sector to cope with the increased risks associated with

capital inflows.

FX-related regulations on FX mismatch ratio or FX liquidity ratio

Surge in capital inflow tends to lead to lending boom and asset

price bubble: amplification of macroeconomic risk.

Need to protect banking system from financial boom-and-bust

cycles

Countercyclical capital buffer can dampen banks pro-cyclical

behavior, restraining risk-taking during booms and cushioning

financial distress during busts.

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Crisis Prevention Policy 3: Capital Controls

Macroeconomic/prudential policies may not suffice for

substantial capital inflows

Capital controls discriminate according to residency, while

FX-related regulation discriminate according to the currency

of transactions.

Macro-prudential stability levy on banks non-deposit FX

liabilities in Korea is a prudential regulation, but it operates

just like a capital control as long as most of funding comes

from non-residents.

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Crisis Prevention Policy 3: Some considerations

Capital controls for macroeconomic reasons should be

imposed on temporary surges of inflows

Capital controls should be applied broadly to all types of

inflows to deal with macroeconomic concerns.

If not, there will be circumvention through exempt

transactions or relabeling.

Capital controls can be more effective than prudential

measures if the inflows effectively bypass the regulated

financial institutions.

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Crisis Prevention Policy 4: Sovereign Wealth Fund

Stabilization fund should aim to insulate government

spending from the swings of the commodity prices.

When the commodity price is high, money flows into the

fund. When it declines, the Ministry of Finance can draw

on the fund to support government spending and finance

fiscal deficit

Source of fund: revenues from mining sector (in foreign

currency)

Investment: assets should be invested abroad in foreign

currency.

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III. Implications on

the Mongolian Economy

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III. Implications

Fast economic growth since the mid-2000s, largely due to the

expanding mining sector and the growing Chinese economy

In 2011, the annual growth rate was over 17%, the highest

among Asian countries.

IMF forecasts that Mongolia will remain strong in coming years.

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Source: IMF

17.5%

- 10%

- 5%

0%

5%

10%

15%

20%

1990 1995 2000 2005 2010 2015

forecast


III. Implications

The Mongolian economy is based around the mining sector and

consequently it is vulnerable to commodity price fluctuations.

The sector accounts for 21% of GDP and over 40% of the

government revenues.

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GDP Share (%)

Source: CEIC

12.3%

21.0%

6.0%

0%

10%

20%

30%

2002 2004 2006 2008 2010

Agriculture Mining and Quarrying Manufacturing

40%

45%

50%

55%

60%

15%

20%

25%

30%

35%

2003- 02 2006- 02 2009- 02 2012- 02

Mining (left axis) Manufacturing (right axis)

Employment Share (%)

* Resource-based economy is defined as an economy which natural resources account for more than 10% of GDP and 40% of exports


III. Implications

Problems surrounding resource-based economies*

Vulnerable to external shock, due to volatile commodity prices

Dutch disease: Exchange rate appreciation and rising inflation

Employment Problem

Risk of Institutional weakness, due to rent-seeking behavior

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* Resource-based economy is defined as an economy which natural resources

account for more than 10% of GDP and 40% of exports


III. Implications

Key Policy Objectives

Short-run: Appropriate macroeconomic policies combined with

sound management of foreign exchange rates

- An early warning system for currency crisis

- Crisis prevention policies in normal times

- Maintaining flexibility of exchange rates, holding adequate

amount of international reserves, and strengthening prudential

regulations on financial institutions

Long-run: Structural transformation towards a diversified

industrial structure

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III. Implications

An EWS is a useful tool, but cannot be perfect.

Underlying vulnerabilities and triggering events of the crises

can be different and the economic structure and behavior

changes over time.

Need to develop different type of models with different data.

Thus, (real-time) Qualitative monitoring is crucial.

Need organization and human resources (KCIF)

Need to enhance statistical capacity, especially quality data

availability (to capture the vulnerability of the economy).

Meanwhile, crisis prevention policies in normal times are

important.

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an early warning system for currency crisis in mongolia

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