The Good, the Bad, and the Ugly…signals of currency crises: Does signal approach work in ex-ante forecasting of currency crises?

This paper re-examines indicators of currency crises from Kaminsky and Reinhart (1999) and subsequent studies using the novel application of a ROC curves analysis. It utilizes a training set (1975-1995) to short-list indicators with the in-sample predictive value and tests their out-of-sample in 1996-2002. Only four variables have both in-sample and out-of-sample predictive value: the deviation of the real exchange rate (RER) from a trend, the foreign reserves, the ratio of broad money M2 to reserves, and the decline in exports. The ROC-optimal thresholds issue more accurate signals than the minimum noise-to-signal ratio previously used in the literature. Modified ROC curves highlight the relationship between the precision of sent signals and the recall of crisis episodes. Proposed forecast combinations using several ad-hoc rules help to improve forecast accuracy.