The Nonlinear Dynamics of Foreign Reserves and Currency Crises

A new early-warning system for international currency crises is developed in this paper. The existing crisis indicators in the literature are essentially static. We examine the relationship between the dynamics of foreign reserves and currency crises. It is shown that rapid reserve depletion is a prominent feature before the collapse of the exchange rate system. The results from our threshold autoregressive model suggest that when the Reserves-to-Short-Term External Debt falls by more than 29.1%, or if the Reserves-to-M2 ratio drops by more than 24.3% within six months, the likelihood of a crisis increases. Our model provides clear warning signals for policy makers to take actions before the reserves have reached a critical value that heralds the arrival of a full-blown crisis.