An Early Warning System for Currency Crisis in Mongolia

Hangyong Lee

Table of Contents

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

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I. KSP with Mongolia 2010-2013 : Overview

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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I. KSP with Mongolia

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

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I. KSP with Mongolia

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

II-1. Motivation

Rapid recovery since 2009. Growth rate slowed down in 2012

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II-1. Motivation

But, high inflationary pressure

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II-1. Motivation

Large current account deficits and large capital inflows

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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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II-2. Methodology & Results

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.

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II-2. Methodology & Results

Three steps: 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)

1)

2)

Selecting leading indicators and performing statistical analysis for the forecasting power of the leading indicators. Constructing a composite index using a group of leading indicators that have the best track records in anticipating crises
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3)

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II-2. Methodology & Results 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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II-2. Methodology & Results Exchange Rate and International Reserves

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II-2. Methodology & Results EMPI (Exchange Market Pressure Index)

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II-2. Methodology & Results 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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II-2. Methodology & Results

Realizations Crisis within 12 months No Crisis within 12 months Signal issued No signal issued A C (Type I error) Missed Calls

B (Type II error) False Alarms

D

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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II-2. Methodology & Results

Indicator Inflation Rate Interest Rate Lending-Deposit Rate Differential Domestic Credit M2 Exports Imports Trade Balance Capital Account Real Effective Exchange Rate Oil Price Index Copper Price Index Threshold 16.06 0.45 18.46 67.45 47.61 6.24 85.69 0.22 0.1 21.27 59.47 20.23 Type I Error 0.13 0.6 1 0.27 0.8 0.73 0.6 0.67 0.4 0.73 0.47 0.67 Type II Error 0.02 0.17 0.34 0.17 0.12 0.14 0.1 0.14 0.08 0.04 0.05 0.07 NSR 0.02 0.43 0.23 0.61 0.51 0.26 0.43 0.14 0.17 0.09 0.22

Nominal Broad Dollar Index

OECD Leading Indicator Chinese Industrial Production
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6.71
-0.32 -8.78

0.67
0.47 0.8

0.09
0.07 0.09

0.27
0.14 0.45

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II-2. Methodology & Results 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.

CI t wi Sit
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.

i 1

We can refine the composite index with more data and other weights.
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II-2. Methodology & Results Composite Index

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II-3. Policy Recommendations 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 Improve

changing risk factors

the quality of the data

Construct

other type of model such as micro-prudential surveillance system for banking industry.
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II-3. Policy Recommendations 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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II-3. Policy Recommendations 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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II-3. Policy Recommendations 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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II-3. Policy Recommendations 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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II-3. Policy Recommendations 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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II-3. Policy Recommendations 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.

17.5%

20% 15% 10% 5% 0% 1990 -5% -10%

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forecast

1995

2000

2005

2010

2015

Source: IMF
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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.
GDP Share (%) Employment Share (%)
35% 60%

30%

21.0%
20% 12.3% 10% 6.0%

30%

55%

25%

50%

20%

45%

0% 2002 Agriculture 2004 2006 2008 2010 Mining and Quarrying Manufacturing

15% 2003-02

40% 2006-02 2009-02 2012-02 Manufacturing (right axis)

Mining (left axis)

Source: CEIC

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

Problems surrounding resource-based economies*

Vulnerable

to external shock, due to volatile commodity prices Problem

Dutch

disease: Exchange rate appreciation and rising inflation

Employment Risk

of Institutional weakness, due to rent-seeking behavior

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

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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. to develop different type of models with different data.

Need

Thus, (real-time) Qualitative monitoring is crucial. Need organization and human resources (KCIF) to enhance statistical capacity, especially quality data availability (to capture the vulnerability of the economy).
Need

Meanwhile, crisis prevention policies in normal times are important.

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