Disparate-ination-and-the-probability-of-currency-crises-empirical-evidence_2004_Economics-Letters.pdf

disparate information and the probability of currency crises empirical evidence peter tillmann 1 institute for international economics university of bonn lenne str 37 d 53113 bonn germany received 7 october 2003 accepted 8 january 2004 available online 20 march 2004 abstract this paper tests the impact of the distribution of information on the probability of currency crises within a markov switching framework less disparate information among domestic and foreign investors proxied by premia on country funds lowers the probability of a crisis d 2004 elsevier b v all rights reserved keywords currency crisis information markov switching country funds jel classification e44 f31 1 introduction this paper tests the role of the distribution of information for the probability of a currency crisis2 for this purpose we extend existing empirical evidence on the determinants of exchange rate pressure in the erm by including a measure of information disparity that is derived from the market for closed end country funds this indicator measures the asymmetry of information between domestic investors and international speculators we model the interest rate spread of the french franc and the italian lira in 1992 as a markov process and show that the disparity of information affects the probability of a currency crisis given a set of fundamentals a smaller disparity of information lowers the probability of a speculative attack 0165 1765 see front matter d 2004 elsevier b v all rights reserved doi 10 1016 j econlet 2004 01 002 tel 49 2 287 39234 fax 49 2 287 37953 e mail address tillmann iiw uni bonn de p tillmann 1 an early version of this paper was presented at the european meeting of the econometric society venice 2002 and the annual congress of the verein fu r socialpolitik innsbruck 2002 2 throughout the paper we use the terms asymmetric information and disparate information interchangeably economics letters 84 2004 61 68 the remainder of the paper is organized as follows section 2 introduces the empirical framework and quantifies the disparity of information section 3 presents the results and section 4 concludes 2 disparate information as a trigger the econometric approach chosen here relies on the markov switching models of devaluation probabilities for the french franc and the italian lira in the erm we ask how information disparity affects the shifts between a speculative attack regime and a tranquil regime by means of time varying transition probabilities several papers analyze the crises of the french franc and the italian lira by means of markov switching regressions in which the transition probabilities are a function of macroeconomic fundamentals mart nez per a 2002 finds that both fundamentals and speculative forces explain the probability of a devaluation in the erm amato and tronzano 2000 explore the link between devaluation probabilities for the italian lira and various fundamentals in the present paper the existing empirical evidence is supplemented by including a measure of information disparity into the regime generating process while fundamental variables are assumed to influence the spread directly as rey 2000 p 178 points out a phenomenon like the 1992 erm crisis could be modeled as unique equilibrium once dramatic shifts in information aggregation are incorporated explicitly moreover recent theoretical work in the spirit of morris and shin 1998 suggests that sudden movements in devaluation probabilities might be related to changes in the information structure of speculators in contrast to second generation models of currency crises devaluation probabilities can be explained without referring to arbitrary sunspots in eq 1 the interest rate differential relative to germany is regressed on a set of five macroeconomic fundamentals the temporary component of the real exchange rate tcreer the temporary component of the unemployment rate tcur the inflation differential relative to germany dp dpdm the differential of money growth rates over the previous 12 months dm2 dm2dm and the change in foreign exchange reserves over the last year dreserves interest rate differentials serves as an indicator of exchange rate credibility the crucial feature of this regression is the fact that both the intercept term and the variance of the error terms depend on the unobservable regime st prevailing in the economy it idm t l st k1 tcreert k2 tcurt k3 dp dpdm t k4 dm2 dm2dm t k5 dreservest utwith utfi i d n 0 r2 st 1 hence shifts in the intercept term and in the variance are inherently unrelated to economic fundamentals whose effects are represented in the coefficients k1 k2 k3 k4 k5 the discrete state variable stshifts between two realizations st mwithmaf1 2g 2 and is governed by a first order markov chain prob st j j st 1 i st 2 k prob st j j st 1 i pij 3 the probability of jumping between states only depends on the realization of the regime variable in the previous period thus the model endogenously separates two unobservable states we can then label p tillmann economics letters 84 2004 61 6862 one regime with a low l and r2 the normal state and a second regime with a high l and r2 the crisis state since the probabilities give a characterization of the likelihood of jumping between regimes we will refer to p12as the probability of a speculative attack the transition probabilities are assumed to be time varying following diebold et al 1994 p12 exp c01 c12 t 1 1 exp c01 c12 t 1 4 p21 exp c02 c21 t 1 1 exp c02 c21 t 1 5 here tdenotes an indicator of the precision of the information or the disparity of information of speculators respectively to be constructed later the coefficient c12 c21 represents the impact of the indicator on the probability of jumping from regime 1 2 to regime 2 1 more disparate information is supposed to raise the probability of a speculative attack the model is estimated using standard non linear algorithms to infer the realizations of the regime variable and to obtain parameter estimates 2 1 country fund premia and asymmetric information as a variable approximating the degree of information disparity we employ the so called country fund discount these funds invest in equities from a specific country and are traded on secondary markets at the fund price the underlying assets are individually traded and constitute the net asset value nav in perfectly integrated markets fund prices and navs should be equal as they are two market values of the same underlying asset however the difference between prices and navs is found to be substantial for the purpose of this paper it should be noted that both series reflect how different investors value the same underlying asset investors who have little country specific information are not willing to pay as much as a well informed investor for a particular asset the discount therefore reflects the informational advantage of domestic investors relative to foreign investors as frankel and schmukler 2000 show asymmetric information between well informed domestic investors and less informed foreign investors can explain the interaction between fund prices and navs the evidence of privileged information of domestic investors is further strengthened by frankel and schmukler 1996 who examine the dynamics of premia on mexican country funds during the currency crisis in 1994 in terms of the evidence provided by the authors fund premia can be explained by divergent expect ations among investors3 we will use premia or discounts respectively on country fund navs paid on international markets as a measure of information disparity we employ data for the france growth fund frf and the italy 3 recent research confirms the relevance of heterogeneous information sets among investors despite ongoing financial market integration calvo and mendoza 2000 p 82 conclude that the issues of concern to international investors are thus radically different from those that worry domestic investors and the costs incurred in gaining an expertise at the same level of that typically acquired for domestic investment are much higher p tillmann economics letters 84 2004 61 6863 fund ita converted into us dollar from frankel and schmukler 1996 to proxy information disparity4 three alternative indicators of information disparity are constructed for each country according to the following definitions 1 tu fund price net asset value t 2 tu j fund price net asset value jt 3 tu fund price net asset value 2 t the first index t 1 measures the difference in us dollar between fund prices and navs a negative t 1 means that fund prices are lower than their nav hence international investors are not willing to pay as much as domestic investors for the same underlying assets therefore following the arguments of frankel and schmukler 2000 international investors have an informational disadvantage hence we will interpret t 1 as the quality of information of foreign investors relative to domestic investors the probability of a speculative attack is expected to decline in the quality of information of the group which is less well informed however this indicator mirrors the informational disadvantage of foreign investors when compared to domestic investors to obtain a measure of the disparity of information irrespective of which party is better informed than the other we construct two other indices the second indicator t 2 measures the disparity of information by taking the absolute difference of fund prices and the nav a higher t 2 reflects more disparate information the index t 2 simply represents a measure of the distance between both information sets finally the indicator t 3 computes the squared difference between both series in order to obtain a positive value indicating the disparity of information the higher the indicators t 2 and t 3 the more disparate is the distribution of information and the less precise is the information flow we expect the probability of a currency crisis to rise in the disparity of information a visual inspection of t 1 for france see fig 1 reveals that the difference between prices and navs was negative with a remarkable peak in 1993 during which the series changed its sign throughout the sample period information is unevenly distributed as indicated by the substantial distance of t 1 from the zero line the indicator starts to increase as soon as the currency crisis of the french franc unfolds during 1992 the disparity of information given by t 2 and t 3 reaches its maximum shortly before the onset of the currency crisis in 1992 1993 in the aftermath of the crisis disparity begins to decrease before it increases again in 1994 thus the devaluation of the currency seems to have revealed information that led to a homogeneous information set among both groups of investors for a short period of time this evolution of the information set is consistent with the predictions of second generation models under incomplete information bensaid and jeanne 1997 model the loss of the government from devaluing the currency as private information market participants engage in a war of attrition and discover the true parameters of the government s optimization problem only after the devaluation finally occurred hence the precision of information increases after an attack for italy see fig 2 the behavior of t 1 reveals that in general domestic investors were better informed with slight exceptions in 1990 and 1993 1994 during which the indicator lies above zero the indicators t 2 and t 3 show that the disparity of information varied substantially over the sample period 4 the dataset was kindly provided by sergio schmukler from the world bank p tillmann economics letters 84 2004 61 6864 and reached a peak before the exchange rate crisis erupted following the devaluation of the lira agents gain some additional information as indicated by the rise in t 1 and t 2 in the aftermath of the crisis around 1992 1993 fig 2 italy indicators of the dispersion of information fig 1 france indicators of the dispersion of information p tillmann economics letters 84 2004 61 6865 3 evidence from france and italy 1992 the data set employed here consists of monthly data for france and italy over the period 1990 11 through1995 10and1987 11through1995 10 respectively thechoiceofthesampleperiodwasdictated bytheavailabilityofcountryfunddata theinterestratedifferentialismeasuredbythedifferencebetween 3 month eurorates for france and italy respectively and germany which was obtained from dg bank the macroeconomic fundamentals comprise the temporary component of the real exchange rate and the temporary component of the unemployment rate both obtained from hp filtering the original series and computingthe difference between the actual series andthe hptrend weuse the temporary componentsof theexchangerateandtheunemploymentrateinordertoobtainameasureofthedeviationoffundamentals from equilibrium data on the real exchange rate was obtained from j p morgan data on unemployment rates thegrowthratesofm2 andthechangeinreserveswastakenfromtheinternationalmonetaryfund s ifs database a higher real exchange rate means a real appreciation of the domestic currency in addition the difference between the french and the italian respectively and the german inflation rate is included which is computed as the difference between yearly changes in consumer price indices obtained from the ifs database the parameter estimates are presented in table 1 for the case of france and in table 2 for the case of italy for each country a linear model is estimated specification i that corresponds to a table 1 results for france from linear and markov switching regression models coefficientlinear modelregime switching model iii with t 1 iii with t 2 iv with t 3 v ftp v1 27 v st 1 0 58 0 67 0 66 0 49 v st 2 2 02 1 65 1 79 1 82 r2 st 1 0 20 0 17 0 18 0 16 r2 st 2 1 17 1 21 1 11 1 19 wald v22 48 27 59 12 65 17 49 wald r242 12 255 79 41 81 172 66 tcreer0 33 0 09 0 11 0 13 0 14 tcur 0 75 0 100 070 070 31 dp dpdm0 090 030 040 030 01 dm2 dm2dm0 03 0 010 01 0 01 0 00 dreserves0 000 000 000 000 00 p120 11 p210 11 c01 3 58 5 06 3 43 c0220 07 0 64 0 55 c12 0 371 28 0 35 c2176 47 2 04 0 49 sample1990 11 1995 10 maximum l 64 75 27 55 35 57 35 72 33 11 wald v and r2denotes the test statistic of a wald test for equal intercepts and variances respectively the test statistic is v2 1 distributed the maximum of the log likelihood function is given by maximum l a significance level of 10 5 and 1 is indicated by and respectively p tillmann economics letters 84 2004 61 6866 regime switching model in which the number of regimes is set to unity in addition the regime switching model is estimated for each country using the indicators of information dispersion specifications ii iv moreover the model is estimated in a variant specification v with fixed transition probabilities ftp pij first note that the regime switching specifications ii iv yield a higher value of the likelihood function than the linear model i this serves as an indicator of the quality of the regressions and lends some support to the choice of the non linear approach second the model separates a normal state and a crisis state for each country all regime dependent parameters are significantly different from zero on high levels of significance the wald test statistics indicate that the intercepts and the variances are significantly higher in the crisis state than in the tranquil state not surprisingly the model hardly detects any significant relationship between the macroeconomic fundamentals and the interest rate differential the real exchange rate and the development of m2 enter significantly positive into the determination of french interest rate spreads while m2 and the inflation differential significantly affect the italian spread rising inflation relative to germany or a stronger growth of m2 increases devaluation expectations the model with fixed transition probabilities delivers comparable effects of macroeconomic fundamentals on spreads and confirms that the findings are not merely artefacts of the time varying nature of transition probabilities table 2 results for italy from linear and markov switching regression models coefficientlinear modelregime switching model iii with t 1 iii with t 2 iv with t 3 v ftp v4 07 v st 1 3 19 2 68 3 28 3 22 v st 2 5 94 4 98 5 62 5 99 r2 st 1 0 57 0 61 0 72 0 57 r2 st 2 0 95 1 76 1 45 0 94 wald v132 13 23 35 39 04 92 16 wald r23 90 4 11 1 512 33 tcreer 0 01 0 02 0 06 0 07 0 02 tcur 1 06 0 93 0 28 0 39 0 97 dp dpdm0 37 0 030 48 0 29 0 02 dm2 dm2dm0 17 0 07 0 15 0 13 0 07 dreserves0 000 01 0 01 0 01 0 01 p120 03 p210 05 c01 3 68 5 88 4 18 c0217 19 2 67 1 84 c12 0 41 1 26 0 18 c21174 45 0 00 0 31 sample1987 11 1995 10 maximum l 165 71 108 12 132 88 131 00 114 10 wald v and r2denotes the test statistic of a wald test for equal intercepts and variances respectively the test statistic is v2 1 distributed the maximum of the log likelihood function is given by maximum l a significance level of 10 5 and 1 is indicated by and respectively p tillmann economics letters 84 2004 61 6867 as a by product of parameter estimation the model delivers a series of conditional probabilities of the crisis regime for france and italy the models clearly identify the crises of 1992 1993 as sudden jumps to the crisis state the series are not reported here in order to save space5 remember that the probability of switching to a crisis state p12 is modeled as a function of the heterogeneity of information on financial markets the impact of t 1 on the probability of a speculative attack is negative for both countries as given by the parameter estimates for c12in specification ii thus the probability of a currency crisis decreases with the quality of information of foreign investors the disparity of information measured by t 2 and t 3 affects the probability of a speculative attack through the significantly positive parameter c12in specifications iii and iv the wider the di