Early Warning System for Currency Crises in Iran: The Markov-Switching Approach

The occurrence of currency crises in recent decades has been one of the problems of the international monetary system. These crises impose heavy costs on the country where they occur and even other countries. For this reason, in recent years, systems for early warning of these crises have been developed to prevent the occurrence of such crises by their early detection and providing sufficient time for policymakers. Meanwhile, Iran's economy has faced several currency crises in the post-revolutionary years and has incurred heavy costs. Under these circumstances, designing an early warning system for currency crises in the Iranian economy can bring many benefits. Therefore, the purpose of this study is to design an early warning system for currency crises in Iran. Based on it, the endogenous crises that occurred in the period under review were identified. Using this system, it is possible to predict future crises and identify the factors affecting the occurrence and intensification of these crises separately in periods of tranquil and crisis.

In order to achieve the above goals, this article used the Markov-switching approach and the quarterly data of the Iranian economy during a period from February 1988 to March 2016. For this purpose, first the components of the designed early warning system, i.e. the dependent variable and the leading indicators of the crisis, were introduced. Afterwards, to estimate the model, first the unit root tests of the variables were used, and then the early warning system was estimated based on the Markov-switching approach in periods of tranquil and crisis. Finally, after diagnostic tests, the in-sample and out-of-sample prediction performances of the system were investigated and the characteristics of periods of tranquil and crisis were studied.

The results indicate that the designed system has a high ability to identify the past crises and anticipate future crises in the Iranian economy. Also, according to the results, in tranquil states, the increase of inflation rate, international reserves to foreign debt ratio, M2 to international reserves ratio, growth of foreign exchange earnings from oil exports and growth of domestic credit have positive and significant effects on the index of foreign exchange market pressure and the greater probability of a currency crisis. But in these tranquil states, the increase in the ratio of foreign exchange earnings to international reserves as well as the growth of industrial production has had negative and significant effects on this index. In other words, they have helped to prevent the occurrence of the currency crisis. Moreover, based on these results, in the crisis states, an increase in the inflation rate, the ratio of international reserves to foreign debt, M2 to international reserves ratio and budget balance to real gross domestic product ratio, with positive and significant effects on the foreign exchange market pressure, will intensify such crises. Of course, if a currency crisis occurs, the increase in the ratio of foreign exchange earnings to international reserves, the growth of domestic credit, the growth of industrial production and growth of real gross domestic product will help improve the crisis state. Finally, based on these results, in the tranquil states, inflation is the most important warning indicator and also the most important factor in increasing the probability of a currency crisis. The growth of industrial production is also the main factor reducing the probability of the crisis. Also, in the crisis states, inflation is the most important factor to intensify the crisis, while the ratio of foreign exchange earnings to international reserves and growth of real gross domestic product are the most important factors in improving the crisis state respectively.

Based on the early warning system designed for the Iranian economy, the occurrence of currency crises and the intensification of crisis states in Iran are due to a set of macroeconomic imbalances. These imbalances and the problems in the monetary, financial and foreign sectors as well as dependence on oil revenues have provided the basis for currency crises in the Iranian economy. However, the results showed that it is possible to deal with the occurrence of a currency crisis in Iran with policies such as inflation control, strengthening and proper management of foreign exchange resources, controlling liquidity growth, managing domestic credit, supporting industrial production, strengthening gross domestic product and controlling the government budget deficit. Also, it is possible to control the critical situation in the event of a currency crisis with such policies.