Abstract

How robust has the ratio of international reserves to short-term external debt been as an early warning indicator of external vulnerability and currency crisis? We examine this issue and, in particular, analyse the significance of the reserve ratio's predictive power and its sensitivity to the database used by estimating regression coefficients for a number of explanatory variables using Probit and Logit methods. The data cover 15 episodes of crisis during 1985 to 2001 in nine emerging-market countries from Latin America and Asia. Our econometric results firmly support the notion that the reserve ratio is a strong indicator of currency crisis and external vulnerability, but its relative significance varies with the source of the data on short-term debt. We also estimate the vulnerability threshold value of the reserve ratio and draw a highly unconventional conclusion: The minimum threshold value of approximately 1 is a reasonable guide to an emerging-market country's reserves policy; higher levels of reserve ratio, while costly to maintain, do not make a country less vulnerable to external crises. Finally, we examine the predictive power of the reserve ratio by using alternative measures of international reserves and short-term debt in the case of 1994 Mexican crisis. Two key findings emerge. First, some of the methodological adjustments recommended by the IMF for calculating the reserve ratio are indeed highly significant. Second, the market amortization component of short-term debt (amortizations of external debt held by private foreign investors scheduled over the next 12 months) is a much more powerful indicator of potential liquidity problem that total short-term external debt (total amortizations over the next 12 months).