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# I. INTRODUCTION

The turbulence and collapse of the European Exchange Rate Mechanism in 1992-93 and the onset of the Mexican crisis in December 1994 have rekindled interest in both academic and policy circles in the potential causes and the symptoms of currency crises. In particular, there is a question as to whether those symptoms can be detected with sufficient advance so as to allow governments to adopt pre-emptive measures. While accurately forecasting the timing of currency crises is likely to remain an elusive goal for academics and policymakers alike, there is no question about the need to develop and improve upon a warning system that helps monitor whether a country may be slipping into a situation that is bound to end up in a crisis.

The purpose of this paper is to examine the available evidence on currency crises and to propose a specific early warning system. To this end, the paper first reviews briefly the theoretical literature on currency crises. Although there are excellent surveys available which provide comprehensive discussions of a number of theoretical issues, this paper narrows its focus to identifying the various indicators suggested by alternative explanations of currency crises. The discussion encompasses papers within the traditional approach, which stress the role played by weak economic fundamentals in inducing a currency crisis, as well as more recent papers, including those that highlight the possibility of self-fulfilling crises.

Second, the paper surveys the empirical literature to take stock of the various approaches that have been used to assess the usefulness of potential indicators of currency crises, and to identify those indicators that have been the most effective. The results indicate that an effective warning system should consider a broad variety of indicators, since currency crises seem to be usually preceded by multiple economic problems.

Third, the paper compares the relative merits of alternative approaches in providing early indications of currency crises, and based on this comparison, proposes a specific methodology for the design of an early warning system. While this methodology is novel in the literature on currency crises, it has a long history in the literature concerned with forecasting turning points in the business cycle.

The warning system proposed in the paper-the "signals" approach-essentially involves monitoring the evolution of a number of economic indicators that tend to systematically behave differently prior to a crisis. Every time that an indicator exceeds a certain threshold value, this is interpreted as a warning "signal" that a currency crisis may take place within the following 24 months. The threshold values are calculated so as to strike a balance between the risk of having many false signals (if a signal is issued at the slightest possibility of a crisis) and the risk of missing many crises (if the signal is issued only when the evidence is overwhelming). Also, since the group of indicators that are issuing signals would be identified, this helps provide information about the source(s) of the problems that underlie the probability of a crisis.

The variables that have the best track record in anticipating crises in the context of the "signals" approach, include: output, exports, deviations of the real exchange rate from trend, equity prices, and the ratio of broad money to gross international reserves. Furthermore, on average, these and other indicators provide signals with sufficient advance so as to allow for pre-emptive policy measures. The evidence does not provide support for some of the other indicators that were considered, including imports, the differential between foreign and