_-5_ domestic real deposit interest rates, the ratio of lending to deposit interest rates, and bank deposits.

The rest of the paper is organized as follows. Section II briefly summarizes the theoretical literature on currency crises, while Section III presents a more detailed discussion of the empirical literature, describing the various methodologies and variables that have been used to assess the probability of a crisis, and highlighting those variables that have been identified as the most useful indicators. Section IV discusses the relative merits of alternative methodologies, and, on this basis, proposes an specific procedure to design of an early warning system. It also uses this methodology to evaluate the predictive ability of fifteen macroeconomic and financial variables. Section V presents some concluding remarks.

## **II.** THE THEORETICAL LITERATURE

This section summarizes the main explanations for speculative attacks and balance-ofpayments crises that have been presented in the theoretical literature. The aim is to provide some background as to why a variety of indicators have been used in empirical work on crises.<sup>2</sup> The theoretical literature on balance-of-payments crises has flourished following Krugman's seminal paper of 1979. Initially, this literature stressed that crises were caused by weak "economic fundamentals," such as excessively expansionary fiscal and monetary policies, which resulted in a persistent loss of international reserves that ultimately forced the authorities to abandon the parity. More recently, however, some papers have argued that the authorities may decide to abandon the parity for reasons other than a depletion of official international reserves. Instead, they may be concerned about the adverse consequences of policies needed to maintain the parity (such as higher interest rates) on other key economic variables (such as the level of employment).

Recent models also have shown that a crisis may develop without a significant change in the fundamnentals. In these models, economic policies are not predetermined but respond to changes in the economy, and economic agents take this relationship into account in forming their expectations. This set of assumptions opens the possibility for multiple equilibria and self-fulfilling crises. These recent theoretical developments accord a smaller role to fundamentals in generating balance-of-payments crises, but they also have highlighted the importance that other variables may have in helping to predict those crises.

# A. **The Traditional Approach**

Krugman's (1979) model shows that, under a fixed exchange rate, domestic credit expansion in excess of money demand growth leads to a gradual but persistent loss of international reserves and, ultimately, to a speculative attack on the currency. This attack immediately depletes reserves and forces the authorities to abandon the parity. The process ends with an attack because economic agents understand that the fixed exchange rate regime ultimately will collapse, and that in the absence of an attack they would suffer a capital loss on their holdings of domestic money. This model suggests that the period preceding a currency crisis 2For detailed surveys of the theoretical literature see Agenor, Bhandari, and Flood (1992), Blackburn and Sola (1993), and Garber and Svensson (1994). Gupta (1996) presents a short survey of theoretical and empirical results on currency and banking crises.