China's vulnerability to currency crisis: A KLR signals approach

In this paper we use the Kaminsky-Lizondo-Reinhart (KLR) [Kaminsky, G., Lizondo, S., Reinhart, C., 1998. Leading Indicators of Currency Crises. International Monetary Fund Staff Papers 45, 1-48.] approach to conduct an ex-post study of the probabilities of China suffering a currency crisis during the period of January 1991 to December 2004. Two high-probability periods are identified: July 1992-July 1993 and August 1998-May 1999. The first period correctly predicts China's 1994 devaluation. The second period predicts currency devaluation in the aftermath of the Asian crisis, which did not occur. The results of the model indicate that the fundamentals were weak enough for China to experience contagion of the Asian crisis, and raise the question of the possible role of China's institutional arrangements in preventing the crisis. The paper further analyzes the economic fundamentals of China that drive the high probability of crises, and provides some suggestions for further reform.