Assessing Banking and Currency Crisis Risk in Small States: An application to the Eastern Caribbean Currency Union
IMF Working Papers, November 19, 2021
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Bibliographic details
- Authors: Carlo Pizzinelli, Kotaro Ishi, Tariq Khan
- Published: November 19, 2021
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781513599861.001
Summary
- Study objective: Complement the early warning signals literature by studying the determinants of banking and currency crises for small states and currency boards.
- Dataset and model: Builds on the crisis dataset by Laeven and Valencia (2020) and estimates a binominal logit model to identify the determinants of crises.
- Case study: Applies models to the Eastern Caribbean Currency Union (ECCU).
- Core conceptual result: Both external and domestic fundamentals matter in predicting crisis likelihood; small states and fixed exchange rate regimes are more sensitive to these fundamentals compared to larger economies.
- Specific result for currency boards: Keeping a high level of the foreign reserve cover—the “backing ratio” defined as official foreign reserves as a share of central bank demand liabilities—is critical to reduce the likelihood of both banking and currency crises.
- Conditional effect: The backing ratio is particularly important during years of global economic downturn.
Methods and Scope
- Empirical approach: Estimation of a binominal logit model using the Laeven and Valencia (2020) crisis dataset.
- Application: Model results applied to the ECCU as a case study.
- Focus variables: External fundamentals, domestic fundamentals, exchange rate regime classification (including currency boards and conventional pegs), and the backing ratio metric.
Key Findings
- Both external and domestic fundamentals are important predictors of banking and currency crisis likelihood.
- Small states and fixed exchange rate regimes exhibit greater sensitivity to those fundamentals than larger economies.
- For currency board economies:
- A high backing ratio (official foreign reserves as a share of central bank demand liabilities) substantially reduces the likelihood of banking and currency crises.
- The protective effect of the backing ratio is especially strong during global economic downturns.
Policy Implications and Recommendations
- For small states and fixed exchange rate regimes:
- Strengthen monitoring of both external and domestic fundamentals as early warning indicators of crisis risk.
- For currency board economies:
- Maintain a high backing ratio (official foreign reserves relative to central bank demand liabilities) to lower the probability of banking and currency crises.
- Prioritize reserve accumulation and reserve management practices that preserve the backing ratio, particularly to buffer against global downturns.
Carlo Pizzinelli, Kotaro Ishi, and Tariq Khan. "Assessing Banking and Currency Crisis Risk in Small States: An application to the Eastern Caribbean Currency Union", IMF Working Papers 2021, 276 (2021), accessed 9/16/2026, https://doi.org/10.5089/9781513599861.001
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