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This study adopts an econometric approach to develop an early
warning system of the vulnerability in the banking system and
currency markets for the 11 EMEAP economies over the period from1990
to 2008. We identify a set of leading indicators of banking
distress and currency pressure and investigate the causal and
contemporaneous linkages between them by using separate panel probit
models and a simultaneous probit equation system. Asset-price
misalignments, default risk of commercial banks and the
non-financial corporate sector, and growth of real credit to the
private sector are found to be significant leading indicators for
both banking distress and currency pressure. Economic growth,
inflation and the ratio of short-term external debt to international
reserves are found to be important determinants of banking distress,
whereas growth of M2 relative to international reserves, total trade
balance over GDP, real effective exchange rate over-valuation and
trade integration with China are identified to be crucial indicators
of currency pressure. Currency market pressure is shown to have
strong leading and contemporaneous impacts on banking distress for
the EMEAP economies but not vice versa. These findings imply that
the policy measures aimed at sustaining exchange rate stability will
have the additional benefit of lowering the likelihood of banking
distress in the region. Lastly, China is found to play a
stabilising role in the region, i.e. the greater the trade with
China, the lower the chance of experiencing currency pressure.
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