25 Years IWH

Volatility, Growth and Financial Crises

This research group belongs to the IWH Research Cluster Financial Stability and Regulation. Against the backdrop of the latest crisis, the link between financial instability and growth is of particular interest in countries with highly developed financial systems. Financial development may dampen volatility if real sector shocks dominate, but it may also enhance volatility if financial shocks dominate. Thus, occasional financial crises may correspond to stronger long-term growth. However, fundamental mispricing and bubbles on asset markets may also create a link between financial stability and growth working in the opposite direction. Mispricing hampers growth by promoting inefficient allocations. The goal of this group is to explore the relationship between finance and growth by disentangling the fundamental links between financial volatility and macroeconomic dynamics. Thus, this group will contribute to the literature on quantitative macroeconomic models as well as the literature on early-warning tools, strengthening the IWH’s competences in the fields of macroeconomic modelling, forecasting and policy analysis.

IWH Data Project: Financial Stability Indicators in Europe

Research Cluster
Financial Stability and Regulation

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Dr Gregor von Schweinitz
Dr Gregor von Schweinitz
Mitglied - Department Macroeconomics
Send Message +49 345 7753-744

Refereed Publications

Real Effective Exchange Rate Misalignment in the Euro Area: A Counterfactual Analysis

Makram El-Shagi Axel Lindner Gregor von Schweinitz

in: Review of International Economics , No. 1, 2016

Abstract

The European debt crisis has revealed severe imbalances within the Euro area, sparking a debate about the magnitude of those imbalances, in particular concerning real effective exchange rate misalignments. We use synthetic matching to construct a counterfactual economy for each member state in order to identify the degree of these misalignments. We find that crisis countries are best described as a combination of advanced and emerging economies. Comparing the actual real effective exchange rate with those of the counterfactuals gives evidence of misalignments before the outbreak of the crisis: all peripheral countries appear strongly and significantly overvalued.

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Financial Constraints on Growth: Comparing the Balkans to Other Transition Economies

Hubert Gabrisch

in: Eastern European Economics , No. 4, 2015

Abstract

This article applies an adjusted growth diagnostic approach to identify the currently most binding constraint on financing growth in the West Balkan countries. Since this group of economies faces both structural and systemic transformation problems, the original supply-side approach might not be sufficient to detect the most binding constraint. The results of the analysis indicate that the binding constraint on credit and investment growth in the region is the high and increasing share of nonperforming loans, primarily in the household sector, due to policy failures. This article compares the Balkan countries to a group of advanced transition economies. Single-country and panel regressions indicate that demand-side factors do not play a constraining role on growth in the West Balkan countries, but they do in the advanced transition economies.

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Risk and Return - Is there an Unholy Cycle of Ratings and Yields?

Makram El-Shagi Gregor von Schweinitz

in: Economics Letters , 2015

Abstract

After every major financial crisis, the question about the responsibility of the rating agencies resurfaces. Regarding government bonds, the most frequently voiced concern targeted “unreasonably” bad ratings that might trigger capital flights and increasing risk premia which sanction further rating downgrades. In this paper we develop a multivariate, nonparametric version of the Pesaran type cointegration model that allows for nonlinearities, to show that a unique equilibrium between ratings and sovereign yields exists. Therefore, we have to reject the concern that there is an unholy cycle leading to certain default in the long run.

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The Impact of Preferences on Early Warning Systems - The Case of the European Commission's Scoreboard

Tobias Knedlik

in: European Journal of Political Economy , 2014

Abstract

The European Commission’s Scoreboard of Macroeconomic Imbalances is a rare case of a publicly released early warning system. It allows the preferences of the politicians involved to be analysed with regard to the two potential errors of an early warning system – missing a crisis and issuing a false alarm. These preferences might differ with the institutional setting. Such an analysis is done for the first time in this article for early warning systems in general by using a standard signals approach, including a preference-based optimisation approach, to set thresholds. It is shown that, in general, the thresholds of the Commission’s Scoreboard are set low (resulting in more alarm signals), as compared to a neutral stand. Based on political economy considerations the result could have been expected.

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Exchange Rate Regime, Real Misalignment and Currency Crises

Oliver Holtemöller Sushanta Mallick

in: Economic Modelling , No. 34, 2013

Abstract

Based on 69 sample countries, this paper examines the effect of macroeconomic fundamentals on real effective exchange rates (REER) in these sample countries. Using the misalignment of actual REER from its equilibrium level, we have estimated the factors explaining the extent of currency over- or under-valuation. Overall, we find that the higher the flexibility of the currency regime, the lower is the misalignment. The estimates are robust to different sub-samples of countries. We then explore the impact of such misalignment on the probability of a currency crisis in the next period, indicating the extent to which misalignment could be used as a leading indicator of a potential crisis. This paper thus makes a new contribution to the debate on the choice of exchange rate regime by bringing together real exchange rate misalignment and currency crisis literature.

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Working Papers

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Optimizing Policymakers' Loss Functions in Crisis Prediction: Before, Within or After?

Peter Sarlin Gregor von Schweinitz

in: ECB Working Paper Series , No. 2025, 2017

Abstract

Early-warning models most commonly optimize signaling thresholds on crisis probabilities. The expost threshold optimization is based upon a loss function accounting for preferences between forecast errors, but comes with two crucial drawbacks: unstable thresholds in recursive estimations and an in-sample overfit at the expense of out-of-sample performance. We propose two alternatives for threshold setting: (i) including preferences in the estimation itself and (ii) setting thresholds ex-ante according to preferences only. Given probabilistic model output, it is intuitive that a decision rule is independent of the data or model specification, as thresholds on probabilities represent a willingness to issue a false alarm vis-à-vis missing a crisis. We provide simulated and real-world evidence that this simplification results in stable thresholds and improves out-of-sample performance. Our solution is not restricted to binary-choice models, but directly transferable to the signaling approach and all probabilistic early-warning models.

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Why They Keep Missing: An Empirical Investigation of Rational Inattention of Rating Agencies

Gregor von Schweinitz Makram El-Shagi

in: IWH Discussion Papers , No. 1, 2017

Abstract

Sovereign ratings have frequently failed to predict crises. However, the literature has focused on explaining rating levels rather than the timing of rating announcements. We fill this gap by explicitly differentiating between a decision to assess a country and the actual rating decision. Thereby, we account for rational inattention of rating agencies that exists due to costs of reassessment. Exploiting information of rating announcements, we show that (i) the proposed differentiation significantly improves estimation; (ii) rating agencies consider many nonfundamental factors in their reassessment decision; (iii) markets only react to ratings providing new information; (iv) developed countries get preferential treatment.

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Macroeconomic Trade Effects of Vehicle Currencies: Evidence from 19th Century China

Makram El-Shagi

in: IWH Discussion Papers , No. 23, 2016

Abstract

We use the Chinese experience between 1867 and 1910 to illustrate how the volatility of vehicle currencies affects trade. Today’s widespread vehicle currency is the dollar. However, the macroeconomic effects of this use of the dollar have rarely been addressed. This is partly due to identification problems caused by its international importance. China had adopted a system, where silver was used almost exclusively for trade, similar to a vehicle currency. While being important for China, the global role of silver was marginal, alleviating said identification problems. We develop a bias corrected structural VAR showing that silver price fluctuations significantly affected trade.

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Much Ado About Nothing: Sovereign Ratings and Government Bond Yields in the OECD

Makram El-Shagi

in: IWH Discussion Papers , No. 22, 2016

Abstract

In this paper, we propose a new method to assess the impact of sovereign ratings on sovereign bond yields. We estimate the impulse response of the interest rate, following a change in the rating. Since ratings are ordinal and moreover extremely persistent, it proves difficult to estimate those impulse response functions using a VAR modeling ratings, yields and other macroeconomic indicators. However, given the highly stochastic nature of the precise timing of ratings, we can treat most rating adjustments as shocks. We thus no longer rely on a VAR for shock identification, making the estimation of the corresponding IRFs well suited for so called local projections – that is estimating impulse response functions through a series of separate direct forecasts over different horizons. Yet, the rare occurrence of ratings makes impulse response functions estimated through that procedure highly sensitive to individual observations, resulting in implausibly volatile impulse responses. We propose an augmentation to restrict jointly estimated local projections in a way that produces economically plausible impulse response functions.

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The Joint Dynamics of Sovereign Ratings and Government Bond Yields

Makram El-Shagi Gregor von Schweinitz

in: Deutsche Bundesbank Discussion Papers , No. 13, 2016

Abstract

Can a negative shock to sovereign ratings invoke a vicious cycle of increasing government bond yields and further downgrades, ultimately pushing a country toward default? The narratives of public and political discussions, as well as of some widely cited papers, suggest this possibility. In this paper, we will investigate the possible existence of such a vicious cycle. We find no evidence of a bad long-run equilibrium and cannot confirm a negative feedback loop leading into default as a transitory state for all but the very worst ratings.

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