A currency crisis, defined as a sharp decrease in the nominal value of the currency, could have a significant impact on the economy in terms of contraction of output, increase in unemployment and even collapse of banks. Over the last three decades, the frequency of currency crises has increased; but it is the increase in their magnitude, particularly that of the East Asian crisis of 1997, that is most significant.

The increase in the number of these crises and the importance of their impact of the economy has generated a large amount of research into their causes. At the theoretical level, the literature distinguishes between two main types of models of currency crises. The first, which was prevalent over the 1980s, identifies weaknesses in economic fundamentals as the causes of the crisis and the persistence of these weaknesses makes maintenance of the pegged exchange rate regime unsustainable and thus the crisis inevitable. The second type of models was motivated by the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) crisis of 1992-93 in which a speculative attack on some currencies resulted in a widening of the band despite the fact that based on fundamentals the pegs were sustainable. This type of models focuses on the self-fulfilling features of currency crises and its major implication is that these crises are very hard to predict.

Based on theoretical priors, a number of models have been developed and applied for the purpose of predicting currency crises. The idea is that if a model that could predict a currency crisis with some degree of accuracy were available, then policymakers could take the necessary actions to avoid the crisis or at least minimize its impact. A few models have claimed success based on in-sample prediction, but have failed when applied for out-of-sample prediction.
The purpose of the present paper is to discuss the issues mentioned above and then apply the main currency crises indicators identified in the literature to the case of Arab countries. Section 2 reviews the main theories of currency crises. Section 3 analyzes three of the most cited models as having provided some conclusive results regarding predictability of currency crises. Based on the discussion in the previous two sections, section 4 focuses on a group of Arab countries that officially adopt a pegged exchange rate regime. The objective of the exercise is to detect any potential vulnerability of these countries to currency crises. Section 5 concludes.