The prediction of financial crisis in Indonesia based on the smoothed probability value from the combination of volatility and Markov switching models

Abstract

Indonesia is a country that applies an open economic system. The application of an open economic system can lead to the transmission of crises from other countries, for example the major financial crisis that experienced by Indonesia in 1997 and 2008. The financial crisis caused disruption to the economy stability of the country itself, so it is necessary to predict the financial crisis with the aim to protect economy stability. The indicators used in this research are the Indonesia Composite Index (ICI) and foreign exchange reserves. The method used is a combination of volatility and Markov switching models, namely the MS-ARCH(2,1) for ICI indicator and MS-GARCH(2,1,1) for foreign exchange reserves indicator. The result showed that based on the smoothed probability value of the combination of those two models, the ICI indicator could explain the crisis that occurred in 1997 and 2008, while the foreign exchange reserves indicator could only explain the crisis that occurred in 1997. In addition, the results of financial crisis prediction in Indonesia show that Indonesia will not experience a financial crisis for the next year. However, if the ICI and foreign exchange reserves indicators decrease by at least 32%, a crisis can occur.