Assessing the Dangers

• Author: Christian Mulder
• Position: Senior Economist in the IMF's Policy Development and Review Department

Spotting vulnerability to financial risks is key to preventing crises.

The most destructive financial crises of recent years involved sudden, sharp capital flow reversals that caused havoc in the emerging market countries affected. To forestall such crises in the future, the IMF has been making a major effort to assess the vulnerability of its member countries to changes in external circumstances. Its goal is to help countries become more resilient to shocks from abroad, particularly by encouraging them to strengthen their financial systems in the widest sense and by improving advance information about possible trouble so that they can take preventive action.

The IMF has conducted vulnerability assessments of all of its members for many years as part of its continuous review of national economic conditions and policies. To strengthen the assessment of risk in the financial system, the IMF and the World Bank have begun to conduct health checkups of members' financial sectors with the aid of national experts. These checkups are part of the Financial Sector Assessment Program (FSAP). Separately, the IMF also assesses and reports on member countries' adherence to international standards and codes, including those on corporate governance, accounting standards, data dissemination, and the transparency of fiscal and monetary policy. Countries' adherence to such standards ensures the availability of valuable information that enables governments to address weaknesses and helps markets to price risks more accurately.

With crises occurring more frequently, becoming more complex, and unfolding more rapidly than in the past-because more countries are susceptible to rapid capital outflows-and with a greater risk of spillovers, a special system has been put in place over the last two years to strengthen the IMF's ability to identify vulnerable emerging market countries. The system focuses on countries with exposure to international capital markets as well as on those whose own vulnerabilities could have an impact on other countries. It should enable the IMF to give better advice to these countries on avoiding trouble and to forewarn other countries so that they can build firewalls in case a crisis still strikes-because even when weaknesses are identified and a high risk of crisis is assessed, countries cannot or do not always take all the measures necessary to prevent it.

IMF economists use a number of analytical inputs to identify weaknesses, including the three discussed below-early warning systems (EWS), analyses of financing requirements and reserve adequacy, and market information.

Early warning systems

The IMF uses econometric models known as early warning system (EWS) models in its efforts to predict currency crises-defined as a sharp currency depreciation...