Early Warning Systems
| Author | Abdul Abiad |
| Pages | 1-4 |
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Crisis prevention is one of the core responsibilities of the IMF. As such, detecting incipient vulnerabilities plays a central role in IMF work, and much research has been devoted to this task in recent years.
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This article focuses on the development of early warning systems to detect currency crises.1
The building blocks of an early warning system consist of a set of vulnerability indicators. Although a large number of indicators are suggested by economic theory-any variable that influences the trade-off between defending the currency or letting it float is a potential candidate-the set of variables is usually constrained by data availability; it is from this set that indicators are selected, based on their predictive ability. Following the Mexican crisis in December 1994, several studies, including Frankel and Rose (1996), Kaminsky, Lizondo, and Reinhart (1998), and Sachs, Tornell, and Velasco (1996), have sought to identify the macroeconomic variables that tend to behave "abnormally" in the run-up to a crisis.2 The variables identified as useful have varied somewhat from study to study, owing to differences in crisis definitions, data sets, and methodologies. However, a small set of indicators-real-exchange-rate overvaluation, reserve adequacy (relative to short-term debt or broad money), domestic credit growth, current account, export growth, and reserves growth-perform well in most studies.
The Asian crisis and the ensuing interest in balance sheets and institutional factors have led researchers to look beyond the standard macroeconomic indicators for signs of vulnerability. Using firm-level data on corporate balance sheets, Mulder, Perrelli, and Rocha (2002) suggest that high leverage and short maturity structures increase both the likelihood and the depth of crises, and that shareholder rights' protection also significantly affects crisis probabilities. Bussière and Mulder (1999b) document potential interactions between economic and political factors: when reserves are low and fundamentals are weak, political instability worsens crisis severity. Rossi (1999) suggests that countries with a less open capital account, stronger bank supervision, and weaker depositor safety are less prone to currency crashes.
Several studies (Goldfajn and Valdés, 1997; Berg and others, 1999; Berg, Borensztein, and Pattillo, forthcoming) have documented the poor performance of exchange rate expectations, credit ratings, bond spreads, and interest differentials in anticipating currency crises. However, recent research has also found that less conventional measures from financial markets might eventually...
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