Early warning systems: fad or reality?

• Author: John Starrels
• Position: IMF External Relations Department
• Pages: 347-348

Page 347

Since the eruption of financial crises in Mexico and Asia in the mid- to late 1990s, there has been a growing demand within the international community for a system that could help predict the onset of such crises. But how realistic is this goal? Do existing models have a good track record? Even if we develop a system that looks as if it would have been successful in the past, can we be confident that it will work in the future?

To tackle these questions, the IMF hosted an Economic Forum on early warning systems on November 1. The panelists were Peter Garber, Global Strategist with Deutsche Bank; Kristin Forbes, Professor,Massachusetts Institute of Technology; and Eduardo Borensztein, Division Chief in the IMF's Research Department. Carmen Reinhart, Senior Policy Advisor in the IMF's Research Department, served as moderator for the panel.

The general consensus among participants was that, although such systems still need to be further refined, they can provide a useful starting point for anticipating the onset of financial crises. However, some speakers were more enthusiastic than others.

Crystal ball?

Garber opened the discussion with a perspective from the private sector, where early warning systems offer the hope of higher profits and lower risks. He said investment banks are busily devising in-house models that attempt to predict currency crises to help clients craft effective foreign currency trading strategies or assess values and risks in emerging market currencies.

How are these models doing? He said that one of the newer economic models-Deutsche Bank's "Alarm Clock" (DBAC)-estimates simultaneously the probabilities of exchange rate and local interest rate "events" in 19 emerging markets on a monthly basis. The DBAC defines separate exchange rate and interest rate events as depreciations greater than a certain size (estimated separately for levels ranging from 5 to 25 percent) and increases in the money market interest rates of more than 25 percent in a month. The methodology for the model jointly estimates the probability of these two types of events, allowing the probability of a simultaneous increase in interest rates to influence the likelihood of an exchange rate crisis and the probability of a depreciation to affect the predictions of an interest rate crisis.

Summarizing the results of some 360 observations over a 20-month period, he said the model's...