Reserves and other early warning indicators of crisis
Can “early warning indicators” predict which countries are most vulnerable to a crisis? This column examines more than 80 contributions to the pre-2008 literature on crisis indicators. It finds that the level of central bank currency reserves can help identify economies worst affected by crises. Other useful early warning indicators include real effective exchange rate overvaluation, current accounts, and national savings.
With aftershocks of the recent global financial earthquake still being felt in some parts of the world, it would be useful to have a set of “early warning indicators” to tell us what countries are most vulnerable. Many scholarly papers in the past have been devoted to identifying leading indicators of crises (e.g. Rose and Spiegel 2009a).
The bar for finding good indicators has sometimes been set too high. Nobody should be surprised that it is not easy to forecast crises with high reliability; the efficient markets hypothesis – under assault as it is – still warns us not to expect easy, low-risk opportunities for profits. Thus it is especially hard to predict the timing of the crisis.
But to say that such indicators are not 100% accurate is not to say they are entirely useless, as some economists do. A common assessment is that such indicators have failed in the sense that in each historical round of emerging-market crises seems to turn on a different set of factors. One can find particular variables that appear statistically significant for each round crises – those of 1982, 1994-2001, and 2008 – but the same variables do not perform well in the subsequent round. This is not the right conclusion to draw.