Assessing Financial Vulnerability in Emerging Economies: A Summary of Empirical Results

Abstract

This paper aims to identify key empirical regularities in the run-up to banking and currency crises that would enable officials and private market participants to recognize vulnerability to financial crises at an earlier stage. This, in turn, should make it easier to motivate the corrective policy actions that would prevent such crises from actually taking place. Interest in identifying early warning indicators of financial crises has soared of late, stoked primarily by two factors. First, there is increasing recognition that banking and currency crises can be extremely costly to the countries in which they originate; in addition, these crises often spillover via a variety of channels to increase the vulnerability of other countries to financial crisis. The second reason for the increased interest in early warning indicators of financial crises is that there is accumulating evidence that two of the most closely watched market indicators of default and currency risks-namely, interest rate spreads and changes in credit ratings- frequently do not provide much advance warning of currency and banking crises. The other reason why market prices may not signal impending crises is that there are often widely and strongly-held expectations of a bail-out of a troubled borrower by the official sector ?be it national or international. Dooley has stressed this point in several papers. If interest rate spreads and sovereign credit ratings only give advance warning of financial crises once in a while, increased interest attaches to the question of whether there are other early-warning indicators that would do a better job, and if so, what are they? This is one of the key questions we address in this paper.