How to foresee crises? A new synthetic index of vulnerabilities for emerging economies

Abstract

We present a novel vulnerability index to monitor crises in emerging economies. To design the index, we identify the empirical regularities that precede sovereign, currency, and banking crises. Because we want to give policy makers the ability to react at an early stage, we focus on six-quarters before the onset of a crisis. We use data for 25 emerging economies and a new quarterly dataset of crisis events. The short-term interest rate is the unique variable that predicts all three types of crisis since it captures bank difficulties and sovereign and currency strains as monetary authorities use it to defend exchange rate pegs and to avoid capital flows. As the predictors of the three types of crisis generally differ, we define a different index for each type of crisis. The index, which is easy to update, outperforms the usual individual leading predictors of crises.