The SHERLOC: An EWS-Based Index of Vulnerability for Emerging Economies

Abstract

This paper presents a tool to detect the accumulation of risks in emerging market economies based on a synthetic index of “vulnerability” for three different types of crisis (sovereign, currency and banking crises). To build the index we first use a signalling approach (Auroc) to preselect the variables that issue adequate signals before the blown up of a crisis. The short-term interbank rate is a leading indicator for the three different types of crises and short term external debt also plays a prominent role. These variables are then introduced in a logistic estimation to obtain the predicted probability of being in a “vulnerable” state for each type of crisis. These indexes, labelled SHERLOC, which stands for Signalling Heightened Emerging Risks that Lead to the Occurrence of Crises, outperform all best single indicators in terms of in-sample and out-of-sample validation. Additionally, a synthetic index for each type of crisis seems to predict better “vulnerable” states than the use of an aggregate index for all types of crises.