Poverty and Development Division
last updated : 27 April 2000
This type of stress relates to those imbalances that affect the economy as a whole, among which are the following:
Fiscal deficit. Large fiscal deficits could lead to excessive domestic credit expansion in order to sustain them. Under a fixed exchange rate regime, this may lead to a loss of international reserves and, if reserves go below a critical level, may precipitate a speculative attack on the currency. This, in fact, is the argument of Paul Krugman mentioned in chapter IV.
Inflation. Excessive inflation without adjustment in exchange rates causes a considerable loss of international competitiveness and can worsen the current account deficit. If exports continue to deteriorate or imports continue to rise, then over time the current account deficit will put pressure on the exchange rate. Alternatively, a boom-and-bust pattern of growth could bring with it the phenomenon of asset inflation. High asset inflation with overvalued exchange rates is symptomatic of a bubble. Asset inflation and high collateral value could in turn feed further expansion of loans. When the bubble bursts, asset values plunge and could cause a crisis in the financial system.
Low real GDP growth. Low real GDP growth, or the more serious case of a recession, can precipitate a financial crisis. Firms may have more difficulty servicing loans in a recession and this may weaken the financial system and lead to a crisis.
Savings-investment gap. A large gap indicates that the economy will have to rely on external resources to support investment. This is not necessarily a vulnerability if the inflow of external resources leads to increases in productivity and the ability to earn foreign currency to service the external liabilities. If not, the flow of new external resources may stop, servicing of current liabilities may become problematic and a crisis can emerge.
Unemployment/underemployment. To a certain extent, this might be subsumed under low real GDP growth or the presence of a recession, as they will usually go together. Additionally, in an export-oriented economy, if the increase in unemployment is due to a decline in exports and has been persistent, it may be a signal that the exchange rate policy will need to be adjusted, failing which a crisis can occur.
Financial markets indices (stock and bond markets). One interpretation is that the stock market index is an expectations variable (the index is theoretically the discounted stream of earnings of a stock). As a proxy for market expectations, a booming stock market is indicative of a rosy economic outlook in the eyes of investors and vice versa for a bearish market. However, excessively high stock market indices can be indicative of irrational investors' euphoria that could be subject to sharp corrections (or crisis), as occurred in some Asian economies.
Government consumption. The level of consumption by a government is a proxy for the size of the government sector in an economy. A high or rising level may indicate a non-productive use of the resources of an economy and so signal a potential problem for sustaining the level of economic growth.
External stress relates to the imbalances in the sectors of an economy which are involved in foreign trade and investment. The stress may originate in the following:
International reserves. This is an indicator of a country's liquidity; a low level indicates that the country is ill-prepared to service the foreign exchange needs of the economy. An illiquid country is most likely to run into problems when the flow of capital reverses; it will also find it difficult to defend its exchange rate. Speculators being aware of this could exert pressure, leading to a sharp correction and a crisis.
Foreign investment. The composition of investment, whether long-term (FDI) or short-term (portfolio), is important in assessing financial stability. Short-term capital flows are often referred to as "hot money". A country with foreign investment dominated by these flows is very much hostage to changes in investor sentiments. Contagion effects are more serious for countries with this type of flows. There are also trade-offs involved in attracting portfolio flows; they are usually determined by differential interest rates. An emerging economy can attract portfolio investment through high interest rates, but these imply a greater cost of financing investment from domestic sources and may crowd out domestic investment flows.
Exchange rate. This is actually a policy variable under a pegged or managed float system and, if set at an unrealistic level, may lead to crisis. In fact, currency crises are commonly defined as a very sharp devaluation, possibly accompanied by high interest rates and a significant drawdown on reserves. Unwarranted appreciation of real exchange rates can suggest a loss of export competitiveness and contribute to expectations of subsequent devaluation and speculation. In many instances, the presence of a parallel market and a significant premium in the black market price for foreign exchange precedes a crisis. Moreover, an overvalued exchange rate makes foreign liabilities look cheap and may lead to overreliance on external financing. Sharp devaluation also increases the local burden of paying foreign debt by governments, banks and corporations, contributing further to stresses in the domestic financial system and economy.
Trade balance. A growing and persistent current account deficit may be indicative of an overvalued exchange rate (deterring exports and promoting imports). Unless foreigners are willing to finance the deficit by holding on to local assets, the current account deficit will be unsustainable and can prompt a strong correction (which can lead to a currency crisis).
Prices of major exports and imports (terms of trade). Deterioration in export prices reduces foreign currency earnings, with an obvious impact on reserves and the ability of an economy to service external liabilities. This is especially important for resource-based economies. On the other hand, sharp changes in import prices can have adverse implications for reserves and also presage inflation.
OECD growth. This variable proxies the demand for export products of developing countries, as OECD arguably constitutes the major market for these countries. The higher OECD growth, presumably the more positive is the outlook for developing countries.
Financial stress relates to financial markets; examples of possible stress include:
Composition of foreign capital inflows. This mirrors the rationale noted under the composition of foreign investment because banks use foreign capital inflows to relend in the domestic market. Mismatches in the maturity of the debt instruments should be highlighted to help assess vulnerability.
Interest rates. Once again, this is a policy variable that involves trade-offs. Low interest rates facilitate local debt payments. Higher interest rates, on the other hand, increases the burden of paying debts (and lead to non-performing loan problems) but can attract portfolio investments or increase the attractiveness of local assets that yield interest income. It can be recessionary through the effect on investment. Excessively high interest rates may lead to adverse selection in lending operations, leading to poor loan quality and problems with non-performing loans. Whether the interest rate is a positive or a negative indicator will depend on the actual conditions of a country (level of debt, non-performing loans etc.).
Credit growth. Banking crises have often been preceded by high credit growth rates. High credit growth puts stress on the credit quality. There may be moral hazard elements (that is, loans were not extended on the basis of business criteria, but rather on that of political connections). With regard to credit to the private sector, the Asian crisis has demonstrated that high private sector debt can be debilitating.
Money supply. This indicator is related to the inflation variable as well as the financing of the fiscal deficit. M1 and M2 are often used as measures of money supply, M2 being a more comprehensive measure.
M2/international reserves. This is an indicator of the pressure on the exchange rate as it measures the domestic money supply in relation to the international liquidity available.
Parallel financial market premium. The higher the premium, the larger will be the unmet credit needs of the economy. A high level indicates an inefficient or underdeveloped banking system and thus stress on the formal financial sector.
Central bank credit (to banks or to the public sector). Again, moral hazard considerations exist. If the exposure of the central bank to government/private sector banks is huge, the central bank may feel constrained to raise interest rates as part of monetary policy designed to maintain systemic stability, due to the increased costs to the government
Private sector debt. The rationale is very similar to that for excessive credit growth. The Asian crisis was a case where private sector debt had got out of hand. Because the exchange rate was pegged in some economies, it made foreign currency look cheap and encouraged the private sector to increase foreign currency debt.
This kind of stress relates to the pressures that arise from institutions/practices, albeit these factors may not always be easily quantifiable:
Exchange rate system. Pegged exchange rates are subject to speculation; almost always, the resources of individual governments will not be enough to defend their pegs against serious market pressures.
Risk management measures. Does the financial system have markets for risk? If not, then this is indicative of vulnerability. Globalization of financial/capital markets entails the challenge of developing markets for risk management. The number of players, market turnover etc., are the indicators of the relative robustness of the markets for risk.
Prudential measures. These are qualitative indicators of institutions that govern or regulate financial systems. The presence of these indicators does not imply that they will work, but their effective enforcement is likely to make an economy less vulnerable.
Capital adequacy provisions. This has to do with solvency of banks and can also be considered an example of a prudential measure. Limitations on the extent to which bank capital is tied up with loans prevents bank owners from taking on too much risk in lending.
Level of non-performing loans. This indicates how weak the banking system is; the higher the non-performing loans, the lesser will be the capacity of the banks to lend. This can also be an indicator of the financial vulnerability of banks.
Measures of transparency. These can help prevent the build-up of vulnerabilities and contribute to the proper conduct of corporate governance. Problems of moral hazard are also prevented when the true state of bank or corporate finances is known. Monitoring banks by supervisors will only be meaningful when there is accurate, current, comprehensive and transparent information about the banks' solvency and liquidity as well as the creditworthiness of their clients. Thus, the presence of such measures will minimize the possibility of crises.
Central bank independence. Independence is important for the objective conduct of monetary policy and supervision of the financial system (less susceptible to be influenced by politics, fewer possibilities for bailing out cronies, mitigates moral hazard problems somewhat).
Measures of creditor and property rights. The existence of bankruptcy procedures (which can be proxied by the proportion of bankruptcies resolved) and property laws, and their timely and effective enforcement are indicators of the institutional robustness of an economy.
Table VI.2 summarizes the foregoing discussion into a set of proposed indicators under their respective stress headings. The indicators can be used as they are or combined with other indicators to form new indicators or ratios. Some of the indicators are qualitative; proxy variables may have to be used to quantify them, supplemented by detailed qualitative analysis.
Each country can and should carry out its own empirical investigation of the predictive ability of these indicators, deleting those that test insignificant. Moreover, a country may include additional indicators that the unique characteristics of its economy may suggest.
In summary, indicators can help policy makers feel the pulse of the economy. One should not set too high an expectation for them (for example, to be able to predict the timing of a crisis). They can, however, provide a useful guide for assessing vulnerability. Signs of vulnerability shown by indicators should be accompanied by detailed policy analysis, including the potential for exposure to contagion. As has been noted, there is ample scope for refining the indicators. This can be fertile ground for informal regional consultations, exchange of experience and technical assistance for capacity-building.
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