It is not humanly possible, or necessary, to monitor everything. Collecting and analysing data is costly in both financial and human terms. Therefore, countries participating in monitoring exercises on their own or regionally have to select a limited number of indicators to monitor. The choice is not obvious. Every economy is unique, with its own peculiar characteristics; some economies are relatively open, while others are closed. Some economies are exporters of primary commodities, while others are exporters of manufactured goods. The financial systems may be advanced in some economies and less so in others. Yet, while economies can differ in a myriad of ways, most modern economies are structured around markets and so share considerable commonalities. This suggests that, although the set of indicators will necessarily differ from country to country, there may be a core set of indicators.

One could identify such core indicators by either using the economic theory of how market economies operate, or from empirical analysis. One could argue that if a core set of indicators does exist, then these indicators should test as significant in empirical studies covering a wide range of countries. A fair starting point for selecting core indicators in the latter approach is the study of Kaminsky, Lizondo and Reinhart reviewed in chapter IV. This provides a fairly comprehensive tally of indicators used in the literature on early warning systems. A wide range of countries and time periods is covered in the papers. All the indicators were tabulated according to the number of papers in which each indicator was used and the number in which the indicator was found to be significant. For the purpose of proposing an initial set of indicators, only those indicators found significant in a majority (more than half) of the papers were included. A shortened version of the results of this work is reported in table VI.1. (Table IV.2 gives the list of indicators used by Kaminsky and others in their own research).

The above list of variables accords well with what economic theory would suggest. The high frequency with which some variables are included in the surveyed studies is noteworthy (real exchange rate, international reserves, credit growth, inflation, real GDP, fiscal deficit). Moreover, the real exchange rate and international reserves indicators have a very high incidence of significance in the statistical tests. Not surprisingly, many of the variables are financial and/or related to the external accounts. However, indicators of the real sector (including the fiscal sector) also figure prominently.

Since the authors culled these indicators from papers that covered a wide cross section of countries, the indicators can be considered to be a common or core set. No doubt individual economies have unique characteristics and require the addition of other specific indicators or the removal of non-relevant ones. For instance, commodity prices may be important in the case of some countries, for example, oil prices for oil-producing countries, or the stock market may be inconsequential in other economies and therefore changes in stock prices would be dropped. Individual economies may have to conduct their own studies to modify the list. It should also be noted that several of the indicators have not really been tested very rigorously in that they have been used in only one study.

Economic theory can also suggest possible indicators. One possible set of indicators is that proposed by Dominick Salvatore, which was also reviewed in chapter IV (Salvatore's starting point for these indicators is the familiar open economy equilibrium condition). His list is much shorter and comprises only eight indicators: savings rate, budget deficit to GDP, current account deficit to GDP, foreign debt to GDP, short-term debt to GDP, current account deficit less FDI, debt service to exports, and months of import cover. This list has the advantage of being easier to monitor and digest. It is skewed towards the external accounts, especially foreign debt, but the other components, such as budget deficit, savings rate and current account deficit to GDP, are sufficiently broad to catch domestic stress factors.

In the light of the Asian crisis, additional indicators could focus on the financial solvency and liquidity of the banking system and corporations. A recent paper²¹ suggests that the main warning indicators in the case of Asia are variables which proxy the vulnerability of the banking and corporate sector. Towards this end, other potential indicators could include private sector financial deficit; risk management measures; prudential management measures (regulatory framework, enforcement and quality of bank supervision); capital adequacy; classification and provisioning for non-performing loans; minimum liquidity requirements; measures of property and creditor's rights; measures of transparency; number of bankruptcies resolved; insider lending limits; and degree of independence of central bank.

Alternatively, the list of indicators could be classified according to the locus of stress (originating in the four sectors that any economy will have): domestic macroeconomic stress, external stress, financial stress and institutional stress. Such a classification could be most useful to policy makers. The list that follows is by no means to be regarded as comprehensive.

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Footnotes:

²¹ Daniel C. Hardy and Ceyla Payarbasioglu, "Leading indicators of banking crises; was Asia different?", in IMF Working Paper, No. 91 (Washington DC, June 1998).