Reserves and Other Early Warning Indicators Forecast Crises After All
Written for VoxEU
Jeffrey Frankel and George Saravelos
With aftershocks of the recent global financial earthquake still being felt in some parts of
the world, it would be useful to have a set of Early Warning Indicators to tell us what
countries are most vulnerable. Many scholarly papers in the past have been devoted to
identifying leading indicators of crises.
The bar for finding good indicators has sometimes been set too high. Nobody should be
surprised that it is not easy to forecast crises with high reliability; the efficient markets
hypothesis -- under assault as it is -- still warns us not to expect easy low-risk
opportunities for profits. Thus it is especially hard to predict the timing of the crisis.
Some economists, however, are skeptical that Early Warning Indicators (EWIs) have any
useful predictive ability at all. A common assessment is that EWIs have failed, in the
sense that in each historical round of emerging market crises (1982, 1994-2001, 2008)
those particular variables that appeared statistically significant in that round did not
perform well in the subsequent round. This is not the right conclusion to draw.
The early literature
In a recent paper,i we have examined more than eighty contributions to the pre-literature
on EWIs. The table below reports which variables were most often found to have
performed consistently well in predicting crises in the past. Among 17 categories of
indicators, the level of international reserves and preceding movements in the real
exchange rate stand out by far as the two most useful leading indicators. The consistency
of these results are impressive, because they hold across different crisis episodes
stretching from the 1950s to the early 2000s, even though different authors have defined
“crisis” and “useful” in different ways. Credit growth and other indicators have also
been useful in many studies. The current account balance has been frequently tested,
sometimes with success but sometimes not.
0%
10%
20%
30%
40%
50%
60%
70%
Reserves
Real Exchange Rate
GDP
Credit
Current Account
Money Supply
Budget Balance
Exports or Imports
Inflation
Equity Returns
Real Interest Rate
Debt Profile
Terms of Trade
Political/Legal
Contagion
Capital Account
% of studies where leading indicator was found to be
statistically signficant
(total studies = 83, covering 1950s-2009)
External Debt
The 2008-09 financial crisis
The recent global financial crisis was in a sense a perfect experiment for testing the
performance of EWIs, because by general agreement it originated in a shock that was
exogenous to the smaller countries of the world -- a liquidity crisis in US financial
markets. Because it hit everyone at the same time, we don’t have to worry about the
issue of timing. We can focus on what economic variables indicate vulnerability to such
a shock.
To summarize the findings in our paper, the EWIs from the pre-2008 literature do
relatively well in predicting which countries got hit in 2008-09, and the indicator that was
found to be the top performer in past crises was also the top performer this time: foreign
exchange reserve holdings, especially expressed relative to a denominator such as debt.
Others have not gotten such strong results. The first wave of analysis of the global crisis
-- by top economists including Blanchard, Obstfeld, and Rose -- found that few, if any,
indicators were useful in explaining which countries got hit the most. ii Why do we get
stronger results? These papers necessarily defined the crisis period as the year 2008;
they lacked data on 2009 at the time when they were written.
We define the global crisis as beginning in earnest in the latter part of 2008. (Recall that
the failure of Lehman Brothers came in September.) We extend the period under
consideration through early 2009, because many aspects of global financial markets and
the real economy did not begin to recover until the 2nd quarter of that year.iii We surmise
that the difference in the period that is defined to be the crisis is the reason for the
difference in results. Sure enough, we have now tried re-running our tests with the
calendar year 2008 taken to be the crisis period as in Rose and Spiegel, and many of our
indicators such as reserves lose their significance, confirming that the dating is what
makes the difference.
The table below summarizes our results. Each column represents another criterion for
gauging the severity of the 2008-09 crisis in a particular country. We consider a country
to have suffered more from the crisis if it experienced larger output drops, bigger stock
market falls, loss in demand for its currency1iv, or a need for access to IMF funds. We
regressed each of these dependent variables against the list of useful EWIs indentified in
our literature review. A darker color in the figure indicates greater statistical significance
for that indicator.
We controlled for GDP per capita, allowing us to mix high-income and low-income
countries in the same data set. The last three years have featured a historic role reversal
in which some “advanced countries” were badly hit (Iceland, Greece, and others on the
periphery of Europe) while some big emerging markets” did much better (China, Brazil,
Indonesia and others).
What works?
At the top of list is the level of central bank reserves. Similar to the findings of the earlier
literature review, we find that the level of reserves in 2007 was a statistically significant
predictor of crisis incidence in 2008-09. Four out of five of the reserve measures used
have statistically significant coefficients at the 5% level or better, across half or more of
the crisis intensity measures considered. The best-performing of the reserve measures
expresses them relative to short-term debt. This is consistent with earlier findings,
including the Guidotti Rule that tells emerging market central banks to hold reserves
equal to at least the amount of debt maturing within one year.v Our findings are robust to
alternative definitions of crisis incidence.
Next on our literature review list is past movements in the real effective exchange rate
(REER). These are not helpful when crisis incidence is measured in terms of real output
losses or stock market performance, but are statistically significant in predicting currency
weakness against the US dollar, exchange market pressure and access to IMF stand-by
arrangement programs.
A few of the other leading indicators stand out as well. A higher current account balance
or level of national savings is associated with lower crisis intensity. Other variables with
some explanatory power but less consistently useful across different measures include the
level of external debt, its composition (e.g. short-term vs. long-term), and the extent of
Foreign Direct Investment (FDI).
We conclude that early warning exercises can indeed be a useful tool for assessing future
vulnerabilities.
The same variable that topped the list of indicators in the earlier
literature, central bank reserves, also worked the best in predicting who got hit in the
2008-09 crisis. Other useful EWIs include real effective exchange rate overvaluation,
current accounts, and national savings.
Regression Heatmap
Regressions of Country Performance on Each Leading Indicator and GDP per Capita*
Darker color shading equivalent to higher statistical significance for leading indicator
Exchange
Currency
Market
Market
Pressure
Leading Indicator
R
E
S
E
R
V
E
S
Equity
Market
Recourse Industrial
to IMF SBA Production
GDP
Statistically
Statistically
significant and significant and
consistent sign in consistent sign
at least two
in at leastthree
regressions?^ regressions?^
Reserves (% GDP)
Yes
Yes
Reserves (% external debt)
Yes
Yes
Reserves (in months of imports)
Yes
Yes
Short-term Debt (% of reserves)
Yes
Yes
REER (5-yr % appreciation of local currency)
Yes
Yes
REER (Deviation from 10-yr av)
Yes
Yes
GDP growth (2007, %)
Yes
GDP Growth (last 5 yrs)
Yes
M2 to Reserves
R
E
E
R
G
D
P
GDP Growth (last 10 yrs)
C
R
E
D
I
T
C A
U C
R C
R
E
N
T
O
U
N
T
Change in Credit (5-yr rise, % GDP)
Change in Credit (10-yr rise, % GDP)
Yes
Credit Depth of Information Index (higher=more)
Bank liquid reserves to bank assets ratio (%)
Current Account (% GDP)
Yes
Current Account, 5-yr Average (% GDP)
Yes
Current Account, 10-yr Average (% GDP)
Yes
Yes
Net National Savings (% GNI)
Yes
Yes
Gross National Savings (% GDP)
Yes
Yes
M
O
N
E
Y
T
R
A
D
E
I
N
F
S
M
T
K
C
T
K
Change in M3 (5-yr rise, % GDP)
Change in M2 (5-yr rise, % GDP)
Trade Balance (% GDP)
Yes
Exports (% GDP)
Imports (% GDP)
Inflation (average, last 5 yrs)
Inflation (average, last 10 yrs)
Yes
Stock Market (5 yr % change)
Stock Market (5 yr return/st.dev.)
Yes
I R
Real Interest Rate
Yes
N A
T T
Deposit Interest Rate
Short-term Debt (% of exports)
C
O
M
P
D
O
E
S
B
I
T
T
I
O
N
Yes
Yes
Short-term Debt (% of external debt)
Public Debt Service (% of exports)
Yes
Public Debt Service (% GNI)
Yes
Multilateral Debt Service (% Public Debt Service)
Aid (% of GNI)
Financing via Int. Cap. Markets (gross, % GDP)
C
A F
P L
I O
T W
A S
L
D
E
E
X
B
T
T
Legal Rights Index (higher=more rights)
Yes
Business Extent of Disclosure Index (higher=more
disclosure)
Portfolio Flows (% GDP)
Yes
FDI net inflows (% GDP)
Yes
Yes
FDI net outflows (% GDP)
Yes
Yes
Net FDI (% GDP)
External Debt Service (% GNI)
Yes
Present Value of External Debt (% exports)
Yes
Present Value of External Debt (% GNI)
Yes
*OLS with heteroscedasticity robust standard errors performed for four continuous variables; probit for IMF recourse variable
^At least two (or three) statistically signficant coefficients at 10% level, of which all must have consistent sign
“Are Leading Indicators of Financial Crises Useful for Assessing Country Vulnerability? Evidence from
the 2008-09 Global Crisis,” NBER WP 16047, June 2010. At www.hks.harvard.edu/fs/jfrankel/SaravelosEWIsNBERWP16047.pdf.
ii
Berkmen, Pelin, et. al., 2009, "The Global Financial Crisis: Explaining Cross-Country Differences in the
Output Impact," IMF Working Papers 09/280.
Blanchard, Olivier, Hamid Faruqee, and Vladimir Klyuev, 2009. "Did Foreign Reserves Help Weather the
Crisis", IMF Survey Magazine, Oct. 8th. http://www.imf.org/external/pubs/ft/survey/so/2009/num100809a.htm
Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor, 2009, “Financial Instability, Reserves, and Central
Bank Swap Lines in the Panic of 2008,” American Economic Review, 99, no.2, May, 480-86.
Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor, 2010, “Financial Stability, the Trilemma, and
International Reserves.” American Economic Journal: Macroeconomics.
Rose, Andrew, and Mark Spiegel, 2009a, “The Causes and Consequences of the 2008 Crisis: Early
Warning,” Global Journal of Economics, forthcoming. NBER Working Papers 15357.
Rose, Andrew, and Mark Spiegel, 2009b, “The Causes and Consequences of the 2008 Crisis: International
Linkages and American Exposure,” Pacific Economic Review, forthcoming.
i
iii
The same dating of the global crisis is adopted by Yacine Aït-Sahalia, Jochen Andritzky, Andreas Jobst,
Sylwia Nowak, and Natalia Tamirisia, “Market Response to Policy Initiatives During the Global Financial
Crisis,” NBER Working Paper No. 15809, March 2010.
iv
Our first measure of currency demand was depreciation, as in the 1990s literature on currency crashes.
But many more emerging market countries float today than in the past, and often with success. Poland
appears to have been hit much more badly than Estonia if one looks at currency depreciation, because the
zloty floated while the kroon was locked in to the euro. But by any other measure, Poland did much better
than Estonia; it was the only EU country that did not lose output. So we try replacing currency
depreciation with exchange market pressure, which combines depreciation with loss of reserves, to get a
better overall measure of loss in demand for a country’s currency.
v
Guidotti, Pablo, 2003, in J. Antonio Gonzalez, V.Corbo, A.Krueger, and A.Tornell, eds., Latin American
Macroeconomic Reforms: The Second Stage. (Chicago: University of Chicago Press). Joshua Aizenman
points out that reserves indeed turned out in 2008 to be a useful form of self-insurance after all: “On the
Paradox of Prudential Regulations in the Globalized Economy: International Reserves and the Crisis – A
Reassessment,” NBER Working Paper No. 14779, March 2009.