Thursday, October 12, 2006

The Next Central Bank Failure

As reported in EmergingMarkets (free registration required), IMF managing director Rodrigo de Rato warned that we're due for another central bank failure, and given emerging markets haven't fully differentiated against risk, pragmatic approaches to the markets is prudent.

So who's a likely candidate? de Rato suggests that while emerging Europe and Latin American reforms have made progress in reducing risk, sources quoted in the article suggest China's loans to Africa and India's export credits might be a place to look.

Some interesting work has been done by Bussiere and Fratzscher in their paper "Toward a New Early Warning System of Financial Crisis" (2002, European Central Bank Working Paper Series) on developing a forecasting model for an emerging market "Early Warning System."

They use six key indicators:
1. exchange-rate overvaluation (which has a strong weight in the crisis probability)
2. lending boom index
3. short term debt to lending reserves
4. cur account to GDP
5. contagion variables
6. growth

While the predictive power of the model is only enhanced to 73.7% (from previous models at 66.7%), and false alarms reduced from 50% to 44.1%, it would be interesting to see an implementation of the model and I'm curious about the extent of use it's seen since the model's discussion in 2002.

An interesting note by the authors is that in the 20-country sample, the only countries that never experienced a crisis are all emerging Europe nations: Hungary, Lithuania, Poland, Slovakia and Slovenia.


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