Elements of and predictive monitor for a financial crisis

Warning: quite complex, we recommend a significant economics background for best understanding. Skip to chart.




Leading indicators of a financial crisis

Leading indicator Rationale
Current Account
Real exchange rate
Exports
Imports
Trade balance/GDP
Current account balance/GDI 		Weak exports, excessive import growth, and currency overvaluation could lead to deteriorations in the current account, and historically have often been associated with currency crises in many countries. External weaknesses and currency overvaluation could also add to the vulnerability of the banking sector since a loss of competitiveness and the external market might lead to a recession, business failures, and a decline in the quality of loans. Banking crises could also lead to currency crises.
Capital Account
Foreign reserves
M2/foreign reserves
Short-term debt/foreign reserves
Foreign liabilities/foreign assets
Deposits in BIS banks/foreign reserves 		With increasing globalization and financial integration, capital account problems could make a country highly vulnerable to shocks. Manifestations of capital account problems could include declining foreign reserves, excessive short-term foreign debt, debt maturity and currency mismatches, and capital flight.
Financial Sector
M2 multiplier (M2/M0)
Domestic credit/GDP
Excess real M1 balances
Central bank credit to public sector/GDP
Domestic real interest rate
Lending–deposit rate spread
Real commercial bank deposits 		Currency and banking crises have been linked to rapid growth in credit fueled by excessive monetary expansion in many countries, while contractions in bank deposits, high domestic real interest rates, and large lending-deposit rate spreads often reflect distress and problems in the banking sector.
Real sector
Industrial production
Stock prices		 Recessions and a bust in asset price bubbles often precede banking and currency crises.
Global Economy
US real interest rate
US GDP growth
World oil prices
Dollar/yen real exchange rate 		Foreign recessions could spill over to domestic economies and lead to domestic recessions. High world oil prices pose a danger to the current account position, and also could lead to domestic recessions. High world interest rates often induce capital outflows. For many East Asian countries, the depreciation of the Japanese yen against the US dollar could put other regional currencies under pressure.
Fiscal Sector
Fiscal balance/GDP
Large fiscal deficits could lead to a worsening in the current account position, which could in turn put pressure on the exchange rate.

GDI = Gross Domestic Investment
GDP = Gross Domestic Product




Taking at least one statistical measure from each of the above groups with high predictive value, the existence of multiple signals and a relatively low signal to noise ratio, we ended up with these:


  1. Currency exchange rate, deviation from trend (27.5%)
  2. Trade balance/GDP, 12 month rate of change (18.7%)
  3. Foreign liabilities/foreign assets, deviation from trend (12.1%)
  4. Ratio of M1 to trend (11.7%)
  5. Dollar/yen exchange rate, deviation from trend (8.6%)
  6. World oil price, 12 month rate of change (7.3%)
  7. Foreign reserves, 12 month rate of change (5%)
  8. Stock price index, 12 month rate of change (5.3%)
  9. Government consumption/GDP, deviation from trend (3.8%)
See pages 16 & 17 of the source document noted below for the full list of individual indicators. There are many more than just the nine we used. Weight/importance is in parentheses. Note: two of the nine inputs lag about five months since they're GDP related and another two lag by about six weeks. The other five have a reporting/availability lag of under a week.
We're also compelled to note that this is a fully automatic system and can not take into account unexpected items like war or bird flu, etc.




Financial crisis predictive monitor, short & long term graphs
(gold added,in light blue, with 1/3 the importance of currency)

(The early warning line is based on a 13 week change rate instead of an annual change rate)





Peak date Event or issue
Mid 1974 OPEC oil crisis & recession
Late 1979 High inflation, gold over $800
Late 1982 Deep recession
Mid 1987 International dollar valuation issues, stock market crash
Late 1990 International dollar valuation issues, Iraq war
Early 1995 International dollar valuation issues, high positive trade balance, oil price up about 60%, crisis in Mexico
Early 1997 Effects from Asian financial crisis
Early 2000 Stock market peak, oil price tripled since early 1999
Early 2003 September 11 effects, oil price increases, dollar value loss
from http://www.nowandfutures.com/financial_crisis.html




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As can easily be seen on the longer term chart, the current level of the crisis is far below the highest levels of prior crises, and also rhymes quite well with the 1973-74 period.