Bulletin Spring‧Summer 2004

Resilience Indications Measuring an Economy's Ability to Withstand Financial Shocks Introduction In the aftermath of the financial crisis in 1997-98, i n t e r n a t i o n al f i n a n c i al institutions, central banks, and academia have devoted a lot of research efforts to the development of forward- l o o k i ng ea r ly wa r n i ng systems (EWS) for predicting the likelihood of financial crises. An EWS usually i n v o l v es the use of a consistent framework to ana l yse h i gh - f r equency macro-prudential indicators. E x p e r i e n ce so f ar suggests that there are limitations to the predictive power of most EWS. For instance, while the two core EWS of the International Monetary Fund correctly predicted that a crisis was impending in Turkey one year before the crisis broke out in February 2001, the models did not issue any warning signals for the January 2002 crisis in Argentina. It is generally acknowledged that predicting the occurrence of financial crises is not easy, given the increasing volatility of financial markets, the scale of contagion, and the magnitude of the damage that the crises may cause. Also, as the markets become more globalized, it would be difficult to isolate the impact of external events on the domestic economy. Because of the difficulty in predicting (financial) crises, there may be some merit in developing models that can assess the level of resilience of an economy to supplement the EWS. The Hong Kong Monetary Authority (HKMA) and the Risk Management Science Programme of The Chinese University of Hong Kong have jointly developed a statistical model for this purpose. The HKMA has also provided a research grant to CUHK to fund this research, which began in early 2002. The conceptual framework and preliminary findings were disseminated to the central banks of the Asian-Pacific region through the Workshop on Resilience Indicators held on 29th January 2003 by the HKMA. Early Warning Systems vs. Resilience Framework The ma j or d i f f e r e n ce b e t we en an EWS and a resilience framework is that the latter does not predict crisis, but only assesses the current state of health of an economy a n d h e n ce its a b i l i ty to withstand financial shocks should one occur. The concept of EWS is b a s ed on t he premise that an economy and its financial markets would behave differently prior to an imminent financial (banking, currency, or debt) crisis. The ‘abnormal, behaviour has a 'Becauseof the difficulty in predicting (financial) crises there may be some merit in developing models that can assess the level of resilience of an economy…' 4 2 Chinese University Bulletin Spring • Summer 2004