A Factsheet - April 2008

Vulnerability Indicators

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As part of its wider focus on crisis prevention, the IMF is improving its ability to assess how vulnerable its member countries are to financial crisis. Vulnerability indicators underpin much of this work. They provide essential input for IMF surveillance and lending, and are used for analysis and stress testing under the Financial Sector Assessment Program and as part of early warning system models.

Assessing vulnerability

In response to the currency crises that afflicted several emerging market economies in the 1990s, the IMF launched a major effort to improve its ability to analyze whether, and to what extent, countries are vulnerable to such crises. Emerging market economies, which often heavily rely on external borrowing and other capital inflows for their economic growth, are especially vulnerable to reversals in investor sentiment. The IMF has therefore paid special attention to this group of countries in its vulnerability assessment work. However, as the recent turmoil in world financial markets underscores, crises can manifest in countries at various stages of development. Work is underway to strengthen the framework for the analysis of financial vulnerabilities in advanced economies.

Much of the IMF's work on vulnerability has focused on improving the quality and transparency of data. Timely and detailed data on international reserves, external debt, and capital flows strengthen the ability to detect vulnerabilities, giving policy makers enough time to put remedial measures in place. These efforts have gone hand in hand with improvements in the IMF's ability to analyze key data, for instance by identifying critical levels for certain indicators, conducting stress tests, or running early warning system models.

Vulnerability indicators

Vulnerability indicators cover the government, the financial sector, and the household and corporate sectors. When economies are under stress, problems in one sector often spread to other sectors. For example, concerns about a country's fiscal deficit might lead to a run on the exchange rate, or undermine confidence in banks holding government debt, thereby triggering a banking crisis.

Below are some of the indicators that the IMF monitors particularly closely:

  • Indicators of external and domestic debt, including debt maturity profiles, repayment schedules, interest rate sensitivity and currency composition. The ratios of external debt to exports and to GDP are useful indicators of trends in debt and repayment capacity. Where public sector borrowing is significant, the ratio of debt to tax revenue is particularly important to gauge the country's repayment capacity.
  • Indicators of reserves adequacy are central to assessing a country's ability to avert liquidity crises. The ratio of reserves to short-term debt in particular is key to gauging the vulnerability of countries with significant but uncertain access to capital markets.
  • Financial soundness indicators are used to assess the strengths and weaknesses of countries' financial sectors. They cover the capital adequacy of financial institutions, the quality of assets and off-balance sheet positions, profitability and liquidity, and the pace and quality of credit growth. Financial soundness indicators are for instance used to assess financial systems' sensitivity to market risk, including changes in interest rates and exchange rates.
  • Corporate sector indicators on the foreign exchange and interest rate exposure of companies are particularly important when assessing the potential impact of exchange rate and interest rate changes on corporate sector balance sheets. Indicators related to corporate leverage, profitability, cash flow, and financial structure are also relevant.

Analyzing vulnerability in the context of IMF surveillance

Much progress has been made in incorporating vulnerability assessments into bilateral surveillance consultations. Vulnerability indicators now routinely inform the IMF's policy advice to its member countries, especially emerging market economies. The IMF has also broadened its multilateral surveillance to include systematic monitoring of capital markets in order to better gauge the risk of crises spilling over from one country to another.

Given the importance of the financial sector in recent financial crises, the IMF and the World Bank launched a joint initiative in 1999 to deepen surveillance of financial sectors. The Financial Sector Assessment Program provides an in-depth assessment of the strengths and vulnerabilities of member countries' financial systems, which contributes to the IMF's overall surveillance effort and also informs specific policy recommendations.

Early Warning System (EWS) models are used by international financial institutions, central banks and private sector forecasters to estimate the likelihood of currency crises. EWS models typically use indicators based on country-specific data, developments in the global economy, and political risk. The IMF has developed its own EWS models, which have been tailored to the specific needs of the institution-including the need for sufficiently long time horizons to allow for corrective policy action. But while EWS models offer a systematic, objective, and consistent method for predicting crises, they have a mixed record in terms of forecasting accuracy, and are only used as one amongst many inputs into IMF surveillance.


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