Financial Vulnerability and Risks to Growth in Emerging Markets

Abstract

This paper introduces a new financial vulnerability index for emerging market economies by exploiting key differences in their business cycles relative to those of advanced economies. Information on the domestic price of risk, cost of dollar hedging and market-based measures of bank vulnerability combine to generate indexes significantly more effective in capturing macro-financial vulnerability and stress compared to those based on information in trade and global factors. Our index significantly augments early warning surveillance capacity, as evidenced by out-of-sample forecasting gains around a majority of turning points in GDP growth relative to distributed lag models that are augmented with information from macro-financial indexes that are custom-built to optimize such forecasts.

Keywords: Financial conditions, price of risk, vulnerability, business cycles, early warning indicators

JEL Classification: C53, E32, E44