 A global early warning system
Can new technologies be used to construct an effective early warning system? The IMF is actively exploring the possibility of using modern computing power and data storage technology to gather information on up to one million financial instruments which are traded globally. The system will gather data on currency exchange rates, interest rates, commodity prices and stock market indices in order to provide a global early warning system. The aim will be to build up a model of financial markets to indicate where volatility will occur and how long it will persist.
The interesting question for economists is how the system intends to model human behaviour! This is not a sphere of activity in which market reactions are uniform or predictable. Added to this, outcomes are very much of the ‘self-fulfilling prophecy’ variety. When others invest, the message is to invest because prices and returns will rise. When others withdraw, the message is to withdraw because prices and returns will fall.
In these circumstances, the role of the IMF must be to convince investors not to withdraw capital if the fundamentals are in place. It requires the IMF itself to have
confidence in the fundamentals, and particularly in the institutions which underpin them. Hence it is necessary for the IMF to strengthen its inspection and supervision procedures so that it does not fall into the trap of propping up incompetent or insolvent institutions.
All regions of the world have suffered major or minor currency crises over the last thirty years.
The crises of the 1970s and 1980s, principally in Latin America, were explained by a firstgenerationof models which focused on government overspending and reserve depletion. A second generation of models took into account the costs and benefits of maintaining an exchange rate with self-fulfilling expectations creating an unstable situation.
The third generationof models, derived from the experience of the Asian crisis in 1997–8, focuses on the role of the financialsectorand the different types of capital flows to emerging markets.
Trade in foreign assets is explained in terms of portfolio choice and portfolio diversification. Cross-border flows of private capital increased dramatically in the 1990s as a consequence of liberalisation,financialinnovation and the growth of pensionandmutualfunds.
The crisis in Asia turned a virtuous circle of capital inflow into a vicious circle of capital outflow. The role of financial intermediaries in the currency crisis was apparent when the Thai bubble burst.
The Russian crisis of 1998 had a number of special features including the capitaloutflowwhich had been taking place since the early 1990s.
‘Contagion’ is the process by which turbulence in one capital market spreads to another. It requires for solution much greater policy co-ordination and trans- parency, and IMF/World Bank surveillance.
When investors and fund managers react similarly to a financial crisis they are behaving like a ‘herd’. Herd behaviour originates in incomplete information and a fear of being different.
Early warning systems which are modelled on past data are rather poor at predict- ing crises. They may do better if they incorporate variables relating to corporate balance sheets and portfolio behaviour.
Safety zones, which focus on the fundamentals which go to make up a safe envi- ronment for capital inflows, can be modelled statistically. The IMF is using modern computing power and data storage technology to build up a global early warningsystem.
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