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The Financial Crisis Index
By: Tracy Porter
Copyright 2007

The 1997-1998 Asian Financial Crisis was highly significant to Western countries, specifically the United States because, by association, it affected their own economy. Due to globalisation, which the International Monetary Fund (IMF) has defined as the increasing interdependence, integration, and interaction among people and corporations in disparate locations around the world, any crisis that occurs in Asia or Latin America is very likely going to affect those economies that trade with it, such at the United States and the United Kingdom. Therefore, if one economy enters into a financial crisis, in all probability associated economies are at risk of entering into a financial crisis as a consequence of the initial crisis (Nanto, 1998).

The East Asian Financial Crisis was significant because it forced banks and other financial institutions to endeavour to look at the weaknesses in their economies, and an index has subsequently been developed that can be used as a guidepost to detecting any potential risks of a currency crisis in emerging market economies, which has been coined the Financial Crisis Index, or FCI.

Index numbers are commonly used to monitor trends in data over time. They are similar in concept to averaging values, and provide a useful overview of the accumulated data, but leave out the finer detail that may otherwise be present in any analytical work. Indexes measure data over a specific period of time; the initial period the data is measured against is called the base period, and is usually assigned an arbitrary value of 100. The indexes for the remaining period are then calculated against the base period, and this calculation reveals the percentage change that has occurred since the last base period (University of Leicester, 2000). For example, if the base period is assigned a base number of 100 and the following year the index is 104, this reveals that a change of 4% has occurred during that period. With regard to the FCI, any values over 100 indicate the threat of a financial crisis has increased, and any values below 100 indicate that the threat has decreased.

In its most basic form, the FCI can be determined by through regression analysis using an algorithm that identifies a simple linear relationship between the FCI and one determinant, or independent variable. This equation is written as:-

Y = a + Bx + e

Y is the dependant variable, or the FCI.
X is the independent variable, or the determinant.
a is a constant parameter.
B is the regression coefficient, which is a quantity between –1 and +1. This quantity is denoted by the letter R. The closer R is to +1 the stronger the positive correlation between the dependant and independent variables. The closer R is to –1 the stronger the inverse correlation between the dependant and independent variables (Arsham, 2007). If R is zero this indicates there is no relationship between the two variables and they are independent of one another. It is interesting to note that in statistical analysis, the value of R, or the regression coefficient, has the same numeric value, excluding the polarity, of the correlation coefficient that is used when composing a correlation matrix of the interdependence of several variables.

e is the error or disturbance, and is also known as the residual, and is calculated by determining the difference between the actual FCI and the estimated FCI values (Watsham and Parramore, 1997).

In order to understand how the FCI is calculated, it is first important to gain an awareness of the part the determinants play in developing the index. The determinants that affect the FCI algorithm will be examined to see what impact they have on a potential financial crisis are: (1) the real exchange rate (RER); (2) the annual reserve money as a percentage of gross domestic product (ARM); (3) the current account balance as a percentage of gross domestic product (CAB); (4) the annual percentage change in terms of trade (TOT); and (5) the ratio of money supply to official foreign exchange reserves (M2R).

Because there are five independent variables, or determinants, that comprise the FCI, multiple regression techniques will need to be employed to examine how each of the determinants will affect the index. Multiple regression requires the basic equation to be modified to account for the fact that there are five separate determinants rather than one. In this instance, the equation must be re-written as:-

Y = a + B(RER)X(RER) + B(ARM)X(ARM) + B(CAB)X(CAB) + B(TOT)X(TOT) + B(M2R)X(M2R) + e

The real exchange rate is a comparison of two currencies against each other and is quite often based on US dollars. For example, on 26 December 2006, one British pound equaled 1.95603 United States dollars, which means that 1.95603 United States dollars can purchase British pound, or Ł0.55124 can purchase one United States dollar. If the British pound continues to strengthen until one British pound can purchase two American dollars, or one American dollar can purchase a half of a British pound, this will have the effect of British purchasing American dollars as an investment and Americans selling British pounds because of their high value. The process of buying American dollars and other stock will raise the value of the dollar again, and selling of British pounds and stock will weaken the pound, which will economically stabilise the two currencies. The side effect of a strong British pound is the British people will want to import more American products, so this will benefit American trade agreements, and is one of the reasons why Americans like to keep their dollar weak in comparison to other countries. Because of the strong British pound, however, Americans will not want to import British goods and services, which will ultimately have an adverse effect on the British trade agreements. It is important, therefore, that both the American dollar and the British pound maintain mutually beneficial exchange rates. It is important that a country have a strong currency, but no so strong that it is unable to export its products and services to other countries.

Annual reserves are the reserves that a central bank maintains, as it purchases an issued currency, exchanging its assets to reduce its liabilities. The reserves are the central bank’s mechanism to stabilise its issued currency from excessive volatility and protect its monetary system from shock. High reserves are seen as a strength to the economy because it indicates the backing a currency has and the money supply will therefore be increased. Low reserves can be indicative of a shrinkage of the money supply and an impending currency crisis (Wikipedia, 2006). The annual reserve money as a percentage of the gross domestic product indicates how efficiently an economy uses its money supply. In 2005 the United Kingdom had an annual reserve to gross domestic product ratio of 2.8%, as compared to the United States ratio of .7%, which reveals the British economy, on paper at least, appears to be more stable than the American economy. It should be noted that America has historically been a heavily indebted country, but they have thus far bee able to accommodate the $8.837 trillion debt that they have incurred as at 2005. The Philippines, in contrast, with 40% of its population living below the poverty line, as compared to Great Britain’s 17% and America’s 12%, has an annual reserve as a percentage of gross domestic product ratio of 20.25%. This reveals that just because an economy has a high annual reserve ratio to gross domestic product does not necessarily mean that the individuals who form that economy will benefit from that economy’s growth (CIA, 2006).

The current account balance of the balance of payments is the sum of the balance of trade, net factor income and net transfer payments. A current account surplus is said to increase a country’s net foreign assets by the corresponding amount, while a current account deficit decreases net foreign assets by a corresponding amount (Wikipedia, 2006). In 2005 the United States had a current account to gross domestic product ratio of –6.64%, while the United Kingdom had a ratio of –2.59% (both countries have deficit current account balances). The Philippines, on the other hand, has maintained a current account to gross domestic product ratio of 2.58% (CIA, 2006). In order for the Philippines to achieve this ratio, however, they have had to comply with very stringent requirements made by the International Monetary Fund and the World Bank with regard to repayment of their $65.71 billion debt, which means they have little money left over for social programmes to improve the welfare of the 40% of their population that live below the poverty line (Hertz, 2004).

The trade that an economy embarks upon is related to their imports and exports. Ideally, an economy should strive to export the same amount or more than it imports. If a country imports more than it exports then this could be a cause for concern because it could mean that their foreign exchange rate is not balanced, or worse, there could be high unemployment, thereby making it difficult for the economy to export goods and services. In 2005, for example, the United States imported $799.5 billion worth of goods and services more than it exported, and the United Kingdom exported $111 billion more than it imported.

The money supply is defined as the quantity of money available within the economy to purchase goods, services and securities. There are several ways to determine the amount of money that is available within an economy. The United States has defined its money supply as: -

M0 = physical currency;
M1 = M0 + current accounts;
M2 = M1 + savings accounts, money market accounts, and certificates of deposits under $100,000;
M3 = M2 + all other certificates of deposits and purchase agreements.

In 2005, the United States had a money supply of $9.7 trillion, which equated to $30,000 per person (Wikipedia, 2006). With a money supply of $9.7 trillion and a foreign exchange reserve of $86.94 billion, the ratio of these two amounts is 111.57 (CIA, 2006). Therefore, even though America’s external debt as at 2005 is $8.837 trillion, there is enough money in the supply to pay off this debt should the need arise.

References

Professor Hossein Arsham (2007)
URL://home.ubalt.edu/ntsbarsh/business-stat/excel.htm#recorr
[24 February 2007]

The Central Intelligence Agency (2006)
URL://https://www.cia.gov/ciapublications/factbook/index.html
[26 December 2006]

The Financial Training Company (2005). Unit 7: Preparing Reports and Returns, FTC Foulks Lynch Ltd: Wokingham, England
Harvey, A (2003). Excel 2002 All-In-One Desk Reference For Dummies, Wiley Publishing: New York, USA
Hertz, N (2004). I.O.U. The Debt Threat And Why We Must Defuse It, Harper Collins: London, England
Lumby, S. and Jones, C. (2003). Corporate Finance: Theory and Practice, Thomson: London, England
Nanto, D. (1998). The 1997-98 Asian Financial Crisis.
URL://http//www.fas.org/man/crs-asia2.htm
[26 December 2006]

University of Leicester (2003). Module 3 MSc in Finance 2502 Financial Modeling, Learning Resources: Cheltenham, England

Wikipedia (2006)
URL://http//www.wikipedia.org
[26 December 2006]