Uncovering a hidden dimension

3 minute read
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I have recently authored a book, Predictability of Financial Crises – the Impact of Fundamental, Policy-induced and Institutional Vulnerabilities on China Compared to Other Emerging Markets

The goal is to analyse the determinants of financial crises, in particular currency crises, to better understand them and deduct implications for predicting and preventing these events. Empirical analysis of crises is one element of early warning systems (EWS) mainly capturing economic and financial factors. The underlying vulnerabilities of EWS are, for instance, macroeconomic variables or balance sheet mismatches. From these variables, the likelihood of a certain type of crisis is deducted. However, this significantly depends on the definition of crisis, as well as on the forecast horizon.

A pure focus on fundamentals leads to a myopic view on the topic of financial crises. An expanded conceptualisation of vulnerability – fundamental, policy-induced and institutional – is necessary to better understand and, thus, predict outcomes from an early warning perspective. 

By detaching the analysis from one specific dimension, I encourage market observers to acknowledge the multiple forms of vulnerability to financial crises. Hence, my book proposes a unified framework for modelling currency crises along these three analytical dimensions.

The expanded scope of the concept of vulnerability to financial crises is applied in detail to China’s state in the second half of 2015 and in 2016. Firstly, however, I analyse why China was less severely affected by historic financial crises over the past 40 years relative to other emerging markets and, thus, the country’s rise did not get derailed. By drawing on lessons from past financial crises, I shed light on the notion that China had advantages along the three analytical dimensions of the conceptual framework which made the country less vulnerable to financial crises, in particular to excess volatility in China’s currency.

I hypothesise, however, that certain variables of these dimensions have changed, thus leading to increased fragilities of China in the second half of 2015 and 2016. Therefore, the question I seek to answer in my book is: ‘Analysis of China’s rise by applying a theoretical framework of fundamental, policy-induced and institutional vulnerabilities of emerging markets. How did China manage to continue its steep rise over the last 40 years while other emerging markets were derailed by financial crises and what caused the country’s struggles in the second half of 2015 and 2016?’

That being said, not only factors relevant in historic crises should be taken into account, but also factors that predict different future crises. 

In this respect, sustainability factors come into the discussion. This could be an underlying dimension hidden in my theoretical framework which needs further attention. While fundamental, policy-induced and institutional vulnerabilities cover part of the environmental, social and corporate governance (ESG) factors, a clearer description of ESG risks would be desirable. Integrating sustainability factors into financial modelling should certainly be part of future work.