Econometric Approach to Early Warnings of Vulnerability in the Banking System and Currency Markets for Hong Kong and Other EMEAP Economies

This study adopts an econometric approach to develop an early warning system of the vulnerability in the banking system and currency markets for the 11 EMEAP economies over the period from1990 to 2008. We identify a set of leading indicators of banking distress and currency pressure and investigate the causal and contemporaneous linkages between them by using separate panel probit models and a simultaneous probit equation system. Asset-price misalignments, default risk of commercial banks and the non-financial corporate sector, and growth of real credit to the private sector are found to be significant leading indicators for both banking distress and currency pressure. Economic growth, inflation and the ratio of short-term external debt to international reserves are found to be important determinants of banking distress, whereas growth of M2 relative to international reserves, total trade balance over GDP, real effective exchange rate over-valuation and trade integration with China are identified to be crucial indicators of currency pressure. Currency market pressure is shown to have strong leading and contemporaneous impacts on banking distress for the EMEAP economies but not vice versa. These findings imply that the policy measures aimed at sustaining exchange rate stability will have the additional benefit of lowering the likelihood of banking distress in the region. Lastly, China is found to play a stabilising role in the region, i.e. the greater the trade with China, the lower the chance of experiencing currency pressure.