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The National Early Warning System in Korea I

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The National Early Warning System in Korea I06



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Title The National Early Warning System in Korea I
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Material Type Report
Date 2015
Language Korean
File Type Theme
Subject Economy < Financial Policy
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Abstract

Sub-Theme 1 | The National Early Warning System in Korea I





As a result of lessons learned from the currency crisis in 1997, Korean government strengthened macroeconomic and financial management. As a part of the effort to prevent another crisis from taking place, the Korean government decided to build up a national early warning system. In 2004, the Presidential Office in Korea launched the project of establishing the national early warning system and it has been operated since the next year. The system covers seven different sectors in the economy to detect early symptoms of crisis in each sector. In addition, the system is designed to monitor potential spillover effects across different sector in a more comprehensive way. 



##3D_LAYER##The seven sectors are foreign exchange market, domestic financial market, domestic financial institutions and industry, petroleum, commodity market, labor market, and real estate market.##3D_TEXT:The labor market early warning system is replaced by the public finance early warning system. Development of more sophisticated early warning models for public finance is currently underway.##3D_LAYER_END## Each sector is equipped with different quantitative early warning models independently developed by different public research institutions. Table 1 shows the seven sectors and the institutions responsible for developing early warning models. 

 
[Seven Early Warning Sectors and Public Institutions]

 







































Early Warning Model Institution
Currency Crisis Korea Center for International Finance (KCIF)
Financial Market Financial Services Commission (FSC)
Financial Institutions Financial Supervisory Service (FSS)
Energy Korea National Oil Corporation (KNOC)
Commodity Korea Institute for Industrial Economics (KIET)
Labor Market Korea Labor Institute (KLI)
Real Estate Market Korea Research Institute for Human Settlements (KRIHS)



##3D_LAYER##The Korea Center for International Finance (KCIF) is operating the early warning system for currency crisis.##3D_TEXT:Jung, H. (2015), 2014/15 Knowledge Sharing Program with Honduras: Upgrading the essential systems countering financial vulnerability in Honduras, Korea development Institute.##3D_LINK: https://www.kdevelopedia.org/Resources/economy/upgrading-essential-systems-countering-financial-vulnerability-honduras--04201602230143474.do##3D_LAYER_END## The KCIF’s early warning system has four models: the domestic crisis assessment model, the international financial market risk model, the domestic financial market risk model and the proximate crisis assessment model. The domestic crisis assessment model was developed in 1999 based on the signal approach. This model uses twenty six leading indicators from four sectors: domestic real sector (such as industrial production), domestic financial sector (such as stock price and dishonored bill ratio), external real sector (such as current account balance, trade volume, and terms of trade), and external financial sector (such as external debt and capital account balance). In this model, a composite index calculated as a weighted sum of signals from the leading indicators summarizes the overall risks of currency crisis in the next twelve months. In addition, composite indexes for each of the four sectors are also constructed independently to measure the risk levels of each sector. 



##3D_LAYER##The KCIF’s model employs the signal approach which was first developed and used by Kaminsky and Reinhart (1999) to assess the predictability of macroeconomic and financial variables for the joint currency and banking crises.##3D_TEXT:Kaminsky, G. and C. Reinhart (1999), “The twin crises: the causes of banking and balance of payments problems,” American Economic Review, vol. 89, no. 3, pp. 473~500.##3D_LINK:https://www.kdevelopedia.org/Resources/economy/twin-crises--05201810190150370.do##3D_LAYER_END## Since then, the signal approach has been widely employed in building up an early warning system in emerging market countries. The underlying assumption of the signal approach is that the behavior of an economy is unusual right before financial crisis and that this unusual behavior would repeat itself systematically in subsequent crises. 



The first step to set up the KCIF’s early warning model is to identify historical crisis periods. ##3D_LAYER##The early warning models for currency crisis typically identify the crisis periods based on a foreign exchange market pressure index (EMPI) proposed by Eichengreen, Rose, and Wyplosz (1994).##3D_TEXT:Eichengreen, B., A. Rose, and C. Wyplosz (1994), “Exchange Market Mayhem: The Antecedents and Aftermath of Speculative Attacks,” Economic Policy, vol.21, pp. 249~312.##3D_LINK:https://www.kdevelopedia.org/Resources/economy/exchange-market-mayhem--05201810180150362.do##3D_LAYER_END## EMPI is a weighted average of the changes in foreign exchange rates and the changes in foreign exchange reserves. Given the identified crisis periods and the forecasting horizon, the leading indicators are selected based on a statistical test. As in usual hypothesis tests, the process of selecting indicators calls for a threshold or critical value which divides the probability distribution of the indicator. The final step is to construct a composite index in order to combine information embedded in the selected indicators.



The global financial crisis casts doubt on the effectiveness of the domestic crisis assessment model. The domestic crisis assessment model is basically designed to assess the likelihood of a crisis caused by problems in domestic factors. Thus, it is not a good monitoring tool when a crisis from abroad spills over into the domestic economy. Faced with this challenge, the KCIF decided to develop new quantitative models. The newly developed international financial market risk index model monitors volatility in international financial markets. 



##3D_LAYER##The Financial Supervisory Service (FSS) in Korea developed the Financial Industry Early Warning System (FIEWS).##3D_TEXT:The Financial Supervisory Service was established in January, 1999, under the Act on the Establishment of Financial Supervisory Organizations. Banking Supervisory Authority, Securities Supervisory Board, Insurance Supervisory Board, and Non-bank Supervisory Authority were merged into a single supervisory authority. The FSS is responsible for examination and supervision of financial institutions.##3D_LAYER_END## The liquidity crunch of credit card companies in 2003 as well as the Asian financial crisis served a momentum to developing the system. The early warning system in the FSS includes the Daily Financial Soundness Indicators (DFSI) and the early warning models. The DFSI, also called the Handy Index Assessment System, is a real time crisis detection system using a small range of handy indices. The early warning models in the FSS include six different models for nine financial sectors and have been operated since 2007. 



Following the FSS, there are three distinct features in the early warning models of the FSS. First, they are designed to detect not only the early signs of insolvency of individual financial institutions, but also the early symptoms of crisis in the financial industry as a whole. Thus, the early warning models of the FSS are designed from both microprudential and macroprudential perspectives. Second, the early warning models incorporate the market assessment including stock and bond market variables and information from credit rating companies as well as balance sheet variables and macroeconomic data. For example, the FSS developed the credit rating prediction model and the expected default frequency (EDF) model which uses stock market information. Third, the FSS minimizes modeling risk by developing several different models. If different models produce the same early warning signals, supervisors may have more confidence in the outcome.