Early Warning Index for Macroeconomic Vulnerability in Kenya

The recent episodes of crisis and shocks make it imperative for countries to develop early warning systems and mitigation measures to enhance their resilience. Many countries, especially developing ones, are yet to develop effective formal frameworks for providing early warning for macroeconomic vulnerability. Kenya is no exception. Monetary authorities often implement expost measures to maintain stability. Such measures can be expensive. The objective of this paper is to develop an instrument that can help to identify situations in which crisis are more likely to occur, and thus aid in design of preemptive measures. The paper develops two indices: an index of speculative pressure and an index of macroeconomic vulnerability. The former is used to identify retrospectively, periods of unusual market volatility, while the latter is an ex-ante measure for macroeconomic fragility. To generate signals, thresholds are obtained using: (i) mean plus 1.5 standard deviations, and (ii) the self-exciting threshold autoregressive techniques. A contingency table is used to assess the validity of the “signals approach”. The findings are that the framework performs well in predicting periods of macroeconomic vulnerability in Kenya. The real effective exchange rate appears to be the main driver of the macroeconomic vulnerability index.