Unstable Debt/GDP Dynamics as an Early Warning Indicator

In this paper we develop a simple neoclassical growth model with perfect international capital mobility to analyze the stability of the differential equation in the foreign debt/GDP dynamics of developing countries in general and Korea, Malaysia and Thailand in particular in the long run using data over the period 1960-2000, and to use it as a counterfactual for bad times. We show that three different regimes can be distinguished: a stable steady state debtor regime, a stable steady state creditor regime and an unstable regime. A switch from a stable debtor or a stable creditor position to an unstable creditor regime with an increasing debt/GDP ratio is a sign of forthcoming trouble. We investigate this issue empirically for the three Asian countries in the run-up to the 1997 Asia crisis. Over the full sample, the evidence suggests that debt dynamics evolved according to the stable debtor case in each country with an equilibrium value of zero for Malaysia but positive ones for Korea and Thailand. Using a rolling regression technique, we find that indeed occasional switches to the unstable regime occurred. We demonstrate that all three countries investigated here were facing deteriorating domestic fundamentals – reflected in a movement towards unstable debt/GDP dynamics – some years prior to the breakout of the Asia crisis. As such, our approach appears to offer an interesting early warning indicator – the vanishing stability and appearance of instability in the differential equation of the debt/GDP ratio - for financial (debt) crises that should be used together with others for countries with fixed exchange rates.