Measuring Economic Downside Risk and Severity: Growth at Risk

Abstract

Using Growth at Risk as a measure of downside growth risk, the authors find that higher perceived levels of downside growth risk seem to be negatively associated with long-term growth.

Output collapses and crises are a fact of life. Severe economic downturns occur periodically and have grave consequences on the poor. Wang and Yao propose a new measurement for economic downside risk and severity: Growth at Risk. Similar to the concept of Value at Risk in finance, Growth at Risk summarizes the expected maximum economic downturn over a target horizon at a given confidence level.

After providing a taxonomy of growth risks, Wang and Yao construct a panel data set on Growth at Risk for 84 countries over the period 1980-1998. On average, different regional groups experience very distinct Growth at Risk patterns over time.

- Non-OECD countries experience a higher downturn risk, while OECD countries' downturn risks for both big and small recessions are the lowest among all groups.

- East Asia countries, which had been growing faster, had a high Growth at Risk for big downturns at around 6 percent, and it rose dramatically at the end of the 1990s.

- Latin America and Sub-Saharan Africa also maintained high Growth at Risk for both big recessions and small recessions through 1980-1998. But for Latin America, Growth at Risk for big recessions declined in the 1990s.

The authors then investigate the relationship between downside risks and long-term average growth in a cross-country analysis. They find that higher perceived levels of downside growth risk seem to be negatively associated with long-term growth. When a country's perceived level of downside growth risk is relatively high, both domestic and foreign investors might be deterred from making long-term investments in the country and instead invest elsewhere. The results suggest that prudent and consistent pursuit of socioeconomic and political stability contributes to long-term growth, and that risk management in a broader sense should be a vital part of the pro-growth and poverty reduction strategy.

This paper - a product of the Economic Policy and Poverty Reduction Division, World Bank Institute - is part of a larger effort in the institute to study and contribute to a large body of knowledge on growth. Yan Wang may be contacted at [e-mail].

JEL Classification: E32, N12, O40