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Identifying a financial conditions index for South Africa

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Author Info

  • Kirsten Thompson

    ()
    (Department of Economics, University of Pretoria)

  • Renee van Eyden

    ()
    (Department of Economics, University of Pretoria)

  • Rangan Gupta

    ()
    (Department of Economics, University of Pretoria)

Abstract

The global financial crisis that began in 2007-08 demonstrated how severe the impact of financial markets’ stress on real economic activity can be. In the wake of the financial crisis policy-makers and decision-makers across the world identified the critical need for a better understanding of financial conditions, and more importantly, their impact on the real economy. To this end, we have constructed a financial conditions index (FCI) for the South African economy, to enable the gauging of financial conditions and to better understand the macro-financial linkages in the country. The FCI is constructed using monthly data over the period 1966 to 2011, and is based on a set of sixteen financial variables, which include variables that define the state of international financial markets, asset prices, interest rate spreads, stock market yields and volatility, bond market volatility and monetary aggregates. We explore different methodologies for constructing the FCI, and find that rolling-window principal components analysis (PCA) yields the best result. We furthermore investigate whether it is beneficial to purge the FCI of the real effects of inflation, economic growth and interest rates, and use the identified FCI in in-sample causality testing with three macroeconomic variables.

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Bibliographic Info

Paper provided by University of Pretoria, Department of Economics in its series Working Papers with number 201333.

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Length: 20 pages
Date of creation: Jul 2013
Date of revision:
Handle: RePEc:pre:wpaper:201333

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Keywords: financial conditions; financial crisis; principal components;

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References

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  1. Gary, Koop & Dimitris, Korobilis, 2013. "A New Index of Financial Conditions," SIRE Discussion Papers 2013-48, Scottish Institute for Research in Economics (SIRE).
  2. Castro, Vítor, 2008. "Are Central Banks following a linear or nonlinear (augmented) Taylor rule?," The Warwick Economics Research Paper Series (TWERPS) 872, University of Warwick, Department of Economics.
  3. Serena Ng & Pierre Perron, 1997. "Lag Length Selection and the Construction of Unit Root Tests with Good Size and Power," Boston College Working Papers in Economics 369, Boston College Department of Economics, revised 01 Sep 2000.
  4. Kasai Ndahiriwe & Ruthira Naraidoo, 2011. "The Opportunistic approach to monetary policy and financial markets," Working Papers 201103, University of Pretoria, Department of Economics.
  5. Alberto Montagnoli & Oreste Napolitano, 2004. "Financial Condition Index and interest rate settings: a comparative analysis," Money Macro and Finance (MMF) Research Group Conference 2004 1, Money Macro and Finance Research Group.
  6. Sydeny C. Ludvigson & Serena Ng, 2005. "Macro Factors in Bond Risk Premia," NBER Working Papers 11703, National Bureau of Economic Research, Inc.
  7. Jan Hatzius & Peter Hooper & Frederic S. Mishkin & Kermit L. Schoenholtz & Mark W. Watson, 2010. "Financial Conditions Indexes: A Fresh Look after the Financial Crisis," NBER Working Papers 16150, National Bureau of Economic Research, Inc.
  8. Kilian, Lutz, 1999. "Exchange Rates and Monetary Fundamentals: What Do We Learn from Long-Horizon Regressions?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 14(5), pages 491-510, Sept.-Oct.
  9. David E. Rapach & Christian E. Weber, 2004. "Financial Variables and the Simulated Out-of-Sample Forecastability of U.S. Output Growth Since 1985: An Encompassing Approach," Economic Inquiry, Western Economic Association International, vol. 42(4), pages 717-738, October.
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Cited by:
  1. Kirsten Thompson & Renee van Eyden & Rangan Gupta, 2013. "Testing the Out-of-Sample Forecasting Ability of a Financial Conditions Index for South Africa," Working Papers 201383, University of Pretoria, Department of Economics.

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