A Financial Stress Index for a Small Open Economy: The Australian Case

We construct a financial stress index for a small open economy, Australia, which aims to provide clear and timely signals of financial market strains. Decomposing the Australian Financial Stress Index (AFSI) into foreign and domestic components, we show that foreign factors can explain about two-thirds of our index. Moreover, we find that the AFSI contains relevant and useful macroeconomic information. In particular, we find that the AFSI Granger-causes subsequent credit supply and unemployment growth. When compared with the Asian Development Bank’s Australian financial stress index, we find that our measure can better capture stress episodes that affect credit provided by banks and other types of financial intermediaries. Finally, we estimate the effect of a financial stress shock, as measured by an increase in the AFSI, on the macro-observables. A financial stress shock triggers an initial increase in both money supply growth and bank loan growth, followed by a notable decline to negative growth, before eventually stabilizing. Yet, in times of heightened levels and volatility of financial stress, the downturns in bank loan growth and retail sales growth are both more profound and prolonged.