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

We construct a Financial Stress Index (FSI) for a small open economy, which aims to provide clear and timely signals of financial market strains. This can be used in developing appropriate responses to address these adverse events. To do so, we use the principal component framework and apply it to Australian monthly data on interest rates, spreads, exchange rates, house price growth and inflation expectations. Decomposing the index into foreign and domestic components, we find that the foreign factors can explain more than half (57.4%) of our Australian Financial Stress Index (AFSI). To determine the information content of our index, we run a series of Granger causality tests on several economic and financial observables. We also estimate whether including the AFSI can improve the prediction of the different economic and financial outcomes relative to a specification that uses only its own previous data. We find that including the AFSI improves the forecasts for future retail sales growth and bank credit growth. Finally, we show that financial stress can have non-linear effects on bank credit growth. In particular, an increase in financial stress affects credit growth more adversely if AFSI is high. This result further highlights the importance of an accurate and timely measure of financial stress in an economy for researchers and policy makers.