Monitoring Financial Stability in Emerging and Frontier Markets

Abstract

This paper outlines a methodology to build monthly financial conditions indicators (FCIs) for developing countries, including a Small Island Developing State (SIDS), least developed countries, and transitions economies as defined by the United Nations’ classification. The proposed composite index uses ragged-edge panel data as well as mixed frequency observations. FCIs are compiled using a Dynamic Factor Analysis (DFA) in order to create a synthetic index in real time (as data is released). Also the choice of variables reflects typical emerging markets considerations given to interdependency issues and include variables like capital flows and real effective exchange rates. We show, that the obtained indicators are able to capture periods of financial stress and near-miss events historically. In addition, although our FCIs are free from the business cycle, it is able to track GDP growth, in several cases with a clear leading effect. Our FCIs are therefore an interesting tool for policymakers and market participants alike since its predictive power allows them to assess financial stability in real time before financial shocks are transmitted to the real economy. Consequently, upcoming stormy macroeconomic conditions can be anticipated well ahead.

Keywords: Financial markets, emerging and frontier markets, dynamic factor models, mixed-frequency observations, Kalman smoother, financial stress indicators, financial crisis, real-time information flow tracking, leading indicators

JEL Classification: C13, C32, C43, D53, E32, E44, F32, F47, G18