An Emerging Market Financial Conditions Index: A VAR Approach

The recent financial crisis has heightened the interest in the impact of financial sector developments on the macroeconomic condition of countries. By employing a rolling-window Vector Auto-Regressive method based on monthly data for a time span between January 2001 and March 2013, this article sets up a comprehensive financial conditions index for a set of major emerging countries. The index sheds light on the various triggers of financial crises during this period and captures both domestic developments as well as global spillover effects. Index dynamics exhibit an overall abrupt slowdown due to the 2007-2008 Financial Crisis, precipitated primarily through a global liquidity squeeze and overall financial sector strain. In some countries, rising volatility of financial conditions thereafter has substantially been sparked by nominal effective exchange rate movements. Tested on its forecasting applicability, the inclusion of macroeconomic and financial variables enables the index to also perform well as a leading indicator for business cycles.