Evaluating financial stress indicators: evidence from Indian data

Abstract

Purpose The purpose of this study is to assess alternative financial stress indicators for India in terms of tracing crisis events, mapping with the business cycle and the macroeconomic effect of stress indices. Design/methodology/approach The study constructs the composite indicator of systemic stress of Hollo, Kremer and Lo Duca (2012) for India using two different methods for computing time-varying cross-correlation matrix, namely, exponentially weighted moving average (EWMA) and dynamic conditional correlation-generalized autoregressive conditional heteroscedasticity (DCC-GARCH). The derived indices are evaluated with widely used, equal variance and principal component weighting indices in terms of tracing stress events, mapping with the business cycles and the macroeconomic effect. For this purpose, the study identifies various episodes of financial stress and uses the business cycle dates in the sample covering from January 2001 to October 2018. Findings The results suggest that stress indices based on EWMA and DCC-GARCH accurately identify the well-known stress periods and capture the recession dates and show an adverse effect on economic activity. Primarily, the DCC-GARCH-based stress index emerges as a better indicator of stress because it efficiently locates all the major-minor events, traces the build-up of stress and reverts to the normal level during stable times. Practical implications The DCC-GARCH-based stress index is a very useful indicator for policymakers in regularly monitoring India’s financial conditions and providing timely identification of systemic stress to avoid adverse repercussion effects of the financial crisis. Originality/value The 2007–2008 financial crisis and subsequent recurrent instability in the financial markets highlighted the requirement for an appropriate financial stress indicator for a timely assessment of the system-wide financial stress. To the authors’ knowledge, this is the first study that incorporates the systemic nature of financial stress in the construction of stress indices for India and provides a holistic evaluation of the financial stress from an emerging country’s perspective.