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Abstract
Abstract This study attempts to develop a financial vulnerability indicator serving as a composite indicator for the state of financial vulnerability. The indicator was constructed from 10 variables of macroeconomic, financial and property market by extracting a common vulnerability component through the dynamic approximate factor model. On the feedback and amplification effects, the outcome revealed that financial vulnerability shock catalysed significant negative effects on economic activity in a high-vulnerability regime, while the impact was negligible in periods of low vulnerability. This study highlighted the usefulness of composite indicators as an early warning mechanism to gauge vulnerabilities in the Malaysian financial system.
Highlights
The global financial crisis in 2008 shed light on the importance in monitoring the state of financial vulnerability for policy makers to provide a buffer for a macroprudential shock
An financial vulnerability indicator (FVI) has been constructed for Malaysia to act as an early warning mechanism for the state of financial vulnerability
An FVI has been constructed for Malaysia to act as an early warning mechanism for the state of financial vulnerability, using a sophisticated modelling approach
Summary
The global financial crisis in 2008 shed light on the importance in monitoring the state of financial vulnerability for policy makers to provide a buffer for a macroprudential shock. The spill-over effect of the global financial crisis was substantial on the real sector for most countries in the world. The impending impacts of the financial vulnerabilities had been severely underestimated resulted in renewed research interest in early warning indicators. In Malaysia, recent property price hikes coupled with a huge demand for property, especially residential property, has raised growing concern on the issue of mounting household debt; the booming property sector represents a vulnerability.. Research conducted by the International Monetary Fund (2012) revealed that a higher level of household debt will result in more severe downturns, and Cecchetti et al (2011) argued that debt has a huge contribution to economic growth, it could bring about an economic slump
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