Track These Indicators To Smell Financial Stress, Says RBI Paper

Reserve Bank of India researchers have mapped out the best leading indicators, which can foretell impending financial stress that eventually hits the real economy.

A new working paper titled Measuring Financial Stress In India by Manjusha Senapati and Rajesh Kavediya said indicators can be used to create financial stress indices, which, in turn, can provide guidance on a potential slowdown in the real economy.

“The world over, central banks measure financial stress by constructing the financial stress index to monitor the functioning and resilience of financial system. Such an index provides an aggregate measure of financial stability to the policymakers,” Senapati and Kavediya said in their paper.

Indicators To Watch Out For

The working paper describes 11 market indicators across five categories, which can be used to create financial stress indices.

1) Money Market Sub-Index

The money market sub-index looks at two major indicators. One is the realised volatility in the three-month interbank rate. Banks in India borrow funds from the interbank market using the Mumbai interbank offered rate or Mibor. Any financial stress, the paper said, is likely to first emerge in this segment.

The second indicator is the TED Spread, which is the difference between three-month Mibor and three-month treasury bills rate. The widening of the spread between risky and safe assets reflects the flight to quality, implying a decline in investors’ willingness to hold risky assets. The higher the spread, the higher is the liquidity and counterparty risk in the interbank loan market.

2. Debt Market Sub-Index

The first indicator in the debt market sub-index is the realised volatility in the 10-year government bond yield. It is expected to measure the stress level in the government bond market.

The second indicator looks at the difference between the 10-year Indian government bond yield and 10-year U.S. government bond yield. The yield gap between Indian and foreign government bonds is a key determinant of cross-border arbitrage flows in the bond markets and is often the source of carry trade. But from the perspective of financial stress, elevated domestic yields often imply that global investors have gone into risk-off mode, the paper said.

3. Equity Market Sub-Index

This sub-index consists of two equity market indicators. The indicators include the realised volatility in the Nifty 500 index and the Cmax of Nifty 500.

Cmax compares the current value of an index with its maximum value over the previous year.

4. Banking Sector Sub-Index

This sub-index includes three indicators, including the realised volatility of the Nifty bank index, Cmax of the Nifty bank index and banking sector beta. The banking sector beta measures the correlation of the banking sector’s stock returns to the overall market returns. Higher values of the banking sector beta are associated with larger volatility of banking stocks as compared to market stocks, indicating higher stress in the sector.

5. Foreign Exchange Market Sub-Index

This includes indicators such as the realised volatility of the exchange rate. In times of stress, increasing uncertainties about the exchange rate or investor behaviour can lead to higher volatility. The daily U.S. dollar/Indian rupee exchange rate movement is tracked for this purpose. The second indicator considered for this sub-index is the Cmax of the foreign exchange rate.

Using these five sub-indices and the indicators within them, the paper says that three financial stress indices or FSIs can be created. These can aid policymakers in assessing the eventual hit to real economic activity and even help decide on the level of countercyclical buffers that need to be released in times of crisis.

To better understand the effectiveness of these indicators to point at financial stress, Senapati and Kavediya charted out the movement in the three FSIs between January 2002 and May 2019. The FSIs indicated that the time when they were close to the 90th percentile coincided with a period of financial stress. These periods included the October-December 2008 global financial crisis period, the August-September 2013 taper tantrum and the January 2016 bout of volatility brought on by the RBI’s asset quality review.

“All the three FSIs were found to be negatively correlated with real economic activity (IIP growth) and can be used as a leading indicator for predicting the real economic activity. Also, the regression analysis suggested that the FSIs could be helpful in predicting IIP growth,” Senapati and Kavediya said.