Analysis and Measurement ofFinancial stress and its relevance to Economic Progress in Pakistan

Abstract

The recurring financial crisis fuelled by financial stress, in recent years, have hit the developed as well as developing economies hard. This study aims to develop the financial stress index (FSI) as a composite measure of financial stress in an emerging economy, Pakistan. This research seeks to measure the financial stress and analyses its relevance to economic activity progress in Pakistan. Monthly data for the study were collected from 2005 to 2019 through various sources including the State Bank of Pakistan, Federal Reserve of Economic Database, and Pakistan Bureau of Statistics, Pakistan Stock Exchange. Under the first objective, the study develops a composite index of financial stress incorporating a broad range of financial and macroeconomic factors. These include fragility and volatility in banking financial, capital, and foreign exchange markets; magnitude of internal and external debt, trade finance, money market spread, stock market spread, and credit stress. The index is developed using Principle Component Analysis (PCA) constructed on monthly data covering the time from 2005 to 2019. The constructed FSI imparts useful details about the economy as a whole and the drivers of financial stress in Pakistan. The results indicate that the major source of financial stress in Pakistan is banking sector riskiness; whereas, other factors such as EMPI, external and debt changing money market spread also play a crucial part. The index fits well in identifying major events of stress and their resulting impact on economic progress in Pakistan. Under the second objective, the study aims to carry out the analysis of the nexus between financial stress and economic progress in Pakistan. To attain this objective, the study applies Vector Autoregression (VAR) methodology, impulse response function, and granger causality test to probe the relationship between financial stress and internal and external economic indicators. The internal economic indicator includes GDP, gross fixed capital formation, and industrial production, whereas external economic indicator is foreign trade. The findings reveal a significant relationship between these variables, suggesting the importance of financial stress as one of the key macroeconomic policy input. The study offers some insightful results for the economic managers of Pakistan. First, it constructs the most comprehensive index of financial stress so far in the context of Pakistan. The index coincides well with events of economic progress and downfall. Second, the index identifies the influencing factors that impact economic progress in Pakistan, which are the banking sector’s riskiness, EMPI, external debt and money market spread. This study also helps to unravel crucial factors that affect GDP and other macroeconomic indicators. Further, the findings suggest that these factors be given greater weightage in financial policy and other economic decision-making.