Asia Regional Integration Center

C-Y. Park and R. Mercado Jr. 2014. Determinants of Financial Stress in Emerging Market Economies. Journal of Banking and Finance 45, 199-224

Methodology

The FSI for each economy is computed using measures for 4 major financial sectors with the equation presented as follows:

1. Banking Sector
   β =

   cov(r,m)

   /

   var(m)

   Where r and m are the returns to the banking sector stock price index and the overall stock price index, respectively. The higher the banking sector β, the higher the greater the banking sector’s stress.

2. Equity Market Returns
   γ_t = ln(γ_t) − ln(γ_t-1)

   Where γ_t is the current period’s equity return and γ_(t-1) is the previous period’s equity returns.

3. Equity Market Volatility

   The volatility follows a GARCH (1,1) process and is given by:

   σ²_t = ω + φ₁ ε²_t−1 + φ₂ σ²_t−1

   Where σ² refers to the variance, and ε the error term in the regression is given by:

   γ_t = α_i,t + βγ_t−1 + ε_i,t

   Where γ_t is the current period’s equity return and γ_t−1 is the previous period’s equity returns.

4. Debt Markets

   Sovereign debt spreads are used to measure sovereign debt stress. Data refers to yield differentials between long-term (10-year) local government bonds and short-term (2-year) local government bonds with available data.

5. Foreign Exchange Market
   EMPI_i,t =

   (Δe_i,t − μ_i,Δe)

   /

   σ_i,Δe

   −

   (ΔRES_i,t − μ_i,ΔRES)

   /

   σ_i,ΔRES

   Where Δe and ΔRES denote month-on-month percent changes in the foreign exchange rate of local currency per US dollar and foreign exchange reserves; while σ and μ are standard deviation and mean, respectively. The exchange market pressure index (EMPI) captures the depreciation of the local currency with respect to the US dollar and the reduction in foreign exchange reserves.