Developing a Financial Stress Index for Pakistan

Abstract

This paper develops a financial stress index for the Pakistan economy covering the post-reform period. We use time series data for the period 1993M1-2016M12 and employ principal component analysis to aggregate various components of financial markets, real economic activity, and political risk in a single financial stress index. The computed index successfully explains the known periods of financial stress in Pakistan. It stresses upon the political and economic risks as important contributors of financial stress along with financial market factors. This composite index assesses the stability of the financial system, which is a public policy concern in most emerging economies. Thus, we believe that it can serve as an important benchmark to describe the systemic risk in the financial system.