Determinants of financial stress in South Africa

Research paper for the degree of Master of Management in Finance & InvestmentWith a globalised system, the credit crunch of 2007/2008 rippled through the global economy quickly and turned a global financial crisis into a global economic crisis, vulnerabilities in the economy surfaced when it hit and these still continue to plague South Africa today. According to the World Bank, South Africa’s real GDP growth estimates are 0.8% in 2016/2017 and 1.1% in 2017/2018. Increasing uncertainty in global financial markets and banking systems, sharp declines in commodity prices, subdued global trade, currency pressure, as well as domestic constraints such as a current account deficit, a negative inflation outlook and high levels of unemployment, lead to increased financial stress in South Africa making the country more vulnerable in the event of an adverse scenario. Clearly, being cognizant of determinants of financial stress in South Africa is of paramount importance to policy makers as it allows them to assess potential risks to financial system stability and to consider timely and appropriate counteractions while maintaining a financial system that is resilient to systemic shocks. (South African Reserve Bank Financial Stability Review, 2016) This study aims to construct a financial stress index using Principal Component Analysis to identify key determinants of financial stress in South Africa. Several variables that have been identified in standing literature as being able to capture certain symptoms of financial strain in emerging market economies are estimated then aggregated into an index using the principal component analysis method. The usefulness of the index in identifying past crises is then assessed, moreover its performance is contrasted against the financial stress index constructed by South African Reserve Bank as well as against a South African composite business cycle leading indicator. Finally, the ability of the index to predict economic activity is examined.MT201