The TEPAV Financial Stress Index was designed to predicate the risk of economic contraction before GDP figures are released.

Last week I talked about a new index TEPAV developed. The TEPAV Financial Stress Index aims to predicate the risk of economic contraction before GDP figures are released. The Index cannot foresee each and every incidence of economic contraction, though. It is indicative of the risk of contraction on the basis of financial factors.

The variables that compose the index were selected among a large number of candidates, on the basis of two criteria: At what accuracy does the candidate variable predicates the episodes of economic contraction? At which frequency is the data on the candidate variable released – with certain delay or not? In addition to these selection criteria one other factor was taken into consideration: assume that the index signaled economic contraction but when actual GDP figures were released it was seen that the economy did not shrink. This obviously is not a desirable feature for a leading indicator. Hence, the possibility of eliminating such “false signals” were also taken into account when selecting index variables.

On the basis of these considerations, three variables were selected: foreign trade deficit to FX reserve ratio; exchange rate volatility; and emerging markets bond index (EMBI). As can be noted, all variables that compose the index are important for the volume of economic activity. Evidently, it can be questioned why other important variables such as credit growth rate or risk premium were not selected. There are two basic reasons. First, index variables are selected upon a technical method, which is explained by the authors in a policy note available at TEPAV’s website. The method in a way identifies the most and least suitable variables.

The second reason is about the economy rather than technique. As can be noted, there is a close relationship between the variables that are involved and that can be proposed to be involved. The Index as it is to a large extent is able to represent the changes in the proposed variables. Let me exemplify the case here.

Savings rate is considerably low in Turkey, which needs international savings even to achieve moderate growth rates. The EMBI variable involved in the index is an indicator of the extent to which the changes in global risk appetite induced by international circumstances affects emerging market economies. The mentioned changes in global risk appetite affect Turkey as well even if the domestic economy is sound and strong. This is why the EMBI is among the index components.

The importance of exchange rate volatility for Turkey is self-evident from the new monetary policy framework. The Central Bank is doing its utmost to minimize the volatility of exchange rate. A chief reason is that the corporate sector and partly the banking sector have FX debts substantially higher than FX receivables. Exchange rate volatility, giving way to fluctuations in balance sheets and cash flows, makes it harder to take prospective decisions. I think it is evident why trade deficit to FX reserve ratio was involved. Consequently, any rise in EMBI, exchange rate volatility and trade deficit to FX reserve ratio indicates that financial stress and thus the risk of economic contraction have been rising. There is one more point that I want to stress. We are not the “slaves” of technical methods and indices. The variables and/or their weights in the index composition can be changed anytime in line with the circumstances, after giving notice to users of course. This way you can have a more flexible index.

This commentary was published in Radikal daily on 30.04.2013