Macroeconomic perspective on constructing financial vulnerability indicator in china

Abstract

This paper attempts to develop a financial vulnerability indicator for China as a barometer for the state of financial vulnerability in the Chinese financial market, possibly for real-time application. Twelve variables from different sectors are utilised to extract a common vulnerability component using a dynamic approximate factor model. Through the implementation of a Markov-switching Bayesian vector autoregression (MSBVAR) model, the empirical results indicate that a high-vulnerability episode is associated with substantially lower economic activity, but a low-vul-nerability episode does not incur substantial changes in economic activity. Notably, the constructed indicator can serve as a real-time early warning system to signify vulnerabilities in the Chinese financial market.