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Appendix to An Analysis of the Financial Crisis Index

Three hypothetical countries; X, Y, and Z have been selected for analysis. They have been assigned a Financial Crisis Index for each year, and for the purpose of this report only the years 1994 to 2003, which is a representation of the years prior to and following the 1997-1998 Asian Financial Crisis, have been analysed.

The index used has a base of 100 (Financial Training Company, 2005), with lower values indicating a decreased risk of a financial crisis, and higher values indicating the threat of a financial or currency crisis has increased.

The data given was presented in a format where the values of the determinants had been multiplied by 1,000 in an attempt to standardize the data. This data was entered into an Excel spreadsheet and functions were used to convert the values to natural logarithms for ease of visually representing the data. The values were also averaged, using the geometric mean because it is the most appropriate tool for measuring average rates of growth (University of Leicester, 2000). Annex E presents the data given, and Annex D presents the data given converted to natural logarithms along with the geometric means for the three countries. The data is displayed in a bar chart, which gives the reader a visual representation of the geometrically averaged values of the analysed countries.

Country Z has consistently had the highest Financial Crisis Index, which reveals it to be at a greater risk of entering into a financial or currency crisis. The fact that the index is steadily inching its way upwards is also a cause for concern because it reveals the country does not appear to be making any progress in correcting any inherent weaknesses within its economy. Country Y has the lowest Financial Crisis Index, but it too is steadily inching upwards, and if steps are not taken to contain the inefficiencies within the system, there could be a problem in the future.

The determinants used as variables composing the Financial Crisis Index are: the real exchange rate (RER); the annual reserve money as a percentage of gross domestic product (ARM); the current account balance as a percentage of gross domestic product (CAB); the annual percentage change in terms of trade (TOT); and the ratio of money supply to official foreign exchange reserves (M2R). These determinants combined together to form the basis of the Financial Crisis Index, is used as a very broad benchmark to determine trends in how well the analysed countries will potentially be able to deal with any adverse changes to their financial infrastructure. The Financial Crisis Index does not, however, reveal the specifics of why the analysed countries have performed in the manner they have because it leaves out the fine details that might be apparent in more complex analytical systems (University of Leicester, 2000).

A correlation matrix for each analysed country can be found in Annex A to Annex C, which was constructed using an Excel spreadsheet and the appropriate correlation function. The correlation matrix gives a numerical value from –1 to +1 to show how the data collected for each determinant affect each other. If one determinant has a negative correlation coefficient to another determinant then these to determinants are said to be inversely proportional to each other. If the determinant has a positive correlation coefficient to another determinant then these two determinants are said to be directly proportional to each other. If the correlation coefficient between the two variables is zero, this indicates the two variables work independently of each other (Watsham & Parramore, 1997). It is important to note that there are no variables within the correlation matrixes for the three countries analysed that have a zero-rating, and this indicates that all of the determinants used to define the Financial Crisis Index are interdependent on each other. That means that if one determinant changes, the other four determinants are also like to change as a consequence.

The coefficients used in the correlation matrix were the Financial Crisis Index and the five determinants, which have been compared to the Financial Crisis Index and then to each other.

Broadly speaking, the real exchange rate (RER) is inversely proportional to the Financial Crisis Index. If the exchange rate of a currency falls, it is said to be weakened, and as a result the government may have difficulties importing goods or paying its external debt requirements. If the exchange rate of a currency is too high, a country will have difficulty exporting its goods and services. Generally speaking, if a currency is too high then a country will sell its currency on the foreign exchange market to force the exchange rate down. If a currency is too low then a country will purchase the currency to bring its value back up (Lumby & Jones, 2003). In all three countries examined, the exchange rate has remained fairly constant, with Country Z making a notable increase in 2003.

The annual reserve money as a percentage of gross domestic product (ARM) is inversely proportional to the Financial Crisis Index. A high annual reserve increases the money supply and ensures that an economy has the ability to pay its external debt obligations. Therefore, if the annual reserve decreases then the Financial Crisis Index is likely to increase as well. In all three countries examined, the annual reserve money as a percentage has steadily increased through the years, which in principal, is a good sign.

The current account balance as a percentage of gross domestic product (CAB) is a reflection of an economy’s net foreign assets, and generally speaking, is directly proportional to the Financial Crisis Index. If the current account balance as a percentage of gross domestic product is high then the economy will be in a better position to readily meet its foreign debt obligations. In all three countries examined, the current account balance as a percentage of gross domestic product has increased.

The annual percentage change in terms of trade (TOT) is generally inversely proportional to the Financial Crisis Index. If trade decreased then the treat of a financial or currency crisis is likely to increase. It is important, therefore, to have a steady level of trade to ensure an economy’s financial stability. Of the countries analysed, Y and Z have made steadily increased each year, with the Financial Crisis Index slightly increasing.

The ratio of the money supply to the official foreign exchange reserves (M2R) is directly proportional to the Financial Crisis Index. Therefore, if this determinant increases, the Financial Crisis Index is likely to increase as well. In all three countries examined, the ratio of money supply to the official foreign exchange reserves has slightly increased, and the Financial Crisis Index for all three countries has slightly increased as well.

The Financial Crisis Index for all three countries has been regressed and the years from 1994 to 2003 have been examined. The charts for these regressions can be found in Annex A to C for Country X to Z. The regressions show that all of the variables used have varied slightly to bring about small changes in the Financial Crisis Index. Nevertheless, the Financial Crisis Index has remained relatively stable over the ten year period examined. Country X has increased by .7 points, Country Y has increased by 1.6 points, and Country Z has increased by 7.2 points.

In conclusion, although the Financial Crisis Index for all three countries has remained stable, they have nevertheless increase, and this should be seen as a warning sign that there may be inherent weaknesses in the financial structures of the examined countries.

Because Country Z has had the most significant increase of 7.2 points, it would do well if this country would endeavour to use some of the tools available to it to make the economy more efficient. One thing that Country Z could do to improve their Financial Crisis Index rating is to slightly raise their interest rates, which would encourage foreign investment along with constricting their own money supply and reducing inflation. The country may also want to use open market operations (OMO) to influence their money supply, which will have an impact on the Financial Crisis Index. It could purchase securities to expand its reserves, and this will have the effect of reducing the money supply to foreign reserve ratio (M2R), which will hopefully serve to decrease the Financial Crisis Index.

It is important to note, however, that the five determinants examined are all interrelated to each other, as evidenced by the correlation matrixes presented in Annex A to C. Therefore, if any one variable in the financial equation is manipulated then the other four variables are also very likely to be affected by the degree shown by their appropriate correlation coefficients. It is important, therefore, to seriously consider the overall impact of any methods used to manipulate the economy. It is also important to remember that any attempts to manipulate the economy are not likely to change overnight, but will usually take several months or years to see noticeable results (University of Leicester, 2006).

References

The Central Intelligence Agency (2006)
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The Financial Training Company (2005). Unit 7: Preparing Reports and Returns, FTC Foulks Lynch Ltd: Wokingham, England

Harvey, A (2003). Excel 2002 All-In-One Desk Reference For Dummies, Wiley Publishing: New York, USA

Hertz, N (2004). I.O.U. The Debt Threat And Why We Must Defuse It, Harper Collins: London, England

Lumby, S. and Jones, C. (2003). Corporate Finance: Theory and Practice, Thomson: London, England

Nanto, D. (1998). The 199-98 Asian Financial Crisis.
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Watsham, J. and Parramore K. (1997). Quantitative Methods in Finance, Thomson: London, England

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URL://http//www.wikipedia.org
[26 December 2006]