Constructing a Financial Condition Index for a Small-Open Economy: The Case of Malta

Abstract

This paper develops a Financial Conditions Index (FCI) for Malta for the period 1996-2017. This index provides a summary measure of financial conditions by combining several financial variables, both domestic and foreign, that influence economic activity. The indicators in the FCI are grouped in four categories: interest rates, bank balance sheet, asset prices and external variables. The weights are derived using Principal Component Analysis (PCA) and cross-checked using simulations from STREAM, the Central Bank of Malta’s macro-econometric model. Financial conditions in Malta were relatively benign in the mid-to-late 90s, followed by a period of tightening in the early 2000s. Financial conditions improved again during the pre-crisis period but deteriorated during the financial crisis and remained tight until 2013. In recent years these have recovered and became broadly neutral by 2017. The proposed FCIs correlate the most with one to three quarters ahead real GDP growth, suggesting potential predictive capacity for short-term forecasting.