Measuring the instability of China's financial system: Indices construction and an early warning system

In this paper, employing several econometric techniques, the authors construct a financial stress index (CNFSI) and a financial conditions index (CNFCI) to measure the instability of China's financial system. The indices are based on the monthly data collected from China's inter-bank markets, stock markets, foreign exchange markets and debt markets. Using these two indices, the authors identify the episodes of systemic financial stress, and then evaluate the indices. The empirical results suggest that the CNFSI performs better than the CNFCI. Furthermore, the authors propose four leading indicators for monitoring China's financial instability, and provide a primary early warning system for China's macroprudential regulations. Finally, they conduct a test to evaluate the predictive power of the CNFSI and the early warning system with reference to the 2015 episode. Their results suggest that both work well.