Since the 2008 global financial crisis, major advanced countries have been active in conducting studies to enhance their financial conditions indexes (FCI), among the representative indexes for financial condition assessment, in efforts to understand the changes in financial conditions more accurately. On the judgment that the previous FCIs using only a few financial variables do not accurately show the overall conditions of complex and diverse financial markets, these studies have focused on an index development by extracting information on financial conditions from various financial variables. In this study, we apply the FCI calculation method used recently by major central banks in order to develop a monthly FCI for Korea and then evaluate its usefulness.

  First, after selecting 50 Korean financial variables and setting up an unbalanced panel using monthly time-series data on these variables for the period of 1990 to the present, we develop a monthly FCI by applying the
principal component approach used in Hatzius et al. (2010). For some financial variables whose most recent data are difficult to obtain, predictive values calculated by a dynamic factor model are used to ensure the maximum
timeliness of the index. Korea’s FCI calculated through this process is seen to be excellent in explaining past financial conditions and predicting macroeconomic variables. Overall, the FCI successfully identifies starting points
of past financial events, including the 1997 currency crisis, the 2008 global financial crisis as well as the credit card crisis of 2003. Moreover, the predictive power of a model that includes the FCI as an explanatory variable is
seen to be greater than that of an auto-regressive model or one that includes individual financial variables.

  Meanwhile, the FCI developed in this study also shows that recent Korean financial conditions have eased slightly, and that this has been greatly affected by the Base Rate being maintained at a low level. When this Base Rate effect is counted out, the FCI is estimated to have shown negative numbers since the global financial crisis.

  In this regard, Korea’s monthly FCI introduced in this study can be effective for assessing financial conditions and predicting the real economy, and is seen useful as an information index in the implementation of monetary policy.