Making sense of India’s financial cycles

For the first time, an RBI study establishes that India too has financial cycles and that the current cycle reached its trough in 2018.

Published: 10th July 2019 08:19 AM  |   Last Updated: 10th July 2019 08:19 AM   |  A+A-

Finance Ministry

For representational purposes

Express News Service

The Indian financial system may be centuries old, but the RBI belatedly found a startling nugget. That Asia’s third-largest economy, like others, undergoes financial cycles, and that the amplitudes of cycles in financial variables are much larger in the expansion phase than in the contraction phase. For the first time, an RBI working paper titled ‘Does Financial Cycle Exist in India?’ found that India too has financial cycles and that the ongoing downturn in the financial cycle (in India) seems to have reached its trough by the fourth quarter of 2018.

It also concluded that while credit and equity prices drive financial cycles in the country, the contribution of house prices has increased since the mid-2000s. Moreover, expansionary phases of the financial cycle, particularly the peak, provides an early warning signal about rising stress in the banking sector and weakening of future economic activity. The existence of this knowledge just a decade could have prevented the recent build-up of bad loans, which peaked to 11.2 per cent in FY18 from as low as over 2 per cent in FY08. 

Measuring a financial cycle helps share policy, and also doubles up as an early warning indicator to detect exuberance or distress in the system. For instance, just before the 2008 global financial crisis, India saw a period of benign inflation, which could have motivated an accommodative monetary policy.

“The easy monetary policy may have assisted if not contributed to the over-exuberant credit growth, leading to a rise in NPAs in the subsequent years. In this context, measurement of the financial cycle becomes useful when it’s critical to be selective and manage risk actively,” noted the authors Harendra Behera and Saurabh Sharma. The authors examined several financial variables like credit, credit-GDP ratio, equity prices, house prices and exchange rate movements to determine the nature of the financial cycle. 

Interestingly, the average duration of a business cycle in India is about 5 years as against 15 years for the credit cycle in the post-reform period. The length of cycles in the exchange rate is nearly identical to the duration of the business cycle, whereas credit-to-GDP ratio and house prices experience cycles of much longer duration. On the other hand, equity prices exhibited both short and medium-term cycles.

Besides, a rising dominance is found in medium-term cycles in explaining overall variation in credit and equity prices in the post-reform period. However, a weakening of the importance of medium-term cycles in shaping the exchange rate behaviour is observed since the mid-90s. Overall, the core empirical features of the cycles from individual variables suggest there exists a financial cycle in India, which has gradually become prominent with the proliferation of financial liberalisation since the mid-90s. 

“The overall financial cycle of India can be best captured by the joint behaviour of credit, house prices and equity prices wherein credit and equity prices play a significant role. Though house prices aren’t that dominant, their importance in determining the overall financial cycle has increased since the mid-2000s. Overall, we find a longer duration financial cycle with an average length of about 12 years - six years expansion and six years contraction — as against a shorter duration business cycle with the overall average length of about 5 years,” the authors noted. 

The study comes amid an ongoing global debate on financial cycles, though its relevance rose to post the 2008 crisis to explain macro-financial dynamics and predict systemic banking crises. In fact, Japan’s lost decade and other crises in emerging economies during the mid-90s were preceded by either prolonged credit or asset price booms. Consequently, central banks started using financial cycle as a basis for counter-cyclical macro-prudential policies to tame the amplifying effects of financial disruptions.

Globally, it’s found that financial cycles predict recessions much in advance and monitoring them smoothens effects through appropriate policy responses. Contemporary studies in other countries indicated that a financial cycle is typically longer and has a larger amplitude than the business cycle. On the other hand, business cycle recessions are much deeper when they coincide with a contraction in the financial cycle. Therefore, the peak of a financial cycle may be seen as a warning sign. Studies also found that GDP growth tends to be stable during expansion phases in financial cycles, due to the fading out of recession risks. 

Post liberalisation

According to the report, the core empirical features of the cycles suggest there exists a financial cycle in the country and that it has gradually become prominent with the proliferation of financial liberalisation since mid-90s

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