ECONOMIC SLOW-DOWN MAY BE LINKED TO FINANCIAL CYCLE EARLY WARNING SIGNALS ABOUT RISING BANKING STRESS
Business cycles have been in use for long to define certain characteristics of economic performance. But ever since the global financial crisis of 2008, there is the new concept of
financial cycles, which is finding increasing importance globally. The debate about financial cycles has finally reached the shores of India. The Reserve Bank of India has in a working paper attempted to identify the existence of a financial cycle in India and explore whether the current slow-down in the economy is the result of an inclement financial cycle. The overall analysis suggests that there is a well-defined financial cycle in India and its expansionary phases, particularly the peak, provide an early warning signal about rising stress in the banking sector and weakening of economic activity in future. The paper has been authored by key officials of Department of Economic and Policy Research (DEPR) of the RBI. Business cycle can be described as the rise and fall in aggregate economic activity over a period of time and can be measured using real GDP data. Financial cycle, on the other hand, maps out the expansions and contractions in the financial activities. The length and duration of financial cycles are much larger than business cycles. The finer aspects of financial cycles and still emerging and there is no consensus on the definition of a financial cycle. India’s financial sector has witnessed a large overhang of balance sheet stress with gross non-performing assets of banks increasing from 2.3 per cent of total advances in 2007-08 to 11.2 per cent in 2017-18. A few nonbanking financial companies have also started defaulting on their loan repayments since August 2018. During the same period, economic activity has been subdued with GDP growth slowing down from 7.7 per cent to 6.8 per cent. It is the coexistence of financial sector stress along with economic slowdown that has prompted the attempt to explore the existence of a financial
cycle. The relevance of financial cycle analysis has increased in the post global financial crisis (GFC) period. Studies have found a deeper recession when the downturn of financial cycle is associated with that of the business cycle. Consequently, central banks, mainly in the advanced countries, have started using financial cycle as a basis for counter-cyclical ‘macroprudential’ policies to tame the amplifying effects of financial disruptions on the overall economy.
Analysis of the factors that determine financial cycles has provided evidence of the existence of a financial cycle in India, particularly in the post-1991 period. Key determinants in this include credit, credit-GDP ratio, equity prices, house prices and exchange rate. The aggregate measure of financial cycle can be useful for several policy purposes, particularly as an early warning indicator for detecting exuberance or distress in the financial system. It is often found that business cycle recessions are much deeper when they coincide with the contraction phases of financial cycle and, therefore, the peak of financial cycle may be seen as a warning sign for financial crisis or distress in the economy. It is assumed that the average duration of financial cycle is much longer than that of business cycle. The longer duration cycle being more persistent and having greater amplitudes could disrupt the structure of financial system immensely. In case it propagates to the business cycle frequency, it can increase the cost of output stabilisation. Additionally, the financial cycle seems to be more volatile than business cycle. On an average, the volatility of financial cycle has been found to be almost 1.5 times larger than that of the business cycle. According to the paper, during 2002-2007 and 2011-2018 there were
periodic co-movements between business and financial cycles. The average duration of business cycle in India has been found to be of about 5 years as compared to 15 years for credit cycle in the post-reform period. The length of cycles in exchange rate is nearly identical to the duration of business cycle whereas credit-toGDP ratio and house prices experience cycles of much longer duration. According to the paper, 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 the most significant role. Though house prices do not play a significant role, their importance in determining overall financial cycle has increased since mid-2000s. Overall, the duration of financial cycle has been seen to be longer, with the average length of about 12 years, including 6 years of expansion and 6 years of contraction, vis-à-vis a shorter duration business cycle with the overall average length of about 5 years. The analysis suggests that the peak of the financial cycle provides some lead information about impending distress in the economy. And it recommends that policies be designed to dampen financial cycle. A close monitoring of financial cycle on a regular interval is essential to enhance macroeconomic and financial stability, it adds.