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One of the most important policy lessons in recent years is that economic stability is no guarantee for financial stability. A country with low inflation, steady growth and a reasonable current account deficit can still experience financial stress. The most costly example of this is what happened in the US in the first decade of the new century. The economic stability during the final years of the Great Moderation masked deep financial fissures that would later lead to the near-collapse of financial systems in many large economies—and subsequently a long recession.
Hyman Minsky had warned in his financial instability hypothesis that a long era of economic stability will, in fact, encourage the sort of excess risk-taking that eventually leads to financial instability. His teaching got a fresh airing after the spectacular events of September 2008 on both sides of the Atlantic Ocean. Regulators in these developed economies had let their guard down. Many years of steady economic growth combined with low inflation had led them to underestimate the risks from poor lending practices, excess leverage and contagion.
The Bank of International Settlements was one of the handful of institutions that came out of the crisis with its reputation intact. It saw the risks building up before most of its peers. And, its subsequent analysis of what went wrong was also effective.
In 2012, its chief economist Claudio Borio argued that it was high time the role of financial cycles was rediscovered by macroeconomists. He put forward four core facts about financial cycles. One, they can be described well in terms of credit growth as well as property prices. Two, financial crises are not necessarily synchronous with business cycles; they have a much lower frequency. Three, the peaks in financial cycles are closely associated with financial crises. Four, they can provide early signals of incipient financial crises.
Much of the recent work on financial cycles has been focused on developed economies. What about India? A new working paper by two Reserve Bank of India economists shows that there is a financial cycle in India as well. Harendra Behera and Saurabh Sharma build their case using quarterly data on credit, equity prices, house prices and the real exchange rate from the first quarter of 1960 to the fourth quarter of 2018.
They have first looked at the cycles in the individual variables, and then combined them to chart out a financial cycle for India. Some of their findings are very similar to what Borio found in his 2012 analysis of developed economies. The length of the Indian financial cycle is greater than the length of the business cycle. The expansionary phase of the financial cycle provides an early warning signal about rising banking stress, as well as an economic slowdown in the future.
There are three other important findings. The financial cycle has become more prominent after the financial liberalisation of the 1990s. The amplitude of the Indian financial cycle is much larger in the expansion phase than in the contraction phase. The role of house prices in the financial cycle has increased since the mid-2000s. The bottomline: India has a financial cycle that stretches over 12 years on an average, compared to the average business cycle of five years.
The renewed interest in financial cycles across the world is welcome, especially since financial markets have only grown in importance. There is an important implicit lesson for policy makers from the recent research showing that financial cycles are not synchronous with business cycles — and have longer average durations. The same policy tools cannot be used to both target inflation, as well as maintain financial stability.
That perhaps explains the growing interest in macroprudential policies to maintain financial stability so that central bankers can use interest rates to manage the real economy. Such macroprudential policies are still largely untested, but the underlying principle is important. Any move to curb financial exuberance using macroprudential tools tends to be unpopular in the financial markets — be it the curbs on bank lending to real estate imposed by RBI under Y.V. Reddy, or the later decision to put weak banks under preventive corrective action during the tenure of Urjit Patel.
The charts in the working paper by the two central bank economists show that the last peak of the Indian financial cycle was in the second quarter of 2008. There have been several ups and downs in the Indian business cycle since then, but the financial cycle has basically been in a trough. The new Financial Stability Report published by the Indian central bank shows early signs of healing in the banking sector, but shadow banks are still struggling because of their exposure to the real estate sector. It has been 12 years since the last peak in the Indian financial cycle, so there is now reason to speculate whether the next uptick is around the corner.