Priyanka Parashar/Mint
Priyanka Parashar/Mint

De-jargoned: Macroeconomic Vulnerability Index

For economic activity to grow at a healthy pace, it is important that the economy is managed well

Financial markets like macroeconomic stability. If the economy is not well-managed, financial markets react negatively, at times even disproportionately, making economic management a lot more difficult, which can lead to a full blown crisis. In 2013, India was struggling with high inflation and high current account deficit. As a result, when the US Federal Reserve started talking about reducing the quantum of its quantitative easing programme, Indian markets were exposed to volatility, which led to a sharp depreciation in the rupee. However, since then, fundamentals have improved a great deal and macroeconomic indicators now look less vulnerable. Inflation has come down, the current account deficit is under control, and the government has committed itself to a lower fiscal deficit target.

WHAT IS MACROECONOMIC VULNERABILITY INDEX?

Macroeconomic Vulnerability Index, as mentioned in the Mid-Year Economic Analysis 2014-2015, released by Ministry of Finance recently, adds together the rate of inflation, current account deficit and fiscal deficit of a country. The Index value can be compared across countries for different time periods to gauge their relative vulnerability. The ministry has done a comparison of the “fragile five" countries—Brazil, India, Indonesia, South Africa and Turkey.

According to the data, in the beginning of 2013, India was on top of the list with an Index value of 22.4. The current account deficit was at 4.7% of the gross domestic product (GDP), inflation at 10.2% and budget deficit at 7.5% of GDP. For the purpose of comparison, the ministry has taken data from the World Economic Outlook of the International Monetary Fund. Though India’s macroeconomic vulnerability has come down, it still needs to be watchful, noted the mid-year analysis. “India still needs to be watchful in terms of its macro-economic fundamentals. The value of the index currently is well above 15 (recognizing that a value below 12—say 4% inflation, 2% CAD, and 6% fiscal deficit—is perhaps safer macroeconomic territory)," stated the document.

THE IMPORTANCE OF STABILITY

For economic activity to grow at a healthy pace, it is important that the economy is managed well. Differently put, for economic activity to prosper, among other things, it is important that inflation is low, government finances are handled well, imbalances are avoided on the external front, and the financial system is stable. Economic activity is likely to suffer if the economy is vulnerable to internal or external shocks. A problem in one area, if not handled well, can percolate into other areas and lead to a bigger crisis. For example, if the government is running a high budget deficit, it will push demand and can create inflationary pressure. High inflation, among other things, affects competitiveness and higher demand will also lead to higher imports. This will lead to imbalance on external accounts and volatility in the currency market. Uncertainty on the external front can lead to financial instability, which will affect economic activity. Therefore, it is important for policymakers to be watchful and take necessary steps, in time, to avoid extreme consequences.

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