Photo: Pradeep Gaur/Mint
Photo: Pradeep Gaur/Mint

Opinion | It’s time for India to devise a truly ‘leading’ lead indicator

Since financial cycles and term spreads can’t reliably presage business cycle downturns in India, we need an alternative

Much ink has been spilt over Indian data on gross domestic product (GDP) growth in the last few years. Such data, however, has to be seen in the light of its ability to help policymakers assess business cycles and provide them signals to carry out contra-cyclical course corrections that could stabilize output fluctuations.

The critical question in the context of such debates over the country’s national income is: What is a good leading indicator of turning points in business cycles? In particular, can one get a sense of recession risks early enough, so as to enable policymakers and business decision-makers to make an analysis of the economic situation well in advance?

The notion of such leading indicators to predict business cycle peaks and troughs well in advance was advanced by G.H. Moore in 1950. Such lead indicators include variables like average weekly work hours in manufacturing, factory orders for goods, housing permits, new companies registered, stock prices, an index of consumer expectations, average weekly claims for unemployment insurance in advanced economies and interest rate spreads.

Term spreads have been an important leading indicator of recession risk in advanced economies. Thus, when long-term bond yields go below short-term interest rates (inverted yield curves), they are seen to be among the best signals of recessions. Term spreads in India, however, may not be the best (or even the correct) predictors of business cycles.

Thus, paradoxically enough, India has experienced a steepening yield curve since 2018, even as other indicators indicated a cyclical downturn. The steepening yield curve may partly be explained by the Reserve Bank of India (RBI) having lowered its policy rates since January 2019 to encourage borrowing.

The emphasis on financial cycles as impacting business cycles has gone up in the aftermath of the global financial crisis a little over ten years ago. The moot question is: Can financial cycles act as better lead indicators for predicting recession risks than conventional indicators?

A recent paper by Claudio Borio, Mathias Drehmann and Dora Xia (bit.ly/2LSJe5n) studies 16 advanced economies and nine emerging market economies, excluding India, to examine the ability of financial cycle proxies to convey information about recession risks. They find that financial sector proxies, especially for advanced economies, are far better predictors of business cycle turning points than term spread indicators, in that they provide information for a horizon of three years. Emerging market economy results, though similar, are far more vulnerable to data limitations.

A study of financial cycles has greater ramifications for macroeconomic stability for other reasons as well. Research on the nature of financial cycles indicates that they typically tend to be much longer than business cycles. Thus, the average length of a financial cycle has been found to be 15-20 years, as opposed to that of business cycles which may last only up to eight years. And thus, financial and business cycles do not coincide. In fact, a financial cycle can span more than one business cycle. As such, a financial cycle peak can actually usher in a recession, though not all recessions need be preceded by financial cycle peaks.

With most countries following inflationary-focused monetary regimes today, central banks may be lulled into a false sense of security by lower inflation, dropping guard and failing to focus on monetary and credit aggregates that may call for active policy responses to growing financial imbalances.

Also, given the overall depressed growth conditions globally and the scenario of competitive trade wars leading to depressed prices, business cycle downturns may actually be brought on by financial cycle downturns rather than high inflation and tighter monetary policies. In fact, Borio et al find evidence for a shift from inflation-induced to financial-cycle induced recessions in the countries examined.

While there has been a paucity of work on financial cycles in India, a recent working paper by Harendra Behera and Saurabh Sharma (bit.ly/2YHhKDx) uses a set of financial sector variables to analyse and point to the existence of a financial cycle in India as well. Using financial variables including real (non-food) bank credit, credit-to-GDP ratio, real equity prices, real effective exchange rate, and real house prices, Behera and Sharma find that, as in the case of other economies, financial cycles in India are of longer duration, as also more volatile compared to business cycles. Interestingly, however, they find no causal relationship between financial cycles and conventional business cycles, even while there appears to be a strong association between long-term cycles in economic and financial activities.

The inability of financial cycles and term spreads to act as credible leading indicators of conventional business cycles in India makes it critical to come up with an alternative leading indicator for the economy. Such an indicator would need to be a composite index, taking into account both financial sector variables, as also early stage indicators and market expectation-based indicators. The non-availability of time series data of a variety of these economic variables, as also their lack of availability at the desirable frequency, will prove to be the biggest deterrents in arriving at a credible composite index. The government may do well to pay attention to this, rather than quibble over mere GDP numbers.

Tulsi Jayakumar is professor of economics and chairperson, Family Managed Business, at SPJIMR, Mumbai

These are the author’s personal views

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