Recalibrating from Divergence to Convergence: The Indian
Experience1
Good morning to you all!
In the Indian tradition, Namaskar, which means I salute the divinity in you.
It is always fulfilling to be here at the Annual Central Banking Seminar of
the Federal Reserve Bank of New York. Over the years the seminar has
become a landmark forum for the intermingling and cross-fertilisation of
ideas and experiences among central bankers from all over the world. It
is no wonder, therefore, that it has come to be regarded as a favoured
stamping ground where practitioners of the profession rub shoulders and
learn from each other about the 'soiling of the hands' in topically relevant
issues in central banking.
I am grateful to Dr. Narahari Phatak, Head of International Policy and
Strategy at the New York Fed - Hari - for inviting me to this year's seminar.
When Hari reached out to me in July, the world was characterised by
considerable differentiation in the macroeconomic pathways being
charted in different jurisdictions. Hence the defining feature of the conduct
of monetary policy by central banks at that time was divergence,
motivating the choice of the theme of this year's seminar. Since then,
however, much water has flown underneath the bridge and the world has
changed in fundamental ways. After the US Federal Open Market
Committee (FOMC) began its rate cutting cycle aggressively on
September 18th this year, preceded by the second rate cut of the year by
the European Central Bank (ECB) and followed by a fusillade of stimulus
measures by China, convergence has become the dominant theme,
barring some holdouts as in Japan, Brazil and Russia. Hence, I chose
"Recalibrating from Divergence to Convergence" as the theme of my
address under which I propose to share with you some aspects of the
Indian experience (please see the Annex for relevant charts and tables).
II. Shock and Awe
The world is awash in an ocean of uncertainty, whipped up by hurricanes
in the form of geopolitical conflict, geoeconomic fragmentation, financial
market volatility, and overall policy uncertainty, including political spillovers
during the Great Election year when more than half of the world's
population faces the ballot box. Financial markets continue to front run
and second guess central banks on the size and timing of policy pivots
and their consequences.
Frenzy rose to a flash point on August 5th following the rate hike by the
Bank of Japan on July 31st and the release of US non-farm payrolls data
on August 2nd. A blood bath reminiscent of Black Monday of 1987 was
unleashed across financial markets worldwide as Yen carry trade
unwound. The fear gauge - the CBOE2 Volatility Index or VIX - jumped
more than 50 per cent, to its highest level since 2020.
Once again, on a single data release on September 3rd - the US Institute
of Supply Management (US ISM) manufacturing index - recessionary
fears resurfaced, setting off a rout in US equity markets that quickly spread
to Asia and Europe. Thus, markets are recalibrating - albeit in a disorderly
manner - from divergence to convergence. Every incoming data seems
to be dispelling the gathering good feeling of soft landing and sparking
fears of a jarring end to disinflationary monetary policy. Overall, however,
markets have demonstrated substantial resilience. The speed of recovery
from the shocks I described has been remarkable. Magnitudes of
exchange rate changes were not outsized compared to past episodes. It
is estimated that about half or US$ 250 billion of Yen carry trade was
unwound3. Leveraged positions have been rebuilt. Risk taking has
resumed, although the widening of the conflict in the Middle East in
October has depressed equity market sentiment and pushed up
commodity prices, especially of gold and crude oil.
III. Assessing Global Risks:
III.1. Geopolitical Stress, Trade and Overall Policy
Uncertainty
In the Reserve Bank of India, we closely monitor global risks through: (1)
the Geopolitical Risk (GPR) Index4, which tracks adverse geopolitical
events through newspaper articles; (2) the Trade Policy Uncertainty (TPU)
Index5, which covers the frequency of articles mentioning trade policy
uncertainty and heightened trade tensions; and (3) the Global Economic
Policy Uncertainty (GEPU) Index, which is a GDP-weighted average of
national EPU indices for 21 countries representing about 71 per cent of
global output on a PPP-adjusted basis and roughly 80 per cent at market
exchange rates6. The GEPU Index gauges the impact of policy-related
uncertainty on global economic activity.
These indices7 collectively provide insights into how uncertainty stemming
from trade, geopolitical events and economic policy measures can
influence economic conditions globally which can potentially spillover to
influence macroeconomic and financial conditions in India.
As of mid-2024, the GEPU Index remains elevated, reflecting ongoing
concerns about economic policies worldwide. The TPU Index has also
been rising since November 2023, particularly influenced by trade
tensions and policy changes among major economies. Meanwhile, the
GPR Index points to significant global risks, with recent increases driven
by ongoing conflicts.
Tensions in the Middle East have disrupted trade through one of the
critical shipping routes - the Suez Canal (shortest shipping route between
Europe and Asia). About 15 per cent of global maritime trade volume
normally passes through the Suez Canal. Instead, several shipping
companies have diverted their ships around the Cape of Good Hope,
which has increased delivery times by 10 days or more, on average.
These disruptions have also led to higher freight rates across major
shipping routes, such as the China-Europe and China-US West Coast,
which have gone up by 3 times over their pre-pandemic levels.
III.2. Global Financial Conditions
The global financial conditions index (GFCI) represents the cost and
availability of credit in the global financial system8. The GFCI captures the
co-movement of common latent factors in credit spreads, asset prices and
volatility across money, bond, and equity markets - they tend to move in
tandem during stress periods.
The GFCI vividly captures the tight financial conditions witnessed during
the global financial crisis of 2008-09, the Eurozone debt crisis during
2011-12 and the recent experience during the COVID-19 pandemic.
Interestingly, unlike previous episodes, tighter financial conditions during
the COVID-19 Pandemic and the Russia-Ukraine War were reversed
quickly, reflecting synchronous monetary policy actions.
III.3. Financial Market Spillovers
Global spillovers are typically transmitted to India through the financial
market channel, mainly in equity and currency segments. Hence, volatility
spillovers in these market segments are tracked through time-varying
indices constructed by using high-frequency data on 21 major equity
markets and 22 major currencies (measured against the US dollar), based
on the Diebold-Yilmaz connectedness approach (2009; 2012)9. The path
of the indices is shown by the thick lines (i.e., median) while the shaded
region around the indices represents the range of spillovers across
8
The index is constructed as a Z-score, such that a positive value represents tranquil
times underlined by easy financial conditions i.e., low cost and easy availability of
funding, while a negative value indicates tight financial conditions.
9
Diebold, F. X., and Yilmaz, K. (2009). Measuring financial asset return and volatility
spillovers, with application to global equity markets. The Economic Journal, 119 (534),
158-171.
- Diebold, F. X., and Yilmaz, K. (2012). Better to give than to receive: Predictive
directional measurement of volatility spillovers. International Journal of
forecasting, 28(1), 57-66.
markets. For instance, global volatility spillovers across both equity and
currency market segments reached unprecedented highs during 2020 as
the COVID-19 pandemic unfolded across the world; and again from 2022
with the Russia-Ukraine war.
IV. Implications for India
IV.1. Economic Policy Uncertainty
Drawing on these global indices, a novel text mining-based policy
uncertainty index for India has been constructed and updated by
economists in the Reserve Bank of India. The index uses internet search
data from Google Trends to construct a measure of policy uncertainty due
to both domestic and global events. The index is updated in real time10.
Applying a one standard deviation shock to the index in a structural vector
autoregression (SVAR) framework on quarterly data for India produces an
interesting result. In the case of advanced economies such as the US,
research suggests that uncertainty shocks lead to lower output and lower
prices11. In the Indian context, however, uncertainty shocks tend to mimic
aggregate supply shocks such that heightened uncertainty leads to slower
growth but higher inflation. These results have been confirmed by multiple
studies using different measures and identification approaches12. This
10
When faced with heightened uncertainty, it is typical of economic agents to 'search'
for more information. The Google Trends-based uncertainty index (India-GUI)
leverages this behaviour to measure overall uncertainty by using internet search
volumes for a list of keywords pertaining to fiscal, monetary and trade policy in India.
The policy-related keywords are curated, based on mentions in central bank policy
statements as well as coverage in the financial press. For more details, please see
Pratap, B., and Priyaranjan, N. (2023). Macroeconomic Effects of Uncertainty: a
Google trends-based Analysis for India. Empirical Economics, 65(4), 1599-1625.
11
Leduc, S., and Liu, Z. (2016). Uncertainty Shocks are Aggregate Demand Shocks.
Journal of Monetary Economics, 82, 20-35; Kumar, A., Mallick, S., and Sinha, A.
(2021). Is Uncertainty the Same Everywhere? Advanced versus Emerging Economies.
Economic Modelling, 101, 105524.
12
Pratap, B., and Priyaranjan, N. (2023), op cit.
presents a dilemma for monetary policy: tighten to control high inflation or
ease to respond to lower growth!
IV.2. Supply Chain Pressures
The Global Supply Chain Pressure Index (GSCPI), developed by the
Federal Reserve Bank of New York integrating over 27 variables, has also
been found relevant for Indian conditions. We have developed an Index
of Supply Chain Pressures for India (ISPI) - based on the methodology
used in the GSCPI - to track supply chain pressures impacting India by
extracting common factors from 19 domestic and global variables. The
ISPI efficiently predicts industrial production and GDP and serves as a
lead indicator for export volumes and inflation - Supply chain pressures
impact growth in industrial production and core inflation with lags.
After witnessing significant spikes in the post-pandemic and post-Ukraine
war periods, both global and domestic supply chain pressures have
hovered around normal or less than normal levels since early 2023. Their
relative softness has played a key role in the ebbing of inflation both
globally and in India.
IV.3. Geoeconomic Fragmentation and Trade Flows
Global uncertainty also impinges on world trade volume growth. Growth
in India's merchandise exports and imports volume has been negatively
impacted during episodes of rising geopolitical risk, especially since the
start of the Russia-Ukraine war in February 2022 and the rise of Middle
East tensions since October 2023. India's merchandise exports, on an
average, recorded a negative growth of 1.4 per cent during 2023-25 (up
to September 2024).
IV.4. Capital Flows at Risk Analysis
Amidst global uncertainties, capital flows to India have been relatively
robust, driven by equity flows. With the inclusion of Indian government
bonds in global bond indices, debt flows have also improved.
The capital flows at risk (CaR) approach is a useful indicator to gauge the
magnitude of expected capital outflows in response to specific shocks13.
The kernel density function or distribution of capital flows over time in
response to push and pull factors shows that in normal times, the chances
of capital flight from India are negligible in view of strong pull factors. A
shock to the US CBOE VIX mimicing the global financial crises makes the
distribution of capital flows flatter and increases the tails of the distribution.
This indicates higher probability of capital outflows in the occurrence of
high intensity tail risk events such as the GFC.
The estimated tail risks (CaR at 5 per cent) to capital flows in case of India
are found to be high and they match with the actual capital outflows during
the GFC and the taper tantrum periods. This analysis helps us to make a
realistic assessment of the adequacy of reserves.
IV.5. Financial Market Volatility Spillovers and Spillbacks
Time-varying measures of net volatility spillovers to Indian equity and
currency markets from the rest of the world show that on a net basis, as
with any other emerging market economy, India tends to be at the
receiving end of global risk externalities14. These spillovers became
heightened in the aftermath of the COVID-19 pandemic and the breakout
of the Russia-Ukraine war. More recently, divergent monetary policies
have produced less severe spillovers to equity markets, but they remained
significant in the currency market. Instances of "spillbacks" - India
transmitting volatility to the rest of the world - remain rare.
IV.6. Global Events and Financial System Stress
We also compile a financial system stress indicator (FSSI) to monitor the
aggregate stress level in the Indian financial system. The FSSI features
risk factors pertaining to five financial market segments - equity; foreign
exchange; money; government debt; and corporate debt markets - and
three groups of financial intermediary segments - banks; non-bank
financial companies (NBFCs); and mutual funds15. It also features a real
sector component encompassing real variables that have a bearing on
financial stability due to their strong interlinkages with the financial sector.
In all, 39 risk factors spread across nine markets/sectors are considered.
The FSSI aims to (a) identify periods of stress; (b) assess the intensity
14
While negative values of the measure indicate that India "receives" spillovers from
the rest of the world; positive values highlight that India "transmits" volatility to the rest
of the world. Please refer to Gupta, R. K., Pratap B., Raut S., and Sonna, T. (2024).
Measuring Inter-Connectedness between Global Financial Markets: A Study for India.
RBI Monthly Bulletin, Reserve Bank of India (forthcoming).
15
Risk factors are normalised by the min-max method by converting into variables
which are unit free AND measured on an ordinal scale between zero and unity. The
transformed risk factors for each market/sector are aggregated BY using equal
weights into a sub-indicator 'yi' representing the ith market/ sector. The composite FSSI
is computed by aggregating the sub-indicators, again based on the equal variance
weighted average method, where the weight 'wi ' of each sub-indicator 'yi ' is inversely
proportional to its sample standard deviation 'si' and is determined as
1
ssss 9
= . The composite FSSI is obtained as = ∑ . Higher valueS of
wwii FFFFFFFFtt ii=1 wwiiyyiitt
9
∑ 1
ss=1
ssss
FSSI indicates more stress [See Box 1.1: Financial System Stress Indicator, Financial
Stability Report, December 2022, RBI for details].
and duration of stress in the financial system; and (c) gauge the ability of
financial markets and intermediaries to withstand shocks and imbalances.
The FSSI has tracked major stress events in the past. As per the latest
FSSI update, India has witnessed a consistent decline in financial system
stress since the Russia-Ukraine conflict.
V. Outlook for India
V.1. Growth
Against this backdrop, let me turn to the outlook for the Indian economy.
We believe that the best defence against global risks is to strengthen the
macroeconomic fundamentals and build adequate buffers, supported by
prudent macroeconomic policies.
As Victor Hugo, the celebrated French writer, famously said: there is
nothing more powerful than an idea whose time has come. Taking a cue
from that influential remark, I do believe with all the strength of my
conviction that India's time has come. India heads into its future with the
youngest population in the world with a median age of 28 years. Unlike in
many parts of the world, the working age population is growing - every
sixth working age person is an Indian. Since independence in 1947,
India's growth path has undergone three structural shifts with trend
growth, having risen to 7 per cent during 2002-2019. After the severe
contraction in the pandemic, a new growth trajectory averaging 8 per cent
seems to be forming during 2021-24. India is now regarded as the fastest
growing major economy in the world. Already the fifth largest economy in
terms of market exchange rates, it is poised to become the third largest
economy by 2030.
It is already the third largest economy in terms of purchasing power parity.
Our projections show that India's real GDP growth will be 7.2 per cent in
2024-25 and around 7.0 per cent in 2025-26 in a cyclical correction to the
rebound from the pandemic. Thereafter, there is a strong likelihood that
India's growth will revert to the 8 per cent trend.
V.2. Inflation
Since 2016, India has adopted flexible inflation targeting (FIT) as its
monetary policy framework. The inflation target is set at 4 per cent in terms
of consumer price index (CPI) headline inflation with a tolerance band of
+/- 2 per cent around it. In the aftermath of the war in Ukraine, inflation
rose to a peak of 7.8 per cent in April 2022. Frontloaded monetary policy
tightening with a cumulative 250 bps increase in the policy rate and a
stance of withdrawal of accommodation guided inflation down to an
average of 5.4 per cent in 2023-24, i.e., back into the tolerance band. It is
projected to average 4.5 per cent in 2024-25 and 4.1 per cent in 2025-26.
Inflation fell below target during July-August but rose to 5.5 per cent in
September on the back of a pickup in price momentum in some food items
and adverse base effects inherent in year-on-year measurement. Our
projection indicates that these price pressures will persist in October and
November before headline inflation realigns with the target from
December 2024 and remains aligned in 2025-26.
V.3. Improving Financial Soundness and Buffers
Since 2018, India has engaged intensely in fortifying the soundness of
financial institutions and building up adequate capital and liquidity buffers.
Through a variety of processes including recognition, restructuring,
resolution and write-offs, impairment in banks' balance sheets has been
brought down. Gross non-performing assets were just 2.7 per cent of total
assets at the end of June 2024. Adjusted for provisions, the net non-
performing asset ratio was only 0.6 per cent. As against the Basel
minimum capital adequacy ratio of 8 per cent, India applies a minimum
ratio of 9 per cent with a minimum of 7 per cent for Tier I capital. A capital
conservation buffer of 2.5 per cent has to be maintained in addition to the
minimum capital requirement, taking the overall regulatory capital
requirement to 11.5 per cent of total risk weighted assets. At the end of
June 2024, banks in India maintained a capital ratio of 16.7 per cent with
Tier I capital of 13.9 per cent. Other buffers include the liquidity coverage
ratio, which is well above 100 per cent, and the provision coverage ratio
which is close to 80 per cent. Macro stress test reveals that no bank in
India will fall below the regulatory minimum capital even under a severe
stress scenario.
V.4 External Sector Indicators
Since the external sector receives the first blow from global spillovers, the
policy endeavour has been to build up external sector soundness. The
current account deficit (CAD) is modest at around 1 per cent of GDP. India
has been a recipient of capital inflows, drawn by its robust macroeconomic
fundamentals and stability. Hence external financing requirements are
comfortably met. India has utilised the opportunity provided by strong
international investors' interest to build up foreign exchange reserves.
Currently, as the fourth largest reserve holding country in the world, India's
reserves cover entirely the level of external debt, comfortably cover all
debt servicing requirements and are equivalent or close to 12 months of
imports. India's exchange rate is among the least volatile in the world. We
intervene in the foreign exchange market on both sides - sell and buy -
to ensure adequate liquidity and minimise volatility so as to preserve
financial stability, but without any view on the level of the exchange rate.
VI. Conclusion
In conclusion, I will briefly address some recent opportunities that have
opened in the Indian context. India is emerging as a world leader in
leveraging digital technologies for transformative change. The trinity of
JAM - Jan Dhan (basic no-frills accounts); Aadhaar (universal unique
identification); and mobile phone connections - is expanding the ambit of
formal finance, boosting tech start-ups and enabling the targeting of direct
benefit transfers. India's Unified Payment Interface (UPI), an open-ended
system that powers multiple bank accounts into a single mobile
application of any participating bank, is propelling inter-bank peer-to-peer
and person-to-merchant transactions seamlessly. Payment systems in
India operate on a 24 by 7 by 365 basis. Functionalities like offline
payments, payments through feature phones and conversational
payments have been incorporated. The internationalisation of the UPI is
progressing rapidly.
Taking these developments into account, a summary measure of
digitalisation for India has been constructed by using a dynamic factor
model (DFM)16. The index has been rising, reflecting the ongoing digital
revolution.
The spread of digitalisation has spurred research on assessing the effects
of digitalisation on the economy and the transmission of monetary policy.
Early results for India suggest steepening of the Phillips curve and
improvement in factor productivity, indicating improvement in the
effectiveness of monetary policy transmission.
India is on the move and transforming rapidly in the quest of its
aspirations. As various forces I have described coalesce and fall in place,
this century could well mark the ascent of India on the world stage.
Thank you.