Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 3 External Sector Openness And Conduct Of Monetary Policy : The Indian Experience

Business Cycle Synchronisation

Apart from influences operating through movement of capital inflows and outflows, external demand and supply shocks can impact upon the domestic economy, especially in view of the growing openness of the economy. Illustratively, domestic prices of key commodities/groups such as iron and steel exhibited co-movements with international prices during 2003-04. Inflation, therefore, in the short-run can be influenced by external developments. Variations in external demand conditions coupled with exchange rate movements affect exports and imports and therefore, domestic demand and output. In view of the growing openness, there has been a renewed interest to assess the degree of synchronisation of output in India with that in its major trading partners.

Business cycles abroad have a relatively larger influence on the Indian economy than was the case during the 1980s and exports and industrial production have started exhibiting co-movement with global business cycles (RBI, 2002). Mall (2001) finds that the Indian output cycles are positively correlated with the UK and the US cycles, especially during the post-1980s. Exogenous oil shocks were found to be more important than non-oil global shocks, which, in turn, were stronger than country-specific shocks. Moreover, correlation between investment and private consumption cycles of India and those from each of the select countries - US, UK, Japan and Germany -turned from negative to positive, albeit small in magnitude, in the post-1980 period. Cyclical output of advanced economies has a unidirectional causal effect on India's cyclical output. According to Dua and Banerji (2001a, 2001b), business cycles in India are more similar in character to those of the market economies in the post-1991 liberalisation phase. The cycles were, however, driven more by endogenous factors than by exogenous shocks. As regards co-movement with ASEAN countries, although there is evidence of synchronisation of growth cycles, similarity seemed to be purely coincidental and driven by domestic factors rather than greater inter-linkages with the ASEAN countries. The cyclical downturn of the Indian economy in synchrony with the East Asian crisis of 1997 is thus to be seen in this light.

This Section updates the analysis undertaken in RBI (2004a) to examine the degree of synchronicity of the Indian business cycle with world output as well as its major trading partners - developed as well as emerging economies. The empirical analysis covers the period 1980-2003. Apart from using overall GDP, non-agricultural GDP and industrial GDP are also used to capture co-movement, since agricultural sector - largely weather driven - still has a significant share in the Indian GDP.

Results show that the synchronicity of the business cycles in India with the world, as a whole, has increased in the post-opening phase (1991-2003) vis-a-vis the pre-opening phase (1980-90). Amongst major trading partners, cyclical synchronicity of India appears to have strengthened with most of the advanced economies during the post-1990 period vis-a-vis the pre-1990 period. Amongst developing country partners, synchronicity was lower with the East Asian partners during the 1990s. This decline in synchronicity with the East Asian trading partners could perhaps be reflecting the aftermath of the Asian financial crisis. While these economies were severely affected by the crisis, India was relatively unaffected, in large part due to prudent macroeconomic policies adopted by India since the early 1990s. Amongst other major economies, there is evidence of co-movement with China during the 1990s vis-à-vis negative correlation in the 1980s.

In addition to analysis of correlation of business cycles, an examination of their amplitude is useful as it is indicative of the severity of expansion and contraction of activities. Amplitude is influenced, inter alia, by the degree of openness of an economy. Often globalisation is held responsible for increasing volatility of business cycles. Theoretically, however, the effects of integration on business cycle volatility are not clear. Increased volatility could as well be an outcome of the rapidly and badly coordinated capital account liberalisation across the countries. For India, results suggest that the amplitude of the business cycle was higher in the post-1990 period, albeit still lower than some of its key trading partners.

The evidence on business cycles thus indicates that co-movement of output in India with the world output has increased in the 1990s. Domestic macroeconomic policies have, therefore, to take into account impact of such developments abroad on the domestic economy. As the Reserve Bank's Monetary and Credit Policy Statement of 2001-02 noted: "Monetary management has now become much more complex than was the case even a few years ago. This is because of several factors, such as, the on-going integration of financial markets across the world, the phenomenal increase in financial turnover, liberalisation of the economy, and the rapidity with which unanticipated domestic and international tremors get transmitted to financial markets across the world because of the new technology. The need to quickly change the policy stance in the light of emerging situation has also been the experience of other monetary authorities including the US and European central banks. Keeping these realities in view, it is particularly important for banks and financial institutions to make adequate allowances for unforeseen contingencies in their business plans, and fully take into account the implications of changes in the monetary and external environment on their operations..." (RBI, 2001).