Financial cycle comovement with monetary and macroprudential policy and global factors: Evidence from India

This paper assesses the interaction of the financial cycle with domestic and global factors. We assess the comovement of monetary and macroprudential policy stance towards financial cycle phases in India and analyze the external influence of two major global economies, the US and China, from 1990 to 2021. To measure the financial cycle, we use credit and equity prices derived from the low-frequency decomposition of wavelet analysis. The analysis suggests that the amplitude of the downturn phase is much smaller than the upswing phase, suggesting the downturn phase of the financial cycle is considerably milder in India. Results indicate that the procyclicality of monetary policy and macroprudential regulations dominates throughout the upward phase of the financial cycle. Further, the interest rate spectrum, short, intermediate, and extended-term rates are discovered to move together. Also, the monetary and macroprudential policies complemented one another throughout the sample period, indicating the effectiveness of these policies in dampening financial imbalances. Based on wavelet coherency analysis, the results of global factors indicate that India shares a long and stable credit relationship with the US. This credit relationship has weakened with China in post-global financial crisis. In comparison, the Indian equity market displays a strong relationship with the US and the Chinese equity markets only during the financial crisis and remains insulated during normal periods. These results thus suggest that in an emerging market economy like India, credit growth in the US creates significant long-term effects, whereas only during crisis periods do the equity markets of the US and China create financial instability in India.