Inter-Linkages, Co-Integration and Global Financial Crisis: India's Experience and Preparedness

Abstract

This paper examines the inter-linkages and long run integration of Indian economy with other economies of the world (US, Europe, Other Emerging markets and World economy) using standard indices of MSCI over the period Jan 2003 to July 2012. We also investigate Indian economy’s response to recent global turbulence (i.e. US subprime crisis and European Debt crisis) and its preparedness to counter global shocks. We use Granger causality test, Johansen co-integration test and Impulse response analysis of Vector auto regression framework to test various hypotheses. We find contagion effect on Indian economy. Although post US subprime crisis there is no observed causal relationship between India and other economies, but post European debt crisis, the Indian economy is granger caused by all other economies. Further during pre US subprime crisis period, India did have a long term co-integrating relationship with all other economies but this co integration almost disappeared in post US subprime crisis as well as post European debt crisis period. This low level of co integration despite the presence of short run causal relationship shows that global shocks might destabilize Indian economy in long run. Especially, Impulse response analysis revealed that Indian economy seems to be immune from the shocks created in the other economies of the world for atleast first two months and negative effects appear after that only. These results have important policy implications. The policy makers need to understand that if domestic economic fundamentals of India are in order, then global shocks have very less destabilizing effect on Indian economy.