Macroeconomic Risks and Financial Stability: An Econometric Analysis for India*

Abstract

While it is difficult to foresee the triggers for crisis, continuous monitoring and assessment of the buildup of risks need to be an integral part of any policy framework for maintaining overall economic and financial stability. This paper is an attempt in that direction. This paper initially attempts to identify the macro risk indicators, which has potential of causing instability to the economic system and which is then transmitted to the financial system. These risk indicators are then combined into single composite index as an indicator of overall macroeconomic stability. The various risk indicators have been appropriately validated through their impact on GDP and NPAs in the banking system. The paper also initially attempts to identify various financial market indicators which reveal the broad dynamics of the financial system. Similar to the macro risk indicators, these financial market indicators are combined into one composite index and then its relationship with macro risk indicators and their composite index is examined in the VAR framework.A VAR analysis reveals that both the composite indices of macro risks and market risks as developed in this paper have adverse impact on the growth in GDP. Among the various macro risk factors, global and external sector indicators appear to have more severe impact on the growth. The adverse impact of macro risk on growth of GDP was found to be immediate but the impact of market risks indicators increase in size and dominate over time. It is observed that the macro risk indicators have substantial adverse impact on the financial market indicator and its optimal lag works out to be about six months. Results of this exercise though exploratory in nature but are meaningful from policy perspective. One of the advantages of this analysis is its flexibility. It can easily be incorporated in a more comprehensive framework for assessment of systemic risks and for stress tests. The findings of this paper can be further developed while retaining the underlying basic structure.