Do financial cycles cause business cycles in India? Evidence from wavelet based causality analysis

• Published date: 01 May 2022
• Author: Lagesh Meethale Aravalath
• Date: 01 May 2022
• DOI: http://doi.org/10.1002/pa.2410

ACADEMIC PAPER

Do financial cycles cause business cycles in India? Evidence

from wavelet based causality analysis

Lagesh Meethale Aravalath

ICFAI Business School (IBS), Hyderabad, The

ICFAI Foundation for Higher Education (IFHE),

Hyderabad, India

Correspondence

Lagesh Meethale Aravalath, ICFAI Business

School (IBS), Hyderabad, The ICFAI

Foundation for Higher Education (IFHE),

(Deemed to be university u/s 3 of the UGC

Act 1956), Hyderabad 501203, India.

Email: lagesheco@ibsindia.org

The recent economic crises caution us that a better understanding of the “financial

cycle”is important in designing the right policy measures to tame the financial and

macroeconomic instability. This study is an attempt to characterize the financial

cycles in India and understand it's linkage with the business cycles during the period

from 1990q1 to 2019q4. First, this study derived an aggregate measure of financial

cycle from the low frequency component of the credit and equity price cycle

decomposed using discrete wavelet transformation method. Next, turning point anal-

ysis is performed to characterize the stylized facts of the financial cycles in India.

Lastly, Toda-Yamotto causality test is performed to understand the linkage between

the financial and business cycles in India. The analysis confirmed presence of financial

cycles in India with the average duration of 12 years and expansion and contraction

lasting 6 years. The causality test provided significant evidence for a causal relation-

ship running from financial cycle to business cycles in India. These findings point to

the need for a carefully designed macroeconomic policy with macro-prudential orien-

tation to achieve financial and macroeconomic stability in India.

JEL CLASSIFICATION

E32; E44; C5

1|INTRODUCTION

In recent decade, the Indian economy has witnessed a mounting stress in

its financial sector coupled with a declining real economic activity.

1

This

should be a major concern to the policy makers as many of the recent

economic crises were preceded by a bubble in the financial sector.

Claessens, Kose, and Terrones (2010) observes that out of 84 cri-

ses experienced by the 24 emerging economies during 1978–2011

period, 42 were associated with credit crunch, asset price bust or

financial crises. Some of the recent examples are the Japanese asset

price bubble of 1990 which was followed by a decade long economic

crisis well known as “lost decade,”Asian Financial Crisis of 1997 and

the Great Recession of 2007–2009. Among these the Great Reces-

sion of 2007–2009 (also called as the Global Financial Crisis) was the

worst financial crisis the world witnessed after the 1930's Great

Depression. All these crises have shown that a country with a stable

macroeconomic condition can experience instability in the financial

sector which in turn could destabilize the macroeconomic perfor-

mance (Creel, Hubert, & Labondance, 2015).

According to Claessens, Ayhan Kose, and Terrones (2011)financial

cycles are the large and lasting fluctuations registered by financial vari-

ables (flowsof credit, financialasset prices, housingprice etc.) relativeto

their long-term equilibrium level.Financial Cycles buildupslowly and last

more than a business cycle. Financial cycle peaks are found closely asso-

ciatedwith the banking crisis (Borio,Drehmann, & Xia, 2018). These fea-

tures of the financial cycles have raised a renewed interest among the

academicians in understand the relationship between financial variables

and real economic activities particularly to appreciate the predictive

power of the financial cycle (Avouyi-Dovi& Matheron, 2003; Claessens,

AyhanKose,&Terrones,2011; Claessens, Kose, & Terrones, 2011;

Edwards & de Gracia, 2003; Gilchrist & Zakrajsek, 2008; Haavio, 2012;

Yepez, 2012).

In fact this phenomenon is not very new. There were theoretical

studies which have shown us how a small shock in the financial sector

Received: 16 April 2020 Revised: 17 July 2020 Accepted: 16 August 2020

DOI: 10.1002/pa.2410

J Public Affairs. 2022;22:e2410. wileyonlinelibrary.com/journal/pa © 2020 John Wiley & Sons Ltd 1of10

https://doi.org/10.1002/pa.2410