The Effect of Foreign Shocks on the Indian Economy Aeimit Lakdawala - - PowerPoint PPT Presentation

The Effect of Foreign Shocks on the Indian Economy

Aeimit Lakdawala Sanjay Singh Michigan State UC Davis July 9, 2019 India Policy Forum

Motivation

India: ◮ Increasing trade and financial linkages with rest of the world in last few decades Questions: ◮ How vulnerable is India to international developments? ◮ What policy actions are needed to combat these developments?

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This paper:

Empirical investigation: Effect of four prominent foreign shocks on the Indian economy

• 1. U.S. monetary policy

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Motivation: U.S. monetary policy shock

Global financial cycle: Rey (2015) ◮ Co-movement of global asset prices and credit conditions not aligned with countries’ specific macroeconomic conditions United States: ◮ “Centre country” of global financial system ◮ U.S. monetary policy shock induces significant fluctuations in financial activity on a global scale (Miranda-Agrippino & Rey (2019))

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This paper:

Empirical investigation: Effect of four prominent foreign shocks on the Indian economy

• 1. U.S. monetary policy
• 2. Oil supply

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Motivation: Oil supply shock

India’s oil dependence ◮ Third largest importer of crude oil. ◮ Contribution to world oil production is less than 1% India’s contribution to global oil price changes ◮ likely driven through demand channel ◮ but not through supply channel

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This paper:

Empirical investigation: Effect of four prominent foreign shocks on the Indian economy

• 1. U.S. monetary policy
• 2. Oil supply
• 3. Economic policy uncertainty
• 4. Geopolitical risk

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Economic policy and geopolitical uncertainty risks

Recent work highlights role of uncertainty for global financial markets ◮ Rey (2015), Bruno & Shin (2015) Bhattarai, Chatterjee & Park (2017) ◮ substantial effects of uncertainty on emerging economies

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This paper:

Empirical investigation: Effect of four prominent foreign shocks on the Indian economy

• 1. U.S. monetary policy
• 2. Oil supply
• 3. Economic policy uncertainty
• 4. Geopolitical risk

Challenge: Estimate dynamic causal effects ◮ Obtain identifying restrictions using exogenous shock measures and recent method of external instruments

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This paper

What we do

◮ Establish stylized facts about resilience/exposure of Indian economy to external shocks: ◮ Compare to benchmark of world & BRICS economies ◮ Discuss implications for policy makers

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This paper

What we do

◮ Establish stylized facts about resilience/exposure of Indian economy to external shocks: ◮ Compare to benchmark of world & BRICS economies ◮ Discuss implications for policy makers

What we find

◮ Substantial effects of foreign shocks on the Indian economy ◮ Exposure of Indian output is lower relative to advanced economies but comparable to BRICS economies

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Empirical Framework

Goal: Estimate dynamic causal effects (impulse responses)

• 1. Structural Vector Autogregression (SVAR)
• 2. Local Projections (LP)

Need identifying restrictions: ◮ Strategy of external instruments In the paper: ◮ Estimate both SVAR and LP framework In this presentation: ◮ Present results from SVAR

Details of External Instruments Identification 8 / 24

U.S. monetary policy shock

High-frequency identification: ◮ Change in interest rate futures prices in narrow window (30 mins) around FOMC announcement We estimate the Gertler & Karadi (2015) setup ◮ Use futures changes as instruments in an external instruments framework ◮ But also control for “information effects” using survey forecasts ◮ Back out structural U.S. monetary policy shock

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Oil supply shock

Challenge in disentangling oil supply from oil demand shocks ◮ Kilian (2009), Kilian & Murphy (2012) ◮ Potentially restrictive assumptions New work using Bayesian approach ◮ Baumeister & Hamilton (2019) ◮ Incorporate uncertainty about identifying assumptions ◮ New estimate of structural oil supply shock

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Economic policy uncertainty & geopolitical risk shocks

Newspaper analysis: relative frequency of specific words

Economic Policy Uncertainty Index: ◮ Baker, Bloom & Davis (2016) Geopolitical Risk Index: ◮ Caldara & Iacoviello (2018)

Concerns about measurement error

• 1. Follow Carreiro et al (2015) and Caballero & Kamber (2019)
• 2. Construct dummy variable as instrument

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The four shocks

1995 2000 2005 2010 2015

• 4
• 2

2 4

U.S. Monetary Policy

2000 2004 2008 2012 2016 50 100 150 200 250 300 0.2 0.4 0.6 0.8 1

Economic Policy Uncertainty

1995 2000 2005 2010 2015 200 400 600 0.2 0.4 0.6 0.8 1

Geopolitical Risk

1995 2000 2005 2010 2015

• 5

5

Oil Supply 12 / 24

The four shocks: response of World industrial production

5 10 15 20

• 0.6
• 0.4
• 0.2

Monetary Policy Shock

5 10 15 20

• 0.6
• 0.4
• 0.2

Economic Policy Uncertainty Shock

5 10 15 20

• 0.6
• 0.4
• 0.2

Geopolitical Risk Shock

5 10 15 20

• 0.6
• 0.4
• 0.2

Oil Supply Shock

Notes: 1 standard deviation shock, bootstrapped confidence intervals

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The four shocks: response of BRICS industrial production

5 10 15 20

• 0.6
• 0.4
• 0.2

0.2

Monetary Policy Shock

5 10 15 20

• 0.6
• 0.4
• 0.2

0.2Economic Policy Uncertainty Shock 5 10 15 20

• 0.6
• 0.4
• 0.2

0.2

Geopolitical Risk Shock

5 10 15 20

• 0.6
• 0.4
• 0.2

0.2

Oil Supply Shock

Notes: 1 standard deviation shock, bootstrapped confidence intervals

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Indian macro and financial data

Monthly data: Jan-1994 to Dec-2017

• 1. Index of industrial production
• 2. Consumer price index
• 3. INR-USD nominal exchange rate
• 4. Stock market index
• 5. Total foreign reserves (excl. gold)
• 6. 10 year government bond yield

SVAR specification: ◮ log level ◮ linear time trend ◮ 12 lags

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Indian response: U.S monetary policy shock

5 10 15 20

• 3
• 2
• 1

1

Stock Market

5 10 15 20

• 0.4
• 0.2

0.2 0.4

USD/INR

5 10 15 20

• 0.1
• 0.05

0.05

Govt 10 year bond

5 10 15 20

• 1.5
• 1
• 0.5

0.5 1

Total reserves

5 10 15 20

• 0.3
• 0.2
• 0.1

0.1 0.2

CPI

5 10 15 20

• 0.4
• 0.3
• 0.2
• 0.1

0.1

IIP

Notes: 1 standard deviation shock, bootstrapped confidence intervals

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Response of industrial production

2 4 6 8 10 12 14 16 18 20 22 24

• 0.4
• 0.3
• 0.2
• 0.1

0.1

Monetary Policy Shock

India BRCS World

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Indian response: EPU shock

5 10 15 20

• 4
• 3
• 2
• 1

1

Stock Market

5 10 15 20

• 0.6
• 0.4
• 0.2

0.2 0.4 0.6

USD/INR

5 10 15 20

• 0.1
• 0.05

0.05 0.1

Govt 10 year bond

5 10 15 20

• 1.5
• 1
• 0.5

0.5

Total reserves

5 10 15 20

• 0.3
• 0.2
• 0.1

0.1 0.2 0.3

CPI

5 10 15 20

• 0.6
• 0.4
• 0.2

0.2

IIP

Notes: 1 standard deviation shock, bootstrapped confidence intervals

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Response of industrial production

2 4 6 8 10 12 14 16 18 20 22 24

• 0.4
• 0.3
• 0.2
• 0.1

0.1

Economic Policy Uncertainty Shock

India BRCS World

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Indian response: GPR shock

5 10 15 20

• 2
• 1

1 2 3

Stock Market

5 10 15 20

• 0.5

0.5

USD/INR

5 10 15 20

• 0.1
• 0.05

0.05 0.1

Govt 10 year bond

5 10 15 20

• 0.5

0.5 1

Total reserves

5 10 15 20

• 0.2
• 0.1

0.1 0.2

CPI

5 10 15 20

• 0.3
• 0.2
• 0.1

0.1 0.2 0.3

IIP

Notes: 1 standard deviation shock, bootstrapped confidence intervals

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Response of industrial production

2 4 6 8 10 12 14 16 18 20 22 24

• 0.25
• 0.2
• 0.15
• 0.1
• 0.05

0.05 0.1 0.15 0.2 0.25

Geopolitical Risk Shock

India BRCS World

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Indian response: Oil supply shock

5 10 15 20

• 2
• 1.5
• 1
• 0.5

0.5 1

Stock Market

5 10 15 20

• 0.2

0.2 0.4 0.6 0.8

USD/INR

5 10 15 20

• 0.1
• 0.05

0.05

Govt 10 year bond

5 10 15 20

• 1
• 0.5

0.5

Total reserves

5 10 15 20

• 0.1

0.1 0.2 0.3 0.4

CPI

5 10 15 20

• 0.5
• 0.4
• 0.3
• 0.2
• 0.1

0.1

IIP

Notes: 1 standard deviation shock, bootstrapped confidence intervals

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Response of industrial production

2 4 6 8 10 12 14 16 18 20 22 24

• 0.45
• 0.4
• 0.35
• 0.3
• 0.25
• 0.2
• 0.15
• 0.1
• 0.05

0.05

Oil Supply Shock

India BRCS World

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Indian response: Variance decomposition

Monetary Policy Econ Pol Uncertainty 1 12 24 1 12 24 Stock market 1.8 12.3 10.2 3.1 4.7 4.9 USD/INR 0.8 1.6 2.1 2.0 0.7 1.4 10 yr bond 2.6 8.5 11.7 0.1 5.1 3.2 Dollar Reserves 2.0 8.9 6.4 0.0 10.0 13.4 Inflation 1.8 3.2 3.7 0.0 1.8 1.6

• Ind. Prod.

1.7 13.5 13.8 0.1 4.4 5.1 Geopolitical Risk Oil Supply Shock 1 12 24 1 12 24 Stock market 0.7 1.9 2.1 1.9 5.4 6.9 USD/INR 0.7 0.6 1.6 0.5 10.2 12.3 10 yr bond 1.2 0.4 0.5 2.3 6.5 4.3 Dollar Reserves 0.0 1.7 2.4 2.0 2.0 2.5 Inflation 0.3 8.7 9.3 0.7 6.5 5.4

• Ind. Prod.

0.0 0.9 1.0 4.8 13.7 16.5

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Main takeways

◮ US monetary, EPU and oil supply shocks have substantial disruptive effects on both economic activity and financial markets

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Main takeways

◮ US monetary, EPU and oil supply shocks have substantial disruptive effects on both economic activity and financial markets ◮ Geopolitical risk shock does not have major discernible effect

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Main takeways

◮ US monetary, EPU and oil supply shocks have substantial disruptive effects on both economic activity and financial markets ◮ Geopolitical risk shock does not have major discernible effect ◮ US monetary policy and EPU have effects similar to domestic demand shocks

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Main takeways

◮ US monetary, EPU and oil supply shocks have substantial disruptive effects on both economic activity and financial markets ◮ Geopolitical risk shock does not have major discernible effect ◮ US monetary policy and EPU have effects similar to domestic demand shocks ◮ Oil shock has effects similar to domestic supply shock

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Main takeways

◮ US monetary, EPU and oil supply shocks have substantial disruptive effects on both economic activity and financial markets ◮ Geopolitical risk shock does not have major discernible effect ◮ US monetary policy and EPU have effects similar to domestic demand shocks ◮ Oil shock has effects similar to domestic supply shock ◮ Exposure of Indian output is lower relative to advanced economies but comparable to BRICS economies

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Policy Implications

For output and inflation: ◮ Tradeoff involved in responding to oil but not US monetary and EPU shocks

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Policy Implications

For output and inflation: ◮ Tradeoff involved in responding to oil but not US monetary and EPU shocks Important for policy makers to recognize external shocks and respond in short/medium run ◮ In addition to structural reforms intended to fix long-term issues

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Policy Implications

For output and inflation: ◮ Tradeoff involved in responding to oil but not US monetary and EPU shocks Important for policy makers to recognize external shocks and respond in short/medium run ◮ In addition to structural reforms intended to fix long-term issues Mild response of Indian 10 year bond rate: ◮ Did monetary policy respond sufficiently to external shocks? ◮ Weak transmission mechanism of monetary policy?

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Conclusion

◮ Empirical investigation of four major international shocks ◮ Establish stylized facts about the response of the Indian economy ◮ Inform the policy response and design of open economy structural models for the Indian economy ◮ Template for future empirical work to investigate broader effects on the Indian economy

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Future work

◮ Detailed analysis of monetary policy response ◮ More comprehensive set of Indian economic variables ◮ Capital flows, short-term rates, net exports ◮ Explore change in sensitivity of Indian economy over time ◮ Broader set of foreign shocks? ◮ Commodity prices (esp. food), disruption in trading partner economies (esp. China)

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SVAR Details

Structural representation: Ayt = α1yt−1 + . . . + αpyt−p + εt (1) Can only estimate reduced form VAR yt = δ1yt−1 + . . . + δpyt−p + ut (2) where ut = Bεt (3) Need restrictions to recover structural shocks εt

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Identification with External Instruments

Find instrument Zt E[Ztεp′

t ]

= φ (4) E[Ztεq′

t ]

= (5) Use these conditions together with E[utu′

t] = BB′ = Σ

(6) to recover structural shocks and impulse responses

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