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? 1 / 24

This paper: Empirical investigation: Effect of four prominent foreign shocks on the Indian economy 1. U.S. monetary policy 2 / 24

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)) 3 / 24

This paper: Empirical investigation: Effect of four prominent foreign shocks on the Indian economy 1. U.S. monetary policy 2. Oil supply 3 / 24

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 4 / 24

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 4 / 24

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 5 / 24

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 6 / 24

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 7 / 24

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 7 / 24

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 9 / 24

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 10 / 24

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 11 / 24

The four shocks U.S. Monetary Policy Economic Policy Uncertainty 4 300 1 250 0.8 2 200 0.6 0 150 0.4 -2 100 0.2 -4 50 0 1995 2000 2005 2010 2015 2000 2004 2008 2012 2016 Geopolitical Risk Oil Supply 600 1 5 0.8 400 0.6 0 0.4 200 0.2 0 0 -5 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 12 / 24

The four shocks: response of World industrial production Monetary Policy Shock Economic Policy Uncertainty Shock 0 0 -0.2 -0.2 -0.4 -0.4 -0.6 -0.6 5 10 15 20 5 10 15 20 Geopolitical Risk Shock Oil Supply Shock 0 0 -0.2 -0.2 -0.4 -0.4 -0.6 -0.6 5 10 15 20 5 10 15 20 Notes: 1 standard deviation shock, bootstrapped confidence intervals 13 / 24

The four shocks: response of BRICS industrial production Monetary Policy Shock 0.2 Economic Policy Uncertainty Shock 0.2 0 0 -0.2 -0.2 -0.4 -0.4 -0.6 -0.6 5 10 15 20 5 10 15 20 Geopolitical Risk Shock Oil Supply Shock 0.2 0.2 0 0 -0.2 -0.2 -0.4 -0.4 -0.6 -0.6 5 10 15 20 5 10 15 20 Notes: 1 standard deviation shock, bootstrapped confidence intervals 14 / 24

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 15 / 24

Indian response: U.S monetary policy shock Stock Market USD/INR Govt 10 year bond 1 0.4 0.05 0 0.2 0 -1 0 -0.05 -2 -0.2 -0.1 -3 -0.4 5 10 15 20 5 10 15 20 5 10 15 20 Total reserves CPI IIP 1 0.2 0.1 0.5 0.1 0 0 0 -0.1 -0.5 -0.1 -0.2 -1 -0.2 -0.3 -0.4 -1.5 -0.3 5 10 15 20 5 10 15 20 5 10 15 20 Notes: 1 standard deviation shock, bootstrapped confidence intervals 16 / 24

Response of industrial production Monetary Policy Shock India BRCS 0.1 World 0 -0.1 -0.2 -0.3 -0.4 2 4 6 8 10 12 14 16 18 20 22 24 16 / 24

Indian response: EPU shock Stock Market USD/INR Govt 10 year bond 1 0.6 0.1 0.4 0 0.05 0.2 -1 0 0 -2 -0.2 -0.05 -3 -0.4 -4 -0.6 -0.1 5 10 15 20 5 10 15 20 5 10 15 20 Total reserves CPI IIP 0.5 0.3 0.2 0.2 0 0 0.1 -0.5 0 -0.2 -0.1 -1 -0.4 -0.2 -1.5 -0.3 -0.6 5 10 15 20 5 10 15 20 5 10 15 20 Notes: 1 standard deviation shock, bootstrapped confidence intervals 17 / 24

Response of industrial production Economic Policy Uncertainty Shock India BRCS 0.1 World 0 -0.1 -0.2 -0.3 -0.4 2 4 6 8 10 12 14 16 18 20 22 24 17 / 24

Indian response: GPR shock Stock Market USD/INR Govt 10 year bond 3 0.5 0.1 2 0.05 1 0 0 0 -0.05 -1 -2 -0.5 -0.1 5 10 15 20 5 10 15 20 5 10 15 20 Total reserves CPI IIP 0.2 0.3 1 0.2 0.1 0.5 0.1 0 0 0 -0.1 -0.1 -0.2 -0.5 -0.2 -0.3 5 10 15 20 5 10 15 20 5 10 15 20 Notes: 1 standard deviation shock, bootstrapped confidence intervals 18 / 24

Response of industrial production Geopolitical Risk Shock 0.25 India 0.2 BRCS World 0.15 0.1 0.05 0 -0.05 -0.1 -0.15 -0.2 -0.25 2 4 6 8 10 12 14 16 18 20 22 24 18 / 24

Indian response: Oil supply shock Stock Market USD/INR Govt 10 year bond 1 0.8 0.05 0.5 0.6 0 0 0.4 -0.5 0.2 -1 -0.05 -1.5 0 -2 -0.2 -0.1 5 10 15 20 5 10 15 20 5 10 15 20 Total reserves CPI IIP 0.5 0.4 0.1 0 0.3 0 -0.1 0.2 -0.2 0.1 -0.5 -0.3 0 -0.4 -1 -0.1 -0.5 5 10 15 20 5 10 15 20 5 10 15 20 Notes: 1 standard deviation shock, bootstrapped confidence intervals 19 / 24

Response of industrial production Oil Supply Shock 0.05 India BRCS 0 World -0.05 -0.1 -0.15 -0.2 -0.25 -0.3 -0.35 -0.4 -0.45 2 4 6 8 10 12 14 16 18 20 22 24 19 / 24

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 20 / 24

Main takeways ◮ US monetary, EPU and oil supply shocks have substantial disruptive effects on both economic activity and financial markets 21 / 24

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 21 / 24