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Fortune at the bottom of the financial cycle

The focus of the government as well as policy advisers is typically on economic growth and the business cycles, formed by the real GDP data. Besides business cycles, it might be a good idea to also look at financial cycles that trace the expansion and contraction in financial activities.

Financial cycles are formed by emotional and behavioural drivers and can be mapped only through indirect data points such as credit growth, and stock and home prices. According to Borio (2012), financial cycles are formed by “the self-reinforcing interactions between perceptions of value and risk, attitudes towards risk, and financing constraints, which translate into booms followed by busts.”

Research on understanding financial cycles has gathered pace only after the global financial crisis in 2008. In the RBI working paper, ‘Does financial cycle exist in India?’, Harendra Behera and Saurabh Sharma establish the presence of financial cycles in India with the help of quarterly data on credit, equity prices, house prices and real exchange rate.

The paper indicates that the trough of the ongoing financial cycle, which has been contracting since the 2008 peak, is being formed now. This implies that companies as well as investors who are willing to take a contrarian stand, stand to gain once the next expansionary phase begins.

The connect

The authors write that as financial cycle is longer and its association with business cycle during a downturn is severe, dampening of the financial cycle through counter-cyclical policy measures is important to enhance macroeconomic and financial stability.

In the expansionary phases, high risk appetite, driven by the perception of strong future growth leads to increase in borrowings, stretching balance sheets. This sets the stage for a contraction, as businesses struggle to meet their commitments, leading to economic slowdown as well.

The global financial crisis in 2008, which was formed due to excessive leverage and risk-taking caused by easy monetary policy in the US and the Euro zone from 2000 to 2004 and the perpetually low interest rate maintained by Bank of Japan since 2000, helps highlight the inter-play between the business and financial cycles.

The financial market crash in 2008, led to sharp decline in real GDP growth across the globe in 2008 and early 2009.

The peak and the length

There are plenty of warning signals available near the peak of a financial cycle, which can warn policy-makers. There is a sharp increase in banking activity, exuberance in equity market, higher speculation and a general sense of complacency all around.

Charles Dow, when giving pointers to identify the last stage of a bull market, in the early 1900s, had said that when general newspapers carry headlines screaming about stock price rally, when the cats and dogs (stocks with poor fundamentals) start rallying and everyone turns into a stock market guru, it’s time to exit.

Looking for similar exuberant behaviour among businesses, the loan-taking individuals and home buyers might provide pointers about peaks in financial cycles in general.

The light that the paper throws on the duration of cycles in the variables can be used as a basis for further work in future. It states that the average duration of a business cycle — the expansionary and contracting stages of GDP growth — in India is about five years as compared to 15 years for the credit cycle. The length of exchange rate cycle is about 3.5 years and it is 12 years for house prices.

For equity prices, the length of the cycle has expanded from 3.4 years before 1991 to 8.3 years now. Short- and medium-term cycles are more predominant in equity price cycles.

The composite financial cycle formed by these variables was much longer than the business cycles and had only one peak in the third quarter of 2008 and two troughs in the second quarter of 2001 and the first quarter of 2017. The paper infers that the ongoing downturn in financial cycle seems to have reached its trough in the fourth quarter of 2018.

The takeaway

The insights provided on the altering duration of cycles in various macro financial variables in India after the liberalisation can be used for further research in this area. Liberalisation in financial markets, more liquidity and greater participation seem to be lengthening these cycles.

Despite lack of data on key variables such as housing prices, the authors have attempted to work around the problem, to arrive at some viable takeaways. The key takeaway is that the financial cycle that has been contracting since the 2008 peak appears to be bottoming.

This fact is corroborated by the improvement in non-food credit growth to 12.3 per cent in FY19, up from 8.3 per cent in FY18. Similarly, the NHB Residex, that captures housing prices data has been inching higher since the last quarter of 2017.

While the ongoing crisis in the NBFC sector is delaying the recovery in the financial cycle, the Centre and the RBI can lend a hand to help the recovery through monetary and fiscal measures.

Equity market participants, those who are willing to play contrarian, can look for bargain picks at this point since investment will revive once credit growth improves. While the recovery could be a few quarters away, those willing to wait will have the satisfaction of having invested close to the lows.

Similarly, corporates will also be relieved that there is some light at the end of the tunnel and that the economy could be near the lows as far as the risk-taking ability and perception about future growth goes.

They can, therefore, gear up to prepare for the next leg of growth that can go on for at least another six years.

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