Political Stability and the Effectiveness of Currency Based Macro Prudential Measures
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Political Stability and the Effectiveness of Currency Based Macro Prudential Measures Smita Roy Trivedi1 Accepted: 16 September 2020 © Springer Japan KK, part of Springer Nature 2020
Abstract The use of multiple currency based macroprudential tools by Reserve Bank of India, India’s central bank, has helped create resilience in the economy, especially during financial turmoil. However, in a democratic set-up like India, the analysis of capital based macroprudential reforms needs to incorporate the political stability, as there is increasing evidence that macroprudential policy effectiveness is closely linked to political conditions. This study incorporates the role of political stability is understanding the effectiveness of currency based macroprudential policies, by using the years of election as a proxy for political uncertainty. I develop an index of capital based macroprudential policies (CMPP) using the notifications on capital flows and risk management guidelines on foreign exchange exposures from Reserve Bank of India. Using a GARCH model, the impact of CMPP on the net capital inflows is analyzed for the period from January, 1997 to March, 2018. I find that while the presence of CMPP leads to a fall in capital flow volatility, such policies in the years of election are ineffective in curbing capital flow volatility. The paper adds to the increasing evidence coming in recent years of the link between political cycles, interest groups and macroprudential policies. Keywords Capital based macroprudential policies · Political instability · GARCH JEL Classfication E58 · F32 · G28 · C32
1 Introduction India, like other emerging market economies, have stood at the fore-front in the use of capital based macroprudential policies. The use of multiple currency based macroprudential tools by Reserve Bank of India, India’s central bank, has helped * Smita Roy Trivedi [email protected]; [email protected] 1
National Institute of Bank Management, NIBM Campus, NIBM PO, Kondhwe Khurd, Pune 411048, India
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create resilience in the economy, especially during financial turmoil. However, capital based macroprudential policies are not just any policies but play an important role in electoral politics. For most emerging market economies including India, liberalization or controls on the capital account are as much a political question as an economic one. That said, there are very few studies on which incorporate the role of political stability in study of macroprudential policy effectiveness. This paper incorporates the role of political stability in the study of capital based macroprudential policy effectiveness. I find that political instability (proxied by the year of election) hampers the effectiveness of currency based macroprudential policies. Emerging market nations, intensely vulnerable in a global stage of financially developed economies with free capital accounts, have always used some form of macro prudential measures to safeguard their economies. This is not surprising
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