'India needs Financial Conditions Index'

Changes in financial market variable have an impact on the real market but the launch of several financial products has resulted in more variables to account for in economic estimates, stated a research paper put out by the Reserve Bank of India (RBI).

The paper titled 'A Financial Condition Index for India' authored by RBI research officer Anand Shankar stated: "Economic agents often alter their expectations about economic activity and hence their behaviour in response to movement in financial variables."

Over the decades there have been tremendous developments in financial markets.

Newer financial products have been invented, cutting edge technology has been increasingly used in financial markets, transaction costs have fallen, innovations in product design have been implemented and financial markets around the world are more integrated today than ever before.

According to Shankar, the increase in the number of financial products has meant that there are more variables to account for in economic estimates/expectations today than in the past.

"The problem is not only that of many variables to monitor but also conflicting signals sent by market variables about financial conditions," the paper noted.

The financial market variables contain information about the future state of the economy. Changes in financial variables often translate into changes in the real economy.

Very often financial variables send contradictory signals to economic agents. Further, acute information asymmetry exists in financial markets especially around trigger events during times of crises, the paper notes.

Breaking information asymmetry assumes importance since lack of timely and correct information further perpetuates uncertainty and deepens the crisis.

To overcome the problem of information asymmetry, financial condition indices (FCI) are constructed.

Even though financial market stress in not directly observable, it often manifests itself in movement of financial market variables.

This paper attempts to capture the state of financial conditions by constructing an ordinal and contemporaneous financial conditions index for India. This index is the synthesis of information content in the money, bond, foreign exchange and stock markets, the RBI said.

The index showed that tight financial conditions in one market can offset accommodative conditions in some other market thereby making the aggregate conditions tight. Therefore, it is necessary to account for financial conditions in all markets simultaneously in the conduct of policy.

According to the RBI, the paper on its website also poses some interesting research questions in context of interaction of financial conditions and real variables like gross domestic product growth.