RBI Experiments With New Model To Detect Economic Twists And Turns

The RBI adds Sensex, nominal effective exchange rate, bank credit to its GDP nowcasting model

 Scientist mixes chemicals inside the new lab at the GlaxoSmithKline Plc facility in Collegeville, Pennsylvania, U.S. (Photographer: Eric Thayer/Bloomberg)
Scientist mixes chemicals inside the new lab at the GlaxoSmithKline Plc facility in Collegeville, Pennsylvania, U.S. (Photographer: Eric Thayer/Bloomberg)

The Indian central bank, which failed to foresee the sharp fall in the country’s economic growth in 2019-20, is experimenting with a new model to strengthen its ability to catch twists and turns in the economy better.

In its new model, the Reserve Bank of India adds financial indicators including the nominal effective exchange rate and the Sensex, along with non-food bank credit, to the list of data points already tracked.

The extracted trend, the RBI said, provides a real-time assessment of the state of the economy and helps identify sectors contributing to economic fluctuations.

The 12-Indicator Model

The RBI so far used a six-indicator and a nine-indicator model that it used to provide an early estimate of GDP growth in a given quarter. This, in technical parlance, is known as the nowcasting model.

In a working paper released on Tuesday, the central bank introduced a 12-indicator based approach.

The indicators used by this model include:

  • Index of industrial production – consumer goods and core sectors
  • Automobile sales
  • Non-oil non-gold imports
  • Exports
  • Rail freight
  • Air cargo
  • Foreign tourist inflows
  • Government tax receipts
  • Sensex
  • Nominal Effective Exchange Rate (NEER)
  • Bank credit

All except the three financial indicators were included in previous models used by the RBI. “Our choice of indicators represents real, external and financial sectors which are used to extract the common underlying trend,” the RBI paper said.

Explaining its approach towards selecting the right indicators, the RBI said it looked for high-frequency data that were either contemporaneous (existing at the same time), leading or lagging indicators. It also looked for indicators that forecast sharp turning points in the economy.

The Sensex, IIP-consumer goods and air cargo proved to have the “highest contemporaneous correlation” with the GDP, the RBI said. Indicators such as IIP-core, commercial automobile sales, and forex reserves display “both cotemporaneous and leading properties”, it added.

What indicators foretell a turning point best?

“In terms of relative ranking, IIP-Consumer goods, auto sales and nominal effective exchange rate have highest relevance around the turning points in GDP,” the RBI paper said.

Why The Rethink?

The RBI paper comes after the central bank faced criticism on its ability to forecast the fall in growth ahead of time.

The central bank cut its GDP growth projection for 2019-20 five times during the course of the year. It’s first projection, made in February 2019, stood at 7.4 percent. It’s final GDP growth projection for the year was at 5 percent.

Data collated by BloombergQuint shows that in at least five out of the last 11 financial years, the central bank’s original growth projection, made at the time of the annual policy in April, has been off the mark by more than 1 percentage point. In other years, while there have misses, the gap between projected growth rate and actual growth rate has been smaller.

The RBI, perhaps, hopes to improve on its forecasting abilities using some these tools. To be sure, the model the RBI’s working paper refers to is a ‘nowcasting model’, intended to get a picture of the economy in the ongoing quarter.

“These indicators represent various sectors, display high contemporaneous correlation with GDP, and co-move in line with the GDP turning points,” the central bank said.