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Posted by: Deepa Vasudevan on Wed, Jan 21st, 2015

How Vulnerable is India to an Economic Crisis?

The Mid-Year Review of the Indian economy introduced the concept of a Macroeconomic Vulnerability Index (MVI), constructed as the sum of the Fiscal Deficit, the Current Account Deficit and Inflation[1]. Fiscal deficit and current account deficit are measured as percentages of GDP, and inflation is calculated as the year-on-year change in the relevant price index.  Thus MVI brings together three key areas where macroeconomic imbalances are most likely to occur- fiscal management, external account and domestic prices.


The Review recommends a threshold MVI level of 12- consisting of 4% inflation, 2% CAD and 6% Fiscal Deficit. The higher the MVI above this ‘safe’ threshold level, the greater the macroeconomic imbalances, and the more vulnerable the economy would be to a crisis. MVI is a measure of economic fragility; it indicates the potential for the occurrence of an economic crisis. The picture below shows how MVI has moved since 2002-03[2]. In this period, MVI has been within the safe   level of 12 barely four times, and never after 2008-09. The best year was 2003-04, and the worst years were between 2009-10 and 2012-13.


Pic 1 Trends in the Macro-Economic Vulnerability Index (MVI)

Trends in the Macro-Economic Vulnerability Index (MVI)

Source: RBI, Union Budget of India, CSO

For 2014-15, MVI can be projected by assuming that the combined fiscal deficit of the centre and states will be at the budgeted level of 6.4% of GDP; and CAD at 2% of GDP. Inflation is simply taken as the actual average CPI inflation over April-December 2014 (6.8%). This adds up to an MVI of 15.2, which is the lowest since 2008-09, but still much higher than the safe threshold of 12[3].


The biggest USP of the MVI is its simplicity. Usually indicators of macro vulnerability are based on complex macroeconomic models and use sophisticated statistical techniques to generate signals of vulnerability[4]. In contrast, the MVI is easy to compute and understand. It is an excellent early warning indicator; and red-flags the presence of a systemic imbalance as soon as there is a spike in its constituent variables. Since the three components are just added up, any change in their values is passed on directly to MVI. This makes it easy to build and analyse alternate scenarios: for example, if inflation is expected to increase by 2%, it simply increases the MVI, and the underlying vulnerability of the economy by a level of 2.


The simplicity of MVI is also its chief drawback. By not indicating exactly which variable is causing an imbalance, a casual observer may not be able to make a nuanced analysis. For instance, note that MVI was well below 12 in 2003-04, despite the high level of fiscal deficit (See table below). This was possible because the economy ran a current account surplus for that year, which simply netted out the excess fiscal deficit! This means that if MVI was tracked exclusively, without looking at its components, it may not give an effective early warning of risk.


Table 1 Components of MVI

Components of MVI

Source: CSO, RBI, Union Budget Documents


MVI has to be interpreted with caution, because every increase in the index does not add to macroeconomic risk in the same way. For instance, compare a 2% increase in inflation from 4% to 6%, with a 2% increase in CAD from 2% to 4%. In both cases, the MVI increases by a factor of 2 (assuming other components are unchanged). But the latter scenario is far more risky for India, because it can rapidly lead to a currency crisis, while the former represents only a mild deviation from the range of tolerance for inflation.


The best solution is to view MVI as a first warning system of the potential for crisis. To fully understand the signals given by MVI, it is necessary to carry out a more detailed analysis of its component variables, the factors that caused them to rise, and their mutual interlinkages.

[1] Mid-Year Economic Analysis 2014-2015, Ministry of Finance, Department of Economic Affairs, Economic Division, Available online at

[2] Inflation based on the new combined CPI index is available only from January 2012. Back-casted CPI data has been sourced from Appendix Table III.6, Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework, RBI, January 2014. Back data for inflation is available only from January 2002.

[3] Actual average CPI based inflation may end up lower by about 1% if oil prices continue to fall in the first quarter of 2015. But that will still not push the MVI below 12.

[4] The IMF conducts an early warning and vulnerability exercise for emerging economies twice a year; based on quantitative models as well as inputs from country authorities, market participants and academics. The output is not made public. See “The IMF Response to the Global Crisis: Assessing Risks and Vulnerabilities in IMF Surveillance”, by David J. Robinson, IEO Background Paper, IMF, October 2014. The World Bank built a Composite Index of Macroeconomic Vulnerability for Latin American countries which generates risk signals using various statistical models. See “User's Guide to an Early Models for an Warning System for Macroeconomic Vulnerability in Latin American Countries”, By Santiago Herrera and Conrado Garcia, World Bank Policy Research Working Paper 2233, November 1999


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