Unpacking the Role of Financial Stress and Borrowing Costs in Shaping India's Economic Growth: Insights From the <scp>SVAR</scp> Framework

ABSTRACT This study examines the dynamic interrelationship between the cost of borrowing, the financial stress index, and economic growth in India over the time period between December 2005 and December 2021. We have used the SVAR method, which incorporates the theory‐based restrictions. These restrictions enable the model to disentangle economically meaningful shocks, thereby providing valuable insights for policymakers. This study finds that financial stress negatively and significantly affects economic growth, indicating that uncertainty in the financial system reduces economic activity. Conversely, the positive and significant impact of economic growth on the financial stress index suggests that higher levels of growth increase systemic risk in the financial sector. However, the analysis reveals an insignificant relationship between the cost of borrowing, financial stress, and economic growth. Further, the impulse response function results indicate a negative relationship between the financial stress index and economic growth over a 10‐period horizon. From the policy perspective, this study suggests that an emerging economy like India needs to improve its financial infrastructure to achieve a higher sustainable economic growth rate. Due to underdeveloped financial markets, emerging markets are more vulnerable to financial stress.