De-stressed India!

The Reserve Bank of India (RBI) recently released the half yearly Financial Stability Report (FSR). A key highlight of the latest FSR is RBI’s confidence in the resilience and sustainability of growth in the Indian economy.

The report notes “heightened risks and uncertainties” in the global economy and financial system, while highlighting the “remarkable resilience” and receding risks of a hard landing. It also cautions, “While near-term prospects are improving, pitstops in the last mile of disinflation, high public debt, stretched asset valuations, economic fragmentation, geopolitical tensions, climate disasters and cyber threats present downside risks. Emerging market economies (EMEs) remain vulnerable to external shocks and spillovers.”

Regardless, the RBI finds the Indian economy on a strong footing. It notes, “Strong macroeconomic fundamentals and a sound and stable financial system have supported the sustained expansion of the Indian economy. Moderating inflation, a strong external position and ongoing fiscal consolidation are anchoring business and consumer confidence. Domestic financial conditions are buttressed by healthy balance sheets across financial institutions, marked by strong capital buffers, improving asset quality, adequate provisioning and robust earnings.”

In particular, the report highlights the robustness of the financial system, boosted by rising profitability, improving asset quality. It notes, “Return on assets (RoA) and return on equity (RoE) are close to decadal highs at 1.3 per cent and 13.8 per cent, respectively, while gross non-performing assets (GNPA) ratio and net nonperforming assets (NNPA) ratios fell to multi-year lows of 2.8 per cent and 0.6 per cent, respectively. This has helped SCBs to maintain strong capital buffers: their capital to risk-weighted assets ratio (CRAR) and the common equity tier 1 (CET1) ratio at 16.8 per cent and 13.9 per cent, respectively, stood well above the regulatory minimum in March 2024.

It is pertinent to note that in the latest systemic risk survey (SRS, May 2024) the RBI had categorized all major risk groups to domestic financial stability as “medium”.

Some of the key highlights of June 2024 FSR are listed below:

Global scenario

·         The global financial system remains resilient and financial conditions stable despite an uncertain and challenging backdrop marked by last mile disinflation process, elevated public debt, geopolitical tensions and economic fragmentation.

·         The International Monetary Fund (IMF) has projected global growth to remain steady at 3.2 per cent in 2024 as in 2023, 0.3 percentage points higher than in its October 2023 World Economic Outlook update.

·         The threat of a looming debt crisis cannot be overemphasized. Coexistence of high debt levels and elevated interest rates can feed a vicious cycle of financial instability through impairment of government and private-sector balance sheets. The frenetic expansion of global public debt in recent years has accentuated concerns about its sustainability. These worries are exacerbated by elevated interest rates and rollover risks for many overburdened economies. Global public debt has increased to 93.2 per cent of GDP by end-2023- nine percentage points above its pre-pandemic level.

·         A key feature of the evolving global economic outlook has been the recent alignment between market expectations and policy stances. The resilience of growth has allayed fears of hard landing and pushed out expectations of early interest rate cuts

·         While several near-term risks have receded, the global financial system continues to face heightened uncertainty surrounding the outer-term outlook for both financial markets and financial institutions. According to the IMF, the medium-term outlook is characterized by weak productivity and retreat in globalization and global growth is expected to decline by more than a percentage point by the end of 2020s compared to the pre-pandemic average.

·         The latest monetary policy cycle has witnessed a departure from past patterns when monetary tightening was associated with risk-off sentiment and decline in prices of riskier assets. To the extent valuations are stretched, sudden shocks could precipitate stress that spreads contagiously across financial market segments through correlated sell-offs and band-wagon effects.

·         Stretched asset valuations have been coterminous with a strong US dollar (USD) as market expectations have gravitated towards prospects of higher interest rates in the US than in other economies. Besides interest rate differentials and currency depreciations, risks to the global economy, especially the EMEs, are being transmitted through multiple channels. First, commodity prices and the USD are moving in tandem in a break from their historical inverse behaviour11 (Chart 1.18). This can compound inflationary pressures for EMEs, especially commodity importers, dampening consumer spending, investment and economic growth. Second, the strong USD can increase debt service costs and prompt rating downgrades, limiting their access to global capital markets. Third, capital flows could become even more volatile.

·         Private credit, which is essentially provided by non-bank lenders to corporates on a bilateral basis, has grown four-fold over the last ten years, emerging as a major source of corporate financing among middle-market firms that have low or negative earnings, high leverage, and lack of high quality collateral.

Domestic economy

·         The Indian economy and the financial system strengthened by solid macroeconomic fundamentals and healthy balance sheets of financial institutions, are exhibiting robust growth and greater resilience. India’s contribution to global growth is rising and currently stands at 18.5 per cent in 2023-24.

·         There are several positives in the near-term economic outlook. The resilience of the external sector has supported India’s overall macroeconomic stability. The merchandise trade deficit narrowed to US$ 238.3 billion in 2023-24 from US$ 264.9 billion in the previous year. Downside risks to this outlook stem from global slowdown and spillovers, geopolitical risks and their impact on supply conditions and commodity prices, slack in the rural economy and uncertainties related to weather conditions.

·         Corporate sector resilience has been bolstered by strengthening balance sheets and steady earnings. Increased capitalisation of profits has augmented equity of non-financial corporates (NFCs) and supported deleveraging. This is reflected in declining debt-to-equity and NFC debt-to-GDP ratios relative to AE and EME peers.

·         Fiscal consolidation, buoyant tax collections and improvement in the quality of spending have been the distinguishing features of the Union Government’s fiscal position. All major deficit indicators of the Union Government are projected to show further improvement. The GFD is pegged at 5.1 per cent of GDP in 2024-25 (BE), 46 basis points lower than in 2023-24.

·         Domestic financial conditions have generally eased since the December FSR, in line with the movements in system liquidity. This is reflected in the easing of money market rates and government securities yields. The weighted average call rate (WACR) generally remained within the policy corridor.

·         The sovereign yield curve has bull flattened (i.e., long-terms rates fell faster than short-term rates), supported by improving fiscal dynamics, anchoring of inflation expectations and positive sentiments in response to inclusion of Indian government securities in global bond indices29. As a result, the average term spread in the G-sec market (10-year minus 91-day Treasury Bills) narrowed to just 16 bps during January-May 2024 from 35 bps during July-December 2023.

Indian Equity markets

·         Supported by strong macroeconomic fundamentals, healthy corporate balance sheets, robust earnings outlook, stable financial conditions and sustained inflows into domestic mutual funds, the Indian equity market has been consistently outperforming its EME peers.

·         A standard discounted cash flow model suggests that the rise in the overall Nifty 50 index since March 2022 appears to have been driven mainly by improved earnings projections and to a lesser extent by investors’ risk appetite (declining equity risk premium). Extending the model to analyse the returns on midcap index shows that investors’ higher risk appetite is the major driver of returns when compared to improved earnings projections.

·         FPI inflows to Indian capital markets rose sharply during 2023-24. After being net sellers to the tune of US$ 5.5 billion (equity- US$ 5.1 billion, debt- US$ 0.4 billion) in 2022-23, foreign portfolio investors made second highest recorded net investments of US$ 41.0 billion in 2023-24 in equity (US$ 25.3 billion), debt (US$ 14.2 billion) and hybrid (US$ 1.5 billion) segments. FPI flows, however, turned negative with net outflows of US$ 3.9 billion in the current financial year so far (up to June 12, 2024). On the other hand, domestic investors remain bullish on Indian equities and provide support to the market even during periods of sharp FPI outflows.

Financial system stress in India

The financial system stress indicator (FSSI), indicated gradual easing of stress during H2:2023-24. The decline in stress indicators has been broad-based, except for the NBFC and money market segments. The decline in government debt market stress was the primary contributor to the improvement in the overall FSSI, aided by fall in long term yields as well as volatility and higher net foreign portfolio debt inflows.

The moot point is whether this time (unlike 2008-09) the Indian economy can successfully decouple from the stressed advanced economies and sustain the higher growth path even when the advanced economies and weaker emerging economies struggle to grow!