RBI released the 22nd edition of its biannual Financial Stability Report (FSR) on Monday, January 11, 2021. The report highlights some key trends that could influence the financial markets in months to come. I note the following red flags raised in the report, which in my view could be relevant to my investment strategy:
Uneven and hesitant recovery, with disconnect
in real activity and asset price
Economic activity has begun making a hesitant and uneven
recovery from the unprecedented steep decline in the wake of the COVID-19
pandemic. Active intervention by central banks and fiscal authorities has been
able to stabilize financial markets but there are risks of spillovers, with
macrofinancial implications from disconnect between certain segments of
financial markets and real sector activity. In a period of continued
uncertainty, this has implications for the banking sector as its balance sheet
is linked with corporate and household sector vulnerabilities.
COVID-19 pandemic-induced economic disruptions have exposed some
fault lines in global economy. Increased public spending (stimulus) and sharply
lower revenue receipts have enlarged the fiscal deficits across geographies,
aggravating global debt vulnerabilities.
The credit risk of firms and households has accentuated.
This could impact corporate earnings in short term. However, the equity
prices continue to reflect strong earnings growth expectations. Developments
that lead to re-evaluation of corporate earnings prospects will have
significant implications for global flows, going forward.
Capital flows and exchange rate volatility
A hesitant recovery in capital flows to emerging markets (EMs)
began in June 2020 and picked up strongly following positive news on COVID-19
vaccines. The response of foreign investors to primary issuances from EMs has
been ebullient. Anticipating the COVID-19 vaccine induced economic boost, US
yields of intermediate tenors (2– and 5-year) have started edging higher. This
could have implications for future portfolio flows to EMs.
EM local currency bond portfolio returns in US$ terms have been
lower than local currency as well as hedged returns since early 2020 as
emerging market currencies have softened against the US$. This has led to
sluggishness in EM local currency bond flows even as global bond markets have
been pricing in a prolonged economic slowdown and benign inflationary
conditions in Europe and US. In this scenario, any significant
reassessment of either growth or inflation prospects, particularly for the US,
can be potentially destabilising for EM local currency bond flows and exchange
rates.
Improvement in bank asset quality might be
misleading
By September 2020, the banking stability indicator (BSI) showed
improvement in all its five dimensions (viz., asset quality; profitability;
liquidity; efficiency; and soundness) that are considered for assessing the
changes in underlying financial conditions and risks relative to their position
in March 2020. This improvement reflects the regulatory reliefs and
standstills in asset classification mentioned earlier and hence may not reflect
the true underlying configuration of risks in various dimensions.
Banks risk losing better quality customers
A sharp decline in money market rates specifically since April
2020, has opened up a significant wedge between the marginal cost of fund based
lending rate (MCLR) benchmark of banks and money market rates of corresponding
tenor. Expensive bank finance may lead to more credit worthy borrowers
with access to money markets shifting away from bank based working capital
finance. Such disintermediation of better quality borrowers from banking
channels could have implications for banking sector interest income and credit
risk.
Banking sector prospects to see marginal
changes in 2021
In the latest systemic risk survey (SRS) of October/November
2020 about one third of the respondents opined that the prospects of the Indian
banking sector are going to ‘deteriorate marginally’ in the next one year as
earnings of the banking industry may be negatively impacted due to slow
recovery post lockdown, lower net interest margins, elevated asset quality
concerns and a possible increase in provisioning requirements. On the other
hand, about one fourth of the respondents felt that the prospects are going to
improve marginally.
…stress to come with a lag
Domestically, corporate funding has been cushioned by policy
measures and the loan moratorium announced in the face of the pandemic, but
stresses would be visible with a lag. This has implications for the banking
sector as corporate and banking sector vulnerabilities are interlinked.
Macro stress tests indicate a deterioration in SCBs’ asset
quality and capital buffers as regulatory forbearances get wound down.
NPA ratio of banks may see sharp rise
The stress tests indicate that the GNPA ratio of all SCBs
may increase from 7.5 per cent in September 2020 to 13.5 per cent by September
2021 under the baseline scenario. If the macroeconomic environment
worsens into a severe stress scenario, the ratio may escalate to 14.8 per cent.
Among the bank groups, PSBs’ GNPA ratio of 9.7 per cent in September 2020 may
increase to 16.2 per cent by September 2021 under the baseline scenario; the
GNPA ratio of PVBs and FBs may increase from 4.6 per cent and 2.5 per cent to
7.9 per cent and 5.4 per cent, respectively, over the same period.
These GNPA projections are indicative of the possible economic
impairment latent in banks’ portfolios, with implications for capital planning.
A caveat is in order, though: considering the uncertainty regarding the
unfolding economic outlook, and the extent to which regulatory dispensation
under restructuring is utilised, the projected ratios are susceptible to change
in a nonlinear fashion.
In light of the findings of FSR, the governor of RBI,
Shaktikanta Das has cautioned the investors and financial institutions that “The
disconnect between certain segments of financial markets and the real economy
has been accentuating in recent times, both globally and in India” and “Stretched
valuations of financial assets pose risks to financial stability. Banks and
financial intermediaries need to be cognisant of these risks and
spillovers in an interconnected financial system.
I take note of the above red flags and continue with my
“underweight financials” strategy for 2021.
