- GS-3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.
- GS-2: Government policies and interventions for development in various sectors and issues arising out of their design and implementation.
Financial Stability Report: RBI’s Warning
Context: Reserve Bank of India (RBI) released the 22nd issue of its biannual Financial Stability Report outlining the risks to financial stability as well as the resilience of the financial system in the contemporary context.
Key takeaways from the latest GDP estimates released: Click Here
Significance of Financial Stability report
- The FSR is a hugely useful publication as it receives contributions from all the financial sector regulators in the country.
- As such, it provides a rather comprehensive picture of the so-called macro-financial risks facing the economy.
- The FSR released by the RBI is the biannual alert of such risks in the Indian economy.
An Example of Macro-Economic Risk – High NPAs
- If lots of banks in an economy find that the loans they extended to different businesses are unlikely to be repaid, it is a macro-financial risk.
- Because if banks do not get their money back, they won’t be able to fund the next set of investments. Lack of access to credit thus impairs the economic growth as expansion of firms is curtailed.
- Even if the government decides to use the taxpayer’s money to bail banks out, it will have to curtail some other expenditure — perhaps on education or healthcare or infrastructure, thus impacting the welfare of citizens
- So, one thing can lead to another and the economic growth of a country can take a massive hit just because too many banks had too many non-performing assets (NPAs or bad loans) all at the same time.
What are the major concerns highlighted by FSR Report of RBI?
- High Bank NPAs
- According to the RBI’s analysis, the level of Gross NPA ratio in India’s banking system could almost double between September 2020 (7.5% of all loans extended) and September 2021 (13.5% to 14.8% depending on economic deterioration)
- To see these percentages in perspective, one must note that when the economy was growing fast — before the 2008 financial crisis — NPAs hovered around the 2.5% level.
- The banking system is the financier of the whole economy. If its wheels get jammed or malfunction, it can derail the fledgling economic recovery.
- Disconnect between certain segments of financial markets and the real economy
- The RBI noted that measures taken to support the economy and safeguard the financial system during the COVID-19 pandemic “may have unintended consequences as reflected, for instance, in the soaring equity valuations disconnected from economic performance”.
- While the country’s experienced historic recession(economic output shrank by 7.5% in Q2 and 23.9% in Q1 of FY21) the stock markets have been seemingly disconnected and soaring to record highs.As of the close of trading on January 11 (the day the RBI released its report), the benchmark S&P BSE Sensex had appreciated almost 90% from its closing level on March 23, 2020.
- It is a fact that stock market indices, both in India and elsewhere, have surged even when the real economy — that is the number of cars/TVs/ACs/ phones/ houses/ travel trips etc. — has struggled in contrast.
- RBI warned, “Stretched valuations of financial assets pose risks to financial stability,” adding, “banks and financial intermediaries need to be cognisant of these risks and spillovers in an interconnected financial system.”
How did the above situation arise (stock market rise while economy shrank)?
- Stimulus Packages across world: The onset of the pandemic saw monetary and fiscal authorities worldwide, including in India, introducing a slew of support measures to ensure that the restrictions imposed on economic activity did not completely devastate national economies and household incomes.
- Easy money in Financial System: The stimulus measures, which included interest rate cuts and infusion of liquidity, have driven a substantial surge in funds in the financial system, including in India’s case from overseas investors. Availability of lower-cost borrowings also spur people to borrow money to invest in stocks.
- Resurgence of Foreign Portfolio Investment(FPI) to India: Latest data from the NSDL. show that net FPI into equities in the current fiscal year had surged more than 38-fold to ₹2,36,781 crore (as on January 16), from the meagre ₹6,153-crore inflow in the preceding year.
- Lack of alternatives for higher returns: Worldwide, easy money conditions have in the past invariably spurred stock market rallies as investors seek higher returns at a time when interest rates on fixed income assets such as deposits and bonds decline.
Why is the RBI worried?
- Creation of Asset bubble: Easy money often creates asset bubbles. An asset bubble is when assets such as housing, stocks, or gold dramatically rise in price over a short period that is not supported by the value of the product. The hallmark of a bubble is irrational exuberance—a phenomenon when everyone is buying up a particular asset.
- Possibility of Economic Crisis caused by bursting of such bubble: RBI is wary of the risk that a sudden sharp reversal in the trend (of easy money flowing into stock markets) could cause the asset bubble to pop, triggering wider contagion effects.
- Example: Imagine a man investing his savings in a travel company because the stock is rising fast in the hope that with a vaccine being available, travel business will take off. But if there is a second, more infectious strain of the virus and the travel company goes bust, its share price will plummet and the pain will be shared with all the shareholders
- Spill over effect: What makes these asset bubble burst worse is the level of interconnectedness it has among financial institutions. A sell-offs can potentially transmit asset market shocks across the financial system (ex Mutual Funds, Asset Management Companies, Banks and NBFCs, HFCs, NABARD, EXIM, NHB, SIDBI etc)
- Worldwide Experience: The 2001 recession in the U.S., for instance, was sparked by the bursting of the dotcom bubble (overvaluation of Tech companies), which, coupled with the September 11 terrorist attacks and a series of accounting scandals at major companies.
Active intervention by central banks and fiscal authorities has to be taken to be able to ward off any risks to macro-financial stability of the system.