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ExplainSpeaking: Ahead of Budget 2021, what RBI is worried about

The latest Financial Stability Report states that non-performing assets could simply double between September 2020 and September 2021.

Written by Udit Misra , Edited by Explained Desk | New Delhi |
Updated: January 22, 2021 2:39:55 pm
A pedestrian walks past the Reserve Bank of India (RBI) building in Mumbai (Photographer: Kanishka Sonthalia/Bloomberg)

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As we approach the Union Budget for 2021-22 there is a natural curiosity about the current state of the Indian economy.

A couple of weeks ago we explained the key takeaways from the latest GDP estimates released by India’s central government.

Last week saw another important report — the Financial Stability Report (FSR), which was released by the Reserve Bank of India (RBI).

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 phrase “macro-financial risks” sounds esoteric and, at some level, it is. But, simply put, it is about systemic risks in an economy. They are difficult to define but, much like obscenity, you know them when you see them.

For instance, 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.

Why?

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Because if banks do not get their money back, they won’t be able to fund the next set of investments. Even if the government decides to use the taxpayer’s money to bail them out, it will have to curtail some other expenditure — perhaps on education or healthcare or infrastructure. 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.

The best recent example of this happening was the sub-prime crisis in the US in 2008 which quickly snowballed and spread all across the world as the Great Financial Crisis of 2008-09.

And the reason why this happened was the deep interconnectedness of the financial entities such as banks and non-bank financial companies and housing finance companies etc. That is what we mean when we say that macro-financial risks are systemic in nature.

It is for this very reason, prevention is better than cure. The FSR released by the RBI is the biannual alert of such risks in the Indian economy.

The last FSR was released in July 2020 and ExplainSpeaking wrote why everyone expected NPAs to rise in the Indian banking system.

The latest FSR confirms those apprehensions. According to the RBI’s analysis, the level of NPAs in India’s banking system could almost double between September 2020 and September 2021.

“(The Scheduled Commercial Banks’) SCBs’ GNPA (gross NPA) ratio may increase from 7.5 per cent (of all loans extended) in September 2020 to 13.5 per cent by September 2021 under the baseline scenario. If the macroeconomic environment deteriorates, the ratio may escalate to 14.8 per cent under the severe stress scenario,” reveals the FSR.

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 per cent level.

The “stress tests” done by regulators also indicate that in the severe stress scenario several banks may fall short of sufficient capital (money) to meet the regulatory benchmarks.

The banking system is the financier of the whole economy. If its wheels get jammed or malfunction, it can derail the fledgeling economic recovery.

But high bank NPAs are not the only thing RBI is worried about.

In his foreword, RBI Governor Shaktikanta Das wrote: “Meanwhile, the disconnect between certain segments of financial markets and the real economy has been accentuating in recent times, both globally and in India. 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.”

In simple terms, RBI is worried that the measures — such as increased availability of money and that too at low-interest rates as well as the fiscal stimulus — that the central banks and governments, both in India and abroad, undertook to cushion the adverse economic impact of Covid-19 and boost economic recovery might have serious side-effects.

“…support measures may have unintended consequences as reflected, for instance, in the soaring equity valuations disconnected from economic performance. These deviations from fundamentals, if they persist, pose risks to financial stability, especially if recovery is delayed,” states the report.

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.

Easy money often creates asset bubbles, which when they burst tend to bring down the real economy. 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. With countries such as the US slated to provide trillions of dollar worth of stimulus package, such fears are not unfounded.

What makes these shocks worse is the level of interconnectedness among financial institutions.

For instance, Asset Management Companies/Mutual Funds (AMC-MFs) are the largest net providers of funds to the financial system. Their gross receivables were Rs 7.74 lakh crore. The top recipients of their funding are banks, followed by NBFCs, HFCs (housing finance companies) and AIFIs (All India Financial Institutions such as NABARD, EXIM, NHB and SIDBI).

Given the interconnectedness among them, a sell-offs can potentially transmit asset market shocks across the financial system.

But there was some relieving news as well. According to the RBI’s systemic risk survey (SRS), prospects of the Indian banking sector have improved (see chart below) since the last FSR.

Prospects of the Indian banking sector in the next one year 

The SRS also provided what are the major impediments to a robust economic recovery post COVID-19. Lack of private sector investments and declining consumer spending (see table below) — the two biggest drivers of India’s GDP growth — top the list and provide a sense of what Finance Minister Nirmala Sitharaman is likely to address in her forthcoming Budget.

Major impediments to a robust economic recovery post covid-19

Take care,

Udit

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