The RBI flashes caution

Over the years, the Reserve Bank of India (RBI) reports show progressive improvement both in presentation and content. Opinion-makers take these comprehensive reports for granted and often pay scant attention to the central message. While comparisons are odious, the Financial Stability Report, Issue No. 4 (December 2011) is an outstanding piece of work and policymakers, market participants, opinion makers and analysts should all give careful attention to this report.

At the outset, the report warns that Emerging Market Economies (EMEs), like ours, face the risk of sudden capital outflows and or a rise in funding costs, both of which could jeopardise the stability of the domestic economy.

This contrasts with the experience in 2008, when policymakers assured that India was different and immune to the headwinds from the global economy. Mercifully, the decoupling theory no longer carries any credibility.

Risks to stability

The RBI has instituted a Systemic Risk Survey, wherein it is recognised that growth in 2011-12 would moderate, while inflation and inflation expectations remain elevated. While the report reassures that the Indian financial sector is sound and resilient, there is a need to be vigilant about asset quality and exuberant credit growth in select sectors. It is reassuring that the RBI is working on a forward-looking provisioning framework.

In the Systemic Risk Survey, the assessment is supplemented through wider consultation. The RBI has constructed a Financial Stability Map based on macro-stability, financial market stability and banking stability, which clearly shows that there is a progressive increase in risks to financial stability of the Indian economy.

The report expresses concern about the widening balance of payments, current account deficit (CAD) as a result of increased imports and moderation of exports. On the fiscal front, slowdown in revenues and increased subsidy expenditures could result in the fiscal deficit exceeding the target.

There has been considerable discontent in the recent period that the Indian rupee has depreciated, in nominal terms, by much more than other Asian EMEs. The report does well to explain that countries such as India, which have a large CAD, have experienced a larger currency depreciation than those with a current account surplus.

The report cautions that the corporate sector will have to refinance its external commercial borrowing (ECB) at significantly higher interest rates.

Hitherto, India Inc. used the soft option of financing itself at low interest rates on ECB and many have opted to keep open exchange positions. A basic tenet is that a corporate should never keep an open position. If a corporate opts to make money on the swings, it should also be prepared to lose on the roundabouts.

Flaw in thinking

In recent years, a dangerous proposition has been doing the rounds, that is, that currency appreciation is disinflationary and that currency depreciation is inflationary. This flaw in thinking has become fashionable in respected circles. The RBI has also embraced this false analysis

When, in the recent period, the rupee exchange rate was appreciating against fundamentals, the RBI followed a policy of “non-intervention”. As a result, when the turn in the cycle took place, the rupee depreciated by much more than what it would have, had the RBI undertaken purchases in the forex market to stem the appreciation.

Given the avowed policy of the RBI to avoid volatility, it was incumbent on it to prevent undue appreciation. Basic international monetary theory teaches us that depreciation of the currency, by absorbing more domestic currency per unit of foreign exchange, is disinflationary and, per contra, an appreciation is inflationary (subject to the Marshall-Lerner Condition of the combined supply and demand elasticity being greater than unity). One cannot fault the Report for merely following the new gospel truth.

The new thesis suited the industrial countries which were preaching to the EMEs. But surely, EMEs with large CADs should not have accepted the reversal of the Law of Gravity. The report cautions that funding constraints in global markets could impact the availability and cost of funding for banks and corporates.

Banks resilient, but..

The report indicates that slippages in asset quality of banks exceeded credit growth. Notwithstanding this, the report emphasises that Indian banks have fared better than in other countries. The report concludes that that the loss of assets in an extreme loss scenario would still leave Indian banks resilient. A word of caution is necessary here.

When a banking system experiences a break down, all earlier stress tests become irrelevant and firewalls protecting the banking system melt away. In the euphoria of the general perception that Indian banks are the soundest in the world, it is necessary to caution that in the current milieu, banks, the government, borrowers and the RBI are all not prepared to be the harbinger of a possible banking crisis, lest the messenger be shot. The report concludes that the Indian financial system remains robust and well-equipped to face the headwinds of instability; however, one can never be too cautious.

(The author is an economist. blfeedback@thehindu.co.in )

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