S S Tarapore

Threats to financial stability

S.S. TARAPORE | Updated on January 28, 2011


When inflation spins out of control, as at present, there can be a jolt to the financial markets and an inevitable dislocation in credit. The widening current account deficit and rising external debt are disturbing trends.

The Reserve Bank of India (RBI) Financial Stability Report (December 2010) is an excellent document which provides a veritable tome of information and analysis for formulating policies.

Buoyed by strong domestic demand, India's GDP has rebounded. The Report stresses that inflation in India has some structural basis, particularly in the case of food inflation. Official statements have claimed that the inflation rate would come down, but this has been belied by the latest food inflation rate zooming to 18.5 per cent. Stressed liquidity conditions have resulted in some hardening of interest rates.


The stressed liquidity conditions are attributed to rising currency in circulation and faster growth of advances relative to deposits. With virtually unlimited access under the Liquidity Adjustment Facility (LAF), at extremely low and fixed rates of interest, there is a vicious circle of each injection of liquidity by RBI resulting in a surge in credit. The signals from RBI through Open Market Operations (OMO) purchases and the reduction of the statutory liquidity ratio (SLR), together with the LAF, inevitably lead to permissive credit expansion and self-perpetuating liquidity stress.

There is the moral hazard of accommodation by the central bank. The low interest rate regime leads banks to ignore underlying credit weaknesses of borrowers and fresh credit is granted on the optimistic assumption that the low interest rate regime would continue. There is the question of credit quality of the banks' loan portfolio and the health of balance sheets, especially when there is a possibility of hardening of interest rates.

The danger is that the central bank has conveyed to banks that there would be baby steps in any tightening. When inflation spins out of control — as it indeed has at the present time — there can be a jolt to the financial markets and an inevitable dislocation in credit.

The RBI needs to give an unequivocal message to banks, in the inimitable style of the late Dr I.G. Patel who would say, “do not lend the money you do not have”. Banks need to be disabused of the view that the present accommodative policy is there to stay indefinitely.

There is a major flaw in the present operation of the LAF. The LAF “auction” is a misnomer, as there is unlimited access at a fixed rate. Since it is the avowed objective of the RBI to move towards a market determined system, the RBI should determine the daily injection it is willing to allow and let the market determine the rate. Of course, there should be a lender of last resort facility at a punitive rate which would ensure that individual banks do not take recourse to imprudent expansion. The Working Group examining these matters should expedite its report forthwith.


The widening balance of payments current account deficit (CAD) and increased capital inflows are a cause for concern. The policy of non-intervention in the forex market, resulting in an appreciation of the rupee, goes against fundamentals. There is the vulnerability of significantly larger portfolio investment as compared with direct investment.

The net international liabilities have risen from $86 billion in June 2009 to $185 billion in June 2010. The external debt to foreign exchange reserves is now close to 100 per cent — the highest for seven years — and the short-term debt to reserves is 21 per cent. After many years, annual imports now far exceed the forex reserves. Surely all this should be flashing the red light.

The RBI, not without justification, stresses the resilience of the Indian financial system, but with increased integration with the global economy, an external shock of large capital outflows and or a sudden spurt in prices of crude petroleum and other sensitive commodity imports could dislocate the system.


The Report refers to the dilemma of deposit insurance. India was the second country after the US to set up a deposit insurance system. The growth of deposit insurance in India has been stunted as it is treated as a fiefdom of the powerful banking operations/supervision wing of the Bank and hence it is bereft of any supervisory powers. Either the RBI top management should give this serious attention or face the consequences of deposit insurance being separated from RBI and be given independent regulatory/supervisory powers. The RBI should not ignore this wake-up call. The Financial Stability Report provides a competent analysis of the state of the financial sector. It is no fault of the Report if the precept (i.e. analysis) is not reflected in practice (i.e. policy). This great divide has to be bridged. After prolonged baby steps the RBI has no option but to step up the accelerator on measures on January 25, 2011.

Published on January 13, 2011

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