RBI and Financial Stability Report

RBI and Financial Stability Report

• On Monday, the 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.
• In his foreword, RBI Governor Shaktikanta Das flagged the many risks ahead, including the recent, accentuating “disconnect between certain segments of financial markets and the real economy”.
• Mr. Das 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.”

What prompted the RBI Governor’s warning?

• While Mr. Das did not explicitly name the stock markets, the RBI is unequivocal in the report’s chapter titled ‘Macrofinancial Risks’ in identifying the asset class triggering major concern among central bankers.
• 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”.
• The backdrop to the RBI’s comments is this: while the imposition in March of the initial nationwide lockdown to curb the pandemic and subsequent State-level restrictions pushed the economy into one of its deepest contractions in the April-June quarter (initial estimates show GDP shrank 23.9% in the period), which then extended into a technical recession as GDP contracted 7.5% in the July-September period, India’s equity markets rallied sharply after plunging to more than three-year lows on March 23.
• 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.
• So, while the country’s economic output as a whole has been contracting — the government’s official advance estimates show GDP shrinking by 7.7% in the 2020-21 financial year — the stock markets have been seemingly disconnected and soaring to record highs.

How did this situation arise?

• 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.
• The 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.
• The RBI noted in the report, “surges of capital flows are being experienced, with the return of risk appetite and a renewed search for yield. Financial markets and asset prices have been lifted by this resurgence of foreign portfolio investment to India.”
• Latest data from the National Securities Depository Ltd. show that net foreign portfolio investments into equities in the current fiscal year had surged more than 38-fold to Rs. 2,36,781 crore (as on January 16), from the meagre Rs. 6,153-crore inflow in the preceding year.
• 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.
• Expectations of an economic recovery undergirded by supportive measures and the availability of lower-cost borrowings also spur people to borrow money to invest in stocks.

Why is the RBI concerned?

• The central bank is wary of the risk that a sudden sharp reversal in the trend could cause the asset bubble to pop, triggering wider contagion effects.
• The 2001 recession in the U.S., for instance, was sparked by the bursting of the dotcom bubble, which, coupled with the September 11 terrorist attacks and a series of accounting scandals at major companies, including energy firm Enron Corporation, pushed the economy into a contraction.
• In RBI’s own words, “active intervention by central banks and fiscal authorities has been able to stabilise financial markets but there are risks of spillovers ... 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.”