Jan 15, 2009

India - Importing Vulnerability

Over the past two years, the Indian financial sector, especially the banking system, has successfully withstood the stresses and strains emanating from abroad. The financial architecture is much more robust today than what it was two years ago, which should augur well for financial stability. However, the Reserve Bank of India in its recent report on the trend and progress of banking points out that that there could be some downside risks in certain areas that might imping e on stability in the near future. Of immediate concern is the turmoil in the developed financial markets where, since August-September 2008, there has been a breakdown of trust even in inter-bank lending. Such extreme risk-aversion can be reversed only slowly. After remaining resilient for a long time, India and other emerging markets have come under increasing stress recently. Since the beginning of 2008, equity markets have declined sharply, and capital outflows have intensified leading to tighter international and domestic liquidity. Financial institutions and borrowers are likely to be confronted with a more difficult macroeconomic environment. Only through appropriate macroeconomic policy responses can financial stability be maintained. Already, the U.S. slowdown, which has spread across markets and nations via trade and financial channels, has caused a significant dip in the global economic growth rate. Despite being driven largely by domestic demand, Indian economy too is adversely affected. The expectation that emerging markets would remain unaffected because of the “decoupling” from mature ones has been belied.

Specifically, the current crisis has pushed up funding costs and severely constrained access to external finance for most Indian companies. The main impact of the global financial crisis has been on the capital account. Capital inflows are expected to be lower in 2008-09 than in the previous year. Equity markets have declined sharply, making the task of raising capital extremely difficult. Tighter liquidity has caused interest rates to go up significantly. Most important of all, the reversal in capital flows has serious consequences for the balance of payments, especially when the current account deficit is widening on the back of mounting trade deficits. Ominously, the global financial situation continues to be uncertain and unsettled. It is still not possible to estimate the fallout for the Indian economy from the global downturn. In the evolving circumstances, the RBI has to remain proactive and look beyond conventional solutions.

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