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Dear Readers,
Last week, the Reserve Bank of India (RBI) released its latest Financial Stability Report (FSR). As the name suggests, it details the state of financial stability in the country, and it is prepared after taking into account the contributions from all financial sector regulators. In other words, it details the current status of different financial institutions such as all the different types of banks and non-banking lending institutions. It also maps the state of credit growth and the rate at which borrowers are defaulting on paying back loans.
To arrive at these conclusions, the RBI looks at the state of both the global as well as domestic economy. It also conducts certain “tests” to figure out how different variables may be affected if the economy does not grow as anticipated.
As part of the FSR, which is published twice each year, the RBI also conducts a Systemic Risk Survey (SRS), wherein it asks experts and market participants to assess the financial system on five different types of risks — global, financial, macroeconomic, institutional and general.
Reading the FSR tells us how robust or vulnerable our financial system — especially our banking system — is to the changes in the economy. As a corollary, it also tells us whether and to what extent will our banks and other lending institutions (such as Non-Banking Finance Companies and Housing Finances Companies) be able to support future growth. For instance, if the FSR reveals that the percentage of non-performing assets (NPAs or bad loans) in the banking system is high and also shows that the government fiscal deficit is also high then it means that not only will the banks struggle to function effectively (and fund future growth) but also that if banks were to falter then the government may find it tough to bail them out.
ExplainSpeaking has been writing about the highlights of each FSR. You can click on the following links to read about the FSR in July 2021 (https://indianexpress.com/article/explained/explainspeaking-making-sense-of-rbis-financial-stability-report-7389244/), January 2021 (https://indianexpress.com/article/explained/explainspeaking-union-budget-indian-economy-rbi-covid-19-7150730/) and July 2020 (https://indianexpress.com/article/explained/explainspeaking-why-everyone-expects-npas-to-rise-in-india-6523697/)
Here are some of the key takeaways and charts from the latest FSR. Since this is a biannual publication, the default comparison is to the last FSR.
#1 Global growth has started to falter
“Since the July 2021 issue of the FSR, the rejuvenation of the global recovery in the first half of 2021 has started losing momentum, impacted by resurgence of infections in several parts of the world, supply disruptions and bottlenecks and the persistent inflationary pressures that have manifested themselves in their wake,” states the latest FSR. “The slowdown in activity is occurring even in countries with relatively high vaccination rates that seemed to be emerging as global growth drivers.”
The FSR details some key variables that capture this slip up.
Chart 1 depicting the World merchandise trade volumes.
For instance, the Goods Trade Barometer (see CHART 1) of the World Trade Organization (WTO) shows that the World merchandise trade volumes, which had risen 22.4 per cent year-on-year in Q2 (April to June) of the 2021 calendar year, have been slowing in the second half of the year. “The decline in the barometer reflects a combination of tapering import demand and disrupted production and supply of widely traded goods such as automobiles and semiconductors,” states the FSR.
Chart 2 shows the Baltic Dry Index, which is a measure of shipping charges for dry bulk commodities.
Another key index is the Baltic Dry Index, which is a measure of shipping charges for dry bulk commodities. This index crossed its highest mark in more than a decade in October 2021, but it recorded a sudden drop after that. (see Chart 2).
Chart 3 shows the Global Economic Surprise Index, which compares incoming data with economists’ forecasts to capture the surprise element.
Similarly, as the actual growth data diverged from the previous forecasts, the Global Economic Surprise Index (GESI), which compares incoming data with economists’ forecasts to capture the surprise element (see CHART 3), went into negative territory during July, August and September (Q3:2021).
What has complicated matters more is the rise of the Omicron variant. All this has a considerable impact on even the emerging economies (such as India) where vaccination rates are even lower than advanced economies and which are also likely to suffer from central banks in developed countries making money costlier (by raising interest rates).
#2 Disconnect between real economy and India’s equity markets
“Lifted by the bull run in equity markets across the globe, the Indian equity market surged on strong rallies with intermittent corrections,” states the FSR. “Strong investor interest has driven up price-earnings (P/E) ratios substantially.”
Chart 4 shows that the one-year forward P/E ratio for India was 35.1 per cent above its 10-year average.
As of December 13, the one-year forward P/E ratio for India was 35.1 per cent above its 10-year average, and one of the highest in the world (see Chart 4).
Table 1 depicts other other valuation metrics.
Other valuation metrics such as the price-to-book value (P/B) ratio, the market capitalisation to GDP ratio, and the cyclically adjusted P/E ratio or Shiller P/E are also above their historical averages ( see Table 1).
“This reflects some disconnect between the real economy and equity markets,” the RBI report. But this is not the first time that RBI frowned at the growing disconnect between the overall state of the economy and the pace at which India’s stock markets have grown. High levels of divergence are a concern from the point of view of financial stability.
#3 Bank credit growth is improving, but not fast enough
According to the FSR, the banking stability indicator (BSI), which indicates the changes in underlying conditions and risk factors of India’s commercial banks, showed improvement in “soundness, asset quality, liquidity and profitability” parameters when compared to the situation in March 2021. Only in the “efficiency” parameter did this indicator worsen. This is good news since this period includes the disruption due to the vicious second wave of Covid-19.
Chart 5 shows the credit growth rate.
Of particular importance is the improvement in the credit growth rate. The blue line in CHART 5 is beginning to look up and form a “U-shaped” recovery. However, within this overall improvement, there are some matters of concern still.
For once, the growth rate is still far off the ideal level. Secondly, retail credit (that is, less than Rs 5 crore) is growing at a decent clip, wholesale credit (Rs 5 crore and above) growth continues to struggle. Moreover, data shows that most of the wholesale credit is being picked up by public sector undertakings while the private sector is holding back from raising fresh funding.
Chart 6 shows the bank credit to the MSME segment.
Equally disappointing is the fact that bank credit to the MSME segment slowed down (y-o-y) by the end of September 2021 vis-a-vis March 2021 (see CHART 6). This points to the weak state of the MSME sector as well as the meagre prospects that face at present.
“Bank credit growth is showing signs of gradual recovery, although flow of credit to lesser rated corporates continues to be tepid. Signs of incipient stress in micro, small and medium enterprises (MSME) as also in the microfinance segment call for close monitoring of their portfolios,” states the FSR.
#4 NPAs may rise by September 2022
A key variable to watch out for in any FSR is the state of bank NPAs. In particular, each FSR conducts some “stress tests” to find what will happen to the NPA level if things go wrong. These stress tests are nothing but “hypothetical adverse economic conditions” and are done by taking progressively worse values of variables such as GDP growth, combined fiscal deficit-to-GDP ratio, CPI inflation, weighted average lending rate, exports-to-GDP ratio and current account balance-to- GDP ratio.
The latest FSR pegs the NPA of India’s Scheduled Commercial Banks (SCBs) at 6.9 per cent at end-September 2021. “Stress tests indicate that the Gross NPA ratio of all SCBs may increase to 8.1 per cent by September 2022 under the baseline scenario and further to 9.5 per cent under severe stress,” states the FSR. Among all the banks typically it is public sector banks that are more guilty of such slippages. That stays true this time too. “Within the bank groups, public sector banks’ GNPA ratio of 8.8 per cent in September 2021 may deteriorate to 10.5 per cent by September 2022 under the baseline scenario,” states FSR.
#5 Systemic risks evenly balanced
Table 2 shows the five main categories and the sub-categories in which different types of risks are classified.
Table 2 details the five main categories and the sub-categories in which different types of risks are classified. There are five levels of risks — very high, high, medium, low and very low.
On the whole, the Systemic Risk Survey (SRS), “across all broad categories of risks to the financial system – global; macroeconomic; financial market; institutional; and general – were perceived as ‘medium’ in magnitude, but risks arising on account of global and financial markets were rated higher than the rest”.
For India, the main sources of risks are commodity prices, domestic inflation, equity price volatility, asset quality deterioration, credit growth and cyber disruptions.
# 6 Banking prospects improve
There are two more interesting charts in the latest FSR.
Chart 7 shows sentiment among respondents when asked about the prospects of banking in the year ahead.
Chart 7 shows a considerable improvement in the sentiment among respondents when asked about the prospects of banking in the year ahead. In the previous round (Yellow bar), most believed prospects would worsen. In the latest round (Purple bar), however, most expect prospects to improve.
Chart 8 asked respondents how long would it take for the Indian economy to recover.
Lastly, Chart 8 asked respondents how long would it take for the Indian economy to make a full recovery from the fallout of the Covid pandemic. Almost 64% expect the economy to recover fully in the next 1 to 2 years while 22% believe it may take up to 3 years to recover completely.
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The upshot: The latest FSR’s analysis suggests that India’s banking and financial system has largely improved since the July 2021 report. But with global growth faltering, monetary tightening in the developed countries (which is likely to hurt foreign fund flows) as well as the rise of omicron, the risks are evenly balanced.
Mask up and take care,
Udit