Stressing stability

Indian policymakers must remain vigilant

The Financial Stability and Development Council, headed by Union Finance Minister Nirmala Sitharaman, this week deliberated the need for having more early stress indicators to enable regulators to identify potential problems and deal with them in time. The focus of top policymakers and regulators on identifying signs of stress in the financial system must be welcomed as it will help strengthen financial stability. The increased global economic and financial interdependence has also increased risks. While interconnectedness has its merits, emerging market countries should build safety margins to limit the downside risks. At this stage, there are several interrelated risks emanating from the global economy. Although they may not pose an immediate threat to financial stability, policymakers would do well to remain prepared.

The most prominent risk at the moment is the ongoing trouble in the US banking system. The authorities had to intervene again this month and seize First Republic Bank. The bulk of its operations were sold to JPMorgan Chase. A number of smaller banks are struggling for some time and are facing withdrawal of deposits. First Republic had over $200 billion in assets and came under significant pressure after the collapse of Silicon Valley Bank and Signature Bank in March. Although the impression given by the authorities indicates that the problem has been contained, surprises could still emerge. Notably, three out of the four biggest bank failures in the US have happened over the past two months. A sharp increase in interest rates by the US Federal Reserve has led to large losses in the investment portfolio of banks. As a result, handling the pressure of deposit withdrawal is becoming difficult for some banks.

Stress in the banking sector can not only interrupt credit flow in the US, affecting overall demand, but could also directly impact the demand for software products and services from Indian IT firms. The banking and financial services sector is a major source of revenue for Indian technology firms. Besides, stress in the banking sector and potential losses can increase risk aversion, affecting capital flows to emerging market countries like India. The other big risk is the high budget deficit in several advanced economies, including the US. Aside from the immediate danger of breaching the debt ceiling, which will lead to default by the US government, the fiscal deficit is expected to average over 6 per cent of gross domestic product (GDP) over the next decade. This will be significantly higher than the average of about 3.5 per cent of GDP witnessed in recent decades and will have implications for the global financial markets.

A structurally higher deficit in the US would mean the Fed will have to do more to contain inflation. It might have to maintain higher interest rates for a longer period, which would only increase the possibility of mishaps in the financial sector. The higher demand for savings by the US and other governments in the developed world would limit the amount of funds flowing to emerging market countries. Sustained higher budget deficits and higher interest rates could also increase volatility in currency markets. Since India has no control over how things unfold in advanced economies, it needs to remain prepared.  On its part, the government should bring down the fiscal deficit at the earliest, which would help reduce dependence on foreign capital and improve macroeconomic stability.