Its own report should remind the RBI there’s no room for complacency about the stability of India’s financial system.
If the real economy is not doing well then the financial system will reflect it. What is important is that the financial system should not add to the problems of the real world by generating volatility of its own making. The regulatory system should be alert to the downside created by the real economy, and take steps to maintain the stability of the financial system. If it does this, market players will be confident about the ability of the system to handle the downside and go about their work in a non-speculative manner. The latest half-yearly financial stability report of the Reserve Bank of India (RBI) has done this — both identified the downside and measured the sentiments of players to find them self-assured. Over half the players in the financial system, an RBI survey finds, are either “confident” or “very confident” about the stability of the Indian financial system. So the message is that there is absolutely no cause for any kind of systemic concern. Yet, given the stresses on the financial system that the report outlines, the RBI and the government have no room for complacency.
A good example of how adverse fundamentals create negative sentiments as well as expectations and lead to speculative put-down is the manner in which the deteriorating balance of payments situation led to a steep decline in the external value of the rupee. The RBI’s action in coming down sharply on speculation that was accelerating the decline is an equally good example of how the regulator has to act with firmness so as to rein in volatility and restore market stability. But it should be clear that this is good only so far as it goes. Ultimate deliverance from problems created in the real world cannot come from firm financial management. The latter in fact slows down already slowing economic activity —and points to an inevitable period of grimness. Deliverance has to come from hard decisions taken to set the real world right. All the self-indulgence that India can allow itself is the thought that its financial system and its regulation are superior to those of China and so the pain of sharp, abrupt and somewhat draconian adjustment can be avoided.
But the bad news from the real economy is real. Weakening growth is affecting the asset quality of banks and lowering capital adequacy, though it is claimed that this remains above regulatory levels. Continuing high inflation has been exacerbated by a depreciating rupee. Domestic firms’ reliance on foreign currency finance to take advantage of interest rate differentials is now coming home to roost with the rupee depreciation raising the cost of servicing such finance. The feedback loop from the real world to the financial world has taken down the stock market and, what is more worrisome, has lately been accompanied by derivatives volumes surging ahead of cash volumes, fuelled by proprietary trading. As the RBI itself acknowledges, this needs close watching.
