Economic stress tests

External sector remains a source of risk

Some of the numbers reported in the Reserve Bank of India’s (RBI’s) Financial Stability Report (FSR) should be comforting for policymakers. After years of stress, the banking sector is looking in good shape. Gross non-performing assets (GNPAs), which have been witnessing a steady decline for some time, were at a seven-year low of 5 per cent in September. Net NPAs also declined to a 10-year low of 1.3 per cent. The level for the private sector was less than 1 per cent. Provisioning coverage has increased, while the net profit for scheduled banks jumped by over 40 per cent in the first half of 2022-23. The RBI stress tests showed that even in severe stress scenarios, banks would comply with minimum capital requirements. Although part of the decline in NPAs is on account of writing off bad loans, the sector is no longer a pain point for the economy.

Encouragingly, credit growth has also picked up, which should support interest income in the coming quarters. Meanwhile, leverage in the corporate sector is also increasing from the lows of the pandemic. However, the share of fixed assets in total assets remains depressed, which indicates that investment activity has still not picked up in a meaningful way. It is worth noting that part of the growth in credit demand is because of reduction in equity-market issuances. Funding by venture capital and private equity funds has also moderated. As the banking system is now in better shape, a revival in private investment will depend on improvement in the macroeconomic outlook.

In terms of policy management this year, external accounts have been an area of concern. The RBI in this context reported that the current account deficit (CAD) in the second quarter expanded to 4.4 per cent of gross domestic product (GDP), compared to 2.2 per cent in the previous quarter. The CAD increased mainly because of the merchandise trade deficit. Further, capital flows fell short of the requirement, which led to depletion in foreign exchange reserves by over $30 billion. The ongoing quarter, however, has seen a recovery in reserves. Although the CAD increased to worrying levels in the second quarter, economists expect it to come down meaningfully. The CAD for the fiscal year is expected to be about 3 per cent of GDP, which is lower than the levels projected until a few months ago. Policymakers nonetheless would need to remain vigilant.
 

Notably, as highlighted in the FSR, of the total decline in reserves by about $75 billion in the current year, 66 per cent was because of valuation losses. A sharp dollar appreciation and a significant increase in bond yields eroded the value of the foreign assets held by the RBI. While part of the valuation loss would be recovered as the global currency markets stabilise, the magnitude deserves attention. To avoid such losses, particularly at a time when India may need to use a large part of the reserves, both the level of currency and asset diversification would need to be reviewed. Broadly, while analysts expect conditions on the external account to improve, it remains a big source of risk. A deep recession in advanced economies or an unexpected turn in the Ukraine war or both could significantly increase policy challenges.