The Reserve Bank of India (RBI)'s Financial Stability Report has raised certain red flags over growing sovereign debt levels, the disconnect between the financial markets and the real economy, the likely deterioration in the banks' asset quality and the unintended consequences of easy liquidity in the market. Let's look at each of these parameters:
Higher govt debt levels
In the post-COVID-19 world , the government was faced with the declining revenues because of a severe lockdown. It also forced the government to provide relief to poor people and support economic growth by way of a fiscal stimulus. The government had claimed that it provided close to Rs 30 lakh crore including liquidity infusion by the RBI, which is around 15 per cent of the GDP. Most experts have pegged the stimulus between 1.5-2 per cent of the GDP. The government is already making additional borrowing this year, which is increasing the Central government debt. In fact, India's public debt-to-GDP is expected to touch 90 per cent. The RBI says the COVID-19 events are increasing sovereign debt to levels that have intensified concerns relating to sustainability with crowding out fears in respect of the private sector in terms of both volume of financing and costs.
Growing disconnect between financial markets and real economy
The RBI has pointed out that there is growing disconnect between certain segments of financial markets and real sector activity. The country's stock market is on fire, rising from a low of 25,000 level on Sensex in March this year to close to 50,000 level in less than a year. The stock market is defying all logics as the economy had been consistently seeing a lower GDP quarter-after-quarter even during pre-COVID days. In 2020-21, the GDP is expected to contract by 7-8 per cent. The RBI had earlier talked about this disconnect, but it says that this disconnect has further accentuated during the interregnum, with abundant liquidity spurring a reach for returns. "Within the financial market spectrum too, the divergence in expectations in the equity market and in the debt market has grown, both globally and in India," says the RBI.
Deterioration in asset quality comes with a lag
The loan moratorium, one-time restructuring, low interest rates and surplus liquidity have created a favourable environment for the corporate sector. The RBI says the corporate funding has been cushioned by policy measures and the loan moratorium announced in the face of the pandemic, but stresses would be visible with a lag. "This has implications for the banking sector as corporate and banking sector vulnerabilities are interlinked," says the RBI.
Unintended consequences of easy financial conditions
The RBI says that while easy financial conditions are intended to support growth prospects, they can have unintended consequences in terms of encouraging leverage, inflating asset prices and fuelling threats to financial stability. "The pandemic has altered behaviour and business models fundamentally. Policy authorities are striving to stay ahead by designing suitable responses," says the RBI. The Central Bank advises that banks need to prepare for these adversities by augmenting their capital bases to support their own business plans and the broader economic recovery process in the post-COVID period.