Banking turmoil in the West has placed India at a fork in the road

Source: The post is based on the article “Banking turmoil in the West has placed India at a fork in the road” published in Live Mint on 27^th March 2023.

Syllabus: GS 3 – Economy – Money and Banking

Relevance: Impact of US bank crisis on the world

News: The failure of three US banks have shaken the global economic crisis and has reminded the Global Financial Crisis (GFC) of 2008. However, the GFC of 2008 is different from the current crisis.

How is the current crisis different from the Global Financial Crisis (GFC) of 2008?

The problem during the GFC was with the credit risk caused by a surge in banks’ bad mortgage loans.

However, the current crisis in US regional banks is due to liquidity risk driven by deposit outflows, and Silicon Valley Bank’s issues.

What are different scenarios emerging from the failure of the bank in the US?

Good scenario: In this, the US Federal Reserve manages to address banks’ liquidity needs via its new bank term-funding programme and its regular discount window.

This would prevent other smaller US banks from selling their assets at a loss. This restores confidence, deposit outflows stabilize and bank runs are avoided.

Bad scenario: It would cause a financial crisis leading to a wave of financial shocks. As seen from last year, there have been instances such as tremors in the cryptocurrency market, the UK pension liability-driven investing crisis and now in US and European banks.

However, in either of the scenarios, there will likely be weaker global growth and recession in both the US and Europe.

Why are recessions likely to happen in the US and Europe?

This is because – a) monetary policy takes time to be effective and the impact of the last year’s tightening policy is yet to fully emerge, b) the banking turmoil will further weaken growth through due to tighter lending standards for the banks and c) these shocks can have ripple effect leading to high cost of capital which in turn delay the capex by the firms along with increase in the saving.

What will be the potential impact of the crisis on India?

The crisis in the West for India means – a) weaker growth and lower inflation, b) slowdown in India’s exports and delay in private capital expenditure, c) moderate consumer demand due to higher interest rates and increased uncertainty.

It is also expected that India’s GDP growth will be moderate at 5-5.5% in 2023-24.

However, the overall impact on India will be limited because both financial and corporate sector balance sheets are stronger. India also has enough foreign exchange reserves to manage any capital account outflows.

Read More: SVB, Signature Bank collapse: What are ‘Too-Big-To-Fail’ banks, and what makes Indian banks safe

What lies ahead?

The worst inflation is yet to come and therefore, it is necessary for India to create buffers through monetary and fiscal policies.

For monetary policy, a forward-looking approach is needed by assessing the impact of past tightening domestic policy and global spillovers along with increasing scrutiny of macro-economic financial risks.

For fiscal policy, there is a need to prepare for a potential slowdown in growth and tax revenues by curbing non-essential spending so that countercyclical public capital expenditure is maintained.