Three economic risks in need of mitigation plans

Source: Live Mint

Synopsis: RBI’s Financial Stability Report listed Inflation, a reversal of capital inflow, and lenders’ mounting bad assets are all listed as potential threats. All three should be avoided.

Introduction

Many central banks throughout the world have recently taken various measures to deal with economic pressures.

• Markets have become agitated as a result of their attempts to increase production growth through extended periods of cheap interest rates and liquidity infusion.
• The matrix of hazards washing up on Indian shores has suddenly become considerably more complex and scary. The US Federal Reserve recently stated that it may start hiking interest rates sometime in 2023. Reserve Bank of India (RBI) governor must keep an eye on threats emanating from global markets as well as those emerging in the home economy.
• The current Financial Stability Report (FSR) from the central bank attempts to acknowledge all of them.
  • A restoration to pre-pandemic levels of economic activity would take longer than previously predicted, as the Indian economy is facing variable speed of covid vaccination and the asymmetric opening up across regions.
• It will take time to repair supply-side capacities that have been harmed. On the demand side, increased employment rates and households’ confidence in converting precautionary savings into consumption are critical.

What are the potential threats listed in the RBI’s Financial Stability Report?

Three vulnerabilities that have an impact on systemic and financial stability stand out in the research and need to be addressed. Commodity inflation and global capital flow curtailment are two external factors. The third concern is our domestic banking sector’s developing fault lines.

• Capital will be critical in weathering a bad-loan catastrophe. If credit demand rises in pace with our economic openness, there are concerns that banks will not only have enough capital to back new lending, but also to cover a rising wave of bad loans.
• The government, which is the sector’s primary source of capital, has limited resources that are being tugged in various ways.

What should be done?

• Firstly, there is no clear risk-mitigation strategy insight. One of them is to use the RBI’s growing foreign exchange reserves for infrastructure investment, which is unwise. Foreign currency reserves will be needed to balance any “taper tantrum” if and when capital inflows revert.
• Secondly, the danger of imported commodity inflation will require more careful monitoring and management. Surveys already show increased inflationary expectations among households, and the RBI should be willing to adjust its rate policy.
  • Long periods of low loan rates have assisted indebted wholesale borrowers, but not capital investment or economic growth.
• Thirdly, to improve the health of the banking sector, the near-term option may be selling modest portions of new shares to individual and institutional investors, rather than complete bank privatisation. State-owned banks would be able to raise money in this way, and the government’s interest in them would be valued more favourably.