RBI raises some red flags

RBI

RBI raises some red flags

RBI released the 22nd edition of its biannual Financial Stability Report (FSR) on Monday, January 11, 2021. The report highlights some key trends that could influence the financial markets in months to come. I note the following red flags raised in the report, which in my view could be relevant to my investment strategy:

Uneven and hesitant recovery, with disconnect in real activity and asset price

Economic activity has begun making a hesitant and uneven recovery from the unprecedented steep decline in the wake of the COVID-19 pandemic. Active intervention by central banks and fiscal authorities has been able to stabilize financial markets but there are risks of spillovers, with macrofinancial implications from disconnect between certain segments of financial markets and real sector activity. In a period of continued uncertainty, this has implications for the banking sector as its balance sheet is linked with corporate and household sector vulnerabilities.

COVID-19 pandemic-induced economic disruptions have exposed some fault lines in global economy. Increased public spending (stimulus) and sharply lower revenue receipts have enlarged the fiscal deficits across geographies, aggravating global debt vulnerabilities.

The credit risk of firms and households has accentuated. This could impact corporate earnings in short term. However, the equity prices continue to reflect strong earnings growth expectations. Developments that lead to re-evaluation of corporate earnings prospects will have significant implications for global flows, going forward.

Capital flows and exchange rate volatility

A hesitant recovery in capital flows to emerging markets (EMs) began in June 2020 and picked up strongly following positive news on COVID-19 vaccines. The response of foreign investors to primary issuances from EMs has been ebullient. Anticipating the COVID-19 vaccine induced economic boost, US yields of intermediate tenors (2– and 5-year) have started edging higher. This could have implications for future portfolio flows to EMs.

EM local currency bond portfolio returns in US$ terms have been lower than local currency as well as hedged returns since early 2020 as emerging market currencies have softened against the US$. This has led to sluggishness in EM local currency bond flows even as global bond markets have been pricing in a prolonged economic slowdown and benign inflationary conditions in Europe and US. In this scenario, any significant reassessment of either growth or inflation prospects, particularly for the US, can be potentially destabilising for EM local currency bond flows and exchange rates.

Improvement in bank asset quality might be misleading

By September 2020, the banking stability indicator (BSI) showed improvement in all its five dimensions (viz., asset quality; profitability; liquidity; efficiency; and soundness) that are considered for assessing the changes in underlying financial conditions and risks relative to their position in March 2020. This improvement reflects the regulatory reliefs and standstills in asset classification mentioned earlier and hence may not reflect the true underlying configuration of risks in various dimensions.

Banks risk losing better quality customers

A sharp decline in money market rates specifically since April 2020, has opened up a significant wedge between the marginal cost of fund based lending rate (MCLR) benchmark of banks and money market rates of corresponding tenor. Expensive bank finance may lead to more credit worthy borrowers with access to money markets shifting away from bank based working capital finance. Such disintermediation of better quality borrowers from banking channels could have implications for banking sector interest income and credit risk.

Banking sector prospects to see marginal changes in 2021

In the latest systemic risk survey (SRS) of October/November 2020 about one third of the respondents opined that the prospects of the Indian banking sector are going to ‘deteriorate marginally’ in the next one year as earnings of the banking industry may be negatively impacted due to slow recovery post lockdown, lower net interest margins, elevated asset quality concerns and a possible increase in provisioning requirements. On the other hand, about one fourth of the respondents felt that the prospects are going to improve marginally.

…stress to come with a lag

Domestically, 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.

Macro stress tests indicate a deterioration in SCBs’ asset quality and capital buffers as regulatory forbearances get wound down.

NPA ratio of banks may see sharp rise

The stress tests indicate that the GNPA ratio of all SCBs may increase from 7.5 per cent in September 2020 to 13.5 per cent by September 2021 under the baseline scenario. If the macroeconomic environment worsens into a severe stress scenario, the ratio may escalate to 14.8 per cent. Among the bank groups, PSBs’ GNPA ratio of 9.7 per cent in September 2020 may increase to 16.2 per cent by September 2021 under the baseline scenario; the GNPA ratio of PVBs and FBs may increase from 4.6 per cent and 2.5 per cent to 7.9 per cent and 5.4 per cent, respectively, over the same period.

These GNPA projections are indicative of the possible economic impairment latent in banks’ portfolios, with implications for capital planning. A caveat is in order, though: considering the uncertainty regarding the unfolding economic outlook, and the extent to which regulatory dispensation under restructuring is utilised, the projected ratios are susceptible to change in a nonlinear fashion.

In light of the findings of FSR, the governor of RBI, Shaktikanta Das has cautioned the investors and financial institutions that “The disconnect between certain segments of financial markets and the real economy has been accentuating in recent times, both globally and in India” and “Stretched valuations of financial assets pose risks to financial stability. Banks and financial intermediaries need to be cognisant of these risks and spillovers in an interconnected financial system.

I take note of the above red flags and continue with my “underweight financials” strategy for 2021.

 

Chart for the day

Author: Midas Finserve

Leave a Reply

Your email address will not be published. Required fields are marked *