It is now almost two years since the infamous taper tantrum sent the rupee reeling. India at that time had the word fragility written all over it. The fiscal deficit had ballooned, the current account gap was at a record level and inflation was persistently high. These macroeconomic imbalances had been allowed to build up when Pranab Mukherjee was finance minister.

That bout of economic instability is now history. The sudden collapse of global commodity prices has undoubtedly helped. But credit is also due to P. Chidambaram, Raghuram Rajan and Arun Jaitley. The lessons from those manic weeks were taken seriously by the Indian policy establishment. The indicators of fiscal discipline, the balance of payments and price trends look far better today than they were two years ago. One has to only take a look at the continuing economic mess in Turkey or Brazil to realize how well policymakers have done to stabilize the macro economy.

The consensus now is that India is in a good position to deal with a new bout of global turbulence when the US begins to increase interest rates. That is only half the story. There is a new class of risks now casting a long shadow on the Indian economy. These risks are to be found in the balance sheets of overleveraged companies as well as the banks that have lent to them.

In other words, the risks to economic stability have shifted from the government to the business sector. The International Monetary Fund estimates that corporate stress in terms of four parameters—interest cover, liquidity, profitability and leverage—is the highest since the turn of the century. This makes the Indian corporate sector prone to trouble in case there are adverse shocks such as higher domestic interest rates, higher global interest rates or sharp currency depreciation. The first seems unlikely right now, but the other two are very real threats.

The genesis of these risks can also be traced to what happened during the second Manmohan Singh government. The massive increase in government borrowing to fund the growing fiscal deficit threatened to crowd out private sector demand for domestic funds. Companies lobbied with the government to allow them to borrow abroad more easily. External commercial borrowings more than doubled from March 2010 to March 2014, as companies rushed to borrow abroad at a time when central banks in the rich countries had cut interest rates almost all the way down to zero. A lot of this enthusiastic borrowing was done by the infrastructure companies that have political heft.

The decision to allow firms in the non-tradables sector to take on dollar liabilities was fundamentally risky. The borrowing companies made matters worse by deciding not to hedge their foreign exchange exposures, which could leave them in trouble in case the rupee takes a deep dive. This could perhaps be one reason why the Reserve Bank of India is maintaining a slightly overvalued rupee through higher interest rates.

A benign view of all this is that the risks in private sector balance sheets are not systemic, and hence in some way are less of a worry than the macro risks that dominated in 2013. There is some merit in the argument, which is why global financial markets believe India is better placed to deal with a rise in global interest rates than many other emerging market economies that have let their macro problems fester.

But there is still the confidence channel to be considered. A default by some large Indian company on its foreign debt could lead to a spike in risk aversion to all Indian assets. The micro risk then may be quickly transmuted into a macro shock. This is admittedly still an outlier possibility, but it is dangerous to ignore the manner in which micro risks can become macro risks through the global confidence channel.

One final point: What are the implications of this switching of risks from the government to the private sector? Higher interest rates were one part of the overall strategy to stabilize the Indian economy after September 2013. The question worth asking—and I am not sure of the answer—is whether the need is now for lower interest rates.

As this column had pointed out in January 2014, there are useful lessons from the previous recovery in the early 2000s: “Low inflation allowed the Reserve Bank of India to retreat from the brutal monetary compression it unleashed when inflation was in the double digits. Governor Bimal Jalan began to ease policy. Borrowing costs tanked. The yield on the 10-year government bond fell by more than six percentage points by the middle of 2003.

This had two effects. One, lower interest costs helped overleveraged companies put their balance sheets in order. Two, banks saw the value of their bond portfolios soar in tandem with declining interest rates; they used these gains to deal with their bad loan problems."

The key is inflation. So, is the disinflation we are seeing deep enough to survive shocks such as a poor monsoon or a reversal in global commodity prices?

Niranjan Rajadhyaksha is executive editor of Mint.

Comments are welcome at cafeeconomics@livemint.com. To read Niranjan Rajadhyaksha’s previous columns, go to www.livemint.com/cafeeconomics

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