Views | The Indian financial system can withstand a nasty global shock

Views | The Indian financial system can withstand a nasty global shock

The last few months have provided enough indication that macroeconomic risks are increasing: slower growth, persistent inflation, weak corporate profits, a falling rupee, weak equity prices and a growing fiscal deficit.

The good news is that the Reserve Bank of India says in its new Financial Stability Report released on Thursday that economic stress is still below levels reached during the global crisis. However, a macroeconomic stability map provided by the central bank shows that six out of seven types of risk have increased: global risk, external, growth, inflation, fiscal and corporate. Only the household sector shows a reduction in risk levels.

The main tool that central banks use these days to assess the ability of their financial system to withstand a shock is the stress test. The Indian financial system comes out well even under the most stringent stress test assumptions. For example, the worst-case scenario for March 2012 is GDP growth of 3.5%, inflation of 9.4%, call money rates of 11.9% and export-GDP ratio of 14.3%. The financial system will obviously be shaken in such tough circumstances, but the RBI’s detailed statistical analysis suggests that it will not topple over. That is a relief.

Though the RBI report does not explicitly deal with policy responses, it is quite clear that risk management will be a very important challenge in 2012, irrespective of whether you are an economic policy maker, a senior banker, a chief financial officer, or a trader. India is clearly on more stable grounds than many major economies in the world. The corporate sector is not overdosed on leverage. The loan books of banks are not ridden with holes. But there has been all round deterioration in the past one year, especially on the macroeconomic front.

Drifting along complacently because India looks better than most countries could be a dangerous course of action, especially if another perfect storm hits the global economy in 2012.