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Business News/ Opinion / Views/  Banking turmoil in the West has placed India at a fork in the road

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

Lower growth and inflation are now more likely and this calls for Indian policy preparedness against emerging global risks

Photo: ReutersPremium
Photo: Reuters

Recent events have shaken the global economic outlook. Three US mid-sized banks have failed, Credit Suisse has had to be taken over by UBS, and the spotlight is now on German banks. These have re-ignited memories of the 2008 Global Financial Crisis (GFC), but the turmoil so far is different from it in a few aspects.

During the GFC, the problem was one of credit risk, caused by a surge in banks’ bad mortgage loans. The current crisis in US regional banks is one of liquidity risk, driven by deposit outflows, and Silicon Valley Bank’s (SVB) issues emanated from large losses on its government bond holdings amid rising interest rates.

However, SVB’s problems are more systemic than idiosyncratic. Many banks on both sides of the Atlantic have unrealized losses on their bond holdings (albeit this in itself is not reason for alarm). SVB’s failure has also resulted in contagion via deposit outflows from other small and mid-sized US banks into larger banks and money market funds, which makes it more systemic.

How the banking turmoil may progress—good versus bad scenario: In the good scenario (our baseline case), the US Federal Reserve manages to address banks’ liquidity needs via its new bank term-funding programme and its regular discount window. This prevents other smaller US banks from having to sell their assets at a loss. The existing backstop restores confidence, deposit outflows stabilize after some time and further bank runs are avoided.

In the bad scenario, this snowballs into a financial crisis. As seen during the GFC, financial shocks come in waves. Since last year, we have seen tremors in the cryptocurrency space, meme stocks, the UK pension liability-driven investing crisis and now in US and European banks. One could argue that the last decade-plus of low rate/easy monetary policies has pushed investors into high-risk/high-return assets, increased financial leverage and shifted risk to non-bank financial institutions that are opaque and harder to regulate. In a higher-rate and slower-growth regime, more financial tremors are inevitable, and a liquidity crisis could morph into a credit crisis.

At this stage, we believe policymakers will succeed in addressing the liquidity problem and in restoring confidence. However, uncertainty is high and this remains an evolving situation.

In either scenario, weaker global growth is likely: Even in our baseline case of no financial crisis, we still expect recessions in both the US and Europe.

First, monetary policy works with lags, and the full impact of the synchronized policy tightening of the last year on final demand has yet to fully materialize. Second, the banking turmoil is likely to further weaken growth through the bank lending channel, due to tighter lending standards, which we would note were already tightening before the recent turmoil. And third, recent shocks may get transmitted further through the confidence channel. With high uncertainty and an elevated cost of capital, firms could delay capital expenditure plans and stop hoarding labour, while consumers may increase precautionary savings.

We currently expect a three-quarter long but mild recession in both the US (starting in the third quarter) and euro area (underway). Further policy tightening in the US is unlikely, as tight credit conditions have already done that job. In its effort to quash inflation, the Fed is likely to pause for the rest of this year .

However, if the banking turmoil becomes a full blown financial crisis (not our base case), then a hard landing is inevitable, because non-linear effects would kick in via falling asset prices, falling confidence, job losses, reduced demand and so on. Hard landings are eventually disinflationary, so the policy trade-off between inflation and financial stability should become less stark.

For India, this means weaker growth and lower inflation: Under our baseline scenario, India appears well placed on financial stability. Direct spillovers from the Western banking turmoil are limited and, after a decade of deleveraging, both financial and corporate sector balance sheets are stronger. India also has enough foreign exchange (FX) reserves to manage any capital account outflows.

However, we believe India’s macro-economic outlook is now at a crossroad, and weaker-than-expected growth and lower inflation have become more likely.

Recessions in the US and Europe mean that India’s export slowdown has further to run. Uncertainty is likely to further delay private capital expenditure. Consumer discretionary demand is likely to moderate due to higher interest rates and increased uncertainty, even as lower inflation boosts real incomes. Although India will benefit from the ongoing public capital-expenditure push and lower commodity prices, we expect gross domestic product (GDP) growth to moderate to 5-5.5% in 2023-24. In a relative context globally, India should still do well.

We also believe that the worst of inflation is now behind us. Weather-related risks bear monitoring, but lower wheat prices, lower oil prices despite China’s reopening and lower goods prices due to weaker aggregate demand should all help moderate both headline and core consumer price index (CPI)-based inflation to below 6% in March and to an average of 4.5-5% in 2023-24.

Time to create policy buffers: During uncertain times, it is crucial to reassess and create buffers. For monetary policy, a forward-looking approach calls for a pause to assess the impact of past domestic policy tightening and global spillovers, with increased scrutiny of macro-economic financial risks. For fiscal policy, it means preparing for a potential slowdown in growth and tax revenues by curbing non-essential spending, so that countercyclical public capital expenditure is maintained, as currently envisaged.

As they say, being prepared is half the battle.

Sonal Varma is chief economist (India and Asia ex-Japan) at Nomura

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Published: 26 Mar 2023, 09:41 PM IST
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