Chapter I Macrofinancial Risks

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Chapter I Macrofinancial Risks

Financial Stability Report June 2022

The global economic outlook is clouded by the ongoing war in Europe and the pace of monetary policy tightening by central banks in response to mounting inflationary pressures. The Indian economy is facing spillovers from global conditions but remains on the path of recovery. The financial system remains resilient and supportive of economic revival. Banks as well as non-banking institutions have sufficient capital buffers to withstand sudden shocks. High inflationary pressures, external spillovers and geopolitical risks warrant careful handling and close monitoring.

1.1 Shock waves from the war in Ukraine and retaliatory economic and financial sanctions have jolted the global economy, already beleaguered by successive waves of the COVID-19 pandemic, the quickening pace of monetary policy normalisation and the associated surges of volatility in global financial markets. Global growth is slowing, and downside risks weigh on the outlook. As the fallout of the war reverberates through commodity markets, price pressures have soared from elevated levels and broadened, threatening to unhinge inflation expectations and trigger second order effects, disrupt international trades and dent consumer and business confidence. Meanwhile, the resurgence of COVID-19 infections in several parts of the world is likely to prolong supply chain bottlenecks, exacerbating the strains that have been persisting over the past two years. Overall, for the global economy, stagflation concerns seem to be transitioning from a risk scenario to a baseline scenario.
1.2 Adverse macrofinancial loops are surfacing with the tightening of financial conditions and spikes in volatility. Across emerging and developing economies, debt distress is rising as external funding conditions turn austere, compounded by currency depreciation and drainage of reserves as investors shun them as an asset class and fly to the safe haven

of the relentlessly strengthening US dollar (USD). In financial markets, volatility has risen in bond markets and patches of illiquidity are evident amidst hardening of yields and instances of inversion of yield curves. Corporate bond spreads are also rising, approaching median levels seen during the global financial crisis. In commodity markets too, dollar funding shortages and liquidity mismatches rose in response to margin requirements by central counterparties (CCPs) as commodity prices head north.
1.3 The Indian economy appears to have weathered the third wave of the pandemic associated with the Omicron variant, although the war in Ukraine is now casting a long shadow on the outlook. While the end-May 2022 data release of the National Statistical Office (NSO) points to real GDP and major supply side categories in 2021-22 exceeding their pre-pandemic 2019-20 levels, high-frequency indicators present a mix picture. Urban demand appears to be on a firmer footing than rural demand, although the outlook for the latter is brightening with the prospects of a normal south-west monsoon predicted by Indian Meteorological Department (IMD) and Skymet. Consumption demand is gradually recovering, with some evidence of the demand for contact intensive services regaining traction, especially transportation and hospitality. Investment activity is also picking

Chapter I Macrofinancial Risks
up but remains incipient at this stage. Exports of merchandise and services are robust and the sustained increase in non-oil, non-gold imports attest to the strength of underlying demand.
1.4 Turning to domestic financial developments, equity markets have seen some recent corrections, although valuations remain stretched. The amount of foreign portfolio outflows has been offset by investments from domestic institutional investors. Domestic bond markets are experiencing global spillovers from hardening bond yields abroad and volatile international crude prices, besides rise in policy rates and bearish sentiment driven by a large government borrowing programme. While the Indian rupee (INR) has been subjected to bouts of downward pressure, it has emerged among the better performing currencies relative to peers. Among financial institutions, banks have reduced gross nonperforming asset (GNPA) ratio through recoveries, write-offs and reduction in slippages. Capital and liquidity buffers have been built up well above regulatory requirements, including by accessing markets, and SCBs taken together are seeing a modest return to profitability. These developments have catalysed the growth of bank credit to double digits, tracking nominal GDP growth. Non-banking financial companies (NBFCs) have also benefited from regulatory dispensations, including the congenial financial conditions engendered by the Reserve Bank’s monetary and liquidity operations.
1.5 Overall, global financial stability risks have risen since the publication of the December 2021 Financial Stability Report (FSR), while domestic macroeconomic and financial developments appear to have decoupled and posted a modest improvement. The nearterm outlook remains uncertain, overcast with the overwhelming geopolitical conditions and their

highly uncertain evolution. Against this backdrop, this chapter analyses macrofinancial risks arising from global developments in Section I.1 and possible spillovers to the domestic economy in Section I.2. The chapter concludes with important findings of the Reserve Bank’s latest Systemic Risk Survey conducted in May 2022.
I.1 Global Backdrop
I.1.1 Macrofinancial Developments and Outlook
1.6 Global economic prospects have deteriorated markedly since the December 2021 issue of FSR as the economic and financial ramifications of the war and sanctions take their toll. As recently as January 2022, the International Monetary Fund (IMF) had projected global growth at 4.4 per cent in 2022, half a percentage point lower than its October 2021 forecast. In April 2022, it expected the shock of the war to interact with the monetary tightening, financial market volatility, the pandemic, and unequal vaccine access to cause global growth to decline to 3.6 per cent in 2022 from 6.1 per cent in 2021. Both AEs and emerging market and developing economies (EMDEs) are expected to lose pace by 1.9 percentage points and 3.0 percentage points, respectively1. Global trade volume is now expected to slow down from 10.1 per cent in 2021 to 5.0 per cent in 2022, mainly because of moderation in merchandise trade, since services trade is likely to remain subdued. Inflation would be pushed up in the range of 2.6 percentage points for AEs and 2.8 percentage points for EMEs (Charts 1.1 and 1.2). Inflation all around is now expected to stay elevated for longer than earlier anticipated. In most EMDEs, rising food prices and shortages of essential commodities have exposed vulnerable sections of society to food insecurity and erosion of livelihood.

1 International Monetary Fund (2022), World Economic Outlook: War Sets Back the Global Recovery, Washington, DC, April

Chart 1.1: IMF Forecasts for Growth and Inflation

Financial Stability Report June 2022
Chart 1.2: Consensus Expectations of Global GDP Growth and CPI Inflation

Note *: Projections. Source: IMF’s World Economic Outlook Database (April 2022).
1.7 EMDEs are likely to be at the receiving end of geopolitical spillovers, in spite of being bystanders. Worryingly, rising interest rates will tighten external financing conditions heterogeneously, but all of them remain vulnerable to a generalised flight of capital to safety. Those with large debt overhang will face pressure on budgets and debt servicing. Scarring effects are large for EMDEs due to human capital and investment losses that will keep output below the pre-pandemic trend till 2026 (Chart 1.3).

Note: Forecasts derived from the latest monthly and quarterly surveys conducted by Bloomberg and from forecasts submitted by various banks. Source: Bloomberg
Chart 1.3: Potential GDP: IMF Projections for AEs and EMDEs

1.8 Reflecting the uncertainty surrounding the

course of the war, persistence of inflation and the

future path of the pandemic, global uncertainty has

surged (Chart 1.4), which by itself, could reduce global growth by 0.35 percentage points2.

Source: IMF.

Chart 1.4: World Uncertainty Index

Note: The chart is prepared by counting the percent of the word “uncertain” (or its variant) in the Economist Intelligence Unit country reports. The index is rescaled by multiplying by 1,000,000. A higher number means higher uncertainty and vice versa. Sources: Ahir, Bloom, and Furceri (2022), IMF.
2 Ahir, Bloom, and Furceri (2022), IMFBlog, Global Economic Uncertainty, Surging Amid War, May Slow Growth, April

Chapter I Macrofinancial Risks

1.9 In addition to the humanitarian crisis, multiple headwinds are impacting the global economy and the international financial system: a terms-of-trade shock that is deleterious for commodity importers; tightening of global financial conditions; repricing of EME assets and consequent flight of capital; and pressures on exchange rates that amplify already persistent inflation. Going forward, the risks are large and to the downside – the possible escalation of war; social unrest due to shortages; resurgence of the pandemic; slowdown in growth in one of the major economies and climate conditions overshooting the Paris Agreement goals.
1.10 As the normalisation of monetary policy, i.e., rate hikes and quantitative tightening (QT) in response to hardening inflationary pressures get synchronised, global financial conditions are likely to tighten significantly, as already being seen in yields across the US and other major AEs. In particular, the US 10-year treasury yield rose by 168 bps (as on June 16, 2022) since end-December 2021 (Chart 1.5).
1.11 The rise in nominal and real yields have resulted in a sell-off in equity markets - technology stocks taking the biggest hit - with concomitant widening of spread on high-yield bonds (Charts 1.6 a and b).

Chart 1.5: G-Sec Yields a. 10-year Nominal Yield in Major Advanced Economies
b. US Treasury Constant Maturity, Inflation Indexed
Source: Bloomberg and FRED.

Chart 1.6: Equity and Bond Indices

a. Equity Indices

b. US High Yield Bond Index

Source: Bloomberg and FRED.

a. 10-Year UST

Chart 1.7: Impact of QT in 2017-18

Financial Stability Report June 2022

b. Yield Curve – Difference between 2-year and 10-year Treasuries (2s10s)

Source: Bloomberg.
1.12 The impact of QT on financial markets and the economy at large is still unfolding. While policymakers have a handle on the implications of interest rate changes, there is less precision on the effects of increase or decrease in asset holdings by central banks, especially when thresholds are less precisely defined. Traditionally, central bank balance sheet policies influence the economy through three channels: signalling, duration risk and portfolio rebalance. The signalling channel influences the future path of interest rates while the duration risk channel influences term premia and the portfolio rebalance channel affects the supply of securities, which, in turn, impact the yields on close substitutes. Just as Quantitative Easing (QE) increases liquidity in the hands of investors and reduces the liquidity premium on the most liquid bonds, QT would decrease reserves and increase demand for safe assets in a period of increased risk aversion, which may partly offset the supply of treasuries, as witnessed in 2018-19 (Chart 1.7). The scale of QT envisaged now has no precedent and its working through the financial system is uncertain, with the possibility that it may induce further volatility in securities markets.

1.13 Signs of stress in short-term dollar funding are also emerging. With the announcement of sanctions, the Forward Rate Agreement – Overnight Indexed Swap (FRA-OIS) spread – a measure of how expensive or cheap it will be for banks to borrow in the interbank market relative to the risk-free rate – has widened, along with spreads on non-financial commercial paper (Chart 1.8).
Chart 1.8: Spreads in Funding Markets
Source: Bloomberg.


Chapter I Macrofinancial Risks
1.14 Another key barometer of funding strains in markets, viz., cross-currency swaps, has also tightened in the wake of the war (Chart 1.9), although the repeat of the “dash-for-cash” witnessed in March 2020 is not evident so far.
1.15 Reflecting the increase in risk aversion and impact of monetary policy tightening, corporate bond spreads in the US and in EMEs have widened despite some moderation in June 2022, as valuations increasingly reflect a weak economic outlook (Chart 1.10).
1.16 In sum, synchronised monetary tightening amidst heightened geopolitical tensions poses several financial stability risks: sell-offs of financial assets and market dislocations, especially since central banks may be constrained in their use of tools to address market dysfunction; rise in interest rates and increase in debt servicing costs with debt levels at record highs; and, higher borrowing costs for governments, wider deficits and rollover risks.
I.1.2 Other Global Macrofinancial Risks
1.17 New stresses have exposed vulnerabilities in hitherto unknown corners of the financial system. Global macrofinancial conditions pose heightened challenges for policy authorities in both AEs and EMEs and threaten to disrupt financial stability.
A. Debt Distress in EMEs
1.18 The economic and financial fallout of the pandemic required active and large fiscal support, which pushed up sovereign debt levels of EMEs

Chart 1.9: FX-implied Dollar Funding Spreads
Note: EURUSD and USDJPY 3m OIS cross currency basis (more negative = more expensive USD funding) Source: Bloomberg
Chart 1.10: Credit Spreads
Sources: Federal Reserve, Bloomberg


a. Government Debt

Chart 1.11: Emerging Markets Debt

Financial Stability Report June 2022

b. Non-Government Debt

Source: IIF.
significantly (Chart 1.11 a and b). While easy financial conditions and the recovery from the pandemic had helped these countries to sustain such high debt levels up to early 2022, the risk of a debt crisis has risen substantially in recent times, driven by the deteriorating external environment for lowincome developing economies and economies that have a high share of dollar-denominated debt. The likely erosion of risk appetite and tighter financial conditions could increase debt-servicing costs at a time when their ability to generate foreign exchange to service debt appear to be more constrained. From a financial stability perspective, higher debt levels in the face of macroeconomic shocks can increase the probability of default. Deleveraging could lead to reduction in aggregate demand, amplifying shocks to the financial system into a systemic shock.
B. Sovereign Debt Holdings and Bank Balancesheet Nexus
1.19 As banks’ holdings of sovereign debt increased in EMEs (Chart 1.12), it has deepened the so-called sovereign-bank nexus3 as governments depend on banks for financing of sovereign bonds and banks

Chart 1.12: Public Debt and Banks’ Exposure a. Public Debt
b. Banks’ Domestic Sovereign Debt Exposure
Source: IMF.

3 International Monetary Fund (2022), “Global Financial Stability Report—Shockwaves from the War in Ukraine Test the Financial System’s Resilience”, Washington, DC, April.

Chapter I Macrofinancial Risks
rely on government securities for investment, for meeting regulatory requirements, and as collateral to obtain funding from central bank and others.
1.20 With the sovereign credit outlook deteriorating in several emerging markets, the nexus between sovereign debt holdings and bank balance sheets poses risks to macro-financial stability. Hardening of government bond yields in the face of additional borrowing could result in mark-to-market losses for banks. This could potentially reduce their lending and adversely affect overall economic activity, especially in countries with high fiscal vulnerability and less capitalised banking systems. If banks’ appetite to hold sovereign debt diminishes in such a scenario, it could trigger negative feedback loops through multiple channels. Other potential channels of risk highlighted by the IMF4 include: (i) reduction in bank soundness and potential for lending to the economy; (ii) diminished ability of governments to support banks in times of stress due to deteriorating government finances; and (iii) headwinds to economic recovery as monetary tightening adversely impacts corporate profitability and increases credit risk for banks.
1.21 The IMF’s recommended policy response to mitigate risks include: (i) fiscal discipline and strengthening of medium-term fiscal frameworks to build resilience; (ii) preserving bank capital resources to absorb losses; (iii) conducting bank stress tests by taking into account the multiple channels of the nexus; (iv) examining options to weaken the nexus once the post-pandemic economic recovery takes hold; and (v) fostering a deep and diversified investor base to strengthen market resilience in countries with underdeveloped local currency bond markets. It also favours a more risk-sensitive regulatory and supervisory treatment with appropriate disclosures on all material sovereign exposures.

1.22 Notwithstanding these multiple challenges, banks exhibit resilience as they entered the pandemic with relatively strong balance sheets, supported by better quality capital and higher liquidity buffers. Losses have been modest and, unlike in the global financial crisis (GFC) when banks deleveraged and cut back on lending, global bank lending remains strong, and the underlying robustness of their solvency and liquidity positions is comforting (Chart 1.13). Market valuations also reflect prices recovering
Chart 1.13: Banks’ Capital and Provisions* a. CET-1 Ratio
b. Loan Loss Reserves
Note *: Sample of select major banks - American (6), European (9), UK (4) and Asian (7). Source: Bloomberg.

4 Ibid.

Financial Stability Report June 2022 Chart 1.14: Equity Prices and Credit Default Swap (CDS) Spreads

a. Equity Indices

b. CDS spreads*

Note *: Sample of select major banks - American (8), European (7), UK (4) and Asian (5). Source: Bloomberg and Refinitiv.
to pre-pandemic levels, even though there has been some moderation in recent period (Chart 1.14).
C. Capital Flows and Exchange Rate Volatility
1.23 The unrelenting ascent of the USD against its AE peers has also contributed to the tightening of financial conditions by triggering a ‘flight-to-home’ bias, especially among passive investors tracking indices (Chart 1.15 a). The USD has now surged to its strongest level in two decades. Even the Japanese Yen (JPY) – usually a safe-haven currency – fell precipitously against the USD as the Bank of Japan reiterated its decision to continue with accommodative monetary policy (Chart 1.15 b).
1.24 Spillovers to EMEs are asymmetric and, in some cases, disruptive, triggering capital outflows

Chart 1.15: Movement in US Dollar a. Dollar Index and Expected Fed Fund (FF) Rate
b. Movement in USD Exchange rates

Note: DXY – US Dollar Index, FF – Expected Federal Funds Rate based on Futures in Dec’ 22 and 23 Source: Bloomberg

Chapter I Macrofinancial Risks
(Charts 1.16 a and b). In some EMEs, local currency bond returns turned negative (Chart 1.16 c), equity prices fell (Chart 1.16 d), and CDS spreads widened

(Chart 1.16 e), tightening financial conditions (Chart 1.16 f).

Chart 1.16: Spillovers to Emerging Markets
a. Movement in Exchange Rates (June 29, 2022 over December 31, 2021)

b. EM Flows

c. Local Currency Bond Returns*

d. MSCI Emerging Markets Index

e. Markit CDX Index

f. Citi EM Asia Financial Conditions Index

Note * : Courtesy J.P. Morgan Chase & Co., Copyright 2022 Source : Bloomberg, Refinitiv, IIF and J P Morgan

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Chapter I Macrofinancial Risks