Financial conditions in the country now are tighter than last decade’s average and expected to tighten further as the Reserve Bank keeps the pedal on excess liquidity absorption and there is faster transmission of rate hikes to the broader market segments, says a Crisil report.
The ratings agency’s Financial Conditions Index (FCI), a summary indicator that combines 15 parameters, indicates a tightening trend in domestic financial conditions since October 2021.
This can be attributed to the Reserve Bank of India (RBI) moving towards normalising monetary policy, the US Federal Reserve’s monetary tightening actions and the impact of the Russia-Ukraine war, the report said.
The index turned negative in 2022, indicating that financial conditions have become tighter than the long-term average observed since 2010. The FCI, however, has not crossed the range beyond which it becomes a matter of concern.
With the RBI aggressively tightening monetary policy this year, the repo rate has crossed the pre-pandemic level (February 2020), though it is lower than the five-year average before the pandemic. Systemic liquidity has reduced significantly, reaching close to the five-year average before the pandemic, the ratings agency said.
According to the report, financial markets have seen significant volatility this calendar year, driven mainly by war-induced shocks and monetary policy tightening by central banks.
Monetary transmission has picked up across segments. Short-term rates are rising at a faster clip but remain below pre-pandemic average levels. In contrast, medium-term corporate bond yields and government bond yields have crossed those levels, it said.
The increasingly tight domestic monetary policy and stronger external headwinds are holding domestic financial conditions in a bear hug. While the initial set of shocks came in from stronger global headwinds, recent months have seen some of these stabilise.
The months to come, however, may see global factors again take precedence as headwinds rise with aggressive monetary policy actions expected to be taken by systemically important central banks such as the US Fed and the European Central Bank to combat inflation.
Policy rate, money market rates and bank lending rates remain lower than the pre-pandemic five-year average, even as they have been rising in the past few months. This reflects that liquidity in the system remains higher vis-à-vis demand. In this fiscal so far, bank credit growth has been higher than the pre-pandemic five-year average.
The US Fed’s aggressive stance, along with RBI’s rate hike, liquidity reduction and increasing transmission will continue to lend a tightening bias to domestic financial conditions, the report said.
The US Fed started the tightening cycle with a 25 basis points (bps) rate hike in March and progressivelyincreased the quantum of hikes to 50 bps in May, and 75 bps each in June and July.
In recent weeks, banks have started raising deposit and lending rates, as demand for credit has begun improving. However, it is unlikely that lending rates will rise so much as to stifle growth. Under the rough assumption that the cumulative repo rate hikes this fiscal would be 180-200 bps (including another 25-50 bps hike from here), and the entire increase is passed on to consumers, housing or auto loan rates would still be lower than their pre-pandemic five-year averages.