CRISIL's FC Index Drops below 'Zero' Indicating Tighter Financial Conditions in March
Moneylife Digital Team 19 April 2022
Reflecting the deterioration in domestic financial conditions, CRISIL Ratings' Financial Conditions Index (FCI) dropped below the zero mark in March, indicating that the economic conditions were tighter than in the previous month and relatively tight compared with average conditions in the past decade.
In a report, the rating agency says, "CRISIL's FCI is responding to adverse impact from the external channel. Surging crude oil prices - a major influence on India's macros - are weighing on investors. The US Fed hiked policy rates by 25 basis points (bps) in March and has indicated aggressive tightening this year. This has led to foreign portfolio capital outflows from India, a depreciating rupee, losses in equity markets, and rising yields on government securities (G-Secs), all of which pushed domestic financial conditions into the 'tighter zone' in March."
The index provides a comprehensive monthly update on India's financial conditions by combining 15 key parameters across equity, debt, money and forex markets, along with policy and lending conditions.
So far, CRISIL says, the Reserve Bank of India (RBI)'s accommodative policy has been a significant cushion for domestic financial conditions; however, rising inflation and external risks will make the central bank tighten its policy this fiscal. "Policy normalisation was already underway with liquidity normalisation through variable-rate reverse repo (VRRR) operations.
"The RBI has hastened the process of normalisation by restoring the liquidity adjustment facility (LAF) policy corridor to its pre-pandemic width and indicating withdrawal of accommodation in the coming months." 
"Given the shifting stance, we believe the RBI will hike repo rate by 50-75 bps over this fiscal, which will transmit to market rates and tighten financial conditions. Banks have already begun raising their marginal cost of funds based lending rates (MCLR) post-April monetary policy, indicating turn of the rate cycle," the rating agency says.
According to CRISIL, rising external shocks, coupled with greater domestic vulnerability, could increase capital outflows from the Indian markets, resulting in tighter domestic financial conditions in the coming months.
"India's vulnerability critically hinges on crude oil prices because they impact its major macros, including the gross domestic product, inflation, current account deficit, rupee and, in some cases, fiscal deficit."
"That said, India is expected to be in a better position than during the 2013 taper tantrum, as the current account deficit (CAD) and inflation are likely to be relatively lower. Moreover, foreign exchange reserves are adequate to cover the country's short-term liabilities. This will help mitigate, if not eliminate entirely, the impact of external shocks on the rupee," it added.
One of the fallouts of the Russia-Ukraine war is a tightening of global financial conditions, CRISIL says, adding, significant geopolitical uncertainty, surging commodity prices, overshooting inflation, and tightening monetary policy have all weighed heavy on markets across the globe. "These external shocks have also trickled into India's financial conditions, which have tightened over the past two months."
In March 2022, foreign portfolio investment (FPI) outflows increased to US$6.6bn compared with US$5.1bn the previous month. The equity market saw higher outflows of $5.4bn than outflows of $0.7bn from the debt market. A series of external factors hit risk sentiment.
Crude oil prices also surged 20.7% month-on-month (m-o-m) to an average US$115.6/barrel in March. This is a key variable of concern as an upswing negatively impacts most of India's macros, the rating agency says.
Rising FPI outflows led the rupee to depreciate 1.7% m-o-m against the US dollar in March faster than the depreciation of 0.8% the previous month.
CRISIL says, "The (Indian) rupee is also facing headwinds from a bloating trade deficit because of rising crude oil prices. The RBI's intervention in the forex market is taming some of the sharp depreciation."
The domestic equity market was dragged down by negative global cues and large FPI outflows in March, with the Sensex declining 2.2% m-o-m. The market also saw higher volatility, as indicated by Nifty India VIX rising to 25.1 in March from 22.1 in the previous month and above the long-term average of around 20.
G-Sec yields hardened across the benchmark yield curve, driven by rising crude oil prices, the beginning of US Fed rate hikes, increasing US Treasury yields, and large FPI outflows. The yield on the 10-year G-sec rose 7bps (basis points) m-o-m to an average 6.83% in March, the highest level since June 2019.
According to CRISIL, external factors are having a more significant impact on yields now that RBI is unwinding its support to the bond market. The central bank has not been buying G-Secs under its open market operations since November 2021 and has also been draining excess liquidity through VRRR operations.
While systemic liquidity remains in surplus, it was lower in March than in the previous month. This is evident from the RBI absorbing a lower quantum under its LAF at Rs6.42 lakh crore daily on average in March, compared with Rs6.88 lakh crore in the previous month.
"The reduction in liquidity was a result of domestic factors like the RBI's VRRR operations, rising currency in circulation, and bank credit growth as well as external factors such as FPI outflows and the RBI's dollar sales in the forex market," the rating agency says.
Further in March, money market rates also increased. CRISIL says, "Reducing excess liquidity is gradually raising money market rates, though they remain below their pre-pandemic levels. In March, the interbank call money rate rose 3bps on-month to average 3.30%, 91-day Treasury bill increased 2bps to 3.78%, and 6-month commercial paper grew 4bps to 4.84%."
However, with RBI keeping the repo rate unchanged since the onset of the pandemic, lending rates and yields on corporate bonds were less affected. "Given the trends in retail inflation, the implied real policy rate or the repo rate adjusting for inflation based on the consumer price index has been negative since November 2019. The gap has widened in the last six months with rising inflation."
Bank lending rates, as indicated by the six-month MCLR, auto loan rate and housing loan rate have been unchanged for the past six months, all lower than their respective pre-pandemic levels. Benign lending rates, along with improving economic prospects, is leading to a gradual revival in bank credit growth, which rose to 9.6% in March, the highest since December 2019.
"In contrast to rising G-sec yields, yields on corporate bonds—both high and low rated—have been stable. Supply of corporate bonds has been low on account of corporates tapping banks for their funding needs, and reluctance to increase capex," CRISIL says.
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