Domestic financial markets have seen significant volatility this calendar year, driven mainly by war-induced shocks and monetary policy tightening by central banks. CRISIL's financial conditions index (FCI), which indicated a tightening trend in domestic financial conditions since October 2021, has now turned negative in 2022. It implies that domestic economic conditions have become tighter than the long-term average observed since 2010, the rating agency says.
In a research note, it says, "These conditions are expected to tighten further as central banks continue to raise rates, the Reserve Bank of India (RBI) keeps the pedal on excess liquidity absorption and there is a faster transmission of rate hikes to the broader market segments."
According to CRISIL, 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. Domestic monetary tightening actions, in fact, have been nudging financial conditions deeper towards the tighter zone. 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 Federal Reserve (Fed) and the European Central Bank to combat inflation."
With RBI aggressively tightening monetary policy this year, the repo rate has crossed the pre-pandemic level of February 2020, though it is lower than the five-year average before the pandemic. The central bank began raising the repo rate in May 2022 and has cumulatively hiked it by 140 basis points (bps) until August. The repo rate stands at 5.40% currently, 25bps above the pre-pandemic level of 5.15% in February 2020.
"In real terms, the policy rate remains negative, as inflation is trending higher than the repo rate. In the first four months of this fiscal, nominal repo rate averaged 4.6%, consumer price index (CPI) inflation 7.1%, implying a real repo rate of -2.6%. Not only is this lower than the pre-pandemic level, but the lowest since fiscal 2011. That said, the gap is narrowing with successive rate hikes and moderating inflation," the rating agency says.
According to CRISIL, systemic liquidity has reduced significantly, reaching close to the five-year average before the pandemic. It says, "Systemic liquidity, while remaining in surplus, was the lowest in July 2022 since October 2019. Rate hikes and liquidity reduction have led to a rise in interest rates to varying degrees across different market segments."
"Monetary transmission has picked up across segments," it says, adding, "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."
"Bank lending rates remain on the lower side, for now. This, combined with gradual economic recovery, has led to a sustained pick-up in credit growth. Tighter financial conditions may not restrict growth for now, as policy rate hikes act with a lag. But their impact would largely be felt from the last quarter of this fiscal," the rating agency says.
In recent weeks, banks have started raising deposit and lending rates, as demand for credit has begun improving. "However, we do not believe that lending rates will rise so much as to stifle growth," CRISIL says.
The report also points out that the Fed stance may continue with aggressive rate hikes, coupled with other volatile and uncertain global cues, which, according to the rating agency, could also keep financial conditions in India on edge.
The CRISIL FCI is still within one standard deviation of the decadal average, beyond which it starts becoming a matter of concern.
The rating agency says, "The tightening which began in late 2021 can be explained by the RBI moving towards normalising monetary policy by halting bond buying and withdrawing excess liquidity, along with the Fed's monetary tightening actions, which began with tapering its quantitative easing program in November."
Tightening gained momentum with the Russia-Ukraine war in February. Risk-off sentiment spread, commodity prices and inflation surged globally, and central banks brought forward their rate hike cycle.
"The impact of baby steps towards the absorption of excess liquidity by the RBI was slow to show up in domestic financial conditions, though bond market yields had started firming up as early as October, indicating rising risk aversion. More recently, the impact of RBI's actions on financial conditions has become more pronounced," the rating agency says.
CRISIL's FCI is a summary indicator that combines 15 parameters reflecting domestic policy conditions, movements in money, debt, equity and foreign exchange markets, and credit conditions in the broader economy. A lower FCI value indicates tighter financial conditions and vice versa.