Tightening in domestic financial conditions in the coming months: report


Financial conditions in the country are set to tighten over the next few months on likely increases in capital outflows driven by mounting external shocks and domestic vulnerabilities, Crisil Ratings said in its Tuesday report.

The agency said its Financial Conditions Index (FCI) fell below zero in March, signaling a deterioration in domestic financial conditions.

Also, the State Bank of India and other leading banks have increased lending rates, which will lead to an increase in borrowing costs.

However, measures to reduce the current account deficit and strengthen foreign exchange reserves will help the country cope with external shocks, the report said.

“Increasing external shocks, coupled with greater domestic vulnerabilities, could increase capital outflows from Indian markets, leading to tighter domestic financial conditions in the coming months,” it said.

Crisil’s Index provides a comprehensive monthly update of India’s financial conditions by analyzing 15 key parameters of the equity, debt, money and foreign exchange markets along with political and credit conditions.

In March, financial conditions were not only tighter than the previous month, but also relatively tighter compared to average conditions over the past decade, the agency said.

The country’s vulnerability hinges crucially on crude oil prices, which affect its key macroeconomic indicators, including gross domestic product, inflation, current account deficit, rupee and in some cases the budget deficit, it said.

The rating agency has said so far that the accommodating policy of the RBI has provided a certain cushion. However, rising inflation and external risks will prompt the central bank to tighten policy this fiscal year.

The RBI has already started the normalization process by returning the policy corridor LAF (Liquidity Adjustment Facility) to its pre-pandemic breadth and has announced the withdrawal from the accommodative stance in the coming months.

“Given the shift in stance, we believe the RBI will hike the repo rate by 50-75 basis points this fiscal year, which will translate into market rates and tighten financial conditions,” it said.

The rating agency said banks had already started raising their marginal cost-of-funds-based lending rate (MCLR) following the RBI’s monetary policy in April, suggesting a return to the rate-hiking cycle.

The country’s largest lender, the State Bank of India, has raised its MCLR by 10 basis points (bps), or 0.1% across all tenures, a move that will lead to a rise in PMIs for borrowers.

Public sector Bank of Baroda and private lender Axis Bank also increased their MCLR by 5 basis points across all maturities.

The report says that rising foreign portfolio investor (FPI) outflows caused the rupee to depreciate 1.7% against the US dollar in March, faster than the previous month’s 0.8% depreciation.

The rupee is also facing headwinds from a widening trade deficit due to rising crude oil prices. The RBI’s intervention in the foreign exchange market is taming part of the sharp depreciation, it said.

The agency said G-Sec yields have hardened across the benchmark yield curve, driven by rising crude oil prices, the start of US Federal Reserve rate hikes, rising US Treasury yields and large FPI outflows.

The yield on the 10-year G-Sec rose 7 basis points to 6.83% in March, the highest since June 2019, it said.

However, according to the report, the country is expected to be in a better position than during the 2013 taper tantrum as the current account deficit and inflation are likely to be relatively lower.

“In addition, foreign exchange reserves are sufficient to cover the country’s short-term liabilities. This will help mitigate, if not eliminate, the impact of external shocks on the rupee,” she added.

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