If 2022 was the year of “heightened global uncertainty”, this year is proving to be no different. Until last week, the US financial system seemed resilient to the aggressive interest rate hikes of the Federal Reserve. That perception has now been shattered. With the collapse of as many as three banks, including the Silicon Valley Bank (SVB) which was the 16th largest bank in the country, cracks have started showing in the US banking system, triggering fears of a possible financial contagion. The macroeconomic repercussions will be felt far away in India, even if our banking system does not immediately face the same kind of problems. How might the US situation play out, and what does it imply for the Indian economy?
The genesis of the SVB episode can be traced to the decisions of the US Federal Reserve during the pandemic period. The Fed lowered interest rates close to zero and injected vast amounts of liquidity. Banks consequently received large volumes of deposits and, invested them in treasury bonds. This meant that many banks, like SVB, whose loans books are much smaller in comparison to their deposits, became dependent on the treasury bonds for earning returns.
This became a problem when the Fed started aggressively raising rates in 2022 in its fight against inflation. As interest rates go up, bond prices fall. As a result, SVB began incurring losses on its bond portfolio. Sensing problems, depositors began withdrawing money from SVB—a classic case of a bank run, which led to its eventual collapse.
The problem, however, is far broader than just SVB. Any bank which has a smaller loan book, a bigger deposit base, and a large portfolio of treasury bonds now faces similar risk. In fact, US banks are currently sitting on an estimated $600 billion in potential losses owing to the erosion of their bond portfolios, on a capital base of $2 trillion. In other words, interest rate risk has eroded about 30 percent of the capital base. Within this aggregate, the distribution varies considerably, with midsize banks facing significantly higher capital erosion, which is why they have been facing runs in recent days.
This has put the Fed on the horns of a dilemma. If it sticks to its current strategy of raising interest rates to curtail inflation, bond losses will only increase, putting more stress on vulnerable banks. Alternatively, the Fed could pause or even start reducing rates, thereby relieving the stress on the banks, but at the cost of worsening the inflation problem. In other words, the important question for the US economy now is: will growing concerns of financial stability deter the Fed from pursuing its goal of price stability?
Irrespective of what the Fed decides, there will still be difficulties for India.
In particular, investors will remain very cautious, and will continue to doubt the financial stability of the midsize US banks – as we have seen over the past week. Things may get even more complicated if there are bank failures in the European Union. EU banks are vulnerable to similar risks given that the ECB has been tightening monetary policy as well. Already, fears of a contagion were running high when Credit Suisse, one of the systemically important banks at a global level, began witnessing rapid fall in its share prices last week. This eventually led to a takeover of the bank by rival UBS, a move orchestrated to calm the financial markets.
Any further bank failure could trigger a system-wide panic, and push depositors away from smaller banks to bigger, more diversified banks thereby precipitating more bank-runs. The resultant uncertainty would lead to heightened risk aversion.
In such an environment of risk aversion, there is typically a flight to safety. This will have important implications for India. There will be a surge in demand for “safe” assets such as gold etc., while the currencies of emerging economies like the Indian rupee will come under pressure as foreign investors flee these markets. The rupee has depreciated a fair bit in the last one year and, this trend may continue.
In addition, risk aversion is likely to dampen sentiments in the US, at a time when concerns about an impending slowdown have already persisted for a while. This may lead to a decline in credit growth and hence consumption, given that a large part of the US consumption is credit-fueled. Simply put, financial market turmoil might cause people to hold back spending. If this takes too severe a shape, then the US economy could fall into a recession, thereby hampering India’s growth prospects through the exports channel. Exports bailed out the Indian economy during the pandemic, but they have now stopped growing and, the situation is likely to worsen if the US goes into a recession.
Finally, if the Fed abandons its fight against inflation, this too will be problematic for India because we end up importing high inflation from the countries we trade with. This would aggravate domestic inflation, at a time when it is already running at 6.5 percent, well above the Reserve Bank of India’s 4 percent target.
The Indian economy has experienced a stuttering recovery from the pandemic. Its medium- term growth outlook remains weak, because private investment continues to be sluggish, exports are declining, consumption demand is lackluster and, the fiscal situation is overstretched. Now, the shockwaves from the banking crisis in the developed world are likely to create further headwinds for India’s growth.
We should consequently gear up for another year of volatility, amidst growing global uncertainty.
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