Sajjid Chinoy, Chief India Economist, JP Morgan, and part-time member, PMEAC, on the US banking crisis, global slowdown and what it means for India. The session was moderated by Executive Editor P Vaidyanathan Iyer On decoding the global banking crisis There are important differences between the banking stress witnessed in March and that in 2008. This time around mid-sized US banks primarily faced a liquidity crisis, not solvency concerns of the kind we saw in 2008, when bank balance sheets were severely impaired. How did we get here? For starters, the massive fiscal and monetary stimulus after COVID led to a huge surge in bank deposits. Banks invested much of these in government bonds and, in doing so, avoided credit risk but were still exposed to interest rate and duration risk. Meanwhile, the gargantuan fiscal and monetary stimulus interacted with a plethora of adverse supply shocks — across manufacturing supply chains, labour and commodity markets — to induce the highest global inflation in 50 years. At first, central banks looked away but were forced to play catch-up, inducing the most synchronised and aggressive monetary tightening cycle in four decades. Consequently, bond prices – which are inversely correlated to interest rates — fell sharply and US banks were left with large “unrealized bond losses” on their portfolios, estimated to be over $600 billion. In the case of Silicon Valley Bank, wholesale depositors realised losses would eat up almost all the equity, and began to rapidly withdraw deposits, forcing the bank to realise the losses and thereby creating a self-fulfilling deposit run. But it’s important to distinguish this kind of liquidity pressure – where illiquidity translates into insolvency – from a true underlying solvency problem when loan books are impaired. It’s important, because if it’s primarily a liquidity problem, central banks can bring to bear their lender of last resort tools to quell the pressure. And that’s exactly what happened. The Fed jumped into creating expansive liquidity facilities and de facto insured all deposits which – while creating significant moral hazard concerns in the medium term – was necessary to mitigate the stress and ring-fence the problem in the short term. The second difference between 2023 and 2008 is the sheer resilience of the global economy this time. The global economy likely grew at four per cent last quarter, a far cry from recession concerns. While some of this is China re-opening, even outside of China, the global economy is accelerating with 2023 reflecting the resilience of private sector balance sheets in advanced economies. Going forward, therefore, central banks will have to pursue two objectives using two instruments: contain inflation using interest rate policy while managing financial stability. On the possibility of a soft landing A soft landing appears unlikely in the US because it will necessitate wage inflation coming off sharply without the unemployment rate rising discernibly. This, in turn, will require a sharp increase in labour force participation which appears unlikely. So some kind of recession to bring core inflation back to target in the US seems inevitable. But given the strength of the US economy, a recession in the next three to six months appears unlikely. Beyond that, two possibilities remain. First, credit conditions tighten after the banking stress, helping the Fed get some traction on monetary transmission. Policy rates peak closer to 5.25 or 5.50 and we get by with a mild recession later this year. A second possibility is the continuing resilience of the real economy forces the Fed to keep moving, albeit in small doses, towards six per cent policy rates which increase the risk of a hard landing in 2024. On other risks to banks Globally, banks are much better regulated and capitalised than they were in 2008. The bigger worries are the other parts of the system. What is happening in the shadow banking space? Do we even know how much leverage there is and where the linkages lead? Regional US banks are big lenders to commercial real estate pose. What happens when that lending slows or stops as appears likely? On the impact on India There are multiple transmission channels from current global events to India: the impact through exports, commodity prices, capital flows, US bond yields on Indian bond yields and changing risk premia from increased uncertainty. We will need to keep a close eye on all these channels of transmission and how they interact with each other. On Indian exports being hit by the global slowdown At some point the global economy will be forced to slow, to generate the needed disinflation, and that will impact all emerging markets. So we should brace for slowing goods exports later this year. What’s new and exciting, however, is the dynamism that service exports have shown, not just software services but other IT-enabled services. Increased digitalisation during the pandemic and an acceptance of work-from-home has increased the attractiveness of offshoring and made services previously deemed non-tradeable to become tradeable. Consequently, India’s service exports have surged from $85 billion pre-pandemic to almost $150 billion in FY23. To the extent that there is a structural element to this increase, it could partially mitigate some cyclical headwinds. The surge in service exports, along with softening of commodity prices, has also contributed to a dramatic compression of the current account deficit (CAD) from almost four per cent of GDP mid-last year to a small surplus last quarter. That said, exports have been key to India’s recovery and a sharp global slowdown will create headwinds for them. Also, elevated global uncertainty is likely to keep some private investment on the sidelines for now. Other drivers of demand will, therefore, have to do the heavy lifting. It’s crucial that the impressive pick-up in the Centre’s capex continues into FY24 and budget capex targets are met. Equally important, state and PSU capex is upped to complement the Centre’s efforts. On the natural hedges that India has As discussed earlier, India will not be immune to what’s happening globally. That said, as a commodity importer, India benefits from several natural hedges. First, oil prices are typically inversely correlated with the US dollar Index. Why does this matter? Because when the dollar index strengthens it’s typically a symptom of “risk-off” during which capital flows to emerging markets, and therefore India, are impeded. But because the dollar index is typically inversely correlated with oil, it’s also a time when oil prices typically soften. So India gets adversely impacted on the capital account but favourably impacted on the current account. And vice versa. That’s the natural hedge. The problem in 2022 was that the natural hedge broke down. On the one hand, the Fed had to raise rates very aggressively causing the US dollar to strengthen. At the same time, however, because of the Russia-Ukraine war, oil prices surged. So India got adversely impacted both on the current and capital account. Thankfully, India had built up a war chest of foreign exchange reserves to buffer the impact on the balance of payments (BoP).The second natural hedge is that we are a commodity importer. So if there’s a demand shock in the world – as we expect to see playing out in 2023 – and global growth slows, India’s exports will be hit. But slowing global growth should also depress commodity prices, and India, as a commodity importer, can benefit from improving “terms of trade.” So improving terms of trade should partially offset weaker exports. There’s a third hedge. Recently US bond yields declined in response to the banking crisis and fears of weaker US growth. That pushed down bond yields around the world, including India. In the US, financial conditions actually tightened as credit spreads rose after the banking crisis. But in India, and other emerging markets, financial conditions eased, as risk-free rates softened without a widening of credit spreads. So worries about a US growth shock translated into an autonomous easing of financial conditions in India. Despite these hedges, however, it needs to be emphasised that if there is a sharp global slowdown, India will not be immune to that. We must anticipate and be ready for that. On policy prescriptions for India Keep pushing on public investment to mitigate slowing exports. Work to crowd in states and PSU capex, and eventually private investment. Furthermore, continue to place a premium on macroeconomic stability, which means keeping inflation under control, continuing with fiscal consolidation, building buffers and keeping a very close eye on financial stability. *** Audience Questions On the GDP growth target for India in FY 2023-2024 Some slowing is inevitable in 2023-24 compared to last year. But given the unprecedented uncertainty we are living through, there is limited utility of providing point estimates for growth or inflation in the current environment because standard errors are very large. A range is more useful to work with at the moment. On public sector banks staving off crisis What matters more than ownership of banks is the quality of regulation. Indian regulators have always placed a great premium on prudence and that has helped India better withstand global shocks. The banking sector’s health has improved as NPAs have been lower and banks are better capitalised today. Financial stability is a must in a world peppered with shocks.
