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A clean chit for now

The Reserve Bank of India's latest Financial Stability Report attempts to assess the health of India's financial sector in a holistic manner and pinpoint the incipient risks to stability that may arise in a systemic sense. Like its counterparts in the advanced economies, the RBI seeks to draw the right lessons from the interplay of the macroeconomic setting, policies, markets and institutions, for which it claims to rely on up-to-date techniques and methodology. The report declares that India's financial system remains “stable in the face of some fragilities being observed in the global macro-financial environment.” Growth has been slackening in most parts of the world and the risks arising from global imbalances and the European debt crisis show no signs of abating. The truth is that the causes for some of these persistent problems have never been fully addressed. India's growth momentum has moderated slightly on account of both domestic and global factors, but its economic fundamentals continue to remain strong despite concerns over inflation and the fiscal situation. The widening current account deficit also is not a matter of serious concern for now, although a slowdown in capital inflows could occur as the advanced economies exit from their accommodative policies. However, government expenditure needs to be more tightly managed as part of a well thought-out process of fiscal consolidation.

The domestic financial markets remain stress-free and are expected to be so in the near future. There has been a strong demand for credit and, consequently, liquidity has tightened recently. One subject of concern has been the currency mismatches that have arisen in the wake of domestic companies relying more extensively than before on external commercial borrowings. A related problem is that many domestic corporate issuers of foreign currency convertible bonds (FCCBs) might face refunding risks by March 2013, when it would be time for redemption. The conversion prices on many of these bonds are much higher than the current prices of the linked equity shares, and it is unlikely that the gap will narrow. The Indian banking system remains well capitalised, with both core capital adequacy and leverage ratios ruling at comfortable levels. Even as credit off-take has rebounded recently, asset quality has improved although certain specific sectors of the economy could pose problems. For now, a rise in net interest income has boosted the profitability of banks, but over the near-term rising costs may weigh in. Banks need to be vigilant in facing up to interest rate risks in the prevailing inflation scenario.

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