India's vulnerability to global shocks to reduce in FY24: CRISIL

Domestic banking insulated from global financial turmoil and better positioned to tackle rising interest rates

India’s vulnerability to global shocks is expected to reduce in FY24 as the Current Account Deficit (CAD) improves amid challenging external financing conditions, according CRISIL Rating.

CAD is India’s major short-term external liability, affecting the exchange rate and investor sentiment. After peaking at 3.7 per cent of Gross Domestic Product (GDP) in the second quarter of the previous fiscal (FY22), CAD shrank significantly to 2.2 per cent in the third quarter of FT23. This decline was driven by falling oil imports, boost from services exports, and rising remittances.

Lower crude prices will reduce CAD further in FY24. Brent crude is expected to average 85 per barrel in the fiscal year compared with $95 per barrel in fiscal 2023. “We expect India’s CAD to moderate to 2% of GDP this fiscal from an estimated 2.5% of GDP in the previous one,” said CRISIL.

The other short-term liability, external debt, has been broadly stable as a proportion of GDP. As of December 2022, short-term external debt was 3.8 per cent of GDP, a tad lower than the pre-pandemic five-year average of 3.9 per cent.

CRISIL said adequate foreign exchange reserves will cushion the impact of external shocks. One way to measure the adequacy of forex reserves is to compare these with short-term external liabilities, namely the sum of CAD and short-term external debt.

Economists apply the rule that the ratio of forex reserves to short-term liabilities needs to be at least one for reserves to be adequate. For India, this ratio has remained more than 1 for the past decade, and is estimated at 2.7 at end of FY23. This rule, formulated by economists Pablo Guidotti and Alan Greenspan (a former chair of the US Fed), is known as the Guidotti-Greenspan rule.

Referring to the impact of challenging external conditions on domestic banking, CRISIL said India’s banking system is better positioned to tackle rising interest rates. The domestic banking system is largely insulated from the current banking turmoil emanating from collapse of few regional banks in the US. The root cause of the turmoil — rising interest rates — is less of a risk for our domestic banking sector, said CRISIL.

CRISIL spelt out three reasons for less risk to Indian banking from turmoil. One, the asset books of banks are dominated more by loans (about 70 per cent of deposits) than investments (about 30 per cent). These investments are more vulnerable to interest rate risks; moreover, a large part of loans in India are at floating rates.

Second, regulations allow banks to hold investments up to 23 per cent of net demand and time liabilities (NDTL) under the held-to-maturity (HTM) category. This significantly shields banks from interest rate movements.

And finally, the interest rates in India did not fall to the same extent as in advanced estimates during the pandemic, while the quantum of rate hikes was lesser. The lower gap between trough and peak interest rates has meant lower sensitivity of bank investments to mark-to-market losses, the rating agency.