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The financial stability report, released on Wednesday, warned of a currency war amid competing central bank policies, and harped on the need for India to carry out crucial reforms amid the uncertainties.
Benign oil prices are not an occasion for complacency for a country like India that runs twin deficits and the government should take the opportunity to improve its finances and push for investment spending that would encourage private sector to come forward with their own investment plans, the report said.
The recent volatility in the global market has shown that the US dollar is becoming more central, despite China's increasing importance and global volatility induced by weakness in that country.
More volatility can be expected in a world where the global central banks are chasing competing and contradictory monetary policies and the US Fed's rate hike impact is yet to be fully seen and should be apparent in the long turn.
In short, the report warned that the world is heading towards more uncertainties and India, expected to show gradual recovery, should be prepared.
"Financial market stress in China and monetary policy dilemmas in advanced economies, amidst a fragile global recovery, have led to increased uncertainty in the global economy," said the Financial Stability Development Council (FSDC) report, adding innovations in financial markets to increase liquidity is also fueling more uncertainties in the markets, threatening financial stability, and should be checked.
According to the report, India could see a gradual recovery as private consumption demand is weak due to weakness in the rural economy. Low capacity utilisation is also negating the need for fresh investment.
"In the corporate sector, the level of profitability, leverage and debt servicing capacity continue to cause concern with their attendant adverse impacts on the industrial sector, notwithstanding some improvement observed in corporate performance during the first half of the current financial year," the report said.
In its fifth bi-monthly monetary policy on December 1, RBI had said its surveys showed early signs of recovery in some pockets but demand from the rural economy would remain soft. While the Fed rate hike on December 16 did not appear to have caused any major immediate impact on financial markets, "its effects will need to be seen in the light of the developments on the real economy front as also the response of the markets, going ahead, especially to the emerging divergence in policy stance in major advanced economies," the report warned.
Even as the US hiked its rates for the first time since 2006, China is depreciating its currency, European Central Bank has promised to further its quantitative easing plans, and Bank of Japan is expected to follow a similar course of action. These, in effect, could "trigger unintended currency wars despite an understanding evolved at the G-20," the report said.
"For the markets in particular, the easy monetary policies across the world, along with increasing market liquidity have also increased potential liquidity risks along the impending tightening cycle and the purveyors of financial stability across the world cannot afford to be agnostic about this," it added.
In this context, giving forward guidance, which is meant for moderating uncertainty in the markets, is going to be a challenging task for central banks around the world, the report warned.
The benign oil prices, caused by low demand, would likely continue for some more time as even Iran would be adding to the global oil glut, but should not make countries with twin deficits - such as India that has both current and fiscal deficits - be complacent.
"... this benign outlook for oil carries the risk of complacency for countries that import significant portions of crude oil as misaligned fiscal priorities and rising oil intensity of aggregate demand in these countries may lead to twin deficits, which they are historically prone to," the report said.
India should also worry about its erratic climatic conditions leading to volatile price conditions, even as for the moment inflation seemed to be low, the report warned.
India's macro-economic fundamentals are improving and rupee is resilient against its peers, but sluggishness in domestic demand and private investment call for higher public investment at a time when the government is committed to fiscal consolidation. While tax collection is improving, government's own expenditure is on the rise without adequate disinvestment support. Carrying out important economic reforms, like goods and services tax, is a necessity and will be highly beneficial to the economy amidst global uncertainties.
"The global headwinds and the attendant risks will continue to pose concerns for India thereby, requiring initiation of suitable measures to control the country specific idiosyncratic risks, keeping in view the volatile financial markets and delicate market sentiments," the report said.
