RBI Guv warns against stretched valuations, says sudden shocks can spread stress across markets

Reserve Bank of India (RBI) Governor Shaktikanta Das on Friday cautioned that to the extent that valuations are currently stretched, sudden shocks could precipitate stress that spreads contagiously across financial market segments through sell-offs and band-wagon effects.

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“Global financial markets have displayed resilience in recent months, with equity and bond yields rallying, volatility remaining low for the most part, and narrowing of corporate bond spreads; but there has been a sharp increase in prices of relatively riskier assets,” Das said at the third annual conference of the Bretton Woods Committee’s Future of Finance Forum in Singapore.

The Governor noted that while stocks have been supported by strong earnings, the narrowing of corporate spreads has coincided with rising episodes of corporate defaults.

“The current scenario also differs from past monetary policy tightening cycles when markets displayed risk-off sentiments and prices of riskier assets declined.

“To the extent that valuations are currently stretched, sudden shocks could precipitate stress that spreads contagiously across financial market segments through sell-offs and band-wagon effects,” he said.

• Also read: RBI Guv Shaktikanta Das signals no policy change despite dip in inflation

Higher interest rates in US

Das observed that market expectations of higher interest rates in the United States (US) along with other factors, had kept the US dollar (USD) strong. The generalized global risk-on risk-off environment had increased the volatility of capital flows for many emerging markets.

Further, a strong USD increases debt service burdens and inflationary pressures for EMEs.

“To what extent this scenario will get impacted would depend upon the quantum and timing of policy pivot by the US Fed, following their recent pronouncements to this effect,” he said.

Proliferation of non-banks

The Governor cautioned that the proliferation of non-bank institutions in financial intermediation may create risks to financial stability due to their size, complexity and interconnectedness with domestic and global financial systems.

“In recent years, a number of vulnerabilities have emerged in NBFIs in advanced economies, contributing to periods of market dysfunction,” he said.

“Hidden leverage and liquidity mismatches of these institutions can amplify shocks and propagate strains throughout the financial system,” he added.

Proliferation of private credit

Referring to private credit growing four-fold over the last ten years, Das said, it is now a major source of corporate financing among middle-market firms that have low or negative earnings, high leverage and lack high-quality collateral.

The Global Financial Stability Report defines private credit as non-bank corporate credit provided through bilateral agreements or small “club deals” outside the realm of public securities or commercial banks. This definition excludes bank loans, broadly syndicated loans, and funding provided through publicly-traded assets such as corporate bonds.

The Governor said proliferation of this asset class, along with intensifying competition with investment banks on larger deals, may shift supply-demand dynamics and result in poorer underwriting standards.

As a consequence, the probability of credit losses can rise and make existing risk management models obsolete.

“The rapid growth of private credit, their increasing interconnectedness with banks and NBFIs and their opacity create vulnerabilities that could become systemic. Regulators world over need to give a closer look to these developments and come out with necessary guardrails,” Das said.

Commercial Real Estate

The Governor said stress in the global commercial real estate (CRE) sector needs to be watched closely.

He noted that Banks exhibit high sensitivity to expected and unexpected CRE losses, due to the relatively high CRE coverage ratios in their loan books.

Further, liquidity squeezes can materialise for banks with large CRE exposures, as short sellers may target them and investor confidence may slip further.

“...staying alert and undertaking forward-looking regulatory measures ahead of the curve can contain the risks to bank balance sheets and systemic stability,” the Governor said.

While market expectations of rate cuts are now regaining momentum, especially after indications of a policy pivot from the US Fed, the adverse spillovers from the ‘higher for longer’ interest rate scenario remain a contingent risk, Das said.

“On the other hand, there are central banks which naturally and justifiably remain averse to premature loosening of policy before inflation has been durably reined in their countries,” he said.

“Central Banks in these countries need to remain watchful of their domestic inflation–growth balance and make policy choices,” he added.