Global financial markets seem to have front-loaded optimism about softening interest rates based on easing inflation and stable global growth. However, the recently released two IMF reports — WEO and Global Financial Stability Report — April 2024 have indicated the incipient risks associated with such buoyancy.
The protracted last-mile disinflationary process when seen together with geopolitical risks could further stretch inflation control. Central banks may have to reschedule their line of action to prioritise inflation control.
In reality, though inflation is on the descent in many economies, still it is away from its targets. It is turning more sticky with an occasional upside bias in its last leg of disinflation. The US inflation moved up from 3.1 per cent in January to 3.5 per cent in March.
The lingering war between Russia and Ukraine and the continuing Red Sea attacks are already causing immense risks of supply-side disruptions and cost escalations. The transportation and insurance costs of international trade routes are zooming. The impulses of potential hikes in crude prices are evident from a 10 per cent increase since the beginning of 2024.
Domestic Markets
To cope with the interconnected risks, domestic financial markets will have to keep a close watch on the inflation trends in the US. The West Asia conflict and, more importantly, the recent hostility between Iran and Israel could derail the descending inflation pathway in India too. The stress is visible in the corporate sector with longer delivery timelines, extended working capital cycles, and raising freight and insurance costs.
According to investing.com, the India Vix (volatility index) fell 2.96 per cent in February, 17.6 per cent in March and 11.94 per cent thus far in April. Effectively, so far in 2024, the India Vix is down by 20 per cent implying raised confidence about the market movement signalling positive sentiments.
Any corrections in stock market indices could raise the Vix index beating the three-month downward move. Recent wild gyrations in stock markets after increased hostility is indicative of risks in making. Though Brent crude closed at $87.39 per barrel on April 19, it may cruise towards $100 per barrel which could impact our inflation descent. According to Crisil, its rupee outlook at $83.88 for the year 2024 is at risk due to the sudden new resurgence of geopolitical risks.
Banks should be able to comprehend the evolving risks of optimism of markets and rework their strategies. Any form of elevated risk will lead to a surge in liquidity risks. Any market corrections or flight of overseas funds on account of delay in rate cuts could trigger frictional liquidity in the near term.
Sticking to its accommodative stance, RBI is sensitive toward frictional liquidity and will initiate VRR auctions to meet the temporary liquidity deficit at any time. Moreover, banks are known to maintain liquidity coverage ratios (LCR) much beyond the mandatory levels.
Going beyond the frictional liquidity, managing durable liquidity is the handiwork of individual banks. Augmenting durable liquidity calls for inclusive efforts by reengineering interest rates and fine-tuning features of liability products to attract resources.
Many banks have raised term deposit interest rates in the recent past. They need to strategically mine the financial inclusion (FI) efforts made since 2010 accelerated by PMJDY accounts. Combined efforts to tap FI and digital banking penetration could help augment stable deposits.
Long-term asset liability management (ALM) strategies and compatible follow-up of operational strategies will have to be well-aligned to manage impending risks. The implications of front-loaded optimism of market participants will have to be managed.
The writer is an Adjunct Professor at the Institute of Insurance and Risk Management, Hyderabad