The risks to the banking sector may have increased in the last six months, the growth impulse may still be weak, and a close watch may need to be kept on the level of non-performing assets of banks; but do not lose heart, for the financial system in India is still resilient. This is the sum and substance of the bi-annual Financial Stability Report (FSR) of the Reserve Bank of India (RBI) released on Monday. Painting a cautious yet an optimistic picture of the state of the financial sector, the FSR, which is a periodic health-check, clearly sets out the stress points. The first reaction of the markets to the U.S. Federal Reserve’s tapering of its stimulus programme may have been positive but the pace of withdrawal will be crucial in managing volatility. The RBI is spot on when it says that national balance sheets, including that of India’s, need to be strengthened to combat the effects of stimulus withdrawal programmes of advanced economies. The global financial system is now accustomed to high liquidity, and the upcoming squeeze as the U.S. tapers its bond-buying programme could prove disruptive. The problem for India will be magnified given the growth slowdown and high inflation, not to mention the uncertainty in the context of the coming general election. RBI Governor Raghuram Rajan has rightly flagged this in the FSR, pointing out that a “stable new government would be positive for the economy.”

Of all the concerns highlighted in the FSR, the most important one is obviously related to the health of the banking sector. The RBI’s stress test has revealed that the total stressed advances ratio has risen to 10.2 per cent of total advances as at end-September, from 9.2 per cent in March. Though the stress tests assume extreme conditions, the fact is that the banking system is now groaning under the weight of rising NPAs. What is worrisome is that the industrial sector, which accounts for the highest share of restructured advances, is not anywhere near a turnaround. The five sectors — infrastructure, iron and steel, textiles, aviation and mining — that together account for more than half of the total stressed advances, are in deep trouble. The RBI’s stress tests indicate that the credit quality of banks could deteriorate if the macroeconomic variables do not improve soon. It is indeed scary when you consider that the failure of a major company or group could trigger a contagion in the banking system due to the exposure of a number of banks. Growth is the only panacea to this problem and that requires bold moves from the government to push reforms and clear stalled projects. The moot question is: how much of this is possible in the run-up to elections?

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