As per a recent World Bank report, for emerging and developing economies over a five-year horizon, a recession combined with a financial crisis could lower potential output by almost 8%. That will worry India, which confronted the Covid-19 crisis on a weak wicket.

In the Greek mythological tale of the six-headed monster called Scylla and a deep whirlpool named Charybdis, sailors had to choose the lesser of the two evils. The pandemic has the economy and policy makers in a similar quandary, a member of the Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) recently said.

If the financial sector – already weak with bad assets and risk averse – doesn’t lend, there cannot be a real recovery. If it does, it runs the danger of accumulating bad debts and eventual collapse. The sector’s wellness is thus critical to enduring the current crisis as well as supporting the economy in its recovery.

Gauging financial wellness can tell if policy responses and measures to combat the large-scale disruption in business activity are working, and if funds are flowing to deficit areas. For this, CRISIL picked metrics that highlight stress points for the sector and combined them into one index to arrive at a measure of financial conditions. We also tracked the movement in key metrics of various financial markets and compared them with previous periods of stress for a broader perspective.

We found that the financial sector is forging a story of intense contrasts. While policy rates have been slashed to record lows and liquidity remains abundant, the broader markets are witnessing one of the tightest financial conditions since the 2008 Global Financial Crisis. Financing is restricted to select safe-haven investments, while the market at large continues to face risk aversion. Unless this is addressed, financing options will not be available to stressed firms, particularly small and medium enterprises, which need it the most. This could aggravate their stress, making the economic impact of the pandemic longer and more painful.

Net-net, the cost of funds remains high and access to capital tight for a number of players. Thus, getting the financial sector back on its feet remains a key challenge for policy makers. The RBI had pointed out in its first policy response after the pandemic struck that the monetary policy will have to be ‘avant-garde’ in its approach. Regulators, indeed, have a tough task ahead as they take extraordinary steps to ease financial conditions.