Financial conditions on the mend, our index shows

Financial conditions in India have staged a full-throttle recovery from the harrowing abyss they had been sent flailing into by the Covid-19 pandemic in April, our new Financial Conditions Index (FCI) shows.

Credit for this is due to the Reserve Bank of India (RBI), whose overtures to maintain easier financial conditions – in lockstep with central banks elsewhere – have helped mitigate the large and broad-based economic damage caused by the pandemic. While easy global monetary policies have helped, the RBI’s accommodative stance has helped contain short-run pressures no less.

“The RBI stands ready to undertake further measures as necessary to assure market participants of access to liquidity and easy financing conditions,” RBI governor Shaktikanta Das said at the October 2020 monetary policy meeting. It sure has, so far.

That said, pockets of stress remain, our FCI shows, as evident in weak bank credit growth, wider spreads on lower-rated corporate bonds, and fundamental pressures due to high government borrowing.

But what led us to construct this new index?

We believe the financial markets are an economy’s critical plumbing system, through which funds flow to those in need. They become all the more important during economic crises, when incomes and cash flows are disrupted for businesses and households. Today, with the pandemic sparking off one of the biggest recessions, the functioning of the financial sector becomes critical – not only for its role of supporting borrowers, but also for policy implementation.

Monetary policy – which has done most of the heavy lifting so far – works its way to the economy through altering financial conditions. This time, a large part of fiscal stimulus is also in the form of credit-enhancing measures, which depend on the financial sector for implementation. Indeed, we estimate that ~65% of fiscal stimulus announced in May was in the form of liquidity and credit support¹.

Some important questions arise in this milieu: How have the financial conditions in India fared amid the pandemic? How does this period compare with earlier periods of stress? How have the RBI measures impacted financial conditions?

To answer these, we looked at movements in key parameters across various financial markets in India, including equity, debt, money and forex markets. We also took into account financing conditions for the broader economy by including variables such as bank credit growth, lending rates, and money supply. Finally, we evaluated the impact of monetary policy environment in the context of prevailing inflation conditions. We chose the indicators such that they reflect the availability of credit and the cost of credit.

Then, we aggregated these variables into an index – the FCI – that can be used to track the state of financial conditions over time.

We believe this summary variable can be used to track the state of financial conditions over time. This can be used as an input in understanding the state of the economy, the impact of policy and, eventually, for assessing the future path of the economy.

¹ CRISIL (May 2020). Minus five : India’s GDP growth outlook for fiscal 2021