Globally, uncertainty and risk aversion reigned in the financial markets as sovereign default risk, fragility in
the banking sector and funding strains for sovereigns and banks continued to haunt the Euro area. Policymakers,
posed with fresh challenges, had to innovate constantly to address the panic and keep the markets stable.
Unconventional policy measures have been initiated by governments and central banks during the last two
years, to deal with the situation. While the measures have brought temporary respite to the financial markets
and the economies, the structural nature of the problems persist and the Eurozone crisis, remains a major threat
to global financial stability. The improvement in sentiment in the early part of 2012 has given way to gloom
as popular dissent against tough austerity measures has made it difficult for democratically elected governments
to act. The concerns of a Greek exit from the European monetary union increased uncertainty during the
period under review. The falling momentum in domestic growth in India as well as the rising current account
deficit and the growing fiscal gap are eroding investor confidence. While the domestic money and bond markets
remain relatively unaffected by external turbulence, the foreign exchange and equity markets have witnessed
high levels of volatility. A combination of foreign exchange market intervention and administrative measures
have been taken to address the stress in foreign exchange markets. Sentiment in Indian equity markets is likely
to remain tied to developments in global and domestic macroeconomic situation.
I. Global Markets
Lingering European debt crisis cast a shadow on
financial markets
2.1 The European sovereign debt crisis had caused
funding strains for sovereigns and, in their wake, for
European banks since the onset of the financial crisis.
This intensified towards the end of 2011. There was
persistent uncertainty over the exact terms of fiscal relief
for Greece. The rating downgrades of European banks
and sovereigns have added to the strains experienced
by financial markets.
ECB’s policy support rescued sentiment temporarily
2.2 Stronger than expected US economic data and the
European Central Bank (ECB)’s first three-year Longer-
Term Refinancing Operation1 (LTRO) in December 2011
were mainly responsible for changing market sentiment
in early part of 2012 as investor risk appetite recovered.
The ECB followed up the first round of LTRO in
December 2011 with another one in February 2012, taking the total policy support from this measure to over
€1 trillion. The LTROs provided finance for stressed
sovereigns and banks. Bank and sovereign CDS spreads
tightened significantly. Strains in US dollar funding
markets appeared to ease (Chart 2.1).
Sovereign debt sustainability concerns resurfaced...
2.3 Policy measures proved unsuccessful in providing
sustained relief. The broad financial market rally that
followed the unconventional monetary policy measures
taken in late 2011 and early 2012 has subsided. Global
markets were concerned about elevated risks from
Greece during the period under review (Box Item 2.1).
While the size of firewalls for fiscal risks in Europe have
been raised, doubts over their capacity to support larger
countries such as Spain or Italy in case of a contagion,
have weakened market confidence.
...with widening of spreads on sovereign bonds
2.4 Sovereign CDS spreads have widened significantly,
especially in Spain and Italy (Chart 2.2). Several
institutions lowered risk limits for sovereign bonds of
the troubled economies in Eurozone due to adverse
developments and the higher notional losses on such
bond holdings (as a result of higher volatility). This
reduced the institutional appetite for bonds and affected
their liquidity. The implied volatilities of the bond, stock,
and foreign exchange markets point to an uncertain
environment (Chart 2.3).
Structural issues remain to be addressed
2.5 Some European banks continue to be heavily
reliant on wholesale funding. However, the maturities
of bank borrowings have been shortened owing to
market conditions. Further, their access to unsecured
funds has also worsened. This fragility makes banks
vulnerable to funding market freezes and has significantly
increased their dependence on central bank support.
Rating agency, Moody’s Investor Service cut ratings of
15 major banks by one to three notches, in another round
of rating downgrades in mid-June 2012.
Box 2.1 : The Greek Dilemma
Greece received a second bailout package from the IMF-EU-ECB
troika in February 2012 after its fiscal situation failed to improve
to the extent expected. The second restructuring involved an
effective loss of as much as 75 percent for private bond holders
in order to reduce Greece’s debt burden. Outcomes of recent
elections in Europe point to anti-incumbency on account of
austerity measures. The contrasting experiences of Ireland and
Iceland are a pointer for the Greek situation. Ireland, which
is in the Euro currency union, is still on negative growth trajectory, despite adhering to austerity measures imposed by
lenders. Iceland, in contrast, has rebounded with good growth
rates in 2011 through depreciation of its currency and by
passing on losses to its lenders. Iceland grew at 4.5 per cent
in Q1 2012 compared to 0 per cent for the European Union. In
fact, the central bank of Iceland has been hiking interest rates
since Q3 2011. The outcome of the second election in Greece
in June 2012 appears to favour the continuation of Greece in
the monetary union.
Accommodative monetary policy in advanced countries
has externalities
2.6 In the United States, macroeconomic indicators
point to a slow recovery, though the sustainability of
the recovery remains uncertain. Central banks in
advanced economies (AEs) are continuing their
accommodative monetary policies. Policy rates have
been at or near historic lows in many AEs, with a
commitment to continue these levels for some more
time. This, in turn, induces greater leverage and a
progressive easing of lending standards. From a
corporate issuer’s point of view, the cost of raising fund
by issuance of bonds has become more attractive, relative
to equity. A surge in corporate borrowings could increase
systemic leverage in the process. There are signs that
continuously low interest rates may start to feed into a
search-for-yield behaviour in global financial markets
(Chart 2.4).
II. Domestic Markets
Foreign exchange market exhibited considerable stress
2.7 Developments in Euro area and deterioration in
global macroeconomy were among the factors that
contributed to stress in the domestic foreign exchange
market during the period under review. The other three
components of the Financial Markets Stability Map
(Chart 2.5), viz. banking sector funding, debt and equity
markets, remained largely unchanged in comparison.
The rise in the Financial Markets Stability Indicator
(Chart 2.6) is largely driven by the fall in the rupee to
historical lows and rise in its volatility.
Sovereign bond yields reflected fiscal slippages
2.8 Bond yields moved higher towards the end of
March and early April 2012 (Chart 2.7) on account of
persistently tight liquidity conditions and an
unanticipated rise in budgeted government borrowings
for 2012-13. Subsequently they have stayed in a range between 8.5 per cent and 8.8 per cent for 10-year
maturities. The financial markets remained unconvinced
about the ability of the government to bring down the
high level of fiscal deficit. The gross and net market
borrowing of the Central Government through dated
securities have been budgeted at ` 5696 billion and
` 4790 billion, respectively during 2012-13. This is higher
by 11.7 per cent and 9.8 per cent, respectively over the
last year. The Central Government proposes to finance
only 2 per cent of the budget through treasury bills,
significantly lower than 22 per cent in 2011-12. A cut in
the Reserve Banks’ policy rate by 50 basis points, inter
alia, brought 10-year government bond yields closer to
8 per cent.
 Indian sovereign bond market remained largely
insulated from overseas pressures
2.9 During the period under review, the rating
agencies, S&P and Fitch, changed the outlook on Indian
sovereign debt and 11 banks /institutions, from stable
to negative. Though the government bond yields rose
marginally on the news of change in the rating outlook,
they quickly retraced. Since the Central Government
does not borrow in the offshore markets and reliance
on outside investors by way of Foreign Institutional
Investment (FII) is limited, the impact was muted.
Liquidity conditions improved after tightness in March
2.10 Liquidity conditions in Indian money market
remained tight, during the period under review, outside
of the Reserve Bank’s indicative comfort level of (+)/(-)
one per cent of net demand and time liabilities (NDTL)
of banks. Average net injection of liquidity under the
daily liquidity adjustment facility (LAF) increased from
around `0.5 trillion during April-September 2011 to
around `1.6 trillion during March 2012. The increase in
currency in circulation, quarterly tax outgo from all firms
and the foreign exchange market intervention operations
sucked liquidity out of the banking system. The Reserve
Bank injected liquidity by conducting open market
operations (OMOs) and reducing the cash reserve ratio
(CRR) by 125 basis points. The Systemic Liquidity
Indicator (Chapter V) exhibits the stress felt in funding
liquidity for banks and others.
Rating change could impact the cost and availability
of foreign currency borrowing
2.11 The process of deleveraging underway among
European banks has raised the cost of borrowing for
Indian firms and banks. Smaller borrowers have found
their traditional funding lines withdrawn. A large part
of foreign currency borrowings of Indian firms and banks
is in the form of loans (External Commercial Borrowings)
rather than bonds. The current external rating of India
stands at BBB- (with a negative watch by S&P and Fitch
and Baa3 by Moody’s). A rating change could have some
‘cliff effects’. This could affect both availability and cost
of foreign currency credit lines for Indian corporates
further. The impact is also being felt by Indian banks as
they are the primary source of foreign currency
denominated funding for Indian firms like buyer’s
credit. Indian financial institutions and non-banking
financial companies (NBFCs) in the public sector have
been large beneficiaries of FII investments in debt in the
past. These institutions, could also face the impact of a
reduction in FII inflows.
Forex market remained volatile
2.12 Concerns over high twin deficits of the country,
re-emergence of global macroeconomic tensions and the
European sovereign debt crisis have been the key factors
behind the weakening rupee. The Reserve Bank has been
using a mix of foreign exchange market interventions
and administrative measures to address the volatility
arising from tensions in the market place. The
depreciation of the rupee followed the general trend of currencies of EDEs, especially those with high current
account deficits (Chart 2.8).
Reserves fell moderately
2.13 Adequacy of reserves has emerged as an important
parameter in gauging the ability of a country to absorb
external shocks. At the end of September 2011, the
import cover declined to 8.5 months from 9.6 months
at end-March 2011.The ratio of short-term debt to the
foreign exchange reserves was 21.3 per cent at end-
March 2011 and it increased to 23 per cent at end-
September 2011. The ratio of volatile capital flows
(defined to include cumulative portfolio inflows and
short-term debt) to the reserves increased from 67.3 per
cent as at end-March 2011 to 68.3 per cent as at end-
September 2011.
2.14 With the changing profile of capital flows, the
traditional approach of assessing reserve adequacy in
terms of import cover has been broadened to include a
number of parameters which take into account the size,
composition and risk profiles of various types of capital
flows as well as the types of external shocks to which
the economy is vulnerable. In the recent period,
assessment of reserve adequacy is being done using
some new measures, including ‘Liquidity at Risk’ (LaR).
The LaR approach requires that a country’s foreign
exchange liquidity position could be calculated under a
range of possible outcomes for relevant financial
variables, such as, exchange rates, commodity prices,
credit spreads etc.
Recent Rupee weakness found echo in stock market
sentiment
2.15 The Morgan Stanley Capital International (MSCI)
Emerging Markets index reported a first quarter gain of
13.2 per cent in Q1 2012. Stock markets in India mirrored
the movement in other emerging markets in Asia and
elsewhere. The initial optimism fuelled by increased
liquidity provided by ECB and the resolution of
uncertainties relating to the second debt package for
Greece quickly waned. Retrenchment by FIIs in India (as
also abroad) led to a correction in Indian stock indices
back to their December 2011 lows. The US dollar rate of
return to foreign investors worsened with the
depreciation of the Indian rupee and this, in turn,
reduced the attractiveness of Indian equity (Chart 2.9).
Some episodes have highlighted the possible risks
from Algo and High Frequency Trades
2.16 In recent period, there have been many instances
of extreme volatility and disruptions witnessed in Indian
stock markets, resulting from various causes which can
be directly or indirectly attributed to the increasing use
of Algorithmic5 (Algo) and High Frequency Trading
(HFT)6. The Financial Stability Report of June 2011 had
mentioned about the possible risk implications of a rapid
move towards technological advancements like
introduction of Direct Market Access (DMA)7, facilitating
Algo trading and HFT for Indian stock markets. In India
only about 17 per cent and 11 per cent of cash market
turnover in NSE and BSE respectively are on account of
Algo and HFT in recent months. This proportion is much
lower than that in developed markets like US and
Europe.
2.17 Indian stock exchanges already have features like
circuit breakers on stocks (having derivative trading)
and indices, dummy price band for no band securities,
quantity alert check, consolidated audit trail and trade
cancellation policy and other risk reduction procedures
to detect manipulation and deal with the possible risks.
There is a need to balance the need for technological
advancements with a pragmatic approach to the
intended benefits of the innovations. This assumes
even more significance for India as efforts are being
made to increase the retail participation in the Indian
securities markets to change the largely institutional
character of the market. The regulators and policy
makers need to continue to assess the system-wide
impact of such trading, from the perspective of current
priority for a broad-based development of financial
markets.
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