The story so far: The International Monetary Fund (IMF) released the latest report on global financial stability on Tuesday, warning of the risks to the global financial system from persistently high inflation, rising lending in the unregulated credit market and increasing cyberattacks on financial institutions.
What concerns does the IMF have about inflation?
The IMF points to increasing investor enthusiasm that the fight against the high inflation of recent years is almost over. Investors have pushed up the prices of financial assets such as stocks in recent months on hopes that central banks will soon start cutting interest rates if inflation is under control. It should be noted that central banks generally attempt to lower interest rates by pumping more money into the economy when inflation falls in order to stimulate economic growth. Although central banks have not yet cut interest rates, investors may see falling inflation as an indication that central banks will soon flood the markets with more money to lower interest rates. So they buy financial assets in anticipation of greater demand for these assets when banks actually cut interest rates, thus driving up the prices of these assets at the moment.
However, the IMF believes that investor enthusiasm about slowing inflation and a possible rate cut by central banks may still be quite premature. It noted that the decline in inflation is likely to have stalled in some major developed and emerging markets, where core inflation was higher in the last three months than in the previous three months. The IMF has also warned that geopolitical risks such as the ongoing war in West Asia and Ukraine could affect overall supply and lead to higher prices. According to them, this could prevent central banks from cutting interest rates in the foreseeable future.
If these risks persist, the IMF believes, investors who have been driving up asset prices and expect fresh money from central banks to push up asset prices in the near future may change their minds. This could lead to a sharp correction in the prices of various assets and cause significant losses for many investors.
What does this mean for India?
The IMF notes that flows into emerging markets have been strong so far on optimism about central banks cutting interest rates. According to Elara Capital, India was the second largest recipient of foreign capital after the US in calendar year 2023. But things could change quickly if Western central banks signal they could keep interest rates high for an extended period of time. This could lead to investors withdrawing money from emerging markets such as India, increasing pressure on their currencies. The Indian rupee has already lost value and traded at a new low of 83.57 against the US dollar last week despite likely interventions from the Reserve Bank of India (RBI). If Western central banks fail to cut interest rates, a significant capital outflow could lead to further devaluation of the rupee and impact the country's financial system. In such a scenario, the RBI is likely to defend the rupee by curbing liquidity to raise interest rates, which could lead to a slowdown in the economy.
What about the private credit market?
The IMF also noted in its report that the growing unregulated private credit market, in which non-bank financial institutions lend to companies, is a growing concern as market problems could impact the financial system as a whole in the future. It is estimated that the private lending market grew to $2.1 trillion worldwide last year. Nonbank financial institutions that lend to corporate borrowers include institutional investors such as pension funds and insurance companies. Institutional investors invest in the private credit market because it offers higher returns than regular investments. In the meantime, borrowers benefit because they cannot obtain convenient long-term funds through other financing options.
However, the IMF fears that borrowers in the private credit market may not be financially healthy, noting that many of them do not have current income that does not even exceed their interest costs. It also argues that it may be difficult for investors to truly assess the risk associated with these loans because, unlike many other securities, these loans are rarely traded in an open, liquid market. The IMF therefore notes that private credit investments have significantly smaller discounts on their market value in times of stress. In a highly liquid market where securities are frequently traded, investors price the actual risk of a loan more directly and more accurately. However, institutional investors may be willing to accept the risk in exchange for higher returns.
In India, a small private credit market has also grown with the advent of alternative investment funds (AIFs). These funds lend money to high-risk borrowers who are not served by the traditional banking system and non-bank financial companies. They also invested in distressed assets that were up for sale under the Insolvency and Bankruptcy Code. The Securities and Exchange Board of India (SEBI) notes that investments made through these funds, while still small, have increased from ₹1.1 lakh crore in 2018-19 to ₹3.4 lakh crore in 2018-19 More than tripled in 2022-23. As financial regulators, both RBI and SEBI have noticed this trend and have sought to tighten control over these funds.
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