Apart from banks and non-banks, headwinds to financial stability can also originate from financial markets.
The increasing frequency and severity of currency and debt crises globally and their ability to cause output loss calls for careful regulation and surveillance of financial markets.
Globalization of finance, by amplifying the risk of contagion, and thereby constraining the policy space for effective regulation, has added to the difficulty of this task. As a regulator of various market segments such as money markets, G-sec, forex and interest rate derivatives, the Reserve Bank has followed calibrated, sequenced and careful approach to develop and integrate these markets. The broad objective has been to keep pace with the requirements of fast-growing Indian economy, while being vigilant of potential risks to financial stability. This is done through freeing up market forces by moving away from prescriptive to principle-based regulation, whose core features are simplification of processes, encouraging product innovation, removing regulatory differentiation across participant categories and ensuring protection for retail market participants.
Adoption of global best practices to improve market integrity is another important aspect of regulation. In the last couple of years, the Legal Entity Identifier (LEI) system has been implemented in a phased manner in all financial markets, including derivative markets regulated by the Reserve Bank, as well as for bank loans. We believe transparency of financial markets
will greatly improve once the LEI system is used widely. The recent regulations to control market abuse, upgrade the benchmark setting process are all consistent with global standards.
A key feature of regulation of derivative markets has been the differential treatment of professional and non-expert clients. Moreover, differential access to derivative markets is being gradually removed. Anyone - resident or non-resident - can now access these markets for hedging on similar terms. In fact, alignment of incentives for non-residents to gradually move to the domestic market is an important regulatory aim. As you would be aware, the Task Force on Offshore Rupee Markets with Mrs. Usha Thorat, former Deputy Governor as chairperson, has made important recommendations that are likely to improve participation of non-residents in the onshore market. Our aim is to make the onshore market more accessible and attract higher transaction volumes.
External headwinds and domestic financial stability
With increased trade and financial linkages with rest of the world, India has become more susceptible to the vagaries of heightened global economic uncertainties. While trade channels take some time to show a tangible impact of global shocks, it is the financial and confidence channels that quickly transmit the global shocks as was evident in the case of India during the taper tantrum period in mid-2013. In fact with negative and low interest rates in major economies, net private capital flows to EMEs in the form of direct and portfolio investments have nearly doubled in the post-crisis period. However, with high monetary policy uncertainties in advanced economies, these flows have proved to be fluid and therefore posed considerable risk to EMEs. Just a year back, EMEs like India faced financial market turbulence due to a faster-than-expected tightening in monetary policies in advanced economies. Many EMEs including India witnessed portfolio capital outflows, exerting downward pressure on domestic currencies.
In recent years, India’s external sector has benefited from a sustainable level of current account deficit, largely financed by robust foreign direct investment inflows and flexible exchange rate policy. Improvement in other vulnerability indicators during 2018-19 such as fall in external debt to GDP ratio (from 20.1 per cent at end-March 2018 to 19.7 per cent at end-March 2019) and debt service ratio (from 7.5 per cent at end-March 2018 to 6.4 per cent at end-March 2019) also augur well for mitigating the spill over.
Edited excerpts from a speech by RBI Governor, Shaktikanta Das on Emerging Challenges to Financial Stability, August 19, at FIBAC 2019, the annual global banking conference organised by IBA and FICCI, Mumbai