Is India on the path to a Sovereign debt crisis?

Posted on December 19, 2011

It begins with the financial instability of a nation’s banking system. Rising interest rates and a higher price tag for insurance against default of a bank’s bonds are the harbinger of difficult fiscal times ahead. These increasing cost of funds for Indian banks are growing at the fastest rate in Asia and are creating a cash crunch for Indian lenders. Indian banks have had to borrrow from the central bank, The Reserve Bank of India, everyday since last April to offset cash shortages. At the same time bank officials continue to raise interest rates to combat inflation. Because of ever increasing interest rates, banks are encountering risks on their profit margins due to the scarcity of liquidity and higher exposure to non-performing assets.

Indian bank lending to corporations and small businesses has steadily decreased month over month on an annual basis, and the central bank has recently forecasted that bad loans will rise 25% in the year. Moody recently downgraded India’s banking system to negative, saying a domestic economic slowdown and the surge in borrowing costs will boost bad loans. The average expense of credit-default swaps that insure against non-payment by several Indian banks have more than doubled in 2011. The cost of these swaps for State bank, the largest lender and standard-bearer of India hit a two year high. In addition, State Bank had its financial strength rating cut due to inadequate capital buffer and rising non-performing assets.The Bankex Index, Indian’s primary gauge of banking stocks, has lost 26% this year.

As the central bank persists in hiking up interest rate, yields on government and corporate bonds continue to climb, augmenting the cost of funds, a slowdown in growth and increased volatility in the foreign exchange markets.  The rupee plunged 16.6 percent this year and touched an all-time record low of 54.30 to the dollar. It’s on track now for the biggest decline since 2008. The Reserve Bank of India today limited trading of Indian Rupee forward contracts in order to restrain speculation.

An increase in its cost of funds, a rising of their non-performing assets, a marked decrease in their business lending, a decline in the growth of the economy and an unstable and explosive currency; Is this the beginning of a lack of confidence with India’s banking system and government financial good faith?

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