The Reserve Bank of India's (RBI's) latest Financial Stability Report is a litany of potential trouble spots - high overseas borrowings, bad loans, leveraged finance companies, shocks from commodities markets, clustered banking system, fiscal excesses and even stagflation due to oil shocks.

But the domestic banking sector could withstand the 'macroeconomic shocks', though high inflation and rising interest rates may take the sheen off its asset quality, which took more than a decade to build after the profligacy of the 90s, the report said.

Global economic recovery may stall and the system shaken again from financialisation of commodities markets, since many of the practices that caused the imbalances of 2008 are still 'unaddressed', it added. The Indian banking system "is substantially connected and clustered", said the third Financial Stability Report released by the RBI. "This intertwined nature of the banking system in any system could leave it vulnerable to domino effects in case of idiosyncratic failure of one or more banks."

The central bank will henceforth release the stability report every six months, in June and December. "Interest rate had the most significant (negative) impact on slippage ratio of banks," said the 97-page report. "The banking sector would be able to withstand macroeconomic shocks, though the prevailing inflation and interest rate situation is expected to have an adverse effect on the asset quality of banks." Relatively higher interest rates compared with international markets, which led companies to arbitrage, may begin to haunt them as quasi-equity securities may not be converted into equities due to poor stock performance. They also face risks due to the depreciation of the rupee against the US dollar.

Reliance on overseas borrowings by corporates "is causing a build-up of currency mismatches in their balance sheets", the report said. "India's International Investment Position (IIP) statistics show that the currency risk exposure of India's non-official sector has increased in the past few years, with an increasing net liability position. This means the translation risk for the non-official sector arises from a depreciation of the Indian rupee."

India's net external liabilities, including loans given by overseas branches of Indian banks to domestic firms, have increased to $158 billion as on March 31, 2010, from $47 billion in 2004, show central bank data. The net liability of the non-official sector has risen to $437 billion from $160 billion. In contrast, China has a net asset position on its IIP at $1.8 trillion in 2009, up from $1.2 trillion in 2007.

"More than a few firms potentially face severe funding problems in the next two years which may not remain confined to their industries," the report said, forecasting that more than $7 billion of convertible bonds will mature by March 2013. The recent easing of some commodity prices may not be of much help in curbing price rise in the country due to subsidies and the failure to pass on previous increases.

"This may not help in inflation management as complete pass-through of previous escalations is still to be effected," it said. "Inflation is likely to face upward pressure from higher subsidy expenditure of the government and rise in wages and raw material prices." These subsidies and slower revenue collections could upset fiscal deficit calculations.