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Volatile financial markets may dent macro-economic conditions
July, 26th 2011

The Reserve Bank of India (RBI) on Monday said volatility in local financial markets may return if the macro-economic situation deteriorates.

If prolonged inflation feeds into inflationary expectations, it would affect all segments of the markets, particularly the G-sec (government securities) markets. A widening of the fiscal deficit, leading to higher-than-budgeted market borrowings, could also exert an upward pressure on G-sec yields, the central bank said in its report on macroeconomic and monetary developments, released on Monday.

A slowdown in economic growth is likely to affect the earnings of companies, and this would weigh on equity markets. However, RBI said despite interest rates rising sharply in the past few months, there was no sign of stress on domestic financial markets. The subdued market volatility is no guidance for the future. Financial market volatility can return if macro conditions worsen, it warned.

The banking regulator said the possibility of a delayed exit from monetary easing by advanced economies, the sovereign default risks in euro zone and the scope of rating downgrades for major economies may hit capital flows and financial markets in India.

While global financial markets remained tepid in the first three months of this financial year, asset price movements in India were broadly range-bound and orderly, despite the high inflation, tight liquidity and uncertainty in global markets.

The volatility in local share markets continued to decline in April-June period and the performance of Indian equity markets was better than that of other Bric nations (Brazil, Russia and China) during this period. Investments by foreign institutional investors in Indian equities also saw a rise towards the end of the last quarter.

The exchange rate remained flexible and saw less volatility, the central bank said.

Home unit prices and transaction volumes also increased in the January-March quarter. RBI said monetary transmission also strengthened, as rates hardened in the credit market after all scheduled commercial banks raised their base rates after a policy rate increase. Base rates, or the minimum lending rates of 47 major banks, with a share of 98 per cent of bank credit, rose 50-125 basis points. Deposit rates of 23 major banks, which account for 65 per cent of bank deposits, rose by 25-175 basis points. The rise in deposit rates was relatively sharper for maturities of up to one year.

Short-term rates moved up further, but there were no signs of stress in money markets, RBI said. This led to flattening of the yield curve. Transaction volumes in the CBLO (collateralised borrowing and lending obligations) and market repo segments were higher in the first three months of this financial year, compared to the preceding quarter.

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