Analysing the Recent Decline in Indian Stock Markets
Indian stocks have declined by 10% over the past four months. A recovery in late November and December was not sustained. Although mid-caps and small-caps were more resilient than large-caps during the declines of October and November, the decline over the past two months was more broad-based. An economic slowdown, inflation pressures, and rising global bond yields were attributed to the challenging market conditions.
It is unambiguous that the Indian equity market has been under tremendous strain over the past three to four months. However, whether the strain is merely a routine correction or a precursor to something more significant—such as a panic, crash, or crisis—is unclear. If so, the financial system provides valuable cues before the onset of the colossal adverse event; early detection and interpretation of such cues could help increase our resilience against the event’s onslaught.
Cues from the Yield Curve
The US had an inverted yield curve for almost two years, from July 2022 to August 2024. An inverted yield curve is a phenomenon in which short-term securities yield higher than long-term securities. An inverted yield curve is unusual and contrary to basic economic principles, which typically hold that long-term securities should yield higher returns than short-term securities. An inverted yield curve is generally regarded as a sign of impending recession. However, the recession predicted by the inverted yield curve in the US since mid-2022 never transpired: the US economy remained buoyant.
Intriguingly, the US yield curve has steepened in recent months; it is no longer inverted, as the inversion was corrected in September 2024. Typically, a decline in short-term yields, such as following a central bank rate cut decision, instigates yield curve steepening. However, the present yield curve steepening is caused by a rise in long-term yields. The phenomenon – yield curve steepening due to rising long-term yields – was previously observed in the stagflation periods of the 1970s and 1980s.
The risk posed by non-banks
The financial strain induced by rising bond yields is extensive. Households, businesses, and governments will feel the pain through increased interest payments on new borrowings; existing borrowings must be refinanced at higher rates. The strain could become a general panic when several economic participants fail to meet their borrowing obligations. A panic might also arise if lenders become risk-averse and refuse to refinance soon-to-mature borrowings.
However, it is unlikely that such risks will emerge from the banking system due to the intense scrutiny banks are subjected to these days, consequent to the increased supervisory and regulatory measures introduced after the 2008 global financial crisis. However, the increased supervision and regulation have also constrained banks’ ability to scale and innovate.
Amidst these constraints, a new class of financial intermediaries, known as NBFIs (non-bank financial intermediaries), has emerged and carved out a prominent space within the global economic system over the past decade. However, these non-banks are relatively opaque in disseminating information regarding their financing activities; since they don’t accept deposits, they are subjected to very low regulatory oversight. The relative opaqueness and reduced oversight have increased the possibility of risks germinating within them.
Spillover of NBFI risks (if any) into the broader financial system would have far-reaching adverse implications for asset prices, economic growth, and job prospects. Regulators are likely unaware of these risks due to their less stringent oversight of NBFIs and their extensive focus on supervising institutions (large banks) considered systemically important.
In its Global Financial Stability Report (GFSR) of October 2024, the IMF expressed “lofty asset valuation, elevated private and government debts, and increased leverage employed by non-banks” as significant risks to global financial stability. Non-banks don’t have access to the kind of liquidity and capital support measures typically provided to banks by central banks under stressful conditions. Even if central bankers are willing to support NBFIs under distress, they are considerably constrained by their poor understanding of NBFIs’ operations.
Cues from Market Volatility
Nikkei 225 – the Japanese stock market index – fell 25 per cent in the one month between July 11, 2024, and August 8, 2024. Although the index regained most of those losses within weeks, it remains 5% lower than its July 2024 high. The S&P 500 – the US stock market index – fell 5% around the same time, in the first week of August 2024, but fully recovered from the decline the following week. Nifty 50 – the Indian stock market index – declined sharply during the first week of August 2024 and recovered fully the following week.
These are cases of sudden spikes in market volatility resulting from adverse shocks to the financial system. The adverse shock in the above episode is the Japanese central bank’s decision to raise policy interest rates by 0.25% in late July 2024. Some believe the US Fed’s decision to keep policy interest rates unchanged in its July 2024 MPC meeting also contributed to the August 2024 global market volatility; some others point to the poor US jobs report and higher unemployment rate.
Nevertheless, the most significant message from the extreme market volatility of August 2024 is that it revealed the vulnerability of the global financial system. The IMF attributed the August 2024 episode of extreme market volatility to the prevailing mismatch between economic uncertainty and market volatility, noting that markets are less volatile than warranted by the prevailing economic situation. In early 2024, investors were optimistic due to the expectation of lower rates globally; this made them oblivious to the increasing financial uncertainty and geopolitical risks. The IMF warns that more extreme market volatilities are likely to occur going forward as the mismatch remains.
The US stock market continued to rise after recovering from the sudden decline in August 2024; it now trades at an all-time high. The UK and German stock markets have followed the same trajectory as the US market; both trade at their all-time highs today. The Indian stock market also continued to rise, but peaked by the end of September 2024; it now trades 12 per cent below its all-time high.
IMF anticipated that easing monetary policy in advanced economies would moderate pressure on emerging markets in the near term in its October 2024 GFSR. However, the Indian stock market’s experience since then has sharply contrasted with what the IMF anticipated. A 10 per cent decline in stock prices, massive capital outflow, a depreciating currency, and an unexpected economic growth slowdown characterised the Indian financial system over the past four months; these developments occurred when most advanced central banks reduced interest rates.
The buoyant equity markets of advanced economies don’t necessarily suggest these economies are doing well; likewise, our sluggish equity markets don’t suggest we are doing poorly. Global economic uncertainty has considerably increased since Donald Trump won the US presidential election. Investors turn risk-averse when economic uncertainty rises. Such risk aversion causes capital flight from riskier emerging markets to less risky advanced markets.
The Japanese Risk Factor
The Japanese central bank followed up with another 25 basis point increase in its policy interest rate on January 24, 2025; it had previously raised rates twice in 2024 – its first rate hike since 2007. Presumably, the Japanese central bank’s decision to raise rates is more consequential to the global financial markets than the US Fed’s monetary decisions.
Japan had followed a zero-interest rate policy for the past twenty-five years. During this period, rates were once raised from zero to 0.5 per cent (in 2006-2007) but were soon reduced back to zero in response to the 2008 global financial crisis. However, Japan’s zero-interest-rate policy since 1999 has given rise to a trading strategy known as the ‘carry trade’.
The strategy involves borrowing in a currency with low interest rates to invest in a currency with a higher interest rate, with the goal of profiting from the interest rate differential. Investors took advantage of Japan’s extremely low interest rates by borrowing heavily from Japan and investing the proceeds in riskier assets elsewhere. This strategy will become less lucrative as Japan continues to raise interest rates, which it has initiated since February 2024.
However, the gravest concern is that all the existing investments made through the Japanese carry trade route will soon become untenable as interest rates in Japan continue to rise. It is estimated that around $4.4 trillion is invested abroad through this route, almost equivalent to the annual GDP of Germany – the world’s third-largest economy. Even a gradual unwinding of investments of such colossal size will have a nearly apocalyptic impact on global financial markets.
Cues from Long-Term Bond Yields
At the beginning of 2022, the 10-year government bonds in the US and Japan yielded 1.50% and 0.10%, respectively; the interest rate differential was +1.40%. Since then, both yields have risen. Today, they yield 4.50 per cent and 1.22 per cent, respectively, and the interest rate differential is +3.28 per cent. This indicates that, although Japanese bond yields have risen over the past two years, the conditions have become more favourable for investing in the US through the Japanese carry trade route, due to the significantly larger rise in US bond yields. However, the interest differential between 10-year bond yields in India and Japan has narrowed from +6.40% at the start of 2022 to +5.50% today. Despite narrowing, the differential is still higher than the US-Japan differential.
Globally, long-term bond yields have either risen or remained steady in almost all major economies over the last two years, except for India, South Korea, and Switzerland, where 10-year bond yields have declined over the same period. However, India differs from South Korea and Switzerland in one aspect: the other two have a positive interest rate differential between their 2-year and 10-year bonds (a normal yield curve), while the differential is zero for India (a flat yield curve).
In India, the yield curve has flattened over the past three years, as long-term yields have declined faster than short-term yields. At the beginning of 2022, there was an interest differential of +1.50 per cent between the 2-year and 10-year government bonds; today, India’s 2-year, 5-year, and 10-year government bonds yield around 6.70 per cent.
Declining long-term interest rates are seen as positive for the economy and equities. They spur economic growth, leading to higher corporate earnings, which drives equity prices higher. However, the flattening yield curve alongside the declining long-term rates has complicated the situation: a flat yield curve indicates elevated economic uncertainty.
Tight domestic liquidity conditions are attributed to the high short-term interest rates. The RBI addressed this issue for the first time in its December 2024 policy review by implementing a 50 basis point cut in the cash reserve ratio (CRR), estimated to have infused ₹1.16 trillion into the financial system. In late January, the RBI followed up with another set of measures, including open market operations (OMOs), a VRR auction, and a $-₹ buy-sell swap; these measures are expected to provide a ₹1.5 trillion liquidity boost to the economy. The measures have also raised hope among market participants for a policy rate cut in February, which was realised on February 7, 2025, when the RBI cut policy interest rates by 25 basis points – its first rate cut in almost five years.
The Indian equity market has undergone a severe correction over the past four months. The impact was more severe on small stocks than on large stocks: the midcap and smallcap indices declined 16 per cent and 20 per cent, respectively, while the Nifty50 index declined 12 per cent during the period. The onset of the correction coincided with the US central bank’s September 2024 policy rate cut decision – its first rate cut after keeping rates higher and unchanged for almost two years.
Typically, a policy rate cut in advanced economies is expected to drive capital towards emerging markets, such as India, thereby boosting asset prices in these markets. However, soon after the US Fed’s September 2024 rate cut, contrary to expectations, our market witnessed significant capital outflows. This large capital outflow had several adverse consequences: a sharp depreciation in the rupee’s value against the dollar, tight domestic liquidity conditions resulting from the RBI’s efforts to support the rupee, and a stock market rout that saw a 20 per cent decline in small stocks.
However, a policy rate cut wouldn’t be that easy for the RBI, considering the intense (and that keeps intensifying) global economic uncertainty now. Market participants have recently started to view the almost 100 basis point increase in US long-term bond yields since the September 2024 rate cut as discounting a high inflation risk. As a result, investors’ expectations regarding the scale and pace of rate cuts by global central banks for this year have been significantly dampened in recent weeks.
Suppose there is an inflation spike this year in advanced economies, as forecasted by rising long-term bond yields. In that case, central banks in those countries will be compelled to reverse their monetary policy direction from rate cuts to rate hikes. This would reduce the investment appeal of Indian assets (stocks and bonds), exacerbating the capital outflow. To avoid such a situation and maintain India’s investment appeal in the global financial markets, RBI may have to raise policy rates to achieve parity with the higher rates of advanced countries.
Cues from Interest Rate Differentials
The rapid narrowing of the interest rate differential between the US and India appears to be a key reason behind the increased financial strain experienced by the Indian economy over the last three months. This demonstrates that the RBI could not adopt a monetary policy that ignores global economic conditions. In its October 2024 GFSR, the IMF identified the necessity of “greater policy alignment to stabilise interest rate differentials between advanced economies and emerging markets.”
The interest rate differential between the 10-year bond yields in the US and India has narrowed from 3.05% in late September 2024 to 2.20% in late January 2025. There was a 50-basis-point decline in India’s 10-year bond yields over the last two years, while the RBI kept its policy rates unchanged. A significantly larger decrease in the 10-year bond yield is more likely as the RBI cuts its policy rates. This could further narrow the interest rate differential with the US, possibly exacerbating the ongoing financial strain experienced in capital flight, rupee depreciation, and a decline in equity prices.
Diverging Long-term Yields
The trajectories of US and Indian bond yields have diverged over the last four months; the US 10-year bond yield increased, while that of India declined. This is confounding as it contrasts with the norm of the past twenty-five years, when the long-term yields in both countries have followed a similar trajectory: as yields fell in the US, so did the yields in India; similarly, as yields increased in the US, India’s yields also increased.
Does this indicate that Indian bond price (or yield) movements have decoupled from the US bond price (or yield) movements? Are they no longer correlated? Will Indian bond yields from now on be dictated solely by domestic economic conditions?
The decoupling theory is fallacious, considering the adverse consequences our economy and financial markets have endured over the last few months due to the large-scale foreign capital outflow. Our economy and financial markets are integrated with the global economic system. Attracting foreign capital is integral to our economic growth and stability, which depends on the investment attractiveness of our markets. The interest rate differential is the primary determinant of our investment attractiveness.
The divergent trajectory of bond yields is unsustainable. It shall soon be corrected. But for that to happen, either the US long-term yields must reverse course and start declining, or the Indian long-term yields must reverse their declining trend and increase. Borrowing insights from Newton’s second law of motion, “a trend already in motion will carry on unless acted upon by an adverse shock.” The trend here is the narrowing of the interest rate differential between the long-term bond yields in the US and India.
In short, the divergent trajectory of long-term yields in the US and India is unsustainable, and as a result, their correction is inevitable. However, an adverse shock to the financial system is imperative to bring about the unavoidable correction, implying that “an adverse shock” to the economic system should be expected soon. The adverse shock will come unexpectedly to the majority; market volatility accelerates with its onset; and most importantly, it shatters investors’ confidence in the financial system, escalating the initial distress into panic or crisis.
The Chinese Risk Factor
The adverse shock could emanate from anywhere – domestic or external. China is one possible source. The Chinese economy and financial markets have been in acute distress over the past four years due to the deflation of its property bubble. The troubles began when the Evergrande group defaulted on its loan in December 2021; Evergrande was then the largest Chinese real estate developer and the world’s most indebted property developer, with over $300 billion in debt. In January 2024, a Chinese court ordered the liquidation of Evergrande after the company failed to provide a restructuring plan.
The most recent episode of this saga concerns China Vanke, another of China’s biggest property developers, whose stock has lost 80 per cent since 2021. In late January 2025, Vanke warned investors of a $6.2 billion loss for 2024, which troubled investors because Vanke is a state-backed developer and has been regarded as one of China’s most conservative real estate companies. Moreover, this event occurs despite the Chinese government’s efforts to revive the property market, highlighting the severity of the ongoing Chinese property downturn.
The root cause of the ongoing Chinese property crisis lies in the debt accumulation at property developers, municipalities, and local government financial vehicles, resulting from the debt-fueled real estate boom of the first two decades of this century. However, four years into the crisis, it is perplexing that none of this is reflected in the Chinese banking system. Chinese banks have the most considerable exposure to the real estate sector. Despite that, Chinese banks have continuously reported low non-performing loan ratios for the past four years. It wasn’t prudent lending practices or robust asset quality that enabled Chinese banks to achieve this feat; instead, it was partly due to the existence of Asset Management Companies (AMCs), also known as bad banks, which were established more than two decades ago to manage non-performing assets in state-owned banks.
These AMCs acquire non-performing assets (NPAs) from Chinese banks, taking them off bank balance sheets, thus cleaning up bank balance sheets. Due to their high growth over the past two decades, these AMCs have gained significant market share and have become highly intertwined with the rest of the Chinese financial system.
Since the onset of the property crisis, the fundamentals of AMCs have significantly weakened; their capital levels have dropped to distressed levels in recent years. In its Oct 2024 GFSR, the IMF warned that “any financial distress in China’s AMC could generate macro-financial instability”. The distress could escalate into a panic engulfing the entire financial system as Chinese banks lose their principal source of disposal for their NPAs.
Few Other Cues – Corporate Credit, Private Credit
Corporate credit – interest-bearing capital that corporations raise to finance their operations and investments – is another area of vulnerability. The low-interest-rate environment of the 2010s has enabled corporations to raise money cheaply and easily; many have utilised the opportunity by loading up on debt. There were several instances of debt capital being utilised for share buybacks. As interest rates have risen over the past two years, several firms are experiencing a deterioration in their debt servicing capacity.
The precariousness of the corporate debt market is evident in the increasing number of bankruptcies among smaller firms, the decreasing average maturity of corporate debt, and the dwindling cash buffers at individual firms. The significantly higher refinancing yields compared to existing yields, coupled with a potential increase in input costs resulting from trade restrictions or geopolitical events, will likely exacerbate the situation.
However, despite increasing risk in the corporate debt market, the corporate bond spreads remain tight, mainly due to investor optimism regarding the global economy and strong demand from overseas investors. However, it only requires a shock to shatter investor confidence and optimism, driving spreads higher. The pace of defaults and bankruptcies could accelerate in the future.
In the past five years, following the pandemic, private credit funds have emerged as a significant source of credit for corporations and small businesses. IMF’s Oct. 2024 GFSR notes that “high interest rates are pressing private credit borrowers” and “underwriting standards at these firms have deteriorated recently due to rapid growth, increased competition, and pressure to deploy capital.”
IMF also warns about “the increased possibility of the private credit industry being vulnerable to episodes of crisis of confidence”, mainly due to two reasons: 1) the difficulty of assessing risks due to the opaqueness of the private credit industry and 2) their uncertain valuation methodology that leads them to defer realisation of losses.
A spike in defaults shall ensue when these firms are forced to realise their losses immediately. If such a situation arises at several private credit funds, it will fuel an adverse feedback loop. According to the IMF, “Such a scenario could force the entire network of institutions that participate in the private credit industry to reduce exposures to the sector simultaneously, triggering spillovers to other markets and the broad economy.”
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