Why in the news? 

The International Monetary Fund (IMF) released its latest Global Financial Stability Report warning about the risks to the Global Financial System.

What is the IMF’s worry about Inflation?

• Premature Investor Enthusiasm: The IMF believes that investors may be overly optimistic about the end of high inflation and the subsequent lowering of interest rates by central banks. This enthusiasm could be premature.
• Stalled Inflation: The IMF highlights that inflation may have stalled in some major advanced and emerging economies. Core inflation in the most recent three months has been higher than in the previous three months, indicating a potential slowdown in the decline of inflation.
• Geopolitical Risks: The IMF warns that geopolitical risks, such as ongoing conflicts in West Asia and Ukraine, could disrupt aggregate supply and lead to higher prices. This could counteract efforts to lower inflation and deter central banks from lowering interest rates.
• Potential Impact on Central Bank Action: The IMF suggests that if these risks persist, central banks may delay or refrain from lowering interest rates as expected by investors, which could have consequences for asset prices and investor losses.

How it will impact the Indian Market?

• Strong Fund Flows: Emerging markets like India have experienced strong inflows of foreign capital, driven by optimism surrounding potential interest rate cuts by central banks.
• Vulnerability: If central banks in Western countries signal a prolonged period of high interest rates, investors may withdraw funds from emerging markets like India, putting pressure on their currencies.
• Depreciation of the Indian Rupee: The Indian rupee has already been depreciating, reaching a new low against the U.S. dollar. This trend could continue if capital outflows accelerate.
  • In response to currency depreciation and capital outflows, the RBI may intervene by curbing liquidity and raising interest rates. However, this could slow down the economy.
• Potential Effects on Financial System: A severe outflow of capital could have implications for India’s financial system, potentially exacerbating the depreciation of the rupee and causing instability.

Private Credit Market Scenario:

• The private credit market globally grew to $2.1 trillion last year, indicating its significant size and importance in the financial landscape.
• The IMF is concerned about the unregulated private credit market, where non-bank financial institutions lend to corporate borrowers. Troubles in this market could potentially affect the broader financial system.
• India has also witnessed the growth of a small private credit market, particularly with the rise of Alternative Investment Funds (AIFs).

Conclusion: The IMF’s concerns over premature investor optimism on inflation and risks from geopolitical tensions highlight potential challenges for India’s financial stability. Vigilance over capital flows and regulation of the private credit market are essential safeguards.

Mains PYQ:

Q The World Bank and the IMF, collectively known as the Bretton Woods Institutions, are the two inter-governmental pillars supporting the structure of the world’s economic and financial order. Superficially, the World Bank and the IMF exhibit many common characteristics, yet their role, functions and mandate are distinctly different. Elucidate.

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