With weakness in the domestic economy, a relatively high exposure to external funding risks, and the backlog of a seven-year period of strong credit expansion to manage, 2012 could prove a challenging year for Indian banks, according to strategists at Morgan Stanley.

 The US investment bank outlined a series of risks for the Indian banking sector, all of which point towards an increased need for constructive policy action in 2012. Viktor Hjort, head of Asia fixed income research and head of global corporate credit strategy and his colleagues, during a call with investors to mark the publication of the bank’s 2012 Asia outlook, were also negative on Indian equities and currency.

 2011 was a rocky year for the Indian economy and markets amid sticky inflation, directional currency weakness and a series of multi-year lows in the sequential growth data. Many of these risks look like spilling over into 2012. Following a good monsoon and stabilisation of food prices, inflation at least seems to have peaked, but the central bank will retain a hawkish underlying bias regarding monetary policy, even as rates cuts become more likely. 

 There have been accusations throughout the year of an insufficient policy response to deteriorating conditions in both the real economy and financial markets. Despite central bank intervention to support the rupee in December, the Reserve Bank of India will be facing an uphill struggle to prevent further currency weakness.

 Among other moves, the Indian central bank tightened the rules for rebooking forward contracts used by residents to hedge contracted current account transactions and capital account transactions within a year. But analysts argue the RBI doesn’t have enough firepower to prevent further directional weakness of the Indian rupee if domestic and external conditions continue to worsen.

 Against this backdrop, softness in Indian bank bonds is slowly shifting from a story of oversupply to more fundamental concerns. India saw net capital outflows in 2011 as international investors withdrew over $300 million in the year, a marked turnaround from 2010’s record $29 billion inflows. Moreover, with the highest recognised debt-to-GDP ratio of any BRIC nation, Indian government bonds would also come under pressure in a macro downturn.

 Indian financials are vulnerable to global funding risks, particularly those associated with a disorderly event in the euro zone, the Morgan Stanley strategists argued. Citibank analyst Manish Chowdhary also highlighted rising asset quality risks in a recent note. “Our base case is still for an elongated asset quality cycle with gradual NPL deterioration. However, risks remain skewed to the downside - NPL accretion can accelerate if extreme tightness in liquidity, currency and rates combine together.”

 Like other economies, India faces tangible downside risks in 2012. But, perhaps to a greater extent than other large emerging markets, analysts are concerned India may be unable to implement the necessary policy responses to counteract these risks.

 At the end of 2011, the government disappointed many when, having announced long-awaited deregulation of the domestic retail sector including a role for foreign capital, it performed a policy u-turn and scrapped the reform. This highlight the difficulties India faces in implementing market-orientated and pro-growth reforms.

 Thus, while its long-term fundamentals remain strong, India may be in for a turbulent ride through a period of shorter term volatility.