Suyash Choudhary

Global markets have remained relatively volatile since chatter of Fed tapering its QE program started in late May. The volatility picked up in June, as Fed Chairman Bernanke appeared to confirm market fears of tapering starting sometime this year and ending my mid of next year, should economic data pan out as per the Fed’s current expectations. Alongside other emerging markets, India has seen substantial outflows, specifically in debt (USD 8 billion since late May). The rupee has depreciated somewhat more than most emerging market peers, given our larger current account deficit and hence a larger dependence on external flows. Over recent days, India’s high short term debt levels have also become a cause for concern. With rupee breaching 60 to the dollar, market expectations started veering towards even higher levels. Bond yields have also sold off by around 40 bps on government bonds whereas corporate bond spreads have widened reflecting liquidity concerns. Amidst this, recent comments from Bernanke have re-kindled hope that the Fed may not rush into tapering. Reflecting this, there has been some pull back in emerging markets. Indian bond yields have retraced by 10 – 15 bps as well.



The environment is understandably volatile enough to create sufficient confusion in the minds of investors. We had assessed this situation last in our previous note (“US FED Meeting: Takeaways for our bond market”, dated 20th June) with the intent of providing some guidance to investors. The attempt here is to further elaborate upon that analysis and re-assess the current broad macro-economic environment and policy rate expectations.


1. Growth versus inflation: The most fundamental reason why there is reason for an underlying bullish theme to continue is that growth versus inflation dynamics still call for easier RBI policy ahead. Even though growth is subdued chiefly due to government policies and supply constraints, a role for monetary policy can be argued as well; although certainly not anywhere near the pace at which the market was expecting until very recently. As far as inflation is concerned, it has been clearly trending down over the past few readings; more so for WPI. Admittedly, the recent rupee depreciation will put some upward pressure on the earlier trajectory for inflation. Besides, temporarily there will be some upward pressure from primary articles as well since vegetable prices have shot up over last month chiefly on account of disruptive rains. However, overall outlook for monsoon and sowing so far indicates better prospects for food inflation in the time ahead. Purely from a growth versus inflation point of view then, it is reasonable to argue for further monetary easing over the medium term.


2. Credit to Deposit Ratio: The banking system continues to struggle with deposit accretion generally. However, credit growth has fallen quite sharply as well; especially so since start of lean season from April (much more so than for same period last year). This has left banks with more than adequate room to continue to buy government bonds and keep SLR ratios at elevated levels of around 30%. Hence there is fundamental support to bond prices so long as credit growth remains muted.


3. Fiscal Situation: Notwithstanding the continued halo effects from the impressive compression exercise of last year, the fiscal situation so far this year is looking quite concerning. We had given a preliminary assessment of this in a recent note (refer: “India’s fiscal deficit: Morning after blues?” dated 5th June for details). Since then, we have full fiscal data for the month of May as well. Fiscal deficit for these 2 months combined is already 33% of total budgeted for the year. This represents a 28% increase over the first 2 months of last year. Besides, the fact that the government has recently gone into overdraft with the RBI after a hiatus of some months suggests that robust spending has continued for the month of June as well. Given these, it is likely that at some point over the next few months, the market may start to get concerned about the fiscal situation. What is quite clear is that, irrespective of recent assurances from the finance minister, if fiscal deficit targets are to be met this year it will most likely again be through expenditure control.


4. External Situation: Global markets may continue to dynamically evolve their expectation with respect to when and how much the Fed will taper. This will depend upon US data as well as occasional guidance from Fed members. This in turn may induce short term volatility to our own bond markets in either direction. However, the broader picture and implications for our market should remain unchanged unless there are drastic changes to expectations with respect to global flows. The underlying theme remains that our current account deficit is uncomfortably large. This is irrespective whether the USD 88 billion deficit posted last financial year improves by USD 10 – 15 billion this year. Even financing USD 75 billion in an environment of volatile capital flows is a challenging task. Besides, our short term debt levels may make us even more susceptible. Hence, managing external risks in context of a wide current account deficit and volatile capital flows has to be the number one priority for policy at this time.In this regard, some have argued that the RBI may even contemplate rate hikes to mitigate external volatility. Just as we did not believe in views floating till some time back that the current macroeconomic set up allows for deep rate cut, we don’t believe views for a rate hike as well. This is because growth remains a big worry for India unlike peers like Indonesia (which has hiked rates by 75 bps over last 2 months) which are seeing more stability and indeed a rising near term inflation. Also, there is a large problem of transmission in India as banks have been unable to fully pass through RBI rate cuts into lending rates. Should the RBI send a contradictory signal now, the transmission channel will get further curtailed. However, the current environment may very well imply that residual rate cuts get pushed back till external risk remains the dominant theme.


The above points are intended to paint the broad macro-economic picture in our view. Irrespective of short term bounces or sell offs, we would urge investors to focus on this overall picture and make investment decisions accordingly. To summarize, the fundamental attraction for fixed income investments remains intact since the growth versus inflation trade-off will keep the cycle from reversing. Within this set up, there are various macro-economic balances that have existed through this cycle and which we have been continually talking about over the past year or so. Hence, it is unreasonable to expect aggressive monetary easing till these imbalances remain. This was true even during May’s bull run when expectations were of back to back rate cuts continuing. Also, given that the current dominant theme is external account management, it is likely that whatever residual rate cuts remained have been at least pushed back by a few months. However, it should be remembered that bond funds that have managed duration actively have done quite well even for the past few years when there were no rate cuts in the market. Given this, active duration management remains our approach. The current context argues for some caution which is reflected in the maturities of our bond funds. As triggers change, we will look to change maturities as well. Importantly, this will be in response to changes in macro-economic triggers and not in response to day to day price volatilities. Investors too should choose funds depending upon risk appetite, investment horizon and the fund house approach they prefer in context of the underlying macro-economic environment. Day to day market moves will only serve to distort the right decision.


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