Recent Environment Developments
After a period of relative calm and a strong year beginning bond performance domestically, the last few days have again been eventful for markets. Towards late last year there was broad global consensus that most emerging markets (EMs) were beginning to stabilize and that incremental tapering from the Fed may be taken more in stride. However, rumblings have erupted lately in various EMs such as Turkey, Argentina, and South Africa whereas there are fresh concerns in China both with respect to slowing growth as well as the fate of some of the alternative investment products sold over the past few years. Turkey and South Africa have hiked rates as well over the past few days, the former by a significant margin while the latter quite unexpectedly. Despite this strong commitment shown there is at best a near term uneasy calm. Meanwhile the Fed continued to taper, delivering another USD 10 billion cut to its bond purchase program, showing scant regard to the EM hiccup (there was no mention at all of this in the accompanying statement) or indeed to the underwhelming employment report received in December (admittedly there may have been significant weather related distortions in that report).
While the above has set the global context, our own RBI has been fairly busy these last few days. The Urjit Patel committee suggested flexible inflation targeting for the RBI with the first year CPI target of 8%. Subsequently, Governor Rajan surprised most by hiking rates. Even though he has verbally sounded non-committal just yet to inflation targeting, for all practical purposes the tone of the policy and the guidance forward suggests no practical difference at least for the first year ahead. Thus the central tendency of RBI’s official CPI forecast for the year ahead is 8% (the same as Urjit Patel committee’s recommended target). It believes that the cumulative rate hike of 75 bps undertaken so far should be enough to achieve that outcome. However, it retains flexibility to act if this were to not be the case. In interactions subsequently, the Governor has reiterated his commitment saying that there is no trade-off between growth and inflation at this juncture since lower inflation is a pre-requisite for sustainable growth. He has also highlighted that cutting rates at this juncture will be quite meaningless since banks will anyway not be able to transmit the signal. This is a point we have been making all through last year (please refer “Can aggressive monetary easing create a funding problem in India?” dated 29th May 2013).
What Has Taper Done?
The possible implications of Fed tapering are already well documented by various commentators. However, we will recap briefly for sake of continuity of view. The period between 2009 and 2012 saw a surfeit of global liquidity courtesy aggressive balance sheet expansion by some of the largest central banks of the world. A significant portion of these flows came to EMs including India. For whatever reasons, many of these countries chose not to follow counter-cyclical policies to adjust for these flows. Thus in India both fiscal and monetary policy remained loose for very long which combined with policy issues created substantial structural imbalances over a period of time. These showed up as a persistent inflation problem along with steadily rising current account deficit even as growth began slowing. The important point is that as long as global investors were convinced that easy money was here to stay for the indefinite future (and this was precisely the case till early 2013), they were willing to overlook our deficiencies. The risk-free rate (proxy US treasury yield) to beat was low and money went everywhere chasing returns. However, with Fed taper in the air, global markets are finally having to come to terms with a scenario where sometime in the foreseeable new additions to global liquidity may come to a halt. This has forced investors to become much more discernable and all of a sudden countries with macro-economic deficiencies are no longer appearing to be as safe as before. This is what is happening since last year. Thus while there has been generalized EM aversion, specific countries have cropped up from time to time as being particularly distasteful. India’s turn came around mid of last year but our policy makers, much to their credit, have acted swiftly to drastically compress our current account deficit as well as ensure policy-induced capital flows. Thus in the current phase of EM aversion, the INR as remained remarkably stable.
What Does This Mean for RBI?
As mentioned above, the underlying current theme seems to be to punish EMs with macro-economic fragilities. The reprieve bought for us by policy makers via FCNR flows and compressing current account may be temporary. While there may be other cards on the table to get capital flows (global bond index inclusion being one), it is unlikely that they would be as significant as the USD 34 billion drive last year. On the current account, while the situation may remain manageable going forward, the extent of deficit is unlikely to be as low should gold curbs get relaxed or some economic growth leads to pick up in non-gold imports. It is clear then that if India needs to grow sustainably in the Brave New World where expectations are of diminishing incremental liquidity, we need to first put our macro-economic house in order or ‘bullet proof our balance-sheet’ as governor Rajan says. Apart from the twin deficits (current account and fiscal), the third integral part of our macro-economic report card is inflation. Thus the RBI’s current resolve comes timely and well in context of emerging global developments. Inflation of the order witnessed over the past two years (averaging 9.9%) may no longer be acceptable to global investors and hence may no longer suffice for macro stability. And without enduring macro stability there is no question of pursuing a sustainable growth agenda.
In our view, the dissenting voices lamenting the harsh monetary medicine in the face of weak growth are under-appreciating the new global paradigm. Assume for a moment that RBI cuts rate in the current environment and it gets transmitted as lower lending rate and adds to growth. This would quickly start pressing on inflation, current account and banks’ credit to deposit ratio. These will force adjustments in form of weaker currency and tighter rates (even if RBI doesn’t hike, market rates would adjust) which will quickly stall the recovery. Given this, we believe the RBI is right in first focusing on creating the conditions for growth before pushing actual growth. An important ingredient to this is obviously complementary government policy. A tighter fiscal situation involving better quality expenditure and policy focus to reform supply side can make the RBI’s job easier and more effective. However, till such complementary action becomes sustained, by definition the RBI will have to do most of the heavy-lifting. An additional uncertainty in this regard is that we are going into elections and the mandate on the other side is not so clear as of date.
How Should This Inform Our Market View?
If indeed average inflation falls from 9.9% to 8 – 8.5% this year as the RBI assesses and (barring new food shocks) we are inclined to believe, it would have ordinarily constituted as a very bullish trigger for rates and invited calls for cutting rates. However, if the new world order continues it may only count as a hygiene factor achieved. On the other hand, if new pressures were to emerge on inflation the RBI will have to act more proactively than before since the same world order will have that much lesser patience with our country. The implication for monetary policy in our view can best be summarized as ‘tighter for longer’. Most likely rates will be on hold at current levels for an extended period of time. At the same time, if new pressures threaten the inflation trajectory the RBI may show lesser patience than before irrespective of near term growth pressures. A large factor at play here will likely be how government policies evolve post elections. If they prove to be complementary, that may allow RBI to shift the burden somewhat. Alternatively, if the world order itself changes (US growth dips again and Fed changes track) that may make the central bank more tolerant.
From a portfolio strategy perspective, as we have highlighted many times before, seasonal triggers on rates have mattered more for bond fund performance over the past few years rather than one-directional movement on rates. As long as such seasonal triggers are captured effectively, it may not matter whether underlying RBI policy rates are static or marginally higher. More specifically in the current context, we have used the bond rally over the first half of January to cut duration in our bond and gilt funds. While lack of near term bond supply may keep yields in a range for now, the outlook may appear less favorable once new supply starts from April. Thus unless new triggers emerge (for instance if inflation falls more than expected in near term), we are likely to rotate into front end assets over the next months. This part of the curve is likely to do better from April on seasonal triggers of falling credit to deposit ratio and possibly better relative liquidity. Longer end rates may give clearer cues once market starts absorbing the new supply calendar and we get a better grip on how complementary government policies will be on the other side of the elections. By that time it will also get clearer whether this is indeed a Brave New World of shrinking incremental global liquidity or we relapse into potentially endless balance sheet expansion by global central banks.
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