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Investment Insights

Suyash Choudhary

1. Food Price Reforms: The RBI is now formally a CPI targeting central bank. Its targets need CPI to be below 6% by next year and head to 4% by the end of 2 years after that. Effectively this implies that we are now in a regime that needs 4 – 5% CPI in the years ahead. Indeed, this framework is one of the anchors to our newly purchased macro-economic stability. The government needs to be credited as well for having signed on for a formal inflation targeting approach with fairly ambitious targets for CPI inflation. However, the targets presuppose a close working co-ordination between the government and the RBI. As is well known and often argued, a large part of CPI basket has closer correlation with government policies than with interest rates. The real utility of RBI’s interest rate setting, in our view, is in terms of offering a real positive rate to savers over CPI. However, CPI itself may be very slow to move to policy rate changes. As a case in point, government’s decision over the last 4 crop cycles to drastically bring down minimum support prices (MSP) has had a meaningful impact on food inflation. As another example, their pro-active cereal management policy last year ensured that food inflation remained relatively well anchored despite substantial deviations in monsoon. It must also be remembered that the current benign inflation is being aided by rural wage growth having fallen sharply to early single digits. Clearly, this is not sustainable from a welfare effect perspective. Furthermore, a sharp fall in oil prices is also contributing to the de-acceleration in inflation momentum. It is obvious that a long term assessment of inflation cannot assume oil prices at their current levels.

It is clear from the above that in order to transition to a 4 – 5% sustainable CPI regime the government needs to follow up with food reforms, and sooner rather than later since the RBI’s ask on CPI gets progressively tighter from here on. It is ridiculous to expect that savers, investors, and industrialists will look to the skies every year beginning to assess outlook for rains and hence interest rates; before making their commercial decisions. Restructuring the Food Corporate of India (FCI), measures to enhance farm productivity, dismantling Agriculture Produce Market Committee (APMC) have all been talked about and we understand that some of these may be politically difficult to implement. Nevertheless, the government needs to start food price reforms now with an aim to bring down food inflation structurally over the next years even as rural wages and oil prices begin rising again. This is may be the most important thing long term fixed income investors should be looking for.

2. RBI’s Real Rate Delivery: Governor Rajan has guided that RBI wants to keep real rate at 1.5 – 2% in the initial part of the cycle. It has been argued by some that he may be tempted to keep it higher than this given his more ambitious inflation target in the years ahead. However this runs the risk of making policy pro-cyclical rather than counter-cyclical. Definitely if the government were to follow through with food price reforms, it would give the RBI greater confidence in pursuing a lower real rate target. However, another important variable that may pressure the central bank’s real rate objective is global monetary policy. Till very recently most discussion on international policy used to centre only around the Fed and how their rate hikes may potential cause capital outflows. However recent RBI commentary is also starting to acknowledge the impact on the rupee, and hence on India’s export competitiveness, from the global competitive devaluation underway currently. Indeed one of the reasons mentioned by the central bank for ‘front-loading’ the last inter-meeting cut in March was ‘the global trend towards easing’. The rupee has appreciated this year against all major world currencies. In absence of corresponding improvements in our productivity this renders us incrementally more uncompetitive in world trade. Also a relatively appreciating currency is incrementally deflationary although the impact will be largely visible on WPI which has a much larger tradable commodity basket. Nevertheless, and barring a global risk-off, the RBI is increasingly likely to feel the impact of the so-called impossible trinity (independent monetary policy, flexible exchange rate, and relatively open capital account). This will be especially the case if emerging market peers continue to ease policy rates. Thus RBI’s delivery on real rate guidance is another important variable in order to assess the eventual quantum of rate cuts and hence impact on bonds.

3. Banks’ SLR Holdings: If this were the start of a normal economic cycle it should be accompanied with significant expansion in banks’ credit portfolios and a corresponding reduction in their SLR investments. However, we see very little evidence of anything of this sort happening. Banks are still working through their asset quality issues, even as provisioning guidelines are becoming more stringent. Besides, there is a tall ask of new capital required in the next few years. The government, via the Union Budget, seems to be indicating that it understands that banks will not be in a position to significantly push its infrastructure drive. Therefore, it has tried to make some space from its own finances for infrastructure spending. It is also relying on private sector and foreign participation including through SPV structures which allow for leverage over initial capital that the government contributes. Furthermore, it has kept the budget allocation for PSU bank capitalization at very modest levels choosing instead to help banks become better managed and help with their capital raising from the market. Largely for these reasons, the Union Budget did not look all that ‘inflationary’ to us since the ‘ investment multiplier’ that the government is hoping to create will mostly offset the lack of any meaningful rise in the ‘credit multiplier’ coming out of the banking system. Also if our assessment is correct, it is unlikely that banks’ will reduce their SLR investments at least in the foreseeable future ahead; never mind the continued reduction in the statutory floor by the RBI. This is especially so as deposit accretion is likely to remain healthy as measures to improve financial savings gradually bear fruit. Given that banks remain the biggest players in the government bond market, this is the third major evolving variable that bond investors should be mindful of in the year ahead.

All told, and we have made this point multiple times before, it continues to make sense for bond investors to not become overly deterministic about levels and instead track incremental developments. We have analyzed here the key developments that we will be watching out for. If they go favorably, it is possible that potential gains ahead from holding bonds may turn out to be bigger than what we currently envisage. If not, exit costs from this market are unlikely to be extra-ordinarily high given that the RBI continues to conduct monetary policy as a risk manager and for financial stability.

Disclaimer:

MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.

The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency and should not be treated as endorsement of the views or as an investment advice. The information/recommendation provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. This update has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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Suyash Choudhary

RBI cuts repo again

By: Punam Sharma

The RBI surprised the market yet again by cutting repo by 25 bps to 7.5%, ahead of the official policy review in April. Again, while the cut itself is not a surprise the timing is; especially as the RBI Governor had seemed to indicate in the February policy that they would like to stick to official dates as far as possible. Nevertheless, we think the cut does the central bank credit as it reinforces to the market that the RBI will act preemptively as and when it sees space to act. Also, it potentially amplifies the signaling effect of the cut for banks.

Key points on RBI’s assessment accompanying the cut are as follows:

1. The new CPI series has reaffirmed the fact that disinflation is progressing faster than earlier envisaged. This is especially evident in the broad-based fall in core CPI. The RBI does, however, flag uncertainties to CPI outlook chiefly through possible strengthening of oil prices, seasonal upturn in food prices, and international volatility impacting exchange rates and asset prices.

2. A big input into inflation impulse is the assessment on strength of aggregate demand relative to available capacity. In this regard the RBI doesn’t pay much mind to the recent revisions to GDP, barring the observation that the directional recovery seems consistent. The recent budget has much more significance in this context. The RBI has obvious worries about the compromise to the fiscal deficit targets. However it notes the better quality of numbers, the extra devolution to states, the shift from subsidies to infrastructure spending, and the joint commitment on inflation targets as compensatory factors. This analysis is very consistent with our view post the budget (please refer to our post budget note for details).

3. The strength of the rupee as imparting disinflationary pressures has been formally recognized by RBI policy. In fact in another indicator that the RBI is now worried about the rupee, global trend towards monetary easing has been mentioned as one of the factors triggering an inter meeting cut. We had flagged this point in a recent note and are happy to see a recognition of it in RBI policy (please see “Interpreting Recent Data and Way Ahead: An India Macro Update” dated 13th February for details).

Takeaways and Market Implications

The RBI’s current monetary policy framework revolves around their CPI forecast and the real rate target that needs to be set over CPI. As we have analyzed before, we think CPI is likely to average towards 5% in the year ahead. Given the RBI Governor’s real rate target indication of 1.5 – 2% in the initial part of the cycle, we have visibility of repo heading towards 7% in the 12 months ahead. A point that had been nagging us recently was this: if RBI is to move towards a 4% target by FY17 then does it mean that it will implicitly settle for a higher real rate target this year; even though CPI averages 5%? This question has been somewhat answered today with the RBI indicating that it will seek to bring inflation to 4% by the end of 2 years starting FY 17. This demonstrates a reasonable patience to let the system dis-inflate slowly; provided of course global and local developments support the disinflation. In this regard, we will closely look for the government implementing some of the statements of intents covered in the medium term fiscal strategy statement: most chiefly the part about reforming the procurement, storage and distribution system for food.

Investors should continue to be engaged in duration. As explained before, there is reasonable visibility of another 50 bps rate cuts in the year ahead. The flip side of this argument that we have heard recently is this: if new 10 year is priced already at 7.50 – 55% then the room available for further fall in yields is limited. In that case why bother running duration? Our counter to this is as follows: one should treat the market currently as a kind of ‘option’. There are various initiatives in the pipeline which, if executed, can lead to a sustainably low inflation regime in India. The food policy of the government is one such that we have highlighted above. Another involves measures to improve financial savings that will further narrow the funds disequilibrium in the system and strengthen the case for structurally lower rates. Most simply put if government and RBI indeed succeed in anchoring CPI to 4% over the next 2 years, then 7.5% nominal 10 year sovereign yield will look almost ridiculously attractive. Thus, and as we have argued before, its best to not be overly deterministic about levels just yet. Rather one should hold one’s underlying framework and continue populating it for incremental developments. Given the institutional focus on inflation and macro-stability, when the time comes it is unlikely that the price of exiting bonds will be unduly high.

Disclaimer:
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency and for informational purpose only. This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the stocks may or may not continue to form part of the scheme’s portfolio in future. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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