-->
Back to insights

Investment Insights

Suyash Choudhary

To recap, RBI’s monetary policy is around a CPI plus real rate framework. Therefore, in order to predict the future direction of rates one has to assess factors that influence each of these two variables (CPI and real rate) as well as the interplay between these variables. In this context, and as explained in detail in a previous note (please refer “3 Themes Bond Investors Should Watch For In The Year Ahead”, dated 16th March), one has to closely track two sets of triggers: One, the government’s response to food prices and most importantly institutional food price reforms. Two, global developments that may influence RBI’s delivery of its earlier stated real rate ‘target’ (1.5% – 2% over CPI). In this note we examine some recent developments in light of these two sets of triggers:

 

1. Food: On the ground developments provide no reason for cheer. Barely recovering from last year’s sub-par monsoons, the farm sector was hit by unseasonal rains over the past couple of months that led to substantial damage to standing crop. Furthermore, India Meteorological Department’s (IMD) first forecast for summer rains ahead provides no cause for cheer as well. Thus the IMD has pegged only a 28% probability of a normal monsoon, and said that rains are likely to be below normal at 93% of long term average. Also, owing to a combination of events, the government is finding itself increasingly under pressure to fight an ‘anti-farmer’ tag which raises the risk (please note our assessment here is purely from a market’s perspective) of an administrative response that slows the food price disinflation that has been achieved over the past one and a half years. On the flip side, despite unseasonal rains food prices haven’t gone up over March and so far in April thus imparting a welcome further downward bias to CPI. In this, the trend from last year is getting carried forward where despite worsening rains food inflation still slowed versus the year before. This seeming break of actual prices from the state of rains so far seems attributable to the government’s proactive management of cereal supply as well as the strong steps taken against hording of vegetables. Going forward one has to track whether this management continues to shield food prices from adverse rains. Furthermore, one has to see both the government’s durable response to the current agrarian crisis as well as any proactive steps taken to reform the food supply chain and hence put a lasting lid on price volatility. On the former, if the response comes via the fiscal then that is easily digestible by our rates framework since some extra spending on this account can be absorbed later via cutting back on something else so that deficit targets remain intact. If, on the other hand, the response entails a significant reset in minimum support prices (although subdued global food prices argue against this) then one may have to reassess the sustainability of a lower CPI trajectory. In terms of steps to reform the food supply chain one chiefly will have to look towards implementation of the report on Food Corporate of India (FCI) restructuring as well as dismantling the Agriculture Produce Marketing Committees (APMCs). If there is progress on either one of these counts, it should provide strong confidence to RBI on its inflation targets. While on the point of RBI, medium term fixed income investors shouldn’t worry excessively if sub-par monsoons lend some temporary upward bias to food prices. What will matter more to RBI’s reaction function is government’s response on the parameters we have evaluated above.

 

2. Global: It must be noted that under the earlier multiple indicators monetary policy regime, the repo rate would already have been significantly lower that where it is now. While bonds would have received immediate gratification as a result, the system would have been prone to much more negative volatility. As opposed to that, the RBI is in essence following a risk management framework currently. By definition then the results of the framework are best appreciated when risk is the primary variable in play. However, as things stand today, the perception on India has moved from being ‘risk oriented’ to being ‘return oriented’. In a phase like this, the costs associated with such a framework start piling up. Our real positive rates are now comparable with most similar peers. Also, it can be argued, that we are setting this positive rate over a nominal anchor (CPI) which is more untradeable and hence more unaffected by global deflationary pressures than for most other peers. Therefore, our nominal policy rates are actually higher than other countries with similar macro-dynamics. It is not for nothing that fixed income flows into the country have shot through the roof over the last year. The rupee is the most apparent channel whereby the costs of our risk management framework are becoming visible. As we have noted before, the rupee has appreciated against virtually every other major currency in the year so far. In the absence of accompanying productivity improvements, this renders our exports incrementally uncompetitive. If major trading peers ease their monetary policy further and we don’t, then on the margin this pressure via the currency channel becomes even more accentuated. If such a scenario continues then it may eventually allow the RBI to settle for a lower real rate target, since this will suffice to achieve the mandate of financial stability (which is after all the end objective of the real rate setting exercise). Recent developments on this parameter have been encouraging from a fixed income perspective. Export weakness has picked up over the past few months even accounting for the value impact from falling oil prices. The month of March has seen a jaw-dropping 21% fall in total exports and media reports quoting the Federation of Indian Export Organizations (FIEO) suggest that April continues the worrying trend. On the import side industries are complaining about dumping by other countries, a phenomenon definitely being aided by relative rupee strength. Furthermore, monetary easing remains a strong theme as evidenced by the aggressive 100 bps reserve ratio cut by China recently. Most forecasters expect more easing through the year. If the RBI stands still in the face of ‘competitive easing’, the pressures described here will get fiercer still.

 

Conclusion:

 

Last year was mostly about India exiting the ‘Fragile Five’ and hence having a top down view was enough. After a 125 bps of rally in bonds and most investors having India as a top emerging market pick, this is no longer enough. The analysis has to become more bottoms up and more ‘if-then-else’. Which is why it is important to hold an underlying framework and keep updating it for incremental developments. This has been our approach and communication since the start of the year and the current note updates our framework for recent developments. In our view there is still reason to be optimistic for medium term bond investors. The next few months will provide more confirmation on government’s food policy. If this aids RBI’s endeavor to take CPI to 4% by 2018, then it is quite obvious that rates still have to be much lower. On the other hand, if food management goes the other way then on its own this is likely to be a speed-breaker. However, the global backdrop provides another dimension to India’s fixed income story. While potential for disruption from the Fed can never be ruled out, to us an equal if not larger story is the possibility of more aggressive easing from our peer nations, if growth and inflation impulses don’t stop deteriorating soon. What is clear to us is that the decision for investors cannot depend upon one trigger like the state of summer monsoons. Instead one has to look at the whole framework and then assess whether the net impulse seems positive for rates or not. To us it still does and we would recommend that investors continue to participate in bonds.

 

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.

Tag:

Suyash Choudhary

The RBI kept all rates on hold in its bi-monthly monetary policy review today. This was largely expected by most in the market. The macro-economic forecasts of the central bank are as follows:

1. GDP under new series projected at 7.8% for FY 16 (from 7.5% in FY 15), but with downward bias.

2. CPI is expected to be around current levels in Q1 FY 16, ease to around 4% by August, and then rise to 5.8% by year end. This is still below the 6% target under the new targets. For the future, CPI needs to fall to 4% +/-2% by end of FY18. The RBI aims to keep inflation ‘at or close to’ the mid-point of 4% and takes comfort from the extended period of time available to achieve this target.

Some noteworthy developmental and regulatory policy announcements are as follow:

1. Cross-holding of banks in infrastructure bonds has been permitted but with some conditions.

2. RBI has ‘encouraged’ banks to move in a time bound manner to marginal-cost-of-fund basis for determining base rate. This will ensure better transmission of policy rate changes to base rate changes.

3. Creation of alternate channels of distribution for government bonds will be explored by the RBI in order to improve access to retail investors / individuals.

Analysis

The RBI notes that recovery both globally and locally remains uneven. On the former improving outlook in US and Europe is getting offset by weakening in Japan and continued slowdown in China. Domestically, the outlook for agriculture and services remains mixed. The RBI sees some pick up in manufacturing but again awaits more sustained pick up in capital goods and also notes ‘persistent contraction’ in consumer durables production. On inflation, protein inflation within primary articles is still a concern. For the rest there is clear intent that seasonal, base-related, and transitory factors will be largely looked through. Most assessment with respect to core inflation seems dovish with the central bank noting the contribution of weak demand conditions as well as fall in rural wages, apart from the contribution from fall in oil prices.

For the future, upside risks to inflation arising from rains, closing of output gap, geo-political risks, and external spillovers are largely getting offset by downsides from global deflation tendencies and still soft outlook for commodity prices and domestic slack. Interestingly, some of these factors seem to be appearing both as upside and downside risks. While geopolitical events and external risks indeed have this feature, the simultaneous assessment of risk from faster closing of output gap while still drawing comfort from slack in domestic economy seems a little curious.

On policy stance, while the RBI explicitly assures that accommodative stance will be maintained, future rate actions will depend upon a host of variables. These include transmission of previous rate cuts by banks, development in food prices from unseasonal rains and assessment of monsoon ahead, proactive efforts from government on supply response towards key inputs, rerouting subsidy into investment spending, reducing pipeline of stalled investments, as well as signs of normalization of US monetary policy.

Implications and Takeaways

As has been the case for some time now, the RBI policy provides little fresh information to market participants. The underlying framework is a “CPI plus real rate” method for assessing terminal repo rate and hence scope for easing. The CPI trajectory expected by the RBI yields an average CPI of 5 – 5.25% for the financial year. Taking the Governor’s guidance of 1.5% – 2% real rate target, this indicates reasonable visibility of repo rate falling to 50 bps in the year ahead. This has been our assessment till now and remains unchanged with the policy. With regard to the future target of 4%, it really depends more on whether the government unveils food price reforms that bring long term food inflation sustainably lower even accounting for interim vagaries of nature and pick-up in rural wages (see “3 Themes Bond Investors Should Watch For In The Year Ahead”, dated 16th March for details). If these are absent then the RBI may want to keep real rates higher now. However, this course of action has two drawbacks: One, monetary policy will become pro-cyclical keeping real rates higher in the initial part of the cycle. Two, the costs of this policy will surface elsewhere most particularly in relative currency strength and hence aggravated global competitive pressures for India’s production. Indeed the RBI’s list of factors that may trigger future cuts reads like a rather large laundry list and could be so precisely owing to the trade-offs we have highlighted here. But what is noteworthy again is that this list also doesn’t provide any new information on when the next rate cut may happen. Banks are likely to start transmitting before the June policy. The government continues to move ahead with ensuring supply, sometimes even at some political cost (as seems to be the case with the land bill). The Governor has said that he will look through transitory factors. So presumably the unseasonal rains matter little so long as there is no durable effect on inflation. And finally US Fed normalization seems some distance away still; especially after the recent spate of weak data. So the RBI can cut again in June or wait; this list makes us none the wiser.

Finally, the market had hoped for some clarification on RBI’s liquidity stance especially as the Urjit Patel Committee itself suggests that liquidity stance should be congruent with the monetary policy stance. Even though there is no direct reference in the policy, it is likely that indeed RBI’s liquidity stance has already changed since January. Its forex interventions have been largely left unsterilized starting that month; with the result that the so called ‘core liquidity’ (total liquidity minus government cash balance) is now in positive zone. Thus as government spending picks up, it is likely that liquidity improves substantially over the next couple of months. This should support demand for bonds from banks especially as, apart from cyclical factors, credit demand is anyway weak for the first six month of the financial year.

All in all, and as stated above, the policy per se provides little additional information. Instead investors should continue to be guided by the underlying CPI plus real rate framework and plug incremental macro-economic developments to the framework. As things stand currently and as explained above, we have visibility of further easing. This allows us to await incremental structural food reforms from the government while still holding positions. Should such reforms materialize then scope of gains from bonds can turn out to be larger than currently envisaged. Also if global deflationary forces and consequent monetary easing elsewhere overwhelm us, again scope of gains can be higher. If not, then cost of getting out of this market should not be unduly high given that we have a risk manager at the helm of monetary policy.

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.

Tag: