By: Punam Sharma
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.
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.
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