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7th Pay comission- Large government capital getting polarised to 10 mn people (0.83% of the population)

 

The 7th Pay commission recommends a 24% hike in salary levels of central government employees which implies an incremental delta in salaries of approximately Rs 1022 bn (0.65% of the GDP).

 

At the onset the above recommendations will have a positive impact on consumer demand and spending. However, the quantum of stimulation provided will depend on the acceptance of recommendations and implementation of the same by the government who will take cognizance of fiscal and inflationary impact of this recommendation. The government may decide to 1) dilute the quantum of hike or 2) to stagger the implementation of the 7th pay commission recommendations to reduce the fiscal impact of the same. Public sector entities and State government also follow the central government Pay scale revision with a lag which will provide impetus and support to the consumer trend incrementally. However the implementation by states is discretionary and quite staggered too.

 

The reality is that India flows today are predicated on the “India macro story” of fiscal consolidation and benign inflation pending corporate sector’s earnings recovery and the government of India is capital constrainted. Thus the 7th CPC If implemented in its entirety would have the following impact-

 

1) Dilute the macro construct of fiscal consolidation and inflationary expectations

2) Divert Capital expenditure towards Revenue expenditure

3) Stimulate consumption demand thereby improving corporate sector’s (consumer companies) revenue growth, profitability and ROE.

 

The government will try to achieve a balance , however in the interim we continue to focus on studying the evolving shifts in government spending patterns and aligning portfolios accordingly.

 

Central Pay Commission – Demand impact and portfolio positioning

 

The CPC touches around 10 mn people (0.83% of the Indian Population) mostly residing in metros, Tier –I and Tier –II cities who have a more discretionary consumption basket.

 

6th CPC implementation had seen robust volume growth across consumer categories. The spending was broad-based across consumer staples, consumer discretionary, autos, valuables and physical assets.

 

7th CPC if implemented should see the following Demand trends

 

A) Premiumization across categories

 

B) Consumer discretionary spends

– Auto
– Housing
– Media and Entertainment
– Leisure Travel
– Healthcare
– Consumer durables

 

C) Retail Banking and Financial services

 

Our Portfolios are favourably positioned to capture the above evolving trend in consumption with exposure to media, 4 wheelers, consumer durables, consumer discretionary and private sector financials.

 

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 about the investment strategy / theme of the Scheme and 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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Suyash Choudhary

The 7th Pay Commission submitted its report yesterday. It recommends a 23.6% average hike in salary and pensions, entailing an additional 0.5% fiscal impact for the Union Budget in FY 17. This is higher than market expectation of around 15% hike. The hike proposed is still conservative with respect to the previous commission which was implemented in 2009 and for which arrears pertaining to period of 2006 – 09 were also paid, distributed over 2 financial years. Basis what gets finally accepted by the central government, states and then PSU enterprises may implement their own salary hikes.

 

The report has led to some concerns on the macro impact with respect to the deterioration in fiscal deficit and inflation. The latter will potentially feed in directly through the house rent hike and indirectly via stronger consumption.

 

It is true that the overall fixed income view has been largely predicated on the stance of public policy. Thus, the government’s role in setting lower MSPs, rationalizing fiscal deficit, and rerouting spending into investment at the cost of consumption even in a difficult demand environment; have all contributed to CPI breaking by half. Obviously, the benign cycle in global commodities has played a large role as well. Finally, RBI’s inflation targeting framework has ensured a positive real rate environment thereby helping in rebalancing the savings – investment imbalance. Hence, it is very important for the macro view that public policy continues in the overall direction it has so far. Having said that, the following points need to be kept in mind with respect to public policy direction in light of the new pay commission:
 
1. Fiscal Stance: The government had taken a relaxation in its journey to 3% deficit target in order to ramp up spending on infrastructure. This they have been doing, even re-routing revenues from oil-related savings into infrastructure spending. The results are already visible in certain areas, most notably in roads. In fact their stance with respect to the farm sector has also been in favor of asset creation and better subsidy targeting, rather than ad-hoc price distortions (via MSP) and enhancing revenue spending. It may be added that they have done this at potentially significant political cost to themselves. Indeed after the pay commission report,  a senior government official has assured that the next year’s fiscal targets will be honored as well and that the intent remains to focus on an investment led recovery rather than a consumption led one.  Hence, accommodating the full pay commission recommendation in FY 17 seems inconsistent on two counts: One, this is against the fiscal stance of the government both in terms of future deficit targets as well as from perspective of the rebalancing of spending from consumption to investment. Indeed there was evidence in the last RBI policy review that Governor Rajan is now on board both with respect to government’s fiscal stance as well as their proficiency in food management. Two, it seems strange both from a political and welfare standpoint that a fiscally constrained government would spend 0.5% of GDP on hiking salaries of 1 crore urban and semi-urban population when it can easily be argued that many crores of farmers are in more urgent need for a wage hike. This is not to say that the commission’s report would be ignored, but rather that the call on resources embedded in accepting the whole recommendation in year one itself may be entirely unjustified.
 
2. Past Experience: It can be said that accepting the report is almost mandatory, and it has been done historically as well. We don’t think this is necessarily true. The last pay commission was implemented in 2009 when the government’s fiscal stance was anyway expansionary. The 6th commission’s recommendations hence were entirely consistent with the government’s fiscal stance then. As has been discussed above, this is not true in the present case. Given that this exercise repeats every 10 years, the next experience to draw from then is 1996 – 98. That is simply too back in the past  and cannot provide a reliable guide. An obvious difference is that India is now very reliant on foreign capital flows for funding its growth. And such capital flow comes on the back of perceived macro stability which in turn is a function of some standard matrices including fiscal deficit and inflation. This is even truer in the current global context where global capital has turned much more selective when choosing its destination. In such a scenario the government can’t risk destabilizing our macro story and risk the global capital that is quite needed to fund our ambitious growth program ahead.

 

Conclusion

 

While a full implementation of the 7th Pay Commission at the risk of compromising the next year’s fiscal deficit target is a clear risk, we think it is simply too premature to draw that conclusion; for the reasons explained above. Investors are likely to get much more color on this in the months to come. For one, we will get the final recommendations of the Jalan panel on expenditure management (due likely at end November and then in January). This may suggest ways for the government to create some fiscal space. Also, and as we have highlighted before, investors must remember that this now very much a global story where the backdrop is one of very challenging growth prospects. This is feeding into India as well through the trade and leverage channels. For these reasons as well, the bar needs to be very high for investors to abandon the asset allocation trade to 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 about the investment strategy / theme of the Scheme and 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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Suyash Choudhary

At the time of writing, bond markets have given up the entire gains posted after the surprise 50 bps rate cut by the RBI at end September. This has happened courtesy a confluence of catalysts.

 

  1. 1. Market Construct: Even though the RBI has cut rates by 125 bps over the year, the path has always been uncertain over the shorter term given the underlying construct of having an inflation target. To some extent, RBI’s own forward guidance has been varying thereby disallowing a firmer forward view. Another reason for the muddle has been global volatility which has kept traders on tenterhooks. Whatever the cause, it is a fact that profits have been hard to come by and hence the mandate to ‘participate’ has been weaker than that to ‘preserve’. This has made the market somewhat ‘asymmetric’, in the sense that positive price action has tended to get sold into more actively and thereby gets muted quickly. Whereas negative price action gets somewhat amplified since market’s ability to stand in the face of selling interest is more limited. An added dynamic has been the pressure to book profits from banks given little other sources of income and the pressure of provisioning for bad assets.

 

  1. 2. Pick up in international volatility: The US Fed surprised most in its last policy by sounding much more deterministic  about the prospects of a December rate hike than it did before. Thus it underplayed the influence from global events even as it sounded more sanguine over local prospects. This led markets to assign an even probability of a December rate hike in sharp contrast to before, when even prospects of further easing where beginning to get discussed. In this scenario, we got a spectacular jobs report from the US which has led market to virtual certainty for a December Fed rate hike. This has put renewed pressure on bond yields globally and on emerging market currencies. A perceived ‘market unfriendly’  election result from Bihar has somewhat added to our own near term concerns.

 

While the above helps explain somewhat price action recently, it obviously does nothing to address some investors’ frustration that 10 year yield has fallen by less than 20 bps in a year where RBI has cut rates by 125 bps. This is then probably a bigger transmission problem than the issue of banks cutting base rates! Of course, overall, rates have indeed rallied 125 bps from 9% last year. However, most of this should anyway be expected given the dramatic change in India’s macro-economic dynamics; most visible in our current account deficit compression and halving of CPI inflation.

 

Investors may well ask, hence, what is the point of continued allocation to bonds. We think the reasons are as follows:

 

  1. 1. This is not an India story alone: If this were indeed only about local growth versus inflation tradeoff then one could justifiably have argued that if CPI is at 5% and repo at 6.75%, shouldn’t one be cutting risk? However, the fact is that India is very well connected to a global economy that is rapidly slowing. We had discussed the impact via trade linkages in greater detail in a recent note (please refer “Three Sides To Every Story: Falling Commodities”, dated 3rd November for details). Given that the global adjustment is likely to continue for the foreseeable future, it is quite likely that RBI will continue with a dovish interpretation of our growth – inflation tradeoff. Indeed it is concerns on global growth that triggered the larger than expected 50 bps rate cut in the last policy. For this reason, it is inadvisable to call either the final ‘terminal’ repo rate or any sort of end point in yields. Indeed, closed ended frameworks of this sort would never have been able to envisage the 125 bps rate cut that the RBI has already delivered.

 

  1. 2. Our external vulnerability has declined dramatically: The other reason that RBI could cut an outsize 50 bps and rupee still strengthened that day, is that we no longer run an external financing risk. The best way to assess this is in terms of our CAD plus net FDI. This number denotes to what extent we can finance our recurring external deficit via the stable element of capital flows, which is net foreign direct investments. This number has swung from negative almost USD 70 billion in 2013, to mildly positive today. This in effect means that we have completely eliminated our reliance on the volatile debt and equity global capital flow for the purpose of funding our CAD. Had this not been the case, the RBI would have had to worry about the currency and external risks in the face of a global risk-off; even if the risk-off were emanating from a growth risk. As things stand, however, the RBI has cut rates into a global growth scare and will likely be able to do that again should such a scare accentuate.

 

  1. 3. The minimal cost of waiting: The frustration with investors today is not so much that there is a price risk in bonds, but rather that bonds are not performing as per expectations. This would have mattered much more had there been an opportunity cost to the trade. For instance, as an average over the past 5 years, 1 year bank CDs have yielded almost 100 bps over the 10 year government bond. This spread used to spike to 200 – 250 bps towards financial year close. This was because we were in an essential bear market for interest rates where, it can be argued, the repo rate wasn’t necessarily reflective of the demand versus supply of funds. So while bank CD rates used to fluctuate in line with the actual ‘funding gap’ in the banking system, the long end was anchored owing to a lower repo rate and the fact that there are statutory buyers for long term sovereign assets (banks for SLR, PFs, insurance). Because of this phenomenon,  the opportunity loss of ‘waiting’ in duration assets was quite significant. In contrast today, this differential between CD rates (or more generally the front end of the corporate bond curve) and medium to long end sovereign bonds has almost completely vanished. This is because we are now in a secular bullish market where the funding gap in the banking system has on an incremental basis all been closed. Hence, the opportunity cost of ‘waiting’ in duration bonds is almost nothing (as an added example the portfolio yield of a AAA oriented short term fund and that of a government bond fund is virtually the same today) provided there isn’t an undue element of price risk in duration. Given that currently 10 year government bonds offer a 2.75% over average CPI, it is very unlikely that there is a large element of price risk in these bonds.

 

Conclusion

 

Traders have clearly had a hard time in the market this year as, despite 125 bps rate cut from the RBI, movement in bonds has been negligible. Worse, there have been enough times where price action has wrong-footed participants. It is understandable if some of this frustration has seeped into asset allocators as well. The point we have tried to make above is that this frustration should not trigger an action bias  from investors given that we are quite inextricably tied to a deteriorating global growth prospect. An additional important point is that there is very little cost, in terms of lost ‘carry’ income, in waiting and finding out what the growth – inflation dynamic may look like in the time ahead. Given that this dynamic continues to evolve, we believe there is little merit in holding closed ended views on terminal rates or on the quantum of gains left on the table.

 

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 about the investment strategy / theme of the Scheme and 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.

 

Tag:

Suyash Choudhary

India has seen a lot of benefit from falling commodity prices, we being a net importer of commodities. Falling oil has been a dominant contributor to the massive drop in our current account deficit. Lower global prices, including those of food, have also helped the government and RBI in bringing down inflation. These two phenomena have helped India visibly plug its external financing risks (CAD plus net FDI is now a positive number) as well as move to a positive real rate regime , both of which have been extremely beneficial to the performance of our financial assets; especially bonds and currency. In a time when global capital has increasingly turned much more volatile, this change to India’s macro dynamic is very well timed and has helped us escape the bulk of the emerging market (EM) stress that has been in play for the past two years. To be sure, the government and the RBI haven’t been silent spectators in the game. The government, via judicious administered price settings and proactive food management alongside prudent fiscal policy, has contributed to the structural lowering of our average inflation levels. It has also re-routed the savings on oil subsidy to capital spending, thereby lending a much needed hand to stabilizing growth. On its part, the RBI has ensured that the real rate incentive to savers remains around 2% positive, thereby helping narrow the negative funding gap for the system that was so starkly obvious in 2013. This real rate incentive, alongside new government measures to further convert physical savings into financial, will continue to work in the time ahead, thereby further cutting our reliance on global volatile capital. Finally, falling commodities have had a salutary effect on many companies’ margins.

 

The benefits as summarized above are immense and certainly merit a lot of attention. However, there is another side to the falling commodities as well which often gets overlooked. A few of the linkages relating to this other side are discussed below:

 

  1. 1. Falling world trade growth: The fall in commodity prices and the fall in world trade are inextricably tied. Both are in a sense symptoms of falling world demand but they also serve to reinforce one another. Thus falling trade reinforces weaker growth which in turn leads commodity prices lower which then further impact the value of trade.  Or vice versa. In the case of India courtesy the fall in commodity prices, particularly in oil, our trade deficit has shrunk visibly. Now since what goes into the aggregate demand identity is the trade deficit, the impact of fall in this deficit may seem unilaterally positive for aggregate demand. However, this is far from the truth. Given that a lot of industry in India either manufactures to export or is engaged in processing imports for exporting, a slowdown in aggregate trade (export plus import) matters for local industry and jobs. The following graph captures this reality.

 

 

One can see how total trade to GDP expanded strongly between 2004 – 2008 and then again between 2009 and 2011. The first of these phases marked the last real robust uniform world recovery and, as can be seen, was accompanied with a dramatic expansion of our total trade to GDP. The second phase marked a hyper-stimulus fuelled (but on hindsight unsustainable) V-shaped recovery out of the global financial crisis. Again it was marked by a robust recovery in our total trade. The other line in the chart plots industrial capacity utilization since 2008. As can be seen, industrial capacity utilization also staged a similar recovery and in fact both peaked around the same time in 2011 – 12. Since then both total trade to GDP as well as capacity utilization have steadily declined, with the decline getting starker since the last one year. Domestic industry complaining against cheap hard commodity imports impacting growth prospects as well as reports of large scale job losses in labor intensive industries like leather are all anecdotal evidence supporting this phenomenon.

 

  1. 2. Effect on leverage: A dramatic fall in inflation courtesy the sharp fall in commodities over the past year, administers a ‘real interest rate shock’ to leverage; all other things being constant. This is because revenue growth (for company) or nominal GDP growth (for country) suffers as price growth falls assuming volume remains constant. This squeezes debt servicing capability. Of course there are exceptions to this phenomenon that bear mentioning. Thus for instance for a net commodity consumer, margins would expand on falling commodity prices which may improve service capabilities. In fact interest cost for such an entity may fall as well as both risk free sovereign rates decline (on falling inflation) and credit spreads fall as credit perception of the entity improves. However, this is unfortunately not true for a large part of the local and global leverage today. This is because most of it was built to effectively service a commodity intensive investment boom, most strongly visible in China but also seen in countries like India in the last infrastructure cycle. While one must caution against over generalization, for a large part of this leverage the sequencing is more like this: revenue growth falls sharply while debt servicing cost remains the same or actually rises. This is because even though sovereign rates fall in line with falling inflation, the individual credit perception of the entity deteriorates leading to a widening in corporate spreads. This starts a self-enforcing ‘debt squeeze’ on the entity. This effect is to some extent visible on the global stage as well where even though incremental debt may not be getting piled on, debt to GDP is still rising since GDP growth rate  has fallen faster. India’s own leverage cycle, while much smaller when compared with many other countries in the world, has still been sizeable. This is captured in the graph below.

 

 

India has been a clear relative beneficiary of the global collapse in commodity prices. This has shown most visibly in our comfort on external account, rebalancing on the fiscal, as well as a handsome fall in inflation. All these, alongside a proactive government and a central bank, have ensured that India has stood out amongst EMs over the past two years’ global volatility. However, when making a full assessment of the country’s macro prospects, one has to examine the other side of the proverbial coin as well. Local trade has suffered in this self reaffirming loop of weaker global growth – lower commodity prices – weaker trade. This has in turn impacted local industry capacity utilization as well as employment. Furthermore, there is one adverse theme from the rest of the world that is broadly consistent in India as well; although it may be argued that the scale of adversity in play here is lower: There has been a long cycle of capital misallocation marked by leverage build up servicing incrementally diminishing return of capital. For the past some time, this leverage is now experiencing a significant interest rate shock.

 

There has been a tendency to position us as an out and out gainer from this commodity collapse. This note is intended to present the other side of the story as well. How the story goes finally may depend a lot on we not taking our growth for granted and getting impatient for it, but appreciating the global context and continuing the pursuit of prudent macro-policies.

 

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 about the investment strategy / theme of the Scheme and 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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