Suyash Choudhary

The clamor for rate cuts has predictably gone up again post the Union Budget. This is understandable since all told the finance minister has done a decent job of fiscal balancing and resisted advisors within his own government who were calling for some relaxations given the imperative to generate growth drivers. Also, the RBI had quite explicitly indicated intent to respond to the Budget should prudence and quality were adhered to. This the Budget has broadly done. However, beyond this rate cut there still seem to be expectations in many quarters that an aggressive easing cycle will continue. In our view, an aggressive cycle beyond this last cut could actually be quite undesirable for India’s macro stability and we present arguments here as to why we think that is the case. Correspondingly, in our view, investors should be cautious on investment themes very predicated on further substantial rate cuts.

 

The Cyclical Vs Structural

 

From RBI’s perspective, a sustainable monetary policy stance has to align to the structural dynamics of the economy; even as some room is exercised to respond to cyclical factors as well. Also, it is generally understood that interest rate changes affect real economic activity with a 3 – 4 quarter lag. This further underscores the need for monetary policy to essentially respond to durable, structural themes rather than cyclical ones. Hence one should look from this perspective at our 3 pillars of macro-stability:  Inflation, fiscal, and current account deficit (CAD). Also, while examining these one must remember that RBI has already cut by 125 bps and will probably do a bit more ahead.

 

a. Inflation: There is no doubt that we have made substantial gains in controlling inflation. The key themes underpinning this success seem to be: 1> A reset lower in our minimum support price (MSP) setting over the past few crop cycles versus double digit growth in the period before. 2> Efficient grain disbursal via in the open market. The results have been dramatic with cereal inflation breaking down dramatically from 10 – 12% between 2012 – 14 to about 2% now. The achievement is especially spectacular as this has been achieved despite 2 successive years of rain deficiency. There is an element of international prices here as well as work by economists suggests that there is reasonable correlation between local and international prices. This makes sense as well since cereals and pulses do get imported and exported quite actively. Meanwhile, rural wages have collapsed reflecting agrarian distress. While this is by no means desirable, it has helped keep a lid on inflation as well. One must remember that the previous episode of double digit wage growth had led to significant protein inflation as demand had risen on rising affordability. The reverse has played out over the past year or so.
 

It is thus apparent that there are cyclical aspects to our current low CPI inflation as well. Most chiefly, rural wages are at a cyclical low and these levels cannot be justified both from a welfare and a political perspective. Indeed, there is recognition of this fact in the just concluded Union Budget. On the other hand, there is limited structural enhancement yet to our ability to supply more (besides cereals) should demand pick up. Also, the 7th Pay commission and military pensions will also lead to some cyclical uptake in urban demand from an already not-so-depressed level. This may show in parts of the ‘core-ex transportation’ part of CPI.

 

The important point here is this: our cereal and vegetable inflation seem already at cycle lows and further durable gains may be difficult. Thus for instance if cereal prices were to fall further, it may create a large disincentive for production. Given this, the incremental gains from a disinflation perspective on these categories from good monsoons ahead may not be as large; simply because we are already enjoying substantial gains on these. Pulses is the only bug-bear where there is scope for significant disinflation if production rises. However, some of this may get taken away if demand were to rise as well on better affordability ahead. On the other hand core ex-transportation inflation, while also having seen declines, is sticky at 5.5%. This probably tells to limited structural gains in productivity having been made. Now if there is a net wage stimulus ahead (urban plus rural), it not immediately apparent how this breaks down further. Putting everything together: rural wages and cereal inflation seem to be at cyclical lows while core inflation faces possible upside risks ahead. Against these, pulses may provide some room for incremental disinflation. Given this, from RBI’s perspective it is difficult to envisage a lower than 5% CPI number on a durable basis; with possible upside risks ahead (we are ignoring here the scope also from some firming up of oil and metal prices owing to limited pass through on way down as well). For a central bank given the task of keeping CPI between 2% and 6% by mandate, if there are possible upside risks to 5%, the room for further rate cuts has to be limited. In fact prudence may suggest waiting here and allowing for fresh disinflationary forces to build up, rather than succumb to the clamor going on currently.
 

 
b. Fiscal: Structural themes contributing to fiscal prudence are chiefly anchored around subsidy rationalization through direct benefit transfer (DBT) and increase in indirect taxes. However, while service tax hikes are here to stay, excise hikes on petro products is a cyclical measure so long as oil prices are low. Direct tax measures to increase buoyancy are yet at a nascent stage to call their structural efficacy. Finally an expenditure commission has submitted recommendations to operationally streamline government spending, but again nothing is yet in the public domain. Against these, some cyclical buffers have emerged which may unwind if the oil bounty diminishes. Overall, and as is apparent from the recently concluded Budget as well, pending structural changes in our tax buoyancy and revenue spending, there are limits to how much fiscal consolidation can be achieved without such targets becoming sub-optimal. Media reports suggest that already stresses are evident as seen in the inability to clear backlogs in fertilizer subsidy, unpaid amounts to states under rural job guarantee schemes, and in finding resources for expanding food security. Should oil prices rise cyclically, there may be further squeeze. Also, a significant part of the infrastructure spend agenda is being driven through off balance sheet initiatives like funding from LIC and rise in non-SLR bond issuances. Given that savings pools are still finite (more on this below), this is contributing to the crowding out phenomenon even though bond markets have cheered the lower net borrowing number of the central government itself. In fact adjusted for not tax receipts, there is not much contraction in the fiscal deficit for the year ahead, even though the headline falls from 3.9% to 3.5%. Additionally, state deficits are rising so that there is limited visibility today to sustain a lower than 6.5 – 7% combined deficit ; unless a structural global bounce is forthcoming which lifts revenue realizations and hence cyclically corrects our deficits. So again from perspective of monetary policy, one cannot oversell the implications from the lower fiscal deficit; as has been the tendency post the recent Budget.
 
c. CAD: Dramatic gains in our CAD since 2013 have plugged our external funding risks and these are unlikely to rear again in the foreseeable future. That is not the point here. However, one must recognize that our CAD also is at a cyclical low. As is evident in the graph below, the fall in our CAD is closely tracking fall in investments to GDP, and is not owing to any durable rise in savings to GDP. As a corollary, if in line with policy’s (and market’s) desperate desire today investments to GDP were indeed to pick up meaningfully, it will start widening the CAD. It is in this context that the arguments of the aggressive rate cut camp sound the strangest to us: for an economy which is struggling to grow savings avenues, it is the saver that needs to be incentivized first. This is because if one is looking for a structural ramp up in investments, then one needs structural enhancements in the savings pool. There are indeed structural measures in the works to enlarge savings pool but these will take time to materialize and improve our savings to GDP ratio. Meanwhile, if we are planning a cyclical revival of investments, surely cost of capital should be less of a concern that the availability of it. In such an environment, the RBI can ill –afford significantly compromising returns to savers from here-on by aggressively cutting interest rates.
 

 
Conclusion
 
We have indeed travelled miles in plugging our macro imbalances. To a large extent this is on the back of structural, policy factors. However, there is a significant contribution of cyclical factors as well. Also, as we have argued above, some of these cyclical factors may already be reaching their peak contribution. It is hence quite unreasonable to use past extrapolation and expect quantum rate cuts in the time ahead. The RBI Governor himself has been warning lately that our growth, though sub-par, is broadly fine and we should focus on retaining our macro stability via low and stable CPI, fiscal, and CAD. Excessive weighting to cyclical factors in RBI’s response function risks making the monetary easing temporary and, indeed, may not even have the effect desired.
 
For arguments sake lets’ examine the marginal utility of an incremental 100 bps rate cut. From the asset side, where all rate cuts arguments rest, banks’ bond holdings will appreciate by may be 3% (assuming 50 bps pass through to bonds and banks running 6 year modified duration) on their mark-to-market portfolios. The quantum of capital thus released will be quite modest. From the argument of asset quality repair, one has to ask how much difference a 50 bps lower borrowing cost (assuming banks pass that to weak corporate and don’t absorb it as higher risk spread) will make to businesses that have seen a halving or more of their value? For anyone else who doesn’t have a balance sheet overhang, surely there will be projects to be had in a 11% nominal GDP growing economy (assumption for next year’s Budget),where the last 50 bps cost of capital won’t matter? Whereas, let’s consider what happens from the funding side: A large part of foreign money today is debt or quasi debt. Even investments made in equities are at best seeking high income. In such an environment the stability of currency matters a lot to these decisions. An aggressive rate cut in the absence of further structural improvements, will keep the risk the same but reduce compensation to the foreign investor. This will likely tell on the currency, especially so as the next 100 bps cut will translate into a marginal improvement at best in our growth outlook. So once tactical gains have been made on bond portfolios, there will be that much more incentive to exit and that much harder for us to keep the foreign funding going at the current pace. The story is similar from a local perspective as well. Banks are already struggling to shore up deposits. If they respond to RBI’s rate and cut deposit rates by 50 bps, it will get even harder to attract savings. This will translate into rising incremental credit to deposit ratios, especially so if credit growth has already reached a cyclical bottom. Thus from all aspects, the marginal utility of aggressive rate cuts looks very limited from the asset or growth side but may actually have a reasonable detrimental effect from the liability or funding side. Although this is by no means a parallel comparison, but it may be remembered that for India the 2013 crisis happened precisely owing to our utter ignorance of the funding side.
 
If the above analysis rings true, investors should be cautious of investment strategies that need aggressive rate cuts for performance delivery. Within fixed income, the long duration trade seems to us as  one such strategy since the substantial bond supply pressure on one hand requires meaningful rate cut expectations being alive on the other, for performance. Whereas, trades anchored around front end rates are much better poised to benefit from modest rate cuts ahead, possible changes in RBI’s liquidity management philosophy, as well as the attractive roll down available.
 

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