By: Punam Sharma
Urjit Patel Signs In
The appointment of Urjit Patel as the next RBI governor rounds off two months of hectic speculation in local financial markets. The consistent underlying theme of this speculation was that the government had just about had it with Rajan’s ‘tight’ monetary policy and now wanted to ‘give growth a chance’. A related line of thinking was that the 4+/-2% target on CPI may be diluted, either via expanding the band or mixing the target variable (CPI) with some bit of WPI. Indeed, some of the names doing the rounds for the new governor may have preferred such a dilution.
As it has turned out and much to its credit, the government has notified the 4+/-2% CPI target as the official mandate for monetary policy all the way till March 2021. Alongside it has appointed Patel, who was the chief architect of the CPI targeting framework of the RBI. With these, it has ensured as much of full continuity as is possible with a change of leadership. It has also laid to rest speculation that Rajan was standing in the way of its endeavor to re-inflate the economy.
From a market’s standpoint, some points are of relevance:
1. There is no reason to assume immediate hawkishness from the new governor. In its last communication the RBI, presumably inclusive of Patel, retained upside risks to its 5% target of 2017 but still kept the stance as accommodative. This stance in turn has two legs to it: One, the central bank will look for room to cut further; presumably if upside risks to CPI were to not materialize. Two, it will continue to execute its new liquidity framework of zero liquidity deficit. We fully expect this stance to get carried forward given that there is almost full continuity with the new governor. It is quite likely that with the disinflation ahead on pulses and vegetables, the upside risks seen today to CPI vanish and a final rate cut may get slipped in. Whereas, with liquidity surplus likely to vanish again over the months ahead, the RBI should resume OMOs. Hence, to reiterate, there is no reason to position for immediate hawkishness. The only caveat here is that if Patel leans also on CRR cuts as a method of liquidity infusion, which Rajan had avoided, then expectations of total OMOs for rest of year (currently around INR 1,00,000 – 1,20,000 crores more) will need to get scaled down. This may lead to some relative pressure on longer duration bonds and associated curve steepening.
2. At the same time the expectations of outlier aggressive easing, based on an entirely new macro-construct of a substantially different governor, will also need to be done away with. Urjit Patel is very much a believer in orthodox monetary and fiscal policy and will no doubt also be concerned about the medium term sustenance of the CPI targets. He will also calibrate liquidity creation with the inflation objectives of the RBI. These are very much along the lines of what Rajan may have done had he continued.
Given the above, and borrowing from a turn of phrase we heard in the market, it seems the most appropriate to position for an environment of ‘constrained bullishness’. Should no unanticipated new pressures emerge, the next few CPI readings will show a substantial collapse which, alongside RBI’s liquidity operations, should provide a reasonably conducive environment for yields. At the same time given almost full continuity at RBI and the underlying structure of our CPI (for details, please refer “Use Your Illusion: A Bond Market Update”, dated 16th August), one should fade the hopes of outlier aggressive easing. Given this, from a portfolio strategy and fund selection stand-point nuances like demand – supply, relative shape of the curve, and volatility versus participation trade-off will need to be kept in mind.
A Thought For The Saver
In this phase of speculation over the past two months, a lot of criticism has also been piled upon the existing monetary policy regime. The central argument seems to be this: Raising interest rates will not control the prices of potatoes and onions, whereas RBI has kept growth ‘hostage’ by not lowering rates. To the extent that this argument is cautioning the central bank that while it has taken on a CPI target its direct ability to control CPI is fairly limited and hence may cause credibly loss down the line, it appears valid. However, in our view, in almost all other aspects the argument seems woefully short of sound logic. Rajan himself has been vocally exposing the hollowness of these arguments via some excellent speeches lately. However, we cannot resist making some more points below.
India has only very recently emerged from a massive savings crisis in 2013. While through a mix of good policy and good fortune our current account deficit is now next to zero, it is quite amazing how still in many macro constructs and commentaries the role of interest rates in incentivizing savings is still almost absent. Even though we don’t have a savings crisis today, we are nevertheless not pursuing many developmental projects owing to lack of savings. Just as one example, our roads, railways and waterways combined can absorb lakhs of crores should that funding be available. While our financial savings to GDP ratio remains this anemic, surely interest rates have a major role to play in incentivizing savings so that our growth ambitions today don’t sow the seeds for the next savings crisis down the line? Looked at from this context, while interest rates may not be able to directly influence CPI, they can at least ensure that savers always get a positive compensation over whatever inflation there is. Overtime this may provide a strong incentive for incremental savings to flow into the financial system. Such a policy framework will also keep the currency stable and hence continue to attract global savings to us.
Instead, the general propensity seems to be to look at interest rates as a cost item only. Corporate credit is stagnant due to capital misallocation decisions taken in the years of loose money since the global financial crisis. The problem is not unique to India and is unlikely to resolve itself if interest rates were to fall another 100 bps. Now if It were a costless decision to make this 100 bps reduction, then it may have been worthwhile to give all the help possible to get incremental loans going. Unfortunately, it is not. Aggressive rate cuts in the face of sticky macro aggregates can jeopardize both domestic and international savings pools that are currently funding our investments/consumption. Even if the cost of borrowing is genuinely high for certain economic entities (for instance SMEs), it is on the back of hefty risk spreads currently being levied by lenders over and above the underlying sovereign rates. These risk spreads are again linked to the current bad loan mix in banks’ books which in turn is a result of the previous cycle of capital misallocation. As an aside, the cost of borrowing certainly doesn’t seem to be a constraint in loan growth of many banks in the private sector and in certain segments of lending, like consumer credit.
In our view, these perspectives are not merely for academic interest but may have real implications for bond investors. This is because the almost righteous view taking that constantly laments high interest rates may cause lazy, ‘perma-bull’ kind of biases that may fail to catch cycle turning points. It also leads one to make simplistic correlations between global and local situations. For instance, as compared with many other parts of the world, our inflation is much stickier, our combined fiscal deficit is much higher, and our avenues for long term productive deployment of capital are much stronger. In such a scenario, while some broad correlations will exist between our rates and those in other parts of the world, it is risky to draw direct conclusions with respect to the quantum of fall possible in our rates just because G3 rates have fallen to the floor. However, these interest rate differentials can certainly narrow overtime, if we continue to erode our emerging market risk premium through sound macro and governance policies.
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