By: Punam Sharma
The year gone by started pessimistically but on balance proved to be quite a rewarding one for fixed income. A complete turnaround in RBI liquidity philosophy leading to quantum bond purchase from the market, Rajan and Britain exits triggering expectations of more monetary easing locally and globally, and finally demonetization resetting RBI rate cut expectations; all played their parts in the continuing bond rally over the year. Towards year end, however, uncertainties have picked up again. The global rate environment has reset meaningfully on expectations of a more pro-active fiscal policy, chiefly in the US. Meanwhile, the macro-gains expected from India’s demonetization exercise seem a little less clearer now and the RBI seems to have taken on a much more hawkish tone than anticipated, causing much more wariness amidst market participants towards the close of the year.
The emphasis here always has been to rely less on deterministic ‘level’ based views and more on underlying frameworks that inform allocation decisions. Towards this same objective, we highlight in this note some of the key themes that we think are likely to shape the bond view over 2017.
1. The net stimulus from Trump policies: The global ‘re-rating’ in bond yields has been largely on expectations that the baton of growth is being passed from monetary to fiscal policy, especially in the US. Trump has proposed an aggressive tax cut agenda while the Speaker of House of Representative Paul Ryan is also working on a plan to adopt a ‘consumption-based approach’ to taxation; in addition to rationalizing tax slabs. If implemented quickly and effectively, and not accompanied by other facets of policy which are growth destructive, this could prove to be a magnet for flow back into the US. To the extent that this is accompanied with continued dollar strength, emerging market economies including India will need to be that much more watchful about their own macro-stability.
While on the subject of global financial stability risks, a matter also on the mind of Governor Patel as seen in the latest minutes of monetary policy, it is useful to see what exactly one has to be wary of. A lot of concern gets expressed about the narrowing interest rate differential between US and India. While no doubt a higher rate differential also serves to attract flows into an emerging market, history has shown that if the narrowing differentials are on account of sound macro-economic logic, they can be sustained. The first graph above tracks India – US rate differential versus our inflation differential since 2001. As can be seen, over periods where inflation differentials are falling/lower we have been able to sustain less than the current rate differential of 400 bps. Indeed if the recent narrowing of inflation differentials sustain there is no reason to expect, ceteris paribus, that rate differentials should necessarily widen. In the second graph, we introduce current account deficit (CAD) as another variable in assessing determinants of rate differentials. Again it can be seen that in periods of low CAD, it has been easier to sustain lower rate differentials. This makes intuitive sense as well since a lower CAD implies a lower savings – investments gap and hence a lower reliance on offshore flows. This again is a condition that is being met currently. Ultimately, the key to sustaining differentials, assuming current lower ranges of inflation and CAD domestically, may depend upon the behavior of the US dollar. As the line graph in the second chart also shows, INR was broadly appreciating during the 2002 – 08 period when we sustained narrowed rate differentials. However, if in the period ahead US dollar continues to strengthen then foreign investors may well demand a larger rate differential to still be interested in Indian rates.
2. The policy response to demonetization: The narrative from India’s demonetization move is ‘short term pain for longer term gains’. There’s no denying the pain being felt by large sections of cash intensive India, which covers almost all of the economically vulnerable population; including farmers and unorganized manufacturing and trade. For the narrative to be complete, the gains need to be made visible after the end of the exercise. These no doubt include curbing counterfeits and black money, and increasing the tax base as well as digitization habits of the population. However, implicit here is also a promise of allocation transfer towards the vulnerable. This last will need to happen via explicit fiscal policies of the government. Apart from the welfare standpoint, there is a macro-economic way to think of this as well. There are four drivers of aggregate demand: consumption (C), investments (I), government spending (G)and net exports (X-M). Out of these, ‘C’ is what has reliably worked for India with some degree of resilience. ‘I’ has been weak, and had turned weaker lately as the Q2 GDP data showed us. ‘X-M’ has lately started rebounding but will be subject to global factors much outside our policy control. ‘G’ has stepped up in terms of quality, but is constrained by deficit targets. Now, post demonetization the hitherto reliable leg, ‘C’ has taken a knock; at least temporarily. The only discretionary lever that can compensate for this in the near term is ‘G’ or government spending. To be clear, it is very unlikely that the government will embark upon any sort of ‘fiscal adventure’; especially given the credibility it has built thus far on macro-stability. However, equally, there seems to be little case for further meaningful fiscal compression from here-on, absent other discretionary drivers of growth.
The other policy lever is of course with RBI. Indeed, post demonetization announcement it had looked very likely that RBI will deploy more easing; especially as the tone of the monetary policy committee (MPC) seemed decidedly dovish and growth oriented in the October policy. However, and as was revealed in greater detail in the minutes of the December policy, there seem to be 5 commonalities in the current thinking of most members of the MPC: 1> They are awaiting more transmission of rate cuts done so far into bank lending rates. This may start happening from January, going by recent media reports. 2> They expect effects of demonetization to be transitory. 3> They seem quite worried about global financial risks. 4> The medium term target of 4%, the mid-point of notified CPI target range, is back in play. 5> There is worry on stickiness of core inflation. While an undershoot of near term growth and CPI from RBI’s assessed ranges may well still invite rate cuts, the bar for these has been decidedly set higher compared with market’s initial expectations.
3. RBI’s neutral liquidity framework: The liquidity dynamics of the banking system have been straightforward thus far: there has been annual leakage of currency into the hands of public in excess of INR 2,00,000 crores annually. Given also a starting point of financial year of net negative liquidity, this has provided RBI with a comfortable framework where it can expand its balance sheet and create reserve money while simultaneously ensuring that overall system liquidity remains neutral. This equation may get tricky going forward. Not only may there be significant liquidity left over getting into the new financial year, but the pace of currency leakage may also diminish substantially going forward given the behavioral changes anticipated post demonetization. This may reduce the need for substantial bond buy backs from the RBI in the year ahead, assuming no large external shock that leads to massive foreign capital drain. At some juncture, as demand for credit picks up, the RBI may have to start to focus again on ensuring enough reserve money gets created to service the ‘legitimate’ demands of the economy.
From a bond market standpoint, the importance of bond purchases by RBI cannot be underplayed; especially as foreign investor demand is also likely to be uncertain in the year ahead. The graphs below help illustrate the significant bond supply lined up in the financial year ahead. There are two elements that bear watching here: One, we are now entering a phase where for the next few years government bond maturities are higher than the recent past run-rate. This is despite bond buybacks done by the government. This matters since, while net supply may not change much, new issuances of bonds add duration to the market. Two, the supply of state development loans (SDL) is picking up appreciably, even outside of the so-called UDAY bonds.
As can be seen in the line graph above, gross supply ex of UDAY and corporate bonds is slated to pick up appreciably. Assuming no support from RBI bond purchases, even the net supply will rise quite meaningfully.
The intent here has been more to lay out the broad framework around which one can seek cues for the bond market, rather than provide a deterministic view of shape of things to come. The reason for this really is that markets are in a bit of a ‘data vacuum’ for some time now; both with respect to local as well as global events. Thus locally the full effects of demonetization on growth are still unfolding whereas globally one waits to see with what speed and efficacy the new US administration’s fiscal policies get implemented. Indian bonds were interpreting the data vacuum bullishly post demonetization but have since turned more cautious. This is basis a more hawkish RBI and Fed compared with expectations. However, if the local growth shock on incoming data proves to be deeper and / or the Trump fiscal plan underwhelms, markets may very easily revert to a dovish interpretation all over again. From the perspective of Indian bonds, a meaningful rally from here has to be predicated on either one of two things: 1>Market bringing back expectations of more than 25 bps rate cut in the near term; or 2> Bond supply assumptions get changed basis final fiscal gains from demonetization. One will have to continually assess the likelihood of these in context of the overall themes as described above, and accordingly adjust the investment risk being taken. From an investors’ standpoint, the banking system is probably providing the best indicator for course of action. Given the hugely positive ‘wedge’ between deposit and credit growth, banks are unlikely to chase aggressive deposits for most of the year ahead. This should serve as a large incentive / trigger for fixed income investors to plug reinvestment risks via products that are suited to their duration and credit risk profiles. The level of risk can be adjusted in the future as more data comes in to feed the framework.
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