By: Punam Sharma
The last few weeks have seen quite a few developments both locally and globally. We take a closer look at some of these in this note, in context of our underlying current framework for bond markets.
1. Escalation in geo-political risks: Global markets finally caught a risk off flavor, at least briefly, as the war of words between the US and North Korea got more intense. Adding to this locally was some jitter with respect to a stand-off between India and China. Risk markets gave off and the rupee suffered over this period; though at the time of writing the perception with respect to the situation seemed more stable. From a view standpoint there is little one can do to build in potential events like these, whose fructification can be of intense magnitude but has to be assigned a very low probability. The more durable macro-theme with respect to prospects of rise in global financial risks is whether G3 inflation is about to pick up or not. In this regard, the latest US CPI data also printed weak and so the narrative continues for now that inflation proves elusive. However, this debate is likely to remain ripe till activity indicators remain relatively strong in these markets.
2. Heightened concern on Indian private sector growth: The key take-away from the recently released ‘Economic Survey Volume II’, is the stark flagging of ‘near-term deflationary impulses’ that ‘reign over the Indian economy’. The concern with respect to the slowing private sector growth is quite visible with the RBI in the latest monetary policy review as well. However, the chief economic advisor (CEA) seems much more concerned and provides a lot more detail on the subject. Thus, the economic survey notes that the deflationary impulses currently are on account of 1> stressed farm revenues, as non-cereal food grain prices have fallen sharply, 2>fiscal tightening by states to keep deficits in check in context of farm waivers, 3> declining profitability in power and telecom sectors further accentuating the twin balance sheet issue, and 4>transitional frictions from implementation of GST. Quite interestingly, and counter to conventional wisdom on the matter, the CEA analyses that the current spate of farm loan waivers could reduce aggregate demand by up to 0.7% of GDP if implemented in full.
The concerns expressed by the RBI and, more vocally, by the CEA are quite legitimate as seen in the graph below of the core GVA growth (GVA stripped of agriculture and government). Not only is the current state alarming but, as we will examine below, there doesn’t seem to be any meaningful near term trigger on the horizon that can potentially reverse this trend.
3. RBI’s lesser dividend to GOI: The RBI has paid only INR 30,659 crores as dividend to the government this year. This is almost INR 35,000 crores lesser than the year before. While the government would have anticipated some slowdown in RBI dividend owing to demonetization related costs (RBI paying interest under reverse repo to market, cost of printing new notes, etc), it had kept overall collections under PSU dividends largely unchanged from last year. This shortfall, along with some concerns with respect to telecom receipts this year, can potentially open up fiscal risks of 0.2 – 0.3% of GDP. Whether or not the government chooses to slip on fiscal deficit targets will probably only be known towards the end of the financial year. Our bias is to believe it won’t since such a slippage will constitute admitting to a macro-economic indiscipline; something the government has steadily avoided thus far. Even if it does, in the overall context of things a 0.2% slippage on account of capital receipt shortfalls will not be taken much adversely either by the markets or by the RBI. However, the larger point is this: Taking forward the point about incremental growth drivers, it is clear that government spending as a growth driver will have to largely take a back seat from here on. Government spending is running ahead of last year’s run-rate already, with the result that the centre has already chalked up 81% of its annual fiscal deficit target by June end. This is by design as the budget was brought forward starting this year precisely so that some spending happens before monsoons start and bring all project activity to a stall. However, this also means that the government will have to belt-tighten in the months ahead, especially now with elements of capital receipts disappointing.
Exports have been another growth driver that had started to rebound at the beginning of the year. However, as is seen in the graph below, they have also started de-accelerating over the past few months. Hence, both government spending and exports can no longer be relied upon as the same magnitude of incremental growth drivers in the time ahead, as they have been over the past few months.
4. Latest CPI release: There has been some concern expressed with respect to the latest CPI print overshooting ‘consensus’ by around 30 bps. To be frank, our only concern here is with the quality of data that the average forecaster has used in predicting this reading. It may be recalled that vegetable prices had shot up over the month and basis data from ministry of consumer affairs we were expecting anywhere between 20 – 25% monthly pass through into the vegetable index of CPI. Hence, the data is broadly in line with our estimate and in fact has left us mildly relieved since HRA pass through has yet been quite modest so far. Core index has gone up largely presumably on account of GST related price hikes, whereas CPI – ex pulses and vegetables has actually continued falling. These are illustrated in the chart below.
Source: CEIC data and IDFC MF Research
Our framework for fixed income, as discussed in a recent post policy note (please refer ‘In the Real World : A Post Policy Analysis, dated 3rd August 2017), is basically this: Now that there is relative comfort on ‘close to 4%’ on CPI getting achieved, the debate will sooner or later shift towards the appropriate real rate setting. A dominant factor here will be prospects of global financial volatility. If this were to escalate on the back of non-temporary factors (for instance G3 inflation returning), then the RBI may be happy to run with higher real rates. However, if the global backdrop continues to be sanguine then the state of the local economy may argue for lower real rates that is currently the case. Now if CPI remains well-anchored (as seems the expectation now) then this would entail further cuts in the nominal policy rates. For this reason, we have argued that it is as yet too early to call the end of the current cycle. Indeed, this is what the CEA seems to have concluded as well. Recent developments discussed here have done little to change this framework. Indeed, while escalation of geo-political tensions is always a risk, we now have a fuller analysis of the state of the local economy, courtesy a government document. This reaffirms the view that the private sector is in a weak state with no apparent near term growth drivers ahead. Till this state of affairs changes, monetary policy will always be in play given a well anchored future CPI expectation.
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