Suyash Choudhary

Introduction

A lot has happened locally and globally over the past few months. If recent narrative is to be believed, India has suddenly sprung a fiscal, current account, and a growth problem; whereas CPI is rising as well thus ‘vindicating’ RBI’s stance. Almost as on cue, the global backdrop seems to have shifted as well with the US Fed turning up the hawkish rhetoric, keeping it’s near term rate hike expectations intact and progressing with its balance sheet reduction program; all with no real strong confidence yet that inflation will move back towards their 2% target. Justifiably then, our own bond market has had a somewhat rough ride over this period. The attempt here is to sift through this noise and try and identify certain anchors for investors.

 

Reassessing Macro and Policy
 
1> Fiscal : The chief economic advisor had raised serious growth concerns with his mid- term review.  This, alongside the latest GDP print, has created serious chatter around India’s dramatic growth slowdown. The discussion has spread to implications for the government’s fiscal stance and sections of the media have gone ahead and even printed detailed plans of a 0.5% slippage on fiscal deficit and where the additional spending will get deployed. However, as it turns out, there is no concrete suggestion yet that there is going to be a deficit slippage owing to enhanced spending. Indeed, the H2 borrowing calendar has stuck to plan albeit with a rider that more can be borrowed if needed. We think it unlikely that an expenditure enhancing conscious budget slippage will come about. Our reasons are as follows:
 
a. The current year is marked with considerable revenue uncertainties. There is slowdown in gross corporate tax, GST receipts on indirect taxes are still stabilizing and there are likely to be shortfalls in other receipts including from RBI dividend and telecom spectrum. In such a scenario, it becomes very difficult for the finance minister to already plan for higher spending.
 
b. It is quite likely that, consistent with what has been done in recent years, the government asks PSU entities to borrow from the market in order to fund projects in their respective sectors. It is even possible that the recent relaxation in corporate bond limits by removing Masala bonds from overall limits may have been done to facilitate such issuances. This allows additional spending on infrastructure projects without any expansion in fiscal deficit; while addressing the phenomenon of ‘crowding out’ to some extent by allowing more access to offshore investors.
 
c. Finally, the principle of materiality. The government has a INR 21.5 lakh crore total expenditure budget. An INR 50,000 crore slippage will not materially enhance that spending power nor will it be meaningful versus the size of our economy. Whereas it will dent the optics of our macro consolidation. From that standpoint as well, it just doesn’t seem worth it.
 

All told then, we think unlikely that there is an expenditure led fiscal expansion. The distinction is important since, apart from the higher bond supply associated with expansion, there are implications for RBI policy as well if there are material changes to total spending. To clarify, then, we don’t think there will be any such implications.

 

From a bond supply standpoint, it is to be noted that H2 gross borrowing for the centre is slated to be the lowest in 3 years (assuming no slippage). Not just that, gross government bond supply is likely to be less than half of that in the first half. Thus not only is the calendar lighter, but the RBI is very likely to reduce the pace of incremental OMO sales if not stop them altogether. This is because currency in circulation, which has expanded by INR 2.45 lakh crores since start of this financial year, is likely to rise by another INR 1.75 – 2 lakh crores over the rest of the year if the seasonality that we saw over 2015 – 16 is to be respected (note that 2016 – 17 data was contaminated by the announcement of demonetization in November 2016). Also, the forex flow problem that RBI has struggled with through the year seems to have somewhat abated. With respect to SDL, although gross supply is likely to be higher by INR 50,000 crores over H2 last year, this will be offset by correspondingly lower issuances of UDAY bonds. Hence, bond supply doesn’t seem to be much of an issue over the next 6 months. It must be said, however, that there is room for  more clarity of communication from government ‘sources’ when they talk of borrowing and / or future fiscal slippages. A large part of market confusion right now can be directly attributable to stray comments from ‘sources’ in the finance ministry.

 
2> Inflation, Growth, and RBI Policy : It is interesting to see how the narrative on CPI has been evolving. It’s not enough that CPI is rising off a ridiculously low level and that even with one-offs like GST and pay commission getting absorbed it is still likely to be closer to the mid-point of the RBI’s target band. Indeed, excluding the optical effect of the HRA hike, it is likely to be around the mid-point over the next year as well. It is to be noted that when last the RBI had sounded dovish in October 2016 (when they had argued that India can do with a lower real rate target of around 1.25%), core CPI was higher than where it is today. Indeed, stripped of housing, the so-called ‘true core’ CPI is around 100 bps lower than where it was then. Whereas, growth dynamics are now in much worse shape and any forward looking view that the output gap in this country will close in the near foreseeable future has all but dissipated.

 
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There are two points about India’s growth rate that are particularly striking. One, as the chart above shows, growth has been slowing as real policy rates (calculated here as average for the quarter) have been rising. Now obviously, the effect is somewhat exaggerated here given that some of the CPI readings were unnaturally low and reversed quickly. However, the larger point remains that policy has incrementally tightened in real terms (even though nominal interest rates have been cut) just as growth has been slowing and, it can be argued, output gaps widening.

 

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The chart above shows why this growth slowdown should be even more concerning than otherwise. India has slowed over a period where the rest of the world has accelerated. The chart compares India real GDP growth with an aggregate of growth in 35 OECD countries. So despite a global tailwind, we have slowed dramatically. This begs the question as to what happens when that tailwind dissipates.
 

The stated goal of monetary policy is defined thus: ‘The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth’. Given this there is perhaps a risk that sometimes the actual policy narrative can be perceived to be too complicated. For instance, in October 2016 the RBI had argued for lower real rates whereas lately the argument, at least from certain sections of RBI, seems to be around the desirability of higher real rates in order to disincentive banks from ever-greening.  The stated goals of policy perhaps allow for a clearer communication. Looked at from that lens, the implications for policy seem fairly straightforward once the average mandates on CPI have been met. In this context, it may not be enough to argue that a rate cut now will not help anything with respect to growth. The sheer fact of a tight real rate stance may have other unintended policy costs; including from costs of currency interventions.

 

3> US Fed: In our current framework of assessing appropriate real policy rates in India, our dominant caveat has been this: should there be a sustained rise in global financial volatility (higher US rates and stronger dollar triggered by inflation returning and / or a credible US fiscal plan being passed) then RBI will consciously choose a higher real rate path and, to that extent, our rate cut cycle will be definitely over. In this context, it is important to assess the recent hawkishness of the Fed. However, so far as this hawkishness is unaccompanied by actual prospects of inflation rising, it will only succeed in further flattening  the US yield curve and will not be detrimental to emerging market bond performance generally and our view with respect to Indian rates particularly. Indeed, this is precisely what seems to be happening to the US yield curve as the graph below shows. The 30 year vs. 2 year spread is the least it has been in almost 10 years.
 

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Conclusion

 

There is no denying the fact that Indian growth has slowed substantially and just as the rest of the world seems to have accelerated. In our view, there is no real space with fiscal policy to react to this given two things: One, our combined fiscal deficit (state plus centre) is already amongst the highest when compared with peer nations. Two, with reasonably revenue uncertainties this year, there is little reason to expand spending at the central budget level. That said an argument can be made that perhaps one can curtail the current amount of uncertainty being inflicted on the market with somewhat tighter communication by ‘finance ministry sources’.

 

On the other hand, monetary policy seems to still have space to respond once one focuses on average real rates today, the confidence that RBI has incrementally being gaining with respect to its inflation targets, and the stated responsibility of ‘keeping in mind the objective of growth’ via its monetary policy. For these reasons, we would think the current cycle is still very much in play with a few months’ perspective in mind; provided the global financial backdrop remains relatively benign.

 

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