Introduction And Recap
The last few days have been nothing short of dramatic as far as financial markets are concerned. The theme of emerging market (EM) contagion has progressed sharply, this time led by Argentina, followed by Turkey. Policy rates in Argentina have been hiked by a dramatic 15% to 60%. Turkey has resisted thus far, but it seems likely that interest rates will have to be deployed despite massive political resistance to the same. Meanwhile, South Africa has registered back to back GDP declines; signaling recession from a technical definition standpoint. Closer home, Indonesian Rupiah has touched its weakest level since the Asian financial crisis. Finally, and most pertinently, the rupee has been progressively weakening setting new all time lows for the past few trading sessions successively. What hasn’t helped matters for us is that the recent episode of heightened EM contagion has been accompanied by a sudden and sharp reversal in oil prices. Thus brent oil prices are up almost 10% since mid of last month, with renewed fears of imminent Iran oil disruption weighing on the market.
Given all that is underway, this seems an opportune time to review our big picture framework as expressed in our note “Making Movies : “The Big Picture”, dated 21st August. To recap, our core views were as follows:
1> The best in growth is largely behind us. Recent spurt in momentum has to be seen in context of pay back of almost two years of slowdown which was largely owing to domestic reasons. The phase of synchronized global recovery is now past us. This combined with recent financial tightening and other factors leads us to expect sequential seasonally adjusted slowdown later in the year.
2> We expected the current rate cycle to be up-fronted but shallow. We expected one last rate hike, most likely in the Jan – Mar 2019 quarter. This is despite a 100 bps plus acceleration in average CPI from last year’s almost unnatural cycle lows of 3.6% and largely owing to the fact that we expected the current comfort that RBI / MPC has with growth and output gap will change with slowing growth. To be sure, we had said that given the hostile global environment this won’t allow degrees of freedom to respond to growth. However, it may allow RBI / MPC to be more patient to let slower growth affect inflation.
3> Given rapidly dwindling core liquidity, and taking into account the INR 2,00,000 lakh crore expected rise in currency in circulation over second half of the financial year, we expected more than INR 1,00,000 lakh crores of open market operation (OMO) purchases from RBI over October to March.
The risk to the above framework we had expressed in the note was from external developments. Thus we had said “The one risk to the framework and view here is from further large disruptions to emerging market risk pricing, most likely from a further appreciable rise in the US dollar. If this were to happen, the RBI / MPC may have to abandon all other considerations and just focus on preserving macro stability. In this case the view both on shallow hikes as well as on liquidity injections may have to be modified”.
Reason Enough to Reassess?
Recent rapid developments have definitely moved in favor of some fructification of the risk factors to our framework. The idea here is to examine relevant factors to see whether a return to cash may be the most appropriate strategy. There are view-points already emerging that an interest rate defense may need to be mounted in India as well. Indeed, the 1 year swap rate has risen by around 30 bps over the past 1 month. Also, as the accompanying table illustrates this is now more than fully pricing in 2 back to back rate hikes in October as well as December ( 1 year swap is around 7.25% at the time of writing)
The following points need to be highlighted:
1. The large wonder here is how did we come about to be in such a situation in the first place? From a place of extreme macro strength and rupee being a ‘low beta’ we are suddenly finding ourselves in a reasonably uncomfortable situation; despite having not taken any apparent macro missteps. Our best guess explanation of this is as follows: One, our macro strength over the past few years has been somewhat exaggerated by the dramatic collapse in oil prices. This allowed a better fiscal (higher tax on oil), current account, and CPI. The oil reversal is now weighing on current account first, then CPI. Fiscal drag is limited so far as the temptation to cut taxes is avoided. Two, owing to domestic reasons largely, India’s growth cycle has become un-synchronized with the rest of the world. This is a point we have made before in context of why we don’t expect the current growth momentum to last. However, this may also have played a part in widening our trade account. Thus, insofar as imports are correlated with growth, our recent growth recovery would have expanded our imports in a context where emerging market exports in general are slowing. This would have widened our trade deficit thereby pressurizing the rupee. Of course, a counterpoint made here is that our exports have anyways been slowing owing to local bottlenecks and hence the trade account may have been pressurized whenever economic recovery started. A related observation, made to us by a good friend, is this: for an economy like ours where one can hypothesize that domestic consumption’s dependencies on imports are high, a depreciation in currency may actually be equivalent to tightening and not loosening as traditional theory would suggest. This is because this makes imports more expensive thus denting demand, without providing the corresponding offset that would have been in place had we a well functioning export chain. Combined with the financial tightening already done via liquidity and rates, this is another argument against India adopting an interest rate defense for its current problem. It also further buttresses our core view that the best of growth is already behind us.
2. Comparisons to 2013 are almost completely without merit in our view. 2013 was the culmination of substantial fiscal stimulus and deeply negative real rates. Versus that, our fiscal largely is well behaved currently and real rates are substantially positive; even accounting for the expected rise in the current year’s average CPI. Thus an immediate intervention was then required from almost an existential standpoint. Even then, it was really the FCNR scheme rather than the interest rate defense that turned the tide for us. Whereas, the issue today is hardly one of existence. Indeed, the rupee has been considerably overvalued over the past few years. Thus the concern currently is only around the pace of depreciation rather than the direction. Also, even in this cycle there are examples of countries resorting to interest rate defenses with little immediate respite in sight. The one country example that obviously comes to mind is Indonesia which has fundamentally sound macros prima facie, but for a heavy foreign ownership of its bond market. The central bank there has hiked rates by 125 bps and the currency has still continued to weaken. Of course, the defense of the argument is to quote the ‘counterfactual’: that one doesn’t know what would have happened if the central bank hadn’t hiked. However, the fundamental point here is that an interest rate defense in India for now will have little advantage but to increase cost of speculation in the currency by a small amount (unless one is talking of shock and awe hikes like 2013!). Also if the solution is the same as it was 5 years back, then one wonders where the benefits of fiscal consolidation and CPI targeting have gone.
3. The notable thing about the recent accelerated pace of rupee depreciation is that it hasn’t yet been accompanied by any significant foreign portfolio investor (FPI) outflow. Thus the bulk of the adverse flow seems to be on account of trade and a possible modification in importer / exporter behavior. Thus it makes imminent sense to offer special windows for large regular flows like oil payments. Without the backing of commercial demand for dollars in the interbank market, speculative interest to short the rupee may also find it difficult going; especially as the rupee isn’t as obviously overvalued anymore.
4. The RBI / MPC have a CPI targeting mandate. The currency stability mandate is only with the RBI and not with the MPC. The stated line on that also is that the RBI only intervenes to curb volatility and doesn’t take a view on the level of the rupee. Given this framework a rate hike via the MPC cannot be for currency considerations, but only if the weaker currency now leads to an assessment of higher CPI in the future. This is a reasonable causation to expect and, alongside higher crude prices, should be the logical way for the MPC. However, what muddies the analysis is that perishable food prices have remained very weak. As of date we are estimating a more than 50 bps undershoot to RBI’s July – September estimate of 4.6%. This undershoot opens up space for accounting for impact from weaker rupee and higher crude and still largely keep the second half CPI trajectory intact.
Conclusions and Takeaways
For the reasons mentioned above, we don’t think the current situation warrants an ‘interest rate defense’ in the traditional sense; at least as yet. There is no escalation yet in portfolio outflows that would give a sense that any sort of an unraveling is in order. Rather, the flow with respect to the trade account needs addressing which can be done via special windows. Give this, it is entirely possible that the market is over discounting the two successive rate hikes currently priced in. This will most obviously unravel should there be some stabilization / pull back in the rupee. However, should the situation worsen and the MPC indeed hikes basis a readjustment of their future CPI forecasts, we still think the current level of pricing more than covers it. Should the MPC hike twice again in the next two successive policies as swap pricing suggests, it would make four rate hikes on the trot. Given that peak growth is past us, this would probably tantamount to overkill.
The other issue is that of liquidity management. It is reasonable to assess that the RBI may be biased towards keeping rupee liquidity tighter given the environment. However, without at least INR 1 lakh crore of OMOs ahead, core liquidity deficit will rise to almost 2% of net demand and time liabilities (NDTL) of banks by March. Given this, it is hard to abandon the OMO view, even with the recent currency pressures.
Putting everything together, and acknowledging the sudden and sharp pain to portfolio positions over the past two weeks, we continue to like front end rates (up to 5 years) and more so now with the recent adjustment in rates. This is not to say that there may not be short term pain. However, once we account for what is already getting discounted in terms of policy rates, and the expected OMOs ahead, it is hard to discard 5 year government bonds at an annualized rate of 8.25%. Longer duration exposures need to be very tactical if at all given no macro reason to be bullish duration and given the fact that the bulk of state loan bond supply is still ahead of us. This should cause the yield curve to start steepening once the current turmoil stabilizes, from a currently very flat curve between 5 and 30 years. What also supports this view is that traditional balance sheet buyers of government bonds may have little appetite for duration given the underlying environment and the experience over the past year.
As before, the preference runs from government bonds to AAA corporate bonds, to lower rated. Given a rapidly tightening financing environment and our view of peak growth behind us, this is actually an extremely hostile environment for high yield credit strategies. Looked another way, the pressure on currency via an adverse flow environment and the problem of supply absorption of bonds is essentially one of lack of adequate availability of financing. This will most directly hit the lower rated/ high yield universe of credits. This basic fact needs to be acknowledged and accordingly portfolios need to be rebalanced.
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