In the monetary policy review last week, the Reserve Bank of India cut the key policy rates, namely the repo rate and the cash reserve ratio (CRR), by 25 basis points each. The current economic environment remains highly uncertain and volatile. At a time when the current account deficit (CAD) is at a record high and the fiscal situation is far from satisfactory, a moderating WPI inflation and a series of structural reform measures taken by the government provided space to the RBI to take this bold step. The RBI has indicated that given the sub-trend growth rate in last three quarters, it is imperative to revive the investment cycle and encourage consumption through monetary measures.
However, given the sticky inflation and high twin deficits on the current account and fiscal fronts, the room for further monetary policy stimulus is fairly limited. The RBI also revised downwards the GDP growth projection to 5.5% for FY13 from 5.8% earlier. As also it revised downwards the inflation projection for March 2013 to 6.8% from 7.5% earlier.
One can immediately appreciate the urgency shown by the RBI in cutting rates at this critical juncture. The manufacturing component of inflation is moderating at a quick pace, suggesting slowing demand and the diminishing purchasing power of manufacturers. Alongside, even though it is too early to get too optimistic, the seriousness and sincerity of the government in addressing some very complicated structural issues has not gone unnoticed to anyone. The current momentum of cost-based pricing of administered articles like diesel, fertilisers and coal etc is definite to reduce the subsidy burden and release the pressure on fiscal deficit in due course.
While initially it may result in higher inflation, it would also optimise the effective cost in the long-term through higher productivity and a more efficient production process. This should address the structural stickiness of non-manufacturing inflation in due course. Recent measures by government towards incentivising allocation of domestic savings towards financial instruments like the Rajiv Gandhi Equity Scheme and the increase in the import duty on gold will release more capital for productive purposes.
Further, a tight control on Plan and non-Plan expenditure in the current year is likely to ensure that the government is able to meet the fiscal deficit target of the current year. Reforms undertaken this year and the incipient recovery in industrial activity will also help in targeting a lower than 5% fiscal deficit target for the next year. Thus, it would appear that with a good monsoon, a space for further monetary easing should be created in due course. As such, one can expect interest rates to come down further in the coming months.
Huge institutional and political intervention in Europe has begun to stabilise those economies. The core of the problem of refinancing maturing debt at reasonable rates has for the time being been addressed by a massive bond buying programme by the ECB. It is important to note that in the last few months, the European debt crisis issue has gradually gone off the radar of market participants as things settled down on that front.
That space was then occupied by the fiscal cliff issue in the US. It seems clear that there would be pressure on political institutions across the globe to reduce fiscal deficit and borrowings. That would support a revival in global economic growth through productivity improvement. This will help Indian exports. Recent reform measures, opening up of FDI in new sectors like aviation will increase the number of multinational companies in India, bringing fresh FDI flows.
Most analysts expects emerging markets to outperform developed markets in the current year and in that positive risk-on atmosphere, recent policy reforms will channel higher FII flows to India. Thus, this will not only reduce the current account deficit it will also significantly improve the quality of capital and trade flows. Resultant appreciation in INR will help bring down inflation as India remains a large importer for industrial commodities.
Budget for 2013-14 will provide a good assessment of how this overly optimistic scenario that this article draws evolves over the next year. Going by the recent developments and current visibility, there stands a good chance of this happening.
On the fixed income side, given the expectation of softer interest rates and earning improvement, subject to investment objectives and risk profile, Dynamic bond funds and short-term income funds appear reasonable investments options for the current year.
The author is executive director & CIO, Fixed Income, Pramerica Mutual Fund