Looking beyond rain shocks, core inflation (adjusted for food, fuel and the Center’s HRA hikes) remains a very reasonable 4% with surplus capacity constraining pricing power.
We think that the G-sec market is oversold, with macro-risks greatly overdone. At the same time, we think the fear of trying to catch a falling knife is likely to keep investors away, given the 90 bps sell-off in yields since the last RBI rate-cut (in August), until RBI and the ministry of finance bolster sentiment with confidence building measures (CBMs). After all, rising yields push back lending-rate cuts, on the one hand, and limit any possibility of fiscal stimulus, on the other. Looking beyond trading positions, the real loser of higher yields is the economy as recovery gets delayed further. We firmly believe that macro-risks are overdone in the G-sec market. Concerns about an RBI MPC rate hike are exaggerated in our view, with inflation peaking at 5.2% in December with the tomato- and onion-price spike reversing, to an average 4.5% in 2018, well within RBI’s 2-6% inflation mandate. In fact, taking out onion- and tomato-prices, inflation is actually a pretty benign 3.9%. In the event, daily data show that tomato prices have fallen 43% for January to date from the December average. In any case, it is supply-side measures from the government—such as hiking minimum export prices or importing onions—rather than monetary policy action that will contain a vegetable price spike.
Looking beyond rain shocks, core inflation (adjusted for food, fuel and the Center’s HRA hikes) remains a very reasonable 4% with surplus capacity constraining pricing power. Against this backdrop, we continue to expect the RBI MPC to cut policy rates by 25 bps in April to signal lower lending rates in the slack April-September 2018 season, especially as the Australian weather bureau expects a La Nina that will lead to a good monsoon and thus cool farm prices. Second, we also think that fears of additional borrowing to fund fiscal slippage are unnecessary. We expect the Centre to adhere to its fiscal deficit target of 3.2% of GDP this fiscal year. There, after all, is little point in expanding the fiscal deficit by a paltry 0.2-0.3% of GDP, if it is largely offset by a spike in yields. In our view, the Rs 500-billion hike in central government borrowing, in place of T-Bills, was an avoidable step at a time when yields were rising. While we expect a step-up in rural spend in the Budget on February 1, in the run up to the 2019 polls, we still expect finance minister Arun Jaitley to target a fiscal deficit of 3.2% of GDP in FY19, a la FY18, cutting down capital expenditure if required.
Finally, we believe concerns of oversupply in the G-sec market are also exaggerated. Durable liquidity injection from RBI has thankfully improved to about $17.5 billion from just $3 billion in November, inching closer to our projection of $30 billion for FY18. RBI and the finance ministry have also infused Rs 440 billion (against Rs 600 billion of buybacks announced) in the G-sec market in the form of government buybacks and cancellations of government auctions to prevent the money market from drifting up to repo mode (in which banks borrow from RBI). On our part, we expect RBI to infuse another $9 billion by March through RBI OMO purchases, government buybacks/cancels and maturity of Treasury Bills under the Market Stabilization Scheme. Looking ahead, we project that the G-sec market will likely see excess demand in FY19 versus the concerns of oversupply now. We expect RBI to infuse $25 billion of liquidity via a combination of OMO purchases, G-sec buybacks by the government, etc, to supply our estimated durable liquidity requirement of about $35 billion, assuming $12 billion of RBI FX intervention. This will likely exceed the gap between overall Government borrowing and market demand for G-secs.
So, what can RBI do to cool the G-sec market? We think that the challenge is to bolster market sentiment with a mix of CBMs, as rising yields, driven up by prolonged RBI OMO sales, have hurt market sentiment. We are relieved to find that the finance ministry has just cut extra borrowing by Rs 300 billion. We have long argued that the easiest way is to cancel additional borrowing (Rs 140 billion so far) and fund fiscal slippage, if any, by drawing down the government’s surplus cash balances with RBI. After all, the Centre has been running surplus cash balances with RBI, averaging Rs 1500 billion on March 31 over the past few years. This arises out of higher-than-budgeted small saving collections, surplus of state governments parked in intermediate T-Bills and non-competitive bids and advance tax payments in the March quarter. Finance minister Jaitley could even utilise this to fund a higher fiscal deficit of, say, 3.7% of GDP in Budget 2018, without additional borrowing and fund a step up in capital expenditure. Incidentally, we are not in favour of the finance ministry’s reported proposals to draw on the RBI’s: (1) Contingency Reserves, created out of past profits, which, at 7.5% of assets, is well below the 12% benchmark; and/or (2) Currency and Gold Revaluation Account, a buffer against sharp FX movements.
Second, government buybacks (Rs 300 billion done of the Rs 750 billion budgeted) should also calm the G-sec market by improving the demand-supply position. This also channels the government’s surplus balances with RBI into the market. Although the G-sec market did not react much to the Rs 600-billion government buyback announcement (Rs 300 billion accepted), this was due to the impression—erroneous, in our view—that the RBI is steepening the yield curve by buying back April maturities and selling longer tenors. Finally, RBI OMO auctions (of about Rs 500 billion) would be the strongest signal as that would not only supply durable liquidity but also reassure market concerns on the yield curve. Could RBI inject liquidity at a time of rising inflation? We don’t see why it can’t, as inflation is driven by supply-side food shocks rather than demand-pull from excessive liquidity. In terms of reserve money expansion, there is little difference versus government buybacks, that print money by driving down the government’s surplus balances with RBI, and OMO, that directly expand the RBI’s balance sheet. In 2002-03, Governor Bimal Jalan continued to ease, ignoring agflation from a bad drought. This put the Indian economy at the head of a global recovery instead of stoking inflation.
Indranil Sen Gupta
Co-head and economist, India Research, Bank of America Merrill Lynch