FY21 GVA could contract by 7.5%. GOvt must stimulate demand, by issuing PSU bonds to fund infra and recapitalising banks via recap bonds or from RBI reserves
By Aastha Gudwani & Indranil Sen Gupta
We expect FY21 GDP contraction to deepen by 150bps to our bear case 7.5% after the June quarter surprised with a drop of 23.9% in real GDP and -22.8% y-o-y in real GVA terms, making this the sharpest fall in independent India’s economic history. The nationwide lockdown that began on March 25 and was lifted in parts starting June 1 was bound to pull down growth as economic activities came to a standstill. GVA data showed that growth in agriculture was underwhelming at 3.4% y-o-y (vs 5.9% seen in March quarter). While industry saw a contraction of 33.8% y-o-y, services fell by 24.3% y-o-y led by construction (-50%) and trade (-47%). An unexpected contraction in government expenditure driven public administration and defence services component was the key gap between our estimate and the actual number.
We are tracking September quarter GVA contraction at 11%. Credit off-take since Unlock 1.0 has declined by Rs 9.8 bn from +Rs 685 bn last year. Kharif farm income will likely slow to 10.4% from 12% last year, although urban income/demand will fall much more. Amidst all this, we retain our FY22 GVA forecast at 9% y-o-y. We assume that current Unlock 4.0 restrictions persist till mid-November with the restart taking December. These could stretch further with daily cases rising 9.4x to 78,512 since Unlock 1.0. We estimate that a month of lockdown costs 100bps of annual GDP and the restart about 120bps, over six weeks.
Low growth naturally pushes up fiscal deficit. As we expect real GVA to contract by 7.5% in FY21, nominal GDP contraction is also expected to deepen. This arithmetically pushes up combined fiscal deficit by 20bps. We thus, now expect FY21 consolidated fiscal deficit of 11.7% of GDP, centres at 7.1% of GDP. Higher fiscal deficit puts further pressure on overall borrowing. We expect Rs 8,507 bn/$113 bn/4.3% of GDP of additional borrowing (Rs 4.2 trn done) to finance our projected 11.7% of GDP FY21 fiscal deficit.
Market sentiment has been impacted by concerns relating to the inflation outlook and the fiscal situation. Higher borrowings only adds to the bad news. However, in the quest to ensure orderly market conditions RBI announced a series of measures, following up on their special OMO announcement:
RBI will conduct additional special open market operation involving the simultaneous purchase and sale of government securities for an aggregate amount of Rs 200 bn in two tranches of `100 bn on September 10 and 17. RBI remains committed to conduct further such operations as warranted by market conditions.
RBI announced term repo operations of Rs 1 trn at floating rates in the middle of September to assuage pressures on the market on account of advance tax outflows.
In order to reduce the cost of funds, banks that had availed of funds under long-term repo operations (LTROs) may exercise an option of reversing these transactions before maturity. Thus, the banks may reduce their interest liability by returning funds taken at the repo rate prevailing at that time (5.15%) and availing funds at the current repo rate of 4%.
Banks will be allowed to hold fresh acquisitions of SLR securities acquired from September 1 under HTM up to an overall limit of 22% of NDTL up to March 31, 2021. This opens up space worth 2.5% of NDTL (~Rs 3.7 trn/ $49.5 bn) to accommodate higher browning.
We have long argued that an increase in HTM limits will incentivise banks to buy G-secs with their money market surplus by defusing MTM risks. As the blended cost of funds is about 5%, should a bank prefer to buy, say, a 10y with a coupon of 5.77% rather than parking its surplus at 3.35% RBI reverse repo? In our view, not really, as it would lose Rs 7.2 if the 10y yield were to rise by 100bps.
RBI also remarked that it stands ready to conduct market operations as required through a variety of instruments so as to ensure orderly market functioning
Our liquidity model suggests that RBI would need to OMO buy $64 bn to clear the G-sec market in FY21. We expect RBI to buy FX ($45 bn in FY21, $34.2 bn FYTD) in the forward market to create headroom for future OMO. While our liquidity model calculates the FY21 durability liquidity requirement at $35 bn, there is already a much larger surplus in money market and M3 growth is in excess supply.
RBI to cut rates: We expect the new RBI MPC to cut rates by an “out-of-the-box” 15bps on October 1, 50bps in December, and a total of another 75bps in FY21 as it gets greater visibility of inflation coming off (see graphic). We expect inflation to peak off to 6.6% in August and 2.5-3% in H2FY21 from 6.9% in July base effects, good rains and low demand. With the “busy” industrial season commencing in October, time is running out for the RBI MPC to cut rates.
Also, an RBI OMO calendar should be supportive for sentiment. In fact, RBI can consider bidding at primary auctions as the FRBM Act allows, if growth in any quarter is 3% below the average of the previous four quarters.
MoF to follow up with demand supportive measures: These could include 1. lending rate subsidies for SMEs/real estate; 2. oil tax cuts; 3. lower-income tax cuts offset by a potential Covid-19 cess on higher-income; as well as 4. recapitalising PSBs through non-fiscal levers like recapitalisation bonds, or, use of RBI revaluation reserves; and 5. issuing PSU bonds to fund infrastructure.
Edited excerpts from BofA Global Research’s Emerging Insight (dated September 2)
Authors are India economists, BofA Securities
Views are personal