With an unrelenting trajectory of core inflation ahead, MPC’s primary inflation-fighting mandate suggests a likely pause in both the upcoming policy review as well as the next, despite the prevailing accommodative stance
The National Statistical Office has pegged the pace of GDP contraction in that quarter at a distressing, albeit unsurprising, 23.9%.
Monetary policy setting in India remains stuck in an unenviable position, with supply disruptions causing inflation to harden to rather uncomfortable levels, even as the Covid-19 pandemic has wreaked havoc on economic activity and government finances.
In its last meeting in August, the Monetary Policy Committee (MPC) had presciently decided to leave the repo rate unchanged, given its primary mandate of ensuring that the CPI inflation remains within a band of 4% +/-2%. Since that meeting, CPI inflation has risen further to 6.7% each in July-August 2020 from 6.2% in June 2020.
At the same time, India emerged as one of the worst-hit economies globally in the April-June 2020 quarter, given the stringent lockdown. The National Statistical Office has pegged the pace of GDP contraction in that quarter at a distressing, albeit unsurprising, 23.9%.
Subsequently, a patchy recovery has taken hold in most economic indicators. In our assessment, the contraction in GDP will halve in Q2FY21, and ease further to single-digits in H2FY21, as the economy adjusts to a new normal. However, the pace of fresh Covid-19 infections in India, as well as the stringency of the renewed restrictions being imposed by major trading partners, needs to be watched with caution.
With vegetable prices climbing in September, we expect the retail inflation to climb further in the ongoing month. Subsequently, the combination of an expected healthy kharif harvest for most crops, modest rise in minimum support prices for the upcoming rabi season, ample reservoir storage, and a favourable base-effect, should suppress the food inflation in Q3FY21.
However, the core-CPI inflation may remain decidedly sticky even in H2FY21, preventing the headline inflation from falling to more comfortable levels. Accordingly, MPC’s primary inflation-fighting mandate suggests an uncomfortable situation of a likely pause in both the upcoming policy review, as well as the next review meeting, despite the prevailing accommodative stance of monetary policy.
On the fiscal front, things appear quite dire for the Centre and the states. Given the revenue shock engendered by the ongoing pandemic, the Government of India’s (GoI’s) fiscal deficit in just the first four months, exceeded the full-year target for FY21.
We project the GoI’s net tax revenues, non-tax revenues and disinvestment proceeds to together fall short of the FY21 Budget Estimate by an alarming Rs 6 trillion. Moreover, the expenditure would be augmented by the fiscal support announced by the GoI under the “Aatma Nirbhar Bharat Abhiyan”, as well as the cash outgo for other items included in the First Supplementary Demand for Grants. Given the rather volatile monthly trend in expenditure so far, savings related to the spending restrictions imposed on various ministries and departments are difficult to quantify.
Our baseline estimate is that the GoI’s fiscal deficit will spike to Rs 14 trillion in FY21 from the budgeted 8 trillion. This exceeds the extent by which the Centre’s gross market borrowings have already been augmented (Rs 4.2 trillion), as well as the additional funds raised through the exercise of greenshoe options (Rs 0.7 trillion). Accordingly, a further expansion in the GoI’s borrowing calendar for H2FY21 of at least Rs 1.1 trillion above the current estimate of Rs 5 trillion is inevitable, even if no further fiscal support measures are announced.
Moreover, state government finances appear to be in a tough spot. In the Goods and Services Tax (GST) Council meeting held on August 27, the ministry of finance of the GoI pegged the gap between the GST compensation requirement of the state governments for FY21, and the expected GST cess collections at Rs 2.35 trillion. It offered two options for additional borrowings to the state governments for bridging this gap.
Based on our analysis of these two options, ICRA estimates that the state governments would be able to incur borrowings, and therefore, a fiscal deficit of a minimum of 4.25% of the gross domestic product (GDP)/gross state domestic product (GSDP) and maximum up to 5.52% of GDP/GSDP in the current fiscal year. This suggests that there is a massive gross supply of state bonds of Rs 5.9-8.3 trillion forthcoming in H2FY21, through normal state development loans and/or the proposed special window to be facilitated by the ministry of finance for a portion of state borrowings (up to Rs 970 billion).
In aggregate, we project the upcoming central and state government bond issuance in H2FY21 at Rs 12-14.4 trillion, resulting in a full-year supply of an eye-watering Rs 23.2-25.5 trillion.
So with an unrelenting trajectory of core inflation ahead, economic activity stuck below pre-Covid levels, and an ominous fiscal situation, what lies ahead for bond yields? This may well depend on the magnitude of bond-buying by the central bank.