Prospects of substantial open market purchases of bonds (~Rs 1 trillion) in H2FY19 could provide some respite at the time, leading to a range-bound market.
Financial markets have been busy absorbing the developments around global trade wars, strong EM FII outflows, high oil prices and record depreciation pressures on the rupee. Recently, a lot of attention also turned to domestic policy with the announcement of the minimum support prices for the 2018-19 kharif marketing season, an announcement that was delayed significantly beyond the onset of monsoons due to its impact on inflation. The final announcement is a steep hike in support prices to the tune of ~24% for 14 crops (simple average basis) and ~14% for the 9 crops that we consider under the CPI basket. The last time such a steep hike was seen was back in FY13 where the simple average increase was ~30% y-o-y. The recent hike is a departure from the fairly benign growth rates of ~6-7% seen over the past four years.
The genesis of this policy decision was the February 2018 budget where the Centre promised a 150% premium over the cost of production. Also, in an unprecedented follow up, the government also committed to ensure that some form of income support would be provided to farmers if they were unable to obtain the floor price set for the crops they cultivate. Against the backdrop of this aspiring policy decision, speculation has predictably been rife for the past few months as to the modalities of this increase. Why are we losing sleep over this announcement that is a routine affair, and which, happens every year? Mainly because this has significant repercussions for prospects for rural income and wage growth, inflationary expectations, the inflation trajectory itself, government’s fiscal costs and monetary policy outlook. We will look at each of these in turn.
Rural wages grew at a CAGR of 30% between FY06-FY12 before dropping to -18% CAGR between FY12-FY18. While the high growth phase is characterised by policy support in the form of MNREGA payments, as well as the construction sector boom, the current phase has seen low food prices (mired by two consecutive droughts followed by a supply glut), and a protracted slowdown in the construction sector. This trend is likely to be reversed this year bolstered by the two-pronged commitment of higher floor prices and some form of income subsidy as well, if the first line of support in the form of prices should fail. This, along with normal monsoons, should have a salutary impact on farm and allied non-farm incomes and boost overall growth prospects.
However, according to us, it should also be kept in mind that food prices (given 40% of India’s consumption basket is food) have a positive bearing on CPI core services inflation through the channel of household inflationary expectations and their positive impact on wages. This leads to higher costs of production, rising prices and, in turn, leads to second order effects of demand for higher wages and inflation.
There are also logistical and execution challenges over this price and income support scheme. The Union government is debating various income subsidy programmes ranging from broad based procurement to a price deficiency payment system. Currently, the procurement system is mostly concentrated in cereals and pulses. Hence, scalability of this programme will have to be considered. Moreover, according to the Commission for Agricultural Costs and Prices, data released by select states shows that paddy procurement from small and marginal farmers was only ~18%, whereas this category of farmers make up ~73% of operational holdings. This skewed procurement pattern would also adversely affect the pass through of policy support to the intended beneficiaries. In a price deficiency payment scheme, transparency of market pricing and awareness among farmers would be important. All these factors would have to be kept in mind while framing the right scheme to best support the rural community this year. So far, the estimates of the fiscal costs of such schemes are fairly manageable at ~0.1% of GDP, but depending on the type of programme and how the season progresses, modalities could change and this risk needs to be monitored.
On the inflation front, the direct full pass through of this announcement would be ~90-95 bps, but the actual pass through is always lower than that estimated. Our estimates peg it at around 50-60 bps on headline inflation. We must note that cereals prices, which are most relevant for CPI considerations, are driven strongly by government food stock management and MSPs. Despite the rather large hike, if food stocks are managed efficiently in tandem, the final impact could be mitigated somewhat. Our own estimates suggest that headline CPI could average ~5-5.1% y-o-y for the year incorporating MSP changes as compared to expectations of ~4.6% y-o-y currently. RBI would also most likely revise their inflation trajectory higher on the back of this steep increase in the next policy meeting. Although the timing of the next hike was largely a tossup between August and October, given higher inflation expectations from MSP hikes, continued strength in crude prices and sharp depreciation in the rupee recently, we believe the probability of an action in August now is much higher than what it was after the last meeting.
Bond markets have been subject to a double whammy of deteriorating macro fundamentals and dislocations in the demand-supply situation. Although the latter is showing signs of some nascent turnaround, the former is likely to have overarching implications for yields. The combination of rising inflation, higher crude prices, fiscal uncertainties and monetary tightening may see yields tipping over even the 8% mark. However, prospects of substantial open market purchases of bonds (we estimate at least ~Rs 1 trillion) in H2FY19 could provide some respite at the time, leading to a range-bound market.
B Prasanna, Group executive, Head of Global Markets Group, ICICI Bank