Crude oil prices have displayed a rather volatile trend in 2018, driven by geopolitical risks and the balance of supply-demand inventories in various parts of the world.
With the relief from the decline in the CPI inflation below the Monetary Policy Committee’s (MPC’s) medium-term target of 4.0% getting offset by the inflation risks posed by higher crude oil prices, a weaker INR and an uneven monsoon, we expect monetary tightening to continue in the upcoming policy review. The year-on-year (y-o-y) CPI inflation corrected to a 10-month low 3.7% in August 2018 from 4.2% in July 2018.
This was led by a sharp drop in inflation for food and beverages, pan, tobacco and intoxicants, housing, and a moderate softening in clothing and footwear, and miscellaneous items, even as the inflation for fuel and light recorded an uptick. Crude oil prices have displayed a rather volatile trend in 2018, driven by geopolitical risks and the balance of supply-demand inventories in various parts of the world. Growing fears about the impact of the looming US sanctions on Iran have led to a surge in global crude oil prices in the recent sessions, as hopes of an increase in supply by the OPEC countries have declined.
Higher fuel prices have contributed to an upward revision in the estimates of India’s current account deficit for FY2019 to as much as 2.8% of GDP, from the muted 0.6% of GDP recorded in FY2017. Moreover, elevated fuel prices have raised the risk that the budgetary allocation made by the Central government for fuel subsidies for FY2019 could be overshot. Such concerns, combined with the faltering global sentiment related to emerging market currencies, resulted in the INR depreciating by around 6% relative to the USD in Q2 FY2019.
A weaker INR has raised the landed cost of various imported goods, including the domestic prices of fuels. This would seep into the costs associated with the provision of other goods and services, including transportation costs, going forward. After a favourable initial turnout, the south-west monsoon has been uneven and sub-par, despite flooding in some areas and a delayed withdrawal, which is unfavourable for yields and crop prices. This, in conjunction with the inflation risks posed by revised minimum support prices, higher crude oil prices and a weaker INR, would push up the headline CPI inflation to 4.6-5.0% in Q4 FY2019.
Accordingly, we expect a third consecutive rate hike in the October 2018 policy review. We anticipate that the rate hike will be accompanied by a change in the stance of monetary policy from neutral to withdrawal of accommodation. This would indicate the possibility of another rate hike in December 2018, unless the inflation trajectory softens by then.
Notwithstanding the expected monetary tightening, the central bank is likely to continue to infuse durable liquidity in the near term. The systemic liquidity shifted from a surplus in early September 2018 to a substantial deficit in the later part of the month, especially after the advance tax payments date. Liquidity is likely to tighten in H2 FY2019, led by the rising currency demand related to the festive season, harvests and state elections, as well as the busy season for credit.
In H1 FY2019, RBI conducted open market operations (OMO) to purchase Rs 500 billion of government securities (G-sec)to infuse durable liquidity, including Rs 200 billion in September 2018. Subsequently, on October 1, 2018, RBI has announced that it would infuse further liquidity through OMO purchases, bringing the total to an amount of Rs 360 billion, to be conducted in three tranches in October 2018. This has been based on the central bank’s assessment of durable liquidity requirements, as well as the seasonal pickup in currency in circulation during the build-up to the festive season.
Accordingly, ICRA has revised their estimate of OMO purchases in FY2019 to around Rs 1.2-1.4 trillion from their earlier estimate of Rs 1 trillion, given the concentration of announcements in September-October 2018, which highlight RBI’s intention to support the availability of credit to the productive sectors of the economy. Following the announcements of the reduction in the Central government’s H2 FY2019 market borrowing calendar and the upcoming OMOs, the 10-year bond yield is expected to range between 7.95-8.05% in the immediate term. Subsequently, domestic factors, such as the outlook for inflation risks and monetary policy action, and the likelihood of continued OMOs in the rest of H2 FY2019, will influence the bond yields.
Moreover, yields would be impacted by emerging information on the balance of various fiscal risks, such as the likelihood of meeting the budgeted targets for revenues related to the GST, dividends, profits, and disinvestment, and whether the outlays required for revised MSPs, the NHPS, fuel and other subsidies, and bank recapitalisation, would prove to be adequate. While corporate bond yields had already hardened over the last year, the uptick in the recent sessions may temporarily impact business sentiment.
Moreover, monetary tightening is expected to partly transmit into higher bank lending rates in H2 FY2019. Overall, interest costs are likely to rise in the current fiscal, which would weigh upon margins as well as the strength of the investment recovery. Furthermore, the ability of the public-sector banks to support lending growth remains a concern. Rising interest rates would aggravate the impact of higher fuel prices on the disposable incomes of consumers.
This may offset the positive impact of the recent GST rate cuts, and temper the consumer sentiment ahead of the upcoming festive season. Such factors would also squeeze the margins of producers, preventing a faster pickup of economic growth. Overall, given the various risks posed by an uneven monsoon, higher commodity prices and interest costs, a weaker INR, and the looming threat of trade wars, ICRA expects a shallow recovery in the GDP growth to 7.2% in FY2019 from 6.7% in FY2018.