The second quarter credit policy review in our assessment has finally indicated a shift in monetary stance that is expected to be relatively more sensitive to growth. The three-point stance of the policy clearly states “stimulation of investment activity to support raising the trend growth” as one of its intentions. RBI in its policy statement has distinctly taken note of the “considerable risks to growth” primarily through the investment leg that has weakened more than what was intended by the tight monetary stance. Furthermore, the outlook on inflation seems more benign on account of the weaker momentum when observed through the lens of seasonally adjusted quarter-on-quarter upticks.
At Birla, we believe the rate hike today was primarily encouraged by risks of a premature halt to the anti-inflationary stance when the headline inflation still remains significantly higher than the perceived medium term guidance of 4-4.5%. But more importantly, the policy action going forward is expected to hinge on the evolving macroeconomic situation and its impact on the potential growth trajectory for the economy.
- Reserve Bank of India (RBI) has distinctly taken note of the “considerable risks to growth” primarily through the investment leg that has weakened more than what was intended by the tight monetary stance
- Lead indicator on domestic capital formation observed in CMIE’s new project announcements has reported no growth since the June 2010
- The consumption slowdown is visible in the 6% growth for June 2011 quarter (200 basis points lower than last 7 year’s growth) and is expected to remain subdued going forward
- Europe is the central risk for global markets right now
- As the run-rate of decline in inflation below the 7% is realised, RBI may correspondingly wish to revert from a neutral to a rate-softening stance
- In essence, the deregulation of the savings rate is akin to an additional tightening of rates
- As 8.50% may be the peak Repo rate for this business cycle, we view the AAAs in the 1-3 year bucket which are currently trading at 9.50% -10% as being attractively priced
What should an investor do?
- Slower growth and lower inflation would take out the steam from interest rates. It is advisable that investors hide their savings in long and mid duration funds. We want to emphasize that the rate easing will not resemble the ‘2008-09 easing period’. It will stay for longer and possibly will go farther.
Domestic growth- A Secular and extended slowdown ahead:
In our assessment the 8% trend growth or arguably the potential growth looks hard to achieve now over the coming 6-8 quarters as the domestic demand slowdown becomes more secular and prolonged. Our 7.25% or thereabouts expectation for GDP growth in FY2011-12 looks to have a longer shelf-life, which would, in a way, bring down the potential growth path for the economy, amid growing risks of contagion from the global economic weakness.
Lead indicator on domestic capital formation observed in CMIE’s new project announcements has reported no growth since the June 2010, the average quarterly run-rate declining from FY2010-11’s INR 4.2 trillion to INR 3 trillion in FY2011-12 so far. Furthermore, the projects under implementation posted their first ever quarterly contraction since March 2004 which is consistent with the central bank’s admission of the investment cycle turning for the first time since FY2003-04. While the investment slowdown has been around for longer, consumption slowdown is visible in the 6% growth for June 2011 quarter (200 basis points lower than last 7 year’s growth) and is expected to remain subdued going forward.
Weaker leveraged consumption owing to higher interest rates and the absence of fiscal support to push the un-leveraged (largely rural) consumption support our expectation of a 7-7.25% growth in private consumption in FY2011-12.
Global growth and its implications:
Furthermore, India’s growth will be impacted by this global growth slowdown through both the trade and financial linkages. These concerns are corroborated by Eurozone PMI falling to 47.2 in October, a reading consistent with economic contraction. Our sense is that RBI is not only concerned about global growth slowdown but also financial linkages if another liquidity event like 2008 was to repeat. As a result, RBI mentions that it’s important for policy makers to be prepared for tail risks. We think Europe is the central risk for global markets right now. The sovereign debt crisis in Europe is primarily a result of countries like Greece, Italy, Portugal etc., having very high debt as a % of their GDP. With economic growth trending 1-1.5% in Europe over the last decade, we don’t think that these countries can sustain Debt/GDP north of 100%. As such, the current problem in Europe is expected to linger till the fundamental problem of high Debt/GDP is resolved. Encouragingly, European policy makers are finally talking about writing down 50-60% of Greek debt, a major pre-requisite to solve the Greek debt problem.
Our assessment on Inflation:
On Inflation, our assessment has been governed by the progressively weaker momentum and the deteriorating domestic demand scenario. With the gradual softening in the core inflationary pressures, we believe the WPI trajectory in the coming months may well be on its way to outperform the 7% guidance of the RBI. Our base case of 6.3% by March 2012 makes us believe that as the run-rate of decline in inflation below the 7% is realised, RBI may correspondingly wish to revert from a neutral to a rate-softening stance. We continue to believe the softer rate regime would be initiated through liquidity infusion by way of OMOs by end-Q3 FY2011-12 and CRR cuts in Q4FY2011-12. Repo rate cuts would find policy preference only later.
Inflation trends across months for various years
For the 7% March 2012 guidance to be realized, we need a 2.7% inflation build-up for the October-March period relative to a 6-year average and our base case build-up of 2% for the same period. In our view, inflation trajectory
Inflation Build-up for the October-March period
Our estimate of inflation trajectory….
Consequence of deregulation of savings rate:
A large portion of the savings bank deposits which constitute ~25% of the total deposits in the banking system are considered to be sticky. Banks apportion a large part (70% to 90%) of such savings deposits as long-term liabilities with maturity greater than 5 years for the purpose of their Asset Liability Matching. Most of this apportionment is based on the behavioral analysis of savings accounts.
The savings rate deregulation shall enable banks with a smaller CASA share to aggressively differentiate their savings deposit product, which can create volatility in the proportion of savings bank deposits to overall liabilities of various banks. Thus, Asset Liability Management for most banks, especially many public sector banks shall become challenging. These banks currently have stretched ALM profiles on account of increased exposures to long term loans, especially in the infrastructure sector. If a few banks display aggressive behavior to capture liability market share, it would increase cost of funds for the system as a whole, at least in the short term. A natural consequence of this re-pricing shall be a steepening of the yield curve on the credit side making long-term credit costlier. Thus the rate deregulation has the potential of creating a structural floor to monetary easing. In essence, the deregulation of the savings rate is akin to an additional tightening of rates.
Be prepared for an extended slowdown:
Since the past two quarters, we have been arguing for a substantial moderation in the growth trajectory for our economy (our growth forecast for FY2011-12 and FY2012-13 is 7% - 7.25%).
We believe that India is entering a slower growth phase which will last for the next 6-7 quarters. The external growth environment has been worsening for some time, and increasingly appears structurally weak. Our economy also faces higher and taxing interest rates which shall hurt growth cyclically. More importantly, the government which generally acts counter cyclically in times of a slowdown, doesn’t have the option to do the same this time round.
Market forces, credit rating agencies and the general political climate across the globe have reduced the government’s ability to pump prime the economy. The Indian government has realised how severe the punishment can be if it deviates from its stated fiscal path. Just 50,000 extra borrowing announcement by the government re-priced the bond yields by 50 bps, despite the common knowledge being that the government would borrow more in this financial year.
Ideally the government should look for alternate sources of funds instead of relying only on the domestic bond market to raise resources e.g. accessing international capital markets, linking small saving rates to the Repo rate or G-sec. We think a lot of such initiatives are being contemplated by the Government.
Bull steepening to play out:
Since May 2010, the big trade was “Anti Liquidity” and now it has given in to “Pro Liquidity”. We believe that markets are geared up for a bull steepening, as the shorter end of the corporate curve gets anchored to the Repo rate (in a slowing economy) whereas longer bonds are anchored to Government bonds. As 8.50% may be the peak Repo rate for this business cycle, we view the AAAs in the 1-3 year bucket which are currently trading at 9.50-10% as being attractively priced. A fairly large distance from Repo rate would ensure that these bonds would rally for considerable period through the slowdown. Longer end too should benefit absolutely, but given the stress in public finances, continuous and increased government borrowing may continue to keep pressure on the 5/10 year corporate bonds. Additionally the savings rate deregulation would result in the longer end of the curve remaining steep.