Analysis projects the beginning of the next big wave of bond rally in India...
30-May-2013 •Manish Bhandari
Over the past two years, there has been an interesting disconnect between the global and Indian business cycles. While the rest of the world, particularly the western central bankers, have steadfastly focused on reviving growth since 2011, India has been caught in a strange dilemma between high inflation and elevated current account deficit (CAD) on one hand and a pretty significant growth slowdown on the other. No wonder our central bank has adopted a cautious and calibrated approach over the past 18 months.
If history is to go by, a slowdown is the best medicine for all macro risks. As economies are smart beings, they tend to correct excesses or imbalances automatically during a slowdown period. Moreover, growth slowdown is generally the automatic response to high inflation or high CAD. In this scenario, central bankers typically pre-empt high inflation or CAD and try to moderate growth by making money pricier. The RBI did the same to tackle these risks, though many argue that the response was delayed and slow.
One of the key economic puzzles in India over the last few years has been the stubbornness in our inflation. Despite growth slowing down from 9.3 per cent in FY11 to 6.2 per cent in FY12, WPI inflation remained sticky at 9.0 per cent in FY12 compared to 9.6 per cent in FY11. Similarly, while growth slowed down to a decade low of ~5 per cent in FY13, WPI inflation at ~7.4 per cent still remained considerably above the RBI's comfort zone of 4-5 per cent.
The Indian economy struggled with this non-textbook macro-economic environment in mid 2012, when we spotted an opportunity for a significant bond rally in India and came out with our 7.5 per cent prediction on the 10-year bond in August 2012. Now that we have travelled by more than 60bps since then and are in striking distance from 7.5 per cent, it's appropriate to look beyond.
Our analysis intends to mark the beginning of the next big wave of bond rally in India, which compels us to put forward our case of 10-year G-sec to breach 7 per cent levels by the conclusion of the current rate cycle. Our projection is based on the analysis of-- the growth-inflation dynamics, demand-supply technicals, liquidity situation, credit segment and security specific factors.
While the consensus on FY13 GDP stood steady at 6 per cent in August 2012 at the time of our earlier forecast. We were amongst the very few looking at a dismal 5-5.5 per cent rate of GDP growth. As unfortunate as it could be, it turns out that we were right and hence, we may end up witnessing a decade of low rate of growth of per cent for FY13. Looking forward, we expect FY14 GDP to remain low at ~5.5 per cent with a downside bias. We also feel that the continued slowdown over the past 24 months is likely to remain protracted in the absence of any turnaround in the current sluggish investment scenario, which in our view is difficult to foresee in this fiscal.
Although growth is expected to remain subdued, the silver lining in India's macro story would come from a further decline in headline inflation. The low-growth, high-inflation scenario haunted us for quite some time, but as it now appears, it was in fact only a matter of time for inflation to follow the declining trend in growth, albeit, with a lag. For FY14, we expect WPI to moderate to ~5.5 per cent from the 7.4 per cent in FY13.
Once the inflation devil is tamed, the next villain threatening the macroeconomic stability is the ballooning CAD. Just like inflation, CAD was another counter-intuitive part of the Indian macro story. Despite continuous growth slowdown, our CAD worsened from 4.2 per cent in FY12 to ~5 per cent in FY13. But looking forward into FY14, we expect CAD to moderate to 3.5-4 per cent largely due to a moderation in our net oil imports, some improvement in the non-oil, non-gold trade balance and rupee remaining stable at current levels.
A macroeconomic scenario characterised by low growth, moderating inflation and receding CAD should eventually pave way for the RBI to become more responsive to the current growth slowdown. In order to arrest the slowdown in growth momentum while risks of inflation re-emergence remain under check, we expect RBI to cut repo rate by another ~75 bps in this fiscal. To top it all, we expect that with a change in guard, RBI's view on liquidity and rates is likely to become more benign and as we bypass the inflation and CAD risks, the entire thesis of maintaining liquidity deficit when in an anti-inflationary stance would undergo an ideological change.
We expect RBI to leverage multiple tools to ease liquidity such as mopping up USD flows, open market operations (OMO) and CRR cuts through FY14 and FY15. All this should translate into an additional effective easing of ~175 bps in the current rate cycle, where we expect middle of the corridor to become the operative rate. Therefore, we expect terminal repo rate to settle at 6 per cent by the end of this cycle. We believe the 10-year G-Sec will rally from the current 7.7-7.8 per cent levels to inside of 7 per cent within one year. Moreover, we believe that there is a good case for State Development Loans (SDL) and corporate bond spreads to tighten further going into FY14 as high quality assets will remain well bid. We see terminal spreads for SDL's at 25bps and AAA PSU's at 50bps.
Will low rate regime be durable?
I think the answer to this lies in the state of corporate balance sheets and increased stress in banks books. The RBI had ensured a low rate regime during 2001-03 to stimulate investments from corporate and heal the balance sheets of banks which came under severe pressure due to protracted slowdown. In the past of couple of years, there has been a similar leverage increase in corporate balance sheets and consequent stress which is manifested in elevated bank delinquencies. All this strengthens the durability of the rate reduction cycle.
Past analysis show us that secular and prolonged rate reductions have been employed by the RBI to stimulate investment. The same has helped to heal non-performing assets (NPA) losses with treasury gains from SLR holdings in bank's books. Years FY01 to FY04 have seen nearly 30 to 50 per cent of operating profits being contributed by treasury gains, largely a function of downward rate resets by the central bank.
But of course, like any other proposition, our hypothesis too is subject to some risks. A key risk that may alter our view is the uncertain political scenario that may result in early general elections. Any such advancement of elections may force the RBI to halt the rate easing cycle as the government recalibrates its fiscal framework and its response to critical policy concerns.
Nonetheless, if everything pans out as we have envisaged, then I would like to argue that we are in the process of setting up the stage for a brand new business cycle, as important condition precedents such as low rates, low inflation, substantial cumulative output gap and awakened government, for sustained recovery are falling into place.
The author is Co-Chief Investment Officer of Birla Sun Life AMC.