A point of note for us over the past few months has been the lack of further weakness in the US dollar. We have delved into this in detail in a previous note (Click here). While watching this closely, the only conclusion we draw for now is the obvious reminder that degrees of freedom for policy making are wider for emerging markets when dollar is weakening, and narrower when its strengthening. Barring this there is nothing alarming yet about the dollar, and we have seen much stronger levels on this earlier in the year.
That said, India continues to see muted capital flows so that despite low levels of current account deficit, the balance of payment (BoP) remains quite modest. One assumes that with the recent nominal growth slowdown having likely bottomed out, growth seeking capital should start seeing us soon with fresh eyes. However, for the time being one sees muted BoP alongside some renewed dollar strength plus some recent rise in goods imports. This last point deserves a closer look and we had done so last week (Click here). Some key charts are presented below:
As can be seen there is notable addition to non-oil-non-gold imports this year so far, over the addition made over the corresponding period last year. At the same time non-oil export growth has come off. While this development is one to monitor, there are nevertheless caveats to remember. One, there are distortions owing to significant tariff volatility and there is a good chance that they settle down eventually. Two, while the ‘core’ goods trade dynamics seem to have worsened this year, there have been offsets from a fall in oil imports and rise in services trade surplus so that overall addition to trade deficit year to date is quite modest.
Thus, what we are tracking so far is some adverse change in direction of travel for the combination of dollar strength+ trade account dynamics, even while recognising that this may be temporary and levels on these remain quite comfortable.
A similar conclusion, differentiating direction of travel from levels, can be made with respect to fiscal developments as well. The chart below tracks the slowdown in tax revenue growth thus far this year and the run-rate needed for the rest of the year to achieve budget targets.
As can be seen the ask now seems steep, even as some of the gap will likely get met with an anticipated rebound in the nominal growth rate of GDP. Also, as the chart below shows, total expenditure growth is tracking well, even as some rejig within capital and revenue spending may very well be in the offing going forward.
Finally, and probably most importantly, the central government has shown strong credibility with respect to fiscal management and there is no serious thought in the market that deficit targets won’t be met. However, there is a case to move to targeting fiscal bands rather than point targets from the next financial year. This will provide greater near term fiscal flexibilities and will be consistent with targeting medium term debt to GDP, which is the framework the centre is anyway moving to from next year. From a market standpoint, positive fiscal surprises are unlikely hereon even as positive duration supply surprises may very well be forthcoming via, as an example, increasing proportion of treasury bill borrowing from the next financial year.
Putting It All Together
The recent direction of travel is for stronger dollar + some widening in our core goods trade deficit + some reduction in fiscal flexibility. It is important, however, to also note that 1>levels aren’t a concern, 2>this recent direction could well reverse. At the same time, and this isn’t of recent origin, bond market’s overall risk appetite is quite low so that there is an asymmetry in market’s response to a positive trigger versus a negative one. Given all of these, we can’t rule out a period of side-ways to somewhat more volatile market even as a final rate cut and possibly substantial RBI bond purchases ahead will decidedly remain reasons to remain engaged.
The net summary of all these factors has resulted in us turning somewhat defensive for the time being, by cutting maturities and increasing cash / quasi cash exposures in some of our portfolios. This is pending further evolution of the dynamics mentioned above and is only meant to navigate potential temporary volatility. As always this represents our thinking at this point in time. This can change basis further developments, or perspective and / or valuation changes.
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