Introduction
India’s once unassailable macro has taken some hits recently. We have argued before that this should be seen in the whole context; that our inflation and current account had compressed to almost unsustainable levels given the context of a growth economy. Nevertheless, the recent deterioration in our macro comes against rising risks in the global environment. The objective of this note is to point out some noteworthy recent data points from our own macro as well as some of the more notable global factors that bear watching. Source for all charts is CEIC and IDFC MF Research.
A List Of Darker Things
1. India’s external account: Till a year ago, India’s external account was a source of significant strength. Backed by perceived macro and political stability, it had helped turn INR into a very low beta currency versus the developed market pack. Indeed, most worries around the INR were whether it was getting overvalued and what this would mean for local industrial competitiveness. Thus our so called basic balance (current account plus net Foreign Direct Investment (FDI)) had turned positive thus entirely removing our reliance on so-called ‘hot money’. As is mostly the case in such situations, the hot money nevertheless continued to chase us leading to a problem of plenty for the RBI as reflected in the ballooning spot plus forward foreign exchange book.
The reality over the past year is now somewhat different. Our trade account has widened consistently as shown in the chart below.
The obvious attribution to this could be on rising crude and metal prices. While these components have no doubt contributed, there has been a significant jump in other classes of items as well including electronic goods and gems and jewellery. Alongside, there has been some slowdown in our net FDI run rate as well which has further contributed to widening of the basic balance. This is shown below.
It is to be noted that even with this deterioration, India’s basic balance deficit is likely to be around 1% of GDP. This is quite acceptable as it is. However, the incremental deterioration is significant and comes in an environment where global liquidity is also tightening. In this context, the sharp rise in USD LIBOR especially since February is quite noteworthy.
2. A pick up in CPI momentum: There has been a lot of noise with respect to Consumer Price Index (CPI) over the past few months. This has largely been owing to the optical effect of HRA in housing, and dramatic changes in vegetable prices (unseasonal inflation) and pulses (massive deflation). The underlying momentum when stripped of these one-offs has been largely stable over the past few months. However, the most recent CPI print has marked some turn in this momentum, as shown in the graph below.
In the graph below, we track CPI ex of food, beverages, fuel, light, petrol, diesel, and housing. This is the so-called core-core-ex housing metric. The upturn in momentum is clearer in this series as shown below.
It must be emphasized that this is just one data point. As the series shows, there have been similar upturns in the past as well, but they haven’t been sustained. Only if this upturn in momentum sustains will this start becoming an item of worry, especially given some uncertainties ahead with respect to food inflation under the new Minimum Support Price (MSP) regime.
3. A sharp rise in currency in circulation: The data on currency in circulation has got distorted for the longest time owing first to demonetization (which collapsed the y-o-y growth rate) and then remonetization (which led to a manifold y-o-y growth rate). However, as the remonetization process seemed to be maturing, there seemed to be some stabilization over the last quarter of calendar 2017. However, currency in circulation growth has spiked again starting the new calendar year, leading to media noise lately around ATMs going dry. A variety of factors are being mentioned with respect to this rise in currency in circulation including higher avoidance owing to higher tax rates on services, higher food grain procurement, upcoming elections etc. It is difficult to judge the relative importance of these as reasons. But unless proved to be temporary, this phenomenon is a set back to the theme of greater financialization, and should generally be associated with higher cost of money, ceteris paribus. However, there is another perverse logic here that may eventually turn out to be supportive of bonds. If the currency bleed continues at current run rate then, alongside a less sanguine balance of payment outlook, this may turn core liquidity negative at some point later in the year. Thus just as RBI sold bonds last year to absorb core liquidity, it may have to buy bonds this year to infuse liquidity. However, given the starting point of positive core liquidity and a substantial forward dollar book still with RBI, we think this is a theme for later in the year.
4. A continuous attempt to readjust bond supply expectations: There was a need for an adjustment to the bond demand – supply balance given the lack of risk appetite locally. This was done with the central government’s borrowing calendar. While the solution was less than optimal given that it raises second half uncertainties, it was probably the best possible given the constraints. This triggered a meaningful rally, especially in the so-called belly of the curve (10 – 14 year). Aided by a perceived dovish RBI policy, the 10 year briefly pierced the 7.15% mark also. This was unthinkable till only a few days back and frankly seemed a little excessive to us even given the new supply realities. Nevertheless, the announcement of the SDL calendar reversed sentiment quite speedily, given that it was around INR 40,000 crores larger than what market would have expected. Thus as things stand now the state plus centre calendar is heavy enough to negate the positive sentiment effect of the ‘Garg Put’ (please refer “The ‘Garg Put’ And Market Implications”, dated 28th March for details). The total volatility associated with these 2 announcements was worth around 70 – 80 bps (move down in yield and then move back up). This has had the result of killing a lot of new risk appetite in the market. As if this weren’t enough, there is now buzz that a sovereign bond issue is being planned to further reduce supply in the local market. As discussed before, this continuous news flow on bond supply is probably not desirable inasmuch that it prevents market participants on focusing on the underlying macro while making investment decisions. Also this is significantly distorting the shape of the curve, keeping it much flatter than it ordinarily should have been between, say, 4 yr and 30 yr for instance while 0 – 4 yr is extraordinarily steep. If the yield curve were being looked at as a transmitter of RBI policy, then the central bank should have been concerned with such elevated front end rates. This is probably hindering corporates and banks from raising short term money at competitive rates despite RBI not hiking interest rates.
5. Global developments: The good thing globally so far is that the dollar remains weak. Thus the INR’s underperformance is starker with respect to peers rather than against the dollar. However, at the same time funding costs are rising globally, as most clearly evidenced in rising LIBOR and widening LIBOR – OIS spreads. Meanwhile, geo-political uncertainties have risen with the US exhibiting a more hawkish foreign policy stance. While trade wars are also thrown into the mix, our chief concern here is the recent renewed strength in oil prices. Thus the USD 70 – 71 per barrel level that had proven to be a top over the past few months, has been breached and prices have sustained here now for some time. There are more geo-political risks around the corner that will bear watching in this context including US review of Iran sanctions waiver by mid-May, and prospects of political risks in Libya.
Conclusion
The underlying story for India remains largely the same: that of incremental deterioration in some macro parameters, but off a very strong base. RBI itself seems largely sanguine as reflected in their second half CPI forecast, despite a rising list of risk factors. Our intent here has only been to quantify the incremental worsening in macro and to flag evolving developments. It has also been to note developments at a global level that may require heightened vigilance from the central bank.
Given this context and the shape of the yield curve, there are 2 strong investor takeaways: 1> The front end of the curve is already building a strong cushion for any potential RBI rate action later in the year. Also, whether this rate action comes will itself depend upon some of the evolving risks mentioned here and by the RBI actually fructifying. The longer the RBI is on status quo, the better the cushion becomes on front end rates, given the already substantial starting carry. 2> There is no strong case for long duration trades, save very tactically to play short term trading ranges; if one has the ability to do so. The 4 to 30 year is too flat given the environment and market risk appetite is too inconsistent to play long duration meaningfully. Needless to say our portfolio strategies are largely anchored around these two takeaways.
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