Policy Responses Step Up…
Global monetary easing is now in full swing with the lead being taken by the US Federal Reserve. Thus the US Fed has cut policy rates to the zero bound, launched a new asset purchase program of at least USD 700 billion, expanded liquidity via repo operations and undertaken other measures to facilitate credit flow including cutting reserve requirements and announce a primary dealer credit facility. Other central banks have acted as well, both in provisioning of liquidity as well as in reducing policy rates. There are emerging signs of government fiscal responses also picking up, over and above the first reactions via emergency packages. The US again seems to be taking the lead with the administration in talks for a substantial USD 850 billion stimulus package with the intent to deliver this fairly quickly. President Trump has indicated there may be bi-partisan support for such a measure. Other geographies including Europe may also step up to the plate in the days to come.
… As the Virus’ Reach Expands
The intensification of growth supportive measures comes as the Coronavirus has spread rapidly in major parts of the world, with the relative intensity now seemingly shifting away from China to other geographies. Thus the earlier narrative that was largely tracking growth peak infection in China as well as Chinese growth linkages to the rest of the world has now been upended, with prospects of a prolonged shut down in large swathes of global economic activity now almost upon us. As noted before, this comes when the global business cycle was already at a mature stage with US and China already expected to slow even without the Coronavirus shock. In the new developing scenario post the virus outbreak many forecasters are now beginning to build in more than a 50% shave-off of 2020 world growth. The sequence of spread of the virus, and the consequent implementation of lock-down measures, will also dictate the timing of the worst economic impact on various geographies. Thus while China may have seen the worst effect in Q1 of the calendar year, for a large part of the developed world this may happen over Q2.
Don’t Blame The Central Banks
Massive monetary easing and a world financial system again awash with liquidity is very reminiscent of the post Global Financial Crisis (GFC) format of the world. However, the important difference lies in the concept of diminishing marginal utility when starting size of global central balance sheets was already quite large and rates in most developed markets were already either close to zero or negative. Thus, for instance, the corporate sector had already taken benefits of this environment by ramping up leverage. It is hard to see another round of the same in response to the new round of global monetary easing. Also the nature of this growth shock is very much embedded in the physical inability of economic activity to proceed. To that extent, it can be argued, monetary policy will likely be more inefficient than usual.
These points have some merit. However, they underappreciate the channel of transmission of monetary policy. Whatever its nature, the world is experiencing a sizeable growth shock. In reaction to this shock and the related uncertainties, financial conditions (defined here as a composite of liquidity, currency movement, credit spreads and equity prices) are rapidly tightening. Even if monetary policy intervention is ineffective to address the growth issue at hand, the least central banks can do is to not allow financial conditions to tighten from what they were before. It is in this light that monetary measures should be looked at in our view, even though the bulk of the solution may indeed be with health and fiscal authorities in the current circumstance.
An Indian Assessment
India has had a challenging growth environment last year. Apart from the global industrial slowdown that had impacted us, there have been two persistent internal drags on India’s growth: 1> Stagnant income growth 2> Continuous impairment of lender balance sheets. On the back of a challenging financial year (FY)20, it is now exceedingly likely that FY21 growth will also take a big hit owing to this global shock. A continued depressed growth environment will further stress the weaker aspects of India’s current macro. In our view, the following are two of the weakest:
1. Credit: India’s perpetual impairment of lender balance sheets comes as a result of two successive ‘boom-bust’ credit cycles over the past 13 – 14 odd years : the first pertaining to the ‘old economy’ corporate assets which ran for the first 5 – 6 years of this phase, followed by the massive expansion cycle in the non-bank space (which has had strong linkages with the banking system as well) which saw its own culmination of sorts from 2018. Some topline growth rebound ahead would have possibly alleviated some macro level concerns in the credit environment (although micro issues with respect to specific balance sheets would have likely remained). However with another year of subdued growth now almost a certainty, general pressures on the somewhat weaker balance sheets are likely to continue.
2. Fiscal: India’s fiscal issues, including the effective public sector deficit versus just the center’s headline deficit, have been well documented. A large part of the pressures recently have come about owing to a fall-off in nominal GDP growth rates in a time when relatively recent measures like GST were still in the process of stabilization. As in the previous financial year, we see risks that in FY20 the actual revenue collections will fall short of the revised numbers presented in the Union Budget. This will make the FY21 projections look quite aggressive, especially given the continued growth shock that India is expected to witness in the year ahead. Furthermore, the FY21 budget relies heavily on non-tax receipts including from telecom and disinvestments. Actual realizations here may be considerably lower than projected now. All told, and after accounting for the prudent recent decision to hike excise duty on petro-products, we see a 100 bps risk to the current fiscal deficit target of 3.5% for FY21.
Against these vulnerabilities, a great strength for India at the current juncture is its substantial forex reserves and a positive basic balance (current account adjusted for net foreign direct investments). This safeguards the external account in a time of capital flow uncertainties and allows significant freedom for local policy makers to address local growth conditions.
Indian Policy Responses
As discussed above, even without undertaking significant new expenditure plans the government will likely face significant fiscal stress in the year ahead on account of the revenue side. Thus the bulk of response has to come from monetary and macro-prudential policy. The principle is similar to that described before with respect to other global central banks: general financial conditions are tightening (notably via the equity, rates, and credit spread channels in India) which the RBI needs to compensate for. Indeed the central bank has already swung into action. It has moved to first provide confidence to the forex market via dollar swaps. Next, it has announced another INR 1 lakh crores of long term repo operations. While policy rates have yet not been cut in any emergency move, the market is largely assured that they are coming sooner rather than later.
The RBI has also been consciously using the market mechanism for greater transmission of policy rates. Thus Governor Das has said that the objective of the so-called ‘twist’ operations was to influence corporate bond yields via government bond yields. Also although the long term repo operations (LTROs) are aimed at incentivizing lending, they also have been providing an important channel for market transmission since there has been no end use restriction on the long term money that the RBI has provided at the repo rate. Given these if at all the RBI seems to have ‘missed a trick’, it is to not yet show its hand in the market channel of transmission in the current sell-off. Thus between foreign portfolio investor (FPI) selling as they de-risk from emerging markets and the local investors’ own current higher preference for liquidity there has been a substantial retracement in bond yields, particularly in quality corporate bonds. This retracement is of the order of 75 – 100 bps in some cases and for the time being has completely undone the market transmission achieved over the past 6 months or so.
What Should Investors Do
Markets are providing little actual signal at the current juncture. Thus local bond markets are today hostage to the panic selling pressures as described above as investors (both local and global) scramble to create liquidity. This comes when market volumes are relatively thin as normal functioning at many places may possibly be impaired owing to social distancing measures adopted at many organizations. Having said that, it is still a bit of a mystery why banks are not showing a stronger hand in buying front end assets given that they are fresh off absorbing a large LTRO program with more on its way.
Thus while market expectations are firm that the next 50 bps rate cuts are coming, they are only currently getting expressed in swaps and in treasury bills. Whereas, even shorter end bond yields have spiked substantially. Ideally, the RBI should have been somewhat more proactive in containing this after having revealed earlier that it is indeed using the market mechanism for transmission. Nevertheless, we do think that this intervention will be forthcoming in some form or fashion and sooner rather than later.
Investors should welcome this retracement as representing yet another opportunity to allocate to quality fixed income. At 200 bps or more over the repo rate currently, front end (up to 5 year) AAA corporate bonds are offering a lot of value in our view, in an environment where more rate cuts are possibly around the corner, liquidity is heavily surplus, and the RBI is actively removing pressure on deposit rates to rise by providing much cheaper long term money at its repo rate.
Finally, it is a false perception in our view that yields on lower rated credits are attractive. At a headline level, the majority of the spread expansion over the past year is owing to a sharp sell-off in select credits where market’s risk perception is elevated. On a standalone basis, very few investors would still want to own these credits. Also, there is limited market appetite currently for lower rated housing and non-bank finance companies causing spread expansion in this segment. If one makes these two adjustments, spreads on other issuers in the AA category have not materially increased over AAA compared with the last few years. These spreads aren’t compensating investors by any stretch of the imagination for the significant financial market and macro risks that are currently in play.
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