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RBI Monetary Policy: An Ideal Mix For Bond And Currency Markets

BloombergQuintOpinion

The Monetary Policy Committee has, in line with our expectations, hiked the repo rate by 25 basis points to 6.50 percent and maintained a neutral stance. The policy decisions were also an ideal mix for the Indian bond and currency markets. Yields remained flat in wake of the priced-in policy move, but it is beneficial for the Rupee over wider rate differentials. Inflation numbers were raised marginally for the second half of the fiscal year 2018-19 and set at 5 percent for the start of FY20, reflecting the Reserve Bank of India’s expectations that inflation will remain above the 4 percent target over the next few quarters, despite an anticipated moderation in the seasonally weak October and December quarters.

The RBI will navigate a challenging landscape in H2FY19 during which inflationary risks surface and growth peaks.

While our inflation views are in sync with the central bank, we are more conservative on growth.

Also read: India Monetary Policy: MPC Hikes Rates For Second Straight Time

A combination of factors complicates the inflation outlook. The government recently raised support prices for the summer crops, as the focus of policies shifts from the consumers to producers, i.e. from containing inflation to protecting incomes. These minimum support price increases carry inflation and fiscal costs, with the gap between the announcement and implementation to see an initial pass-through of 25-30 basis points this year, and the rest spilling over into next year. A more sustained lift to inflation also hinges on the procurement strategy—especially if prices fall below MSPs—through price or income support.

Most market prices of the 14 Kharif crops have been below MSP levels in the past month.

Any plans to reinforce these support prices will not only prove inflationary but also entail substantial fiscal costs.

Meanwhile, sowing activity for the summer crop continues to lag despite these MSP hikes and a narrower deficit in July’s rainfall. This likely owes to lower price realisations by farmers in the last cycle, with a likelihood of weak harvests to hurt supplies in the second half of the year, stoking price pressures.

Among the exogenous factors, the impact of higher oil/fuel prices cannot be undermined, even as the basket composition translates to a smaller direct impact on CPI inflation. The second-order pass-through to high transport costs feeding into manufacturing/food costs is worrisome. A weak rupee is also a second-order risk; the RBI estimated that a 5 percent depreciation could push inflation up by 20 basis points.

The RBI-led committee is wary about a closing output gap. We maintain our 7.2 percent gross domestic product growth forecast for the year, up from 6.7 percent in FY18. A strong first half is likely to be followed by a weaker second. The economy has recovered swiftly from the impact of demonetisation and the Goods and Services Tax. Growth improved for four consecutive quarters and hit a peak of 7.7 percent in the Jan-March 2018 quarter.

For Q1FY19 , the DBS GDP Nowcast model sees India’s growth moderating to 7-7.2 percent, followed by another quarter of around 7 percent YoY growth, before rolling off in H2FY19 on unfavourable base effects.

We expect firm urban consumption, better rural demand, and an increase in public spending to offset the negative impacts from a tighter monetary policy environment, tougher trade dynamics and elevated oil prices.

Also read: India Snatches the Punch Bowl, Just in Time

Looking ahead, fresh reforms will be less forthcoming in a pre-election year. With Parliament disrupted, public support for growth will be minimal and selective. For example, there will be incremental efforts towards boosting farmers’ incomes and ironing out GST glitches. As for the public banks, addressing the balance sheet difficulties and capital infusion will help revive private investments. The rollout of the nationwide health protection scheme will be another plus.

The bond market witnessed a sell-off in the past twelve months. The 10-year government yields ended July at 7.77 percent, up from 6.47 percent the same month a year ago. Yields have stabilised in July on improved demand for the papers. Trading volume has picked up while volatility subsided. Local demand for the sovereign paper is showing signs of revival, led by public-sector banks. Foreign debt investors continue to scale back exposure, but month-to-date outflow has moderated.

The cautious rates outlook in H2FY19 will be influenced by the inflation trajectory, evolving demand-supply dynamics and external developments. The bonds’ supply pipeline is likely to be heavy in the second half as states and the centre delay their borrowing plans.

This will necessitate the central bank to undertake more bond buybacks/open market operations to restore balance.

Here, Rs 30,000 crore has been completed till date with another estimated Rs 50,000-80,000 crore to be undertaken in H2.

Apart from the central bank turning into a net buyer, the ability of public sector banks, foreign investors and domestic institutions (provident funds, mutual funds etc.) to absorb the additional supply will dictate where the yields head to. Externally, DBS expects two more U.S. Federal Reserve hikes in 2018 to further lift U.S. rates and the dollar.

These factors suggest that a near-term consolidation in the 10-year yields is likely to be followed by a gradual rise over the next twelve months.

Also read: RBI Encourages Banks, Large NBFCs To Jointly Originate Priority Sector Loans

Lastly, markets have yet to price in political risks. Key states are facing elections at the end of 2018 before the general elections in mid-2019. There is broad concern that the united front opposition parties put up in Karnataka could turn national. On the other hand, these parties face the daunting challenge of bridging their vast ideological difficulties. More interestingly, the upcoming state elections will be a litmus test to gauge the strength of the anti-incumbency forces.

Radhika Rao is an economist and Vice President, DBS Bank, Singapore.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.