Worrying fiscal and current account deficits and high inflation have been the low points for the economy for quite some time. But statements from government officials appear to suggest the worst is behind us, especially on the current account deficit front. Would you concur with the view?
There is a good chance that the current account deficit will improve from the highs of last year as the trade deficit narrows somewhat. Gold imports will fall with various policy measures having been implemented lately. Growth rates in oil imports have also been coming off with administered price hikes as well as growth slowdown telling on demand. On the other hand, however, some of the benefit from slowing imports on these items may get offset by higher imports of other items like coal and other inputs. This will be especially true if growth starts picking up without some of the supply side bottlenecks being adequately cleared.
A similar assessment can be made of inflation. Stable global commodity prices, lower primary inflation locally due to better rains, and lack of domestic pricing power should continue to exert downward pressure on inflation in the near term. However, a part of this may get neutralized from pass-through and data updating gaps in the areas of diesel, coal, and electricity. Furthermore, the recent depreciation in the rupee if sustained may also slow the fall in inflation.
It is as yet too early to call whether the fiscal story continues to improve in line with the trend since late last year. A large part of course correction done by the finance minister over second half of FY 13 was on account of compressing plan expenditure. This year the minister has assured that spending will not be reduced and instead deficit targets will be met through higher revenues. As things stand, and especially in context of a slowing economy, a substantial uptake in revenues may be difficult to achieve. To put things in context, the government has budgeted for a 22% growth in total receipts this year over provisional numbers of last year.
In the light of slowing economic growth and easing inflation, the RBI has cut repo rates by 75 bps this year so far. Do you see the central bank announcing more rate cuts in the coming months, and by how much? What is your target yield for 10 year benchmark bond by the end of 2013?
A narrow reading of the growth versus inflation dynamics for India would certainly argue for more rate cuts from the RBI. However, there are many other factors that the central bank has to also keep in mind. Topmost amongst these is India’s outlier current account, both in context to our own history as also when compared with most other emerging market peers. This poses a substantial vulnerability should capital flows to the country begin reducing. Indeed, over the past month a similar fear has been gripping markets on the back of speculation that the US Fed may reduce its QE program. Moreover, India has seen a substantial erosion in efficiency of capital over the past few years owing to issues on project and land clearances, supply linkages etc. The RBI often argues, and we concur, that government policy on these issues has a large role to play in bringing growth back and one cannot excessively rely on monetary policy alone. Finally, banks have struggled to pass through even historic rate cuts to lending rates since they are unable to bring down cost of deposits. This, in turn, is a function partly of high levels of retail inflation over the past few years that may have made rates unattractive to savers and encouraged holding of non-financial assets. Hence, even the efficacy of further rate cuts is doubtful till transmission improves.
All told, we would think that the room for further substantial monetary easing will only open up if some of the macro-economic risk factors mentioned above begin to smoothen out. On the 10 year benchmark, while we don’t work with targets, our bias will be to expect lower yields by year end. However, given the balance of risks as outlined above, there is nothing inevitable yet about the India macro story. Hence, the interest rate market may also witness its share of two way volatility.
What is your take on the liquidity situation? How do you expect short term rates to pan out in the near future?
Liquidity has been improving lately and the trend is expected to continue over the next few months. This is on account of higher government spending as well as inflows from seasonal reduction in ‘currency in circulation’ between now and September. The one wildcard obviously will be forex interventions by the RBI which in turn may have an impact on rupee liquidity. Short term rates should do well in near term subject to currency volatility and the recent FII selling subsiding.
How are you positioning your medium to long term debt funds, and dynamic bond fund now? Are you cutting or adding duration in these funds? Please elaborate with reasons for the same.
Our medium term fund is predominantly anchored around the 1 – 5 year segment of corporate bonds. Dynamic and income funds have been running longer duration bonds as well via corporate and government bonds. We have tactically taken some profits lately on these segments and reduced portfolio maturities. This is in light of a very sharp rally over last month and with renewed macro-economic concerns owing to currency volatility. We will increase maturities again once these risks stabilize.
Would you recommend investors to go in for longer-duration funds at this juncture, or rather opt for short-term bond fund?
Taking 10 year government bond as benchmark, yields have fallen from 9% in 2011 to 7.30% now. Mutual fund industry trends indicate that bulk of investor allocations since late last year have happened to long bond funds. At this juncture, after a 170 bps fall in yields the market is debating the last 50 bps odd or so. Give some macro risks as discussed above, this 50 bps may come with substantial two way volatility and over a prolonged period of time. Hence, the risk versus reward indicates that investors adopt a more medium duration strategy in this phase. This may cause them to lose some participation in periods of market frenzy (as happened in May). However, it will also plug downside risks in volatile times and help preserve returns already made over the last year. Towards this end we are advising investors to make half of new allocations to short term and medium term funds. Also, as per our underlying philosophy, we are managing our ‘longer-duration’ funds actively as well.
Weak domestic fundamentals like a record current account deficit and still high inflation has led Indian rupee to fall. This was further accentuated by the recent global dollar rally after talk that the U.S. Fed may gradually phase out its asset purchases. How do you see this impacting the domestic bond market?
Should this trend continue it will definitely be a worry for the domestic bond market. However, it is likely that the currency eventually stabilizes at some level as some of our local macro-risk factors subside. This may prolong the rate cycle and impart more near term volatility to it. However, the overall supportive themes are likely to be broadly intact for medium to long term investors.
Yields on US treasuries have spiked up recently. Do you see any impact of that on Indian bond yields?
The direct linkage is not strong given limited FII ownership of Indian debt. However, to the extent that the rise in US yields is reflective of market expectations of a change in Fed policy, it has implications for all emerging markets and currencies.
Please share your views on Inflation Index Bonds recently launched by the RBI and whether they will be of use to bond investors? How do you see retail participation panning out in this segment?
IIBs are a step in the right direction, insofar as they aim to provide an additional avenue for savers within financial markets. Retail interest may eventually pick up as price discovery improves. Also, if issuances in the future are linked to the CPI, then retail interest may get stronger.
Which segment of the market--gilts or corporate bonds--do you expect to perform better this year? Can you also share the factors which are expected to affect them?
Within the overall direction of rates, there are typically various seasonal triggers that influence demand versus supply and hence impact performance of various parts of the fixed income market. If underlying directional expectations are strong (as has been the case recently), then the impact of seasonality can get muted. Hence, portfolio strategy has to be continually evaluated depending upon the mandate of the fund as well as seasonal and directional triggers from the market.
There has been selling by FIIs in the debt markets in recent times. Do you think the sharp fall in the rupee is causing that, or are there some more reasons to this recent sell-off? Please also share your views on how you see FII flows panning out in the debt segment for the rest of 2013.
The FII selling seems part of a larger global rebalancing triggered by fears of the US Federal Reserve reducing the quantum of its liquidity injection at some point in the future. The rupee weakness partly reflects the impact of this selling. In the near term, it is difficult to take a view on FII behavior given that it is likely to be influenced by evolving expectations with respect to the Fed. Over the medium term, as the rupee stabilizes and more clarity emerges with respect to Fed policy, FII behavior may stabilize as well.