In its sixth bi-monthly meeting for FY 2019-20, as widely expected and in line with our expectations, RBI’s Monetary Policy Committee (MPC) decided to keep the policy repo rate unchanged at 5.15%. Consequently, the reverse repo rate stands unchanged at 4.9%, and the marginal standing facility (MSF) rate and the Bank Rate at 5.4%. All members of the MPC voted unanimously to keep rates unchanged and to maintain an accommodative stance as long as it is necessary to revive growth, while ensuring inflation remains with the target.
The central bank revised its inflation and growth forecasts. Headline CPI inflation for Q4 is revised upwards to 6.5%, H1 2020-21 is revised upwards to 5.0%-5.4% from 3.8%-4.0% projected in December and is expected to moderate around 3.2% in Q3 FY21, with risks broadly balanced. Inflation estimates are revised upwards mainly due to pick-up in prices of non-vegetable food items, volatile crude oil prices, input costs of services and increase in custom duties of certain items. GDP growth for FY21 is projected at 6%. GDP growth for H1 FY21 was earlier projected at 5.9%-6.3%, which is now revised to 5.5%-6.0%.
Our Take
Drawing from the Union Budget
The government projects FY21 nominal GDP growth at 10%, which translates to a real GDP growth projection of 5%-6%. Tax revenue projections are toned down significantly for FY20. In fact, tax revenue growth rates for FY21 are dependent on FY20 actuals, which are expected to be below the revised estimates – resulting in FY21 growth numbers at higher levels vis-à-vis current Budget Estimates (or BE) and appear difficult to achieve, given a slowing economy. The expenditure growth rate is projected at 13% in FY21 BE, supported by 18% growth in capital expenditure including transport (roads and other infra) and parts of health, agriculture and rural development expenditure – should help boost rural income and demand. Revenue from disinvestments projected on the higher side including the sale of Air India, BPCL, LIC (IPO), etc. seems to be a huge task for FY21. Also, telecom spectrum sale might not fetch the budgeted amount due to sector level stress and pending AGR dues. FY20 revised fiscal deficit target is projected at 3.75% and FY21 deficit is budgeted at 3.54% and are on the expected lines. The government’s decision of not opting for additional G-sec borrowing in FY20 and a marginal increase in net borrowing for FY21 gave some respite to the bond market, resulting in 5-10 bps fall in G-sec yields. The government managed financing the fiscal deficit by increased reliance on small savings fund, cutting down buybacks and cash draw down buffer.
The fiscal measures announced by the government might not address the immediate near-term slowdown in demand as there was no fiscal response to increase disposable income directly. Personal tax structure rejig would eventually lead to more tax payout if opted under the new tax regime which does not offer any major exemption/deduction except investment in pension schemes unless the tax payer didn’t opt for any exemption in the old regime. Although, spending on rural, agriculture, infra, social and healthcare schemes to boost rural income and continue to support GDP growth as private consumption and capex growth remains muted.
Mixed signals by lead indicators: The latest manufacturing PMI reading of 55.3 for January, up from 52.7 in December, suggests strong growth for new orders and production. Services PMI reading of 55.5 for January is up from 53.3 in December, driven by pickup in demand. The composite PMI output index rose from 53.7 in December to 56.3 in January, reflecting growth improvement in both the manufacturing and service sectors. Urban consumption demand remains week as passenger vehicle sales continue to be in the contraction zone (-16% in Dec’19), although improving marginally as compared to previous months. Domestic air traffic growth at 3.7% for December continues to be below double-digit growth seen in previous years. Tractor sales saw nominal growth in December (up 2.4%), whereas contraction in two-wheeler sales, labor-intensive export sectors such as garments, leather and jute manufacturers (-8.5%), suggest a weak growth in the rural demand. However, this may see some improvement with pick up in food inflation, higher rabi sowing compared to the last year and government expenditure.
Sectoral deployment of bank credit shows y-o-y growth of 6.2% in the services sector for December 2019, down from 23.2% growth seen in December 2018, whereas credit growth in priority sector was at 6.1%, lower than last year, but saw some m-o-m improvement. Credit to micro & small, medium and large enterprises remains weak. Few sub-sectors saw double-digit credit growth, although broad-based recovery is still missing.
The transmission of lower policy rates saw some improvement in recent months, with banks moving to external benchmarking. Although, it may get difficult with the government’s increased reliance on small savings fund to finance the fiscal deficit, which may continue to offer attractive interest rates and could negatively impact policy rate transmission. The weighted average lending rate (WALR) on fresh loans is down by 69 bps as of December 2019. Whereas, WALR on outstanding loans is down by 13 bps. Money market rates have come down significantly, suggesting effective transmission of rate cuts. However, surplus banking system liquidity has so far not translated into higher credit growth mainly due to subdued business and consumer sentiments.
Lately, corporate bond spreads have come off due to monetary transmission, liquidity improvement, RBI’s operation twist and resolution of stressed assets. Spreads are below their long term average for AAA corporate bonds and close to long-term average spreads for AA-rated bonds. Whereas, spreads for A-rated issuers continue to remain at elevated levels (above the long-term average), although they have come off from their mid-2019 highs. Speedy resolution of the stressed assets is needed to improve the credit flow further.
Additional measures announced by RBI:
The central bank has been trying to optimally utilize available tools at disposal to support growth, improve liquidity, monetary transmission, and flow of credit – along with the traditional use of policy rate. Some additional measures announced by the RBI today are:
• Long term repo operations for improving monetary transmission. This will provide one- and three-year repos to banks at the current repo rate for up to the total amount of INR 100,000 crores. This additional window would help banks significantly in lowering their cost of borrowing and encourage them to reduce lending rates. The current one-year CD rate is around 6% and three-year corporate bonds (PSU / FIs / Banks) at around 6.7%.
• SCBs will be allowed to deduct incremental credit disbursed by them as retail loans for automobiles, residential housing, and loans to micro, small and medium enterprises (MSMEs), from their net demand and time liabilities (NDTL) for maintenance of CRR. This should help reduce the cost of funds for banks and potentially lending rates for these sectors. This exemption will be available for incremental credit extended upto the fortnight ending 31 July, 2020.
• External benchmarking of new floating rate loans by banks to medium enterprises. Currently, all new floating rate personal or retail loans and floating rate loans to micro and small enterprises (MSEs) are linked to external benchmarks.
• Extend the benefit of one-time loan restructuring without an asset classification downgrade to GST registered MSMEs that were in default as on January 1, 2020. This will benefit the eligible MSME entities which have recently become stressed.
What next?
With front-end policy rate cuts in 2019 by RBI and fiscal support by the government, RBI may continue to be on pause and wait for the measures to transpire into the economy. Spike in non-vegetable food prices and core CPI inflation (ex-food and fuel) is something that would restrict RBI from cutting rates soon. Although the MPC does expect inflation to moderate in H1 FY21 based on their forecasts. The accommodative monetary policy stance continues to provide room for further rate easing. Focus on improving ease of doing business, land and labour reforms, pick-up in government expenditures, capex and measures to directly increase the disposable income, are few immediate essentials needed to revive domestic growth – some of this has made progress, but the current economic situation warrants improved effectiveness.
What do our Valuation Implied Return (VIRs) forecasts for fixed income indicate?
Based on our valuation-driven asset allocation approach, Short and Medium-term debt offers a relatively attractive spread over its fair value return estimates as compared to Long-term debt and Cash within the Indian fixed income basket.
How have we positioned our Managed Portfolios?
Real rates driven by high term spreads, offered by the 3-7 year segment, look reasonably attractive from a reward to risk perspective. Accordingly, last month we added exposure to medium-term debt and reduced allocation to cash. We continue to remain overweight short and medium-term debt, and the current portfolio level exposure is in line with the target allocation. On the longer end, portfolio exposure is similar to benchmark or neutral allocation. We continue to monitor the portfolios closely and stay focused on helping investors achieve their goals over the long term.
