‘Omicron’ delays policy normalisation

By Chintan Mehta |  08-12-21 | 
 

All members of the Reserve Bank of India (RBI’s) Monetary Policy Committee (MPC) decided to keep the policy rate and its accommodative stance unchanged (5 to 1 majority), with the focus being on growth revival as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward.

Concerns around rising global covid infections and new variant Omicron cases led RBI to take a cautious stance on the growth-inflation dynamics. The focus continues to be on growth revival as the economy is not completely out of woods.

The GDP (Q2 2021-22) is down ~6.8% when measured from the level of GDP recorded pre-pandemic (Q4 of 2019-20). Q2 numbers show that government expenditure, exports, and imports are well above the pre-pandemic levels, however, private consumption and capex are still below the levels seen in Q4 of FY 2020. With FY 2022 GDP expected to grow at 9.5%, the economic activity would then be above pre-pandemic levels. High-frequency lead indicators are seeing a month-on-month improvement across segments. Both, urban and rural consumption demand is inching close to pre-pandemic levels.

Indian manufacturers signaled a growth pick up in November as the demand outlook improved. The services PMI continued to show strength in November supported by improvement in overall demand. Although, rising input cost pressures remain a major challenge.

Auto sales demand sees improvement, however, semi-conductors shortage is severely impacting the supply with sales still below the pre[1]covid levels. Both direct and indirect tax collection numbers continue to show strong growth. This would give some more flexibility to the government for extra fiscal spending. The government is considering extra spending of around INR 3 trillion which will be used for equity infusion into Air India assets holding company, fertiliser subsidies, export incentives, food warehouses, and rural job schemes.

The formal sector unemployment rate has stabilized around pre-covid levels. RBI’s survey shows improving business outlook and consumer confidence. Businesses plan to expand production volumes as they expect a pick-up in new orders. Other lead indicators (fuel and power consumption, e-way bills, etc.) also show improvement in business activity.

However, much of the near-term growth outlook is dependent on the progress of the vaccination coverage, which is progressing well with ~52% of the adult population fully vaccinated. The recent rise in global covid infections and emergence of a new covid variant can pose a serious risk to the growth prospects. On the inflation front, headline CPI inflation inched up marginally in October to 4.5% from 4.3% in September, driven by a rise in vegetable prices and fuel inflation (up 14.3%). Core inflation remains sticky at around 5.9% with continuing input cost pressures. However, the recent fall in global crude prices and reduction of excise duty and VAT on petrol and diesel should help to scale down fuel inflation.

The headline inflation projection for FY 2022 is retained at 5.3% with risks broadly balanced. High inflation lowers the relative real rate attractiveness among EM peers (Brazil and Russia have hiked rates by more than 3%), which could lead to FPI outflows from the debt market. We believe, moderation in core inflation with improving supply conditions should give room to the RBI to maintain a growth supportive stance. As a result, the RBI could maintain a status quo on the policy stance until the economy sees a robust and durable growth recovery. Although it may initiate further measures to roll back the excess liquidity.

The household sector has seen a rise in debt levels as the pandemic impacted earning capacity. Additional direct fiscal boost (MGNREGA) by the government to improve disposable income should help in reviving consumption demand on a durable basis. Strong external demand is an opportunity for India and further policy support should help in capitalizing on this.

The Production Linked Incentive (PLI) scheme to boost local manufacturing is a step in the right direction. Also, the government’s focus on capital expenditure bodes well for the investment cycle which started to gain momentum. This along with the recently launched National Monetisation Pipeline (NMP) should give a boost to capital formation and infrastructure development. These measures should help to get private consumption and capex overshoot pre-pandemic levels by the end of FY 2022.

Market participants were largely expecting a reverse repo rate hike in today’s policy. The governor mentioned its approach to use 14-day variable rate reverse repo (VRRR) auction as the main liquidity management operation. The amount parked in overnight reverse repo has seen a reduction with the major portion of banking liquidity being parked in longer tenor VRRRs offering higher rates (~3.98%), making it the effective policy rate.

The shorter end of the yield curve could flatten in the near term with further normalization in the banking system liquidity. Recently, the yields at the shorter end have firmed up by 30-35 bps. The 10-year benchmark G-sec is hovering in a tight range of 6.3% - 6.4% and may continue to be in this range amid a lack of fresh triggers. The RBI and markets would track commentary & steps taken by major central banks particularly the US Federal Reserve to normalise monetary policy with the rebound in growth and signs of persistently high inflation.

Our asset class research suggests that going ahead, investors will struggle to post significant gains in bonds as we are around the turning point of the current low-interest rate cycle. The annual return expectation from bonds would be more normalized as compared to high teen returns delivered in the last couple of years.

From a long-term perspective, we think bonds remain a necessary stabilizer for multi-asset portfolios, and medium-long duration bonds are likely to provide a cushion when equities sell-off as they offer attractive real rates. Based on our valuation implied return (VIRs) forecasts, the medium to long-term debt segment (5-10 years maturity) looks relatively more attractive than cash and high credit quality short-term debt.

On the corporate bond side, credit spreads have also narrowed lately, compressing the net of expenses yield difference between banking PSU debt funds and credit risk funds. Although the absolute return expectation for credit risk is slightly higher due to better carry. However, one should be mindful of potential downgrades and defaults and their impact on the credit spreads which needs to be monitored carefully.

On the corporate bond side, credit spreads have also narrowed lately, compressing the net of expenses yield difference between banking PSU debt funds and credit risk funds. Although the absolute return expectation for credit risk is slightly higher due to better carry. However, one should be mindful of potential downgrades and defaults and their impact on the credit spreads which needs to be monitored carefully.

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