March 2019

India: Calmer waters ahead?

Paharganj_New_DelhiAfter a less-than-stellar 2018, investors in Indian sovereign bonds could be in for a pleasant 2019. the outlook for the rupee, despite being mostly stable, is harder to ascertain, writes Dilsher Dhillon. India ended last year in a better-than-expected position owing to the collapse in global oil prices, which considerably eased currency and inflation pressures and boosted import coverage. Despite an exodus of foreign portfolio investment, domestic investors kept equity markets humming along. Meanwhile, the Reserve Bank of India (RBI) provided ample liquidity support amid a shadow banking crisis through its bond-buying programme and a currency swap arrangement with Japan. After depreciating by 14% between January and October, the rupee rebounded to finish 2018 below the 70-mark against the US dollar – capping an annual decline of 8.5%. The yields on India’s ten-year government bonds also experienced a sharp late-year drop, closing at 7.4% as the liquidity and inflation situation eased, after rising for five successive quarters. Looking ahead to this year, a number of factors bode well for India’s bond and currency markets. Retail inflation crashed to 2.19% in December 2018 – an 18-month low – owing to a reduction in fuel prices and an oversupply of agricultural commodities. Inflation will continue to be subdued in 2019. In its monetary policy meeting on February 7, 2019, the RBI lowered its inflation forecast for the first half of the coming fiscal year to between 3.2% and 3.4% from 3.8% and 4.2% previously. At the same meeting, the central bank cut interest rates for the first time in 18 months – a move that will likely offset an uptick in bond yields following the announcement of a rather profligate interim budget by prime minister Narendra Modi’s government. The RBI also shifted its policy stance from “calibrated tightening” to “neutral”, indicating that another rate cut might be on the cards. Staying attractive
“Lower inflation projections could spur the RBI to continually ease its monetary policy,” says Praveen Jagwani, chief executive of Singapore-based UTI International Private Limited. “This, in addition to a fiscal stimulus, will result in bond yields trending down over the course of 2019 barring any external factors like an oil shock.” Another rate cut and liquidity support by the RBI, which is slated to continue its open-market purchases of government securities, will keep bond yields low. Away from home, an expected pausing of rate hikes by the US Federal Reserve (Fed) will prove to be favourable to India, according to Steven Leslie of the London-based Economist Intelligence Unit. “Recent market weakness, combined with a more accommodating stance by the Fed in the US, means that India is likely to retain its attractiveness for investors in 2019, bolstering local securities markets and providing a cushion for the value of the rupee,” says Leslie. In addition, robust private consumption and credit growth as the effects of economic reforms like the Goods and Services Tax (GST) regime and the bankruptcy code bear fruit will cement India’s status as the world’s fastest-growing economy. A higher ranking in the World Bank’s Ease of Doing Business Index (77th in 2018 as opposed to 100th in 2017) will also please investors. Both the International Monetary Fund and the World Bank predict that India’s GDP will grow by 7.5% this year, well ahead of China, which is forecast to grow by 6.2% amid trade tensions with the US and lower domestic demand. There are, however, two big areas of uncertainty: the price of crude oil and national elections. It’s all about oil
While sluggish global demand due to trade tensions, China’s economic slowdown and Brexit uncertainty are expected to keep oil prices stable in the first half of 2019, a rebound in oil prices at the beginning of year due to Opec cuts has made investors jittery. A renewal of hard US sanctions on Iranian oil in mid-2019, when waivers are set to expire, will have a significant impact on oil markets and emerging market currencies. India in particular will likely be nervous, given that it imports 80% of its oil requirements. But Jagwani is not too perturbed by oil prices. “We think that the impact of the slowing global growth will effectively counter falling output in Iran and Venezuela in addition to Opec-directed cuts,” he says. He adds that this will keep oil in a narrow range for most of the year, which portends a solid level of import coverage for India. “Hence, the case for a stable INR in the band of 70-74 against the US dollar is reasonably strong.” Second time lucky for Modi?
In the build-up to elections, the risk of fiscal slippage could subdue foreign investment inflows, especially to sovereign debt. Irish playwright George Bernard Shaw once referred to elections as a “mudbath for all souls concerned”. As India prepares to go to national polls in May, the next government will have a lot of cleaning up to do once it inherits the balance sheet. Despite its constrained finances, the Modi administration has unveiled a series of handouts to farmers and business owners – two key voter blocs – and other stimulus measures to boost its re-election chances. In its interim budget, released on February 1 this year, the government ramped up funding for a rural jobs programme and announced a cash transfer scheme for the nation’s farmers – an initiative that it has allocated 750 billion rupees towards. In a bid to keep business owners happy, the government is also expected to go easy on the enforcement of GST compliance norms for small and medium enterprises, which will culminate in a greater-than-expected shortfall in tax revenues. This level of generosity will add to India’s already high debt burden. The current government had originally targeted a fiscal deficit of 3.3% of GDP for the year ended March 2018, a figure it expects to breach by only ten basis points, as indicated in its budget announcement. However, that seems to be an optimistic estimate. “The government is likely to miss its fiscal deficit target by around 0.3%-0.4% of GDP,” suggests Abhishek Goenka, CEO of India Forex Advisors. “This will roughly translate to a 800- 900 billion rupee hit to the Exchequer” he adds. To minimise the damage, the Modi administration is expected to secure a sizeable interim dividend from the central bank. Despite a setback in three recent state elections, a victory for Modi’s Bharatiya Janata Party (BJP) is predicted in the national elections, albeit with a less conclusive majority than in 2014. As campaigning gets underway, the party is putting all its muscle behind its populist leader, whose welfare schemes, oratory skills and humble background as the son of a tea seller continue to resonate with the masses. A second term for the BJP will ensure policy stability and the continued implementation of economic reforms, boding well for the rupee and bond yields. A coalition government, or one that is led by the re-energised Congress – the BJP’s main rival – will put this at risk, but the impact may not be felt for long. While an unfavourable election result could lead to some panic and corrections in the immediate term, things are expected to smoothen afterwards. “Capital markets are going to be volatile because of elections but will stabilise in the second half of the year” says Srinivasan Subramanian, the head of institutional equities at Axis Capital Ltd. “Inflation is very nominal, so bond yields will fluctuate within a narrow range” he adds. Optimism meets prudence
Like most of India’s emerging market peers who had a forgettable 2018, the low valuation in its currency and debt markets offers an enticing invitation to foreign investors. Risks of fiscal profligacy may be rising, but the impact on bond yields and rupee will likely be offset by sluggish inflation and rate cuts. In fact, monetary easing by both the RBI and a dovish stance by the Fed could push the yield on India’s ten-year sovereign bonds to below 7%. This will, of course, depend on oil prices remaining stable, which in turn will allow the rupee to depreciate within a narrow band and prevent a widening of India’s current account deficit. As a sudden shock to oil markets in 2019 does not appear likely, the rupee is expected to perform convincingly better than it did last year. ©2019 funds global asia

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