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Last one year has been an exceptional year for Indian Interest rates. While Policy rate viz. Repo Rate has been cut by 25 basis points, the official stance of monetary policy is neutral, and market yields have jumped more than 100 basis points. This behaviour could be the function of rising US yields, the hawkish tone of the Monetary Policy committee, fiscal slippage, expected rise in inflation, absence of bank treasury in Gilts market or combination of all the above factors. This has resulted in above average real interest rates in India which are higher than nominal interest rates in most parts of the world. High real interest rates are benefitting savers but hurting investment. Despite the annual oil bonanza of more than $50 billion, investments are falling as demand is subdued. High real interest rates are resulting in an overvalued rupee which has attracted more than $120 billion plus of carry flows in last three years from global debt investors.
The overvalued rupee is adversely impacting exports and permitting dumping especially from countries like China. India’s trade deficit with China is likely to exceed $60 billion in FY18 based on official as well as unofficial data. There is no other country in the world whose trade deficit with China is as high as 2.5 % of GDP. This is hurting India’s small and medium enterprises in the manufacturing sector. Under the twin burden of high real interest rates and overvalued currency they are facing immense pressure.
Rising US yield can’t explain the rise in Indian yields. Historical spread between Indian and US 10 year yields have been 4.5%. If we adjust for improvement in inflation difference and fiscal deficit difference between US and India than a much lower spread is justified. At 480 basis point spread between Indian and US 10 year yield we have more than adequately discounted future US rate hikes. Case in point is Thailand with similar macro data like India has a 10-year yield well below US yields. US Fed along with other central banks of the world are likely to be calibrated and gradual in their approach in raising rates. Case in point is Japan which hasn’t been able to reduce its liquidity support and zero interest rate regime for the last 28 years.
Monetary policy committee has been mandated to manage inflation around 4% with a leeway of 2%. They are managing headline inflation rather than core inflation which makes their job difficult. Obviously raising interest rates in India doesn’t bring down onion prices or global oil prices. In fact, managing food or fuel inflation through an interest rate policy is counterproductive. India is a borrow to invest economy rather than borrow to consume economy like the US. In the US raising interest rates have an immediate impact on household spending. This means aggregate demand as EMI increases is met from a reduction in other spendings. In India, raising interest rates impacts investments and capacity creation rather than aggregate demand as we are hugely an under-leveraged economy and most of the borrowers are from the upper end of society who don’t reduce their spending to meet the increased EMI burden. The market is used to the RBI managing conflicting objectives like growth, inflation, Currency, Borrowing Program etc. They are getting used to the regime of MPC. MPC, on the other hand, is being judged on the narrow inflation targeting objective.
Inflation is down from double-digit to mid-single digit but inflationary expectations aren’t down commensurately. High real interest rates are necessary to rein in inflationary expectations. This phase is like the Paul Walker era at US Fed which broke the back of inflation in the US.
Fiscal slippage in FY18 as well as FY19 Budget is marginal and can easily be absorbed by the market even without opening additional FII limits. The RBI having done OMOs during the demonetisation induced liquidity phase should have enough dry gun powder. While the trajectory of inflation is on the higher side, it is well within the comfort zone of the RBI. It has the component of housing inflation coming through the Seventh Pay Commission pay hikes on Housing Rent Allowance. We are a unique country which has allowed a circular relationship between HRA allowance of Government employees being used to calculate housing inflation and Inflation being used to calculate Pay hikes. It is of extreme importance to modify MPC mandate to allow them to focus on inflation which can be influenced by interest rate and liquidity rather than broad headline inflation. In the absence of such modification, we might end up putting a Blood Pressure affected patient on a treadmill for exercise rather than ICU for taking rest in the event of a heart attack.
Banks turned sellers of Gilts on Jan 18 after a long period of time. Their buying absence in Gilt Market is felt significantly. They are facing capital shortage despite a $31 billion infusion by the Government to cover NPAs. Rising yields have adversely impacted their profit and consequently capital requirement. They are reducing their Gilts exposure to manage Duration Risk. Without their participation, no borrowing program of the government can be completed. Indian yields will be influenced to a great extent by how banks resume buying of Gilts in FY19.
Indian yields on a fundamental basis look attractive. Case in point is Fully utilized FII limits in the Gilt market despite India not being a part of the Bond Index.
The technical factor of absence of banks from buying Gilts has pushed yields to an elevated level. In the near term, yields will be influenced by how banks resume buying of Gilts. In the medium, to long term it will be influenced by how the mandate of MPC is modified to manage influenceable inflation rather than broad headline inflation. Let us hope that better senses prevail in understanding the fact that global oil prices and food prices can’t be influenced by interest rates.
Nilesh Shah is MD, Kotak Mahindra Mutual Fund .