Bank of America Merrill Lynch firmly believes that macro risks are overdone in the G-sec market. Moody's upgrade of Indian sovereign rating to Baa2 from Baa3 endorses our view. We continue to expect the Reserve Bank of India Monetary Policy Committee (RBI MPC) to cut the repo rate on December 6 to signal a bank lending rate cut before the 'busy' industrial season intensifies, as inflation remains well within the RBI's 2-6 per cent target, even after the temporary onion/tomato price spike.
Even if we go wrong, we think concerns of an RBI hike are surely exaggerated. Second, we continue to expect the RBI to reverse OMO sales (by Rs 50,000 crore) by March via OMO purchases/government buyback/maturity of MSS bonds to ensure sufficient reserve money to fund recovery.
Finally, Finance Minister Arun Jaitley has already deflected talk of a fiscal 'stimulus'. In sum, the government/RBI will, sooner or later, have to take measures to cool the G-sec market as a rising risk will prevent lending rate cuts and undo the benefits of its bank recapitalisation plan to delay recovery.
Since Jaitley has already deflected the possibility of fiscal 'stimulus', we expect any fiscal slippage to be offset by cutting expenditure. We also do not expect the Ministry of Finance to raise bank recap bonds from the market. As the G-sec market is finely balanced with RBI OMO capped by capital flows, higher borrowing would otherwise push up the risk free – as is already happening – prevent lending rate cuts, and stub out fiscal support.
The author is India Economist at Bank of America Merrill Lynch. Views expressed are his own