Look at medium-term debt funds

Short-term tactical considerations also suggest long trades in the financial sector

The last week has seen a bewildering quantum of news flow. It all adds up to a good chance of a large increase in liquidity as the general elections draw nearer.  The five Assembly elections indicated a clear pattern of rural distress. Rural voters are unhappy with the BJP. Farm loan waivers, plus higher minimum support price, plus power subsidies, etc., will all be on the agenda for all parties in their campaigns. 

A falling trend of retail inflation creates an economic rationale for cutting rates. A headline inflation rate of less than 3 is definitely a signal for a rate cut. The Consumer Price Index (CPI) has trended down due to falling food prices for the past two months. That is again, a major cause of farm distress and lower rural consumption. 

The other components of CPI are also easing. The fuel and light basket is likely to come down as global crude prices stabilise at lower levels and base effects dissipate. Even core inflation (ex-food and ex-fuel) is down, to 5.7 per cent in November from 6.1 per cent in October. 

The Gross Domestic Product (GDP) growth is not as strong as it could be, either. Despite the encouraging rise of 8.1 per cent year-on-year for the Index of Industrial Production in October, there's a consensus that second-half growth will be low.  Many brokerages and rating agencies have cut estimates for GDP growth in H2, 2018-19.  Again, this creates a rationale for opening the tap. Cheap credit could fuel consumption demand and make life easier for working-capital-intensive businesses as well. Who knows, cheap credit may even stimulate investment? 

The government wants a looser monetary stance and rate cuts. It is reasonable to make a rational case for a looser stance and lower rates. The new Reserve Bank of India (RBI) governor is a bureaucrat, who will probably back the Ministry of Finance stance. Therefore, a looser monetary stance and lower rates are an extremely high probability scenario. 

What does that do for investors? It should help keep the stock market buoyant and it could reverse the 18-month bear market in debt. We are likely to see mutual fund allocations switching from the short-end of the debt market — liquid and money market funds — to the medium term and long-term schemes. We are also likely to see some speculative flows into the more capital-intensive sectors.  

There has already been a burst of bullish enthusiasm about public sector banks and non-banking financial institutions (NBFCs), which had been under pressure for months. There is an expectation that the RBI will ease PCA norms for bankrupt PSU banks and that in turn, will reopen the channel for lending to NBFCs, which can pass money onto micro, small and medium-scale enterprises (MSMEs).  This is quite likely since it is one route for disbursing cash where it counts — to voters. 

The danger is that uncontrolled lending will lead to another huge mass of non-performing assets being created. It is almost an axiom that farm loans will be forgiven. MSME loans also have a habit of going sour in large quantities. Since due diligence procedures will probably be deliberately bypassed in opening the tap pre-elections, the chances of NPAs are higher. 

In addition, the question of recapitalising banks with toxic balance sheets to meet Basel III norms has already been postponed by a year. It's an open question if RBI reserves will be used for the purpose of recapitalisation, or not. Even if RBI Reserves are fully transferred for bank recapitalisation, it won't be enough, anyhow, since the best guesses suggest that over Rs 4 trillion will be required for that purpose. 

The net effect could be another period of inflated valuations for the financial sector, and for capital-intensive sectors, which are currently undergoing a squeeze. But a year down the line, balance sheets of already dodgy banks and debt-laden corporations will be looking even worse. There's a good chance that the rupee will continue trending down. The central fiscal deficit is bound to expand well beyond the target of 3.3 per cent of GDP and the combined fiscal deficit (states plus centre) will expand even more dangerously. That could be good for exporters but it probably means more FPI exits. 

So, short-term tactical considerations suggest long trades into the financial sector and perhaps, a look at medium-term debt funds.  Exporters may be worth a punt. But the long-term prospects for government banks just seem to have got worse.