Bond yields, oil shock rattle markets; can India withstand macro headwinds?

Economic environment is changing fast. The pace of change is high in this modern VUCA (Volatile, Uncertain, Complex, Ambiguous) world. At the beginning of this year, the Indian economy was in a sweet spot with decent growth, low inflation, and macro stability with declining fiscal and current account deficits. The US-Israel attack on Iran and the closure of the Strait of Hormuz triggered a totally unexpected energy crisis, impacting big energy importers like India, hugely. Fiscal and current account deficits are rising, bond yields are headed north, the rupee is depreciating, and inflation is on an uptrend. The macro headwinds are strong. 

 

 

Will this become a perfect storm? 

 

Inflation is on the rise globally. This has triggered a bond market sell-off, spiking bond yields. The US 10-year bond yield is now at 4.66 per cent, and the 30-year yield has jumped to 5.19 per cent, which is a 22-year high. The message from the bond market is that it will be difficult for central banks to contain inflation. Therefore, markets expect interest rates to rise.

 

In India, the 10-year yield has risen to 7.15 per cent. This will raise the cost of borrowing for the government and the private sector. 

 

India’s fiscal deficit will shoot up in FY27, far beyond the target of 4.3 per cent. The cumulative impact of the cut in excise duty on petrol and diesel by ₹10 a litre, the rise in fertiliser subsidy and the expected dip in corporate tax from oil marketing companies has the potential to push the fiscal deficit to about 5 per cent of the GDP. This will impair the fiscal consolidation programme, which the government has been implementing successfully after the Covid shock. The rise in fiscal deficit will crowd out private investment with implications for growth.   CHECK Stock Market LIVE Updates

 

Rupee depreciation is not a problem alone, it is part of the solution

 

Rupee depreciation has been sharp. The rupee, which was around 90 versus the US dollar at the beginning of this year, touched a low of 96.96 on Wednesday, making it one of the worst-performing EM currencies. 

 

Rupee depreciation will lead to imported inflation, and further depreciation expectations can trigger more foreign portfolio capital flight. But it is important to understand that rupee depreciation is not a problem alone; it is part of the solution, too.  A more expensive dollar will automatically curtail expenditure on imported goods and services like foreign travel. This will be more effective than austerity appeals. Therefore, there is no harm in allowing the rupee to depreciate so long as it doesn’t trigger speculative capital flights, endangering financial stability. 

 

Despite the strong macro headwinds, the stock market has been reasonably stable, supported mainly by domestic investment. Since the market valuations are fair now, a sharp correction appears unlikely. The situation will change if the West Asia crisis aggravates and crude spikes above $140. 

 

India can manage this threat, but at a cost

 

India can withstand these macro headwinds, but there will be a cost in the form of lower growth and higher inflation. India’s success in fiscal consolidation - bringing the deficit down from 9.2 per cent in FY21 to 4.4 per cent in FY26 - has enabled the economy to largely absorb this shock. But the macro headwinds will depress GDP growth and increase inflation. If crude prices remain elevated for an extended period, the hit will be hard. But even then, the crisis can be managed, preventing it from developing into a perfect storm.

 

In the worst-case scenario, FY27 GDP growth may decline to 6 per cent, and CPI inflation may rise to 5.5 per cent. The situation calls for debt management from the RBI and the government. 

 

=================================

Disclaimer: This article is written by VK Vijayakumar, chief investment strategist, Geojit Investments. Views expressed are his own.