Suyash Choudhary, Head – Fixed Income, IDFC AMC
“Just what the truth is I can’t say anymore”
The Moody Blues
Global rating agency Moody’s downgraded India’s sovereign rating by one notch to the threshold of investment grade. The outlook assigned continues to be negative which is somewhat of a surprise. With this Moody’s has unwound the “leap of faith” upgrade made in 2017 and goes back to the equivalent of where the other large agencies are on India’s rating. Insofar as this still preserves the investment-grade status, the move isn’t too damaging (or unexpected) by itself. Indeed the upgrade hadn’t had any discernible impact at the time as well.
Not on action, focus on assessment
That said, certain points from the assessment ring true and indeed present a somewhat challenging macro picture for India ahead. As is well known, India entered the COVID growth shock already on the path of a multi-year growth slowdown, and with clearly defined vulnerabilities. The most obvious of these was a significantly impaired lending system characterised by high banking NPAs and many non-banks struggling to preserve their existing growth models post the 2018 IL&FS shock. Additionally, partly owing to the growth slowdown and partly due to the anticipated tax buoyancies not yet picking up on GST implementation, the effective fiscal deficit had been high and sticky over recent years thereby diminishing fiscal space with the sovereign. It is with this backdrop that we entered the COVID crisis.
There are some aspects of the crisis which are common globally. It is by now clear that a significant growth payoff for the year has been extracted worldwide. Not just that, the low multiplier characteristic of necessary preservation oriented fiscal response, a somewhat more than temporary dislocation to factors of production, the unabated setbacks to globalisation and to trade consequently, and the possible persistence to the difficulties in some sectors fully opening up all point to a difficult road ahead for growth coming back full swing. However, while this assessment may hold for most economies around the world, India’s starting vulnerabilities where somewhat more pronounced in this case, as noted above.
Thus India’s twin challenges of an impaired lending system and a constrained fiscal situation will tell upon the response to and recovery from the growth shock, even as the growth shock itself will further accentuate these vulnerabilities. As an example, even with a relatively muted direct fiscal response so far, public debt to GDP (Gross Domestic Product) will go up substantially this year from an already relatively elevated level. Furthermore, it will take longer to come back lower if the future trajectory of the denominator (nominal GDP) isn’t robust enough. A similar case can be made for the lending system as well. Note, however, that the progression of the denominator (and hence the ratios) is also a relative game. The point which is somewhat concerning is that India may no longer have embedded advantages that would necessarily argue for better relative growth in a post COVID world. Of course, the evolution of public policy from hereon may contribute significantly towards changing these adverse dynamics.
A Word on RBI
RBI has been quite proactive so far in conventional policy with respect to rates and liquidity. So much so that it has led us to recently assess that further moves in this direction may be down the path of diminishing marginal utility (https://taxguru.in/rbi/path-diminishing-marginal-utility-rbi-policy-2020.html). What it has arguably done lesser on is with respect to the markets for financing. While addressing credit spreads would have been trickier, the general assessment (including ours) has been that it could have been more proactive in the market for sovereign financing and hence on term spreads.
However, on further thought, one can argue that RBI understands that it has to play a long game. And hence what it’s offering the market is of the nature of a “passive put”. This was somewhat revealed in the following statement in the document on regulatory measures in the May policy.
“In response to COVID-19, the requirement of fiscal resources has increased with likely implications for market conditions going forward. The RBI shall remain watchful and support the smooth completion of the borrowing programme of the Centre and States in the least disruptive manner.”
Thus it is ensuring that the mammoth amount of the government’s financing requirement goes through without incremental tightening to financial conditions, presumably evidenced as a rise in yields. Looked at this way, it would amount to an enviable execution should it manage to do so. It must also be said that it has been fairly successful so far. However given that the bulk of the bond supply lies ahead of us, and with a strong likelihood of a further upward revision in the borrowing calendar, RBI’s firepower may be better used later than now. This also means that bond market investors may have to cease looking for active support from the central bank that is aimed at substantially bringing down yields across the curve, but rather settle for a still strong passive support that disallows yields across the curve from rising while providing dollops of commercial incentive to buy bonds, by keeping overnight rates very low and liquidity abundant. Thus bond investors may have to choose their own best-suited risk versus reward points on the yield curve. This currently looks to us to be 6 -7 year bonds on the sovereign curve, and these now constitute our most overweight positions for our active duration funds. As always views may change basis changes to information, perception and / or assumptions.
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