Interest rates hold the key

We believe that Budget 2018 faces a key challenge in rising yields. In itself, the Budget was broadly in line with our and market expectations in terms of focusing on stepping up rural spend in the run up to the summer 2019 general elections, income tax relief and re-introducing the long-term capital gains tax. For our part, we think that the selloff in the G-sec market is overdone. At the same time, policy makers will have to calm sentiment with confidence building measures as it is unlikely that investors will buy bonds when they are perceived to be a falling knife.

We do not think it is an exaggeration to say that lower rates hold the key to India's recovery. ‎Rising yields push back lending rate cuts by raising the risk free rate. At a time when there is a question mark on asset quality, banks are unlikely to cut risk premia to cut lending rates.

We think, that macro risks are overdone in the G-sec market. It is true that we expect finance minister Jaitley to breach his fiscal deficit target of 3.3% of GDP (3.2% BofAMLe) by 20bp to 3.5%, like this fiscal year. This, however, should get funded by a further drawdown of the Center’s surplus with the RBI. In fact, we see the G-sec market switching to excess demand. Although the market seems to have been spooked by the hike in minimum support prices (MSP) prices announced, the actual inflationary impact is likely to be far more moderate as ruling market prices are higher in many cases.

We do not mind some fiscal slippage, ‎given that growth is running 100bp below potential. After all, the overall government fiscal deficit is broadly in line with its long-run average of 7.3%. We are far from a situation of crowding out, as the upturn in growth for the next few quarters will be largely driven by base effects. Nonetheless, we are relieved to find that the finance ministry has decided to draw down its surplus cash balances with the RBI to fund capital expenditure at a time of fiscal consolidation.

We think that inflation risks are overdone. The inflationary impact of MSP hikes is likely to be far more moderate as ruling market prices are higher in many cases. We also do not see much inflationary impact from higher customs duty. That said, inflation will likely climb to 5.4% in the June quarter, albeit purely on base effects, and recede thereafter. If we look beyond, fundamentals – excess capacity, tight money supply, a possible La Nina – actually point to a benign inflation outlook. Against this backdrop, we expect the RBI MPC to cut rates in August, a la 2017, if good rains dampen agflation.

As mentioned above, we continue to believe that macro risks in the G-sec market are overdone. Our calculations suggest that the G-sec market will see excess demand in FY19. Net borrowing at Rs 4,79,000 crore is in line with our estimates. We estimate that the RBI will inject about $37 billion next year to fund 6% real growth (in old series terms).  Our BoP forecasts place RBI FX intervention at about $13 billion. As a result, we expect the RBI to buy $24 billion of gilts through open market operations and buybacks (Rs 71,900 crore budgeted). This would exceed our estimated market gap in FY19, as was the case in FY16.

At the same time, we think the RBI/MoF will have to come out with confidence building measures (CBMs) to calm market sentiment.

We think that the easiest way out is to cancel additional borrowing (of Rs 20,000 crore, Rs 30,000 crore cancelled) and fund fiscal slippage, if any, by drawing down the government's surplus cash balances with the RBI. The Center has been running surplus cash balances with the RBI averaging Rs 1,50,000 crore as of March 31 over the past few years. This arises out of higher-than-budgeted small savings collections, state government surpluses parked in intermediate T-Bills and non-competitive bids and advance tax payments in the March quarter. Incidentally, we are not in favor of the MoF's reported proposals to draw on the RBI's: (1) Contingency Reserves, created out of past profits, which, at 7.5% of assets, is well below the 12% benchmark; and/or (2) Currency and Gold Revaluation Account, a buffer against sharp FX movements.

Government buybacks (Rs 30,000 crore done of Rs 57,000 crore budgeted) should also calm the G-sec market by improving the demand-supply position. This also channels the government's surplus balances with the RBI into the market. Although the G-sec market did not react much to the Rs 60,000 crore government buyback announcement (Rs 30,000 crore accepted), this was due to the impression - erroneous, in our view- that the RBI is steepening the yield curve by buying back April maturities and selling longer tenors.

RBI OMO auctions (of Rs 30,000 crore approx) would be the strongest signal as that would not only supply durable liquidity but also re-assure the markets on the yield curve. In any case, the RBI has injected about $23 billion of the $30 billion we estimate is needed to fund a recovery in FY18.

(The author is economist and co-head, India research at Bank of America Merrill Lynch. The views expressed in this article are not those of Fortune India )