Bond markets in India are on fire with sharp fall in bond yields on the back of expectations of rate cuts by the incoming RBI governor. Chart 1 The present RBI Governor, Dr. Raghuram Rajan has indicated that he will not seek a second term when his first term ends in September 2016. The government is close to finalizing a new RBI governor and the bond markets expect the governor to fulfill government’s wishes for lower rates in the economy.
The fact is interest rates have come off sharply in the economy. The Repo Rate has been cut by 150bps since January 2015 and at 6.5% levels is at multi year lows. Government and corporate bond yields have fallen by around 150bps across the yield curve over the last couple of years. Banking system liquidity too has eased considerably from deficit liquidity of around Rs 1500 billion to almost no deficit levels. Yet, there is clamor for rate cuts by the government and the industry in the belief that lower rates will spur economic growth.
The question is what can lower rates do to spur economic growth? Interest rates in Europe and Japan are negative and yet economic growth is barely seen. Brexit has added concerns to growth. What will happen to markets and the economy once rates start rising from unsustainable negative levels? Will rising rates pull down nascent signs of economic recovery? There are a lot of questions that cannot be answered now, as these are unprecedented times where there are really no right or wrong levels for asset prices.
In such highly uncertain and volatile times globally, emerging markets are highly vulnerable to shocks in the global financial system. Capital flows turning deeply negative could prove disastrous for economies especially when the global economy is still showing weakness.
India cannot stay isolated from the world and live under the relative safety of better macro economic fundamentals. Hence, it is extremely important that policy makers take steps that will protect India from storms caused by shocks in the global markets and economies. India may not escape the storm but can weather the storm with prudent policies.
Rate cuts by RBI when a new governor takes over will send out wrong signals to the market that the governor is kowtowing to the government’s wishes. Instead, RBI should be seen as a strong bastion against the lashes of global financial storms and that requires steady policies that ensure price stability, internal strength of the currency and sustainability of economic growth.
Economic Data Analysis
IIP (Index of Industrial Production) growth for May 2016 was at 1.2% as against negative 1.2% growth seen in April and against a growth of 2.5% seen last year. Manufacturing growth was negative 0.7% against a negative growth of 3.1% last month and growth of 2.1% last year. Capital goods growth was negative 12.4% against negative growth of 24.9% last month and against growth of 3% last year while consumer durables growth was 6% against 11.8% growth last month and against negative growth of 3.9% last year.
IIP is expected to pick up in this fiscal year on improved demand conditions in the economy.
Bank credit growth marginally grew 0.2% month on month in June as banks shored up books for the quarter end. However credit growth at 9.42% is still low and needs to pick up to fund economic growth.
CPI inflation for June printed at 5.77% against 5.76% levels seen in May. Food inflation was 7.79% against 7.55%. Vegetables, pulses and sugar and confectionary led inflation higher with rise of 15%, 27% and 17% respectively. Food inflation will stay sticky at higher levels given monsoon supply disruptions.
Tax collection growth was positive with direct taxes growing by 25% and indirect taxes growing by 33% in the April-June 2016 period. If the GST bill is passed in the parliament in this monsoon session, tax growth expectations will be high for the next fiscal year.
Trade data shows that exports fell 0.81% in May on a year on year basis while imports fell 23% and trade deficit fell by 13%. In the April 2015 – March 2016 period, exports fell 15.8%, imports fell 15.3% and trade deficit fell 14%. Oil imports fell 40% and non oil imports fell 4%. Gold and silver imports fell 2.5%. Rising fuel demand coupled with stable oil prices could push up oil imports for this fiscal year and trade deficit could rise.