By Avnish Jain
The monetary policy committee (the MPC) will meet in the first week of August 2020 to deliberate and are likely to have their task cut out with the economy staring at a contraction and the need to manage inflation. The MPC has already delivered 115 bps repo rate cuts along with a slew of liquidity measures from RBI like CRR cut and open market purchases and introduced new liquidity tools like long term repo operations (LTRO) to support the economy and stabilise markets in these uncertain times.
The pandemic and subsequent lockdown have disrupted both supply and demand, diminished consumer confidence and increased risk aversion. As per IMF estimate, global output is likely to drop by 4.9% in CY2020, with India seeing a contraction of 4.5%. Renewed increase in COVID-19 cases across the world points to slow opening of economies and slow recovery into 2021.
Huge fiscal and monetary stimulus has been taken across the world to tackle the pandemic-induced lockdowns. India has undertaken stimulus of about 10% of GDP, but direct fiscal measures have been limited. RBI has till now ensured lower rates and good liquidity to support economic recovery. However, the recent high inflation numbers may force a rethink within the MPC, though growth concerns continue to remain at forefront with GDP growth likely to contract in FY2021.
In the last policy meeting a few MPC members noted that current high inflation may moderate in 2HFY2021 on back of restoration of supply chains, good monsoons, low oil prices and deficient demand putting a lid on core inflation, and hence focus should remain on growth. Some MPC members opined that policy measures to address growth need to be used frontally and aggressively but also to boost the economy when growth recovers. The fight for pandemic is likely to be a long drawn one, necessitating future policy actions.
The August policy is likely to see a tug of war between growth and inflation concerns. Since the MPC have already front-loaded rate cuts, there is a possibility of pause. However, there is a good probability of rate action as the MPC believes that inflation is likely to trend down in the latter part of FY2021. Further growth is picking up as the economy slowly limps back to normalcy and will require continued support from the monetary authorities. The MPC could further announce liquidity measures to support markets, as liquidity is down considerably from levels seen since the start of FY2021. There are likely to be some regulatory measures as well to address expected increase in stressed assets of financial companies due to the pandemic as well improving financial transmission through the economy.
Debt markets were volatile in the early part of FY2021 as they adjusted to lockdown challenges. Sustained RBI action on rates and liquidity supported markets during the early period of lockdown enabling adjustment of markets to the “new normal”. Higher government borrowings (extra Rs 4.2 lakh-crore in FY2021) continues to pressure government bonds.
Government bonds have been lacklustre since the last rate cut in May, as market participants were expecting more action from RBI to support the extra borrowings in form of open market purchases or twist operations. Corporate bond markets have fared much better. RBI’s targeted long-term repo operations (TLTRO) prompted banks’ investment in corporate bonds. Further, due to extreme credit risk aversion, after the closure of schemes of a large mutual fund, investors rushed to the safety of funds investing in highly rated government or AAA corporate bonds. This led to a good rally in AAA segments, especially in short end of the curve, and spreads of AAA corporate over similar maturity sovereign have compressed
Going forward, the debt market is likely to be driven by monetary actions as well as pace of global and local economic revival and vaccine efforts. Government fiscal space is very limited and thus overall revised borrowing numbers may not see much increase. Borrowing in 2HFY2021 is likely to be lower than the current rate, which may lead to a rally in government bonds in the latter part of FY2021. RBI’s action to support liquidity via open market operations is likely to continue to support debt markets. Corporate spreads have already compressed in the recent rally and the corporate yields may now move in tandem with the sovereign curve.
Mutual funds have seen good inflows in the last few months especially in gilt funds and funds investing in high quality AAA papers. Post credit scares in the last few years, investors have become more safety conscious. While monetary policy may create short term volatility, fund flows are a function of investors’ asset allocation pattern and overall market liquidity. With the MPC likely to remain accommodative and likely ease further, there could be continued flows in gilt funds and AAA quality debt funds.
(Avnish Jain is head of fixed Income at Canara Robeco Mutual Fund.)