Demand picture in the economy is still weak, says Deutsche Bank’s Sameer Goel
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Any protectionist act by the US such as an announcement of sanctions against Chinese imports will have an impact on most of Asia, including South Korea, Taiwan, Malaysia and Thailand; but countries such as India and Indonesia stand to lose the least in the event of a shift in the global trading order, Sameer Goel, head of Asia macro strategy at Deutsche Bank AG, said in an interview.
India, however, will be more exposed to changes in policies with respect to services outsourcing by US firms, he said.
Were you surprised by the Reserve Bank of India’s (RBI’s) decision to keep rates unchanged and switch the policy stance to “neutral” from “accommodative”?
Yes, more so by its decision to change stance, than necessarily by the fact that they stayed on hold. RBI seems to have effectively shifted to a harder interpretation of the medium-term target for inflation at 4%, instead of the relatively flexible near-term targeting around 5%. To our mind, however, the near-term growth risks are still more skewed to the downside; and the upside risks to inflation relatively limited in view of the negative output gap (between growth and growth potential). The demand picture in the economy continues to be weak, as suggested by low levels of credit growth, low capacity utilization by industry, and even a current account gap which is running significantly below trend. Given then that the government is constrained to provide a large fiscal push, and that it—rather commendably—avoided the temptation for a populist budget which would threaten inflation, we would have expected the central bank to see room for further monetary support to the economy.
RBI’s point about the need to improve transmission through resolution of the bad loans issue in the banking sector, and the need for speedier bank recapitalization, is well taken. But given again the fiscal constraints, we don’t see that helping effectively with the cyclical impulse in the near term.
Indian bond yields saw a 30 basis points sell-off after the policy. Are you worried RBI is becoming less predictable and opaque?
Given that RBI effectively signalled an end to the policy easing cycle earlier than the markets expected, a sell-off in bond markets of this scale is not unreasonable, in my opinion. Following the announcement, residual positions in anticipation of further rate cuts would have been adjusted.
As for the surprise in policy itself, note that there is a long-standing and largely unresolved debate in literature about the merits of rules versus discretion in central bank policy making. In some sense, the formal adoption of inflation targeting should have made this debate redundant in the Indian context.
But in that we are still in a transition phase, where the central bank is improving its communication, and where markets are trying to get a better grip on the practice around how flexible or otherwise this inflation targeting is; such surprises cannot be ruled out.
Possibly added to the mix is the difference in understanding on the optimal real interest rate targeted by the central bank. While most of the market was looking for a deeper trough in cycle to go with the metric of 1.25% real rates, the Reserve Bank’s inflation projections suggest that it might be more comfortable with a range of between 1.5% and 2%.
What is your outlook on Indian yields, is the record out-performance which they saw after demonetisation over?
The outperformance of Indian yields post-demonetisation was a mix of factoring in the liquidity implications of the exercise, and the outlook on policy. The former was exaggerated arguably by concerns that RBI’s outstanding facilities to mop up excess liquidity in the banking system weren’t sufficient to handle the sharp swing. Besides, the markets expected RBI to be biased towards providing additional policy support to mitigate the possible disruption to economic activity due to demonetisation.
What has made the outperformance starker is that globally bond yields have re-priced significantly higher over this period—10-year US yields are up by more than 60 basis points—in anticipation of a more expansionary fiscal policy in the US.
With RBI effective signalling an end to the policy easing cycle, and given that the technical picture for bond markets is more mixed ahead, we see little reason for Indian bond yields to go significantly lower, though they will likely still outperform global core yields, given the relatively insulated nature of Indian markets. If indeed 6.25% is to be the base in the repo rate in this cycle, which is our view, and going by the post GFC (global financial crisis average) term premia on 10-year yields versus policy rate, Indian bond yields should be supported towards 7%. There is also the supply risk from state government issuance to consider, as indeed that there is a less obvious policy case for RBI to buy bonds, now that the banking system liquidity is in surplus. Note though, on a total return basis, and versus the US, Indian bonds still present an attractive investment option.
Will many central banks in Asia hike rates this year, given where the dollar and US treasuries are headed?
While we think the space for central banks in Asia to ease policy further has mostly run out, we also do not currently forecast any of them to hike rates this year, with the exception of Hong Kong where the policy rate is effectively linked to the US via the currency peg. There are two main reasons for this. One, while inflation has bottomed out in most of Asia over the past couple of quarters, in no place is it really threatening—or expected to, this year—the tolerance levels of central banks. Two, central banks in Asia typically allow for policy tightening by the Fed to indirectly act in a counter cyclical fashion for them via the impact on export demand.
Given also that the business cycle in Asia is lagging behind the US, we see no reason why monetary authorities in the region would want to, or indeed be in a position to, get ahead of the curve and tighten interest rate policy this year. This should leave the interest rate curves pricing in a higher inflation premia, and for currencies in the region to likely weaken versus the dollar as interest rate differentials versus the US narrow. That said, central banks in Asia also use liquidity and macro prudential policies, in addition to interest rates, to manage monetary conditions. To that effect, there could be a move towards tightening some of the non-benchmark interest rate policies this year. China is one example where we expect the authorities to keep nudging the price point on interbank liquidity higher (in yields), and possibly impose more loan quotas to contain credit growth.
What do you make of the MPC (monetary policy committee) and the way it has steered rate decisions in India?
The establishment of the monetary policy committee is a significant institutional advancement in the way policy is conducted in the Indian context. It should lead to greater transparency and a more informed debate on the various inputs into policymaking. To be sure, it is too early to judge the performance of the committee with only three MPC meetings thus far, all of which ended in consensus decisions. The minutes of the meetings have, meanwhile, provided a more comprehensive insight into the discussion that underpins the decision-making by the committee. We look forward to greater public engagement of the committee members, which should allow the Reserve Bank, like the US Federal Reserve, to signal the direction of its policy thinking on a more regular basis rather than only at the bi-monthly meetings.
Your views on the rupee?
The rupee has been on the whole towards the better end of the emerging market spectrum since US elections. Its relatively lower exposure to potential US trade sanctions and/or adjustment to border tax, and the fallout of the demonetisation exercise keeps it a relatively lower beta to the broader dollar move. There are several crosswinds to consider at this stage. On the one hand, the compression in carry, a slowdown in foreign flows, a busy political calendar, and risks to the current account from higher oil prices and potentially lower outsourcing revenues, all point to some caution on the rupee.
Equally though, the budget has added to the credibility premium on rupee assets, and the authorities appear to be refuting the idea that India has lost export competitiveness due to its currency. The rupee’s medium-term credentials are well supported by strong reserve buffers and a credible inflation targeting regime.
The rupee should outperform much of the rest of Asia were there to be a ‘trade war’, but equally will participate to a lesser extent in a cyclical upswing in the global and particularly, US economy. We expect the rupee to weaken versus the dollar in the next few months, but unlikely to underperform the interest rate differentials or forwards in any significant manner.
If protectionism triumphs over free trade, which countries in Asia do you think will be most impacted, and what about India?
Protectionism will indeed be negative for Asia, given that it is one of the most export-dependent regions in the world, with exports averaging around 50% of GDP (gross domestic product), though with large variation.
Five out of the top 10 contributors to the trade deficit in the US are in Asia, with China clearly the elephant in the room, making up for nearly 50% of the deficit. Again, even in terms of exposure to manufacturing, China stands out as one of the most exposed, both in terms of manufacturing exports as a percentage of total, and of value-added GDP.
Note though that the Chinese portion of the US trade deficit looks optically exaggerated because China is often the end-assembler in the regional processing trade chain. To that extent, protectionism which results in sanctions or tariffs against imports from China would likely impact a lot of the other parts of the region too, including the likes of Korea, Taiwan, Malaysia and Thailand. In contrast, the likes of India and Indonesia stand to lose the least in the event of such a shift in the global trading order. Of course, India would be more exposed to any changes to policies with respect to services outsourcing by US firms, and in terms of their ability to engage Indian workers.