India has adopted a reflationary fiscal policy in a bid to accelerate the nominal gross domestic product (GDP) growth beyond the 10-year yield, conforming to chief economic adviser Arvind Subramanian’s earlier prescription, according to a report by Emkay Global.
Of the 60-basis-point (bp) decline in 10-year yields, close to 25-30 bps is attributable to decline in the US 10-year yields and balance 30 bps to decline in banks’ credit or foreign currency asset. One basis point is one-hundredth of a percentage point. Strengthening of US job markets and domestic growth could neutralise the above factors, said the report, India Strategy: Weekly Musings.
Government revenue expenditure has risen by close to 17% over the past couple of quarters, compared to 5% during financial year (FY) 2015-16. This has resulted in an improvement in demand, increase in inflation (to 6.2-6.5%), pick up in credit demand and still weak household financial savings. Impending conditions suggest unchanged policy rates for the rest of FY17. With this, government securities (G-sec) yields could harden from here on. For banking stocks, the outlook would be driven by credit growth of private banks—predominantly retail lenders rather than trading gains and liquidity—which have fueled the recent rally in public sector bank stocks. These banks are still at risk in the context of gaining market share of the private players, especially retail lenders. G-sec yields in the last six months have eased considerably, by 60 bps from a peak of 7.85% to the current 7.25%. The primary reason behind this is the sustained decline in credit growth to 9.1% from 11% in March 2016, despite leading indicators suggesting otherwise. Continuance of cleansing of corporate lending book and perceived gains from G-sec investments may have suppressed credit demand in the first quarter ended June 2016.
Credit growth to improve
The credit growth would improve to 13.5% given: higher inflation, improving corporate sales growth and low base. Secondly, sharp ease in US treasury yields due to concerns raised by the UK’s decision to leave the European Union, commonly known as Brexit and temporary weakening in the labour market, also aided in easing of Indian G-sec yields.
Improving labour market conditions and higher US inflationary pressures may lead to further hardening of yields. Aggressive open market operations (OMO) by the Reserve Bank of India (RBI) and restrained primary supply of G-secs also contributed to the moderation in yields.
The improvement in liquidity deficit, from a peak of 3% of net demand and time liabilities (NDTL) to surplus, due to reduction in government surplus cash balance and aggressive OMO, has further aided in softening of yields. Lastly, speculation of the next governor being more dovish also contributed to the rally.
Exuberance in the bond market post Brexit turmoil in June 2016 has catapulted daily secondary market transaction in G-secs to over 1 trillion, more than twice the average during FY16. Importantly, the surge in turnover has been fueled by RBI’s OMOs, followed by private sector banks, foreign banks. Mutual funds appear to be more active buyers of corporate bonds.
Primary dealers and PSU banks have been net sellers. Banks have participated significantly with the excess statutory lending rate (SLR) rising to 5.2% of NDTL from 4% in March 2016. Following this, the credit or deposit ratio for the banking sector declined to 75.7% from the recent peak of 77.6% in March 2016.
Edited excerpts of Emkay Global report, India Strategy: Weekly Musings.