India: RBI moves closer to a 25 bp hike – BBH

Analysts at BBH explain that the Reserve Bank of India delivered a hawkish hold and was critical of fiscal policy, and they think risks of tightening are higher than the market expects.  

Key Quotes

 “Economic Outlook

• The economy is recovering but risks remain.  Demonetization and introduction of the GST last year were headwinds on the economy.  GDP growth is forecast by the IMF to accelerate modestly to 7.5% in FY2018/19 from an estimated 7.1% in FY2017/18, before picking up to 7.7% in FY2019/20.  GDP rose 6.3% y/y in Q3, up from the trough of 5.7% y/y in Q2.  Q4 growth is expected at 7.0% y/y but we believe recent readings highlight downside risks to the growth forecasts.  
• Price pressures are rising.  This is due in part to the impact of higher taxes.  CPI rose 5.2% y/y in December, which is in the upper end of the 2-6% target range.  January CPI data will be reportedon Monday, and we see upside risks.  WPI inflation has also been accelerating, which suggest consumer price pressures will rise further in the coming months.  
• Reserve Bank of India just delivered a hawkish hold.  The vote to hold was 5-1, with the lone dissenter seeking a hike.  The RBI warned that "Apart from the direct impact on inflation, fiscal slippage has broader macro-financial implications, notably on economy-wide costs of borrowing which have already started to rise. This may feed into inflation."  As such, we think a rate hike is becoming more likely at the next policy meeting April 5.  
• Fiscal policy is deteriorating.  Whilst the introduction of the Goods and Services Tax (GST) was positive, its impact will be muted by the expansionary fiscal stance planned for FY2018/19.  The government now targets a budget deficit equal to -3.3% of GDP for FY2018/19 starting April 1.  This is up from its previous target of -3%.  The deficit was estimated at -3.5% of GDP for FY2017/18 ending March 31, up from -3.2% previously forecast.  
• The external accounts should worsen modestly.  Over the past couple of years, low commodity prices helped reduce imports.  Those trends have now reversed.  The current account deficit was an estimated -1.4% of GDP in FY2017/18, and is expected by the IMF to widen to -1.8% in FY2018/19.  However, the rapidly widening trade gap suggests upside risks to the external accounts.  
• Foreign reserves have risen to record highs.  At $418 bln in January, they cover nearly 9 months of import and are almost twice as large as the stock of short-term external debt.  Thus, external vulnerabilities remain fairly low.”

“Investment Outlook

• The rupee has done OK after performing with the rest of EM in 2017.  In 2017, INR rose 7% vs. USD and was in the middle of the EM pack.  The best performers were KRW (+13%) and MYR (+11%), while the worst were ARS (-14.5%) and TRY (-7%).  So far in 2018, INR is -1% YTD and is still in the middle of the EM pack.  The best performers YTD are MXN (+4%) and COP (+4%) while the worst are ARS (-6.5%) and PHP (-3%).  Our EM FX model shows the rupee to have STRONG fundamentals, so it should start to outperform more.
• Indian equities continue to modestly underperform in EM.  In 2017, MSCI India rose 29% vs. 34% for MSCI EM.  So far this year, MSCI India is flat YTD and compares to 1% YTD for MSCI EM.  This underperformance should grow, as our EM Equity model has India at an VERY UNDERWEIGHT position.  
• Indian bonds have performed OK recently.  The yield on 10-year local currency government bonds is about +15 bp YTD, also in the middle of the EM pack.  The best performers are Peru (-42 bp) and Brazil (-45 bp), while the worst are Pakistan (+59 bp) and Hungary (+58 bp).  With inflation likely to continue rising and the central bank likely to tighten this year, we think Indian bonds will start underperforming more.  
• Our own sovereign ratings model showed India’s implied rating falling a notch to BBB/Baa2/BBB, giving back last quarter’s improvement.  Several years ago, India was facing downgrade risks to its BBB-/Baa2/BBB- ratings.  While we are still seeing some modest upgrade potential, it seems to be ebbing.”