In order to understand the impact of announcements made by the government in the federal budget for FY 21-22 and the RBI in its last week’s monetary policy, let us take a step back and assess the global and local economic circumstances. Last year the world was struck by an unexpected event which brought the global economy to a standstill. Lockdowns in all major economies including India led to a global recession.
In India, the fight against the virus began in March, when the nation went through one of the strictest lockdowns in order to stop the spread of the virus and build adequate infra to tackle the unprecedented situation. As a consequence, India witnessed double digit contraction in Q1, however as the nation reopened steadily one saw growth recover gradually in the subsequent quarter with a single digit contraction in Q2 and a likely positive growth in Q3. Positively for India, it has been spared from the second wave which several countries across the globe are struggling with.
In 2020, central banks and governments ensured financial stability through adequate liquidity and also took social initiatives to protect the affected. As a result of this uncertainty central bankers dropped interest rates to record lows and investors fled to safety as one saw capital move from risky assets to safe haven such as g-secs or treasuries. In India the yield for 10Y dropped to low of 5.75-80% and the spreads across the tenures compressed to historically low of 35-40 bps amidst demand for high quality securities.
Under these challenging circumstances compounded by a year of deep recession as well as few years of falling growth the finance minister presented India’s first paperless budget. Fiscal deficit was the most anticipated metric amongst the debt investors which came in at 9.5% against market expectations of 7.5-8.0%. This surprised the markets initially with yields sharply moving up 15-20bps but on reading the fine-print, investors took this positively as the budget math comes off clean with realistic revenues (disinvestments lowered to 1.75 lac crs vs previous year estimate of 2.10 lacs crs, including the highly anticipated IPO of LIC), subsidies (food subsidy) included and push for higher capex (~35% higher than the previous year). It is expected that this capex will prove to be a double bonanza in terms of creating employment as well as durable growth. Also, this time the budget has estimated a higher deficit, if the government underspends the deficit might surprise on the positive side.
Post the budget all eyes were on RBI’s policy as to how the central bank will support the growth agenda set by the government. However, one has to consider that MPC was running an ultra-loose policy to provide support in this extraordinary situation. We expect the central bank to return to the policy normalization stance as growth returns. This indication was already given before the policy by announcing variable rate reverse repos, the restoration of CRR has just been another step towards the liquidity normalization. However, given the large expected borrowing of the government (gross borrowing of 12.06 lakh crores against an average of 7.0-7.5 lakh crores pre-pandemic), RBI is likely to take steps to keep the rates stable. The good news is the macro economic environment is stable with inflation dropping and growth returning but the supply side needs to be carefully handled.
The budget and the monetary policy combined is likely to put some pressure on the bond markets. The large borrowings combined with slow recovery would put pressure on yields. Mutual Fund Investors with asset allocation approach and long-term investment horizon may like to continue to remain invested but should expect elevated volatility in days ahead. The focus of investors will now move on to inflation and yield curve management.
In conclusion, the key takeaways from the budget and policy are that the fiscal deficit is higher than expected but is positive for the economy on account of capex. There is a likelihood that the government may be over-budgeting and the underspending might lead to a positive surprise. Inflation is getting back in the target range which should put less pressure on RBI and keep the focus on growth. Nevertheless, investors should expect the policy normalization in a gradual calibrated form which doesn’t hamper growth.
(The author is the CIO – Fixed Income, Mirae Asset Investment Managers India.)