India: what is going on?

It’s easy to look at the economic situation in India and wonder what exactly is going on. Despite a slew of bad macro data – which indicate a slowing economy, financial sector problems and a worsening fiscal position – the rupee and bond yields have been remarkably resilient.

In ANZ Research’s view, India’s weak economy lies at the heart of the paradox. A slowing demand for credit, combined with rising risk aversion, is causing the financial sector to increase its exposure to government bonds.

The rising surplus on the basic balance of payments (BoP) is not only anchoring the rupee but allowing the Reserve Bank of India (RBI) to inject liquidity through its intervention in currency markets.

An official acknowledgement of the fiscal slippage may break the current trends in bond yields and the rupee - but only temporarily. A more sustained reversal will need to wait for a durable revival in growth.

Deep

With the central government’s net tax receipts rising by 4.2 per cent year-on-year in the first half of the fiscal year ending March 2020, compared to the full-year target of 11.1 per cent, the consensus call is that the FY20 fiscal deficit will likely slip by 0.5 per cent to 0.7 per cent of gross domestic product.

ANZ Research thinks policymakers are aware of this, despite their announcement of a second-half borrowing program which conforms to the original fiscal deficit target of 3.3 per cent of GDP.

Adding to the fiscal pressures is the continuing deterioration of the macro momentum. ANZ Research estimates GDP growth will have slowed to a multi-year low of 4.6 per cent in the second quarter, with the output gap widening to 0.8 per cent of GDP. It’s likely the earliest that gap can close is the fourth quarter.

The macro situation is further complicated by deepening stress in the financial sector, which now includes public sector banks, cooperative banks and non-bank financial companies (NBFCs).

These developments have together led to a downgrade in Moody’s credit rating outlook for India, from ‘stable’ to ‘negative’.

Resilience

The reaction of the bond market (government securities, or ‘G-Secs’) to these developments has been mild and short-lived. While the improving global risk appetite has probably helped, domestic developments have played a complex role.

Against a backdrop of a wider output gap (which encompasses all major components of growth) combined with impaired transmission from the policy rate to lending rates, demand for funds has perceptibly fallen.

Aggregate bank lending has decelerated, even for large enterprises. As the latter constitutes arguably the stronger segment of borrowers in the economy, this deceleration reflects a waning trend.

The incremental loan-deposit ratio has consequently eased, allowing banks to continue investing in G-Secs well over levels prescribed by the statutory liquidity ratio (SLR).

Excess SLR is lower than it was in 2018, although that was largely a legacy of the November 2016 demonetisation. A change in this environment is unlikely anytime soon.

Apart from the ongoing weakness in coincident indicators, deteriorating confidence in both households and corporates does not augur well for the demand for funds. ANZ Research expects spending, particularly the kind supported by higher leverage, will continue to decline.

As with episodes of financial sector stress elsewhere, financial institutions are increasing their exposure to low-risk government bonds. While banking system exposure is generally well documented, it is less so for non-banking financial companies.

We know mutual funds have been steadily reducing their debt exposure to NBFCs and simultaneously raising exposure for G-Secs. Once again, this de-risking is likely to continue as financial sector stresses are unlikely to be resolved soon.

While banks’ non-performing assets (NPAs) have been mildly reduced, the process has been slower than anticipated following the passage of a new bankruptcy code in India.

More than a third of debt resolution cases now exceed the stipulated time limit of 270 days. In addition to the banking system, the asset quality of NBFCs and housing finance companies (HFCs), which have significant exposure to the troubled real estate sector, should deteriorate after the start of stringent NPA recognition norms.

The exposure of NBFCs and HFCs to the economy is not trivial, amounting to around 13 per cent of GDP.

After a formidable deficit in 2018, India’s BoP position has steadily improved. This is not confined to just portfolio flows but is across the current account, FDI flows and external borrowings.

For the four quarters ending June 2019, the current account deficit dropped to 2.1 per cent of GDP from a peak of 2.4 per cent in the final quarter of 2018.

Gauging by contemporaneous trends in the customs-cleared trade balance, further compression in the current account deficit is likely. This compression correlates well with the widening output gap.

In ANZ Research’s view the strengthening BoP position allows the RBI to inject liquidity into the economy via its FX operations. Indeed, the relationship between FX intervention and banking system liquidity has tightened of late. RBI money growth is increasingly driven by a rising contribution from net foreign assets (NFA). It has even allowed the RBI to step down on its open market purchases to provide liquidity.

Funding

In the last few years, two formidable changes in the sources of government funding have occurred.

The first is growing demand for duration from the non-banking system, including insurance companies and mutual funds. The demand from these sources has offset the weaker demand from banks which peaked in the first quarter of 2018.

Consistent with rapid secular growth in the insurance sector, this dynamic probably has further to run. Moreover, as cited earlier, financial sector stresses are leading financial institutions to increase exposure to G-Secs.

The second change has been a growing recourse to small savings. These are quintessentially retail savings tapped directly by the government. From a negligible amount in 2013, small savings financed roughly 18 per cent of the central government’s deficit in fiscal 2018 and 2019.

Interest rates on small savings tend to be higher than on government bonds and are therefore a more-expensive source of funding. In the short term, however, when credit demand is weak and banks are less inclined on add duration to their portfolios, small savings have become a captive source of funds for the government.

This represents a form of financial repression but, in the short term, it has helped restrict government borrowings via issuance of G-Secs.

Precedent?

Unfortunately, there is no precedent for the current state of affairs as the macro backdrop in the past was quite different. Only twice since 2007 has India’s GDP growth rate been slower than the fiscal deficit as a percentage of GDP.

The first time was after the GFC in fiscal 2019 and the second in fiscal 2012. Bond yields performed differently in the two episodes, falling in the first and rising in the second.

Different macro environments and policy objectives explain the divergence. In the first episode, the RBI’s key policy objective was to restore normalcy in financial markets in a short period of time by expanding its balance-sheet to offset capital outflows.

This affected the expansion via open market operations, repo operations and unwinding of sterilisation bonds.

In addition, the RBI reduced the cash reserve ratio by an unprecedented 400 basis points over the course of the year. The current environment is clearly not the same.

While government borrowings need periodically to be supported by open market operations, the BoP position is far more sanguine. In other words, the combination of weak growth and fiscal expansion in 2009 does not make for an appropriate comparison. Neither does 2012, which was characterised by a combination of rising inflation and twin deficits.

The RBI then addressed the problems by raising the repo rate by 200 basis points over 12-months. This tightening had significant impact on G-Sec yields.

The environment is now different. The BoP is in good shape and inflation has been unusually benign.

Sanjay Mathur is Chief Economist Southeast Asia & India and Rini Sen is an Economist, India at ANZ

Thgis story is an edited version of an ANZ Research report. Registered users can find the full report here on ANZ Live.