With at least one rate cut expected by year end, gilt yields are definitely headed lower from current levels says Pradeep Madhav, managing director, STCI Primary Dealer. According to Madhav, the current as well as expected rally in gilts can be attributed to a large extent to demand supply mismatch of Statutory Liquidity Ratio (SLR) securities. In an interview with Neelasri Barman he shares his views on liquidity, fiscal deficit and inflation. Excerpts:
Banks borrowing under daily Liquidity Adjustment Facility (LAF) had crossed the Rs 1 lakh crore mark last week. What is the outlook on liquidity?
The systemic liquidity deficit, taking into consideration government’s cash balance with RBI, currently should have been around Rs.60,000-70,000 crore. However, because of expiration of forex forward contracts of RBI, the deficit has been exacerbated and LAF figures have crossed the Rs1 lakh crore at RBI repo window. If we go by past experience also, October and November have historically witnessed rise in currency circulation of about Rs.30,000-40,000 crore, largely owing to festive season. Hence, without any RBI action, the deficit is expected to widen. However, we expect RBI to alleviate the situation and bring the deficit back into comfort zone either by conducting Open Market Operations (OMOs) purchase auction of gilts or by cutting Cash Reserve Ratio (CRR).
What are your expectations from the RBI's monetary policy review on Oct 30 and what is your outlook on rate cuts till March 31?
The current sluggish growth scenario in India definitely calls for some sentiment boosting measures. The government has undertaken some steps recently to bridge the fiscal deficit and support the depreciating rupee. The RBI’s hands are, however, still tied owing to the persistent high inflation. I would expect the RBI to stay pat on interest rates but cut CRR to infuse liquidity into the system to boost sentiment and lower the cost of credit to the commercial sector. However, going forward, one can expect RBI to cut rates by 25-50 basis points in fourth quarter of FY13 provided government undertakes further measures to ensure fiscal discipline, administrative steps to alleviate supply side constraints and further reforms to boost the economy and investor confidence.
What kind of slippages do you expect from the fiscal deficit target of 5.1% of Gross Domestic Product (GDP) for FY 13?
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The estimate for slippage in fiscal deficit will be a bit more pessimistic than one given by government officials. We expect fiscal deficit closer to 5.5% taking into consideration the subsidies on oil, food and fertilizer. However, the recent moves by the Government to fast track the spectrum auction process and the public sector undertakings disinvestment lineup through the exchange traded fund route are encouraging and provide some room for fiscal consolidation. Even if these moves materialise, I expect the additional borrowing to be in the range of Rs.40,000-60,000 crore for FY 13.
Inflation is again becoming a challenge for the RBI. Do you agree with Goldman Sachs' recent report that India needs a formal inflation target?
Inflation in India is becoming more of a structural issue, driven largely by supply side constraints rather than demand side pressures. However, the long term solution to taming inflation lies in building capacities and not curbing demand in short term as being a developing economy with 1 trillion plus population, demand for goods and services will obviously keep rising with rising incomes and consumer aspiration levels. Hence, setting a formal inflation target carries an inherent risk of unduly hurting growth. In fact, with world economy still in recession, huge downside risks to growth still exist due to the uncertainities in the Euro and also in USA or any other event of that order. To combat the slow down in growth, Central Banks across the globe have resorted to unprecedented measures and we think that RBI too has to be prepared to take such measures if growth slows down any further. Setting formal inflation target would certainly limit the reserve bank's ability to tackle such situations.
What is your outlook on gilt yields by March 31?
With at least one rate cut expected by year end, gilt yields are definitely headed lower from current levels. Whether yields drop to 7.80-90% levels or even lower will depend largely on the quantum of rate cuts or OMOs, if any. The current as well as expected rally in gilts can be attributed to a large extent to demand supply mismatch of SLR securities. With credit growth slowing down, banks are buying much more SLR securities than mandated 23% of Net Demand and Time Liabilities (NDTL). The demand is also emanating from mutual funds, which are seeing large real money flows in fixed income bond and gilt funds. With such high demand for SLR, the fall in yields becomes possible even in the absence of a dovish rate stance from RBI.
What is your outlook on Current Account Deficit (CAD)?
We expect the CAD for FY 13 to be around 3.5% of Gross Domestic Product. Despite the government’s measures to boost exports, they are expected to remain sluggish on the back of weak global demand. However with India’s import bill largely inelastic on the back of oil, gold and steel imports, it seems unlikely that the situation will improve dramatically.
What are your expectations of OMOs for the rest of the fiscal and the estimated quantum?
The estimated liquidity drain from maturing forex forward contracts and requirement for currency in circulation till March 2013 is about Rs 1.2 lack crore. Out of this, about Rs 50,000 crore would be infused by means of CRR cut (50-75 basis points) and the remaining Rs 70,000 crore could be infused by OMOs.
Where do you see the spread between gilts and corporate bond yields by December?
The spreads have compressed from a high of 100-110 basis points to around 60 basis points presently. However, going forward the spreads may stabilise at around similar levels or may slightly widen as the expectations of a rate cut get priced in and gilt yields drop to 8% and even lower. The commensurate fall in corporate bond yields may not happen as issuers would look to issue bonds at levels which are at least 100 basis points lower than base rates of major banks.
What is the quantum of additional government borrowing you expect?
I expect the additional borrowing to be in the range of Rs 40,000-60,000 crore for FY 13.
What is your outlook on the rupee against dollar?
In the short term, the dollar rupee could trade in the Rs 52.50 -54.50 range. However, with the government’s moves on reforms to boost investor confidence and sentiment the range could shift to Rs 51.50-53.50.