Inflation should be managed carefully

It's one of those rare periods where deflation is also possible. The RBI may have to adjust money supply in either direction

May has seen the return of foreign portfolio investors (FPIs) in selective fashion to Indian equity. Net purchases of equity in May ran at above Rs 9,000 crore (cr) by last weekend. Most of the buying was in pharma and chemicals, with some purchases in the information technology (IT) sector. At the same time, FPIs have sold Rs 20,000 cr in rupee debt and also opened new short positions in derivatives. This is an improvement on April, which saw FPI sales of Rs 6,884 cr (equity) and Rs 12,552 cr (debt). 

Since April, the FPIs have sold a cumulative Rs 32,600 cr of rupee debt and bought Rs 2,400 cr of equity. Yields of government debt (roughly half of FPI debt exposure is in sovereign debt) have fallen despite FPI sales. This is partly due to a flight to safety. Investors have moved from high-yield, high-risk corporate debt to safe government debt. 

Another major reason for low yields is the Reserve Bank of India’s (RBI’s) version of a Quantitative Easing programme coupled with rate cuts. The repurchase rate (repo) is down from 6.5 per cent in August 2018, to 4 per cent in May 2020, with the last two out-of-turn rate cuts totalling 115 basis points. In addition, RBI has eased monetary conditions in other ways and taken emergency measures like opening the special Rs 50,000 cr window for debt mutual funds. 

Since mid-March, the RBI has also bought Rs 160,000 cr of government paper in the secondary market. The new issues are managed by the RBI, which sets a cut-off yield and auctions of government papers to banks, mutual, FPIs etc. But the RBI has bought older issues in the secondary market. 

This puts money back into the market and ensures government bond auctions are at low yields. It is similar to the QE programmes of the US Federal Reserve and the European Central Bank, though it is not officially a QE and it’s not been done on the same scales. 

This easing started before the pandemic. In the past 12 months, the RBI has bought over Rs 2 trillion of government bonds – it now owns over Rs 11 trillion. It has also bought over $45 bn of forex –that releases the rupee equivalent (roughly Rs 3.2 trillion) into Indian markets. 

The liquidity has ensured the government borrowing programme of Rs 60,000 cr a month is funded at low yields. In turn, low yields and low policy rates help reduce cost of other debt. It’s a different matter that the bond market has become risk-averse and very suspicious of corporate paper. 

Inflation edged higher through the last few months of 2019-20, mainly on high food costs. In March, the headline Consumer Price Index was at 5.84 per cent year-on-year on incomplete data. The April CPI is impossible to calculate with any accuracy but food inflation is supposedly at 8.6 per cent. The YoY CPI for Jan 2020 was at 7.6 per cent so March was down. The 10-year GoI bond traded at a yield of 5.95 per cent last week and it will very likely, drop further.  That’s zero or even negative real yield. 

The relief package along with the RBI’s measures ensures liquidity will remain high. Banks’ investments in commercial paper, bonds, debentures and equity (up to May 8) increased sharply by Rs 66,757 crore, against a decline of Rs 8,822 crore during the same period of 2019. 

It’s important to push up liquidity – the millions who have suffered hardship must have money in their pockets. Indeed, higher direct benefit transfers would have been a good idea. But the supply of goods and services has been severely disrupted and curtailed. High liquidity versus poor supply may result in inflation until such time as supply picks ups. In addition, the global price of commodities will start to rise again as the world moves out of lockdown. The RBI believes that agriculture did well during the pandemic so food inflation may moderate. 

Any inflationary spiral will have to be managed carefully. It’s one of those rare periods where deflation due to lack of demand is also possible. The RBI may have to adjust money supply in either direction. Covid 19 is still raging and may continue to do so indefinitely. Many, if not most, mid caps and small caps are trading below respective long-term median price-to-earning ratios. There’s value visible but also a chance of sharp price collapse.