Indian economy's battle against inflation and fiscal indiscipline has shown improvement. But economic activity remains subdued, and concerns around capital inflows and exchange rate have worsened in recent times. The US Federal Reserve's indication of tapering Quantitative Easing (QE) had triggered a sell-off across bond markets and currencies. India has been particularly impacted having witnessed net bond outflows of $8 billion which led to the rupee depreciating by 10 per cent against the dollar since May.
India runs the largest current account deficit (CAD) in Asia-ex Japan, which is being increasingly funded through debt flows. Over the last three years ending March 2013, of the total $220 billion of capital flows that India has received, nearly half have been in the form of debt flows, mainly commercial borrowings and non-resident Indian deposits. Any sudden stop or reversal in capital flows could result in increasing macro stability risks to fund this high CAD, resulting in BoP (balance of payment) stress in the near-term.
However, the dollar itself has strengthened globally against all currencies. Fears of a dollar liquidity shortage also impacted emerging market currencies as a result of sell-off in both the bond and equity markets. So, it is a global phenomenon. India is one of the best fixed-income markets to operate in and also exit with least impact cost. So when the reversal in trend comes, India is likely to be the first beneficiary.
The CAD for FY13 stood at 4.8 per cent of gross domestic product versus 4.2 per cent in FY12. However, CAD is falling swiftly. A weakening economy will hit imports while a weak rupee will improve export growth, thereby further moderating CAD.
Inflationary expectations, growth and CAD are important aspects that get considered by the Reserve Bank of India (RBI) while it decides on rate cuts. The IIP coming in negative zone makes the situation far more challenging for RBI. We feel inflation will be lower than RBI's expectation of 5.5 per cent for FY14. It will be a challenge to grow at the estimated rate of 5.7 per cent. Now, with improving data on trade deficit, we feel incrementally, it will not have any adverse effect on the rupee. Looking ahead, rupee appreciation seems more likely, assuming nothing adverse happens globally. We estimate a recovery of three to five per cent over the next three to six months.
While the chances of an immediate rate cut in the July policy have diminished, there is scope for 50-75 basis points rate cut over this financial year. We also believe the rate cut cycle is going to last for a long period of time (two to three years) which should benefit duration funds.
RBI has cut key interest rates by 125 basis points since April 2012, while long-term debt funds and gilt funds have offered 12 per cent and 13 per cent returns, respectively, over the past year ending June 2013. Bond yields should come off in the medium-term on the back of a stable rupee as RBI will have to lower rates in the face of falling growth expectations. The recent pull back in the yields of long duration papers provides a potential opportunity for entry in duration funds.
In the previous one year, gilt funds have rallied. We believe gilt and income funds should be able to deliver better returns than term deposits and short-term funds over the next 12-18 months. Investors could also look at dynamic bond funds since it allows the fund manager the flexibility to take active calls on duration based on risk and volatility.
The author is CIO, fixed income, ICICI Prudential AMC
