There is an optimism often felt as one runs out of pages on one’s calendar; a feeling that what’s done is done and buried in the pages already turned. That the next page will be a new slate, a break as it were to start things afresh. For those who have travelled well, or can seek comfort from the road behind, there is gratitude too as these last pages are flipped through one last time and then place is made for the new calendar to start recording one’s ongoing journey as the year turns.
Every new year’s resolution at some level reflects this turning of pages, of looking forward or leaving behind, though most such resolutions may not be described with the mediocre prose that the current reader is being subjected to. Nevertheless the emotion runs true, even as ennui soon sets in in many cases and realization dawns that these new pages are very similar to the ones before and that not much changes even in the new dates. The same line of thinking, however, can be turned entirely around and equally a realization may spring that, even though it is part of the same ongoing book, each page is in fact a new one and a day can be seized for new beginnings even if it doesn’t coincide with the beginning of a new year.
If the reader finds their patience running thin by now, it is understandable. A fund manager attempting to wax poetic may be looked at with alarm by an investor as being in danger of losing their marbles. In our defense, this has been a year like no other in the last many decades. While life shows kindness and pain to individuals all the time, this year has inflicted much cruelty to the collective of humanity. And it wants to draw as much as it can even as it leaves, refusing to at least bow out with a bit of penance. For all its cruelty, however, it has been met with a wall of human resilience, enterprise, determined execution of duties at almost infinite personal costs, and kindness. It has been a matter of personal astonishment to see this in play daily, almost as if it is routine, and in most cases done silently. For many people all that has mattered, and continues to matter, is simply the doing of the deed and not the telling of it. That such capacity for humanness exists is the greatest reason to both view one’s own struggles and ambitions in context as well as seek inspiration for future endeavors.
A Brief Macro Assessment
Let us now hasten and shift narrative to an area where we have some pretense of understanding. That said, even this small cover of make-believe expertise has been severely shaken both by the intensity of this shock as well as the nature of its progression. With the first lockdowns, a hope almost globally was that the virus would run its course soon and that activity will be back to some semblance of normality. A lot of fiscal policy response, even in some emerging markets with obvious resource constraints, were thus designed to be intensive and aimed for a short period of high expenditures as a bridge before normality resumed. As it became clearer that this is a longer drawdown, policy had to start recalibrating towards more medium term handholding. Some of the more resource constrained nations will probably find this recalibration harder to execute as debt sustainability questions start getting asked around by investors.
Growth forecasts have similarly yo-yoed as the year has progressed. In the first few months of lockdowns the concurrent drop-off in the economy was so alarming and the path to resolution so uncertain, that economic forecasts were understandably quite dire even after accounting for a way towards normalization in the time ahead. However, the intensity of global policy response was large and it did prove to be an effective bridge over this dark period in many economies. Then, even as the virus has moved in multiple waves in many major economies, the general return to economic activity has been somewhat more widespread than probably earlier imagined. But most of all the permanent damage to the system, at least on initial assessment, seems to have been lesser than what was earlier feared.
This last point is nuanced and needs further exploration. Imagine companies and consumers as two sets of entities facing one another. When the lock-down induced economic disruption occurred, it brought about a standstill in activity. For companies it meant that capacities idled while consumers faced a fall-off in the discretionary aspects of their consumption. For the relatively well-sized companies while production was halted capacities were relatively preserved. Similarly, the relatively well-off consumers were forced into saving even as their purchasing powers were intact. When economic activity started to return, these companies stepped up production while the more privileged consumers came back with ‘revenge spending’. This saw a huge bump up in both production and consumption especially in many goods producing sectors. It is also these sets of economic agents that are better captured in the initial release of many economic data. Sure enough, data also rebounded strongly.
However, the reality may have been quite different for the smaller companies or businesses and for consumers who have been more susceptible economically. For many such enterprises the starting cushions are weak and therefore survivability may depend upon continued business. Here the activity fall-off may have extracted a higher price in the form of permanent shutdowns or capacity reductions. Similarly, for the weaker income groups in consumers, including where purchasing power would have been additionally impacted via loss in pay or jobs, savings may have actually diminished over the lockdown period. In many cases there would have been none to begin with. This diminishing is importantly also to do with the much lower discretionary component of spending here and hence the negligible element of forced saving that could come back as higher spending later. Government policies have been critical like, in the case of India, the credit facilities forwarded to small and medium businesses and the multi-month provisioning of food for the economically vulnerable.
Even so, it is here where the maximum permanent or long period damage will occur. From a welfare standpoint this implies an impact or disruption in means for people who were already vulnerable to begin with. It also means that purchasing power for the collective of consumers has actually gone down and may begin to show when the pent-up phase as described above starts to abate. This is certainly the conclusion one can draw when looking at aggregate labor market commentaries. Thus while aggregate numbers on unemployment have diminished, the incremental healing seems to have stagnated. Importantly, the aggregate quality of employment may have been impacted significantly as more people have had to settle for lower wages / salaries including via return to agricultural employment. For small businesses that have been impaired, the return would be slow as capacities are rebuilt and labor rehired. These will have an element of additional costs for now as well since all sorts of factors-of-production dislocations are slow to normalize. There are also businesses that would have shut down and the revival, including the employment that they used to generate, will take a significant amount of time.
All of the above helps explain the nuance around the economic damage. While the resilience of the relatively larger companies and the more fortunate consumers had probably been underestimated before, there are also aspects of permanent damage that may not be immediately apparent in headline economic numbers or in concurrent lender balance sheet commentaries. It is also not a foregone conclusion that such damage cannot be reversed, provided that public policy continues to actively address these issues. There is reason, however, for caution in future extrapolations. Thus suppose output was 100 as at February 2020. The changes in economic projections basis the faster return of activity so far pertain largely to now many economies re-attaining this level of 100 sooner than earlier envisaged. However, whether there is a stronger growth path from there will crucially depend upon the underlying drivers of aggregate demand (incomes for example) reverting to a more robust path of recovery. The next section examines whether India may be on the cusp of a cyclical upturn in such drivers.
Is It India’s Turn Now?
India’s cyclical slowdown has been in play for the last few years. It has broadly been marked with muted income growth, elevated stress on aggregate in the financial system, and a somewhat bloated public sector deficit (our apologies for conflating cause and effect in this description). While consumption had been a key anchor for growth it had been backed by rising leverage over the past few years, and investment growth has been weak. Global factors have been in play as well including a manufacturing recession that hit major economies in 2019.
Given the above, it can be argued that a cyclical bounce for India was well overdue just before the virus hit. Indeed, even the world would have probably seen a manufacturing sector rebound as inventory adjustments would have run their course. The same would be true for India as well. Besides there are other potential tailwinds for us. Our outlier stress on banking balance sheet, courtesy a previous corporate loan cycle, seems to be stabilizing as recognition and provisioning seem to be finally ahead of formation. While fresh stresses on account of the current economic shock are to be expected, they may not carry very large exposures per account and most institutions seem to have proactively prepared for them. Given this, an element of tightening in credit conditions may be no longer in play in the few years ahead. This can be supported further by monetary policy that is now genuinely accommodative (more on this later) and leading to very low borrowing rates. Should the real estate sector be able to find some legs as a result, it could feed into better employment prospects via a construction cycle. The corporate tax cuts announced earlier alongside a robust production incentive scheme roll out, may similarly provide some tailwinds to manufacturing. This may especially get a launchpad should global trade witness a cyclical rebound as well over the next few years. Finally, and through a benign channel of positive feedback loop, some of the above may help the government better its revenue profile and hence step up discretionary policy focused public spending which can help buttress another pillar for growth.
Just as the above factors provide cause for optimism, however, we should take caution as well that the sustenance of a cyclical rebound will involve enhancements in the drivers of aggregate demand as well. In particular, and as discussed before, the income slowdown cycle needs to be reversed and the elements of permanent damage to smaller balance sheets be controlled. Reviving the investment cycle, with its attendant job creation and value chain benefits, will thus be a key policy priority in the years ahead.
The Role of Monetary Policy
After the 2013 external account debacle, the macro priorities for India understandably shifted towards prioritizing stability above all else. This was truly required for survival and growth and indeed cannot be ignored at any point in time. However, given the context, the objective was front and center for policy in the years after that crisis. It is within this that the new CPI targeting regime was envisaged and vigorously adopted by the RBI. For a number of years, the central bank’s approach to policy rates and liquidity was designed with almost a single-minded focus on a 4% CPI target. Reversals to accommodations provided at points in time also tended to be abrupt given the dominance of the 4% target (for example in the period after demonetization). Partly as a result of this, and significantly owing to a benign food price and wages cycle, CPI objectives were largely met.
At this juncture, however, it may be argued that India’s macro-economic priorities have shifted. Thus while macro-stability has to be an enduring objective and policy has to be always anchored in it, there is now an imperative to get an investment cycle going. This is required both for creating productive capacities and thereby reverse the recent few years’ decline in our potential growth rates, as well as for the positive feedback loop that it brings for jobs and incomes. It has also been observed by many that while deeply negative real rates are obviously detrimental to savings, it doesn’t automatically follow that the level of savings keeps rising with rising real positive rates. Incomes play a much larger role in determining savings once real rates are decently anchored. This also seems corroborated with the years of our “success” with CPI targeting.
In our view, public policy (both fiscal and monetary) is largely aligned to this objective of investment revival at this juncture. This may be partly driven by the context of a once-in-two-lifetimes growth shock and partly by the experience of the last few years. At any rate we think that while the CPI targeting framework is alive and well (and it is unlikely we go back on this after the scare of 2013), the interpretation of it is now truly flexible. Thus, as an example, the unsaid comfort band may already be 4 – 6%. To that extent, any formal change to target may be unnecessary and irrelevant (although it may make sense to move up the bottom of the range which will serve to both narrow the range and move up the mid-point). Equally, the logic that higher inflation may be tolerated when growth is weaker is fundamentally flawed save when inflation is high owing to extreme supply shock / congestions like in the present case. This is because monetary policy works through the channel of muting aggregate demand and hence impacting inflation. If aggregate demand is already weak then by definition demand led inflation must be too. To say otherwise is to basically admit that monetary policy has no role in inflation management.
The Old Crystal Ball
Rather than courting future potential embarrassment for ourselves with definitive predictions put in writing, we will undertake the somewhat less (but only just) daunting task of putting in place some markers.
1. If the factors detailed above supporting India’s cyclical rebound come to fruition, a lot of macro-economic headaches feared at the beginning of the year will ease. Thus some of the fiscal inflexibilities and associated risks of sovereign rating downgrades will abate, the external account will build even further buffers as capital flows remain strong, and hopefully India’s appeal will percolate to global fixed income investors as well (this has seen a very long hiatus).
2. Monetary policy will gradually move from the level of emergency level accommodation today to one of still high accommodation. This will likely be a slow process and will involve more discretionary adjustments to the price of liquidity (for instance by starting to narrow the repo-reverse repo corridor at some point, most likely in the second half of the calendar) rather than the quantity of it. The latter is currently too large and given likely still substantial capital flows next year will be slow to normalize. Any substantial policy steps taken to reduce the excess liquidity (automatic lapsing of CRR relaxations, minor MSS issuances, etc are par for the course, in the realm of current expectations, and don’t count as substantial policy steps in the current description) will risk disrupting markets and send adverse intent signals. For that reason, we think they are unlikely in the current regime or at least a long time away. The market has seen abrupt reversals in accommodation in the previous rigid CPI targeting regime and this fear still colors many market participants’ expectations. However, as we have explained here, we don’t think that is the policy thinking today and extra cover for looser policy is in any case available for the foreseeable future with a very strong external account, as well as with average CPI print next year likely to be significantly lower than this year. The so-called reflation expected ahead will most likely manifest in the narrowing of WPI vs CPI prints over the year.
3. Yield curves will gradually bear flatten. Put in the bond market’s perspective, the current difference between 10 year bond yield to overnight rate is roughly around 275 - 300 bps. This will likely fall over the year ahead, although it will still be higher than the last few years’ average given that monetary policy will likely be more accommodative on average and bond supply will be higher for the next few years when compared with the last few years. It is also very likely that the bulk of this adjustment will be made by the very front end rates. This is not to say that long end rates won’t have to adjust. Rather, the quantum of adjustment there may be of a relatively smaller magnitude when compared with rates at the very front end. It is also to be noted that such adjustments are likely to be gradual and the ground to cover till normalization, at least till the first such equilibrium, may not be anywhere as large as has been the case in previous such episodes of very low front end rates.
4. The starting point today is one of a very steep yield curve. Thus unlike in normal times when the yield curve is quite flat, the decision on duration isn’t a binary one any more. Rather, one has to examine the steepness of the curve and position at points where the carry adjusted for duration seems to be the most optimal. That is to say, even if yields are to go up there are points on the curve where the extra carry compensates enough for a limited rise in yields so that the trade still earns better than the rate on offer on (let’s say) 1 year treasury bills today. This also means that the cost of keeping cash is quite high, especially as one doesn’t expect any abrupt reversals ahead.
5. Credit spreads, including on lower rated assets, have compressed meaningfully. These reflect the chase for ‘carry’ in an environment of abundant liquidity and funds flow, as well as the relatively muted supply of paper as companies have belt tightened and focused on cash generation. As activity resumes over the year ahead, issuances will likely increase thereby pressuring spreads to rise. Paper supply may also increase as institutional investors redeem some of their treasury investments to deploy in business. The extent of such expansion will likely be higher for companies that can absorb higher borrowing costs given the nature of their activities or whose paper tends to command lesser liquidity when market turns “two-way”. Also, as a general principle, at the bottom of a rate cycle it is prudent to demand higher compensation for deeper commitments of capital. While a steep yield curve is possibly providing this for longer tenor commitments (at least at particular points on the yield curve where implied forward rates are quite attractive), credit spreads on lower rated assets in general may no longer be doing so.
Towards The Light
We would most likely have lost our readers somewhere in this exceptionally long-winded year end piece. What is written now is therefore likely to just gather dust. Irrespective though here’s wishing that we can leave this year well and truly behind, that the next page is indeed a chance to begin things anew, that there’s a warm and benign light that shines upon us all which brings joy and fulfillment, that we never forget to be grateful for what we have nevertheless, and that we are always awed and inspired by the kindness of strangers.
Wishing You A Very Happy New Year.
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