MPC statement tomorrow

My 2-bits : the MPC statement tomorrow should err on the side of sounding more hawkish than the market expects.

If the MPC went purely by its CPI mandate, it can actually afford to be more benign than it was in February. After all, with lower vegetable prices, average CPI inflation for January - March 2018 will likely end at 4.6%, well short of the 5.1% MPC estimate. In addition, the initial forecast for monsoon is encouraging, and many analysts now project a more benign FY19 CPI path than the MPC did.

However, the MPC should look beyond this. After all, projecting India’s CPI is like throwing darts at a board. Who knows where food, oil and commodity prices will be in 6-12 months time.

What bears watching instead is financial stability, and there is ample cause to be cautious here.

First, the fiscal situation looks tough – on both expenditure and revenue fronts. In the run-up to general elections, the government will be under severe pressure to spend on farmers, rural India and perhaps oil and other subsidies. On the revenue side, GST is yet to stabilize, and we are banking on very steep increases in FY19 collections. Across all this, we risk serious fiscal slippage, which will have a cascading impact on other areas of financial stability.

Second, the external sector looks uncertain as well. Our trade deficit has been stubbornly high the last few months. With USD funding costs rising (1Y LIBOR is now at 2.67%, up 0.90% in the last year), capital flows remain soft. Net FDI has disappointed in FY18. The external macro context remains clouded by the populist bluster around trade wars and geopolitics. In the meantime, there is an overhang of open INR carry positions that have built up over the years.

On the flip side, India’s private sector investment cycle is absent, current sentiment is clouded by questions around governance and politics, and capacity utilization remains low. However, we do not have the luxury of low interest rates now. Instead, we have to guard against the possibility that any worsening of sentiment could impact external flows and financial stability even further.

When MPC issued its last statement in February, Indian bond yields were about 25-30 bps higher than they are now, and climbing.  Since the bond market was then doing MPC’s job of being a cautious watchdog, MPC could afford to benevolently talk about nurturing a nascent recovery.

With 10Y bond yields below 7.30% now and maybe heading lower, with a possible increase in FPI limits, large bond redemptions and a benign H1 issuance calendar, the MPC should tilt the other way, and sound a strong note of caution and vigilance.

If instead it adds to the bond rally with dovish commentary, and 10Y yields drop to 7.1% and below, do not be surprised if FPI and traders actually trim down positions and book profits both on bonds and currency. After all, the second half of FY19 promises a good chance of re-entry at better levels.