The flight of risk capital

So far, domestic institutions have been net buyers. But if there are redemption pressures, this could change

Inflation worries prompted the Reserve Bank of India (RBI) to maintain status quo in the latest Monetary Policy Review. While five Monetary Policy Committee members voted to hold rates, one wanted a hike. The central bank thinks growth is rebounding. But it sees multiple threats on the inflation front, including an inflationary Budget.

Strong job growth in America makes it likely that the US Federal Reserve will accelerate normalisation, by hiking interest rates faster and selling off excess bonds acquired during the taper years. That would reduce the risk appetite of investors while leading to a stronger USD.

Inflation will be driven up for sure, by rising crude prices and rising prices of non-oil industrial commodities. Given improving growth, rising input costs are likely to be passed on to consumers. The monsoon is an imponderable. The RBI assumes it will be normal in its projections.

The policy statement mentioned the following risk factors from the budget but it couldn't quantify the potential impact of these. The revised minimum support prices (MSPs) for crops could be inflationary. So could higher customs duties. The slippage in fiscal deficit targets will directly impact inflation, and also drive up borrowing costs for everybody.

In the first half of 2018-19, the RBI assumes retail inflation as measured by the Consumer Price Index will be between 5.1-5.6 per cent. It hopes inflation will drop to 4.5-4.6 per cent in H2, but there are upside risks. The moderation could be due to favourable base effects. A softer food inflation forecast assumes a normal monsoon and competent food supply management.

The growth estimates for 2017-18 projects Gross Value-Added (GVA) to grow at 6.6 per cent in 2017-18. In 2018-19, the positives include stabilisation of GST implementation. There are also early signs of revival in investment as reflected in improving credit offtake, primary capital market activity, and rising capital goods production and higher capital goods imports.

The recapitalisation of public sector banks should improve credit flows. But while export growth is expected to improve on account of improving global demand, elevated commodity prices, especially of crude oil, may act as a drag. The GVA growth for 201819 is projected at 7.2 per cent overall, and in the range of 7.3-7.4 per cent in H1 and easing off to 7.1-7.2 per cent in H2. Note that growth is actually expected to fall in the second half of 2018-19.

Those numbers aren't very encouraging. The expected growth acceleration would translate to about 0.5-0.75 per cent in either GVA or GDP terms for the next fiscal. The inflation forecast suggests that inflation will run somewhat higher for the next fiscal. This could well be an under-estimate, since it doesn't quantify the admittedly inflationary elements in the Budget.

Higher borrowing costs are already visible. The 10year treasury yield is up and there's a flattening of yields across short-term treasury bills. The recapitalisation could help funnel cheaper funds through the financial system but that will be balanced off by the government's expanded borrowing needs. The RBI's Financial Stability Report projects that NPAs will peak around September 2018. The recapitalisation corpus of ~2.2 trillion may not be enough.

At the same time, the corporate results from Q3 2017-18 do suggest that earnings growth is finally picking up. There's optimism on this front. However, corporates will be paying interest for borrowings, at 4 per cent over the retail inflation benchmark at the very least (or even more if we use the Wholesale Price Index). If they tap the bond market as the Budget suggests, it might take some pressure off the banking system but it will lead to higher yields for most corporates.

The ‘risk-off’ attitude of global investors is already evident. Every major global stock market has been hit in the last week. In India, there's been selling by foreign portfolio investors and by retail. So far, domestic institutions are net buyers. But they cannot shore up the market if retail investors step up the pace of sales and mutual funds are forced to meet redemptions.

In terms of valuations, the Nifty has edged down from price-to-earnings of 27.8 in late January to 25.3 in early February. Earnings growth for that sample of 50 large caps has accelerated. But valuations still look very rich. If the risk-averse trading mindset continues, the market could see a deep correction.