India: Growth spurt in 2Q, rates eye trade-off
- India’s growth held up well in 2Q, running at 20.1% YoY
- The trade-off between growth and inflation needs to be considered
- Policy normalization is likely
- Government bonds could underperform
India’s GDP growth rose by 20.1%yoy in 2Q21, (1Q of FY22) quickening from 1.6% in 1Q, marking the strongest pace of rebound amongst EM economies. Base effects magnified the scale of jump, with the impact of the second Covid wave better reflected in the sequential contraction (-16.9% qoq nsa), keeping output at a tenth below the pre-pandemic trend. To recall, 1Q20 growth had contracted -24.4% y/y (~-30% qoq nsa) due to a nationwide lockdown in response to the first Covid wave.
The supply-side measure, Gross Value-Added growth rose 18.8% vs 3.7% in 1Q21. Nominal GDP growth surged 31.7%, benefiting from a double-digit deflator, as both the retail and wholesale inflation gauges had risen sharply in the period due to idiosyncratic drivers and supply side disruptions. Internals include:
• Under supply, farm output is back to trend, but industry and, to a larger extent, services are below pre-pandemic levels. Agriculture (and allied) proved to be resilient, benefited from a strong rabi harvest, higher nominal rural farm wages on record procurement of cereals, and employment support schemes. Industrial sector jumped 46% y/y, dominated by a nearly 50% y/y jump in manufacturing output and 68% surge in constriction owing to less stringent localised restrictions vs the first Covid wave. Corporate earnings before interest, depreciation and taxes also fared well, especially metals, cement, trade etc. The dominant service sector rose a modest 11% despite a 21.5% contraction in 2Q20, most adversely affected by the pandemic, reflected in a broad-based fall in momentum in sub-components
• Core GVA (ex-farm and ex-public services) expanded 25.2% vs 1Q21’s 4.1% but contracted on sequential terms revealing that private sector activity was affected/delayed by the second wave
• Under demand, consumption (private and government) rose by double digits but contracted on the quarter as spending was constrained by the onset of the second wave. Real incomes were hurt by high inflation and renewed income/ employment uncertainty, leading to longer-term scarring especially in the informal sector. Fixed capital formation rose by a strong 55.3% vs -47% in 2Q20 but fared poorly on sequential basis suggesting that higher public capex disbursements and gains from accelerated formalisation did not percolate to the private sector capex cycle. Notwithstanding upbeat exports, net trade emerged as a drag on the headline growth.
Outlook: Our Weekly activity gauge indicates that the economy continued to recover into July-August, benefiting from a moderate case count and expectations of a shallow third wave, if any. This supports our expectation of a sequential rebound in 3Q21 (2QFY22). Base effects will, nonetheless, pull the 3Q21 (2QFY22) yoy growth lower, as captured by our GDP Nowcast model, which is likely to persist in 4Q as well. We maintain our FY22 growth forecast at 9.5% vs -7.3% contraction year before. Calendar 2021 growth is seen at an average of 8%.
Growth has evolved along the RBI’s expectations in the June quarter, likely turning policymakers more confident on the growth outlook and warming up to policy normalisation, starting with a calibrated adjustment in the reverse repo rate in late 2021. Global developments warrant attention as Covid cases have risen sharply in many pockets, amidst moderating growth in China, US Fed’s taper indications and fallout of supply chain disruptions, for instance chip supply shortage impacting key domestic automakers at home.
Inflation concerns linger
Inflation concerns continue to linger, despite the recent pullback in CPI inflation. While off highs, headline inflation has remained stubbornly north of the 4% midpoint target since late 2019, driven by a mix of sticky drivers, during as well as after Covid spells. There are latent pressure points to keep an eye on, as inflationary expectations firmed up further in the latest survey. As states ease restrictions, there is likely to be a shift away from goods to services-led inflation, with firmer demand to also encourage producers to increasingly pass on higher input prices. With the upward revision in the inflation forecast, the central bank has built-in sufficient buffer for potential upside risks. Broader policy direction is still pointing to a preference for growth over inflation in the near-term, with liquidity moves setting the stage for policy normalisation down the line.
Sticky inflation and a heavy bond supply pipeline have seen risk-free borrowing costs drift up in the past couple of months – generic 10Y yields are up 20-25bps since May - even as bond purchases under the G-SAP facility continues. This rise was further fuelled by the perception that August’s rate review was hawkish at the margin, owing to a) dissent by an external member on the policy stance; b) increase in the variable rate reverse repo auctions to up to INR4trn; c) higher than anticipated revision in the inflation forecast for FY22.
While outright rate hikes are a distance away (2H22), Policy normalisation could take different shades, if kickstarted towards late-2021. Whilst the VRRR (variable rate reverse repo) auctions absorbs short-term and transient liquidity, the current strong surplus will necessitate lowering durable liquidity, issuance of MSS bonds etc. lowering purchases under GSAP over time to ease the extent of incremental increase, change in the policy stance accompanied by reverse repo hikes to normalise the policy corridor (needs to be adjusted up 40bps to restore pre-pandemic corridor) between late 2021 to 1H22, eventually followed by repo rate adjustments in the second half.
Concerns over price pressures reflected in other RBI surveys
- Current and forward-looking consumer confidence indices continued to diverge, with the current period reading remaining weak, and the current situation index (CSI) falling to a fresh low, with perception of households’ deteriorating further on income and price levels vs the previous round. Forward-looking sentiments fared better.
- Services and infrastructure outlook survey respondents were downbeat in the current situation but expected to fare better over the next three quarters. For 1QFY22, enterprises faced significant deterioration in the overall business situation due to the second pandemic wave. On other metrics – employee assessment and profit margins turned more negative, input price pressures rose, which were partly reflected in output prices. Firms are expecting to gain ground in 2Q to 4QFY22, but this improvement in sentiments (and profit margins) is also accompanied by expectations of higher input cost pressures especially by service sector players, rising cost of finance and selling prices to harden further.
- The bank lending survey points to optimism from demand as well as supply over 2Q-4QFY22. From the demand end, banks expect demand for loans to rise across sectors – manufacturing, retail, and services. Whilst banks exercised restrain in 1QFY22 in midst of the second wave, they expect the terms and conditions to ease, for the agri and manufacturing sector to begin with and to broaden to all sectors by end-FY22.
In midst of the growth vs inflation trade-off, INR rates are now assigning a greater weight towards inflation worries. We think that this makes sense given that growth risks have receded in the past few months recovering after a sharp increase in cases few months ago. Daily COVID-19 cases have dipped below 50k, from over 400k at the peak of the crisis in May. With reports indicating that two-thirds of the population may already have antibodies against the coronavirus and the daily vaccination drive picking up, we argue that India may be one of the best placed emerging market to recover. To put things into perspective, India is seeking a total vaccine supply of ~1.1bn doses by end-2021, as the production capacity of the key domestic supplier doubles from April’s levels. While these numbers may look optimistic, it does not detract from the fact that India (and the economy) may be relatively resilient (compared to other EMs) to COVID-19.
Risks of another COVID-19 wave notwithstanding, we think that the bond market will increasingly focus on inflation risks. India’s headline CPI has nudged above 6% YoY for two consecutive months before easing in July. While base effects would turn more favourable out to December (pushing down headline figures), market participants and policy makers are unlikely to be able to shake off their discomfort with rising prices. At the last Reserve Bank of India (RBI) meeting, one dissent on the stance and upward revision is the inflation forecast is expected to spur an internal debate over the policy direction.
Compared to the largest EM economies, the RBI appears slightly behind on normalisation plans. Brazil has hiked rates by 325bps since the start of the year. Note that the policy rate is already above pre-pandemic levels (which we peg at the start of 2020). Similarly, Russia has hiked rates by 225bps this year and the policy rate is also above pre-pandemic levels. Comparisons to China have to be more nuanced. The People’s bank of China’s (PBoC) stance is probably better reflected in the 7D repo. This rate was already normalized by mid-2020 (generally in the 2-2.5% range) when China got COVID-19 under control. While there has a been a modest easing bias recently, we see the PBoC as merely tweaking to make policy less tight. In short, the RBI’s stance is arguably the loosest within the BRIC economies. With the Fed likely to announce taper in the coming meetings, tighter monetary policy by the RBI could be needed.
As we discuss in the section above, we suspect that the RBI would first normalize liquidity, allowing the overnight interbank rate (currently hugging close to the reverse repo rate of 3.35%) to drift closer to the benchmark repo rate of 4%. If interbank rates rise, it should be viewed as less loose monetary policy and could take place over the course of the year if economic recovery is on track.
The market has already factored in an increase in the interbank rate back above pre-crisis levels in two years. Having factored in 50bps worth of hikes in 2H22, we think that this pricing is reasonable, but risks are probably skewed to the upside. We are in the pay on dips camp for 2Y-5Y NDOIS. We have also tweaked our 10Y yield forecast higher to 6.4% and 6.7% respectively for end-2021 and end-2022. On a relative basis, we think that India government bonds are likely to underperform IndoGB, playing on a likely policy divergence between the RBI and Bank Indonesia (more focused on growth).
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