Changing
Tides - INFLATION

In India too inflation seems to be perking
up. 10-year bond yields have jumped by 130 basis points to 7.30% over the past
few months. Rising crude prices, additional borrowings by the Government of
India and a higher than provisioned fiscal deficit at 3.5% of GDP, have sent
markets into a flurry with investors dumping government securities. The budget
announced a Minimum Support Price that the government would provide to farmers,
at 1.5 times the cost of production. This together with somewhat generous
assumptions on GST collections all point to higher fiscal pressures on the
government’s balance sheet. Under these set of circumstances, it now seems
unlikely that the Reserve Bank of India will have any sort of leeway to reduce
interest rates further. On the contrary, a rise of 25-50 basis points before
the end of the year now appears more plausible.
In a paper
entitled ‘Irrational Exuberance – October
2017’, I argued that global asset prices including stocks, bonds and
property, were frothing and a correction was perhaps overdue. In India too,
equities had risen by 283% following the collapse that shadowed the global
financial crisis. Price earning multipliers of 24 for the Nifty 50 and 35 for
mid-caps seemed a stretch, as companies were unlikely to match market
expectations on future profits. The recent collapse in Indian equities,
triggered allegedly by amendments on the treatment of long term capital gains
tax, was really a reflection of inherent weaknesses in the props that supported
the financial markets. The bubbles in bonds and equities have consequently
begun to deflate.
Be that as it
may, the economy is structurally strong. With the proposed recapitalisation of
banks and a greater reliance on bond markets, investment is bound to perk up.
The increase in entitlements and rural spending will ultimately feed into the
consumer markets with rising demand. The government’s own spending programme in
infrastructure specifically in roads and the railways will not only generate
greater demand but also provide the logistical support for greater economic
activity. If the RBI can get the right
balance in its monetary policy stance, the much awaited shift in the economy
from a vicious to a virtuous cycle could well be on its way. Clearly, a lot
will depend on the global environment and money flows into and out of emerging
markets. If growth in America, Europe and China is sustained over the coming
years, India will benefit with stronger investment and trade. If on the other
hand, global financial markets take a dramatic turn for the worse, persuaded
conceivably by triggers that create capital shifts out of emerging markets,
then the situation could turn worrying.
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