India's Whatever It Takes Moment !

On 04 Oct, 2019 we did it. The statement out of the RBI was akin to the European 'Whatever it takes' Statement. Let me not mince words, the RBI states "The MPC also decided to continue with an accommodative stance as long as it is necessary to revive growth, while ensuring that inflation remains within the target" This says it all, we are headed to lower interest rates for months to come till inflation rears its head. Starting 2019 RBI started to acknowledge that India is slowing a bit on growth. It is that acknowledgement that has allowed us to get where we are today.

So What came first? the economic growth slowdown or interest rates falling. More than a year ago I started to highlight that the high levels of credit in the system would eventually cause the economy to slow down in the detailed economic winter reports. I maintained that the coming fall out of the excesses in the private sector would show up in the financial system and keep the market from growing exponentially. However, the one warning that remained was that if the government steps in with fiscal policy or monetary stimuli, then things could change. It does not matter whether the change would be temporary or create bubbles, it would definitely create a liquidity driven boom that could keep market is going up.

Despite a slowdown in the economy in 2014, the market took off to new highs after the Modi 1.0 government was elected. My thoughts were similar that the run-up would not be sustainable. Given that we had issues billing under the surface, by 2015 the NPA crisis was out in the open. The markets continued higher due to the liquidity created in the past. However, there was no clear sign of fresh infusion either from the fiscal side, because we wanted to maintain our tight fiscal deficit numbers and interest rates were still elevated because of the risk of inflation. Both of these have eventually fallen over the last two years while this tightening effect took place.

We are fortunate to now have another strong government at the Centre. Most western countries would love to be in the situation where they are able to conduct a fiscal policy along with monetary policy. The US has done some of it one at a time, but most other countries have not especially in Europe, where the slowdown has been the hardest. There is, of course talk now of moving towards MMT or some kind of fiscal stimulus in various countries at some point of time. However, right now, all the announcements are purely on the monetary side, Europe has planned to resume its QE from November and has been cutting interest rates into negative territory. The US is also in a situation where interest rates that have moved up may again be brought down over a period of time. What most have missed however is that in Sept the US ended its QT program or the reduction in its balance sheet, but also turned right around to buy bonds from the market without announcing it as QE. Some people are calling it the 'Permanent Market Operations', that will now continue into the future. The FED will intervene as and when it is needed without announcement. This has become the need of the hour because Donald Trump expanded the budget to a point where their deficit entails increased borrowing from the market, and that could tilt interest rates higher. The FED therefore needs to provide some of that funding else the dollar will get too strong. This is in other words a weakening of the dollar to finance US sovereign borrowing. This week alone we have added 88$bn to the FEDs balance sheet. Don't believe me just look at this chart off the internet that is doing rounds.

However, they are still not committed to the fiscal side again. The markets are starting to anticipate that in future especially in Europe. What today's RBI meet highlights is that the Indian economy has been slowing rapidly, but is still growing at 6%, well above what the rest of the world is doing. We are in a unique place because we are approximately 10 years behind in the cycles that many other countries are facing. For example, I could say India is either in the pre-2008 Era, compared to the US. Today Europe cannot grow its economy even with negative interest rates, but in 2001 the US could do that. In other words, US has had room to cut interest rates and spur the economy back into growth or maybe into what some people call an everything bubble. In India we have the same luxury in India. We are now in a position where even as growth slows interest rates remain at a much higher level, leaving the room for rate cuts and at the same time because the government has been fiscally prudent for almost 2 decades, there is room for the government to step in and take risks.

The first sign of this showed up in the recent announcements made by the Finance Ministry by putting out tax cuts that no one was expecting immediately. These tax reforms may come across as fiscal policy. However, some people look at it as some people do not believe that it will create the required growth. Most other countries would die to be able to implement both of these together lowering interest rates as the RBI has been doing over the last few policies and simultaneously using fiscal policy to create demand. The reason people are concerned is that tax cuts by themselves may not be demand driving till invested in business activity, and might have liked the government to step in with direct investment. However, what they miss is that the government has done this to some extent over the last couple of years by trying to clear various projects in India to implement direct investment. This has helped create Capex at 8 to 9% over the last several years. That said, it might still appear insufficient because demand has not grown at the same pace the market expects to therefore wait for the impact of these tax cuts to show up on the demand side before discounting the steps that have been taken in the current case. What they will wait for is to see if the money that has been put in the hands of corporates gets invested in future growth plans, rather than simply sitting as cash on books or being distributed as dividends. Simultaneously, if the FDI plans of the government also take off because of the low tax rate on new investments at 15%, it could become a demand driver. Once the market starts discounting these long term possibilities, it will start looking to the upside and this will eventually result in a bubble. Given that we are starting our fiscal and monetary policy actions at an elevated market level, rather than after a complete collapse in front line valuations the market may continue to look overvalued. The truth is that we have seen a collapse in prices of stocks across the board, which shows up in either the MidCap indexes or the nifty next 50 index, but not in the main nifty and Sensex indexes. Therefore, the large caps or the big stocks that remain at higher valuations might end up seeing even more elevated valuation levels. This would then put us clearly and bubble territory,

The event may be months away where inflation finally rises to push up interest rates and prick the bubble. My view was that the systemic banking crisis would cause a risk off in bond markets and cause an interest rate spike. That view has now been averted by the government by stepping in and postponing recognition of new NPAs for a while. Simultaneously the stimulus being given to the market from all sides is an attempt to get animal spirits back and move the boat. Usually after a few early movers show the benefits of doing so everyone joins in and the mood changes. When liquidity and markets expand again to the upside the only risk at high credit levels in India and abroad then remains of a take off in inflation. But that has not happened as of now and gives us a lot of time in between. In the meantime money may flow back into markets because of these actions and take us to new heights. Remember this is also the first year of a newly elected strong government and that is a Seasonally bullish year.