Indian Economy: Respite from the gauges

Inflation based on the Consumer Price Index (CPI) dropped to 0.25% in October, the lowest since the start of the 2011-12 series; the Wholesale Price Index-based gauge entered deflation zone at -1.2%. Historically, low inflation has been associated with decreases in food inflation, underscoring the importance of controlling food inflation to consistently meet the Reserve Bank of India’s (RBI) target of 4%. With the latest print falling below our expectations and averaging 1.9% over the first seven months of this fiscal, we have lowered our inflation forecast to 2.5% from 3.2%.

Government bond yields have remained high despite favourable macro conditions such as the sharp decline in inflation, cut in the repo rate and cash reserve ratio, timely central government borrowings and low crude oil prices.

Despite the 100 basis points (bps) repo rate cut this year, the yield on the Indian 10-year government securities (G-secs) has only fallen 23 bps. This month's analysis identifies three factors contributing to the persistently high yields on G-secs:

1. The pause in the repo rate cuts and a shift to a neutral policy stance since June, which has led market participants to believe that the rate cut cycle is ending.
2. An increase in state government bonds supply, especially in the second quarter.
3. Limited bank capacity to absorb the sudden oversupply.

While macro conditions will continue to support lower yields, the three factors are also expected to help reduce the 10-year bond yield to ~6.4% by fiscal-end. The lower inflation increases the likelihood of a rate cut in December. We expect a 25 bps cut by the United States (US) Federal Reserve this year, lowering US yields and creating room for a cut here. The widening spread with US government bonds will encourage inflows.

The economy is poised to end the year on a positive note, with growth at 6.5% and inflation at ~2.5%. This provides a better-than-expected backdrop for the upcoming budget on most parameters, except nominal gross domestic product (GDP) growth, which trails the budgetary assumption of 10.1% for the fiscal. The next fiscal should see higher nominal growth as real GDP maintains momentum and inflation normalizes.

However, as global trends shift towards protectionist policies, the budget must also support tariff-impacted sectors and accelerate reforms to enhance India's growth potential. Some initiatives aiming to aid exporters have commenced, such as the credit guarantee scheme and the RBI’s moratorium on loan repayments.