India's macros have improved significantly since 2013, thus reducing the risk of large pullout by FPIs, says Suyash Choudhary, Head – Fixed Income at IDFC AMC.
Given the global turmoil, is RBI likely to cut rates?
The RBI has a medium term target of 4+/-2 per cent on CPI. While the central bank talks of targeting the mid-point of this range, we think it will be happy if inflation starts to trend around 5 per cent with limited durable upside risk. Indeed, at this juncture inflation seems to have broken the 5 per cent level.
However, commodity prices pose a risk. For the RBI’s confidence to increase, the government will have to continue proactive food supply management and prevent administered price distortions, as well as continue fiscal consolidation.
Additionally, if the gap between financial savings and investments continues to close, then RBI can eventually settle for a lower real rate target. If public policy continues to move in the right direction, we can see significantly lower rates over the next three years or so.
What are the domestic risks to rate cuts?
The biggest risk to rate cuts comes from a potential directional change in government efforts. For instance, if the government were to compromise on deficit targets due to revenue spending pressures over the next few years, then that will count as a big risk. However, as of now there is no indication of any likely change in the policy direction of the government.
With the rupee weakening, investors are worried about a repeat of 2013. Is that likely?
The rupee continues to be reasonably overvalued on a real effective exchange rate (REER) basis.
There has been an important change to India’s macros since 2013; we no longer run that magnitude of external funding risk.
The best measure to look at is basic balance--sum of current account deficit and net FDI. This measures the extent to which we can fund our external deficit without the contribution of the so-called volatile capital flows. We were running a funding deficit of close to $70 billion in 2013. This has now turned positive.
What are you recommending to bond investors now?
There are three distinct themes that we think investors should be focused on. One is a core portfolio of sovereign bonds . Attractive real rates, narrowing financial savings’ imbalance, and the lack of strong cyclical recovery ahead are all arguments for this allocation This allocation can be achieved via an actively managed bond or gilt fund.
Two, minimise reinvestment risk. As our macro-economic dynamics improve, interest rates will head lower over the next few years. This creates reinvestment risks for investors who have very short-term investments.
Reinvestment risk should be plugged by choosing intermediate bond funds between two and five years of maturity, provided they have a conservative approach to credit. Three, it is best to minimise credit risk.
The macro-economic environment is one of falling nominal GDP growth rates.
Also, credit risk in India cannot be hedged due to lack of a robust secondary market and the non-availability of hedging tools.