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Moody’s upgrade positive, but don’t forget near-term risks

Improved sentiments, FPI flows will provide a fillip to the rupee

India’s rating upgrade by Moody’s reaffirmed the long-term positives of the recent reforms and measures. We believe that while it is positive for rates and FX, near-term concerns remain from likely fiscal slippage, rising inflation trajectory and RBI’s consequent reaction, and domestic liquidity tightening. We pencil in the 10-year yield in range of 6.8-7.0% by end-FY2018 with the lower end moving towards 6.6% in case of no fiscal slippage. We revise our average FY2018 USD-INR estimate to 64.8 (earlier 65.25).

The move to Baa2, the highest for India, comes after India’s last upgrade to Baa3 in 2004. India joins Bulgaria, Colombia, Italy, Oman, Panama, Philippines, Spain, and Uruguay in the Baa2 basket. The upgrade has been predicated on (1) reforms and measures such as implementation of GST, demonetization, improved monetary policy framework, UID and DBT framework, (2) greater confidence that these will lead to a stable to declining public debt path, (3) further strengthening in India’s institutional framework, and (4) mitigation of PSB risks which will likely be positive for growth.

Even as Moody’s noted the long-term positives for the economy, it highlighted that challenges remain in certain areas such as land and labor market reforms, private sector investments, and resolution of the banking sector’s asset quality issues. We note that India is at BBB- (a notch below Moody’s) by both S&P and Fitch.

While Moody’s upgrade is undoubtedly positive for India assets in the medium to long term, the near-term risks remain intact. Apart from the initial short squeeze, we continue to maintain a negative bias in the near term given the risks emanating from (1) fiscal slippage (we expect the government’s fiscal deficit in FY2018 at 3.5% as against the budgeted 3.2% given the downside risks on receipts specifically from lower RBI dividend, excise duty cut on petroleum products, and GST collections), (2) upward trend in inflation trajectory, (3) higher crude oil prices, (4) end of the rate cut cycle, and (5) tightening domestic liquidity.

From foreign flows perspective in GSec debt segment, there is currently limited room as the GSec limits are mostly utilized. However, positive sentiments may help in utilization of open SDL limits (Rs252bn) and the remaining general category limits in GSec (Rs31 bn) and corporate bonds (Rs40bn). But we need to note that continued FPI equity inflows will keep alive the risks of further OMO sales, implying higher supply pressure on bonds in the near term.

We, therefore, expect the benchmark 10-yr yield to range from 6.9-7.1% for the remainder of 3QFY18. However, some respite may come in 4QFY18 as FPI limits in GSec bonds open up (around Rs15 bn), helping the benchmark paper to move towards 6.8-7.0%. We do note that possible fiscal prudence with government sticking to FY2018 GFD/GDP at 3.2% (Kotak: 3.5%) and FY2019 at 3.0% could turn the tide further in favour of bonds.

Alongside, a technical adjustment due to the introduction of a new benchmark 10-year paper could move the lower end of the range towards 6.6% in 4QFY18.

Meanwhile, improved sentiments and FPI flows will likely provide a fillip to the rupee unless the RBI intervenes heavily. We now expect USD-INR to trade in the 64.25-65.75 range for the rest of FY2018, averaging 64.8 in FY2018 compared to 65.25 earlier.

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