The lockdown measures taken around the world in response to the Coronavirus early this year, were akin to a master switch getting turned off. Thus economic activity stalled suddenly backed by a collapse in mobility as governments around the world sought to delay and diminish spread of the virus.
There was hope then that this switch has been turned off for a limited period and will be turned on as well once the intended health outcomes had been achieved. Indeed, a lot of economic policy responses were also designed seemingly with this assumption in mind.
Thus initial fiscal responses were forceful (not just in developed countries but also, in varying magnitudes, in parts of the developing world) and designed as a “bridge” for economic agents while the master switch was off. It was hoped that these can taper off significantly once economic activity rebounded.
However, the reality is turning out to be messier as it often is. While turning off was an event, the turning back on is proving to be a long and tiring process. The first impact of resumption is obviously very particularly in manufacturing sector / goods production, as India also is currently witnessing. But as it gets clearer that mass vaccination is a longer road, the prognosis for smaller balance sheets and those operating in the services sector is increasingly turning pessimistic.
Also, the Western world is throwing up a grim reminder of the resurgence in infections that mass re-opening can potentially bring. From an economic standpoint, this necessitates fresh mobility restrictions to varying degrees as parts of Europe are now being forced to impose.
Implications For Macro Policy
As this turns to be a long and arduous process rather than a high intensity adverse event, macro policy also has to now pivot towards providing continuous support rather than just the first aggressive response referred to above. With incremental efficacy of additional monetary policy easing in the next to nothing territory, the thrust is largely on fiscal policy.
Indeed the aggressive cheerleading for fiscal expansion by Western central bankers, while seemingly appropriate in the context of the once-in-two-life-times shock that we are witnessing, is nevertheless notable to witness. However, and while it should still soon be forthcoming, the second response of fiscal policy is still getting somewhat delayed. More worryingly, for emerging markets that were somewhat bold with their first responses, fiscal sustainability may become a dominant issue going forward.
Consumers and companies had to switch off as well with the flipping off of the master switch. This was true for most things apart from essentials. Wherever incomes have been preserved and starting balance sheets were sizeable and strong, demand and production is coming back with the reopening.
However elsewhere where these conditions weren’t met, permanent damage is the concern. It is largely here that fiscal policy will have to do the most significant handholding as this tunnel becomes longer and more winding.
India’s Fiscal and Monetary Response
For all the criticism of the relatively modest direct cash spending so far, India’s fiscal response may well turn out to be better suited to the situation eventually. This is keeping in mind both the long drawn nature of the issue which requires continuous support, as well as the obvious starting constraints that India was already working with.
Whether enough has been done to preserve smaller entities in the system will remain an open question and will probably only be answered with the benefit of hindsight. However, the initial focus on food provisioning for the poor and credit guarantees for lending to small businesses has perhaps allowed for some room for incremental support (probably high growth multiplier spending) even as general fiscal stress is still quite evident given the massive fall off in revenues of the government.
As far as monetary policy is concerned, what should have been a straight forward format has been somewhat complicated by the unexpected persistency in inflation. To their credit, however, the RBI and the monetary policy committee (MPC) aren’t taking cover behind this data muddle.
Instead there is a clear-headed prioritization of objectives even as this comes with the attendant risks of being proven wrong with the benefit of hindsight. This clarity was abundantly highlighted in the October policy review where the dovish stance was further enhanced by also attaching a time guidance to it. Presumably this could be achieved since the new external members as a collective sound somewhat more dovish than their predecessors (again as a collective) and with RBI member Dr. Patra seemingly having resolved his earlier conflict in favor of supporting growth.
In our view this additional strength to guidance was also timely given the recent inadvertent gap in communication that had somewhat cropped up between RBI’s intent and the market. The other notable aspect of the recent policy, as detailed in subsequently released minutes, is the reference to transmission in long term yields. This was referred to by new member Prof. Varma (“I believe that excessively high long term rates are inflicting damage to the economy in two ways..” and “A sharp reduction in long term rates is therefore important.”) as well as by Governor Das (“This enhanced guidance should strengthen and quicken the pace of transmission to longer-term yields and help support consumption and investment demand in the economy”).
While the former’s role may be purely advisory in nature as far as usage of direct tools that address bond yields are concerned given that they largely are within the exclusive ambit of RBI, these references are nevertheless significant since they also seem to find support with the Governor. The stepping up of open market operation (OMO) purchase of bonds including in state development loans, was definitely aimed at bridging the communication gap with the market. Its persistence, or lack thereof, going forward will decide whether it was also as an outcome of the bond yield references by MPC members.
A Strategy Update
We have tactically gone overweight in the 9 – 14 year government bonds in our actively managed duration funds. While the medium term assessment as detailed before remains the same , this change from our “stickier” preferred stance of 6 – 8 year bonds is basis a few tactical considerations.
Despite an increasing in issuance in the 3 – 5 year segment under the revised borrowing calendar and with RBI stepping up OMO purchases, the steepness of the 9 – 14 year segment to 6 – 8 year had been largely intact. Put another way, the underperformance of the 6 – 8 year segment that we had feared wasn’t in evidence initially thus allowing us to shift towards higher duration with minimal impact.
Had the market already flattened the curve readily then it is likely that we would have not executed the shift basis valuation considerations. Also, we are intrigued by the references to long term yields in the minutes of the recent policy. While our bias is to not make much of this, a reduced weekly auction size in the 10 – 14 year segment backed (hopefully) by regular OMOs provides a conducive window to at least test out this theory. As always, we reserve the right to modify our stance at any time given the active duration mandates of these funds.