Wondering where the economy is headed? Brace for higher inflation, fiscal risks

NEW DELHI: It is no secret that India has been witnessing a significant hardening of inflationary pressures over the last couple of months, with the surge in commodity prices following the Ukraine war making matters worse.

Providing a snapshot of how key macro-economic variables may play out in coming months, Nomura predicts higher inflation, higher terminal rates and fiscal risks on the horizon.

“We expect 100bp of cumulative repo rate hikes in 2022, starting with a 25bp hike in June, followed by another 100bp of rate hikes in 2023, which would take the terminal repo rate to 6.0% by Q3 2023,” the foreign firm said.

“We also see growing risks of a fiscal slippage in FY23 from the target of 6.4% of GDP, due to higher food and fertilizer subsidies and the continued prioritisation of capex spending.”

On Wednesday, ET NOW reported, quoting sources that the Union Cabinet has approved an increase in phosphatic and potassic fertiliser subsidy for kharif season FY23, from Rs 21,000 cr to Rs 60,000 cr.

The benchmark policy repo rate, which is the rate at which the Reserve Bank of India lends to banks, has been held steady at a record low of 4.00 per cent for around 2 years now as the central bank has extended prolonged policy accommodation to revive the economy from the scars of the COVID crisis.

However, with inflation outturns surprising on the upside – the latest CPI print clocked in at a 17-month high of 6.95 per cent-the RBI has announced earlier this month that it is prioritising inflation over growth after a span of three years.

The central bank sharply increased inflation forecasts and launched a new floor to the interest rate corridor at a higher rate than the one that previously existed.

It also said that it would start a multi-year process of reducing the massive liquidity surplus that was maintained in the banking system over the last couple of years.

Currently, the liquidity surplus in the banking system is estimated at around Rs 6 lakh crore.

“We expect excess liquidity to be withdrawn over the coming months. Banks are likely to be the most impacted, and call rates should move closer to the RBI’s repo rate,” Nomura wrote.

“We expect MIBOR (Mumbai Interbank Offered Rate) to edge towards the repo rate by August, as liquidity is withdrawn. The market is pricing in a MIBOR of around 5.15% by end-2022 and 6.5% in 2023, versus our base case of 5.0% and 6.0% respectively.”

While the RBI has several times said that it will telegraph its actions clearly, for financial markets the shift away from ultra-loose monetary policy poses headwinds.

Equities have notched up substantial gains over the last couple of years as a portion of the liquidity surplus amid low interest rates found its way into the stock markets.

Moreover, higher policy rates translate into higher bond yields and therefore higher cost of capital for companies and an erosion of valuations.

Bond markets have benefited from the low interest rates and easy liquidity with benchmark yields remaining depressed for the larger part of the last couple of years despite significant fiscal risks and signs of policy tightening in the US.

A jump in sovereign bond yields does not bode well for other borrowers in the economy as gilt yields are the pricing benchmarks for a vast variety of credit products.