RBI pre-policy: neutral with a dovish tilt. FY2020 budget was aimed at providing marginal relief to certain sections of the population. While this could have some positive demand in low-ticket items, the impact on headline inflation may not be too significant. High public sector borrowings remain a sore point. Given our benign inflation trajectory, we maintain our call for (1) stance changed to ‘neutral’ in February, and (2) 25 bps repo rate cut in April and June.
Budget may not alter inflation much…
In the December policy, MPC members (DG Acharya, Dr Dua) had highlighted that fiscal slippages would have a bearing on the inflation outlook though Dr Dholakia had asserted that the impact would be lagged and insignificant. We believe that sops for small and marginal farmers and select tax payers may contribute to positive demand in low-ticket items but unlikely to impact headline inflation significantly. According to RBI’s estimates, a 100 bps increase in consolidated GFD/GDP increases inflation by 50 bps (in a non-linear manner). The consolidated GFD/GDP is expected to remain unchanged at 6.2% in FY2020 against an implied GFD/GDP of 5.7% (as per MTFP of FY2019 budget) (Exhibit 1). However, with consolidated GFD/GDP likely to remain flat and inflation trajectory expected at sub-4% till August 2019, RBI will have room to provide a dovish tilt to the upcoming policy along with a change in stance (Exhibits 2-3).
… but concerns on crowding out increase as public sector borrowings rise
We note that the fiscal deficit slippage is only part of the story. While the borrowings used to finance current expenditure (RD/GFD) have increased only marginally in FY2020 (Exhibit 4), the bigger concern is crowding out private investment due to on-budget and off-budget borrowings. In fact, the off-budget financing has steadily built up over the past few years to reach record levels (Exhibit 5). Aggressive public sector borrowings risk impeding monetary policy transmission as well. Given the increasing dominance of off-balance sheet borrowings (such as NHAI and FCI), consolidated public sector debt/borrowings should be assessed for comprehensive policy decisions (Exhibit 6).
Inflation trajectory has remained in line with expectations
The December policy had estimated 2HFY19 inflation range at 2.7-3.2% and 3.8-4.2% in 1HFY20. Headline inflation has been benign with the 2HFY19 lower bound been breached and it is likely that inflation would remain in in the expected range in 1HFY20. In fact, core inflation will be a bigger worry for the MPC. Some additional understanding would be required on the more recent sequential increases in rural education and health and their durability. However, cyclical economic slowdown is expected to cap the upside, if any. We expect core inflation to glide down to 4.4% and headline inflation at 4.5% by March 2020 (Exhibit 7).
Retain our view of a shallow rate-cut cycle but expect MPC to maintain caution
We expect the MPC to be cautious on the inflationary impact of the budget even as fiscal slippage seems manageable. The MPC might raise concern on the quality of expenditure, especially when the borrowings (government and public enterprises) have increased significantly. However, the MPC decision will hinge solely on the expected benign inflation trajectory. We maintain our view that a shallow rate-cut cycle (25 bps each in April and June) remains on the cards with the stance being changed to ‘neutral’ in February meeting. We reiterate our view that bond markets are unlikely to see much relief in the near term and maintain our view for the 10-year yield within 7.25-7.75% in FY2020.