Interest rates will likely harden with no rate cuts and persistent fiscal pressure. Key risks for the government will be to steer through any financial sector stress, reviving the weak investment cycle and any adverse issues with global liquidity.
Two issues will shape India’s macro-economic situation in CY2021; easy money policies in developed markets and rollout/mass availability of Covid vaccines. Easier global monetary policies will aid risk-on flows, while vaccine rollouts will aid faster normalisation of growth.
However, risks of higher commodity prices (especially that of crude oil) could weigh on India’s inflation and external sector balance. Expect a cyclical recovery in growth and a gradual adjustment in interest rates. Beyond FY2022E, growth will likely moderate, as interest rates move higher, global tailwinds fade and the fiscal stress continues even as benefits from production-liked incentives in manufacturing and labour reforms would start yielding early benefits.
The Indian economy is likely to see a gradual cyclical recovery unless there is a large base effect. The FY2022E real GDP growth is estimated at 9.3% (6.1% in FY2023E) after (-)8.6% in FY2021E. The services sector will likely outpace the manufacturing sector in H2 of FY22E. The investment cycle will remain a drag, with the financial/ corporate sectors and the governments staying under pressure.
We assume normalisation of supply-related issues in inflation through the first half of CY21, thereby, drop in food prices. While inflation is still not driven by monetary causes, it is certainly more broadbased and the upside risks could emanate from demand side pressures given the normalisation in economic activity. However, the base effect will keep inflation on a gradual glide path towards 4.8 per cent. We estimate average FY2022E inflation at 4.7 per cent (6.4% in FY2021E).
Most of RBI’s liquidity injection (which has driven market interest rates lower) has been through forex accretion in FY2021 and is likely to continue. With inflation expected to settle above 4 per cent, expect RBI to begin liquidity normalisation from FY2022 onwards, even while keeping the repo rate steady.
Accordingly, market rates are expected to harden across the curve in FY2022, with the shorter end of the curve underperforming the far end. Fiscal consolidation is also unlikely to be sharp (FY2022E GFD/GDP at 5.5%) with gross borrowing only marginally lower than FY2021E. Expect the 10-year yield to inch higher towards the 6.25-6.5% range in H2FY22, given RBI’s increasing constraints to support the bond market amid huge forex-related liquidity.
The forex market outlook will broadly be determined by a secular weakness in the dollar, sustenance of easy monetary policies in developed markets and the pace of vaccine rollout. While these are favourable for risk-on flows across emerging markets, the consequent growth recovery will provide a fillip to commodity prices, capping some of the gains in the rupee.
Meanwhile, rupee moves are likely to remain a function of RBI’s forex intervention. Thus, expect the rupee to trade with an appreciating bias through H1FY22 (72-75), with risks emanating in the latter part of the year (74-77), with a sharp depreciation bias stemming from the enormous forex accretion.