MNI ANALYSIS: Weak Rupee, Bonds Not Justified By India Economy

--Growth/Infla Dynamics Not Pointers To Weaker Currency, Higher Yields

By Stuart Allsopp

     SINGAPORE (MNI) - Indian local bonds have been the worst performing in Asia

since the start of the year amid widespread expectations of interest rate hikes,

while the rupee has also underperformed as inflation pressures have risen,

painting a picture of an economy with weakening growth and rising inflation. 

     However, fundamental inflation pressures remain contained and economic

growth is likely to continue to outperform given continued structural reforms. 

     These factors, combined with the fact that the yield curve has already

steepened to its widest level in two years, should cap the rise in the 10-year

yield, currently at 7.6%, even as the Reserve Bank of India seems guaranteed to

hike by 25bps over the coming months. 

     The rupee, while slightly overvalued in real effective terms, should also

be supported by high real bond yields, which are among the highest in the world.

     --INFLATION PRESSURES CONTAINED

     India's consumer price inflation came in at 4.4% y/y in February, which

although above the June-2017 level of 1.5%, marked a drop from the 5.2% figure

seen in December. Wholesale price inflation came in at 2.5%, the slowest pace in

six months. 

     Rising oil prices and the impact of the recent increase in import duties on

certain goods will likely see CPI rise over the coming months, but fundamental

inflation pressures should remain anchored. 

     Money supply and loan growth remain historically low, and even as central

and local governments are seeing a widening of their fiscal deficits, the

long-term trajectory of India's public finances remains positive -- a view

recently reiterated by the IMF.

     --GROWTH OVER 7% RETURNING

     Regarding economic growth, industrial production has rebounded strongly

from the weakness seen last year and real GDP growth looks set to return to

above 7% for fiscal year 2018. Positive demographics and a concerted effort

among policymakers to improve the country's business environment are major

supportive factors underpinning real GDP growth. 

     Unlike in developed markets where strong growth tends to send bond yields

higher, India's bond yields have shown a tendency to decline in periods of

strong growth and vice versa, due in part to declining risk premiums. This

suggests that the yields can fall alongside a rising rupee. 

     --RISKS RELATIVELY CONTAINED

     The main risks that could upend the current benign growth-inflation

dynamic, and thus justify the ongoing weakness in the INR and bonds, are a surge

in oil prices, a rise in global protectionism, and a potential rise in global

credit stress as the U.S. Federal Reserve continues to hike interest rates. Of

these three, an oil price surge poses the largest threat. 

     Given the relatively closed nature of the Indian economy and the fact that

the bulk of India's external liabilities are in local currency, India's economy

and bond market are likely to be less negatively impacted by a trade war or

global credit crunch. Indian yields plunged during the global financial crisis

while most emerging market yields shot higher. 

     Besides, India's external balance sheet is in the best shape it has been in

years, with foreign reserves having continued to build up throughout the recent

period of rupee weakness, suggesting that the Reserve Bank of India has been

steering the currency weaker in order to support exporters rather than yielding

to fundamental depreciatory pressure. 

--MNI London Bureau; tel: +44 203-586-2225; email: les.commons@marketnews.com

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