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By Indranil Sen Gupta

The recovery can be expected to remain shallow with the CLSA Activity Index still weak. After all, it is constrained by weak demand and a slowing US economy thanks to Fed tightening to reduce inflation. The only support for growth comes from soft real lending rates. Despite rising growth risks, the RBI MPC has little choice but to hike policy rates by 25 bps on June 8, and 100 bps by April 2024, atop the 80 bps done, to combat inflation and Fed hikes.

Real GDP growth could slip to 6.7% in FY23 and 5.5% in FY24 from FY22’s 8.7% announced on Wednesday. The March quarter also came off to a 4.1% growth from 5.4% in December. Looking ahead, a 12% growth for the June quarter can be pencilled in, because of base effects. The call of a shallow recovery is supported by the sustained weakness in the CLSA India Activity Index.

Demand remains a problem: It is up just 1.4% from FY20 levels. Investment, at 32.5% of GDP, is close to the long-run average on a low GDP base. Public capital expenditures ended at 98.4% of the budget estimate. A slowing US will also impact export demand. A CLSA scenario analysis suggests a US recession (defined as zero export growth) hits India’s growth by 100 bps.

Low real lending rates are the only support for a recovery. Nominal bank marginal cost-based lending rates (MCLR) should rise by 75 bps, over a year, as RBI hikes repo rates by another 100 bps, almost nullifying the 100 bps drop since the pandemic. The saving grace is that the real MCLR, at -0.9%, was well below 7.1% in March 2020.

Lending rates for bank priority sector loans to micro and small industries (MSI) are now linked to the RBI repo rate. It can be reasonably expected that Delhi will offer a 1% subvention, to a support recovery, at a fiscal cost of 0.05% of GDP in FY23-FY24.

The 10-year government bond yield could peak at 7.75% by March 2023. This is driven by the higher-than-expected RBI rate hikes in the face of rising inflation and steeper Fed rate hikes. At the same time, a step-up in RBI Open Market Operations (OMOs) to offset a wider current account deficit should prevent yields from flying over 8%. While the Centre’s fiscal deficit, at 6.7% of GDP in FY22, ended slightly below the budget’s 6.9%, there could be a slippage of 40bps to 6.8% (vs estimated 6.4% of GDP) in FY23, which adds further upside pressure to bond yields. Can the 10-year not hit 8%? It is very unlikely that a 8% rate will be sustained as RBI will likely step up OMOs to offset FX intervention sales (CLSA: $58 billion in FY23, $1 billion FYTD). It is likely that foreign portfolio investors (FPIs) would begin to buy at 7.75%-plus with the rupee at 77 to the dollar.

The rupee is likely to temporarily slip to 77 to the dollar over the next few months breaching our 73-76.50 forecast based on adverse trade seasonality, US dollar strength due to Fed rate hikes and high oil prices. That said, it bears highlighting that RBI has sufficient FX reserves ($650-billion-plus, inclusive of forwards) to buffer the rupee from any major sell-offs because of global risks. A CLSA stress test places adequate FX reserves at $600 billion. RBI should, thus, safely be able to fund an FY23 FX outflow of $58 billion, especially if it raises NRE/FCNRB deposit rates to raise FX. CAD should come in at about 3% of the GDP due to higher commodity prices.

(The writer is the head of research at CLSA India. Views are his personal.)

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Author: Howard Caldwell