From EPS to vote share

While the Reserve Bank of India’s (RBI’s) attitude was dovish at last week’s monetary policy review, the policy statement had quite a few negative takeaways. There’s a global slowdown and this will mean some sort of domestic slowdown. The RBI also noted that there is a manufacturing slowdown and that core inflation (ex-food, ex-fuel) is rising.  

The central bank has cut Gross Domestic Product (GDP) estimates by 20 basis points, though the current estimates are still much higher than high-speed indicators, tax collections, etc., seem to warrant. Unless there’s a sudden pickup in business activity, perhaps driven by unrestrained election spending, those GDP numbers will look unrealistically high by the next review in June.  

The Monetary Policy Committee (MPC) has opted to cut the policy rate by 25 basis points, which was expected. But it wasn’t a unanimous decision with a four-two vote in favour of a cut. The minutes would be interesting. The RBI will continue to maintain a neutral stance in theory. In practice, it is likely to try and find ways to release more liquidity into the market.  

The decision to do another swap auction for $5 billion this month is a clear indicator that the RBI intends to pump in more rupee liquidity. Fair enough — since it got $16 billion worth of bids at the last swap auction — it may as well do another one. We’ll only know three years later whether it’s the RBI, or the commercial banks, that gains from these swaps, but in the meantime another ~35,000 crore will be released for commercial lending.

In addition, there was a decision to let an additional two per cent of Statutory Liquidity Ratio (SLR) to be considered as Level 1 High Quality Liquid Assets (HQLAs) for the purpose of computing the Liquidity Coverage Ratio. This will also lead to additional funds being available for loans.

The central bank has also postponed the proposed linking of new floating rate personal or retail loans (housing, auto, etc) and floating rate loans to Micro and Small Enterprises, to an external benchmark. This was supposed to start from April 1,2019.  The postponement has no explicit timelines and it was done at the behest of representations by banks. 

External benchmarking is normal and SBI had already started benchmarking. If loans are benchmarked to Repo, banks would not be able to arbitrarily charging high floating rates even if there are policy rate cuts. Benchmarking would therefore, lead to quicker transmission of policy changes. 

Benchmarking helps borrowers (if the rate cycle is trending down). But the Net Interest Margins will drop for most banks. There are several implications. One is that banks are indeed charging more than they should. Another is that benchmarking would put more pressure on profits at a time when banks are still struggling to contain NPAs. But there is also a risk of reverting to the bad, old days when commercial interest rates were directly set. 

India Ratings & Research estimates that a shift to a repo-based benchmark could reduce interest expense of Indian corporates by Rs 12,500 crore in FY 2019-20. This would improve aggregate interest cover to 2.97 from 2.87, and median interest cover to 2.01x from 1.86x.  Of course, when rates trend up, there would be a negative impact on borrowers but banks tend to pass on rate hikes immediately! Typically, sectors like automobiles, construction, gems & jewellery, textile, chemicals and real estate would see profits linked more directly to policy rate changes if there is benchmarking. 

The market’s initial response to the review was negative. This was a classic “buy on rumour, sell on news situation” with profit-booking. In the longer-term, a falling rate cycle should sustain higher valuations for equities. Balanced against that, political uncertainty remains until the next government takes charge, and, if global sentiment turns sour on risky assets, India will surely be affected.

We’ve seen through the last several quarters that the market can shrug off poor earnings estimates and ratings downgrades and keep going up, so long as liquidity is high. But this sort of market is also inordinately sensitive to sentiment as well, since it is driven by the aggregated sentiments of short-term, highly leveraged traders.

The very long election cycle starts in a few days and it will coincide with the Q4 results. The news flow will be dominated with estimates of vote share and seat-share rather than earnings per share estimates. If the market does see a deep correction, that could be a fresh investment opportunity.