Inflation at 3.5% could make room for a 100 bps rate cut: Pankaj Vaish

Pankaj Vaish

Head South Asia Markets | Citi Group

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In an interview to CNBC-TV18's Shereen Bhan, Pankaj Vaish Managing Director Global Head-Local Markets, Rates & Treasury CITI, spoke about Indian equity markets and global economy.

Below is the verbatim transcript of the interview.

Q: It has been quite a journey for you from India to Mexico and now to London in your new global role. What is this whirlwind meant for you?

A: It has been a lot of fun, quite honestly. I had a wonderful time in India. In Mexico, we own a very big bank, Banamex. So my seniors had asked me to go and turn that around. And then in London, the role is a global role to look after all emerging markets, trades business, we are in about 75 countries. So it is a lot of fun, it keeps me intellectually stimulated. All the learnings I had from India and Mexico and previously I worked in New York for 17 years have been very helpful.

When I meet the People's Bank of China (PBOC) or when I meet the Russian Deputy Minister of Finance, I can give them examples of what some leading emerging markets have done and they are always very keen on that. The PBOC is very keen on what India is doing, what RBI is thinking. The Russians like the analogy of what Brazil or South Africa is doing. So it is just very interesting to be able to cross-mingle ideas and give the best of ideas to other countries. That is fun. That is a lot of fun and it sort of helps the countries because they get to hear what they are thinking at some of the leading central banks and governments.

Q: Let me ask you about what you see from your vantage point as far as the big global growth engines are concerned and let us start talking about the US. Rate hike by the Fed in December, at least consensus on the street is that there will be a hike. In fact commentary seems to suggest that there will be three in 2018. You believe that the market seems to want to believe otherwise, but what is your take on what the Fed tightening is actually going to mean for flows into emerging markets?

A: Just on the Fed, they are dying to hike more than what the market believes. In fact 2-3 weeks ago, the market was building in no tightenings till the beginning of 2019 which the Fed was sort of taking a little bit of insult. Why don’t you trust that I am telling you, I am going to admonish you if you do not behave? So it was a very strange kind of a set up. North Korea tensions was of course a part of it but still. Now the market has priced in the very high probability of a hike this year. But, the Fed is saying three more in 2018. The market does not believe them. They just do not think they will have the wherewithal to do it.

 Q: But you believe that they will?

A: I am more on the Fed camp. Maybe it is not three, maybe it is two, I do not know. Maybe the weighted probability will settle somewhere around 1.5, but there is room. Unemployment rate is low and while inflation has not picked up, I believe the Fed just wants to have enough gap so that if there is a synchronous global slowdown, they have enough room to come down.

And frankly, 50 basis points here or there does not make that much of a difference in today's US economy because the leverage ratios are not that high, most balance sheets are pretty clean. Given the tightness in the labour market, it is probably okay as some of the Fed governors are suggesting. So I think they have an argument there. The European Central Bank (ECB) is also dying to hike. At least they are trying to initially start with the tapering of the balance sheet.

So the two big banks out there are telling us that they want to contract a little bit extraordinary stimulus that has been given and it is good to listen to the people who control the levers, what they are about to do and you sort of ignore them at your peril. So, I think it is fine. At the Fed, as you probably know that five out of seven seats will have to filled by President Trump and that is the big question mark. What kind of people he will put in there, the big one is the Fed Chairman. There are a lot of names that had been floated about.

Q: Are you in the camp that believes that Yellen will return?

A: No I think the probability of that is low. It is not zero, maybe it is in the order of 10 percent or something. But I think President Trump seems to have shown us in all his appointments, he has wanted to put his person in there, the person who will adhere very strongly to the agenda.

Q: That is not unusual, we are seeing it happen everywhere in the world.

A: I guess that is the prerogative of being an elected leader. You want to put in people in seats that will do the agenda that you want to dictate. So I think that is fair. And I think he will want to put a fresh person. That is what it sounds like right now from the political pundits we talk to who are very close to the Washington machination.

So, the names that we are hearing, I think they are all very competent names. Kevin Warsh is there, Glenn Hubbard, these are all people who are good sound monetary people who maybe a little bit – John Taylor, who are talking about rates are a little bit too low, that the Fed has been a little  bit too accommodative. So, if any of these people come in, there could be an initial sell off in the US fixed income market and thus in the global fixed income market, but it will probably be limited because there is a limit to how much the Fed can hike.

So, I think there will just be some limited sell off including in major emerging market countries in the bond market, so rates could go slightly higher.

Q: It is interesting that you talk about how the two major central banks are looking at contracting the stimulus and here, in India, the bug is around bringing back a stimulus to try and ensure that the economy gets a helping hand so to speak, if I could use the language that is being used by people in power today. What do you make of that?

A: Do you mean the fiscal, the stimulus from the government's side or the monetary?

Q: Monetary as well because the clamour here in North Block as well as in corporate India is that the Monetary Policy Committee (MPC) should do at least 100 basis points.

A: Let us separate the two. I would say on the fiscal side, given how bad the budget deficit outlook seems to be for fiscal year to date, there is probably very limited room of what the government can do. They will want to keep an eye that the fiscal deficit does not get too out of control. A 0.1 or 0.2 over-breaching is probably okay by global measures but anything beyond that, rating agencies and global investors will start questioning. So far, they have had very good discipline, so far they have also had good luck with the rains and crude. So, so far everything has lined up quite well on the fiscal side and there is no reason to ruin that at this stage because the government actually has a fair amount of credibility with global investors.

So there is no reason to tamper with that. On the monetary side, what I can say is that I know when I was leaving India, I was talking about that the RBI will take the scenic route, but will eventually get there and I think they have eventually gotten there after a lot of analysis, a lot of hand ringing, I think they have eventually gotten to the rates much closer to where they belong. But I say, even in the process, there was a lot of worrying about many different things. New topics would keep getting put on into the pot of things to worry about. But globally inflation has collapsed.

Q: You believe that, that fear is exaggerated? The government's argument is and the Chief Economic Advisor has publically stated this several times over that look the RBI has got it wrong on its inflation forecast not once, not twice but several times over. Hence the government believes that there is a very strong case for an aggressive rate cut.

A: When I was leaving India about a year and a half ago, I remember there was a chart I used to show that even though RBI talked about being in a 150-200 basis points real rates, because their forecast of inflation was incorrect - every central bank around the world got it wrong including the Fed, so RBI is not alone in that, but given that the inflation forecast was incorrect, ex-post real inflation at least a year and half ago for the prior 3 or 4 years was more like 400 basis points rather than 150-200. So, India has run a tight monetary policy if you look at it in an ex-post analysis versus what they have been aiming for. Now I think cyclically it becomes a little bit harder, I think 100 basis points is very difficult to do because lets us say inflation bounces to 4 percent or slightly over 4 percent, you can't cut rates to 5 percent right now because then your real rates are too low. Plus the fiscal deficit noise, the current account coming back a little bit, I think now is not the good time to be able to do a 100 basis points.

Q: How much do you think they have the room for?

A: I think it will be very data dependent. We will just have to see how much the inflation bounces, does it just go to 4 percent, 4.2 percent or does it go towards 5 percent or it goes to 4.2 percent and then comes back down to 3.5 percent. I think if it comes down to 3.5 percent then you could probably argue for a 5 percent policy rate. However if it doesn't then I don't think that room is there.

In some sense by being very tight and somewhat hawkish - I remember at one stage someone even talked about a pre-emptive policy hike, so by being that hawkish I think somehow the window is sort of slightly missed by how much could have been done but that is for policy makers to decide.

From a global point of view, sitting far away, most investors think that India has done a good job in terms of staying a little bit on the hawkish side but that tends to reassure global bond investors and they are not very nit-picky about 25 basis points here or there. From a corporate India point of view I can understand their concern. I think there is still room to cut rates more but very short term cyclically this is a little more awkward of a point to be aggressive than last 12 months or last 18 months, there was a much easier opportunity.

Q: Given the context that we are speaking in and from a global bond holder's perspective, what would be the key concerns then? You spoke of the fact that if there is a breach on the fiscal deficit by 0.1 percent or 0.2 percent that would still be okay but anything more than that would perhaps get the alarm bells ringing but outside of veering away from the path of fiscal consolidation what else would worry global investors today?

A: From equity markets the problem also is valuation. Valuations are pretty high. Our India strategist says the same thing, so I am not saying something out of consistency with our house view. If you look at Indian equity index overall or the banking sector or the midcap sector, those valuations are very high, they are even much higher than 2007 and 2008. So, that kind of concern is valid for global investors to say let me just take some profits, let me shave my exposure a bit. However what I am told is that finally the Indian house hold money into equity market phenomenon is taking place. This was something for five years when I was in India, I used to keep thinking when will this happen. The percentage of equities in a house hold balance sheet was so low by global standards and also by emerging market standard in the phase of recovery that we were in, it used to surprise me. So, I think finally it is happening. That is the money that is coming in but unfortunately it may be coming in at little bit high valuation. So, I hope these house holders will stay 10-15 years. However global investors are not turning negative on India, they just feel it is fully priced. Even the Indian rupee is fully priced and so at 63.50 they just did not see how much more you could do especially when RBI is not looking for it to appreciate too much. I think global investors are just saying, I have made my money, I think the market is fully priced, let me just stand back, there may be a better entry point, I can re-enter at a better opportunity and that is all. I don't think people are turning negative on India.