Business cycle is turning, for sure

The writing is on the wall. We have been led into the fallacious belief that all is well on the economic front and that the economy has left behind the scars of the sub-prime crisis, dubbed by many as the worst crisis since the Great Depression.

Higher gross domestic product (GDP) growth rate seems to be the mantra as our economic planners applaud the restored resilience in the economy.

Ironically, income wealth distribution was much more balanced during the crisis.

The reform process, which started with making public sector banks more accountable, was so successful that banks are getting fixated on only net interest margins (NIMs).

Rising government deficit in the last couple of years has largely been in the area of revenue expenditure, which is a sure shot way of getting a short-term spike on GDP. 

Revenue expenditure tends to bring forward the GDP from future. We tend to forget that if too much money is spent without creating a capital asset, it tends to show up as inflation.

Rising inflation erodes purchasing power. If people don’t get any attractive savings avenue, they tend to consume more as tomorrow the value of money will be less than today.

Rising costs in the form of wages and other raw materials are essentially a corollary of too much money being pumped into the economy, which will gradually take a toll on corporate profit margins.

Bank deposit rates have been suppressed for so long that the deposit growth is much below credit growth. Banks, to protect their NIMs, took the easy way out by borrowing short-term and volatile deposits and lent their money for long duration, thus creating an illusion of a healthy banking system.

We believe bank deposit rates will rise another 100 basis points before we see any meaningful increase in deposit creation in the banking system.
This is where the business cycle becomes tricky.

Rising deposit rates will lead to a rise in the cost of funding for banks, which in turn will lead to corporate and retail lending rates rising sharply.

Over a period, this will lead to rising non-performing assets in banking book and rationing of credit to the needy.

Throw in a central bank, which will largely be hawkish on rates as it has been found wanting on containing inflation and inflationary expectation for too long, and you have GDP growth, which will start getting constrained as rates and liquidity tighten again.

Foreign institutional investors (FIIs), being relative value players, will find other markets more attractive, such as the US, which is expected to surprise positively on growth in the next quarter. Also, while a slowdown in FII flows is expected to make our external account more volatile, a reversal in rupee fortunes will be the last nail in the coffin.

The writer is head - fixed income, Canara Robeco Asset Management. Views are personal.