India Outlook For Fy 10

India Outlook FY10

Rocky Road to Recovery

Index •

Growth fears to be allayed by policy response and faster global recovery

3

FY09 saw a dramatic turnaround in global and domestic conditions post the Lehman collapse that shattered the relatively robust working of the economy in the first half. Uncertain global conditions along with evolving domestic conditions make a point forecast for GDP growth in FY10 virtually impossible and hence we approach the growth forecasting issue from several alternative dimensions.

•

Inflation is expected to remain benign

16

Reversal in global commodity prices led to swift decline in price pressures since end of last year. We expect inflation to tread into the negative zone, however the threat of structural deflation remains distant. Favourable base effect, along with moderate global commodity prices would keep inflation at benign levels in FY10.

•

Expansive fiscal policy to continue

18

Expansive fiscal policy has become the order of the day, as governments world over try to shore up economic growth. The initiation of fiscal measures in India since late last year has been prompt, however they have led to a deterioration of the fiscal parameters. We expect the fiscal deficit to touch 7% in FY10 on account of further increase in plan expenditure.

•

Softer interest rates to stay

23

Changing global and domestic conditions warranted the adoption of an accommodative monetary policy since September last year. In its fight against the global crisis monetary policy has acted as a ‘first line of defense’ for RBI. We expect a softer interest rate regime to continue with a downward bias on rates. Though easing of rates have had an expected impact on yields till Q3 FY09, the same is not true since then as fears of excess supply of government issuances have dominated sentiment. Considering the market sentiment towards the problem of excess supply and RBI’s response thereof, on an average we expect the 10Y yield to lie in the range 6.5-7.0% over the next few months. However, in the medium to long term yields should start reflecting macro fundamentals of benign inflation and moderate growth when the market recognizes the balance in demand-supply. We expect yields to head towards 6% at that point.

•

Near term risks to undermine INR, strength to return on benign BoP outlook FY10 is likely to see a more balanced BoP as a narrowing trade deficit helps to improve the current account and capital account doesn’t deteriorate significantly from current levels. In the medium to long run, Rupee would take cues from the overall benign BoP outlook along with a weakening of the dollar against the major currencies. In the near term, however, the Rupee will be at depreciated levels as risk appetite remains largely on the sidelines and dollar trades firmly. Further, with event risks lurking in the near term, the downward pressure on the domestic currency can get exacerbated.

33

FY09 – The year of two halves •

The year FY09 can actually be called the year of two halves, where the relatively robust working of the economy in the first half was shattered by the impact of the global meltdown post the Lehman collapse.

•

In the early part of the year, the ongoing cyclical moderation was accentuated by rapid tightening of monetary policy to counter record inflation levels. This softening up of the economy made us susceptible to the global shock.

•

Under the impact of the crisis, growth fell, liquidity tightened and in response governments initiated expansive monetary and fiscal policies.

(% YoY) 11 10 9 8 7 6 5 4 3 2

GDP Growth

D e c -0 4 M a r -0 5 J u n -0 5 S e p -0 5 D e c -0 5 M a r -0 6 J u n -0 6 S e p -0 6 D e c -0 6 M a r -0 7 J u n -0 7 S e p -0 7 D e c -0 7 M a r -0 8 J u n -0 8 S e p -0 8 D e c -0 8

GDP falters after 5 years of plus 8% growth

Source: CEIC, ICICI Bank Research

•

Growth of industrial production had started indicating the slowdown since last fiscal.

•

The sharp drop in IIP growth in October gave credence to the worst fears that industrial production has virtually stalled leading to rapid build-up of inventories across different industry segments.

•

•

The average growth of IIP declined sharply in Q3 FY09 to 0.4% compared to 8.4% in Q3 FY08. The Dec’08 and Jan’09 figures are also in the red indicating that the pain has not eased yet. However, there are some nascent signs of stabilizing in sectors like cement, steel and auto.

(% YoY) 16

Growth

14

IIP 3 month MA

12 10 8 6 4 2 0 -2 O ct-05 Dec-05 Feb-06 Apr-06 Ju n -06 Au g -06 O ct-06 Dec-06 Feb-07 Apr-07 Ju n -07 Au g -07 O ct-07 Dec-07 Feb-08 Apr-08 Ju n -08 Au g -08 O ct-08 Dec-08 Feb-09

IIP – Precursor to the deteriorating conditions

Source: CSO, ICICI Bank Research

12 10 8 6 4 2 F e b -0 9

M a r-0 9

J a n -0 9

D e c -0 8

N o v -0 8

O c t-0 8

S e p -0 8

J u l-0 8

A u g -0 8

J u n -0 8

0 M a y -0 8

The peak in inflation was also accompanied with fiscal and monetary tightening measures, which led to strained liquidity and high interest rates thus accelerating the cyclical downfall.

WPI

A p r-0 8

•

Rising inflation was essentially contributed by increase in manufacturing articles prices (base metals, edible oil) and fuel prices (increase in regulated prices of petrol, diesel and LPG).

(% YoY) 14

F e b -0 8

•

As growth momentum started faltering in the beginning of last year, inflation reared its ugly head on the back of steep increase in global metal and fuel prices. Inflation zoomed into the double-digit zone peaking at near 13% level in early August’09.

M a r-0 8

•

J a n -0 8

Inflation – Does a U-turn

Source: Bloomberg, ICICI Bank Research

3

FY09 – The year of two halves

With evolving global conditions, the months of September – October saw a dramatic tightening of money markets with call rates jumping to 20% levels.

8

The situation necessitated a change in policy stance and since then RBI has reduced the CRR by 400 bps to 5% and repo rate by 350 bps to 5.5%.

5

(% YoY)

M a r-0 9

J a n -0 9

N o v -0 8

S e p -0 8

J u l-0 8

M a y -0 8

J a n -0 8

N o v -0 7

M a r-0 8

Trade balance (RHS)

(USD bn) 0

40

-2

30

-4

Export growth has remained in the negative for the fifth consecutive month.

•

Export growth averaged 22.7% in H1 FY09 while 10 it has averaged –12.2% between Oct’08-Feb’09. 0 Average import growth has fallen to –3.2% -10 between Oct-Feb’09 from 38.7% in H1 FY09.

-6

20

-8 -10 -12 -14 F e b -0 9

O c t-0 8

J u n -0 8

-16 F e b -0 8

-20

F e b -0 6

The trade deficit, which had ballooned in the earlier part of the year, has started to ease on account of falling imports.

Exports growth (3m MA)

50

•

•

S e p -0 7

Source: Bloomberg, ICICI Bank Research

O c t-0 7

The downward growth momentum and falling external demand in the face of global recession has started to reflect in the external trade data.

4

J u n -0 7

•

6

F e b -0 7

Virtual paralysis in the external sector

7

J u l-0 7

Moving in sync with policy rates, the overnight call rate and bond yields eased significantly from the stressed levels of October.

Repo rate

9

O c t-0 6

•

CRR

M a y -0 7

•

(%) 10

M a r-0 7

•

The monetary tightening measures took the form of CRR and repo rate being raised by 250 bps and 225 bps respectively to 9% each.

J a n -0 7

•

J u n -0 6

Policy rates – Switching modes

Source: CSO, ICICI Bank Research

Analysing the growth outlook for FY10 – A conceptual framework Uncertainties about the prognosis of global recovery and inability to fathom the dent in sentiments would make a point forecast for GDP growth in FY10 virtually impossible and hence we approach the growth forecasting issue from several alternative dimensions. Our broad thought is to look at GDP growth from both demand side and supply side as well as from the perspective of how the long-term structural factors would play out. We start off with an analysis of the savings-investment trends and try to arrive at growth estimates through the productivity of these investments, as reflected in ICOR. The demand side approach concentrates on the drivers of consumption and investment demand. We identify the possible trends in consumption that could emerge in FY10 and also discuss how the quantum of investment would be conditioned by both business sentiment and availability of finance. In supply side analysis we focus on the outlook for agriculture, industry and services. All through our analysis, we are aware that the outlook for FY10 would have to be conditioned for extreme volatility. So simultaneously we undertake a historical exercise of trying to gauge how much different components of GDP respond in slowdown years. These approaches lead us to construct 3 possible scenarios for growth in FY10.

4

Savings & Investment – structural determinants Paradigm shift in savings propelled growth…

The structural shift of the economy is visible with average savings rate rising to 33.6% in the last five years from 24% in the prior five year.

2 0 0 7 -0 8

2 0 0 6 -0 7

2 0 0 5 -0 6

2 0 0 4 -0 5

2 0 0 3 -0 4

2 0 0 2 -0 3

2 0 0 1 -0 2

2 0 0 0 -0 1

1 9 9 9 -0 0

1 9 9 8 -9 9

2 1 9 9 7 -9 8

3

0

Source: CSO, ICICI Bank Research (%) 30

Investment growth Savings growth Real GDP growth (RHS)

(%) 11 10

25

9

20

8

15

7

10

6 5

5

4

2 0 0 7 -0 8

2 2 0 0 6 -0 7

3

-5 2 0 0 5 -0 6

0 2 0 0 4 -0 5

The trend in investment growth shows its erratic nature before FY03 but since then the stability in investment growth has been remarkable.

4

5

2 0 0 3 -0 4

•

The financing of investment shows that domestic savings accounts for roughly 96-99% of total investment indicating that the reliance on external sources of financing is minimal.

5

10

2 0 0 2 -0 3

•

In a scenario of rising domestic savings, availability of capital is easier which fuels investment demand.

6

15

2 0 0 1 -0 2

•

The shift in trajectory of India’s growth path has been a result of the turnaround in investment growth from negative and single digit levels.

7

20

2 0 0 0 -0 1

•

9 8

1 9 9 9 -0 0

...and led the upsurge in investment

10

25

While household savings account for almost 70% of gross domestic savings, its share has fallen from close to 90% in 1990’s. The share of private corporate savings has increased markedly from close to 14% in FY02 to 23% in FY07. Of equal importance is the fact that public sector has turned into a net saver from being a net dissaver in FY03.

(%) 11

Real GDP growth between 7.59.4% when savings between 3035% of GDP

30

1 9 9 8 -9 9

•

Real GDP growth (RHS)

Real GDP growth between 4-6% when savings ranged between 22-23% of GDP

35

1 9 9 6 -9 7

•

Savings as a % of GDP

1 9 9 7 -9 8

•

(%) 40

Savings and Investment are the traditional structural determinants of growth; more so in a developing economic set up.

1 9 9 6 -9 7

•

Source: CSO, ICICI Bank Research H o u s e h o ld S a v in g s

FY 95 FY 98 FY 01 FY 03 FY 07

P r iv a t e C o r p o r a t e s a v in g s P u b lic s e c to r s a v in g s C a p it a l f o r m a t io n P vt c o rp o ra te C h a n g e fro m P u b lic sec to r H H sa vin g s C h a n g e fro m sa vin g s to G DP p revio u s sa vin g s to C h a n g e fro m G DC F to C h a n g e fro m to G DP (% ) p revio u s yea r (% ) yea r G DP (% ) p revio u s yea r G DP (% ) p revio u s yea r 20.5 1.4 3.8 0.0 2.6 1.2 25.5 3.0 19.4 1.7 4.7 -0.3 2.0 -0.4 25.3 1.3 23.6 0.5 4.2 -0.7 -1.9 -1.0 24.3 -1.6 25.2 1.1 4.2 0.5 -0.7 1.5 25.2 2.4 26.1 -0.3 8.5 0.4 3.5 0.7 35.9 0.4

Benchmark years

Slowdown years

•

The data suggest that a slowdown year impacts private and public sector savings while household savings remain stable. With sluggish growth expected in FY09 and FY10 private corporate sector savings as a proportion of GDP would fall - historically, the fall has been less than 1%. However, in FY09 and FY10 the fall could be higher since the ratios are at elevated levels initially.

•

With falling corporate and public savings we expect gross domestic savings as a percentage of GDP to fall to near 32% levels in FY10 from the high of 37.7% in FY08. 5

Productivity gains catalyze investment into growth Productivity of investment dips in slowdown (% YoY) 11 10 ICOR rises sharply during slowdown years

8

9 8

7

7

6

6

5

5

FY 08

FY 09 AE

FY 07

FY 06

FY 05

FY 04

FY 03

FY 02

FY 01

FY 00

2 FY 99

3

2 FY 98

4

3 FY 97

4

FY 96

Between 2000-06 India’s ICOR averaged 4, lower than that of China at 4.3 and Brazil at 5.1. ICOR has tendency to rise in a slowdown year. During the slowdown of FY03 ICOR jumped to 6.9 from 4.5 in the previous year. ICOR for FY09 based on advanced estimates is at 5.3 from 4.2 in FY08.

GDP (RHS)

9

FY 95

•

Productivity gains on the back of technological progress and entrepreneurial innovations have been reflected in the incremental capital output ratio (ICOR - a measure of how much capital is needed to produce an additional unit of output).

ICOR

10

FY 94

•

The impact of investments on overall GDP growth is conditioned by the productivity of those investments.

FY 93

•

Source: RBI, ICICI Bank Research

Efficiency loss to be offset by investment

GDP Growth in FY10

(%)

Flight to quality a natural response of the household investor in bad times leading to a rise in the ‘safe haven’ components

120

Changes in household assets shows that slowdown years are marked by a rise in deposits and LIC funds – indicating the risk averse nature of households.

80

We expect the share of financial savings in total savings to decline, as households would turn averse to risky assets. This could potentially thwart the productivity of investable funds.

20

2.3

12

7

0

10.2

20

During slowdown years proportion of LIC & deposits rises

100

60 40

0 FY 08

FY 03

-20 FY 02

During previous slowdown years share of financial savings in total savings has dropped between 5-7% while that of physical savings has increased by a similar amount.

-7

Proportion in change HH assets Deposits Currency LIC PPF Shares & Debentures Others

FY 97

•

6.5

Source: ICICI Bank Research

•

•

6 -6 3

Implied investment rate

Safe-haven component may pose a challenge

•

5.5 6

FY 01

Analysis for FY10 shows that for the GDP to grow by 6.5% and with assumed ICOR at 6, investment would have to grow by 12%. With investment growth already moderating to near 8.5% levels in FY09 such a scenario in FY10 seems fraught with difficulties.

ICOR levels 5 5.5 -21 -13 -14 -5.5

FY 00

•

The table on the right shows, the assumed GDP growth for FY10 and the ICOR levels expected to prevail in FY10, different combinations of which yield an implied investment growth.

FY 99

•

We have tried to simulate the implied investment growth for a given level of GDP growth and ICOR for FY10.

FY 98

•

Source: RBI, ICICI Bank Research

6

Demand side developments in past slowdowns Consumption growth falters in slowdown

9

8

7

6

5

4

3

2 22

Y(t) = -0.0651Y(t-1) + 10.103 R2 = 0.0042

19 16 13 10 7 4 1 -2

22

19

16

13

10

7

4

-5 Investment growth (t) *Highlighted years are slowdown year – FY98, FY01, FY03 Source: CEIC, ICICI Bank Research

10 Y(t) = 0.3961Y(t-1) + 3.6819 R2 = 0.1698

9 8 7 6 5 4 3

10

2 9

In a slowdown year as expected GDP growth drops sharply compared to the previous year,. A similar pattern for consumption growth seems to indicate that the projection of GDP growth for FY10 would depend critically on how consumption responds.

*Highlighted years are slowdown years – FY98, FY01, FY03 Source: CEIC, ICICI Bank Research

8

•

With most of the points falling to the right of the 45 degree line, we see that growth has been on an uptrend.

Private Consumption growth (t)

7

•

The chart on the right shows the scatter plot of GDP growth in the year t vis-à-vis the previous year t-1. The points above the 45 degree line represent a slowdown in year t vis-a-vis in year t-1.

2

6

•

3

5

GDP growth deviates from its upward trend

4

1

It is interesting to note that in 2 out of 3 cases poor investment growth actually preceded a slowdown year rather than following it. The implications for FY10 would depend on how deeply entrenched is the investment deceleration.

5

4

•

The chart on the right shows the scatter plot of investment growth in the present year t vis-à-vis the previous year t-1. Absence of a particular pattern corroborates with the erratic nature of investment growth.

6

-2

•

The share of investment rose from 23% of GDP in FY03 to 32% in FY08. Improving corporate balance sheets was a big contributor to this.

7

3

•

R2 = 0.0581

-5

Investment growth follows a volatile trend

Y(t) = 0.2208Y(t-1) + 3.8163

8

2

The highlighted points indicate consumption growth in a slowdown year vis-à-vis the previous year. This analysis reveals that private consumption growth could fall by 3 - 5% points from the previous year and could make a significant difference to the forecast for FY10.

P r iv a te C o n s u m p tio n g r o w th (t-1 )

•

The chart on the right shows the scatter plot of consumption growth in the year ‘t’ vis-à-vis the previous year ‘t-1’. The points on above the 45 degree line represent a slowdown in year t visà-vis in year t-1.

9

In v e s tm e n t g r o w th (t-1 )

•

Moving on from the savings – investment approach we look at the consumption – investment angle in the demand side of the growth dynamics.

G D P g r o w th (t-1 )

•

GDP growth (t) *Highlighted years are slowdown years – FY98, FY01, FY03 Source: CEIC, ICICI Bank Research

7

Criticality of consumption to the overall growth

D ec -08

J u n -08

D ec -07

J u n -07

D ec -06

J u n -06

D ec -05

J u n -05

D ec -04

J u n -04

D ec -03

J u n -03

The 15 consecutive quarters of more than 5% consumption growth has not been at the expense of domestic savings, but primarily because of the rising disposable incomes. Maintaining a healthy consumption growth will be critical for overall GDP growth in FY10.

D ec -02

•

J u n -02

The chart here shows the stable and rising consumption growth. The quarters of a fall in growth are largely associated with a bad monsoon.

Private Consumption growth

D ec -01

•

(% YoY) 10 9 8 7 6 5 4 3 2 1 0 J u n -01

Consumption accounts for 70% of GDP and its significant expansion has been promoted by the emerging middle class and ably supported by a transformation in rural India.

D ec -00

•

J u n -00

The story of consumption evolution

Source: CEIC, ICICI Bank Research

Consumption Sustainers

Potential pitfalls in consumption growth

•

Rural demand – to remain resilient (~57% workforce in agriculture). Agriculture & government services remain unaffected and to benefit from govt measures. State pay commission to infuse purchasing power

•

Falling industrial output and uncertain global environment to reduce employment opportunities in near term

•

•

Lagged effect of downturn on services could feed into employment uncertainty

Faster rising affordability on the back of falling prices

•

•

Lower interest rates to boost consumption

On the back of uncertain job climate and falling availability of credit consumers might be forced to defer discretionary purchases

•

Favorable wealth effect – a surge in income levels over the past years to provide a cushion during this period of slowdown

•

•

Long term structural factors intact demographic advantage, rising middle class and fast rising skilled labour

With a sharp reversal in equity and real estate markets, more and more consumers would feel the pinch and this erosion of wealth could have an adverse impact on a particular segment

•

Global risk aversion consumer sentiment

Pay Commission impact to linger on •

Government’s measures – centre & state pay commission, employment programs – would help to mitigate pressure on consumption.

•

The table shows that there was a staggered impact of the 5th pay commission on the wage expenses for the centre and the state lasting till FY01. Wages and salaries of the centre as a % of GDP rose from 2.7% to 3.3% while that of the state rose to a high of 7.2% on account of the 5th pay commission.

•

Thus taking into account a similar rise of the wage bill for the centre and state, the 6th pay commission would give an income boost of upto 1.4% of GDP.

to

weigh

down

on

Wages, salaries and pension State Governments (Consolidated)* INR bn % to GDP 912 6.7 996 6.5 1156 6.6 1357 7 1508 7.2 1525 6.7 1588 6.5 1847 6.7 1847 5.9 2069 5.8 2131 5.1 2259 4.8 2700 4.9 3300 5.5

Central Government INR bn % to GDP 1996-97 371 2.7 1997-98 500 3.3 1998-99 572 3.3 1999-00 648 3.3 2000-01 661 3.1 2001-02 640 2.8 2002-03 706 2.9 2003-04 735 2.7 2004-05 808 2.6 2005-06 906 2.5 2006-07 941 2.3 2007-08 1005 2.1 2008-09 1357 2.5 2009-10^ 1561 2.6

* : Non-plan revenue expenditure of the States going to social, economic and administrative services

^ : Assuming similar impact as of 5th Pay commission and nominal GDP growth of 10% Note - Data for state govt post 2005-06 is calculated assuming similar growth as for central govt over the subsequent years

Source: RBI, ICICI Bank Research

8

Lower prices and rates to provide further relief

•

•

6

However, falling inflation could also have an adverse impact wherein consumers would defer purchases in anticipation of further fall in prices.

4

The current fall in prices is a phenomenon driven by the statistical base effect, and hence this is expected to wane at the latter part of the year, diluting its impact on consumer behavior.

0

Auto sales correlate well with WPI trends •

8

M ar

Feb

Jan

Dec

N ov

Oct

2

Apr

•

10

Source: Bloomberg, ICICI Bank Research

(% YoY)

(% YoY) 0

Auto Sales 3 Month MA WPI lagged by 3 months (inverted, RHS)

To substantiate the above point we analysed the 35 trend of auto sales growth with the headline 25 inflation figure.

2 4

The graph shows clearly that an inverse relation 15 exists between falling prices and auto sales 5 growth and the correlation between auto sales -5 and WPI lagged by 3 months is close to –0.5. Auto sales is a component of leveraged -15 spending by the consumers. Hence we feel that the impact of falling prices on auto sales could -25 be coming through the interest rate channel phases of falling prices are also associated with easing interest rates.

6 8 10 12

Falling inflation to prop up auto sales

14 M a r -0 0 S e p -0 0 M a r -0 1 S e p -0 1 M a r -0 2 S e p -0 2 M a r -0 3 S e p -0 3 M a r -0 4 S e p -0 4 M a r -0 5 S e p -0 5 M a r -0 6 S e p -0 6 M a r -0 7 S e p -0 7 M a r -0 8 S e p -0 8 M a r -0 9

•

12

S ep

Inflation as measured by WPI has convincingly reversed its tract after growing at double digits last year. We expect negative inflation to prop up this year for a few months, before prices start rising again.

Inflation FY08 FY09

Aug

•

(% YoY) 14

Jul

As mentioned earlier affordability could outpace the fall in income

Jun

•

M ay

How much will falling prices matter?

Source: Bloomberg, ICICI Bank Research

•

With PLR rates expected to fall in FY10, we could see a potential upside for consumption.

(%) 10

Correlation of -0.74

9

9

6

5

5

4

4

3

3

2

2 2007-08

6

2006-07

7

2005-06

8

7

2004-05

8

2003-04

We have used the 1-year prime lending rate adjusted for inflation for the purpose of analysis. The relationship is sensitive to the use of the PLR and it weakens significantly on taking the 1year deposit rate (correlation falls to –0.4).

Private Consumption Real Interest rates (t-2) (RHS)

2002-03

•

However the relationship works with a lag. As per economic logic, lower rates help to stimulate demand as cost of credit reduces and this is reflected in the high correlation of –0.7.

(% YoY) 10

2001-02

•

Private consumption, has an inverse relationship with interest rates adjusted for inflation.

2000-01

•

1999-00

Falling rate could support leveraged spending

Source: RBI, ICICI Bank Research

9

Investment and exports could be a drag on growth Falling rates to shore up investment…

0

In case of consumption the mechanism works through a lag, for investment though counter intuitive the relation holds in the immediate period. However, a depressed business sentiment could delay this impact.

0

-5

External sector to shave off GDP growth The share of external sector (exports and imports) has risen from 17% in 1991 to 36% recently. With imports been much higher than exports, net exports usually has been a negative contributor towards GDP growth Looking at the trend of contribution of net exports to GDP growth since FY01, we see that it could shave off between 0.5-3.5% points from the overall GDP growth. With a high probability of stagnating exports being counteracted by declining imports, negative contribution of net export to GDP growth would be muted in FY10.

Source: RBI, ICICI Bank Research

(%) 12

Contribution of Net exports to GDP growth GDP growth

10 8 6 4 2 0 -2 -4 -6

2008

Other sources of foreign flows such as FDI which have seen a spurt in FY09 might not be forthcoming in FY10 thus worsening the outlook for FY10.

2007

•

2006

In an environment where investment grows, its financing would increasingly depend on bank credit. However with the proportion of bank credit to total financing rising to 60%, its sustainability remains questionable in the future.

2005

•

Sources of financing as % of total credit to industry FY08* FY09* INR FY08* FY09* INR bn bn A) Bank credit to the industry 45 60 2249 2932 B) Flow from non banks 55 40 1509 980 B.1. Domesstic Sources 25 19 1259 933 1. Public issues 7 3 344 136 2. Gross pvt placements 6 8 323 391 3. CP's subscribed by non banks 6 4 314 200 4.Others 6 4 278 207 B.2. Foreign Sources 30 20 1487 981 1. ECB/FCCB 13 6 630 276 2. ADR/GDR 5 1 250 47 3. Short term credit 8 3 416 123 4. FDI to India 4 11 191 536 Toral Credit (A + B) 100 100 4995 4847 * as reported by RBI in the Macro & Monetary Development Jan'09

2004

The freezing of global financial markets post the Lehman collapse led to ripple effects in India adversely affecting the foreign flow of funds.

Source: CEIC, ICICI Bank Research

2003

•

2007-08

2

2006-07

5

2005-06

4

2004-05

10

2003-04

6

2002-03

15

2001-02

8

2000-01

We analyze the impact of lower rates on investment and it indeed does have a positive relation. Lower rates reduces cost of funds relative to potential returns and this helps encourage more investment. Lower rates would also help to make some projects more viable.

In the recent past the proportion of foreign flows helping finance investment had increased markedly.

•

(% YoY) 25

Correlation of -0.8

20

•

•

Investment (RHS)

10

…but financing could be an area of concern

•

Real interest rate

2002

•

(%) 12

1999-00

•

From the demand side, analysing investment demand will be complementary to the analysis that we have done for consumption demand.

2001

•

Source: CEIC, ICICI Bank Research

10

Analyzing past slowdowns from the supply side

12

10

8

6

4

2

0

-2

Agriculture growth suffers from sharp volatility owning to exogenous factors. A scatter plot is used to depict agriculture growth in year t vis-àvis the previous year t-1. Points above the 45 degree line represent slowdown in year t compared to year t-1. The negative slope of the regression line could indicate severe base effects. Poor agriculture growth generally accentuates the slowdown but is generally not caused by an industrial slowdown.

Y(t) = -0.7346Y(t-1) + 5.2377 R2 = 0.5435

-4

•

12 10 8 6 4 2 0 -2 -4 -6 -8 -10 -6

Moving on from the demand side analysis of GDP to the supply side analysis, we try to investigate the probable paths of agriculture, industry and services growth in FY10.

A g r ic u ltu r e g r o w th (t-1 )

•

-8

Wide variations in agriculture growth

Agriculture growth (t) *Highlighted years are slowdown years – FY98, FY01, FY03 Source: CEIC, ICICI Bank Research

Industrial growth may be affecting with a lag

12

Industry growth (t)

10

8

6

4

2

0

*Highlighted years are slowdown years – FY98, FY01, FY03 Source: CEIC, ICICI Bank Research

(% YoY) 14 12

IIP growth fell for 14 months prior to reaching the trough during the slowdowns of FY98 and FY03. While in the case of FY01 we see sideways movement of IIP growth for upto 10 months after reaching the trough, in case of FY98, IIP growth shows some semblance of recovery in the subsequent months.

10

In the current phase too IIP has been in a downtrend for a similar time, but we would have to wait to conclude if the trough has been hit. The pace of recovery in FY10 would depend on inventory adjustment, global factors and business sentiment, among other things.

-2

IIP Slowdown of FY98 Slowdown of FY01 Current Slowdown t - month of lowest growth

8 6 4 2

t+ 1 0

t+ 8

t+ 6

t+ 4

t+ 2

t

t-1 3

0 t-1 1

•

2

t-9

•

We looked at the movement of IIP growth in the slowdown phase of FY01 and FY98.

4

t-7

•

6

t-5

Message from past industrial growth cycles

8

0

With a sharp drop in industrial growth in FY09, it is possible to have a somewhat better industrial growth number in FY10.

Y(t) = 0.4957Y(t-1) + 3.2765 R2 = 0.2488

10

t-3

•

However not in all slowdown years, do we see a moderation in industrial growth. Probably slower industrial growth in one particular year impacts other segments of the supply side with a lag and GDP growth contracts with a lag.

12

t-1

•

The graph on the right shows industrial growth in year t vis-a-vis in year t-1. The upward sloping regression line indicates that a good production year is followed by a better one. Points above the 45-degree line represent slowdown in year t compared to year t-1.

In d u str y g ro w th (t-1 )

•

Source: CSO, ICICI Bank Research

11

Will service sector be able to hold on?

5 4 12

11

10

9

8

7

6

5

3 Services growth (t) *Highlighted years are slowdown years – FY98, FY01, FY03 Source: CEIC, ICICI Bank Research

(% YoY) 3

Community, Social & Personal Services Contribution to GDP growth Share in GDP (RHS)

(%) 21

2.5

18

2 1.5

15

1 12

0.5 0

9

-0.5 Dec-08

Dec-07

Dec-06

6 Dec-05

-1 Dec-04

Going forward this sector could hold the key for a robust service sector growth as stress on fiscal stimulus remains.

6

Dec-03

•

The chart clearly shows that while its share in GDP is at a modest 13-14%, its contribution to GDP doubled in Q3 FY09 to 2.05% from 1.08% in Q2 FY09.

7

Dec-02

•

We looked at the community, social and personal services segment, which essentially reflects the government revenue expenditure and has a correlation of close to 80% with the same. Q3 growth of 17.3% YoY reflects the same.

8

Dec-01

•

9

Dec-00

Government expenditure to aid recovery

R2 = 0.3372

10

4

Extending this logic further, FY10 service sector growth seems to be less at risk, but the extent of global meltdown would pose significant challenges.

Y(t) = 0.5788Y(t-1) + 3.0906

11

Dec-99

•

In a slowdown phase, the drop in service sector growth in one year has not been rapid except in one instance. However that occurred in the time of the tech bubble burst and therefore understandable.

12

3

•

The chart here shows a scatter plot representation of service sector growth in year t vis-à-vis that in year t-1. Points above the 45 degree line represent slowdown in year t comapred to year t-1.

Dec-98

•

S e rv ic e s g ro w th (t-1 )

Service sector has defied growth cycles

Source: CEIC, ICICI Bank Research

4

Trade, Hotels and Communications Contribution to GDP growth Share in GDP (RHS)

(%) 30

3.5

27

3 2.5

24

2 1.5

21

1 0.5 Dec-08

Dec-07

Dec-06

Dec-05

Dec-04

Dec-03

18 Dec-02

0 Dec-01

However the heterogeneity of this sector could pose a problem in terms of analyzing its future growth path. While poor global conditions and heightened security concerns post the terror attacks could adversely affect the trade and hotels segment, domestic demand for communication services still remains strong.

(% YoY) 4.5

Dec-00

•

Trade, hotels and transport segment of services has not only gained importance in terms of share in GDP but its contribution to GDP has also witnessed marked improvement. Its contribution to GDP rose from 1.5% in 1997 to 3% in 2007 before falling to 1.8% in Q3 FY09.

Dec-99

•

Dec-98

Trade, hotel and transport could be at risk

Source: CSO, ICICI Bank Research

12

How vulnerable is India to the global crisis? The vulnerability indicators Share in GDP

Proportion of Contribution to GDP growth in FY08 Least affected sectors 30%

Least affected sectors 20% Worst affected sectors - 55%

Worst affected sectors - 42%

Moderately affected sectors - 25%

Moderately affected sectors - 29%

Source: McKinsey, CEIC, ICICI Bank Research

•

We have defined sectors with maximum domestic linkages and easy supply of credit as the least affected sectors – as the risk stemming from a global downturn is minimal. Sectors that have greater exposure to external sector and face credit constraints along with an overhang of supply are deemed worst affected.

•

The moderately affected sectors are the ones facing demand constraints, however credit availability remains strained.

Agriculture, Forestry & logging, Fishing, Public administration & defence services, Other services Mining & Quarrying, Registered ,Trade, Hotels & Restaurants, Banking & insurance, Business Services Railways, Transport by other means, Storage, Communications, Unregistered Manufacturing

•

Having discussed the sectoral composition of the GDP, it would be useful to see this in the context of vulnerability of the sectors.

•

It is interesting to note that while the worst affected sectors account for 42% of the GDP, they contributed roughly 55% of the GDP growth in FY08. * The vulnerability classification is by McKinsey

Vulnerability risk to the global crisis stand evenly balanced for India Region

External debt

China Indonesia Brazil India Russia South Korea S Africa

(% GDP) 2 4 1 6 8 10 5

Forex reserves

Short term debt

Short Equity Domestic term debt markets credit (% total (% change (% debt) (% reserves) debt) since Jan'08) (% GDP) 1 1 12 10 11 8 7 3 7 2 11 4 4 2 6 4 2 5 8 5 5 6 6 12 4 6 10 11 3 10 7 9 8 1 12

Fiscal deficit

Current Account Balance

Average score

(% GDP) 4 6 7 8 12 3 11

(% GDP) 2 6 8 9 3 7 12

5.4 5.4 5.4 5.9 7.0 7.5 8.1

Source: IIF, Ecowin, ICICI Bank Research

Based on a host of parameters different countries have been ranked according to their vulnerability to the global crisis with the rank 1 given to the least vulnerable country. Countries are then judged as highly vulnerable or least vulnerable using the average score of the ranks for different parameters. Such an exercise has yielded the result that vulnerability risk to a global crisis is evenly balanced for India compared to its peer group. 13

Looking ahead to FY10 Growth rates (%) Avg growth in last 13 years Avg growth last 5 years Avg growth during slowdown Minimum Maximum FY08 FYTD

GDP

Private consumption

Govt consumption Investment

6.93

5.81

5.51

8.92

7.01

5.11 3.77 9.69 9.00 6.80

4.60 2.67 8.67 8.30 6.50

Exports

Imports

10.21

14.37

15.51

4.76

15.76

15.03

22.12

6.59 -0.35 13.23 6.90 13.20

6.44 -4.10 21.99 13.80 10.00

12.55 -2.33 31.40 7.50 15.50

9.71 -2.44 45.58 7.60 25.30

Source: CEIC, ICICI Bank Research

•

Having analysed growth dynamics through different appraoches, we now try to construct probable scenarios that could emerge in FY10.

•

The trends of the GDP components show that consumption has had a more stable past than the widely fluctuating investment. However the India growth story with plus 8% growth over the last five years, has been fuelled by a surge in investment growth led by healthier corporate balance sheets, capacity expansions and enhanced productivity.

•

While during a slowdown average rate of consumption growth has slipped only by 1-1.2%, investment growth falls by a greater amount of about 4% compared to the long term average.

•

Consumption growth has a tendency to dip in years with a bad monsoon and the lowest consumption growth of 2.6% too occurred in a drought year.

•

With lack of fiscal room available in previous years, we see that average government consumption growth during slowdown years is only marginally higher compared to the long term average. However there is reason to believe that the trend would not hold in the current slowdown phase with the government boosting the economy through doses of higher expenditure.

Challenging times ahead •

While growth in FY09 is expected to fall below the 7% level, the challenges seem to multiply in FY10.

•

With a dismal global backdrop and poor domestic conditions the FY10 seems to be a lot more difficult year than FY09.

•

For GDP growth in FY10 to reach near 6-6.5% levels, consumption would have to grow by 57% and investment would have to grow by 710%. This would be plausible if the government measures to boost consumption growth seep into the system rapidly and early signs of pickup in demand encourage capacity expansion plans.

Scenarios for FY10 GDP 8

6 GDP (% YoY)

All possible scenarios 4 2 0 2

5

4

7 Investment (% YoY)

10

3 12

7 Consumption (% YoY)

Source: CEIC, ICICI Bank Research

14

Constructing growth scenarios for FY10 The bare minimum Global headwinds: • Export growth contraction continues for most part of FY10 • Outflow of foreign funds on worsening global condition and rating downgrade Domestic conditions: • Corporate savings led collapse in gross domestic savings • Cost and availability of credit continue to remain a sore point for consumers and corporates • Tight consumer lending, employment uncertainty and adverse wealth effect to weigh on private consumption • Inventory build-up stalled by uncertain consumption outlook • Investment projects shelved with no intention of adding new projects • Financial instability due to global developments • Depressed asset prices keep business and consumer sentiment down • Political uncertainty worsens post elections GDP growth of 5.5 - 6%

Propelled by policy push

Signs of recovery, domestic fundamentals support

Global headwinds • Export growth falters but manages positive growth of 2% • Some FDI inflows but FIIs and ECB lenders remain on the sidelines Domestic conditions: • GDS does not drop below 32% of GDP • Gap in investment financing partially bridged by government initiatives and partly by RBI’s liquidity providing measures • Discretionary purchases deferred, rural spending helps maintain growth of consumption around 6% • Inventory drawdown in H1 paves way for a buildup later • Investment pipeline to be completed as per schedule but fresh proposals would not be forthcoming • Sentiment improves in H2 FY10 on the back of global developments • Election results throw up at least a stable government GDP growth of 6 - 6.5%

Aided by global recovery

Shorter global recession, proactive policy action

Global headwinds: • Global economy sees some recovery by 2009 end • FDI continues, FIIs search for relative valuation and some appetite for ECBs revive • Export growth recovers in H2 FY10 Domestic conditions: • Bank credit flows helps to revive investment – investment growth does not drop below 7% • The recovery process is swift with the crisis not spreading to other sectors • Retail credit resumes providing impetus to consumption • Business and consumer sentiment recovers quickly • Inventory adjustment is prompt and this fuels capacity expansion and fresh projects • Election results throw no surprises and new govt committed towards further reforms GDP growth of 7 – 7.5% 15

Inflation – Diverging trends

12

30

10

25

8 6

20

4

15

2

10

0

Source: Bloomberg, ICICI Bank Research

(% YoY)

CPI

With the rise in WPI last year, the consumer 12 price index also rose, however the drop in the 10 WPI off late has not been mirrored by the CPI. While WPI averaged 3.2% in Feb’09, the CPI reading for Feb’09 was at 9.63%. It is expected that CPI would fall, however only with a lag.

8

The differing weights for food, fuel and metals between CPI and WPI are the main reason for this divergence. While food prices have been moving up and account for 47-57% of CPI fuel prices, which are falling account for only 3-7% of CPI.

4

WPI (RHS)

(% YoY) 14 12 10 8

6

6 4

D e c -0 8

F e b -0 9

J a n -0 9

F e b -0 9

0 O c t-0 8

0 A u g -0 8

2 J u n -0 8

2

A p r-0 8

•

14

35

F e b -0 8

•

16

D e c -0 7

•

(% YoY) 18

Correlation of 0.65

O c t-0 7

CPI and WPI paint different inflation scenario

Inflation (RHS)

40

A u g -0 7

Our forecast of negative inflation in the first few months of FY10 confirms that this inverse correlation will continue. However, any rapid monetary growth to finance fiscal deficit would have potential long-term inflationary bias.

M3

J u n -0 7

•

While inflation peaked at near 13% levels in Aug’08, money supply growth dipped at that time from 22% levels in the previous months to around 20% levels. Correlation of money supply and inflation turned inverse in the period of Jan’07 and Feb’09.

(% YoY) 45

A p r-0 7

•

Historically money supply growth and inflation have depicted positive correlation of 0.65%.

F e b -0 7

•

M a r-91 M a r-92 M a r-93 M a r-94 M a r-95 M a r-96 M a r-97 M a r-98 M a r-99 M a r-00 M a r-01 M a r-02 M a r-03 M a r-04 M a r-05 M a r-06 M a r-07 M a r-08 M a r-09

Money Supply Inflation link breaks down

Source: CEIC, ICICI Bank Research

10 8 6 4 2 M a r-0 9

D e c -0 8

N o v -0 8

O c t-0 8

0 S e p -0 8

The sensitivity of policymaking to primary article prices would deter any strong reaction to negative headline inflation numbers.

Primary Index

12

A u g -0 8

•

Higher prices of food articles also have an indirect impact on WPI through higher prices of manufactured items.

Whole Index

J u l-0 8

•

The high MSPs set by the government for rice, wheat, urad and tur have been precluding the fall in food prices.

(% YoY) 14

J u n -0 8

•

While headline inflation figure has been edging down rapidly since Oct last year, driven by fall in fuel and manufacturing good prices, the primary articles inflation has not eased as much.

M a y -0 8

•

A p r-0 8

Primary articles inflation still elevated

Source: Bloomberg, ICICI Bank Research

16

Structural deflation is not a serious threat Recessions need not always be deflationary •

Historically, the notion of deflation has been associated with periods of recession due to the Great Depression experience.

•

To analyse the same we empirically study the relationship between inflation rates and GDP growth of 22 countries over the period 19602005.

•

Our results point to no clear link between inflation and GDP growth. While we found 31 cases where low inflation occurred with periods of positive GDP growth, 22 cases of high inflation occurred in periods of recession.

Inflation 0-1 1-2 2-5 5-10 10-15 15-20 20-30 30+

<0 1 5 11 18 12 6 19 22

0-2 10 23 50 26 21 11 11 8

2-5 15 31 186 115 43 19 15 19

Growth 5-8 6 16 92 54 33 10 10 13

8-10 0 5 20 18 8 5 5 4

10-12 0 0 8 10 3 3 3 4

12+ 0 1 1 1 0 1 3 0

Source: World Bank, IFS, ICICI Bank Research

As per our analysis inflation would enter the negative zone over the next few weeks and remain in the red for most part of 2009. This fall in the year on year inflation is essentially on account of the base effect.

3

12 9 6

0 -3 Jan -10

M ar-10

S ep -09

-6 N o v-09

Our forecast chart of the inflation figures for FY10 is a statistical exercise to reflect the base effect. However going forward as commodity prices pick up from the abysmally low levels, we expect inflation to average about 3% in FY10.

WPI inflation (% YoY) Forecast

Actual

Ju l-09

•

15

M ay-09

•

On the basis of a simple statistical exercise assuming primary, manufacturing and fuel indices to closely mirror the trend in the past five years, we have tried to forecast the weekly inflation figures for FY10.

N o v-07

•

Jan -09

Inflation expected to average close to 2-3%

1998 Q4 0.5 0 0.15 0 0.21 0.43 0.25 0.13 0 0.27 0.1

Source: IMF, ICICI Bank Research

M ar-09

The deflationary risks for the global economy as a whole (GDP weighted) has increased to 0.34 in 2009 from 0.32 in 2003. This rise in risks is primarily driven by negative output gaps and low asset prices.

S ep -08

•

N o v-08

Japan is the only country, which has very high risks while 13 other countries (out of 35) display moderate risk of deflation. For India, the index suggests minimal deflationary risk.

Ju l-08

•

Deflation Vulnerability Index Countries 2009 Q4 2008 Q4 2003 Q1 Japan 0.71 0.64 0.86 United States 0.53 0.47 0.27 Germany 0.38 0.23 0.54 Italy 0.38 0.38 0.23 France 0.36 0.36 0.5 China 0.27 0.23 0.18 Russia 0.27 0.18 0 Canada 0.2 0.2 0.53 United Kingdom 0.13 0.27 0.2 Brazil 0.11 0 0.5 India 0.11 0.09 0.09

M ay-08

An index of Deflation Vulnerability constructed by IMF shows that the deflationary risks have increased in the global economy, particularly in the G 7 countries. Higher the value of the index, the more the deflationary pressures.

Jan -08

•

M ar-08

India’s vulnerability to deflation relatively low

Source: Bloomberg, ICICI Bank Research

17

Overview and comparison of fiscal deficit India fares poorly in comparison •

•

•

Expansion of fiscal deficit has become a global theme as governments across the world are trying to cushion the falling economic growth. Among the developed countries, US, UK, and Japan are expected to record extremely high deficit numbers over the next two years as governments in these countries provide stimulus in a phased manner. Russia has slipped from surplus to deficit mode rapidly. India’s performance on the fiscal parameter has deteriorated because of stimulus measures, populist expenditure, and high commodity prices in the recent past.

2008

2009

2010

-9

-7

-5

China India Russia Brazil US UK Japan Germany Canada Australia -11

-3

-1

1

3

5

Government balance as % of GDP

Source: IMF, ICICI Bank Research

Combined fiscal deficit looks onerous

10 8 6 4 2

10

Bulk of the increase in fiscal deficit in FY09 (increase of INR 1932 bn) has come from an increase in the primary deficit of the center as interest payments are expected to have risen by approximately INR 19 bn only.

4

FY 08

FY 10 E

FY 06

FY 04

FY 02

FY 00

FY 98

FY 96

FY 94

FY 92

FY 88

FY 90

Primary deficit

Revenue deficit

(as % of GDP)

8 6

2 0

Source: RBI, Parliament of India, ICICI Bank Research

FY 10 BE

FY 08

FY 06

FY 04

FY 02

FY 00

FY 98

FY 96

FY 94

FY 92

General elections

-2

FY 90

The upward risk to fiscal deficit in FY10 would emanate from a higher than expected primary deficit.

Fiscal deficit

FY 88

•

Historical data suggests that on an average, fiscal deficit has a tendency to rise post the general elections, the last election being a pleasant exception.

FY 82

•

FY 86

Source: RBI, ICICI Bank Research

Post election, deficits carry an upward bias •

FY 84

0

FY 86

Off-balance sheet items, which are expected to be less in FY10, could potentially add another 0.7% (compared to the 2.4% in FY09).

Fiscal deficit (as % of GDP) Center State

12

FY 84

•

The combined fiscal deficit of the government is budgeted to be close to 8.5% of GDP in FY10. However, we expect center’s deficit to touch 7% due to 1% increase in plan expenditure and approx. INR 300 bn of tax cuts announced post the interim budget. Considering about 1% stimulus by the new government in FY10, the deficit could touch 8%. These correspond to two likely scenarios A and B, for the FY10 deficit (for details see the bond market section). Hence the combined deficit could lie between 10.511.5% under the two different scenarios considered above.

FY 82

•

18

Fiscal stimulus varies across countries • In most countries discretionary fiscal stimulus has so far focused on 2009, with the 2010 amounts generally representing phased implementation of programs initiated in 2009. •

•

According to the IMF, for the G20 as a whole fiscal stimulus would amount to 1.8% of GDP in 2009 and 1.3% of GDP in 2010. Difference in the size of stimulus comes primarily from two sources – ability of the government (i.e., the level of the deficit at which they entered the recession) and the presence of in-built automatic stabilizers in each economy.

Average announced fiscal impluse as % of GDP (2008-10)

Fiscal stimulus and deficits 2.5 China 2.0 US

Australia

1.5 Germany

1.0 UK

0.5

Russia Canada

Japan

Brazil

India

0.0 -10

-8

-6

-4

-2

0

Average government balance as % of GDP (2008-10)

Source: IMF, ICICI Bank Research

India’s fiscal stimuli has so far been prompt • Fiscal stimulus in India was introduced in late 2008 and as elsewhere, it came in the form of both an increase in expenditure as well as a cut in taxes. •

•

So far, a total of INR 500 bn increase in combined government expenditure has been earmarked under the two different stimulus measures along with tax cuts to the tune of INR 375-400 bn. Although not a part of any fiscal stimulus, but schemes like the farm debt waiver and sixth commission payouts could very well reduce the need for aggressive fiscal stimulus.

Summary of announced fiscal stimulus measures in India INR bn First stimulus package Increase in plan expenditure 200 Reduction in CENVAT 87 Infrastructure promotion through IIFCL 100 Scheme for textile and SMEs 14 Second stimulus package Increase in state government expenditure Increase in tax-free bond limit for IIFCL Special credit line and liquidity support through SPV for NBFCs FII investment in corporate debt increased to USD 15 bn from 6 bn ECB relaxation Others Tax cuts announced post interim budget

300 300 250

300

Source: Press releases, ICICI Bank Research Fiscal defict (inverted, RHS)

(% of GDP) 2 3

10

4

8

5

6

6

4

7

FY 10 BE

FY 08 RE

FY 04

FY 06 P

FY 02

FY 00

FY 98

FY 96

FY 94

9 FY 92

0 FY 90

8 FY 88

2

FY 86

•

Although the direction of causality between deficit and growth is far from clear, but nevertheless a higher deficit (or a lower surplus) is beneficial in times of slowing economic activity as government spending substitutes the fall in private spending in order to sustain aggregate demand. Hence, a higher deficit need not always be a macro risk (through rise in interest rates and crowding out). It can very well be a muchneeded growth booster.

Real GDP

FY 84

•

(% YoY) 12

FY 82

High deficit to support growth • Except FY09, the government had been curbing fiscal largesse since the introduction of the FRBM Act by trying to maintain a somewhat counter cyclical fiscal policy structure.

Source: RBI, ICICI Bank Research

19

Assessing the determinants of deficit in FY10 (%) 24

45

23

40

22 21

35

20

30

19

25

18

20

17

FY 06 FY 07

FY 05

14 FY 03 FY 04

15

5 FY 01 FY 02

16

10 FY 99 FY 00

15

FY 98

This would have an adverse impact on the taxto-GDP ratio, which is already depicting signs of fatigue.

Excise/ Industrial output (RHS)

FY 96 FY 97

•

The reduction in indirect tax rates (as a part of fiscal stimuli) and the expected slowdown in nominal growth to around 10% would impact revenues from indirect taxes in FY10.

Customs/ Imports

(%) 50

FY 93

•

As part of tax reforms, indirect taxes (customs and excise) were reduced substantially since mid 1990s resulting in fall in collections vis-à-vis nominal growth.

FY 94 FY 95

•

FY 91 FY 92

Indirect tax revenues to be impacted further

Source: RBI, ICICI Bank Research

8.0

14

7.5

12

7.0

10

6.5

FY 08

FY 10 BE

FY 06

FY 04

FY 02

FY 00

FY 98

FY 96

FY 94

FY 92

5.5 FY 90

6 FY 88

6.0 FY 86

8

Source: RBI, ICICI Bank Research (INR bn) Subsidies Food Fertilizer Petroleum Others 800

Total (RHS) (INR bn) 1400

700

1200

600

1000

500

800

400

600

300

400

200

200

100 FY 10 BE

FY 09 RE

0 FY 08

0 FY 07

If a faster than expected recovery in global economy escalates commodity prices, then chance of a rise in FY10 estimate of cash subsidy later on in the year cannot be ruled out.

8.5

FY 06

•

Cash subsidy bill for the government is also expected to come down (driven by a drop in fertilizer subsidies) from its decade high level of INR 1292 bn in FY09 to INR 1009 bn in FY10.

16

FY 05

•

The plunge in global commodity prices will act as blessing for the off-balance sheet deficit that is expected to drop from about 2.4% in FY09 to about 0.7% in FY10.

(% of GDP) 9.5 9.0

FY 04

•

Tax revenue (RHS)

18

FY 03

Pressure from subsidies to come off

Nominal GDP

FY 02

Driven by a slightly higher fall in indirect tax revenue, during 1997-98, tax-to-GDP ratio fell by 0.5% as nominal growth dropped from 15.7% to 6.3% - this could be repeated to a lesser extent in FY 10 as the ratio could slip towards 8% from the expected 8.6% in FY09.

(% YoY) 20

FY 84

•

Share of direct tax revenue in gross tax revenue is expected to increase from 55% to 57% in FY10 – we see upside risks to these estimates, as the new government is likely to implement stimulus measures through a reduction in indirect tax rates (revenues from which are generally more sensitive to slack in economic activity).

FY 82

•

FY 01

Bleak year for direct tax revenues?

Source: RBI, ICICI Bank Research

20

Assessing the determinants of deficit in FY10 Can higher expenditure be avoided? •

•

Although the Indian economy has undergone structural changes over the last two decades, a crude analysis suggests that the correlation between nominal growth and government expenditure falls substantially during times of slowdown (which implies increased government expenditure) – the average correlation coefficient lies close to –0.4 compared to close to 0.2 observed during expansion phases. Higher government expenditure acts as a natural stress reliever and is a preferred form of fiscal stimulus, considering the relatively higher value of fiscal multiplier over the tax multiplier.

Correlation between

0.6

Growth in Nominal GDP & Expenditure Growth in Nominal GDP & Revenue

0.4 0.2 0.0 -0.2 During a slowdown phase expenditure rises but revenue falls

-0.4 -0.6

Slowdown

Expansion

Source: RBI, ICICI Bank Research

How productive is increased expenditure?

This is in contrast to the fall in capital expenditure, which is expected to drop to about 1.7% of GDP in FY10 from about 1.8% in FY09.

FY 10 BE

FY 06

FY 08 RE

FY 04

FY 02

1 FY 00

8 FY 98

2 FY 96

9 FY 94

3

FY 92

10

FY 90

4

FY 88

11

FY 86

5

Source: RBI, ICICI Bank Research (INR bn) 2500

Interest Payments - size

as % of revenue receipts (RHS) 55 50

2000

45 1500

40

1000

35 30

500

25

FY 09 RE

FY 07

FY 05

FY 03

FY 01

FY 99

FY 97

20 FY 95

0 FY 93

However, what is more worrying is the likelihood of interest payments (as percentage of revenue receipts) rising for the second consecutive year in FY10 after the improvement seen since FY02.

12

FY 91

•

Total interest payments are expected to increase by INR 328 bn in FY10 – this happens to be highest single year increase.

6

FY 89

•

The difference between the gross fiscal and primary deficit has increased by close to 2% over the last decade primarily due to rising interest payments.

8

13

FY 87

•

Capital (RHS)

7

FY 85

Rising deficits imply larger interest payments

Revenue

14

FY 84

The moderation in capital expenditure is a concern, as it is not helping in enhancing the productive capacity of the economy, whereas the increase in revenue expenditure is just reflective of the increase in government consumption through the implementation of various stimulus measures.

Expenditures as % of GDP

FY 83

•

15

FY 82

•

According to the interim budget, revenue expenditure for the government is expected to rise above 14% of GDP in FY10 from close to 12% in FY09.

FY 81

•

Source: RBI, ICICI Bank Research

21

Issues in financing the deficit Heavy reliance on market borrowings…

Net market borrowings (as % of fiscal deficit) increased from the budgeted 75% to 80% in FY09 – this is expected to touch a record 93% in FY10.

60% 40% 20%

Since there are significant upside risks to the budgeted fiscal deficit estimate, this share could even go higher – however since short-term borrowings have not been considered in the FY10 interim budget, a part of the increase in deficit could potentially be offset through this.

0%

FY 10 BE

FY 06

FY 08 RE

FY 04

FY 02

FY 00

FY 98

FY 96

FY 94

FY 92

FY 90

FY 88

-20% FY 86

•

80%

FY 84

•

Financing of fiscal defict External sources Net market borrowings Draw down of cash balances Others 100%

Since FY99, major part of the financing of the fiscal deficit has been borne by market borrowings.

FY 82

•

Source: RBI, ICICI Bank Research

…might increase the onus on banks

75 70 65

7

60

6

55

5

50

FY 07

FY 06

FY 05

FY 04

FY 03

FY 02

FY 01

FY 00

40 FY 99

3 FY 98

45 FY 97

4

FY 96

However, with the fiscal deficit rising once again in FY09 and FY10, the incremental appetite for g-secs is likely to come more from the bank’s side given their huge deposit base.

8

FY 91

•

Banks' holding of G-Secs as % of outstanding stock (RHS)

FY 95

G-sec holdings by banks (as % of outstanding) have somewhat moderated in the four years till FY07, with increased participation seen from PFs and LIC.

Fiscal deficit as % of GDP

FY 94

•

9

FY 93

The share of market borrowing in financing the fiscal deficit has picked up after FY05.

FY 92

•

Source: RBI, ICICI Bank Research

Elevated yields to pose further problem •

•

The moderation in average rate of interest on domestic government liabilities has been beneficial in bringing down the interest cost (as % of receipts) after FY04. However, there would be two factors acting against the interest costs this year – (i) the increase in magnitude of the deficit per se will result in higher interest costs, and (ii) buoyancy in bond yields is expected to continue and since majority of the financing would be through market loans, the interest cost for the government runs the risk of carrying an upward bias.

Average Interest Rates on Outstan din g Domestic Liabilities of the Centre (%) Market S mall S pecial Y ear Loans Savings S PFs Deposits FY91 - FY95 (avg.) 10.86 10.85 11.63 11.53 FY96 - FY00 (avg.) 12.39 11.62 11.62 10.93 FY01 12.99 11.6 10.54 9.87 FY02 12.83 11.61 9.09 10.5 FY03 12.11 11.56 8.53 8.82 FY04 11.11 10.88 7.39 7.94 FY05 9.87 9.37 7.99 7.65 FY06 10.07 8.9 7.46 7.25 FY07 8.9 8.91 7.63 6.85 FY08 9.45 8.33 7.83 5.67 Source: RBI, ICICI Bank Research

22

Monetary policy response so far Liquidity seems to be the prime concern •

Even before the fiscal stimulus across the world gained traction, deployment of monetary policy happened in both conventional and nonconventional forms.

•

While growth concerns prompted easing of policy rates, liquidity concerns and financial stability seems to be the principal objective behind the use of non-conventional methods.

•

Policies dealing with toxic assets, capital injection programs, and creditor protection in case of further deterioration have not been needed in the Indian context.

Over view o f p o lic y mea su r es C o n tain m en t Reso lu tio n Strengthe Establish/ ned ReAsset Increase Wholesale Deposit Borrowing Liquidity Capitalizati Purchase Plans Insurance Guarantees Measures on Plans Develo p ed C o u n tr ies Australia x x x x Canada x x x Germany x x x x x France x x x Italy x x x Japan x x x UK x x x x x US x x x x x E M C o u n tr ies Brazil Russia India China South Korea

x

x x x x x

x

x

x

x x

x

x

Source: IMF, ICICI Bank Research

Repo

Reverse Repo

CRR

9 8 7 6 5 4 M a r-09

S ep -08

M a r-08

S ep -07

3 M a r-07

Apart from this CRR and SLR were also brought down by 400 bps and 100 bps to 5% and 24% respectively.

Policy rates

S ep -06

•

Even before fiscal policy was considered as a possible tool, financial stability and growth concerns prompted the RBI to cut policy rates aggressively - the repo and reverse repo rates were pruned by 400 bps and 250 bps to 5% and 3.5% respectively in less than five months.

(%) 10

M a r-06

•

In the fight against the ongoing crisis, monetary policy from the RBI indeed acted as the “first line of defense”.

S ep -05

•

M a r-05

RBI does the most aggressive policy easing…

Source: Bloomberg, ICICI Bank Research

…and infuses liquidity as well •

The spillover from the ongoing global financial crisis resulted in an unprecedented tightening of liquidity conditions after the collapse of Lehman Brothers, which was exacerbated by seasonal tax outflows and fx intervention by the RBI.

•

Since Sep-08, RBI released about INR 4300 bn liquidity in FY09 through various measures.

•

Further support came through in the form of a 100 bps cut in the SLR, and measures to counter the shortage in fx liquidity (e.g., Dollar swap line for banks, increase in rates for NRI deposits, resumption of SMO, etc.)

Actual/ Potential release of liquidity since Sep-08 Measure/ Facility Size (INR bn) CRR cuts 1600 MSS unwinding 631 Term repo facility 600 Increase in export credit refinance 255 Special refinance facility 385 Refinance facility for SIDBI/NHB/EXIM 160 Liquidity facility for NBFCs 250 OMO purchases 466 Total

4347

Source: RBI, ICICI Bank Research

23

Quantitative Easing and the RBI Fed's asset size (RHS)

(USD bn) 2300 2100

250

1900 1700

200

1500 150

1300 1100

100

900 Feb-09

N ov-08

Aug-08

M ay-08

Feb-08

N ov-07

700 Aug-07

50 M ay-07

Monetization of government debt through buying of treasuries and corporate bonds by Fed, BoE, BoJ, SNB, etc. would further lead to an expansion in their balance sheet size.

BoE's asset size

Feb-07

•

Since Sep-08, the Fed started increasing its balance sheet size through purchases of assets of different types and maturities. Similarly, the BoE has also increased its balance sheet size by implementing various schemes like the Asset Purchase Facility.

(GBP bn) 300

N ov-06

•

Various policy initiatives taken by the central banks are resulting in an expansion of their balance sheets.

Aug-06

•

M ay-06

Central banks expanding their balance sheets

Source: Bloomberg, CEIC, ICICI Bank Research

14000 13000 12000 11000 10000 9000 8000 7000 Mar-09

Dec-08

Sep-08

Jun-08

Mar-08

Dec-07

Sep-07

Jun-07

6000 Mar-07

Changes in other parts of the balance sheet would most likely be of little significance in FY10.

15000

Dec-06

•

OMOs till date have been the preferred route of monetization of deficit since possibility of private placement has been shrouded in mystery. Stock of Rupee securities held with the RBI increased by INR 383 bn in FY09.

(INR bn) RBI's Assets - FCA Gold Rupee securities (incl T-Bills) Others 16000

Sep-06

•

Although RBI has not bought any private securities from the market, the effect of the ongoing monetization of government deficit would be reflected in its balance sheet.

Jun-06

•

Mar-06

RBI’s version of QE

Source: CEIC, ICICI Bank Research

Money multiplier spikes up •

Money multiplier has lied between 4.5 – 5.0 for most part of last seven years.

5.3

•

However, the aggressive amount of monetary easing in the form of cuts in the CRR (which was pruned by 400 bps in just about three months) resulted in a sharp spike in the money multiplier, thereby pushing it to an all time high.

4.9

Since the RBI could resort to further CRR cuts if required, money multiplier could possibly stay in a higher range in FY10. Any effort to expand RBI balance sheet would result in liquidity infusion unlike other countries where this transmission mechanism has failed.

4.1

CRR (%, inverted, RHS)

5.1

4 5 6

4.7

7

4.5

8

4.3

9

Mar-08

Mar-07

Mar-06

Mar-05

Mar-04

Mar-03

11 Mar-02

3.7 Mar-01

10 Mar-00

3.9 Mar-99

•

Money Multiplier

Source: CEIC, ICICI Bank Research

24

Forecasting key monetary variables 13000

(INR bn) 60000

Sources of M3 - Net bank credit to govt to comm sector

NFA of banks

M ar-03

Sources of M0 - Net RBI credit to govt NFA of RBI NNML of RBI

M ar-00

(INR bn) 15000

Bank credit

NNML of banks

50000

11000 9000

40000

7000

30000

5000

20000

3000 1000

10000

-1000

0

-3000

9000

M ar-09

M ar-08

M ar-07

M ar-06

M ar-05

M ar-04

M ar-02

Source: CEIC, ICICI Bank Research (INR bn) 50000

Components of M0 Currency in circulation

M ar-01

M ar-09

M ar-08

M ar-07

M ar-06

M ar-05

M ar-04

M ar-03

M ar-02

M ar-01

M ar-00

M ar-99

Source: CEIC, ICICI Bank Research (INR bn) 10000

M ar-99

-10000

-5000

Bankers' deposit with RBI

Components of M3 - Currency with public Demand dep with banks

45000

Time dep with banks

40000

8000

35000

7000

30000 25000

6000 5000

Source: CEIC, ICICI Bank Research

M ar-09

M ar-08

M ar-07

M ar-06

M ar-05

M ar-04

M ar-03

M ar-02

M ar-01

M ar-99

M ar-09

M ar-08

M ar-07

M ar-06

M ar-05

M ar-04

M ar-03

0 M ar-02

1000 M ar-01

5000 M ar-00

10000

2000 M ar-99

15000

3000

M ar-00

20000

4000

Source: CEIC, ICICI Bank Research

Measures of money supply could carry an upside risk in FY10 •

Although net foreign exchange assets and net non-monetary liabilities of RBI were the major drivers of M0 in FY09, their significance would reduce dramatically in FY10 as no significant net foreign inflows are expected (see our BoP forecast below for details). RBI’s credit to the government gained importance in FY09 because of the temporary immunity from FRBM leading to the start of monetization of fiscal deficit and also because of the depletion of the MSS stock. Both these trends are expected to gather pace in FY10.

•

The impact of this expansion would get reflected in net bank credit to government, which would finally affect M3. In our opinion, the expansion in net bank credit to government would offset the decline in bank credit to the commercial sector on the back of falling nominal growth in FY10.

•

This expansion in M3 will eventually be reflected in an increase in aggregate deposits of the banking system.

25

Path of key monetary and credit ratios Investments to increase as…

Ratios - Deposits/M3

Credit/M3 (RHS) Investments/M3 (RHS)

0.65 0.60

0.80

0.55

0.78

0.50 0.45

0.76

0.40

0.74

0.35 0.30

0.72

0.25 Mar-09

Mar-08

Mar-07

Mar-06

Mar-05

Mar-04

Mar-03

0.20 Mar-02

0.70 Mar-01

•

0.82

Mar-00

•

The pick-up in credit-to-M3 ratio since FY05 was associated not only with a higher growth for the economy, but also with an improvement in financial deepening. Going forward, although we expect the ratio of aggregate deposits-to-M3 to remain around 80%, credit-to-M3 ratio is likely to moderate to below 60% (for reasons enumerated above). The effect of this decline would be somewhat offset by an increase in the investment-to-M3 ratio that can be expected to almost touch 26% in FY10.

Mar-99

•

Source: CEIC, ICICI Bank Research

10

100

20

80

30

60

40

40

50

FY 10 E

FY 08

FY 06

FY 04

FY 02

FY 00

FY 98

70 FY 96

0 FY 94

60 FY 92

20 FY 90

Investment-deposit ratio could turn marginally higher as banks are expected to increase their holding of excess SLR.

0

120

FY 88

•

The fall in the credit-deposit ratio would also be driven by deposit growth, which can be expected to remain buoyant on the face of RBI’s monetization.

Incremental ratios Credit-Deposit Investment-Deposit (inverted, RHS) -10 140

FY 86

•

As growth slows down further, credit demand would moderate further – at the same time the supply of credit would also come down as banks are expected to become more risk averse.

FY 84

•

FY 82

…credit offtake is expected to moderate

Source: RBI, ICICI Bank Research

Structure of RBI balance sheet to get altered

0.8 0.6 0.4 0.2 0.0 Mar-09

Mar-08

Mar-07

Mar-06

Mar-05

-0.2 Mar-04

The increase in this ratio would be vital for providing cushion to the economy suffering from a withdrawal in economic activity.

1.0

Mar-03

•

We expect the ratio of RBI’s NDA-to-NFA, which started increasing in FY09, to become positive and increase further in FY10.

1.2

Mar-02

•

Since BoP is expected to remain close to zero next year, the result would be an expansion of net domestic assets of the RBI vis-à-vis its net foreign assets.

Ratio of NDA to NFA of RBI

1.4

Mar-01

•

FY10 could end up being a unique year as temporary immunity from the FRBM act will allow RBI to monetize government’s fiscal deficit.

Mar-00

•

Source: CEIC, ICICI Bank Research

26

Framework for analyzing monetary policy stance Changes in Key monetary variables FY07 INR bn %

FY08 INR bn

%

FY09 INR bn %

FY10 (Scen A) INR bn %

FY10 (Scen B) INR bn %

MO

1360

24

2194

31

595

6.4

561

6

1010

10

M3

5807

21

6964

21

7512

19

7497

16

3502

20

Aggregate Deposits

5029

24

5802

22

6320

20

5927

15

7763

20

Credit

4241

28

4173

22

5167

22

4011

14

4870

17

Source: CEIC, ICICI Bank Research RBI's L iq u id ity M a n a g em en t O p er a tio n s (IN R b n ) FY 07 FY 08 FY 09

FY 10 S c en A S c en B -1117 -1117 0 0 -1167 -1167 0 0 50 50

A. Dr iver s o f L iq u id ity RBI's net purchase from ADs Currency with the public Centre's surplus cash balances with RBI Others

623 1190 -698 -12 142

2040 3121 -846 -266 31

-416 227 -993 300 50

B. M a n a g em en t o f L iq u id ity Change in LAF balances Change in net OMO Change in MSS outstanding Liquidity impact of CRR changes

-243 364 7 -339 -275

-1177 212 135 -1054 -470

2861 576 466 796 1023

2798 776 1142 880 0

3197 676 1641 880 0

C . Ba n k Reser ves (A+ B)

380

863

2445

1681

2080

(+) indicates injection and (-) indicates absorption

Source: RBI, ICICI Bank Research

Liquidity provision to remain key for RBI in FY10 • • • • • • •

We have envisaged two plausible on-balance sheet deficit scenarios - A and B for FY10, wherein A corresponds to 7% of GDP and B corresponds to 8% of GDP (for details see the fiscal section). RBI’s pump priming carries the potential to keep growth in M3 and deposits at a robust level. The only monetary variable that can be expected to moderate would be credit. On the supply side, credit growth is expected to come off as banks generally become more cautious in their lending activities, while on the demand side fall in input costs and a overall slowdown in activity would tend to dampen demand for credit. Apart from sounding concerned on growth, RBI has become extremely cautious about financial stability – and hence liquidity management would continue to enjoy paramount importance. Since we expect FY10 BoP to remain close to zero, currency with the public would become the most important driver of liquidity. Any possible sell side intervention by the RBI in the beginning of the year would possibly be offset by a reverse transaction later (please refer to our Rupee view below). Management of liquidity would come in the form of bond purchases under OMO and a depletion of the MSS stock. CRR would be deployed only if liquidity conditions begin to tighten despite these efforts. Additionally we expect 50-100 bps cut in the repo and reverse repo rates. 27

Fundamental factors affecting bond yields Reverse Repo Rate

10Y G-Sec Yield

10 9 8 7 6 5 4 M ar-09

M ar-08

M ar-07

M ar-06

3 M ar-05

Although, the 10Y benchmark bond yield barely stayed within the LAF corridor over the last two years, its average spread above the repo rate stayed at just 12 bps between Dec-06 to Dec-08.

Repo Rate

M ar-04

•

The effect of aggressive policy easing was limited only till Q3 FY09 after which the 10Y gsec yields climbed up by more than 180 bps.

(%) 11

M ar-03

•

Although we expect further policy easing from the RBI, but it is likely to be of less significance for bond yields as long as supply concerns continue to dominate sentiment.

M ar-02

•

M ar-01

Effect of monetary policy on bonds diluted…

Source: Bloomberg, CEIC, ICICI Bank Research

…as 10Y stays much above policy rates •

The average spread of 10Y bond yield over the repo rate increased to about 72 bps in Q4 FY09, while the current spread would be close to 200 bps.

•

Such a high level of spread with the policy rate is not very common

•

Data since Jun-00 suggests that the 10Y bond yield has stayed 150 bps above the repo rate only 2% of the time.

•

However, if we consider the entire LAF width (which currently is at 150 bps) as the spread, then the frequency turns out to be 16%.

Spread of 10Y G-Sec above repo rate* Frequency (%) Above 50 bps 52 Above 100 bps 20 Above 150 bps 2 Greater than 1/3 LAF Greater than 2/3 LAF Greater than LAF

50 34 16

* Data since Jun-00

Source: Bloomberg, ICICI Bank Research

Effect of inflation and oil could also ease

0.50 0.25 0.00 -0.25 -0.50 -0.75 Mar-09

Mar-08

Mar-07

Mar-06

Mar-05

Mar-04

-1.00 Mar-03

However, there is a slim possibility that the global economy starts to recover in early 2010, and with the ongoing monetization in most of the countries inflation could become a possible threat thereafter – this could restore the long term correlation to higher levels once again.

0.75

Mar-02

•

With both staying low for the time being, the high level of long-term correlation with bond yields can be expected to moderate in FY10.

1Y rolling correlation of 10Y G-Sec yield with WPI and Oil price

1.00

Mar-01

•

Apart from policy rates, inflation and oil price are other traditionally important drivers of bond yields.

Mar-00

•

Source: Bloomberg, ICICI Bank Research

28

Bond market outlook FY09

Estimation of supply-demand situation for G-Secs in FY10 (INR bn) A. SLR demand by banks* B. Demand from all PFs C. Demand from LIC and other insurance companies D. Demand from RBI E. Total demand (A+B+C+D) F. Announced government borrowing G. Additional government borrowing H. Change in MSS outstanding I. SDL issuance J. Oil bonds (adjusted for RBI's SMO) K. Fertilizer bonds L. Total supply (F+G+H+I+J+K) Excess supply (D-J) * Assuming SLR mainained at 28.5%

1940 150 500 466 3056 2620 0 -796 700 345 300 3169 113

FY10 Scenario A Scenario B 2175 2754 175 175 550 550 1098 1621 3998 5100 3086 3086 902 1504 -790 -790 800 1200 0 50 0 50 3998 5100 0 0

Source: RBI, ICICI Bank Research (INR bn) Demand-supply gap for G-Secs 10Y yield (inverted, RHS) 400

Borrowing summary (INR bn) FY09 Gross borrowing 1,060 Maturities (dated) 440 Net borrowing 620

FY10 2,410 331 2,079

6.5

MSS OMO

110 0

-330 -800

7.0

Net increase in supply

730

949

30%

Gross borrowing Maturities (dated) Net borrowing

1550 0 1550

1,208 200 1007

-22%

MSS OMO

-475 -545

-110 -550

Net increase in supply 529 * Figures are expectations for H2 FY10

347

(%) 5.0

200

5.5

0

6.0

-200 -400

H1

Change 127% 235%

7.5

-600

8.0

Source: RBI, CEIC, ICICI Bank Research

Feb

Jan

D ec

N ov

Oct

S ep

Aug

9.5 Jul

-1200 Ju n

9.0 M ay

8.5

-1000 Apr

-800

H2*

-35%

-34%

Source: RBI, ICICI Bank Research

RBI actions to tackle excess supply and the outlook for bonds •

In the first part of FY10, fundamental factors might play a very limited role in determining bond yields. We have noticed that in the last quarter of FY09 excess supply emerged as the key factor which kept sentiment at bay. Even in FY10, the overall supply of g-secs could potentially lie between INR 39005000 bn – this would be about 23%-58% higher than the net supply in FY09.

•

The overall demand-supply balance does not look that threatening because of heavy OMO purchase by RBI in H1. Such a trend is expected to continue in H2 as well.

•

However, since fiscal slippage is expected to be much higher (1.5-2.5% of GDP), market is factoring in a risk of the supply-demand balance getting jeopardized once again. RBI has so far shown little inclination towards private placement, in which case the effective management of the problem of excess supply would come only via OMO purchases.

•

Considering the market sentiment towards the problem of excess supply and RBI’s response thereof, on an average we expect the 10Y yield to lie in the range 6.5-7.0% over the next few months. However, in the medium to long term yields should start reflecting macro fundamentals of benign inflation and moderate growth when the market recognizes the balance in demand-supply. We expect yields to head towards 6% at that point.

29

Behaviour and outlook on key spreads Spread of 10Y G-Sec over 3M T-Bill Average spread = 116 bps 400

Min spread = -47 bps

300

Max spread = 453 bps

200 100 0

M ar-09

S ep-08

M ar-08

S ep-07

M ar-07

M ar-06

S ep-06

-100 S ep-05

There could be some near-term bias for this spread to remain at elevated levels as RBI can be expected to announce further rate cuts, but going forward, RBI’s purchase of more longer dated bonds through OMO while issuing a higher percentage of short-to-medium term securities can put a cap on this spread.

(bps) 500

M ar-05

•

Since Sep-08, the combination of rate cut expectations from the RBI, and medium term inflation concerns, which later got replaced by concerns about issuances, contributed to a steepening of the yield curve in India.

S ep-04

•

M ar-04

RBI could influence the long-short spread

Source: Bloomberg, ICICI Bank Research

0 -50

M ar-09

S ep-08

M ar-08

S ep-07

M ar-07

Max spread = 167 bps S ep-06

Min spread = -143 bps

M ar-06

-150

S ep-05

-100

M ar-05

While monetary policy expectations and RBI’s commitment to maintain ample liquidity would support swaps more than bonds, supply concerns will have a greater negative influence on bonds – hence the spread should remain elevated.

50

S ep-04

•

Average spread = 19 bps

100

M ar-04

This led to a widening in the bond swap spread to a record high level.

150

S ep-03

•

Spread of 5Y G-Sec over 5Y OIS

(bps) 200

M ar-03

Swaps outperformed bonds (by approximately 24 bps) during the down move in rates in Q3 FY09, as well as during the up move in rates in Q4 FY09.

S ep-02

•

M ar-02

Swaps to outperform bonds?

Source: Bloomberg, ICICI Bank Research

350 300

3M MIBOR - 3M OIS (RHS) (bps) 600

Avg FY05 to FY08 = 89 bps

Avg in FY09 = 247 bps

500

Avg FY05 to FY08 = 89 bps

Avg in FY09 = 273 bps

400

250

300

200

200

150

100

100

0

50 M ar-09

S ep-08

M ar-08

S ep-07

M ar-07

-100 S ep-06

0 M ar-06

Apart from this, strains were so visible in the form of an explosion in offshore CDS spreads for some of the large Indian corporates.

400

S ep-05

•

This unusually high level of risk aversion permeated the thin corporate bond market and manifested itself in historically high levels of spread with the g-sec – at one instance the spread of 5Y AAA corporate bond over corresponding g-sec rose above 400 bps. With ample liquidity, the spread should moderate further in FY10.

(bps) 5Y AAA Corp Bond - 5Y G-Sec 450

M ar-05

•

The worsening of liquidity conditions post the fallout of Lehman raised the risk premium – as evident in the high TED spreads in the US.

S ep-04

•

M ar-04

Corporate bond spreads to moderate further

Source: Bloomberg, ICICI Bank Research

30

Auction dynamics to hold key in FY10 Q4 FY09 sets the tone for lack of interest… •

•

•

Excess supply has dampened buying interest at the regular auctions, resulting in total devolvement on PDs to the tune of INR 108 bn in FY09 with most noticeable lack of interest found in the long dated securities.

FY09 devolvements as % of notified

25%

Q1

Q2

Q3

Q4

20% 15%

Devolvement in Q1, Q2, and Q3 had two important characteristics – (i) they were not very high in percentage terms and (ii) they were localized in a particular segment.

10%

This is where Q4 differed in which not only were the share of devolvement higher, but they were also spread across various segment of the curve.

0%

5%

5-9 yrs

10-14 yrs

15-19 yrs

20+ yrs

Source: RBI, ICICI Bank Research 5.0

4.0

6.6

3.5

6.4

3.0

6.2

2.5

6.0

2.0

5.8

1.5 20-M ar

6.8

13-M ar

4.5

6-M ar

7.0

27-Feb

Similarly, the received bid-to-notified ratio has also declined from 4.5 in the first auction to 1.79 in the last auction for the new 10Y bond in FY09.

6.05% 2019 security Cut-off yield Bid/Notified ratio (RHS)

20-Feb

•

The sell off in bonds in Q3 FY09 resulted in an almost 100 bps increase in the cut-off yield for the new 10Y bond in just about four auctions – the cut-off yield for the 91 day T-Bill increased by about 20 bps in the same period.

(%) 7.2

13-Feb

•

The new 10Y benchmark (6.05% 2019 security), which was issued slightly earlier than anticipated, also saw tepid response.

6-Feb

•

30-Jan

…impacting even the popular benchmarks

Source: RBI, ICICI Bank Research

RBI trying to mange duration risk in FY10 •

•

•

Keeping in mind the huge increase in government borrowing and the associated upside risks, RBI has assured that the management would be done in the most nondisruptive manner. Apart from MSS unwinds and OMO purchases RBI has also decided to act on the shape of the curve by increasing issuances in the short segment of the bond market while reducing issuances in the longer segment. A flatter yield curve could result if RBI tries to reduce duration risk by focusing aggressively at the longer end for OMO purchases.

60

% share of gross borrowing H1 FY09 H1 FY10 OMO in Q4 FY09

50 40 30 20 10 0 5-9 yrs

10-14 yrs

15-19 yrs

20+ yrs

Source: RBI, ICICI Bank Research

31

Other determinants of interest rates GDP

10Y G-Sec Yield (RHS)

(%) 13 12

10

This would be important because a combination of falling growth and rising bond yields could spawn instability within the system.

11 10

8

9

6

Although the government has attained immunity from the FRBM Act in FY09 and FY10, rising bond yields in a falling growth environment would tend to have an adverse impact on interest payment costs for the government.

8 7

4

6

2

5 M ar-09

M ar-08

M ar-07

M ar-06

M ar-05

M ar-04

4 M ar-03

0 M ar-02

•

(% YoY) 12

M ar-01

•

Policy response in FY10 is likely to be geared towards controlling the upside risk to bond yields.

M ar-99

•

M ar-00

Rising bond yields unsupportive of growth

Source: Bloomberg, ICICI Bank Research SBI 3-5Y Deposit Rate

10Y G-Sec Yield

13 12 11 10 9 8 7 6 M ar-09

M ar-08

M ar-07

M ar-06

M ar-05

M ar-04

5 M ar-03

Rising bond yields makes the adjustment of lending and borrowing rates delayed.

SBI PLR

M ar-02

•

Lending rates react to bond yields with a slightly greater lag than borrowing rates – moreover their elasticity is also lower.

(%) 14

M ar-01

•

Since market linked interest rates normally serve as a benchmark for other rates in the economy, it is natural for the government and the RBI to become uncomfortable if yields start moving in a direction opposite to what fundamentals would warrant.

M ar-00

•

M ar-99

Can put unwarranted pressure on other rates

Source: Bloomberg, ICICI Bank Research

Correlation with US yields merits mention

10.0 8.0 6.0 4.0

7.5

6.5

5.5

4.5

2.0 3.5

Going forward, US yields would carry a natural upward bias due to huge supply in 2009 – but aggressive purchase of treasuries by the Fed could provide intermittent succor.

y = 1.77x - 0.0923 R2 = 0.54%

12.0

2.5

•

This association stems from the importance of monetary policy by the Fed in US and its repercussion on the global economy as well as other markets like commodities and equities

14.0

1.5

•

A simple regression on last ten years data suggests that almost 54% of the movement in domestic 10Y bond yield is explained by the US 10Y yield.

India 10Y yield

•

US 10Y yield

Source: Bloomberg, ICICI Bank Research

32

Tracing INR trajectory in 2008 USD/INR

53 51 49 47 45 43

Relatively stable Rupee moves as depreciation pressure due to outflows balanced by overall dollar weakness along with belief of a soft landing for Indian economy

The worsening C/A situation due to record high oil prices puts pressure on the Re, but start of SMOs limit the fall, resulting in only a mild depreciation

The intensification of the financial crisis exerted a strong outflow pressure, which together with refinancing issues and deteriorating BoP caused Rupee to weaken sharply

41

Apr-09

Mar-09

Feb-09

Jan-09

Dec-08

Nov-08

Oct-08

Sep-08

Aug-08

Jul-08

Jun-08

May-08

Apr-08

Mar-08

Feb-08

Jan-08

39

Source: Bloomberg, ICICI Bank Research

-2

2

-4

4

-6 6 -8 8

-10

(INR cr)

•

5000

Feb -09

J a n -09

D ec -08

N o v -08

O c t-08

S ep -08

Phase I

Phase II

Phase III

(%)

4 3 2 1

3000

0 2000

-1 -2

1000

-3 3 -A p r -0 9

1 3 -M a r -0 9

2 0 -F e b -0 9

3 0 -J a n -0 9

9 -J a n -0 9

1 9 -D e c -0 8

2 8 -N o v -0 8

7 -N o v -0 8

-4 1 7 -O c t-0 8

0 2 6 -S e p -0 8

Of the INR 759 bn worth of oil bonds issued by the government in FY09, RBI has purchased INR 419.97 bn via SMOs. There is no target for FY10.

Weekly purchase of oil bonds by RBI for SMO Weekly change in USD/INR (appreciation(+)/depreciation(-))

5 -S e p -0 8

•

These operations did have the desired impact on the Rupee as periods, which saw RBI purchasing oil bonds, did largely corresponded to periods of Rupee appreciation.

4000

1 3 -J u n -0 8

•

A u g -08

Source: Bloomberg, ICICI Bank Research

…but RBI SMO mutes the impact As dollar demand by oil companies soared RBI started with Special Market Operations (SMO), to contain the depreciation pressure on the currency. Under this, RBI bought oil bonds from these companies (ceiling Rs 10 bn a day) and in return supplied them with dollars.

J u l-08

12 J u n -08

-14 A p r-08

10

M a y -08

-12

1 5 -A u g -0 8

As India’s crude oil prices came down to USD 44pb from USD 133pb, oil imports came down to USD 4.04bn in Feb09 from USD 10.96bn in Aug08.

(USD bn)

Oil imports (RHS, inverted scale)

0

M a r-08

•

Further, the domestic currency came under pressure as talks that global crude oil would cross USD 200 a barrel (in the future) gave rise to concerns of a significant deterioration in the country’s current account position.

Trade balance

0

2 5 -J u l-0 8

•

With the first half of the year, seeing a sustained uptrend in global energy prices, dollar demand by Indian oil companies saw a sharp increase, resulting in a depreciation of the currency.

(USD bn)

Feb -08

•

In the past year, months with higher oil imports registered a higher trade deficit & vice versa.

4 -J u l-0 8

•

J a n -08

Oil spoils picture for Rupee in H1-08

Source: RBI, Bloomberg, ICICI Bank Research

33

INR - a victim of financial meltdown in H208 INR reacts sharply to massive outflows in H2

• • •

The year 2008 began with the FII flows reversing their trend (net inflows 2007 USD 19.5bn), which continued for most part of the year. Even though there were substantial FII outflows in H1’08, the Rupee did not depreciate sharply as a weak dollar cushioned the impact. However, the Rupee reacted adversely to the strong FII outflow pressure following the intensification of the financial crisis in Sep’08. Oct’08 was the worst as FII outflows amounted to an astronomical USD –4.04 bn, and the INR weakened sharply by 6%, despite the massive central bank intervention (USD 18.67 bn).

USD/INR

53

(USD mn)

FII flows (RHS)

1100

51

800

49

500

47

200

45

-100

43

-400

41

-700

39

-1000 J a n -0 8 F e b -0 8 M a r -0 8 A p r -0 8 M a y -0 8 J u n -0 8 J u l-0 8 A u g -0 8 S e p -0 8 O c t-0 8 N o v -0 8 D e c -0 8 J a n -0 9 F e b -0 9 M a r -0 9 A p r -0 9

•

Source: Bloomberg, ICICI Bank Research

Increasing macroeconomic risks bring…

5 0 -5

C h in a

R u ssia

T h a ila n d

In d o n e sia

K o re a

B ra z il

In d ia

-10 P o la n d

S&P, in Jan’09, put India on negative watch and with fiscal balances likely to deteriorate further, the possibility of a downgrade to junk cannot be ruled out.

10

H u n g ary

•

The significant deterioration in global economic conditions brought to the forefront vulnerability of many of the developing economies due to their macroeconomic imbalances, fuelling downgrade concerns. As a result, EM currency basket came under immense pressure.

Current account balance (as % of GDP) 2007 2008 2009 F

15

T u rke y

•

The twin bogey of fiscal deficit and current account deficit dogged the Rupee outlook for most part of FY09. This was further accentuated by the risk of failure to roll over external debt especially short-term trade credit.

S o u th A fric a

•

Source: IMF, ICICI Bank Research

…EM currencies under pressure, incl. INR Change in currency vs. USD

2007 2008 2009YTD Appreciation

10 0 -10 -20 -30 -40

Depreciation

C h in a

H u n g a ry

T h a ila n d

R u s s ia

P o la n d

-50 In d ia

In 2009, Rupee has suffered far less than many of its peers such as Polish Zloty, Ruble. This reflects the relatively stronger economic fundamentals along with RBI intervention.

20

B r a z il

•

The Korean won and Brazilian Dollar were the worst hit, each depreciating by more than 30% in 2008. The Indian Rupee was not far behind, weakening close to 24% last year.

(%)

K o rea

•

Emerging market currencies suffered heavily in 2008, first on account of the strong outflow pressure and then due to the increasing concerns over rising current account deficits, fiscal imbalances and short term external debt.

S o u th A f r ic a

•

Source: Bloomberg, ICICI Bank Research

34

Risks to India’s current account balanced 30 20 10 0

The current account briefly turned positive (FY02-FY04), helped by a relatively stable trade balance and growth in invisibles on account of software services related flows and remittances.

-10

Current account has been worsening since then (Apr-Dec 09 at USD -22.3 bn), as strong import demand (both oil and non oil) widened trade balance, while invisibles remained modest.

-40

-20

Q3FY09

Q3FY08

Q3FY07

Q3FY06

Q3FY05

Q3FY04

Q3FY03

Q3FY02

-30 Q3FY01

•

Invisibles Trade balance Current account

(USD bn)

Q3FY00

•

India’s current account has been in deficit mostly, as invisibles were unable to finance entirely the shortfalls on the trade side. Even then, the CAD was largely at manageable levels (generally less than 1.2% of GDP since 1997).

Q3FY98

•

Q3FY99

Trends in India’s current account position

Source: RBI, ICICI Bank Research

Increased trade linkages together with…

This does put to jeopardy, the prospects of India’s export sector as India’s trade linkages with ROW have seen a marked increase over the decade. India’ two-way trade (exports and imports as a proportion of GDP) has risen from 25% in FY00 to around 38% in FY08.

30

2007

FY 07

2008

2006

FY 05

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

(%YoY)

Export growth

45

According to WTO, the contraction in global demand would cause exports to decline in 2009 by nearly 9% in volume terms (for developed economies 10%, developing countries 2-3%).

35

Global exports could receive a severe blow should protectionism emerge on a large scale. According to World Bank, 17 of the G20 countries imposed 47 trade restrictions between the Nov and Apr G20 meeting.

5

Import growth

25 15 -5 -15 FY 09e

FY 03

FY 01

FY 99

FY 97

FY 95

-25 FY 93

India might not be as severely affected as others as it has a relatively small part to play in global trade. Its share in global exports and imports in 2008 was a mere 1.1% and 1.8% respectively.

1993

Source: Bloomberg, ICICI Bank Research

FY 91

•

15

FY 89

•

20

FY 87

•

25

FY 85

…shrinking global trade to impact external sector

35

1992

Even then India’s external openness as gauged by this is much less than of many of its peers. For Asians economies such as South Korea, Singapore, the two-way trade is more than 100%, implying a greater dependence on trade.

Exports plus imports (as a percentage of GDP)

FY 83

•

40

1991

•

With global economy facing one of its worst contractions since World War II, countries with high dependence on trade would receive a much severe blow than others.

FY 81

•

Source: CEIC, ICICI Bank Research

35

Exports under pressure FY06

FY08

20 15 10 5

Japan

Hong ko n g

UK

0 S in g a p o r e

The government response in the form of duty drawback benefits for certain items, credit line to EXIM bank. – has been able to arrest the collapse but a recovery is not yet in sight.

FY01

UAE

•

Despite the diversification of export markets, prospects of the export sector look shaky, as not only the developed economies but also EM’s are to see a sharp decline in demand.

Share in total exports

25

E u ro zo n e

•

(%)

India’s dependence on the US has been decreasing, with its share in overall exports declining from around 21% in FY01 to 12% in FY08. At the same time, exports to GCC and other markets have been expanding. UAE is currently the third largest export destination.

US

•

C h in a

Regional diversification could aid exports

Source: Commerce Ministry of India, ICICI Bank Research

But steep fall in the value of crude and iron ore exports signals the adverse impact… Commodity PETROLEUM GEMS & JEWELLERY MACHINERY AND INSTRUMENTS TRANSPORT EQUIPMENTS IRON & STEEL IRON ORE READYMADE GARMENTS COTTON PLASTIC PRODUCTS MANMADE YARN,FABRICS CHEMICALS

%Growth (Nov 08) -23.0 -8.7 -57.7 -196.5 -36.0 -58.8 10.4 -8.1 -1.8 16.3 33.3

%Growth (Oct 08) 4.0 -1.3 63.2 35.2 23.2 -76.0 10.1 3.8 -6.1 19.1 63.2

%Growth (Sep 08) 36.1 72.2 58.4 27.3 67.8 -19.8 43.9 2.8 0.0 1.8 83.3

%Growth (Apr- %Share (AprNov 08) Nov 08) 36.75 18.27 12.43 11.55 84.56 5.91 36.96 5.96 51.08 3.08 4.18 2.3 9.93 4.01 54.12 2.51 12.88 1.87 23.88 1.82 62.01 2.1

Source: Commerce Ministry of India, ICICI Bank Research

…of global recession on export industry

25 20 15

Possible trajectory for exports

10 5 0

Source: Bloomberg, World Bank, ICICI Bank Research

2009

2007

2005

2003

-5 2001

Commerce Ministry expects Indian exports to be around USD 170-175 bn in FY10.

30

1999

•

The correlation coefficient between global growth and Indian export growth, is quite strong at 87% (from the start of the decade).

4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

1997

•

Despite the export diversification, foreign demand for Indian manufactured goods tends to decline during periods of global slowdown.

India export growth (RHS) (%) 35

World GDP growth

(%)

1995

•

In Feb’09, total value of exports declined by – 21.7%YoY to USD 11.91 bn. The fall in exports was exaggerated by a steep fall in petroleum products (accounts for 18.2% of exports), which primarily reflects the steep fall in energy prices.

1993

•

36

Oil prices, domestic slowdown to ease imports Commodity PETROLEUM GEMS & JEWELLERY MACHINERY AND INSTRUMENTS TRANSPORT EQUIPMENTS IRON & STEEL IRON ORE READYMADE GARMENTS COTTON PLASTIC PRODUCTS MANMADE YARN,FABRICS CHEMICALS

%Growth (Nov 08) -23.0 -8.7 -57.7 -196.5 -36.0 -58.8 10.4 -8.1 -1.8 16.3 33.3

%Growth (Oct 08) 4.0 -1.3 63.2 35.2 23.2 -76.0 10.1 3.8 -6.1 19.1 63.2

%Growth (Sep 08) 36.1 72.2 58.4 27.3 67.8 -19.8 43.9 2.8 0.0 1.8 83.3

%Growth (Apr- %Share (AprNov 08) Nov 08) 36.75 18.27 12.43 11.55 84.56 5.91 36.96 5.96 51.08 3.08 4.18 2.3 9.93 4.01 54.12 2.51 12.88 1.87 23.88 1.82 62.01 2.1

Source: Commerce Ministry of India, ICICI Bank Research

6

20 10

4

0

2

-10

D e c -0 8

D e c -0 7

D e c -0 6

D e c -0 5

D e c -0 4

0 D e c -0 3

-20 D e c -0 2

India’s non-oil imports have started to moderate in response to the slowdown in domestic demand (Feb’09 non-oil imports contracted by 10.2%YoY).

8

D e c -0 1

•

10

30

D e c -0 0

The degree of responsiveness of non-oil imports to GDP is quite high, as the elasticity of demand is at 2.4% (from 1997).

(%)

12

40

Imports of many of these non-oil commodities depend upon domestic growth prospects. Periods of a relatively high economic growth have seen a surge in non-oil imports, while the reverse is true when domestic activity slows down.

•

GDP growth (RHS)

60 Correlation 0.61 50

D e c -9 8

•

Non-oil imports growth

(%)

D e c -9 9

Non oil imports at risk by domestic slowdown • While petroleum and its products account for bulk of India’s imports, other important imports of the country include machinery, gems, electronics etc.

Source: Bloomberg, RBI, ICICI Bank Research

10

10

8

8

6

6

4

4

N o v -0 8

S e p -0 8

J u l-0 8

M a y -0 8

0 M a r -0 8

0 J a n -0 8

2

N o v -0 7

2 S e p -0 7

With oil prices expected to remain subdued in 2009 (av USD 55pb), the oil import bill is likely to be around USD 60 bn in FY10. This excludes any impact of the KG Basin gas production.

12

12

J u l-0 7

•

The sharp increase in India’s crude oil basket had driven the oil import bill to record highs. With global energy prices declining rapidly, oil import bill has also fallen sharply (USD 4.1 bn in Feb’09).

14

14

M a y -0 7

•

Since FY05, India’s oil import bill has increased at a rapid pace, of around 40% (FY08 USD 79bn, FY09e USD 88bn). During this time, however, crude oil imports, in volume terms, have seen only a modest increase of around 8.5%.

(USD bn)

Total volume of crude oil imports Total value of crude oil imports (RHS)

M a r -0 7

•

(mn tons)

16

J a n -0 7

Oil import bill to decline on price effect

Source: CEIC, Bloomberg, ICICI Bank Research

37

Uncertain outlook for invisibles in FY10 Global meltdown could risk remittance flows

(%) 120 100 80

Oil Price Shock

60

25

Although data is yet to confirm, there is increasing fear that the burden of layoffs in developed countries could fall on migrant workers. This together with the fall in the income of oil workers in the Gulf region could slow down remittance flows into India.

5

-20

0

-40

Despite these facts, FY10 is likely to see a more subdued growth in invisible flows, as gloomy world outlook dominates other positive factors.

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

Source: Bloomberg, ICICI Bank Research

12

(%) 10 8 6 4 2 0 -2 -4 -6 -8

Total private transfers Quarterly Change in USD/INR (RHS)

D e p re c ia t io n

(USD bn)

14 10 8 6 4 2 0

D e c -0 8

Even the hike in interest rate ceilings on NRI deposits since Sep’08 (175 bps for NRE and 100 bps for FCNR (B) deposits), has boosted inflows.

0

10

D e c -0 6

Despite the ongoing global meltdown, there are indications that the recent Rupee weakness had led to an increase in inflows.

20

15

D e c -0 4

Apart from global macroeconomic conditions, exchange rate movements and interest rate differentials also determine remittance flows.

40

20

D e c -0 2

•

Dot com bubble burst and global slowdown

30

D e c -0 0

•

Adverse impact of Gulf crisis along with recession in US

D e c -9 8

•

35

Growth (RHS)

According to World Bank, in 2007 India received the highest remittance flows. North America and Middle East account for the bulk of remittance inflows (44% and 24% respectively).

A weak Rupee could offset the moderation

•

Shocks

D e c -9 6

•

Remittances

40 Oil Price

1980

•

(USD bn) 45

India benefited vastly from the oil boom in the Middle East and the Technology revolution. The share of private transfers to total GDP has risen steadily from 2.8% in FY01 to 3.7% in FY08.

D e c -9 4

•

Source: Bloomberg, ICICI Bank Research

The IT sector boom has led to a surge in software related flows (USD 5.8bn in FY01 to USD 29 bn in FYTD09). While NASSCOM has not given any estimates for FY10, cutback in tech budgets and depreciation of non-dollar currencies can pose negative surprises.

15

Oil Imports

25 20

10 5

D e c -0 8

J u n -0 8

D e c -0 7

J u n -0 7

D e c -0 6

J u n -0 6

0 D e c -0 5

We are worried by the sharp drop in the core trade balances for Dec’08 quarter, but feel that the situation could improve going forward.

Core Trade Balance

J u n -0 5

•

30

D e c -0 4

•

While India’s overall trade balance has been negative, its core trade balance (merchandise and software service exports less non oil imports) has been strictly positive.

D e c -0 3

•

(USD bn)

J u n -0 4

Risks to core balance emerging

Source: RBI, Bloomberg, ICICI Bank Research

38

Global recovery to script the fate of capital flows Decline in global capital flows could hit India

•

•

•

Turning to the capital account side of BoP, while record high capital flows in FY08 (USD 108 bn) had led to a sharp Rupee appreciation, the reverse was true in FY09, as capital flows fell sharply (Apr-Dec USD 16 bn). Globally as well, private capital flows have nearly halved in the last two years. According to the International Institute of Finance (IIF), net capital flows to EM’s are likely to be an abysmal USD 165bn in 2009 from USD 466bn last year. Emerging Europe followed by Emerging Asia are likely to be the two worst hit regions from the sharp reduction in net flows during 2007-09.

Private financial flows to Emerging Market economies (USD bn) 2006 2007 2008e 2009f Total Private flows 564.9 928.6 465.8 165.3 Equity investment 222.3 296.1 174.1 194.8 Private Creditors 342.6 632.4 291.7 -29.5 Latin America Equity investment Private Creditors

51.5 28.9 22.6

183.6 81.5 102.1

89.0 48.4 40.7

43.1 42.0 1.0

Emerging Europe Equity investment Private Creditors

226.3 50.2 176.2

392.8 81.1 311.7

254.2 50.3 203.9

30.2 48.6 -18.4

Emerging Asia Equity investment Private Creditors

258.9 122.6 136.3

314.8 112.9 201.9

96.2 57.9 38.2

64.9 85.7 -20.8

Source: IIF, ICICI Bank Research

FII flows at mercy of global liquidity position

0.2

0

-0.2

-50

-0.6 F e b -0 9

O c t-0 8

J u n -0 8

O c t-0 7

F e b -0 8

F e b -0 7

J u n -0 7

O c t-0 6

J u n -0 6

O c t-0 5

F e b -0 6

J u n -0 5

-100 O c t-0 4

-1.0

Source: Reuters Ecowin, SEBI, ICICI Bank Research (USD bn)

Since FY07, FDI inflows have been increasing, reflecting the strong economic fundamentals along with opening up of the economy. Indian firms have also stepped up their foreign investment, causing some FDI outflow.

15

According to official estimates, Apr- Jan FDI inflows stood at USD 23.9 bn, lower than the USD 34.3 bn received in FY08.

6

Govt. has been clearing several FDI proposals in recent months (March around 30 cleared amounting to Rs 1042 cr). Even then, FDI flows could moderate in FY10 as PE funds and foreign companies slowdown their investments.

0

FDI Flows

Inflows

Outflows

Net

12 9

Q 3FY 09

Q 1FY 08

Q 3FY 06

Q 1FY 05

3

Q 3FY 03

•

50

Q 1FY 02

•

0.6

Q 3FY 00

•

100

1.0

Q 1FY 99

Even FDI flows could be hampered

150

1.4

F e b -0 5

In the ongoing financial crisis, liquidity apart, investor perception of risk is an important driver of FII flows. So, while we might see an up tick in G5 liquidity (due to the various central bank actions) elevated levels of risk could continue to keep FII flows at bay.

G5 liquidity index (RHS) 200

1.8

Q 3FY 97

•

According to our G5 liquidity index (measures changes in G5 money supply), G5 liquidity was expanding till as late as Mar’08 and started to moderate post that. It contracted towards the end of 2008, as massive global deleveraging pressures emerged (index fell to –20 in Dec’08).

Monthly FII flows (12M MA, USD bn)

2.2

J u n -0 4

•

The sharp decline in capital flows seen over the past few months is likely to be due to a contraction in liquidity in developed markets.

Q 1FY 96

•

Source: RBI, ICICI Bank Research

39

Balance of Payment outlook for FY10 (USD bn) 1 Merchandise - Exports - Imports Non oil imports Oil imports 2 Invisibles Total Current Account 1 Foreign Investment - FDI - Portfolio Investment 2 Loans 3 Banking Capital 4 Other capital Total Capital Account* Overall Balance of Payments (* includes errors and omissions)

FY07

FY08

FY09f

-61.8 128.9 190.7 121.0 58.0 52.2 -9.6 14.8 7.7 7.1 24.5 1.9 4.2 45.2 37.6

-91.6 166.2 257.8 160.0 79.0 74.6 -17.0 45.0 15.4 29.6 41.9 11.8 9.5 108.0 93.4

-119.0 169.0 288.0 187.0 88.0 84.0 -35.0 6.0 20.0 -14.0 7.0 0.0 -4.0 9.0 -26.0

FY10f Optimistic Pessimistic -89.0 -119.0 171.0 160.0 260.0 279.0 185.0 193.0 60.0 71.0 85.0 80.0 -4.0 -39.0 25.0 6.0 20.0 8.0 5.0 -2.0 8.0 4.0 4.0 1.0 1.0 0.0 38.0 11.0 34.0 -28.0

A more balanced BoP on the cards •

In light of the considerable uncertainty surrounding global economic and financial conditions, we decided to come out with two plausible scenarios for our FY10 BoP forecasts, taking into account two extreme scenarios that can serve as benchmarks for the coming year.

•

Coming to the specifics of our BoP forecast, we think that exports are likely to remain muted as global growth is expected to recover only towards the end of 2009. While some growth in exports can be expected towards the end of FY10, a more prolonged global recession can change that. Imports on the other hand, are expected to decline, as subdued oil prices (in the range of USD 55-60 a barrel), sharply bring down the oil import bill, and the domestic slowdown leads to only a modest rise in the non-oil import component. The overall trade deficit is likely to narrow against this background.

•

On the invisible side, some moderation can be expected in remittance flows, but a weaker currency along with the recent hikes in NRI deposit rates are more likely to ensure a steady inflow. While software service receipts, the other major component of invisibles are showing signs of moderation, they are unlikely to see a very sharp drop. On the whole, we see net invisible receipts stable at around USD 80 - USD 85 bn. However, we acknowledge the possibility of substantial downward risks to this.

•

On the capital flows side, we think that FII flows could surprise us, both on the upside as well as the downside. On one hand, a further deterioration in global financial conditions would result in elevated levels of risk aversion, keeping the FII outflow pressure intact. This can get intensified, particularly in the near term, if India’s sovereign rating is downgraded. On the other hand, signs of global recovery could see a spurt in risk appetite, aiding capital flows to emerging markets. We however, have taken a more conservative view on FII flows, and see FII flows around USD –2 bn - USD 5 bn.

•

Some respite could be provided by FDI inflows, as one off deals could take place. However, these would not amount to a very significant sum, keeping the overall capital account around neutral levels.

•

We don’t expect a large inflow or outflow in other components of the capital account, such as ECBs, trade credits etc, and see loans (ECBs plus trade credits) to be around USD 4 bn to USD 8bn.

•

On the whole, we think that in FY10 a more balanced BoP is likely as current account sees some improvement on the back of a narrowing trade deficit and the capital account does not see any significant deterioration from current levels. However, our BoP outlook has not budgeted for any oil discovery in the KG basin and a development of the same could result in a positive surprise.

•

This rather benign outlook for BoP prompts us to forecast an appreciation path for rupee in the medium to long term.

40

Risks of external vulnerability exaggerated

•

Outflow risk for NRI deposits is small as nearly 85% of these are for maintenance purposes. The outflow risk for even the part of the deposits meant for investment purposes is low due to India’s strong fundamentals. Repayment due on ECBs over the next one year at USD 7 bn is also relatively small.

Near term FCCB redemptions pressure trivial

•

•

•

Borrowing via the issuance of FCCBs had been a preferable route for Indian firms. Total FCCBs approved shot up from 77 in FY07 to 113 in FY08. However, this dropped sharply to only 7 during Apr-Aug’08 (none since Sep), reflecting the difficulty in raising capital via this route. In the ongoing global meltdown, it is quite likely that FCCBs maturing in the near term (USD 1.29 bn in FY10 as per Bloomberg) come for redemption as their conversion price is much higher than the market price. Last Nov, RBI decided to consider premature buyback of FCCBs by Indian firms. It has extended the deadline for this to 31st Dec’09.

T h a ila n d

M a la y sia

M e x ic o

In d ia

H u n g ary

0

Source: Reuters Ecowin, Ministry of Finance, ICICI Bank Research (USD bn)

(As of Dec'08)

100

Short term debt by residual maturity Components of ST debt by residual maturity

90.0

80 60

Short term debt by original maturity

43.8

40

31.8

20 2.2

0

7.8 1.4

0.1

2.9

S o v ereig n d eb t

•

Of the USD 43.8 bn of trade credits as per ST debt by residual maturity, USD 28.1 bn has been disbursed during Apr-Nov’08 (RBI data), leaving a balance of roughly USD 15 bn.

20

C o m m erc ia l Bo rro w in g s

•

Recently there were concerns that India could face some liquidity issues in meeting its external debt obligations, particularly in the near term.

40

O th ers

•

60

E xt lia b o f b a n kin g sy stem

Near term risks on external debt overdone

80

B r a z il

India is much better placed than many of its peers, with a relatively small debt to GDP ratio. More importantly, its ST debt to total debt and ST debt to FX reserves is amongst the lowest.

100

FII In v

•

ST debt to total debt Total FX reserves to total debt

120

P o la n d

Poland and Hungary are the most vulnerable, in terms of all the external vulnerability indicators.

140

T ra d e c red its

•

Total debt to GDP Total ST debt to FX reserves

160

S o u th Ko rea

Difficulty in accessing international capital markets, particularly for shorter maturities, together with unfavorable currency movements has raised refinancing concerns and possibility of a sovereign default by some of the countries.

(%)

N RI D ep o sits

•

Moving away from BoP, investors are positioning for a potential risk to the currency, arising from the country’s external vulnerability.

R u s sia

•

T o ta l

India ranks low on external vulnerability

Source: Ministry of Finance, ICICI Bank Research

(USD bn)

Outstanding amount of FCCBs maturing in

6 5 4 3 2 1 0

FY10

FY11

FY12

FY13

Source: Bloomberg, ICICI Bank Research

41

Risk appetite & dollar moves to impact INR Short term INR dynamics affected by risk

49

2

47 1

45 0

43

Apr-09

Feb-09

Dec-08

Oct-08

Aug-08

Jun-08

-2

Apr-08

39 Feb-08

-1

Dec-07

41

Oct-07

While the index is currently (1.21) substantially off its peak, it is still well above its historical average (0.1 from May’96), possibly signaling Rupee weakness to remain in the near term.

4 3

Aug-07

•

The index peaked last October (3.91) as global financial meltdown gathered pace. Correspondingly, the Rupee saw one of its worst performances, depreciating by over 8%.

Global Risk Index (RHS)

51

Jun-07

•

Selling Rupee is a favorable trade in the off shore market, when risk aversion runs high.

USD-INR

53

Risk Aversion

•

Our Global Risk Index (GRI), has been able to successfully map periods of increasing and falling risk appetite.

Apr-07

•

Source: Bloomberg, Reuters Ecowin, ICICI Bank Research

Fate of Asians and major crosses linked

A p r -0 8

A p r -0 7

A p r -0 6

A p r -0 4

A p r -0 5

A p r -0 9

J a n -0 9

O c t-0 8

J u l-0 8

A p r -0 8

In the coming year, we think that in the EM space, relatively strong fundamentals of Asians, would aid a faster recovery of their currencies, including Rupee.

J a n -0 8

•

O c t-0 7

Generally, any sustained deviation in this correlation gets corrected through the NDF market as has been observed in Sep’08.

J u l-0 7

•

6M rolling correlation between USD-INR and AXJ

1 0.8 0.6 0.4 0.2 0 -0.2 -0.4 -0.6 -0.8 J u l-0 6

Since Asian currencies tend to move together, movements in Rupee have largely followed those of the Asians. The correlation between the Rupee and our trade weighted Asian currency Index excluding Japan (AXJ) has been strongly positive (generally above 0.8).

A p r -0 6

•

A p r -0 3

Source: Bloomberg, ICICI Bank Research

Rupee moves to be in sync with Asian basket

A p r -0 7

With Dollar as the preferred safe haven currency, currencies, both majors and Asians, are likely to under-perform in the near term.

A p r -0 2

•

J a n -0 7

The 6M rolling correlation between ADXY (index of 10 Asian currencies) and DXY (dollar trade weighted index) has generally been around -0.9. Last summer, this correlation broke down (–0.1) as a worsening European economic outlook aided the dollar while the Asians, still largely unaffected from the crisis traded firmly.

O c t-0 6

•

6M rolling correlation between DXY and ADXY

1 0.8 0.6 0.4 0.2 0 -0.2 -0.4 -0.6 -0.8 -1

A p r -0 1

Currencies normally tend to move in the same direction, as overall dollar weakness (strength) imply stronger (weaker) major crosses, which in turn spills over to the other EM currencies.

A p r -0 0

•

Source: Bloomberg, ICICI Bank Research

42

RBI intervention – a choice between ability & willingness

•

The need to maintain ample INR liquidity could weigh on RBI’s intervention strategy in FY10.

-35 Russia

India

Indonesia

South Korea

Thailand Malaysia

Poland

Source: Reuters Ecowin, Bloomberg, ICICI Bank Research (USD bn)

Change in foreign currency assets Total Due to valuation change

40 30 20

Estimates

10 0 -10 -20 -30

Q 4 FY 09

Q 3 FY 09

Q 2 FY 09

Q 1 FY 09

Q 4 FY 08

Q 3 FY 08

Q 2 FY 08

Q 1 FY 08

-40

Source: RBI, Bloomberg, ICICI Bank Research (USD bn) Average monthly LAF balances

800

Net intervention by RBI (RHS) (USD bn) 28 21

400

14

200

7

0

0

-200

-7

-400

-14

-600

-21 J a n -0 9

600

J u l-0 8

The surge in the dollar demand, in the aftermath of the Lehman crisis, saw RBI intervene to the tune of USD 18.67 bn in Oct’08. This also corresponded to a sharp fall in domestic liquidity with avg. LAF shortfall of INR 400 bn.

-140

J a n -0 8

•

-30

J u l-0 7

While the central bank intervened heavily in 2007 to contain Rupee appreciation, intervention in 2008 (particularly H2) was to stem the depreciation pressures on the Rupee.

-120

J u l-0 6

•

-25

J a n -0 7

RBI’s intervention action in the FX market gets reflected in the domestic INR liquidity dynamics.

-20

J a n -0 6

•

-80 -100

J a n -0 5 J u l-0 5

INR liquidity could modulate intervention call

-15

J a n -0 4 J u l-0 4

In this light, the drop in FX reserves in FY09 is not so alarming and we think that it will not act as a severe constraint on intervention in FY10.

-60

J u l-0 3

•

The picture changed in 2008, as foreign currency assets have depleted by USD 56 bn during Jul-Dec’08. Of this, USD 33bn is due to a valuation change (depreciation of currencies vs. USD) and the rest is dollar outflows.

-10

Q 4 FY 07

•

In 2007, India added a record USD 96 bn to its FX reserves, of which valuation effects accounted for only USD 10.5

-40

J u l-0 2

•

Change in India’s FX reserves during any given period is the cumulative effect of the actual inflow/outflow and valuation gain/loss, on the major currencies that form the reserves.

-5

J a n -0 3

•

0

Q 3 FY 07

FX reserves – not a restraint for intervention

0 -20

J a n -0 2

The drop in India’s FX reserves was USD 30bn, with the Rupee weakening by close to 11%.

5

Change in currency between Sep - Dec'08 (RHS)

Q 2 FY 07

•

Korea was a close second, seeing a fall in its FX reserves close to USD 38 bn with its currency depreciating by 15%.

20

J u l-0 1

•

In the period Sep- Oct’08, Russian central bank heavily used its FX reserves (declined by a massive USD 131 bn) to preserve the value of its currency (depreciated by 19%).

(%)

(USD bn) Change in FX reserves during Sep -Dec'08

J a n -0 1

•

In the aftermath of the Lehman bankruptcy, emerging market economies faced huge outflow pressure, which pummeled their domestic currencies.

Q 1 FY 07

•

J u l-0 0

Reserves deplete as central banks intervene

Source: Bloomberg, RBI, ICICI Bank Research

43

FY10 Rupee outlook

•

The Rupee has started to depreciate not just against the dollar but also its other major trading partners as REER has fallen below 100 (99.24 as of 19th Feb’09) from as high as 115.

•

Any further fall in rupee against dollar from here on would skew the valuation towards excessive depreciation if the other crosses were not moving simultaneously. Such an outcome could warrant intervention from RBI.

•

However, any generalized dollar strength would effectively reduce the need for any intervention.

(USD bn)

15

Net intervention by RBI

REER (6 country, 1993-94 base, RHS)

10

120 115

5 0

110

-5

105

-10

100

-15 -20

95 M a y -0 3 S e p -0 3 J a n -0 4 M a y -0 4 S e p -0 4 J a n -0 5 M a y -0 5 S e p -0 5 J a n -0 6 M a y -0 6 S e p -0 6 J a n -0 7 M a y -0 7 S e p -0 7 J a n -0 8 M a y -0 8 S e p -0 8 J a n -0 9

REER movement to guide intervention decision • RBI’s intervention decisions are not only affected by the volatility in USD/INR, but also by the movement in effective exchange rate.

Source: RBI, ICICI Bank Research

FY10 Rupee View – Near term risks to undermine Rupee, but strength to return in long term Overall Rupee moves will depend on several factors, such as •

Capital flows – In the near term, possibility of sporadic capital outflows could not be ruled out, keeping the currency under pressure. However, over the medium to long term, we could see capital flows trickling into the economy as financial conditions stabilize. This would in turn be supportive of a stronger domestic currency.

•

Risk aversion - While short-term Rupee dynamics are often driven by investor perception of risk, this relationship seems to have weakened in recent times. Reemergence of this relationship could exert downward pressure on rupee in the near term. This is based on our assessment that certain risk events can still materialize in the next quarter.

•

Event risks (Political uncertainty, sovereign downgrade) – Among event risks, the uncertainty surrounding the forthcoming general elections, along with, the risk of a ratings downgrade, as fiscal position deteriorates, would severely dampen investor confidence, causing the currency to depreciate.

•

Oil prices – With global demand contracting severely, oil prices should remain muted. This would not only help to improve the current account but also bring down the dollar demand by oil companies, easing the depreciation pressure on the Rupee.

•

Dollar View – In the near term, we think that the Dollar will trade firmly, benefiting from its safe haven currency status. However, in the long term as global economy shows signs of recovery Dollar strength is likely to wane. This would have a positive influence on rupee.

•

RBI Intervention – Intervention by the central bank holds the key to the extent to which Rupee can depreciate in the future. We believe that the central bank is unlikely to be constrained by falling FX reserves. Apart from the stated goal of arresting sharp rupee movements, domestic liquidity conditions together with the level of REER would be the guiding principles for the central bank.

Assimilating the views stemming from the above factors, our bias is towards a weaker rupee in the near term. The trading range on INR could extend to 53 levels in June quarter. However, the overall benign BoP scenario and depreciation of dollar against other crosses would make the conditions ripe for a rebound in rupee in the medium to long term. Our target for March end 2010 stands at 47 levels. Risks to the view arise from a faster than anticipated global recovery, which could prevent the possibility of near term depreciation. 44

Treasury Research Group Economics Research Samiran Chakraborty

Chief Economist

(+91-22) 2653-7548

[email protected]

Ruchi Singh

Economist

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