India EcoTrix Mar '10 - Liquidity - From Overhang to Hangover

8/6/2019 India EcoTrix Mar '10 - Liquidity - From Overhang to Hangover

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Anand Rathi Financial Services, its affiliates and subsidiaries, do and seek to do business with companies covered in its research reports. Thus, investors should beaware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in makingtheir investment decision. Disclosures and analyst certifications are located in Appendix 1.

Anand Rathi Research Ind

India I EquitiesEconomics

Theme Report

Sujan Hajra+9122 6626 6720

[email protected]

Gautam [email protected]

12 March 2010

India EcoTrix Mar 10

Liquidity From overhang to hangover

GDP Growth: 6.5% (FY11e)Inflation: 6.9% (FY11e)INR/USD: 42 (Mar 11e)


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12 March 2010 India EcoTrix Mar 10 Liquidity From overhang to hangover

Anand Rathi Research 4

supply- and demand-side GDP calculations is the treatment of indirecttaxes and subsidies. Supply-side GDP excludes indirect taxes and includesgovernment subsidies, while it is the other way around for demand-sideGDP.

GDP internals suspect quality. Indias supply-side GDP growth

numbers for FY09 and FY10 at 6.7% and 7.2%, respectively, lookimpressive in the current global backdrop. Adjusted for indirect taxes andsubsidies, demand-side GDP growth during FY09 and FY10 comes to5.1% and 6.8%, respectively losing some shine, but still impressive. Apartfrom cutting taxes and hiking subsidies, the government has also boostedGDP by increasing own consumption. Excluding governmentconsumption, GDP growth would have been 3.8% in FY09 and 6.6% inFY10 (see Fig 1). Interestingly, the turn in foreign trade has alsosubstantially boosted Indias GDP growth in FY10. India generallymaintains a deficit in international trade in goods and services. Negativenet exports, therefore, are generally a drag on Indias GDP growth. Thelarger fall in real imports than real exports, however, supported Indias

GDP growth in FY10. Net of government consumption and net exports,Indias GDP growth in FY10 at 4.7% is a far cry from the headline growthnumber of 7.2% and bullish expectations of doing even better (see Fig 1).

Fig 1 Government and net exports pumping up growth in India

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6

7

8

FY09 FY10

(Growth,

%)

GDP, supply side

GDP, demand side

GDP excluding govt consumption (demand side)

GDP excluding govt consumption and net exports (demand side)

Source: GoI and Anand Rathi Research.

Subdued growth outlook for FY11

We expect FY11 GDP growth at 6.5%. Our GDP growth estimate forFY11 at 6.5% is substantially lower than consensus 8%+. Our GDP

growth view is conditioned by the following key factors:

Government consumption to be a drag. In real terms, governmentfinal consumption grew at a compound annual growth rate (CAGR) of12.5% in FY09 and FY10. In comparison, the long period average was5%. We expect fiscal consolidation requirements to keep governmentconsumption growth subdued below the long period average inFY11. The FY11 budget shows this, too. Above, we have describedhow growth in government consumption was the key driver of growthin FY09 and FY10. So a sharp deceleration in such spending would bea drag on FY11 growth.

Net exports to soften growth. Like government consumption, netreal exports would also change from a growth driver during FY09 andFY10 to a drag in FY11.

Hike in indirect taxes and cut in subsidies to depress growth.As


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discussed above, cuts in indirect taxes and increases in subsidiesinflated supply-side GDP growth in FY09 and FY10. During FY11,the partial roll-back of customs and excise concessions and more than10% reduction in subsidies announced in the recent budget woulddepress supply-side GDP, the number which is taken as headlinegrowth.

Smart jump in private consumption. Our estimates factor inmodest recovery in private consumption from 4% real growth tonear 7% in FY11. Note that unlike highly volatile investment, privateconsumption is a far more stable component of GDP.

Strong but no explosive growth in investment. In almost allperiods of high growth, Indias economy has been driven by a strongspurt in investment. We do expect a major rebound in investmentgrowth in FY11 to 13% from 4% in FY10. Yet, the factors mentionedabove would keep GDP growth in FY11 lower than in FY10.

View on investment cycle key difference. We feel that the only way

India could achieve 8%+ GDP growth in FY11 is if investment growthrebounds to nearly 20%. Although we do expect a major rebound ininvestment in FY11, we do not expect such an explosive pace. Our viewabout the trajectory of the investment cycle is why we have a lower-than-consensus GDP growth target for FY11. Given this, we elaborate on our

views about the investment cycle.

Steady but not explosive pick-up in investment cycleChange in base makes outlook on investment cycle hazy.The realGDP series with FY00 as the base year showed a clear deceleration inIndias investments since FY05 (see Fig 2). The new real GDP series withFY05 as the base year has, however, drastically changed the data. For

example, the previous series showed 8.3% growth in real investment inFY09, whereas the new series shows a 1.7% contraction in FY09 andestimates 4% growth in FY10 (see Fig 3). The new data, in fact, validatesour long-held conviction that real investment growth would turn negativebefore accelerating. With the earlier data series, we expected negativeinvestment growth in FY10; the new data show that it happened in FY09.Drastic changes in past data, coupled with the non-availability of the longtime series data with the revised base, makes it somewhat difficult toestimate the trajectory of the investment cycle. Nevertheless, it is possibleto draw certain inferences on the likely future course of Indias investmentcycle.

Fig 2 Fixed investment registered a modest rebound in 2QFY10

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QFY07

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QFY09

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(Realinvestmentgrowth,

%)

Total investment Fixed investment

Source: GoI and Anand Rathi Research.


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Fig 3 Sharp downward revision of yearly real investment growth for FY09

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vestment,%)

Series with 99-00 base Series with 04-05 base

Source: GOI and Anand Rathi Research.

Inventory cycle unlikely to propel investment in FY11. The new data

series shows that fixed investment growth bottomed out at 0.8% in3QFY09 and has accelerated since then, reaching 8.9% in 3QFY10. Dragsfrom elsewhere, mainly lower inventory addition, however, led to a 4.1%contraction in overall investment in 3QFY09 and kept overall investmentgrowth low at 5.1% in 3QFY10. While a larger addition to inventory islikely to positively influence overall investment in FY11, it is unlikely toresult in very high investment growth in FY11 for the following reasons:

Continued positive addition to inventory. Indias GDP data showthat unlike in the previous phase of growth deceleration (FY02) wheninventories were depleted (de-stocked), this time around, inventorybuild-up continued even during FY09 and FY10 although the net

inventory additions were substantially lower during this period than inthe preceding quarters.

Reason for lower addition to inventory not apparent. With positiveinventory addition in each quarter of FY09 and FY10, Indiasinventory cycle does not fit in with the inventory de-stocking re-stocking cycle playing out in other parts of the world. Equallyimportant, inventory additions in the first three quarters of FY10 havebeen lower than in FY09. This again is not in line with theinternational trend. The lower inventory additions in FY09 and FY10in India could be part of rationalisation and/or more efficientinventory/production management. Therefore, a case for inventorybuild up-led sharp acceleration in overall investment during FY11 is

far from obvious.

Low share of inventory in total investment. The share of inventoryin overall investment during both FY09 and FY10 was 3.8%. Even

with the assumption of 40% increase in inventory factored in ourestimates, its impact on overall investment growth would be onlyaround 1.5 percentage points. Therefore, even a strong pick-up in theinventory cycle would not influence the overall investment by a largemargin.

Bottoms-up estimates do not support strong capex growth in FY11.Recently released data on sectoral trends in real investment growth inFY09 suggest a strong decline in industrial capex (-20.5%), the largest

component of overall capex (see Fig 4). There has been a major slowdownin infrastructure capex (from 18.1% in FY08 to 1.9% in FY09). In line withthe governments advance estimate of 4% overall investment growth in


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FY10, we expect industrial capex to remain negative in FY10 beforebouncing back in FY11 (see Fig 5). Our estimates suggest infra capexgrowth has gathered pace in FY10 and would accelerate sharply in FY11.Despite such optimistic assumptions and expectations of continuing robustcapex in agriculture and services, overall investment growth in FY11 islikely to be less than 15%.

Fig 4 Share of manufacturing capex remains the highest in overall investment

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Fig 5 Turnaround in infra and industrial capex in FY11

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Primacy of growth to prevail

Growth in India remains fragile. The above discussions show that GDPgrowth in FY09 and FY10 has been driven by, inter alia, tax cuts, risinggovernment expenditure and a sharp contraction in imports. Apart from itssuspect quality, GDP growth numbers and the impressive industrialproduction and export growth rates are also coloured by low bases. Weexpect significant acceleration in overall investment growth from 4% inFY10 to 13% in FY11 and private consumption from 4% in FY10 to7% in FY11. Yet, overall GDP growth in FY11 at 6.5% is likely to fallshort of the 7.2% growth in FY10 estimated by the government. In short,growth in India remains fragile.


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Macro policies to support growth through accommodative policies.The government and the Reserve Bank of India (RBI) are unlikely todisregard the fragility of the underlying growth drivers. The key channelsto revive growth would be to take measures to nurture investment andprivate consumption. Adequate access to liquidity at low interest rates isgenerally a necessary condition to stimulate investment and leveragedconsumption, especially in an economic environment characterised bylarge uncertainties. Therefore, we do not expect aggressive liquidity

withdrawal and/or policy rate tightening by the RBI in FY11.

The course of inflation remains crucial for accommodative policy.The extent of the accommodative policy stance, however, hinges cruciallyon the course of inflation. If inflation, measured by the wholesale priceindex (WPI), hits double digits and remains there or worse still, continuesto accelerate, the policy stance cannot remain accommodative. We expectinflation to worsen over the next three months, necessitating a 50 basispoint (bps) hike in the repo and reverse-repo rate in Apr 10. We, however,expect inflation to soften thereafter, averting further strong

liquidity/interest rate tightening in FY11. The rationale for our medium-term benign view on inflation is explained in the next section.

Inflation: Scary now, to subside by 2HFY11

Elevated inflationary expectations

High inflation raising tightening expectations. Inflation in India hasrisen much faster than the global average. The four consumer price index(CPI) inflation rates are currently in the range of 14% to 18%. WPIinflation emerged from deflation in Aug 09 and reached 8.6% by Jan 10and is set to nudge 10% by Feb 10. Partly owing to high inflation, the RBIinitiated monetary tightening in Jan 10 by raising banks cash reserve ratio

(CRR) by 75bps. Flare in inflation coupled with high GDP, industrial andexport growth have raised expectations of further monetary tightening.While we expect a 50-bp repo/reverse-repo rate hike in Apr 10, majormonetary tightening during FY11 seems unlikely.

Predominantly supply-side inflation. The spike in inflation in India isbeing led by food products both primary and manufactured that havebeen hit by supply shocks. On the other hand, the rise in non-foodinflation is largely due to an unfavourable base (see Fig 6). Given this, thechoices before the RBI are limited. First, monetary policy is not thateffective at addressing supply-side inflation. Second, the impact ofmonetary tightening in inflation control works through compression ofdemand, which negatively impacts immediate-term GDP growth. In the

current fragile growth environment, the RBI is unlikely to take a chance ongrowth through aggressive tightening.


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Demand side feedback to food inflation, if at all, remains small. Theimprovement in rural income through initiatives such as the MahatmaGandhi National Rural Employment Guarantee Act (NREGA) or other

welfare measures and a resultant rise in food demand, however, cannot betotally ruled out, either. If this is taking place, it is extremely welcome. Thepertinent point, however, is that available data suggest that the supplyshortfall is the key reason for the rise in food prices, rather than higherfood demand.

No large divergence between WPI and international prices.Afterhitting crisis lows in early 2009, international commodity prices haverebounded. This, however, is unlikely to impact domestic prices for severalreasons:

Limited impact of global prices on Indian agro prices. Indianagro prices are largely insulated from international prices, given hightariffs on agro imports and quantitative restrictions on various agroexports. Therefore, a rise in international prices has little impact on

domestic prices of most agro products. Spike in import-dependent agro prices unlikely. Among agro

products, pulses and edible oil are import-dependent. This year India isalso importing sugar. A large part of such imports, however, arethrough canalised agencies and are distributed at subsidised ratesthrough the public distribution system. Moreover, prevailing domesticprices of most of these products are higher than international prices.

Therefore, a further spike in import-dependent agro product prices isunlikely.

Discrete data revision in official inflation index unlikely. Forproducts that India imports a lot (such as edible oil) and for items

whose domestic price is linked to a landed import cost (such as certainvarieties of iron and steel), there have historically been large levels ofco-movement (see Fig 10 and 11). Interestingly, these relationshipsbroke down between mid-2007 and early-2009. Why this happened isdifficult to explain and perhaps can partially be explained by the lackof appropriate update of these prices in the official inflation indices.

The pertinent point, however, is that since early-2010, the co-movement has been restored. In fact, the recent softening ofinternational commodity prices should reduce the internationally-linked domestic commodity prices with some time lag.

Rupee appreciation to dampen internationally linked prices. TheIndian rupee appreciated considerably until Feb 08, but depreciated

sharply thereafter until Mar 09. The rupee has bounced back sincethen. This trend suggests that other things remaining equal, thedepreciation of the rupee should have led to a higher rise ininternationally-linked commodity prices in rupee terms during Apr 08and Mar 09 compared to these prices in dollar terms. The converseshould be true since Apr 09, when the rupee started appreciating.

Therefore, there is little chance of the pass-through of internationalprices raising domestic inflation. If anything, such pass-through shouldhave a deflationary impact.


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Fig 10 Narrowing divergence for edible oil prices

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Source: GOI, Bloomberg and Anand Rathi Research.

Fig 11 Domestic iron and steel prices largely in line with international prices

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I ron and Steel-Domestic Iron and Steel -Internat ional

Source: GOI, Bloomberg and Anand Rathi Research.

WPI-CPI divergence. Currently, Indias consumer price inflation is muchhigher than wholesale price inflation. The available data by mid-Mar 10show that CPI inflation, according to various indices (India has fourofficial CPI series), ranges between 14% and 18%, while WPI inflation is at8.6%. The divergence between WPI and CPI inflation is mainly because ofthree factors: (a) higher weight of food in CPI than WPI, (b) sharper rise inretail food prices than wholesale prices, and (c) revision of imputed rentfor owner-occupied houses with the CPI, in line with the revision of such

rent for public servants under the 6th Pay Commission. Rent is a part ofCPI, but not of WPI.

Scare of vicious inflationary cycle overblown

Wage-price spiral unlikely to have a major impact on inflation.Higher food prices/CPI inflation results in a wage-price spiral through twokey channels increase in inflation-indexed salaries and demand fromlabour for higher salaries. In Indias case, both have limited impact. Theorganised sector in India employs around 30m persons, while the work-agepopulation (age group: 16-64 years) is 780m. Only part of organisedemployees has salaries linked to inflation. As for increasing salaries throughcollective wage negotiations, this is unlikely as labour is unorganised in

most segments of the economy.


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Input cost pass-through-led inflation spike also unlikely. Commodityprice inflation could also lead to pass-through inflation. As discussedabove, strong rupee appreciation since Mar 09 has neutralised part of therise in international commodity prices. Moreover, recent corporateperformances suggest modest sales growth. Therefore, lack of strongdemand growth coupled with a far lower rise in domestic commodityprices compared with international prices are likely to limit the pass-through of higher input costs and thereby rise in inflation.

Budget FY11 likely to lead to rise in inflation. While most drivers ofinflation discussed above coupled with a favourable base effect beyondMar 10 indicate that inflation would peak by Mar 10 at around 9.6%, themeasures in Budget FY11 could raise it by a further 160bps. The budgetmeasures: (i) reversal of customs duty concessions on crude oil andpetroleum products, (ii) reversal of Re1/ltr cut in excise duty on petroleumand diesel and (iii) reversal of cut in median excise duty by 2%.

Inflation trajectory

WPI inflation to peak around 11%. Our time series estimatesincorporating the impact of the budget on prices suggest that WPIinflation would peak around 11% by Apr 10 and start softening thereafter.Our model suggests that food inflation (both primary and manufacturingtaken together) has peaked in Dec 09 and should come to single-digitlevels by Sep 10. We expect WPI inflation to fall to around 5% by Dec10. We expect CPI (for industrial workers) inflation to peak at near 17%by Mar 10 and soften to single digits by Aug 10 (see Fig 12).

Fig 12 WPI Inflation likely to peak near 11% by Apr 10

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AR Estimate


Balanced rise in liquidity supply and demand

Accommodative actual liquidity conditions. In spite of the argumentsin the last section about a largely accommodative policy stance by thegovernment and the RBI towards liquidity conditions, we recognise thatthe actual liquidity/interest rate condition can tighten, inter alia, throughreduced supply and/or large increase in liquidity demand. In this section

we argue that the domestic liquidity supply and demand conditions wouldalso support an accommodative situation.


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Favourable domestic liquidity supply situation

Deterioration in government balance impacted liquidity supply inFY09. From a macro perspective, domestic liquidity is conditioned largelyby the domestic savings rate gross domestic savings as a percentage ofGDP. In FY09, the domestic savings rate declined to 32.5% from 36.4% in

FY08 (see Fig 13). This was largely on account of the deterioration of thegovernments budgetary balance. The primary balance of the government(the difference between the governments non-interest revenueexpenditure and revenue receipt) turned from a surplus in FY08 to a deficitin FY09. Household savings and corporate savings, both as a percentage ofGDP, remained largely unchanged at the FY08 level in FY09.

Fig 13 Domestic savings rate set to rebound in FY11

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Largely unchanged liquidity supply in FY10. In line with the wideningprimary deficit, we estimate government savings to deteriorate further andbecome nearly balanced in FY10. Against the backdrop of subduedcorporate profits, our estimates indicate a slight fall in the corporatesavings rate in FY10. Our model, however, suggests strong improvementin household savings in FY10, which counterbalanced the deteriorationfrom government and corporate savings. Historically, a salary hike forgovernment employees, especially payment of back wages, results in ajump in household savings for two consecutive years. We expect such aneffect to play out in FY10 and FY11. Despite this, the drag from lowgovernment savings is expected to keep the overall domestic saving ratelargely unchanged in FY10 at 32.5%.

Domestic liquidity supply likely to improve in FY11. We expect thedomestic savings rate to show significant improvement in FY11 onaccount of three factors. First, in line with the FY11 budget, we expect theprimary deficit of the government to decline in FY11. Second, as a resultof the payment of back wages to the nearly 20m public servants, we expecthousehold savings to continue to expand in FY11. Third, estimates of ourstrategist Ratnesh Kumar suggest considerable improvement in corporateprofitability in FY11 for non-financial companies. This would result in amodest recovery in corporate savings rate. On the whole, we expect thedomestic savings rate to rise to 34.3% in FY11 from 32.5% in FY10.

Indian households no leveraged consumption. In a macroeconomic

sense, liquidity demand arises from two main sources consumption andinvestment. In India, households do not indulge in leveraged consumption.In fact, changes in financial assets net of financial liabilities of households


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as a proportion of disposable income has consistently been positive (seeFig 14). Even households gross leverage, ie, gross addition to financialliabilities as a proportion of disposable income, close to 5%, is modest.Overall, households are net suppliers of liquidity in India.

Fig 14 Increase in financial assets exceed change in liabilities for households

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Government administration borrows to meet current expenditure.With the exception of FY08, government administrations savings balancehas been in negative territory since the late 80s. Interestingly, in thisperiod, the Centre and states consolidated revenue deficit has been higherthan the overall dis-savings by government administration (see Fig 15).

This indicates that the governments dis-savings is because of meetingcurrent rather than capital expenditure needs.

Fig 15 Current rather than capital spending makes govt a dis-savings unit

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Positive overall savings balance of the government.Apart fromadministration, the government has two other components departmentalenterprises (such as Indian Railways, Post & Telegraph) and non-departmental enterprises (public sector units). In contrast to dis-savings bygovernment administration, departmental and non-departmentalenterprises have consistently generated positive savings. Since the 70s,apart from the FY99-FY03 period, the combined savings of thegovernments departmental and non-departmental enterprises has been in

excess of the dis-savings by government administration, making overallgovernment savings positive (see Fig 16).


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Fig 16 Overall government savings remain positive

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Rising liquidity demand, but in tune with supply

Demand for liquidity.As shown above, Indian households have netfinancial claims rather than liabilities on the rest of the economy (see Fig14). In addition, households also save in physical assets such as investmentin fixed assets (construction, machinery, equipment and change in stocks).Households physical savings as a share of overall savings declined betweenthe early 70s and the mid-90s, but has risen thereafter and currently is justabove 50% (see Fig 17). Households physical savings is also considered aninvestment. Therefore, given households have positive financial savings,they are net suppliers of liquidity in the Indian economy.

Fig 17 Household saves more in physical assets

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Households funding corporate and government investment. Incontrast to households positive saving-investment balance, institutions(corporate and government sectors) saving-investment balance is in thenegative (see Fig 18). That is, these institutions invest more than they save.

The government and the corporate sector, therefore, are the main sourcesof liquidity demand. Indias overall savings is broadly in line with overallinvestments. That is, households savings largely funds the excessinvestment by the government and the corporate sector. While foreignsavings bridge Indias overall saving-investment gap, it normally is small.

Our estimates suggest a rise in household savings in FY11.


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Fig 18 Household savings the main source of investment funding in India

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Investment cycle key in deciding liquidity conditions in FY11. During

FY11, we expect liquidity supply to rise, given the improvement in eachcomponent of savings household, government and corporate. Moreover,

with the improvement in the governments fiscal position both at theCentre and at the states we expect a sizable fall in the consolidatedrevenue deficit. That is, liquidity demand from the governments currentconsumption is likely to fall. Overall domestic liquidity in FY11 would,therefore, depend largely on the course of the investment cycle.

Spurt in investment cycle to increase liquidity demand. In theopening section of this report we showed that we expect investmentgrowth to accelerate from 4% in FY10 to 13% in FY11. Consequently, theinvestment rate (investment to GDP ratio) is likely to jump from 35.1% in

FY10 to 36.7% in FY11.

No liquidity tightness or increased dependence on foreign savings.A marked turnaround in domestic investment in FY11 coinciding with thecontinuation of large borrowing by the government is unlikely to lead toexcess liquidity demand, resulting in either a spike in market interest ratesor increased dependence on foreign savings to finance domesticinvestment. The key here is the improvement in the household savingsrate. In fact, we estimate that Indias dependence on overall foreign savingsas a percentage of GDP to remain largely unaltered during FY09-11 ataround 2.4% of GDP. Domestic savings would continue to fund 95% ofdomestic investment even in FY11.

India to remain an important investment destination in FY11. Evenunder a conservative assumption that in FY11 portfolio inflows wouldbecome half of the US$30bn inflow registered in FY10 and net FDIinflows during FY10 and FY11 would remain largely unchanged, ourestimates suggest that Indias access to foreign savings would improvemarginally in FY11 over FY10. In fact, with the improvement in growthquality, continuation of strong growth in India relative to the rest of the

world and significant softening of inflation in 2HFY11, Indias attractionas a destination for foreign investment is likely to improve. This raises thepossibility of much stronger capital inflows to the country, which would beable to support an even stronger capex cycle in India without putting strainon the liquidity situation in the country. These issues are discussed below.


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India to continue attracting global liquidity

We expect a modest tightening in India during 2010. Our assessmentof the global economy in the next 9-12 months indicates that globalliquidity would remain accommodative amid asynchronous monetarymeasures by countries. We expect India to be in the tightening camp,

although our estimate of policy rate tightening in 2010 at 75-100bps islower than the prevailing consensus expectation of around 200bps. Theincreased interest rate differential coupled with a better growth outlook forIndia relative to almost all other economies raise the possibility of largescale capital flows into India.

India received large capital inflows in 2010. Last decade, India sawlarge capital inflows owing to the global accommodative liquidityconditions, surge in investors risk appetite and sharp improvements inIndias macroeconomic fundamentals. Indias external capital accountsurplus surged from a quarterly average of US$3.6bn during FY01-05 toUS$14.8bn during FY06-08. The reversal of global liquidity conditions, de-leveraging and strong rise in investors risk aversion, however, changedconditions drastically Indias annual capital account surplus collapsedfrom US$107bn in FY08 to US$7bn in FY09. In fact, during 4QCY08,India recorded the first capital account deficit in a decade. The situation,however, has once again changed with India recording a capital accountsurplus of US$24bn in 3QCY09 the highest in any quarter apart fromFY08 (see Fig 19).

Fig 19 Capital flows have resumed strongly

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Dec-06

Jun-0

7

Dec-07

Jun-0

8

Dec-08

Jun-0

9

Dec-09

(INRapp/depvsUSD,

%,Q

oQ,

rev.scale)

-9

0

9

18

27

36

(Capitala/cbalance,U

S$bn)

Capital account balance Rupee appreciation (-)/depreciation (+) vs USD


Apprehension about negative real interest rates. Given the highcurrent inflation rates in India, the real interest rate in the country iscurrently in the negative (see Fig 20). This situation, many believe, maydeter cross-border inflows in 2010, especially the carry trade kind. Such

views have certain limitations. Our estimates suggest that inflation in Indiais likely to peak soon and start softening thereafter. Therefore, in a short

while the real interest rate differential in India is likely to become attractivefor foreign inflows.


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Fig 20 Real interest rates in India currently negative

-2

0

2

4

6

8

Australia

Brazil

Canada

India

Japan

UK

US

(Realinterest

rate,

%)

Latest real interest

36.4

Note: Real interest rate refers to bank lending rate deflated by consumer price index.Source: Country sources and Anand Rathi Research.

Weak link between capital inflow and real interest rate in India. Moreimportantly, the interest rate differential alone cannot lead to capital flows,including carry trade. Among other factors, risk appetite plays a key role inthis process. In Indias case, capital inflows accelerated between 2003 and2008, a period when real interest rates were declining (see Fig 21). GivenIndias strong economic fundamentals, stable political environment andexpectations that Asian currencies would appreciate during 2010, India islikely to remain an attractive destination for foreign investments of variouskinds.

Fig 21 Capital flows accelerated when real interest rates declined

-2

0

2

4

6

8

10

12

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009(

Realinterestrate,

capitalinflow,

India,%

)

Real interest rate Net inflow as % of GDP

Note: Real interest rate refers to bank lending rate deflated by consumer price index.Source: GOI and Anand Rathi Research.

Larger equity inflow reduces impact of interest differentials. Thereare several reasons why current negative real interest rates will not detercapital inflows to India in 2010. Capital flows into India are generallydominated by equity flows (see Fig 22), which are influenced by the overalloutlook for economic fundamentals rather than real interest rates alone.


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Fig 22 Equity flows generally dominate overall capital inflows to India

-3

-2

-1

0

1

23

4

5

6

7

8

1QFY95

2QFY96

3QFY97

4QFY98

1QFY00

2QFY01

3QFY02

4QFY03

1QFY05

2QFY06

3QFY07

4QFY08

1QFY10

(Debt/equityratio)

-8

-4

0

4

8

1216

20

24

28

32

36

(Netcapitalinflow,

US$billion)

Debt e uit ratio Ca ital account balance

9.9

Source: RBI and Anand Rathi Research.

FDI inflows to maintain momentum. Given the long-term nature of

FDI, such investment inflows to India remained relatively resilient evenduring the worst phase of the recent global crisis (see Fig 23). In the past12 quarters, India, on an average, received US$8.8bn of FDI per quarter the lowest during any quarter in this period has been US$4.8bn. Given thestrong fundamentals, India is likely to continue attracting large FDIinflows. At the same time, Indian companies global ambitions wouldresult in significant outflow of FDI from India. We also expect net FDI(gross inflow net of Indian direct investment abroad) to maintain strongmomentum. On average, net FDI inflow to India in the past 12 quartershas been US$4.3bn. We expect the average net FDI inflow in the next twoyears to be higher than the recent trend and with an upward drift.

Fig 23 FDI inflows likely to remain strong

-2

0

2

4

6

8

10

12

14

16

1QF

Y01

4QF

Y01

3QF

Y02

2QF

Y03

1QF

Y04

4QF

Y04

3QF

Y05

2QF

Y06

1QF

Y07

4QF

Y07

3QF

Y08

2QF

Y09

1QF

Y10

(FDI,US$billion)

Net FDI FDI inflow FDI by India


Trend reversal in portfolio flows. Apart from a modest outflow in FY99,India has always received a net positive portfolio investment flow sincesuch flows were allowed in the early 1990s. For the first time ever, thistrend reversed in FY09. Interestingly, while monthly FII (foreigninstitutional investor) flows, the predominant part of portfolio flows,remained negative in 9 of 12 months in FY09, during FY10 so far (11months) the flows have been positive every month.

Factors likely to shape future portfolio flows. We expect strongportfolio flows into India during the next two years because of (a) theIndian economys strong fundamentals, especially domestic demands


23/44



strength and resilience and renewed focus on infrastructure investment, (b)likely continuation of accommodative global liquidity conditions relative tohistoric standards and (c) current relatively low portfolio allocation to Indiaby various large global long-term investment funds. At the same time,there are reasons for an outflow, too. They include (a) the relatively high

valuation multiples of Indian companies relative to peers, and (b) increasein international investors risk aversion, especially towards high-risk, high-return asset classes.

On balance, India is likely to receive strong portfolio inflows. Ourassessment suggests that while the worst of the global crisis is behind us,the recovery in the developed countries even over the next two years couldbe anaemic. This would keep global liquidity largely accommodative.Meanwhile, Indias economic performance is likely to be much strongerthan not only the global average, but also one of the best among emergingmarket economies. These factors would make India a net recipient ofglobal portfolio flows, although fluctuations in global liquidity and investorsentiment would keep volatility of such flows high. Yet, as indicated

before, our conservative estimates incorporate a sharp decline in portfolioflows in FY11 as compared to the same in FY10.

Debt flow key swing factor. While equity capital flows have been themainstay of Indias external capital account, debt flows have been theswing factor in both boosting the capital account surplus during FY07 andFY08 and deflating it in FY09. In particular, ECBs (external commercialborrowings) by Indian companies declined sharply and short-term loansand banking capital excluding NRI (non-resident India) deposits turnednegative in FY09. The situation, however, has changed once again in2QFY10 with all these flows turning positive. Our assessment suggeststhat debt flows would play a major role in boosting Indias capital account

surplus in FY11 and FY12.Demand for foreign borrowing to remain strong in India. Asindicated before, the current negative interest rate in India is perceived tobe a stumbling block for foreign debt inflows in FY11. It is, however,important to note that debt capital inflows into India are usually long-termin nature, which is influenced by the long rather than the short-term realinterest rate outlook. Moreover, irrespective of the current real interest rateenvironment in India, demand for foreign borrowing is likely to remainhigh in India as long as the cost of such borrowing is perceived to be lowerthan domestic borrowing.

ECB flows to pick up. After a secular decline between Jul 08 and Feb

09, ECB approvals by Indian corporates have bounced back since Mar 09(see Fig 24). In terms of actual flows, after turning negative in 1QFY10such flows have once again turned positive in 2QFY10. We expect ECBflows to remain strong in the next two years for the following reasons.

For Indian corporates that can access the ECB market, suchborrowings offer substantially lower interest rates than domesticborrowings.

For international lenders, the interest rates offered by Indian ECBissuers would look attractive on a risk adjusted basis, given thelikelihood of interest rates remaining low in developed countries.

At the height of the financial crisis, both approvals and actual flows ofECBs declined sharply, with the latter declining much more than theformer, reducing the conversion ratio (see Figs 24 and 25). Typically, a


24/44



depressed conversion (disbursement to approval) ratio in a periodresults in strong disbursement in the next period.

India has an aggressive infrastructure investment plan. To fund suchprojects, the government and the RBI are likely to introduce furthermeasures to facilitate ECBs by infrastructure-related companies.

Fig 24 ECB approvals bounced back since Mar 09

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Feb-0

6

May-06

Aug-0

6

Nov-06

Feb-0

7

May-07

Aug-0

7

Nov-07

Feb-0

8

May-08

Aug-0

8

Nov-08

Feb-0

9

May-09

Aug-0

9

Nov-09

(ECBapprovals,

US$billion,

3MMA)


Fig 25 ECB conversion ratio likely to go up

0.5

0.7

0.9

1.1

1.3

1.5

FY92

FY93

FY94

FY95

FY96

FY97

FY98

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

1HFY10

(ECBdisbursementtoapprovalratio)

0

6

12

18

24

30

(ECBdisburse

ment,US$billion)

Conversion ECB


Short-term loans also likely to bounce back. The international de-leveraging cycle and extreme risk aversion contributed to a strong outflow

of trade credit during Jul 08-Mar 09 from India. Incidentally, over 90% ofshort-term loans (by original maturity) comprise import credit. Fall inimport volume over 2HFY09-1HFY10 also played an important role in theslide in gross short-term inflows. Indias imports moved into positiveterritory in Dec 09 (see Fig 26). The risk premium on emerging countryborrowers, too, has reverted to normal. Accordingly, net short-term loanflow in 2QFY10 turned positive after remaining negative for the threeprevious quarters. We expect sizable growth in net trade credit flows in thenext two years.


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Fig 26 With import recovery, short-term debt likely to rebound

-6

-4

-2

0

2

4

6

1QFY95

3QFY96

1QFY98

3QFY99

1QFY01

3QFY02

1QFY04

3QFY05

1QFY07

3QFY08

1QFY10

(Short-termdebt,US$billion)

-50

-25

0

25

50

75

100

(Importgro

wth,

%)

Short-term debt Import growth


Buoyant cross-border flows to make rupee stronger

Foreign inflows likely to surprise on the upside. The foregoingdiscussions suggest that even with a marked increase in investment growth,continued large government borrowing and modest dependence on foreignsavings, liquidity demand in India would remain in line with liquiditysupply. Our assumptions on foreign inflows to India during FY11 shownabove remain largely conservative. In fact, there are possibilities thatforeign inflows in FY11 could exceed the normal domestic absorptivecapacity, leading both to forex market interventions by the RBI andappreciation of the rupee.

RBIs counter-cyclical forex intervention. Other things remainingunchanged, resurgence in the capital account surplus in excess of currentaccount deficit during FY10 and the likely continuance of the same inFY11 suggests the rupee should, on balance, continue to appreciate. This,however, depends to a large extent on the RBIs intervention strategy inthe foreign-exchange market. Past intervention patterns by the RBI (seeFig 27) suggest three broad trends:

The RBIs interventions in the forex market are generally counter-cyclical, ie, the RBI is a net forex buyer when the rupee appreciatesagainst the US dollar and vice versa. This is in keeping with itsexchange rate policy stance that its aim is to manage volatility in theforex market rather than manage the value of the rupee.

The RBIs interventions in the forex market, however, have beenasymmetric. The RBI is generally a persistent net forex buyer when therupee appreciates, but its net forex sales have been more sporadicduring periods when the rupee has depreciated against the US dollar.

The RBIs interventions might have reduced the volatility of therupees external value. Yet, during periods of strong forex inflows, therupee has appreciated (despite the RBIs net purchase of forex) and therupee has depreciated during periods of forex outflow (despite theRBIs sale of forex).


26/44



Fig 27 Counter-cyclical and asymmetric forex interventions by the RBI

-5-4-3-2-1012

3456

7

May-02

Dec-02

Jul-03

Feb-0

4

Sep-0

4

Apr-05

Nov-05

Jun-0

6

Jan-0

7

Aug-0

7

Mar-08

Oct-0

8

May-09

Dec-09

(INRapp/depvsUSD,

%,

rev.scale)

-21

-18-15-12-9

-6-303691215

(RBI'snetforexbuy,US$billion)

RBI net purchase Rupee appreciation (-)/depreciation (+)


Rising capital account surplus to strengthen rupee. Our capital

account projections for FY10-12 suggest a progressive increase in Indiascapital account surplus (Fig 28). We also observe a positive relationbetween Indias capital account surplus and rupee appreciation (see Fig 19).

The scatter diagram on capital account balance and quarterly rupeeappreciation/depreciation (see Fig 29) also validates this point. This islikely to be the single largest factor driving rupee appreciation in the nexttwo years.

Fig 28 Strong turnaround on capital account expected(US$bn) FY07 FY08 FY09 FY10e FY11e FY12e

Foreign Investment 14.8 43.3 3.5 54.9 41.2 47.2

FDI 7.7 15.9 17.5 25.0 26.5 28.2

In India 22.7 34.7 35.0 44.0 49.3 56.7 Abroad -15.0 -18.8 -17.5 -19.0 -22.8 -28.5

Portfolio 7.1 27.4 -14.0 29.9 14.8 19.0

In India 7.0 27.3 -13.9 30.0 15.0 19.5

Abroad 0.1 0.2 -0.2 -0.1 -0.3 -0.5

Loans 24.5 40.7 8.7 9.5 22.0 28.5

External borrowing 16.1 22.6 7.9 5.5 12.5 17.0

Short-term borrowing 6.6 15.9 -1.9 2.5 7.5 9.0

Others 1.8 2.1 2.6 1.5 2.0 2.5

Banking capital 1.9 11.8 -3.2 -3.5 5.0 7.0

NRI deposits 4.3 0.2 4.3 5.0 3.5 4.5

Others -2.4 11.6 -7.5 -8.5 1.5 2.5

Rupee debt servicing -0.2 -0.1 -0.1 -0.1 0.0 0.0 IMF loans 0.0 0.0 0.0 0.0 0.0 0.0

Other foreign capital 4.2 11.0 -1.5 2.0 3.5 4.0

Capital account balance 45.2 106.6 7.2 62.8 71.7 86.7



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Fig 29 Larger capital account surplus leads to stronger rupee appreciation

-8

-6

-4

-2

0

24

6

8

10

12

-10 -5 0 5 10 15 20 25 30 35 (Quarterly capital a/c balance, US$ bn)

(INRapp/depvsUSD

,%,

QoQ)

Note: Rupee appreciation against dollar has been shown as negative and depreciation as positive.Source: RBI and Anand Rathi Research.

Trade accounts impact on rupee declined during the last decade.Since the 50s, except for two years in the 70s, India has maintained adeficit on the external goods trade (merchandise) account. Despite Indiagenerally maintaining a capital account surplus, the trade deficit has

weighed heavy on the performance of the rupee. Since the 50s, thecurrency persistently got devalued (during the fixed exchange rate regimeunder the Bretton Woods system) and depreciated (after the Bretton

Woods system collapsed) against the US dollar except during FY77-80 andmore recently since FY03. Indias merchandise deficit zoomed fromUS$9bn in FY03 to US$108bn in FY09. Yet, in most years since FY03, therupee actually appreciated against the US dollar. This shows the greaterimpact of the capital account over current account flows in this period.

Commodity prices led to widening of the trade deficit. An importantfactor behind the widening trade deficit since FY03 has been the sharp risein crude oil prices. Indias oil imports increased at a compound annualgrowth rate (CAGR) of 35% between FY04 and FY09. Incidentally, amongthe larger economies of the world, India is the most vulnerable to an oilprice spike as the country has the largest share of oil imports in totalimports. This share jumped from 15% in FY99 to 31% by FY09. Part ofthis jump reflects Indias increased refining capacity, whereby the countryimports crude oil and exports petroleum products. The more importantfactors are, however, rising oil prices, increased oil intensity of theeconomy and stagnation of domestic crude oil production.

Largely unchanged trade deficit till FY12. Despite a strong pullback fromcrisis lows, international oil prices are currently half the high reached in 2008.

Although the oil price outlook is uncertain, oil prices are unlikely to reachthe previous high in the foreseeable future. Moreover, Indias new-foundnatural gas resources are replacing use of petroleum products like naphthaand fuel oil, especially in fertilizer production. This, on the one hand, wouldreduce fertilizer imports, which stood at US$12bn in FY09. On the other,India would become a larger exporter of petroleum products, which arebeing replaced by natural gas. Even after incorporating 11% and 16%growth in imports during FY11 and FY12, respectively, our estimatessuggest that Indias trade deficit during FY10-FY12 would remain largelyunchanged at the FY09 level (see Fig 30). Beyond FY12, factors such as

increased natural gas output, increased energy efficiency and technologyadoption increasing greater substitution of petroleum products by natural gascould start reducing Indias trade deficit.


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Fig 30 Marked improvement in current account likely(US$bn) FY07 FY08 FY09 FY10e FY11e FY12e

Goods trade -61.8 -91.5 -118.7 -115.1 -126.9 -126.0

Exports 128.9 166.2 189.0 166.3 189.3 237.3

Imports 190.7 257.6 307.7 281.4 316.2 363.3

Invisibles 52.2 75.7 89.9 84.7 93.3 108.3

Services 29.5 38.9 49.6 37.2 43.5 53.2

Travel 2.4 2.1 1.5 1.6 1.9 2.2

Transportation -0.1 -1.5 -1.5 -1.0 -1.5 -1.8

Insurance 0.6 0.6 0.3 0.4 0.6 0.7

Govt. not included elsewhere -0.2 0.0 -0.4 -0.5 -0.6 -0.6

Software 29.0 36.9 43.5 39.1 44.6 51.8

Other miscellaneous services -2.3 0.8 6.3 -2.5 -1.5 1.0

Transfers 30.1 41.9 44.8 52.1 54.9 60.3

Official 0.3 0.2 0.2 0.1 0.3 0.2

Private (workers' remittance) 29.8 41.7 44.6 52.0 54.6 60.1

Income -7.3 -5.1 -4.5 -4.6 -5.0 -5.2

Current Account -9.6 -15.7 -28.7 -30.5 -33.6 -17.8

Current Account (as % of GDP) -1.0 -1.3 -2.4 -2.4 -2.1 -0.9


Support to rupee from the current account as well. Indias trade deficit(on balance of payments basis) jumped from US$14bn in FY04 toUS$119bn in FY09. During the same period, Indias current accountturned from surplus of US$14bn to a deficit of US$29bn. It is clear thatbut for the widening of the trade deficit, Indias current account surplus

would have continued. With the trade deficit remaining at the FY09 levelin the next three years, Indias current account balance is likely to improvesignificantly and the country can turn current account surplus again beyondFY12. The likely improvement in the current account position is yet

another factor that is likely to strengthen the rupee.

Cross-currency movements impact rupee. Clearly, the outlook on theexternal value of the rupee is not independent of the trends in the globalforeign exchange market. In fact, the movement of the rupee-dollarexchange rate since 2003 has been largely synchronous with the dollarindex (see Fig 31), which is the weighted index of the US dollar against sixmajor currencies. In this sense, the rupee outlook against the dollar isinfluenced by how the US dollar moves against the other major currencies.

Fig 31 Rupee dollar movements generally synchronous with the dollar index

38

40

42

44

46

48

50

52

Feb-0

3

Feb-0

4

Feb-0

5

Feb-0

6

Feb-0

7

Feb-0

8

Feb-0

9

Feb-1

0

(INRperUS$)

70

75

80

85

90

95

100

105

(Dollarindex,majorcurrencies)

Rupee per USD Dollar Index

Source: Bloomberg and Anand Rathi Research.


29/44



Rupee can appreciate even with a rising dollar index. Yet, the rupee isneither explicitly nor implicitly pegged to the US dollar or any othercurrency. In the past decade, the rupee has shown considerable two-waymovement against all major currencies including the US dollar. Therefore,even if the US dollar strengthens against other major currencies in theforeseeable future, the rupee can still strengthen against the US dollar.Historically, we have seen such movements in patches during FY97-00.Over the next two years, we believe there are reasons to expect the USdollar would appreciate against select industrialised countries currencies(which may move the dollar index up), while the rupee continues toappreciate against the US dollar. The key reasons:

Relatively modest appreciation of the rupee since Mar 09. Duringthe financial crisis, the US dollar had appreciated against mostcurrencies, but between Mar 09 and Nov 09 it depreciated. While therupee depreciated strongly against the US dollar during the crisis, thebounce back during Mar-Nov 09 has been modest relative to mostother currencies (see Fig 32). This makes it relatively undervalued,

which can lead to a relatively sharper rebound.

High volatility to continue. Although we do expect the rupee toappreciate against the US dollar in FY11, we also expect volatility inthe external value of the rupee during the year. Exchange rates the

world over have been volatile for the past two-and-a-half years, and sohas the rupee-dollar rate (see Fig 33).

Fig 32 Modest appreciation of the rupee against the US dollar

-30

-20

-10

0

10

20

30

40

50

60

China

Japan

Philippines

Euroarea

India

Indonesia

Brazil

Australia

Russia

Korea

(Currenciesapp(-ve)/dep(+ve)vsUSD,

%)

Mar08-Feb09 Mar09-Nov09 Dec09-Feb10



30/44



Fig 33 Rupee movements against the US dollar

30

33

36

39

42

45

48

51

54

FY94

FY96

FY98

FY00

FY02

FY04

FY06

FY08

FY10YTD

(INRper

US$)

Max Min Average


Likely increase in risk appetite. The US dollar has strengthened sharply

since Dec 09 mainly because of the general decline in investors riskappetite (see Fig 34), unwinding of dollar carry trade and country-specificdisappointments, especially in Europe. These factors led to a reallocationof assets away from high-risk, high-return assets to low-risk, low-returnassets. As expectations get adjusted to sub-par global recovery, the near-zero policy rates and strong growth in emerging economies like China andIndia, risk appetite is likely to return. This could to lead to the appreciationof various Asian emerging market currencies vis--vis dollar. In Indiascase, current high inflation and expectations it would remain high have ledto rupee depreciation against the US dollar in the recent past. We,however, expect inflation to start softening in 2HCY10, which is likely tolead to rupee appreciation.

Fig 34 After a sharp fall, risk aversion bottoming out

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Sep-05

Dec-05

Mar-06

Jun-06

Sep-06

Dec-06

Mar-07

Jun-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Feb-10

(TEDspread,

bps)

100

200

300

400

500

600

700

800

900

(EMBIspread,

bps)

TED spread EMBI



31/44



Macro Snippets


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GDP: Investment decline hurts growth

After 7% growth in 1HFY10, GDP growth fell to 6% in 3QFY10,mainly reflecting negative farm sector growth. With the largerevisions in the past GDP data by the government, we revise

upwards FY10 and FY11 GDP growth forecast to 7% and 6.5%,respectively, and introduce FY12 forecasts at 9%.

GDP growth slows in 3Q. Indias GDP growth declined to 6% in3QFY10, after strong growth of 7.9% in 2QFY10, mainly owing to anegative contribution from agriculture. Surprisingly, social and personalservices, too, declined (-2.2% in 3QFY10).

Industrial growth rebounds, but services declines. Industry grew11.6% in 3QFY10, way ahead of the 7.5% average recorded in the pastdecade. Manufacturing grew a whopping 14.3%, the highest growth inmore than a decade. On the other hand, services reported a decade-low

growth of 6.3%.

Non-government GDP bounced back.The 6% growth in 3QFY10 iscloser to reality, in our view, than the previous quarters rate, which wasinflated by government consumption. In 3QFY10, governmentconsumption declined 10.3%, after an increase of 26.9% in 2QFY10.Excluding government consumption, GDP (at constant market prices)grew 8.5% against 4.8% in 2QFY10.

Investment growth remains subdued. Real investment grew a tepid5.1% in 3QFY10. Investment growth continues to be sluggish with ameagre 2.4% average growth in the past seven quarters. The investmentcycle, however, seems to have bottomed out and has started moving up.

We expect investments to gather further momentum in FY11/FY12.

Soft outlook in FY11, but strong thereafter.The Economic SurveyFY10 estimates FY11 GDP growth at 8.2%, which seems quite optimistic,in our view. The strong contributions to FY10 growth coming fromgovernment consumption and falling real imports would fizzle out inFY11. Rise in private consumption and investment are unlikely to fullycompensate for this, dragging FY11 growth below FY10s.

Fig 35 FY11 growth is likely to be lower than in FY10AR Estimate

(YoY change, %) FY07 FY08 FY09 3QFY10 FY10 FY11 FY12

GDP 9.7 9.2 6.7 6.0 7.0 6.5 9.0 Agriculture 3.7 4.7 1.6 -2.8 -0.5 3.6 3.4

Industry 12.7 9.5 3.9 11.6 8.3 7.6 10.2

Mining & quarrying 8.7 3.9 1.6 9.6 8.7 7.5 8.0

Manufacturing 14.9 10.3 3.2 14.3 9.3 7.4 9.9

Electricity, gas & water supply 10.0 8.5 3.9 4.9 7.0 6.5 8.0

Construction 10.6 10.0 5.9 8.7 6.5 8.5 12.0

Services 10.2 10.5 9.8 6.3 8.5 6.7 9.8

Trade, hotel, transport & comm. 11.7 10.7 7.6 10.0 8.0 6.9 9.6

Finance, insurance, real estate 14.5 13.2 10.1 7.8 9.0 7.1 11.8

Social & personal services 2.6 6.7 13.9 -2.2 8.6 6.0 7.5

Private final consumption 8.2 9.8 6.8 3.4 4.4 6.3 6.5

Government consumption 3.8 9.7 16.7 -10.3 8.5 3.8 3.5

Investment 16.1 14.8 -1.7 5.1 4.3 12.8 16.2

Source: Government of India and Anand Rathi Research.


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IIP: Rebound with a bang

The strong rebound in industrial production took the market bysurprise, with IIP growing 10.6% during Jun-Dec 09. Strongdomestic demand and improving conditions for exports coupled

with a favourable base effect boosted industrial production. Werevise our FY10 and FY11 industrial growth targets upwards to 9.5%and 6.1%, respectively, and introduce FY12 target at 7.2%.

Impressive IIP growth. IIP clocked spectacular growth of 13.1% in3QFY10, following 9.1% growth in 2QFY10. Strong domestic demandcoupled with improving conditions for exports provided a boost toindustrial growth. During Apr-Dec 09, IIP grew 8.7% compared with3.6% during the same previous period.

Manufacturing leading the rebound. The manufacturing sector made aremarkable comeback in 2QFY10 (9.2%) and continued the strong growth

momentum in 3QFY10 (14.3%).

Recovery spread across broad industry groups. A redeeming feature ofindustrial growth in FY10 so far has been that it has been spread acrossbroad industry groups. Intermediate goods recorded a sharp jump ingrowth (18.7%). Consumer durables and capital goods also clockedspectacular growth of 33.8% and 21.7%, respectively, 3QFY10.

Base effect coloured the FY10 performance. Despite the fact that thestrength of industrial growth in FY10 has surprised us and the market, thelow base of FY09 is also playing a crucial role in spectacular IIP growthnumbers in recent months. Therefore, any linear extrapolation of therecent IIP growth numbers into FY11 is likely to create disappointments.

Expect industrial growth to decelerate in FY11. We expect industrialgrowth to be modest in FY11 before it improves in FY12. Three keyfactors are likely to keep industrial growth modest in FY11. These are: (1)

weak global economic growth coupled with large industrial excess capacityin most parts of the world, (2) embryonic revival in foreign trade and (3)an unfavourable base effect. We revise the FY11 industrial growth from5.5% to 6.1% and introduce the FY12 growth at 7.2%.

Upside from electricity and mining.The electricity and mining sectorsare likely to grow strongly in FY11 and FY12. We expect electricity togrow by 6.4% in FY11 and by 8% in FY12. For mining, the markedincrease in oil refining capacity and start of gas extraction from the KGBasin could result in 8.4% and 7.3% growth in FY11 and FY12,respectively.

Fig 36 The current strong growth unlikely to continue in FY11AR Estimate

(YoY change, %) FY08 FY09 Apr-Dec'09 Dec-09 FY10 FY11 FY12

Index of Ind. Production 8.5 2.7 8.7 16.8 9.5 6.1 7.2

Mining & quarrying 5.1 2.6 8.5 9.5 8.3 8.4 7.3

Manufacturing 9.0 2.7 9.0 18.5 10.0 5.9 7.2

Electricity 6.3 2.8 5.8 5.4 5.4 6.4 8.0

Basic goods 7.0 2.6 6.2 7.5 6.2 6.1 7.7

Capital goods 18.0 7.3 11.1 38.8 16.0 3.3 4.2

Intermediate goods 8.9 -1.9 12.5 21.7 12.2 5.2 6.5

Consumer goods 6.1 4.7 7.1 12.0 7.9 4.5 5.8



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WPI: To worsen before softening

The sharp acceleration of WPI inflation and CPI inflation in theteens has created a scare about a vicious cycle of price increases. Wedo expect WPI inflation to cross 11% by Apr 10, but soften

significantly in 2HFY11.

Inflation heading north.After remaining in deflation zone during Jun-Aug 09, WPI inflation has surged since then, reaching 7.31% in Dec 09and 8.56% in Jan 10. The inflation rate is likely to move into double digitsby Mar 10, well ahead of the RBIs forecast of 8.5%.

High food inflation. Overall food inflation both primary food articlesand manufactured food products has been in double digits since thebeginning of the current fiscal (19.4% in Jan10). Moreover, owing to the

worst monsoon since 1973, kharif foodgrain production declined by21.07m tons (mt) compared with last year. A likely bumper rabi (winter)

crop could lead to a significant decline in food prices after Apr 10.

Fuel price hike to push inflation to double digits. The increase indiesel and petrol prices by Rs2.55/litre and Rs2.71/litre, respectively,

would directly push WPI (wholesale price index) inflation by over 30 basispoints (bps). The indirect impact would also be roughly of the samemagnitude. Therefore, we expect inflation to peak at around 11% by Apr10 before it starts softening thereafter and reach 6% by Nov 10.

Inflation outlook. In line with our earlier estimates, food inflation seemsto have already peaked and there has been a noticeable softening in foodprices, particularly under the primary articles category, in recent weeks.However, due to the fuel price hike, we revise our earlier peak inflation

estimate of 9.6% by Mar 10 to over 11% by Apr 10. We revise our FY11inflation estimate to 6.9% from 4.7% and introduce FY12 WPI inflationforecasts at 4.5%.

Interest rate outlook. As inflation has picked up sharply, itis likely tolead to a 50bps hike in the repo and reverse-repo rates in the Apr 10Monetary Policy.Thereafter, though the RBI may further tighten thepolicy rate in the course of FY11, we expect the tightening measures to bemodest and an accommodative monetary policy stance is likely to continuethrough FY11.

Fig 37 Food inflation still a concern, but to soften

AR Estimate(YoY change, %) FY08 FY09 Apr-Jan FY10 Jan10 FY10 FY11 FY12

WPI 4.7 8.4 2.4 8.6 3.6 6.9 4.5

Food 5.5 8.0 13.9 17.4 14.6 8.5 3.9

Non-food 12.7 11.2 1.7 10.6 3.7 8.8 3.7

Mineral oils 1.0 11.1 -8.3 10.3 -5.0 10.0 7.1

Food product 4.3 10.0 16.3 22.6 16.8 9.0 3.2

Textiles -1.1 6.0 4.8 9.0 5.7 6.0 0.9

Chemicals 5.6 7.2 3.7 8.0 4.5 3.8 3.6

Non-metallic minerals 8.9 3.8 2.8 -1.7 2.3 1.8 6.1

Basic metals 6.9 14.4 -11.7 -2.6 -9.7 8.6 8.4

Machinery 7.1 4.7 -1.2 0.9 -0.7 4.4 4.6

Transport equipment 2.7 5.2 0.1 0.2 0.2 2.7 3.1

CPI-Industrial workers 6.2 9.1 11.9 16.2 12.6 8.8 3.6



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Govt. finance: On the mend

The FY11 budget starts the process of fiscal consolidation, which islikely to gather momentum in FY12. Even after factoring in certainslippages, we expect government borrowing to remain close to the

budget target in FY11.

Taming the fiscal deficit. The FY11 Budget projected that the fiscaldeficit would shrink to 5.5% of GDP from 6.8% in FY10. This marks asignificant improvement over the 7.8% deficit in FY09 and 6.8% in FY10(both included fertilizer and fuel subsidies).

Possible upside to tax revenue.The change in the source of GDPgrowth from rising government expenditure and falling real imports inFY10 to rising private consumption and investment in FY11 is likely toimprove tax collection. In particular, we expect considerable upside fromdirect taxes. Furthermore, successful implementation of the direct tax code

and goods and services tax (GST) in the FY12 budget is expected to leadto a marked increase in the governments total tax receipt.

Non-tax revenue and divestment to support. The 3G spectrum auctionhas been rescheduled to FY11, which is expected to add Rs350bn to thegovernment kitty. While the divestment proceeds target of Rs400bn inFY11 budget looks ambitious, there are other avenues, which can morethan make up for any likely shortfall on this account.

Absence of one-offs to contain spending.There is considerablescepticism about the budget estimate of a modest 8.5% jump in overallexpenditure and, within that, a mere 0.3% rise in non-plan revenueexpenditure. We, however, feel that it is a reflection the absence of large

one-off expenditures undertaken in FY10 on account of heads such aspayment of back wages to public servants, farm loan waiver, stimulus-related spending and drought-related spending.

Market borrowing to be lower. We estimate that considerablemobilization under the small savings schemes is likely to contain themarket borrowing requirement in FY11 close to the budget target.

Heading toward fiscal consolidation.The Finance Minister has statedthat the fiscal deficit would fall to 4.8% in FY12 and 4.1% in FY13. Weestimate that the fiscal deficit target for FY11 is very much achievable.Moreover, our estimates suggest that the fiscal deficit could shrink fasterthan government estimates in FY12.

Fig 38 FY11 budget sets off fiscal consolidation processAR Estimate

(Rsbn) FY08 FY09 Apr-Jan FY10 Jan10 FY10 FY11 FY12

Tax revenue 3,512 4,395 4,660 2,139 282 4,510 4,848

Personal income tax 751 1,026 1,226 597 100 1,163 1,303

Corporate income tax 1,443 1,929 2,220 1,115 70 2,398 2,734

Customs duty 863 1,041 1,080 452 74 988 1,028

Excise duty 1,176 1,234 1,084 455 86 964 1,012

Non-tax revenue 832 1,023 962 706 118 1,348 1,537

Revenue expenditure 5,146 5,944 8,034 4,913 818 9,957 10,853

Capital expenditure 688 1,182 975 456 62 1,154 1,292

Net market borrowing 1,104 1,318 2,620 3,182 273 4,285 3,710

Fiscal deficit 1,426 1,269 3,265 2,451 473 4,325 4,032



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Foreign trade: On the recovery path

After 13 months of decline, Indias export growth turned positive inNov 09; positive import growth followed in Dec09. Imports are nowrising faster than exports, leading to an increase in the trade deficit.

A strong rebound in foreign trade, however, seems far off.

Recovery in foreign trade. Maintaining its momentum, Indias exportsgrew 11.5% in Jan 10 the third straight month of growth. Imports grewmuch faster at 35.5% the second straight positive month. In FY10 YTD(Apr-Jan), exports and imports contracted 18% and 20%, respectively.

Sharp jump in oil imports. In Jan 10, oil imports rose 56% (yoy),following 42.8% growth in Dec 09. Since Aug 09, oil imports have beenaround US$6.5bn a month. In Jan 10, however, oil imports were atUS$7.1bn, the highest in the past 15 months, reflecting the impact of therebound in international oil prices.

Trade deficit to widen but moderately. The trade deficit increasedsharply in recent months after shrinking to a mere US$2.2bn in Feb 09.During Jan 10, it rose to US$10.4bn, the highest trade deficit in the last 14months and for FY10 ytd (Apr-Jan), it stood at US$86.6bn. We revise ourFY10 and FY11 trade deficit targets upwards to US$105bn (fromUS$85bn) and US$113bn (from US$95bn), respectively, and introduce theFY12 target at US$113bn.

Non-oil imports recovered strongly. After turning positive in Dec 09,non-oil import growth maintained its positive trend, with 28.8% growth in

Jan 10 the strongest in the previous 16 months. Stabilization in thiscategory indicates significant improvement in industrial activity and

domestic demand.

Exports set to grow faster than imports in FY11. Larger contraction ofexports as compared to imports in FY10 coupled with containment ofcrude import growth in FY11 due to likely decline in volume is expectedto lead to stronger growth in exports than imports in FY11.

Outlook.International oil prices play a key role in determining the size ofIndias trade deficit. While there are uncertainties about the outlook oninternational oil prices, it is unlikely that oil prices would reach theprevious high in the near future. Moreover, Indias new found natural gasresources are replacing use of petroleum products like naphtha and fueloil, especially in fertilizer production. This would reduce fertilizer imports.On the exports front, a likely recovery in global demand would supportIndias exports, going forward. A strengthening rupee, however, couldhamper Indias export competitiveness for low-end price sensitive exports.

Fig 39 Broadly range bound trade deficitAR Estimate

(US$bn) FY08 FY09 Apr-Jan FY10 Jan10 FY10 FY11 FY12

Imports 250 291 219 25 268 298 346

Oil imports 80 91 65 7 78 80 84

Non-oil imports 170 199 154 18 190 219 262

Exports 163 183 132 14 163 186 233

Trade balance -87 -108 -86 -10 -105 -113 -113



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BoP: Back to normal

Higher-than-expected current account deficit and a strong reboundin debt inflows in 2QFY10 came as a surprise. We expect the currentaccount deficit to soften significantly after FY11 and the capital

account position to continue to improve in FY11 and FY12,reinforcing our call that the rupee would strengthen further.

Services disappoint. During 2QFY10, the surplus on Indias servicestrade account shrunk to a 10-quarter low. This, in turn, widened theoverall current account deficit to US$12.6bn, well above consensusexpectation (US$5.6bn). Software exports continued to decline qoq for thesixth consecutive quarter. Moreover, business services, which generallymaintains a small positive balance, has turned into a huge deficit.

Debt flows turn positive. For the first time since the onset of the globalfinancial crisis, all major debt inflows ECB, trade credit, NRI deposit,

banking capital (excluding NRI deposits) turned positive in 2QFY10.The marked difference in the interest rate on debt funding in India relativeto international market rates seems to be a key driver in this process.

Strong equity flows continue. Net FDI inflows in 2QFY10 remainedlargely unchanged at the 1QFY10 level although both the gross inflow andoutflow increased significantly. Portfolio inflows reached the highest levelin seven quarters.

Higher current account deficit in FY11. Indias current account deficitin FY11 is likely to remain high at 2.1% of the GDP before it shrinkssignificantly to 1% in FY12.

Surplus capital account to support our strong rupee call.With debtinflows gathering momentum, the capital account surplus is likely tosubstantially exceed earlier expectations. This is likely to more thancompensate for the larger-than-expected widening of the current accountdeficit, supporting rupee appreciation. We maintain our call of the rupee at42 per USD by Mar 11 and introduce rupee forecast at 40 per USD byMar 12.

Fig 40 Current account deficit to soften after FY11AR Estimate

(US$bn) FY07 FY08 FY09 2QFY10 FY10 FY11 FY12

Current account balance -10 -16 -29 -13 -30 -34 -18

Trade balance -62 -91 -119 -32 -115 -127 -126

Invisible balance 52 76 90 20 85 93 108 Services 29 39 50 6 37 43 53

Software 29 37 43 10 39 45 52

Private transfer 30 42 45 14 52 55 60

Capital account balance 45 107 7 24 63 72 87

FDI, net 8 16 17 7 25 26 28

Portfolio investment 7 27 -14 10 30 15 19

Commercial borrowing 16 23 8 1 6 13 17

Short-term loan 7 16 -2 1 3 8 9

Banking capital 2 12 -3 4 -4 5 7

NRI deposit 4 0 4 1 5 4 5

Other capital 4 11 -2 0 2 4 4

BoP balance, net of error 37 92 -20 9 32 38 69

Source: Reserve Bank of India and Anand Rathi Research.


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Macro Snapshot


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Macro Snapshot

AR Estimate

(Unit) FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12

GDP

GDP, current prices (INR bn.) 32,392 37,065 42,840 49,479 55,744 61,621 70,668 80,200

GDP, current prices (US$ bn.) 721 837 946 1,230 1,214 1,297 1,625 1,956

Real growth - GDP (%) 7.5 9.5 9.7 9.2 6.7 7.0 6.5 9.0

Real growth - Agriculture (%) 0.0 5.2 3.7 4.7 1.6 -0.5 3.6 3.4

Real growth - Industry (%) 10.3 9.3 12.7 9.5 3.9 8.3 7.6 10.2

Real growth - Services (%) 9.1 11.1 10.2 10.5 9.8 8.5 6.7 9.8

Real growth - private consumption (%) 5.2 9.0 8.2 9.8 6.8 4.4 6.3 6.5

Real growth - investment (%) 23.5 15.3 16.1 14.8 -1.7 4.3 12.8 16.2

Real growth - government consumption (%) 3.6 8.3 3.8 9.7 16.7 8.5 3.8 3.5

Per capita GDP, current prices (US$) 662 757 843 1,080 1,052 1,109 1,370 1,627

Industry and infrastructure

Industrial production (growth, %) 8.4 8.2 11.5 8.5 2.7 9.5 6.1 7.2

Manufacturing (growth, %) 9.1 9.1 12.5 9.0 2.7 10.0 5.9 7.2

Electricity (growth, %) 5.2 5.2 7.3 6.3 2.8 5.4 6.4 8.0 Steel production (growth, %) 12.2 7.0 9.4 6.0 1.2 6.4 4.0 13.1

Cement production (growth, %) 8.6 11.2 9.1 8.8 7.8 11.0 9.1 12.6

Refinery throughput (growth, %) 4.6 2.1 12.6 6.5 3.0 16.0 2.0 4.2

Passenger car sales (growth, %) 19.7 7.3 19.7 12.0 5.9 27.0 14.0 18.0

Saving-investment

Gross dom. saving (% of GDP) 32.2 33.1 34.4 36.4 32.5 32.5 34.3 37.9

Household saving (% of GDP) 23.3 23.2 22.9 22.6 22.6 24.1 25.2 26.3

Corporate saving (% of GDP) 6.6 7.5 8.0 8.7 8.4 7.9 8.1 8.5

Foreign savings (% of GDP) 0.3 1.2 1.0 1.3 2.4 2.4 2.1 0.9

Domestic investment (% of GDP) 32.5 34.3 36.3 38.1 35.6 35.1 36.7 39.2

Prices

Wholesale price inflation (%) 6.5 4.4 5.4 4.7 8.4 3.6 6.9 4.5 Consumer prices inflation (%) 3.8 4.4 6.7 6.2 9.1 12.6 8.8 3.6

Government finance

Tax revenue (% of GDP) 9.4 9.9 11.1 12.0 10.9 10.3 11.1 12.4

Personal income tax (growth, %) 19.0 13.6 34.1 36.7 3.3 17.9 10.0 22.0

Corporate income tax (growth, %) 30.1 22.5 42.5 33.7 10.6 19.5 25.0 30.0

Customs duty (growth, %) 18.5 12.9 32.7 20.6 -4.1 -15.4 35.0 25.0

Excise duty (growth, %) 9.2 12.2 5.7 5.1 -12.1 -6.1 30.0 25.0

Non-tax revenue (growth, %) 5.7 -5.4 8.3 23.0 -5.3 15.7 19.2 11.4

Revenue expenditure (% of GDP) 11.9 11.9 12.0 12.0 14.2 14.7 13.9 13.2

Capital expenditure (% of GDP) 3.5 1.8 1.6 2.4 1.6 1.9 2.1 2.1

Net market borrowing (US$ bn.) 10.2 21.5 24.4 32.7 50.9 83.9 82.6 73.8

Fiscal deficit (% of GDP) 3.9 4.0 3.3 2.6 6.0 6.7 5.6 4.3 Source: GoI, Anand Rathi Research


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Macro Snapshot

AR Estimate

(Unit) FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12

Money and finance

Bank deposits (% of GDP) 51.6 55.9 60.0 63.7 67.9 71.6 72.1 72.5

Bank deposits (growth, %) 11.2 23.9 24.1 22.5 20.2 16.5 15.5 14.2

Bank credit (growth, %) 26.2 38.0 28.1 22.3 17.5 15.1 16.2 17.8

Credit-deposit ratio (ratio, %) 65.3 72.7 75.1 75.0 73.3 72.4 72.9 75.2

Bank investments (growth, %) 6.4 -1.8 9.3 22.6 20.3 18.2 29.1 10.5

Money supply (M3) (growth, %) 12.3 21.2 21.3 21.4 18.6 16.3 14.0 16.5

Money supply (M3) (% of GDP

India EcoTrix Mar '10 - Liquidity - From Overhang to Hangover

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Transcript of India EcoTrix Mar '10 - Liquidity - From Overhang to Hangover