Random Musings

Show me the money

As I listen to CNBC TV18 & read the pink papers, there seems to be a consensus
that interest rates are set to ease further. The argument I hear is that inflation has
come off and the economy needs a boost. So RBI has to cut rates and hence
interest rates (I guess that implies lending rates) will fall.
I think interest rates may have bottomed out. Its a big non-consensus call, but I
have 3 strong reasons to think so. I present them in this note. I would be delighted
to hear your thoughts/comments/critique on the same.

First, Bond markets have been way ahead of the RBI so far. And they are now
showing signs of rates bottoming out. Dont believe me? See the graph below:
Policy Repo Rate

(%)

10yr Govi

9.50
9.00
8.50
8.00
7.50
Mar-15

Feb-15

Jan-15

Dec-14

Nov-14

Oct-14

Sep-14

Aug-14

Jul-14

Jun-14

May-14

Apr-14

Mar-14

Feb-14

Jan-14

7.00

Source: Reserve Bank of India

10-yr bond yields peaked in April 2015 at 9.12%. From there on they have been on
the downslide 8 months before RBI cut its repo rate in January 2015! 10-yr yields
had fallen 120bps by the time the RBI cut its policy repo rate by 25bps. Interestingly
10-yr yields have stabilised around the 7.75% mark ever since. So its quite possible
that even as the RBI cuts repo rates, the bond market ignores it and continues to
lead rather than follow the RBI.

Second, inflation as measured by CPI Combined (ie rural + urban) actually bottomed
out in November 2014 and has been rising ever since. CPI declined 5.3 percentage
points from 8.6% in Jan 14 to 3.3% in Nov 14. Of that 5.3ppt decline, Food
products contributed to 3.5ppt or 66% of the decline.

Random Musings
Show me the money

Components of Inflation
Food

Tobacco

Clothing

Housing

Components of Food Inflation

Fuel

Others

10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%

Cereals

Milk

Vegetables

Others

Others

5%
4%
3%
2%
1%
0%
-1%
Feb-15

Jan-15

Dec-14

Nov-14

Oct-14

Sep-14

Jul-14

Aug-14

Jun-14

Apr-14

May-14

Feb-14

Mar-14

Jan-14

Feb-15

Jan-15

Dec-14

Nov-14

Oct-14

Sep-14

Jul-14

Aug-14

Jun-14

Apr-14

May-14

Mar-14

Feb-14

Jan-14

-2%

Source: Ministry of Statistics web site, Govt of India

Now given the recent freak weather rains & hailstorm which have destroyed
standing crop, it is quite possible that we could see a 25% jump in vegetable & fruit
prices over the coming months. These two items carry a combined weight of 9% in
the CPI. That alone would add 2.3ppt to inflation without counting any compounding
effects. CPI inflation which is currently at 5.4% could easily rise to 7.7% by June
2015!
Is a 25% jump in vegetable prices a reasonable assumption? I think so. Vegetable
inflation in February was 13%, up from -17% in Nov 14. Look at it this way, a 25%
rise in vegetable prices would take them back to the levels in October 2014
nothing too dramatic.

Third, Show me the money!

The Union Budget projects a fiscal deficit of Rs 5,556 bn for FY16, up from Rs 5,126
bn in FY15. A large part of this Rs 4,564 bn would be raised as market loans and
another Rs324 bn are to be mopped through small savings & PF.
Public sector units (PSUs) will raise additional Rs 1,176bn, up a whopping 92% from
FY15. (See Annexure)
The third claim on the pool of funds will be from the private sector. I am assuming a
loan growth of 14% for FY16. This assumption is based on the 11.5% GDP growth
estimated in the Budget and a factor of loan growth to GDP growth. This factor is
based on the median of 1.13 & an average of 1.32 over the last decade.

Random Musings
Show me the money
Loans/GDP

YoY Loan growth

Nominal GDP grwth

35%

60%

30%

55%

25%

50%

20%
45%
15%
40%

10%

FY16 BE

FY15 RE

FY14

FY13

FY12

FY11

FY10

FY09

FY08

30%
FY07

0%
FY06

35%
FY05

5%

Source: Reserve Bank of India, Ministry of Finance web sites

That puts incremental loan demand from private sector at Rs 9,128 bn.
A clarification: The private sector loan demand is calculated separately to avoid
double counting with the PSU borrowing estimated in the Budget. PSUs have
typically accounted for around 7% - 8% of the banking sectors loans. This number
has been declining over the last few years, but as a thumb rule we can safely say
that 7.6% of the loan book is lending to PSUs.
Thus the total demand for credit in FY16 will be Rs 14,890 bn, broken up as follows:

Rs 4,564 bn Govt borrowing

Rs 1,176 bn Demand from PSUs
Rs 9,128 bn Demand from the private sector

(Rs bn)
Govt of India Mkt loans
Public Sector (see Annexure)
Private Sector loan demand
Total Demand for Domestic Credit

FY12
4,362
703
6,930
11,995

FY13
4,674
733
6,490
11,896

FY14
4,536
614
7,333
12,482

FY15 RE
4,469
614
5,682
10,765

FY16 BE
4,564
1,176
9,128
14,868

Incremental M3 in the year

Surplus/deficit

8,611
(3,384)

10,359
(1,537)

11,214
(1,269)

11,043
278

?
?

13%

14%

13%

11%

14%

7.99%
8.57%
10 yr yield at start of the fiscal
8.57%
7.95%
10 yr yield at end of the fiscal
58
(62)
Change during the year (bps)
Source: Budget Papers, Min. of Finance, Govt of India & RBI

7.95%
8.84%
89

8.84%
7.70%
(114)

7.70%
?
?

M3 growth YoY

Random Musings
Show me the money
To meet this demand of Rs 14,868 bn, Broad Money (M3) will need to grow 14% if
interest rates have to stay stable. For interest rates to fall, it would have to grow
even faster.
In addition to the above, there are multiple global factors like the US Fed, ECB, BoJ
etc on which I have a view (just like any of us), but no particular insight. My view is
that the US Fed.s decision on raising rates is a question of When and not If.
So the call one needs to make is: will the RBI allow M3 growth to accelerate to 14%
15% against the backdrop of inflationary pressures and Fed tightening. We will
know that in a few weeks when RBI comes out with its April policy statement.
Until then, I dont think the RBI will oblige. Hence my view is that interest rates are
set to rise. If the RBI does oblige, then inflation pressures will likely rise and that
may cap any fall in rates. Either way, 10-yr yields seem to be close to their bottom.
So what does it mean for equities?
On one hand, rising interest rates would imply that economic activity has resumed.
On the other, there are a whole lot (30%+ as per some bankers) of stressed loans
on banks books. Rising rates are unlikely to help that resolution and banks will be
constrained to lend.
My strategy is to buy Nifty Dec 2015 Puts and exit high beta, leveraged & value
propositions. Whats yours?

Random Musings
Show me the money
Annexure
(Rs bn)
Department of
Atomic Energy
Nuclear Power
Corp (NPCIL)
Ministry of Coal
Neyveli Lignite
Corp (NLC)
Min. of IT &
Communications
Bharat Broadband
Network Ltd
BSNL
Min. of Housing
and Urban Poverty
Alleviation
HUDCO
Min. of Petroleum
& Natural Gas
BPCL
IOC
Ministry of Power
Power Grid Corp
NTPC
Min. of Road
Transport
NHAI
Min. of Railways
Other Ministries
GRAND TOTAL
YoY increase

FY14A

FY15RE

FY16BE

Internal

Domestic

ECB

Others

Total

Internal

Domestic

ECB

Others

Total

Internal

Domestic

ECB

Others

Total

23

33

57

25

39

64

32

60

92

20
76

33
17

10

1
1

54
104

23
73

39
15

16

11

61
115

29
85

60
28

11

89
126

17

25

10

15

25

14

28

42

61

63

(26)

38

184

196

(117)

302

186

52

52

4
(24)

75
95

79
71

(1)
(85)

100
183

99
98

6
6

68
68

74
74

7
7

30
30

82
82

118
118

7
7

145
145

151
151

1,074
36
118
144
60
74

254
110
98

69
30
30

23
-

1,074
36
118
490
200
202

595
26
47
116
40
71

7
7
267
135
87

41
12
6
96
25
66

83
20
34
19
-

726
58
94
498
200
224

585
1
36
172
40
94

7
7
245
130
79

114
47
47
96
30
57

60
10
22
34
-

766
65
104
546
200
230

94
2

80
80
209
0

9
0

80
80
313
3

164
2

30
30
178
0

30
30
342
3

178
2

427
427
406
0

427
427
584
3

1,722

614

102

138

2,576

1,167

614

169

420

2,370

1,180

1,176

235

588

3,179

-32%

0%

65%

204%

-8%

1%

92%

39%

40%

34%