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

India I Equities
Economics Theme Report
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)
Sujan Hajra
+9122 6626 6720 sujanhajra@rathi.com
Gautam Singh
gautamsingh1@rathi.com
Anand Rathi Financial Services, its affiliates and subsidiaries, do and seek to do business with companies covered in its research reports. Thus, investors should be aware 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 making their investment decision. Disclosures and analyst certifications are located in Appendix 1. Anand Rathi Research India Equities
11 March 2010
India EcoTrix Mar 10 Drain liquidity at your own risk
Macro theme and investment ideas

We highlight investment ideas that flow from our macro view Positive on domestic consumption. We expect growth in private consumption to jump from 4% in FY10 to 7% in FY11, driven by the payment of back wages to state government employees, cut in the effective personal income tax rate and continued strong spending on welfare schemes. This should translate into strong demand for FMCG, white goods, two-wheelers and small cars. Strong pick-up in infra capex. We believe that Indias capex cycle is undergoing a major transformation. First, after slumping in FY09, the cycle is moving up and we expect it to gather momentum in FY11. Second, the share of infrastructure in overall capex is on the rise. This process is likely to benefit equipment and material suppliers to infrastructure developers. A continued real decline in manufacturing capex would, however, negatively impact companies concentrating on such areas. As infra capex has a long gestation period compared with manufacturing capex, it would mean that the order books of capital goods companies may bulge, but execution period would get lengthened. Mixed bag for real estate sector. Low interest rate bias, accommodative liquidity environment, strong competition among banks and nonbanking companies to increase their mortgage lending portfolios, increase in disposable income and strong increase in investment by households in physical assets are all positive for residential real estate assets. The imposition of service tax on under construction projects, withdrawal of attractive teaser rates for housing loans and strong run-up in property prices in various micro markets could become headwinds for the real estate sector. Overall, we believe the affordable housing segment would remain the bright spot in FY11. Modest headwinds for export-intensive sectors. Likely rupee appreciation and continued low growth in major industrialized countries would be negative for export-intensive sectors such as IT Services. The need to improve productivity, however, seems to be driving IT spends in many industrialized countries. This is positive for the Indian IT sector. We think rupee appreciation is likely to be modest and gradual. Therefore, the impact of rupee appreciation on export-intensive sectors is likely to be modest, particularly for sectors where companies offer differentiated products and command some degree of pricing power. Price deflation for materials. The subdued growth outlook in industrialized countries coupled with excess global capacity in various segments of the materials industry is likely to keep a lid on their global prices. Therefore, Indian materials companies may face falling realizations per unit where the Indian price of a product is linked to the international price and/or where the international transportation cost of a product is not prohibitive. Several negative developments for banks. The rising share of infrastructure and the falling share of manufacturing in overall capex do not bode well for banks. Infrastructure capex requires longterm, lumpy funding while banks liabilities are largely short-term in nature. Moreover, infra lending by most banks are currently close to exposure norms, thus limiting banks ability to substantially increase participation in such activities. Infra projects long gestation period is also leading to a large divergence in loan sanction and disbursement amounts for banks. Competition from domestic non-banking companies is limiting banks pricing power in the personal-loan market. Highly rated corporates ability to avail of low funding costs in the international markets is also eating into banks prime clientele. With the current large divergence between the interest rates offered by banks on fixed deposits and by the government under the small savings rates, bank deposit growth rates are also shrinking and banks are losing autonomy to cut interest rates on deposits.
Anand Rathi Research
Economics
India I Equities
Theme Report
12 March 2010

Theme: Liquidity. In FY11, we expect Indias policy bias to favor an accommodative liquidity scenario, conditioned by slowing GDP growth and softening inflation. A rising overall domestic savings rate should boost liquidity supply in FY11, enabling funding of large government borrowing and rising investment demand without either a spike in interest rates or increase in Indias reliance on foreign funding. Yet, we do expect Indias strong fundamentals and global liquidity overhang to enhance foreign flows, leading to forex purchases by the RBI and appreciation of the rupee. Also in this issue GDP. With large revisions of back data by the government, we revise FY11 growth to 6.5% and introduce FY12 target at 9%. IIP. IIP growth has surprised in FY10, but it is also coloured by low base. We revise FY11 target to 6.1% and introduce FY12 target at 7.2%. Inflation. We expect inflation to peak at 11% in Apr 10 and soften significantly in 2HFY11, keeping monetary tightening modest. Govt. finance. FY11 budget starts the process of fiscal consolidation, which is likely to deepen in coming years. Foreign trade. Contained growth in oil import volume likely to lead to stronger rebound in exports than in imports in FY11. BoP. Current account deficit likely to remain range bound during FY10-12. Strong capital inflows, however, are likely to strengthen the rupee.
Household savings the main source of investment funding in India
(Savings-investment gap, % of GDP) 15 12 9 6 3 0 -3 -6 -9 -12 FY90 FY92 FY94 FY96 FY98 FY00 FY02 FY04 FY06 FY08
GDP Growth: 6.5% (FY11e) Inflation: 6.9% (FY11e) INR/USD: 42 (Mar 11e)
Sujan Hajra
+9122 6626 6720 sujanhajra@rathi.com
Gautam Singh
gautamsingh1@rathi.com
Key macro forecasts

(%) FY11e FY12e
Real growth - GDP Wholesale price inflation Consumer price inflation Fiscal deficit to GDP Credit growth Export growth Import growth Current account deficit to GDP INR/USD year end
Source: Anand Rathi Research.
6.5 6.9 8.8 5.6 16.2 13.9 11.3 2.1 42
9.0 4.5 3.6 4.3 17.8 25.3 16.0 0.9 40
Household sector
Source: GoI, Anand Rathi Research.
Corporate sector
Public sector
Foreign
Anand Rathi Financial Services, its affiliates and subsidiaries, do and seek to do business with companies covered in its research reports. Thus, investors should be aware 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 making their investment decision. Disclosures and analyst certifications are located in Appendix 1. Anand Rathi Research India Equities
12 March 2010
India EcoTrix Mar 10 Liquidity From overhang to hangover

Liquidity From overhang to hangover Liquidity From overhang to hangover .....................................3
Policy support for adequate liquidity ......................................................3 Balanced rise in liquidity supply and demand ......................................13
GDP: Investment decline hurts growth ....................................30 IIP: Rebound with a bang.........................................................31 WPI: To worsen before softening.............................................32 Govt. finance: On the mend .....................................................33 Foreign trade: On the recovery path ........................................34 BoP: Back to normal ................................................................35 Macro Snapshot.......................................................................37
12 March 2010

In FY11, we expect Indias policy bias to favour maintaining adequate liquidity and low interest rates, conditioned by slowing GDP growth and softening inflation. Rising household income, better corporate profitability and fiscal consolidation should boost overall domestic liquidity supply in FY11. Such supply would be enough to meet large government borrowing and rising domestic investment demand. With this, either a spike in interest rates or increase in Indias reliance on foreign savings to fund domestic investment is unlikely. Yet, we do expect Indias strong macro fundamentals and continued global liquidity overhang to enhance foreign flows to India. This is likely to make the RBI a net buyer of forex in FY11 and also pressure the rupee to appreciate.
Policy support for adequate liquidity

Growth illusion to wear off. Indias recent strong growth (reflected in GDP, industrial production and export data) and spiralling inflation have raised expectations that FY11 would be characterized by high growth and high inflation. Such expectations have led to the consensus view that liquidity would be aggressively tightened and policy interest rates would be increased considerably. We believe part of this is a mirage, created by a favorable base and strong stimulus measures. In our view, yes, inflation would worsen in the next few months, but it should soften thereafter. Below we explain why the governments focus in FY11 would be on fostering growth through accommodative policies and interest rates. Fostering growth to remain the key policy objective
Impressive growth, but suspect quality
Growth continues, but on a non-linear trajectory. Indias GDP grew 7.9% in 2QFY10 and 7% in 1HFY10, significantly above our and consensus expectations. Although growth softened to 6% in 3QFY10, it was largely because of a contraction in agriculture and fall in government spending. For FY10, the government estimates 7.2% GDP growth, though official circles expect an even better outcome. Industrial growth, too, has accelerated sharply in recent months, running at double digits. A similar trend is playing out in foreign trade, where exports have recorded impressive positive growth for the latest three months, after contracting for 13 consecutive months. A stellar growth performance, for sure, but the numbers are coloured by the very low bases last year against which they are measured. Growth internals, too, show that the quality of growth in FY10 is suspect. Against this backdrop, our estimates suggest deceleration in FY11 rather than acceleration (as expected by consensus and government officials). Foreign trade and government primed GDP numbers. The recent revision of GDP numbers by the government has sharply altered growth internals, especially for FY09 and FY10, while leaving overall GDP growth largely unchanged. Yet, even with such changes, the broad picture remains the same Indias real growth rates during FY09 and FY10 have been propelled by government consumption, cuts in indirect taxes, increases in subsidies and decline in real imports, especially commodity imports. The sharp cut in indirect taxes and increase in subsidies during FY09 and FY10 have coloured GDP growth numbers. This is evident from the divergence between supply-side and demand-side GDP. A key difference between the
Anand Rathi Research 3
12 March 2010
supply- and demand-side GDP calculations is the treatment of indirect taxes and subsidies. Supply-side GDP excludes indirect taxes and includes government subsidies, while it is the other way around for demand-side GDP. GDP internals suspect quality. Indias supply-side GDP growth numbers for FY09 and FY10 at 6.7% and 7.2%, respectively, look impressive in the current global backdrop. Adjusted for indirect taxes and subsidies, demand-side GDP growth during FY09 and FY10 comes to 5.1% and 6.8%, respectively losing some shine, but still impressive. Apart from cutting taxes and hiking subsidies, the government has also boosted GDP by increasing own consumption. Excluding government consumption, GDP growth would have been 3.8% in FY09 and 6.6% in FY10 (see Fig 1). Interestingly, the turn in foreign trade has also substantially boosted Indias GDP growth in FY10. India generally maintains a deficit in international trade in goods and services. Negative net exports, therefore, are generally a drag on Indias GDP growth. The larger 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 growth number of 7.2% and bullish expectations of doing even better (see Fig 1).
Fig 1 Government and net exports pumping up growth in India
8 7 (Growth, %) 6 5 4 3 FY09 FY10 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 for FY11 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, government final consumption grew at a compound annual growth rate (CAGR) of 12.5% in FY09 and FY10. In comparison, the long period average was 5%. We expect fiscal consolidation requirements to keep government consumption growth subdued below the long period average in FY11. The FY11 budget shows this, too. Above, we have described how growth in government consumption was the key driver of growth in FY09 and FY10. So a sharp deceleration in such spending would be a drag on FY11 growth. Net exports to soften growth. Like government consumption, net real exports would also change from a growth driver during FY09 and FY10 to a drag in FY11. Hike in indirect taxes and cut in subsidies to depress growth. As
12 March 2010
discussed above, cuts in indirect taxes and increases in subsidies inflated supply-side GDP growth in FY09 and FY10. During FY11, the partial roll-back of customs and excise concessions and more than 10% reduction in subsidies announced in the recent budget would depress supply-side GDP, the number which is taken as headline growth. Smart jump in private consumption. Our estimates factor in modest recovery in private consumption from 4% real growth to near 7% in FY11. Note that unlike highly volatile investment, private consumption is a far more stable component of GDP. Strong but no explosive growth in investment. In almost all periods of high growth, Indias economy has been driven by a strong spurt in investment. We do expect a major rebound in investment growth in FY11 to 13% from 4% in FY10. Yet, the factors mentioned above 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 growth rebounds to nearly 20%. Although we do expect a major rebound in investment in FY11, we do not expect such an explosive pace. Our view about the trajectory of the investment cycle is why we have a lower-thanconsensus GDP growth target for FY11. Given this, we elaborate on our views about the investment cycle.
Steady but not explosive pick-up in investment cycle
Change in base makes outlook on investment cycle hazy. The real GDP series with FY00 as the base year showed a clear deceleration in Indias investments since FY05 (see Fig 2). The new real GDP series with FY05 as the base year has, however, drastically changed the data. For example, the previous series showed 8.3% growth in real investment in FY09, whereas the new series shows a 1.7% contraction in FY09 and estimates 4% growth in FY10 (see Fig 3). The new data, in fact, validates our long-held conviction that real investment growth would turn negative before accelerating. With the earlier data series, we expected negative investment growth in FY10; the new data show that it happened in FY09. Drastic changes in past data, coupled with the non-availability of the long time series data with the revised base, makes it somewhat difficult to estimate the trajectory of the investment cycle. Nevertheless, it is possible to draw certain inferences on the likely future course of Indias investment cycle.
Fig 2 Fixed investment registered a modest rebound in 2QFY10
25 20 (Real investment growth, %) 15 10 5 0 -5 -10 1QFY01 4QFY01 3QFY02 2QFY03 1QFY04 4QFY04 3QFY05 2QFY06 1QFY07 4QFY07 3QFY08 2QFY09 1QFY10
Total investment
Source: GoI and Anand Rathi Research.
Fixed investment
12 March 2010
Fig 3 Sharp downward revision of yearly real investment growth for FY09
24 (Real growth in investment, %) 20 16 12 8 4 0 -4 -8 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10
Series with 99-00 base

Source: GOI and Anand Rathi Research.
Series with 04-05 base
Inventory cycle unlikely to propel investment in FY11. The new data series shows that fixed investment growth bottomed out at 0.8% in 3QFY09 and has accelerated since then, reaching 8.9% in 3QFY10. Drags from elsewhere, mainly lower inventory addition, however, led to a 4.1% contraction in overall investment in 3QFY09 and kept overall investment growth low at 5.1% in 3QFY10. While a larger addition to inventory is likely to positively influence overall investment in FY11, it is unlikely to result in very high investment growth in FY11 for the following reasons: Continued positive addition to inventory. Indias GDP data show that unlike in the previous phase of growth deceleration (FY02) when inventories were depleted (de-stocked), this time around, inventory build-up continued even during FY09 and FY10 although the net inventory additions were substantially lower during this period than in the preceding quarters. Reason for lower addition to inventory not apparent. With positive inventory addition in each quarter of FY09 and FY10, Indias inventory cycle does not fit in with the inventory de-stocking restocking cycle playing out in other parts of the world. Equally important, inventory additions in the first three quarters of FY10 have been lower than in FY09. This again is not in line with the international trend. The lower inventory additions in FY09 and FY10 in India could be part of rationalisation and/or more efficient inventory/production management. Therefore, a case for inventory build up-led sharp acceleration in overall investment during FY11 is far from obvious. Low share of inventory in total investment. The share of inventory in overall investment during both FY09 and FY10 was 3.8%. Even with the assumption of 40% increase in inventory factored in our estimates, its impact on overall investment growth would be only around 1.5 percentage points. Therefore, even a strong pick-up in the inventory cycle would not influence the overall investment by a large margin. Bottoms-up estimates do not support strong capex growth in FY11. Recently released data on sectoral trends in real investment growth in FY09 suggest a strong decline in industrial capex (-20.5%), the largest component of overall capex (see Fig 4). There has been a major slowdown in infrastructure capex (from 18.1% in FY08 to 1.9% in FY09). In line with the governments advance estimate of 4% overall investment growth in
12 March 2010
FY10, we expect industrial capex to remain negative in FY10 before bouncing back in FY11 (see Fig 5). Our estimates suggest infra capex growth has gathered pace in FY10 and would accelerate sharply in FY11. Despite such optimistic assumptions and expectations of continuing robust capex in agriculture and services, overall investment growth in FY11 is likely to be less than 15%.
Fig 4 Share of manufacturing capex remains the highest in overall investment
100 90 80 70 60 50 40 30 20 10 0 FY90 FY92 FY94 FY96 FY98 FY00 FY02 FY04 FY06 FY08
Services
(Share in investment, %)
Agriculture
Industry
Infrastructure
Fig 5 Turnaround in infra and industrial capex in FY11

60 (Real growth in investment, %) 45 30 15 0 -15 -30 -45 FY91 FY93 FY95 FY97 FY99 FY01 FY03 FY05 FY07 FY09
Industry
FY10e
FY11e
Agriculture
Infrastructure
Services
Primacy of growth to prevail
Growth in India remains fragile. The above discussions show that GDP growth in FY09 and FY10 has been driven by, inter alia, tax cuts, rising government expenditure and a sharp contraction in imports. Apart from its suspect quality, GDP growth numbers and the impressive industrial production and export growth rates are also coloured by low bases. We expect significant acceleration in overall investment growth from 4% in FY10 to 13% in FY11 and private consumption from 4% in FY10 to 7% in FY11. Yet, overall GDP growth in FY11 at 6.5% is likely to fall short of the 7.2% growth in FY10 estimated by the government. In short, growth in India remains fragile.
12 March 2010
Macro policies to support growth through accommodative policies. The government and the Reserve Bank of India (RBI) are unlikely to disregard the fragility of the underlying growth drivers. The key channels to revive growth would be to take measures to nurture investment and private consumption. Adequate access to liquidity at low interest rates is generally a necessary condition to stimulate investment and leveraged consumption, especially in an economic environment characterised by large 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 crucially on the course of inflation. If inflation, measured by the wholesale price index (WPI), hits double digits and remains there or worse still, continues to accelerate, the policy stance cannot remain accommodative. We expect inflation to worsen over the next three months, necessitating a 50 basis point (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 mediumterm 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 has risen much faster than the global average. The four consumer price index (CPI) inflation rates are currently in the range of 14% to 18%. WPI inflation emerged from deflation in Aug 09 and reached 8.6% by Jan 10 and is set to nudge 10% by Feb 10. Partly owing to high inflation, the RBI initiated monetary tightening in Jan 10 by raising banks cash reserve ratio (CRR) by 75bps. Flare in inflation coupled with high GDP, industrial and export growth have raised expectations of further monetary tightening. While we expect a 50-bp repo/reverse-repo rate hike in Apr 10, major monetary tightening during FY11 seems unlikely. Predominantly supply-side inflation. The spike in inflation in India is being led by food products both primary and manufactured that have been hit by supply shocks. On the other hand, the rise in non-food inflation is largely due to an unfavourable base (see Fig 6). Given this, the choices before the RBI are limited. First, monetary policy is not that effective at addressing supply-side inflation. Second, the impact of monetary tightening in inflation control works through compression of demand, which negatively impacts immediate-term GDP growth. In the current fragile growth environment, the RBI is unlikely to take a chance on growth through aggressive tightening.
12 March 2010
Fig 6 Non-food inflation largely driven by base effect

30 24 (Infaltion rate, YoY, %) 18 12 6 0 -6 Dec-05 May-05 Nov-08 Sep-07 Oct-04 Feb-07 Jul-06 Mar-04 Apr-08 Jun-09 Jan-10
Primary food
Manufactured food
Non-food
Agro prices likely to soften further. The seasonality trend suggests agricultural prices generally fall during Nov-Feb (see Fig 7). This time around also this trend remained intact. The food price index has largely been falling since late Nov 09 and food inflation since early Dec 09. Moreover, with improved acreage, better topsoil moisture conditions and strong efforts by the government to increase agricultural production (after the worst drought since 1973) are likely to result in a bumper winter (rabi) crop. This is also likely to douse agricultural prices. The advance estimates of the winter crop by the government also indicate this.
Fig 7 Seasonality trend softened primary food prices since late Nov 09
293 278 (Primary food index) 263 248 233 218 203 188 May Jul Nov Dec Apr Aug Sep
FY10
FY09
FY08
FY07
FY06
Drivers of inflation
Food price inflation largely in line with fundamentals. With a few exceptions, current inflation for major food items is largely in line with the fall in production during the FY10 kharif (summer) crop season (see Fig 8). While the relationship is strong for cereals, for some pulses and, to a limited extent, even oil seeds the relationship is not that strong. Even for these food items, however, inflation is in line with the supply conditions if the previous cropping season is also taken into account.
Mar
Feb
Jun
Jan
Oct
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Fig 8 Rise in food prices largely in line with supply

90 75 (Output and price, %) 60 45 30 15 0 -15 Cereals Rice Ragi Jowar Bajra Maize Pulses Arhar Moong Urad Oil seeds Castorseed Groundnut Soybean Sunflower Cotton Jute & mesta Sugarcane Kharif shortfall Inflation
Note: Kharif shortfall relates to the percentage reduction in output in the latest kharif season over the previous season. A shortfall has been shown as positive and excess (over the previous kharif season) has been shown as negative. Source: GOI and Anand Rathi Research.
Previous crop failure impacting select pulses prices. Two kharif pulses, arhar and urad, registered modest production growth in the latest kharif season, but continue to show very high inflation. They had, however, recorded a 25% production decline in the previous season. As a result, arhar has had high inflation since mid-2007 and urad since end-2008. Interestingly, gram, which is the most used pulse in India and a predominantly rabi (winter) crop, currently has a relatively low 4% inflation. Gram production increased over 20% in the last rabi season. Overall, it looks like fundamentals rather than speculative activity are keeping food prices high. Therefore, it is unlikely that easy liquidity conditions would fuel food prices in the future. Rising income levels lead to lower expenses on food. Food remains the single largest head for personal final consumption expenditure. Its share, however, has declined since the mid-70s with the acceleration of real per capita disposable income (see Fig 9). In this sense, historical data does not support the argument that food prices rise because of higher demand following rising rural and low/lower-middle class income. Note that the fall in the share of food in overall consumption started immediately after the Green Revolution in the 1970s, a period which is associated with increased rural property.
Fig 9 Share of food consumption falls with rising income
6 (Real personal disposable income per capita, growth, 5Y avg, %) 5 4 3 2 1 0 -1 FY56 FY60 FY64 FY68 FY72 FY76 FY80 FY84 FY88 FY92 FY96 FY00 FY04 FY08 32 (Share of food in personal cons. expenditure, %, rev. scale) 36 40 44 48 52 56 60
Disposable income
Food in personal consumption
10
12 March 2010
Demand side feedback to food inflation, if at all, remains small. The improvement in rural income through initiatives such as the Mahatma Gandhi National Rural Employment Guarantee Act (NREGA) or other welfare measures and a resultant rise in food demand, however, cannot be totally ruled out, either. If this is taking place, it is extremely welcome. The pertinent point, however, is that available data suggest that the supply shortfall is the key reason for the rise in food prices, rather than higher food demand. No large divergence between WPI and international prices. After hitting crisis lows in early 2009, international commodity prices have rebounded. This, however, is unlikely to impact domestic prices for several reasons: Limited impact of global prices on Indian agro prices. Indian agro prices are largely insulated from international prices, given high tariffs on agro imports and quantitative restrictions on various agro exports. 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 is also importing sugar. A large part of such imports, however, are through canalised agencies and are distributed at subsidised rates through the public distribution system. Moreover, prevailing domestic prices of most of these products are higher than international prices. Therefore, a further spike in import-dependent agro product prices is unlikely. Discrete data revision in official inflation index unlikely. For products that India imports a lot (such as edible oil) and for items whose domestic price is linked to a landed import cost (such as certain varieties of iron and steel), there have historically been large levels of co-movement (see Fig 10 and 11). Interestingly, these relationships broke down between mid-2007 and early-2009. Why this happened is difficult to explain and perhaps can partially be explained by the lack of appropriate update of these prices in the official inflation indices. The pertinent point, however, is that since early-2010, the comovement has been restored. In fact, the recent softening of international commodity prices should reduce the internationallylinked domestic commodity prices with some time lag. Rupee appreciation to dampen internationally linked prices. The Indian rupee appreciated considerably until Feb 08, but depreciated sharply thereafter until Mar 09. The rupee has bounced back since then. This trend suggests that other things remaining equal, the depreciation of the rupee should have led to a higher rise in internationally-linked commodity prices in rupee terms during Apr 08 and Mar 09 compared to these prices in dollar terms. The converse should be true since Apr 09, when the rupee started appreciating. Therefore, there is little chance of the pass-through of international prices raising domestic inflation. If anything, such pass-through should have a deflationary impact.
11
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Fig 10 Narrowing divergence for edible oil prices

270 250 230 210 190 170 150 130 110 90 70 50 May-98 Dec-98 Jul-99 Feb-00 Sep-00 Apr-01 Nov-01 Jun-02 Jan-03 Aug-03 Mar-04 Oct-04 May-05 Dec-05 Jul-06 Feb-07 Sep-07 Apr-08 Nov-08 Jun-09 Jan-10 Edible oil-Domestic
Source: GOI, Bloomberg and Anand Rathi Research.
(Price index, Apr-98=100)
Edible oil-International
Fig 11 Domestic iron and steel prices largely in line with international prices
400 350 (Price index, Apr-98=100) 300 250 200 150 100 50 May-98 Dec-98 Jul-99 Feb-00 Sep-00 Apr-01 Nov-01 Jun-02 Jan-03 Aug-03 Mar-04 Oct-04 May-05 Dec-05 Jul-06 Feb-07 Sep-07 Apr-08 Nov-08 Jun-09 Jan-10 Iron and Steel-Domestic
Source: GOI, Bloomberg and Anand Rathi Research.
Iron and Steel-International
WPI-CPI divergence. Currently, Indias consumer price inflation is much higher than wholesale price inflation. The available data by mid-Mar 10 show that CPI inflation, according to various indices (India has four official CPI series), ranges between 14% and 18%, while WPI inflation is at 8.6%. The divergence between WPI and CPI inflation is mainly because of three factors: (a) higher weight of food in CPI than WPI, (b) sharper rise in retail food prices than wholesale prices, and (c) revision of imputed rent for 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 of CPI, 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 two key channels increase in inflation-indexed salaries and demand from labour for higher salaries. In Indias case, both have limited impact. The organised sector in India employs around 30m persons, while the work-age population (age group: 16-64 years) is 780m. Only part of organised employees has salaries linked to inflation. As for increasing salaries through collective wage negotiations, this is unlikely as labour is unorganised in most segments of the economy.
12
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Input cost pass-through-led inflation spike also unlikely. Commodity price inflation could also lead to pass-through inflation. As discussed above, strong rupee appreciation since Mar 09 has neutralised part of the rise in international commodity prices. Moreover, recent corporate performances suggest modest sales growth. Therefore, lack of strong demand growth coupled with a far lower rise in domestic commodity prices compared with international prices are likely to limit the passthrough of higher input costs and thereby rise in inflation. Budget FY11 likely to lead to rise in inflation. While most drivers of inflation discussed above coupled with a favourable base effect beyond Mar 10 indicate that inflation would peak by Mar 10 at around 9.6%, the measures in Budget FY11 could raise it by a further 160bps. The budget measures: (i) reversal of customs duty concessions on crude oil and petroleum products, (ii) reversal of Re1/ltr cut in excise duty on petroleum and diesel and (iii) reversal of cut in median excise duty by 2%.
Inflation trajectory
WPI inflation to peak around 11%. Our time series estimates incorporating the impact of the budget on prices suggest that WPI inflation would peak around 11% by Apr 10 and start softening thereafter. Our model suggests that food inflation (both primary and manufacturing taken together) has peaked in Dec 09 and should come to single-digit levels by Sep 10. We expect WPI inflation to fall to around 5% by Dec 10. 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
24 21 18 15 12 9 6 3 0 -3 -6 May-05 Dec-04 Nov-07 Apr-08 Jul-09 Dec-09 Mar-06 Aug-06 Sep-08 Feb-09 Jan-07 Jun-07 Oct-05
AR Estimate
(Inflation, %)
May-10
WPI
CPI-IW
Food inflation
Balanced rise in liquidity supply and demand

Accommodative actual liquidity conditions. In spite of the arguments in the last section about a largely accommodative policy stance by the government and the RBI towards liquidity conditions, we recognise that the actual liquidity/interest rate condition can tighten, inter alia, through reduced supply and/or large increase in liquidity demand. In this section we argue that the domestic liquidity supply and demand conditions would also support an accommodative situation.
Mar-11
Oct-10
13
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Favourable domestic liquidity supply situation Deterioration in government balance impacted liquidity supply in FY09. From a macro perspective, domestic liquidity is conditioned largely by the domestic savings rate gross domestic savings as a percentage of GDP. 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 the governments budgetary balance. The primary balance of the government (the difference between the governments non-interest revenue expenditure and revenue receipt) turned from a surplus in FY08 to a deficit in FY09. Household savings and corporate savings, both as a percentage of GDP, remained largely unchanged at the FY08 level in FY09.
Fig 13 Domestic savings rate set to rebound in FY11
40 (Domestic savings rate, % of GDP) 35 30 25 20 15 10 5 0 -5 FY11e FY91 FY93 FY95 FY97 FY99 FY01 FY03 FY05 FY07 FY09
Household
Corporate
Government
Largely unchanged liquidity supply in FY10. In line with the widening primary deficit, we estimate government savings to deteriorate further and become nearly balanced in FY10. Against the backdrop of subdued corporate profits, our estimates indicate a slight fall in the corporate savings rate in FY10. Our model, however, suggests strong improvement in household savings in FY10, which counterbalanced the deterioration from government and corporate savings. Historically, a salary hike for government employees, especially payment of back wages, results in a jump in household savings for two consecutive years. We expect such an effect to play out in FY10 and FY11. Despite this, the drag from low government savings is expected to keep the overall domestic saving rate largely unchanged in FY10 at 32.5%. Domestic liquidity supply likely to improve in FY11. We expect the domestic savings rate to show significant improvement in FY11 on account of three factors. First, in line with the FY11 budget, we expect the primary deficit of the government to decline in FY11. Second, as a result of the payment of back wages to the nearly 20m public servants, we expect household savings to continue to expand in FY11. Third, estimates of our strategist Ratnesh Kumar suggest considerable improvement in corporate profitability in FY11 for non-financial companies. This would result in a modest recovery in corporate savings rate. On the whole, we expect the domestic 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 and investment. In India, households do not indulge in leveraged consumption. In fact, changes in financial assets net of financial liabilities of households
12 March 2010
as a proportion of disposable income has consistently been positive (see Fig 14). Even households gross leverage, ie, gross addition to financial liabilities 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
(Change in household's financial asset - liability, % of disposable income) 25 20 15 10 5 0 -5 -10 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY05 FY07 FY07 FY08 FY09
Net financial assets

Financial assets
Financial liabilities
Government administration borrows to meet current expenditure. With the exception of FY08, government administrations savings balance has been in negative territory since the late 80s. Interestingly, in this period, the Centre and states consolidated revenue deficit has been higher than the overall dis-savings by government administration (see Fig 15). This indicates that the governments dis-savings is because of meeting current rather than capital expenditure needs.
Fig 15 Current rather than capital spending makes govt a dis-savings unit
4 2 (% of GDP) 0 -2 -4 -6 -8 FY81 FY83 FY85 FY87 FY89 FY91 FY93 FY95 FY97 FY99 FY01 FY03
Revenue balance
Saving balance of government administration
Positive overall savings balance of the government. Apart from administration, the government has two other components departmental enterprises (such as Indian Railways, Post & Telegraph) and nondepartmental enterprises (public sector units). In contrast to dis-savings by government administration, departmental and non-departmental enterprises have consistently generated positive savings. Since the 70s, apart from the FY99-FY03 period, the combined savings of the governments departmental and non-departmental enterprises has been in excess of the dis-savings by government administration, making overall government savings positive (see Fig 16).
15
12 March 2010
Fig 16 Overall government savings remain positive

(Components of Govt. savings, % of GDP)
6 4 2 0 -2 -4 -6 -8
FY73
FY76
FY79
FY82
FY85
FY88
FY91
FY94
FY97
FY00
FY03
FY06
FY06
Administration Non-departmental enterprise

Departmental enterprise Overall government savings
Rising liquidity demand, but in tune with supply Demand for liquidity. As shown above, Indian households have net financial claims rather than liabilities on the rest of the economy (see Fig 14). In addition, households also save in physical assets such as investment in fixed assets (construction, machinery, equipment and change in stocks). Households physical savings as a share of overall savings declined between the early 70s and the mid-90s, but has risen thereafter and currently is just above 50% (see Fig 17). Households physical savings is also considered an investment. 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
(Physical savings in household savings, % share) 80 75 70 65 60 55 50 45 40 35 30 FY70 FY73 FY76 FY79 FY82 FY85 FY88 FY91 FY94 FY97 FY00 FY03 FY09
Households funding corporate and government investment. In contrast to households positive saving-investment balance, institutions (corporate and government sectors) saving-investment balance is in the negative (see Fig 18). That is, these institutions invest more than they save. The government and the corporate sector, therefore, are the main sources of liquidity demand. Indias overall savings is broadly in line with overall investments. That is, households savings largely funds the excess investment by the government and the corporate sector. While foreign savings bridge Indias overall saving-investment gap, it normally is small. Our estimates suggest a rise in household savings in FY11.
FY09
16
12 March 2010
Fig 18 Household savings the main source of investment funding in India

15 (Savings-investment gap, % of GDP) 12 9 6 3 0 -3 -6 -9 -12 FY90 FY92 FY94 FY96 FY98 FY00 FY02 FY04 FY06 FY08
Household sector
Corporate sector
Public sector
Foreign
Investment cycle key in deciding liquidity conditions in FY11. During FY11, we expect liquidity supply to rise, given the improvement in each component of savings household, government and corporate. Moreover, with the improvement in the governments fiscal position both at the Centre and at the states we expect a sizable fall in the consolidated revenue deficit. That is, liquidity demand from the governments current consumption 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 the opening section of this report we showed that we expect investment growth to accelerate from 4% in FY10 to 13% in FY11. Consequently, the investment 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 the continuation of large borrowing by the government is unlikely to lead to excess liquidity demand, resulting in either a spike in market interest rates or increased dependence on foreign savings to finance domestic investment. The key here is the improvement in the household savings rate. In fact, we estimate that Indias dependence on overall foreign savings as a percentage of GDP to remain largely unaltered during FY09-11 at around 2.4% of GDP. Domestic savings would continue to fund 95% of domestic investment even in FY11. India to remain an important investment destination in FY11. Even under a conservative assumption that in FY11 portfolio inflows would become half of the US$30bn inflow registered in FY10 and net FDI inflows during FY10 and FY11 would remain largely unchanged, our estimates suggest that Indias access to foreign savings would improve marginally in FY11 over FY10. In fact, with the improvement in growth quality, continuation of strong growth in India relative to the rest of the world and significant softening of inflation in 2HFY11, Indias attraction as a destination for foreign investment is likely to improve. This raises the possibility of much stronger capital inflows to the country, which would be able to support an even stronger capex cycle in India without putting strain on the liquidity situation in the country. These issues are discussed below.
17
12 March 2010
India to continue attracting global liquidity We expect a modest tightening in India during 2010. Our assessment of the global economy in the next 9-12 months indicates that global liquidity would remain accommodative amid asynchronous monetary measures by countries. We expect India to be in the tightening camp, although our estimate of policy rate tightening in 2010 at 75-100bps is lower than the prevailing consensus expectation of around 200bps. The increased interest rate differential coupled with a better growth outlook for India relative to almost all other economies raise the possibility of large scale capital flows into India. India received large capital inflows in 2010. Last decade, India saw large capital inflows owing to the global accommodative liquidity conditions, surge in investors risk appetite and sharp improvements in Indias macroeconomic fundamentals. Indias external capital account surplus surged from a quarterly average of US$3.6bn during FY01-05 to US$14.8bn during FY06-08. The reversal of global liquidity conditions, deleveraging and strong rise in investors risk aversion, however, changed conditions drastically Indias annual capital account surplus collapsed from 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 account surplus of US$24bn in 3QCY09 the highest in any quarter apart from FY08 (see Fig 19).
Fig 19 Capital flows have resumed strongly
(INR app/dep vs USD, %, QoQ, rev.scale)
-8 -4 0 4 8 12 36
18 9 0 -9
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Capital account balance

Rupee appreciation (-)/depreciation (+) vs USD
Apprehension about negative real interest rates. Given the high current inflation rates in India, the real interest rate in the country is currently in the negative (see Fig 20). This situation, many believe, may deter cross-border inflows in 2010, especially the carry trade kind. Such views have certain limitations. Our estimates suggest that inflation in India is likely to peak soon and start softening thereafter. Therefore, in a short while the real interest rate differential in India is likely to become attractive for foreign inflows.
Dec-09
Jun-03
Jun-04
Jun-05
Jun-06
Jun-07
Jun-08
Jun-09
(Capital a/c balance, US$ bn)
27
18
12 March 2010
Fig 20 Real interest rates in India currently negative

8 6 36.4
(Real interest rate, %)
4 2 0 -2
Australia
Canada
Japan
Brazil
India
UK
Latest real interest

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. More importantly, the interest rate differential alone cannot lead to capital flows, including carry trade. Among other factors, risk appetite plays a key role in this process. In Indias case, capital inflows accelerated between 2003 and 2008, a period when real interest rates were declining (see Fig 21). Given Indias strong economic fundamentals, stable political environment and expectations that Asian currencies would appreciate during 2010, India is likely to remain an attractive destination for foreign investments of various kinds.
Fig 21 Capital flows accelerated when real interest rates declined
12
(Real interest rate, capital inflow, India, %)
10 8 6 4 2 0 -2
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
US 2009
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. There are several reasons why current negative real interest rates will not deter capital inflows to India in 2010. Capital flows into India are generally dominated by equity flows (see Fig 22), which are influenced by the overall outlook for economic fundamentals rather than real interest rates alone.
19
12 March 2010
Fig 22 Equity flows generally dominate overall capital inflows to India

8 7 6 5 4 3 2 1 0 -1 -2 -3 9.9 36 32 28 24 20 16 12 8 4 0 -4 -8
1QFY95
2QFY96
3QFY97
4QFY98
1QFY00
2QFY01
3QFY02
4QFY03
1QFY05
2QFY06
3QFY07
4QFY08
Debt equity ratio

Source: RBI and Anand Rathi Research.
Capital account balance
FDI inflows to maintain momentum. Given the long-term nature of FDI, such investment inflows to India remained relatively resilient even during the worst phase of the recent global crisis (see Fig 23). In the past 12 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 the strong fundamentals, India is likely to continue attracting large FDI inflows. At the same time, Indian companies global ambitions would result in significant outflow of FDI from India. We also expect net FDI (gross inflow net of Indian direct investment abroad) to maintain strong momentum. On average, net FDI inflow to India in the past 12 quarters has been US$4.3bn. We expect the average net FDI inflow in the next two years to be higher than the recent trend and with an upward drift.
Fig 23 FDI inflows likely to remain strong
16 14 12
(FDI, US$ billion)
10 8 6 4 2 0 -2
1QFY01
4QFY01
3QFY02
2QFY03
1QFY04
4QFY04
3QFY05
2QFY06
1QFY07
4QFY07
3QFY08
2QFY09
1QFY10 1QFY10
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 since such flows were allowed in the early 1990s. For the first time ever, this trend reversed in FY09. Interestingly, while monthly FII (foreign institutional investor) flows, the predominant part of portfolio flows, remained negative in 9 of 12 months in FY09, during FY10 so far (11 months) the flows have been positive every month. Factors likely to shape future portfolio flows. We expect strong portfolio flows into India during the next two years because of (a) the Indian economys strong fundamentals, especially domestic demands
(Net capital inflow, US$ billion)
(Debt/equity ratio)
12 March 2010
strength and resilience and renewed focus on infrastructure investment, (b) likely continuation of accommodative global liquidity conditions relative to historic standards and (c) current relatively low portfolio allocation to India by 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) increase in international investors risk aversion, especially towards high-risk, highreturn asset classes. On balance, India is likely to receive strong portfolio inflows. Our assessment suggests that while the worst of the global crisis is behind us, the recovery in the developed countries even over the next two years could be anaemic. This would keep global liquidity largely accommodative. Meanwhile, Indias economic performance is likely to be much stronger than not only the global average, but also one of the best among emerging market economies. These factors would make India a net recipient of global portfolio flows, although fluctuations in global liquidity and investor sentiment would keep volatility of such flows high. Yet, as indicated before, our conservative estimates incorporate a sharp decline in portfolio flows in FY11 as compared to the same in FY10. Debt flow key swing factor. While equity capital flows have been the mainstay of Indias external capital account, debt flows have been the swing factor in both boosting the capital account surplus during FY07 and FY08 and deflating it in FY09. In particular, ECBs (external commercial borrowings) by Indian companies declined sharply and short-term loans and banking capital excluding NRI (non-resident India) deposits turned negative in FY09. The situation, however, has changed once again in 2QFY10 with all these flows turning positive. Our assessment suggests that 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. As indicated before, the current negative interest rate in India is perceived to be a stumbling block for foreign debt inflows in FY11. It is, however, important to note that debt capital inflows into India are usually long-term in nature, which is influenced by the long rather than the short-term real interest rate outlook. Moreover, irrespective of the current real interest rate environment in India, demand for foreign borrowing is likely to remain high in India as long as the cost of such borrowing is perceived to be lower than 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 1QFY10 such flows have once again turned positive in 2QFY10. We expect ECB flows to remain strong in the next two years for the following reasons. For Indian corporates that can access the ECB market, such borrowings offer substantially lower interest rates than domestic borrowings. For international lenders, the interest rates offered by Indian ECB issuers would look attractive on a risk adjusted basis, given the likelihood of interest rates remaining low in developed countries. At the height of the financial crisis, both approvals and actual flows of ECBs declined sharply, with the latter declining much more than the former, reducing the conversion ratio (see Figs 24 and 25). Typically, a
12 March 2010
depressed conversion (disbursement to approval) ratio in a period results in strong disbursement in the next period. India has an aggressive infrastructure investment plan. To fund such projects, the government and the RBI are likely to introduce further measures to facilitate ECBs by infrastructure-related companies.
Fig 24 ECB approvals bounced back since Mar 09
4.0
(ECB approvals, US$ billion, 3MMA)
3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
May-06
May-07
May-08
May-09
Feb-06
Feb-07
Feb-08
Aug-06
Aug-07
Aug-08
Feb-09
Aug-09
30 24 18 12 6 0
Nov-06
Nov-07
Nov-08
Fig 25 ECB conversion ratio likely to go up

1.5
(ECB disbursement to approval ratio)
1.3 1.1 0.9 0.7 0.5
Short-term loans also likely to bounce back. The international deleveraging cycle and extreme risk aversion contributed to a strong outflow of trade credit during Jul 08-Mar 09 from India. Incidentally, over 90% of short-term loans (by original maturity) comprise import credit. Fall in import volume over 2HFY09-1HFY10 also played an important role in the slide in gross short-term inflows. Indias imports moved into positive territory in Dec 09 (see Fig 26). The risk premium on emerging country borrowers, too, has reverted to normal. Accordingly, net short-term loan flow in 2QFY10 turned positive after remaining negative for the three previous quarters. We expect sizable growth in net trade credit flows in the next two years.
FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 1HFY10
Conversion ECB
(ECB disbursement, US$ billion)
Nov-09
22
12 March 2010
Fig 26 With import recovery, short-term debt likely to rebound

6 100 75 50 25 0 -25 -50
(Short-term debt, US$ billion)
4 2 0 -2 -4 -6
1QFY95
3QFY96
1QFY98
3QFY99
1QFY01
3QFY02
1QFY04
3QFY05
1QFY07
3QFY08
Short-term debt
Import growth
Buoyant cross-border flows to make rupee stronger Foreign inflows likely to surprise on the upside. The foregoing discussions suggest that even with a marked increase in investment growth, continued large government borrowing and modest dependence on foreign savings, liquidity demand in India would remain in line with liquidity supply. Our assumptions on foreign inflows to India during FY11 shown above remain largely conservative. In fact, there are possibilities that foreign inflows in FY11 could exceed the normal domestic absorptive capacity, leading both to forex market interventions by the RBI and appreciation of the rupee. RBIs counter-cyclical forex intervention. Other things remaining unchanged, resurgence in the capital account surplus in excess of current account deficit during FY10 and the likely continuance of the same in FY11 suggests the rupee should, on balance, continue to appreciate. This, however, depends to a large extent on the RBIs intervention strategy in the foreign-exchange market. Past intervention patterns by the RBI (see Fig 27) suggest three broad trends: The RBIs interventions in the forex market are generally countercyclical, ie, the RBI is a net forex buyer when the rupee appreciates against the US dollar and vice versa. This is in keeping with its exchange rate policy stance that its aim is to manage volatility in the forex market rather than manage the value of the rupee. The RBIs interventions in the forex market, however, have been asymmetric. The RBI is generally a persistent net forex buyer when the rupee appreciates, but its net forex sales have been more sporadic during periods when the rupee has depreciated against the US dollar. The RBIs interventions might have reduced the volatility of the rupees external value. Yet, during periods of strong forex inflows, the rupee has appreciated (despite the RBIs net purchase of forex) and the rupee has depreciated during periods of forex outflow (despite the RBIs sale of forex).
1QFY10
(Import growth, %)
23
12 March 2010
Fig 27 Counter-cyclical and asymmetric forex interventions by the RBI

-5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 15 12 9 6 3 0 -3 -6 -9 -12 -15 -18 -21
(INR app/dep vs USD, %, rev.scale)
Dec-02
Nov-05
May-02
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 Indias capital account surplus (Fig 28). We also observe a positive relation between Indias capital account surplus and rupee appreciation (see Fig 19). The scatter diagram on capital account balance and quarterly rupee appreciation/depreciation (see Fig 29) also validates this point. This is likely to be the single largest factor driving rupee appreciation in the next two years.
Fig 28 Strong turnaround on capital account expected
(US$bn) FY07 FY08 FY09 FY10e FY11e FY12e
Foreign Investment FDI In India Abroad Portfolio In India Abroad Loans External borrowing Short-term borrowing Others Banking capital NRI deposits Others Rupee debt servicing IMF loans Other foreign capital Capital account balance
14.8 7.7 22.7 -15.0 7.1 7.0 0.1 24.5 16.1 6.6 1.8 1.9 4.3 -2.4 -0.2 0.0 4.2 45.2
43.3 15.9 34.7 -18.8 27.4 27.3 0.2 40.7 22.6 15.9 2.1 11.8 0.2 11.6 -0.1 0.0 11.0 106.6
3.5 17.5 35.0 -17.5 -14.0 -13.9 -0.2 8.7 7.9 -1.9 2.6 -3.2 4.3 -7.5 -0.1 0.0 -1.5 7.2
May-09
Sep-04
Aug-07
54.9 25.0 44.0 -19.0 29.9 30.0 -0.1 9.5 5.5 2.5 1.5 -3.5 5.0 -8.5 -0.1 0.0 2.0 62.8
Dec-09
Jul-03
Jun-06
Jan-07
Mar-08
Feb-04
Oct-08
Apr-05
(RBI's net forex buy, US$ billion)
41.2 26.5 49.3 -22.8 14.8 15.0 -0.3 22.0 12.5 7.5 2.0 5.0 3.5 1.5 0.0 0.0 3.5 71.7
47.2 28.2 56.7 -28.5 19.0 19.5 -0.5 28.5 17.0 9.0 2.5 7.0 4.5 2.5 0.0 0.0 4.0 86.7
24
12 March 2010
Fig 29 Larger capital account surplus leads to stronger rupee appreciation

12 10
(INR app/dep vs USD, %, QoQ)
8 6 4 2 0 -2 -4 -6 -8 -10 -5 0 5 10 15 20 25 (Quarterly capital a/c balance, US$ bn) 30 35
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 a deficit on the external goods trade (merchandise) account. Despite India generally maintaining a capital account surplus, the trade deficit has weighed heavy on the performance of the rupee. Since the 50s, the currency persistently got devalued (during the fixed exchange rate regime under the Bretton Woods system) and depreciated (after the Bretton Woods system collapsed) against the US dollar except during FY77-80 and more recently since FY03. Indias merchandise deficit zoomed from US$9bn in FY03 to US$108bn in FY09. Yet, in most years since FY03, the rupee actually appreciated against the US dollar. This shows the greater impact of the capital account over current account flows in this period. Commodity prices led to widening of the trade deficit. An important factor behind the widening trade deficit since FY03 has been the sharp rise in crude oil prices. Indias oil imports increased at a compound annual growth rate (CAGR) of 35% between FY04 and FY09. Incidentally, among the larger economies of the world, India is the most vulnerable to an oil price spike as the country has the largest share of oil imports in total imports. This share jumped from 15% in FY99 to 31% by FY09. Part of this jump reflects Indias increased refining capacity, whereby the country imports crude oil and exports petroleum products. The more important factors are, however, rising oil prices, increased oil intensity of the economy and stagnation of domestic crude oil production. Largely unchanged trade deficit till FY12. Despite a strong pullback from crisis lows, international oil prices are currently half the high reached in 2008. Although the oil price outlook is uncertain, oil prices are unlikely to reach the previous high in the foreseeable future. Moreover, Indias new-found natural gas resources are replacing use of petroleum products like naphtha and fuel oil, especially in fertilizer production. This, on the one hand, would reduce fertilizer imports, which stood at US$12bn in FY09. On the other, India would become a larger exporter of petroleum products, which are being replaced by natural gas. Even after incorporating 11% and 16% growth in imports during FY11 and FY12, respectively, our estimates suggest that Indias trade deficit during FY10-FY12 would remain largely unchanged at the FY09 level (see Fig 30). Beyond FY12, factors such as increased natural gas output, increased energy efficiency and technology adoption increasing greater substitution of petroleum products by natural gas could 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 Exports Imports Invisibles Services Travel Transportation Insurance Govt. not included elsewhere Software Other miscellaneous services Transfers Official Private (workers' remittance) Income Current Account Current Account (as % of GDP)
-61.8 128.9 190.7 52.2 29.5 2.4 -0.1 0.6 -0.2 29.0 -2.3 30.1 0.3 29.8 -7.3 -9.6 -1.0
-91.5 166.2 257.6 75.7 38.9 2.1 -1.5 0.6 0.0 36.9 0.8 41.9 0.2 41.7 -5.1 -15.7 -1.3
-118.7 189.0 307.7 89.9 49.6 1.5 -1.5 0.3 -0.4 43.5 6.3 44.8 0.2 44.6 -4.5 -28.7 -2.4
-115.1 166.3 281.4 84.7 37.2 1.6 -1.0 0.4 -0.5 39.1 -2.5 52.1 0.1 52.0 -4.6 -30.5 -2.4
-126.9 189.3 316.2 93.3 43.5 1.9 -1.5 0.6 -0.6 44.6 -1.5 54.9 0.3 54.6 -5.0 -33.6 -2.1
-126.0 237.3 363.3 108.3 53.2 2.2 -1.8 0.7 -0.6 51.8 1.0 60.3 0.2 60.1 -5.2 -17.8 -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 to US$119bn in FY09. During the same period, Indias current account turned from surplus of US$14bn to a deficit of US$29bn. It is clear that but for the widening of the trade deficit, Indias current account surplus would have continued. With the trade deficit remaining at the FY09 level in the next three years, Indias current account balance is likely to improve significantly and the country can turn current account surplus again beyond FY12. 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 the external value of the rupee is not independent of the trends in the global foreign exchange market. In fact, the movement of the rupee-dollar exchange rate since 2003 has been largely synchronous with the dollar index (see Fig 31), which is the weighted index of the US dollar against six major currencies. In this sense, the rupee outlook against the dollar is influenced by how the US dollar moves against the other major currencies.
Fig 31 Rupee dollar movements generally synchronous with the dollar index
52 50 48 46 105 100 95 90 85 80 75 70
44 42 40 38
Feb-03
Feb-04
Feb-05
Feb-06
Feb-07
Feb-08
Feb-09
Rupee per USD

Source: Bloomberg and Anand Rathi Research.
Dollar Index
Feb-10
(Dollar index, major currencies)
(INR per US$)
26
12 March 2010
Rupee can appreciate even with a rising dollar index. Yet, the rupee is neither explicitly nor implicitly pegged to the US dollar or any other currency. In the past decade, the rupee has shown considerable two-way movement against all major currencies including the US dollar. Therefore, even if the US dollar strengthens against other major currencies in the foreseeable 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 US dollar would appreciate against select industrialised countries currencies (which may move the dollar index up), while the rupee continues to appreciate against the US dollar. The key reasons: Relatively modest appreciation of the rupee since Mar 09. During the financial crisis, the US dollar had appreciated against most currencies, but between Mar 09 and Nov 09 it depreciated. While the rupee depreciated strongly against the US dollar during the crisis, the bounce back during Mar-Nov 09 has been modest relative to most other 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 to appreciate against the US dollar in FY11, we also expect volatility in the 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 so has the rupee-dollar rate (see Fig 33).
Fig 32 Modest appreciation of the rupee against the US dollar
(Currencies app (-ve)/dep (+ve) vs USD, %) 60 50 40 30 20 10 0 -10 -20 -30 Euro area Philippines Indonesia Australia Japan China Brazil India Russia Korea
Mar08-Feb09
Mar09-Nov09
Dec09-Feb10
27
12 March 2010
Fig 33 Rupee movements against the US dollar

54 51
(INR per US$)
48 45 42 39 36 33 30
FY94
FY96
FY98
FY00
FY02
FY04
FY06
FY08
900 800 700 600 500 400 300 200 100
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 risk appetite (see Fig 34), unwinding of dollar carry trade and country-specific disappointments, especially in Europe. These factors led to a reallocation of assets away from high-risk, high-return assets to low-risk, low-return assets. As expectations get adjusted to sub-par global recovery, the nearzero policy rates and strong growth in emerging economies like China and India, risk appetite is likely to return. This could to lead to the appreciation of various Asian emerging market currencies vis--vis dollar. In Indias case, current high inflation and expectations it would remain high have led to rupee depreciation against the US dollar in the recent past. We, however, expect inflation to start softening in 2HCY10, which is likely to lead to rupee appreciation.
Fig 34 After a sharp fall, risk aversion bottoming out
4.5 4.0 3.5 (TED spread, bps) 3.0 2.5 2.0 1.5 1.0 0.5 0.0 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
TED spread
EMBI
(EMBI spread, bps)
FY10 YTD
28
12 March 2010
Macro Snippets
29
12 March 2010
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 large revisions 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% in 3QFY10, after strong growth of 7.9% in 2QFY10, mainly owing to a negative contribution from agriculture. Surprisingly, social and personal services, too, declined (-2.2% in 3QFY10). Industrial growth rebounds, but services declines. Industry grew 11.6% in 3QFY10, way ahead of the 7.5% average recorded in the past decade. Manufacturing grew a whopping 14.3%, the highest growth in more 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 is closer to reality, in our view, than the previous quarters rate, which was inflated by government consumption. In 3QFY10, government consumption 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 tepid 5.1% in 3QFY10. Investment growth continues to be sluggish with a meagre 2.4% average growth in the past seven quarters. The investment cycle, 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 Survey FY10 estimates FY11 GDP growth at 8.2%, which seems quite optimistic, in our view. The strong contributions to FY10 growth coming from government consumption and falling real imports would fizzle out in FY11. Rise in private consumption and investment are unlikely to fully compensate for this, dragging FY11 growth below FY10s.
Fig 35 FY11 growth is likely to be lower than in FY10
AR Estimate (YoY change, %) FY07 FY08 FY09 3QFY10 FY10 FY11 FY12
GDP Agriculture Industry Mining & quarrying Manufacturing Electricity, gas & water supply Construction Services Trade, hotel, transport & comm. Finance, insurance, real estate Social & personal services Private final consumption Government consumption Investment
9.7 3.7 12.7 8.7 14.9 10.0 10.6 10.2 11.7 14.5 2.6 8.2 3.8 16.1
9.2 4.7 9.5 3.9 10.3 8.5 10.0 10.5 10.7 13.2 6.7 9.8 9.7 14.8
6.7 1.6 3.9 1.6 3.2 3.9 5.9 9.8 7.6 10.1 13.9 6.8 16.7 -1.7
6.0 -2.8 11.6 9.6 14.3 4.9 8.7 6.3 10.0 7.8 -2.2 3.4 -10.3 5.1
7.0 -0.5 8.3 8.7 9.3 7.0 6.5 8.5 8.0 9.0 8.6 4.4 8.5 4.3
6.5 3.6 7.6 7.5 7.4 6.5 8.5 6.7 6.9 7.1 6.0 6.3 3.8 12.8
9.0 3.4 10.2 8.0 9.9 8.0 12.0 9.8 9.6 11.8 7.5 6.5 3.5 16.2
Source: Government of India and Anand Rathi Research.
30
12 March 2010
IIP: Rebound with a bang

The strong rebound in industrial production took the market by surprise, with IIP growing 10.6% during Jun-Dec 09. Strong domestic demand and improving conditions for exports coupled with a favourable base effect boosted industrial production. We revise 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% in 3QFY10, following 9.1% growth in 2QFY10. Strong domestic demand coupled with improving conditions for exports provided a boost to industrial growth. During Apr-Dec 09, IIP grew 8.7% compared with 3.6% during the same previous period. Manufacturing leading the rebound. The manufacturing sector made a remarkable comeback in 2QFY10 (9.2%) and continued the strong growth momentum in 3QFY10 (14.3%). Recovery spread across broad industry groups. A redeeming feature of industrial growth in FY10 so far has been that it has been spread across broad industry groups. Intermediate goods recorded a sharp jump in growth (18.7%). Consumer durables and capital goods also clocked spectacular growth of 33.8% and 21.7%, respectively, 3QFY10. Base effect coloured the FY10 performance. Despite the fact that the strength of industrial growth in FY10 has surprised us and the market, the low base of FY09 is also playing a crucial role in spectacular IIP growth numbers in recent months. Therefore, any linear extrapolation of the recent IIP growth numbers into FY11 is likely to create disappointments. Expect industrial growth to decelerate in FY11. We expect industrial growth to be modest in FY11 before it improves in FY12. Three key factors are likely to keep industrial growth modest in FY11. These are: (1) weak global economic growth coupled with large industrial excess capacity in most parts of the world, (2) embryonic revival in foreign trade and (3) an unfavourable base effect. We revise the FY11 industrial growth from 5.5% to 6.1% and introduce the FY12 growth at 7.2%. Upside from electricity and mining. The electricity and mining sectors are likely to grow strongly in FY11 and FY12. We expect electricity to grow by 6.4% in FY11 and by 8% in FY12. For mining, the marked increase in oil refining capacity and start of gas extraction from the KG Basin could result in 8.4% and 7.3% growth in FY11 and FY12, respectively.
Fig 36 The current strong growth unlikely to continue in FY11
AR Estimate (YoY change, %) FY08 FY09 Apr-Dec'09 Dec-09 FY10 FY11 FY12
Index of Ind. Production Mining & quarrying Manufacturing Electricity Basic goods Capital goods Intermediate goods Consumer goods
8.5 5.1 9.0 6.3 7.0 18.0 8.9 6.1
2.7 2.6 2.7 2.8 2.6 7.3 -1.9 4.7
8.7 8.5 9.0 5.8 6.2 11.1 12.5 7.1
16.8 9.5 18.5 5.4 7.5 38.8 21.7 12.0
9.5 8.3 10.0 5.4 6.2 16.0 12.2 7.9
6.1 8.4 5.9 6.4 6.1 3.3 5.2 4.5
7.2 7.3 7.2 8.0 7.7 4.2 6.5 5.8
31
12 March 2010
WPI: To worsen before softening

The sharp acceleration of WPI inflation and CPI inflation in the teens has created a scare about a vicious cycle of price increases. We do expect WPI inflation to cross 11% by Apr 10, but soften significantly in 2HFY11. Inflation heading north. After remaining in deflation zone during JunAug 09, WPI inflation has surged since then, reaching 7.31% in Dec 09 and 8.56% in Jan 10. The inflation rate is likely to move into double digits by Mar 10, well ahead of the RBIs forecast of 8.5%. High food inflation. Overall food inflation both primary food articles and manufactured food products has been in double digits since the beginning of the current fiscal (19.4% in Jan10). Moreover, owing to the worst monsoon since 1973, kharif foodgrain production declined by 21.07m 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 in diesel and petrol prices by Rs2.55/litre and Rs2.71/litre, respectively, would directly push WPI (wholesale price index) inflation by over 30 basis points (bps). The indirect impact would also be roughly of the same magnitude. Therefore, we expect inflation to peak at around 11% by Apr 10 before it starts softening thereafter and reach 6% by Nov 10. Inflation outlook. In line with our earlier estimates, food inflation seems to have already peaked and there has been a noticeable softening in food prices, 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 FY11 inflation estimate to 6.9% from 4.7% and introduce FY12 WPI inflation forecasts at 4.5%. Interest rate outlook. As inflation has picked up sharply, it is likely to lead to a 50bps hike in the repo and reverse-repo rates in the Apr 10 Monetary Policy. Thereafter, though the RBI may further tighten the policy rate in the course of FY11, we expect the tightening measures to be modest and an accommodative monetary policy stance is likely to continue through 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 Food Non-food Mineral oils Food product Textiles Chemicals Non-metallic minerals Basic metals Machinery Transport equipment CPI-Industrial workers
4.7 5.5 12.7 1.0 4.3 -1.1 5.6 8.9 6.9 7.1 2.7 6.2
8.4 8.0 11.2 11.1 10.0 6.0 7.2 3.8 14.4 4.7 5.2 9.1
2.4 13.9 1.7 -8.3 16.3 4.8 3.7 2.8 -11.7 -1.2 0.1 11.9
8.6 17.4 10.6 10.3 22.6 9.0 8.0 -1.7 -2.6 0.9 0.2 16.2
3.6 14.6 3.7 -5.0 16.8 5.7 4.5 2.3 -9.7 -0.7 0.2 12.6
6.9 8.5 8.8 10.0 9.0 6.0 3.8 1.8 8.6 4.4 2.7 8.8
4.5 3.9 3.7 7.1 3.2 0.9 3.6 6.1 8.4 4.6 3.1 3.6
32
12 March 2010
Govt. finance: On the mend

The FY11 budget starts the process of fiscal consolidation, which is likely to gather momentum in FY12. Even after factoring in certain slippages, we expect government borrowing to remain close to the budget target in FY11. Taming the fiscal deficit. The FY11 Budget projected that the fiscal deficit would shrink to 5.5% of GDP from 6.8% in FY10. This marks a significant 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 GDP growth from rising government expenditure and falling real imports in FY10 to rising private consumption and investment in FY11 is likely to improve tax collection. In particular, we expect considerable upside from direct taxes. Furthermore, successful implementation of the direct tax code and goods and services tax (GST) in the FY12 budget is expected to lead to a marked increase in the governments total tax receipt. Non-tax revenue and divestment to support. The 3G spectrum auction has been rescheduled to FY11, which is expected to add Rs350bn to the government kitty. While the divestment proceeds target of Rs400bn in FY11 budget looks ambitious, there are other avenues, which can more than make up for any likely shortfall on this account. Absence of one-offs to contain spending. There is considerable scepticism about the budget estimate of a modest 8.5% jump in overall expenditure and, within that, a mere 0.3% rise in non-plan revenue expenditure. We, however, feel that it is a reflection the absence of large one-off expenditures undertaken in FY10 on account of heads such as payment of back wages to public servants, farm loan waiver, stimulusrelated spending and drought-related spending. Market borrowing to be lower. We estimate that considerable mobilization under the small savings schemes is likely to contain the market borrowing requirement in FY11 close to the budget target. Heading toward fiscal consolidation. The Finance Minister has stated that the fiscal deficit would fall to 4.8% in FY12 and 4.1% in FY13. We estimate that the fiscal deficit target for FY11 is very much achievable. Moreover, our estimates suggest that the fiscal deficit could shrink faster than government estimates in FY12.
Fig 38 FY11 budget sets off fiscal consolidation process
AR Estimate (Rsbn) FY08 FY09 Apr-Jan FY10 Jan10 FY10 FY11 FY12
Tax revenue Personal income tax Corporate income tax Customs duty Excise duty Non-tax revenue Revenue expenditure Capital expenditure Net market borrowing Fiscal deficit
3,512 751 1,443 863 1,176 832 5,146 688 1,104 1,426
4,395 1,026 1,929 1,041 1,234 1,023 5,944 1,182 1,318 1,269
4,660 1,226 2,220 1,080 1,084 962 8,034 975 2,620 3,265
2,139 597 1,115 452 455 706 4,913 456 3,182 2,451
282 100 70 74 86 118 818 62 273 473
4,510 1,163 2,398 988 964 1,348 9,957 1,154 4,285 4,325
4,848 1,303 2,734 1,028 1,012 1,537 10,853 1,292 3,710 4,032
33
12 March 2010
Foreign trade: On the recovery path

After 13 months of decline, Indias export growth turned positive in Nov 09; positive import growth followed in Dec09. Imports are now rising 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 exports grew 11.5% in Jan 10 the third straight month of growth. Imports grew much 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 been around US$6.5bn a month. In Jan 10, however, oil imports were at US$7.1bn, the highest in the past 15 months, reflecting the impact of the rebound in international oil prices. Trade deficit to widen but moderately. The trade deficit increased sharply 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 14 months and for FY10 ytd (Apr-Jan), it stood at US$86.6bn. We revise our FY10 and FY11 trade deficit targets upwards to US$105bn (from US$85bn) and US$113bn (from US$95bn), respectively, and introduce the FY12 target at US$113bn. Non-oil imports recovered strongly. After turning positive in Dec 09, non-oil import growth maintained its positive trend, with 28.8% growth in Jan 10 the strongest in the previous 16 months. Stabilization in this category indicates significant improvement in industrial activity and domestic demand. Exports set to grow faster than imports in FY11. Larger contraction of exports as compared to imports in FY10 coupled with containment of crude import growth in FY11 due to likely decline in volume is expected to lead to stronger growth in exports than imports in FY11. Outlook. International oil prices play a key role in determining the size of Indias trade deficit. While there are uncertainties about the outlook on international oil prices, it is unlikely that oil prices would reach the previous high in the near future. Moreover, Indias new found natural gas resources are replacing use of petroleum products like naphtha and fuel oil, especially in fertilizer production. This would reduce fertilizer imports. On the exports front, a likely recovery in global demand would support Indias exports, going forward. A strengthening rupee, however, could hamper Indias export competitiveness for low-end price sensitive exports.
Fig 39 Broadly range bound trade deficit
AR Estimate (US$bn) FY08 FY09 Apr-Jan FY10 Jan10 FY10 FY11 FY12
Imports Oil imports Non-oil imports Exports Trade balance
250 80 170 163 -87
291 91 199 183 -108
219 65 154 132 -86
25 7 18 14 -10
268 78 190 163 -105
298 80 219 186 -113
346 84 262 233 -113
34
12 March 2010
BoP: Back to normal

Higher-than-expected current account deficit and a strong rebound in debt inflows in 2QFY10 came as a surprise. We expect the current account 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 services trade account shrunk to a 10-quarter low. This, in turn, widened the overall current account deficit to US$12.6bn, well above consensus expectation (US$5.6bn). Software exports continued to decline qoq for the sixth consecutive quarter. Moreover, business services, which generally maintains a small positive balance, has turned into a huge deficit. Debt flows turn positive. For the first time since the onset of the global financial crisis, all major debt inflows ECB, trade credit, NRI deposit, banking capital (excluding NRI deposits) turned positive in 2QFY10. The marked difference in the interest rate on debt funding in India relative to international market rates seems to be a key driver in this process. Strong equity flows continue. Net FDI inflows in 2QFY10 remained largely unchanged at the 1QFY10 level although both the gross inflow and outflow increased significantly. Portfolio inflows reached the highest level in seven quarters. Higher current account deficit in FY11. Indias current account deficit in FY11 is likely to remain high at 2.1% of the GDP before it shrinks significantly to 1% in FY12. Surplus capital account to support our strong rupee call. With debt inflows gathering momentum, the capital account surplus is likely to substantially exceed earlier expectations. This is likely to more than compensate for the larger-than-expected widening of the current account deficit, supporting rupee appreciation. We maintain our call of the rupee at 42 per USD by Mar 11 and introduce rupee forecast at 40 per USD by Mar 12.
Fig 40 Current account deficit to soften after FY11
AR Estimate (US$bn) FY07 FY08 FY09 2QFY10 FY10 FY11 FY12
Current account balance Trade balance Invisible balance Services Software Private transfer Capital account balance FDI, net Portfolio investment Commercial borrowing Short-term loan Banking capital NRI deposit Other capital BoP balance, net of error
-10 -62 52 29 29 30 45 8 7 16 7 2 4 4 37
-16 -91 76 39 37 42 107 16 27 23 16 12 0 11 92
-29 -119 90 50 43 45 7 17 -14 8 -2 -3 4 -2 -20
-13 -32 20 6 10 14 24 7 10 1 1 4 1 0 9
-30 -115 85 37 39 52 63 25 30 6 3 -4 5 2 32
-34 -127 93 43 45 55 72 26 15 13 8 5 4 4 38
-18 -126 108 53 52 60 87 28 19 17 9 7 5 4 69
Source: Reserve Bank of India and Anand Rathi Research.
35
12 March 2010
36
12 March 2010
Macro Snapshot
37
12 March 2010
Macro Snapshot
AR Estimate (Unit) FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12
GDP GDP, current prices GDP, current prices Real growth - GDP Real growth - Agriculture Real growth - Industry Real growth - Services Real growth - private consumption Real growth - investment Real growth - government consumption Per capita GDP, current prices Industry and infrastructure Industrial production Manufacturing Electricity Steel production Cement production Refinery throughput Passenger car sales Saving-investment Gross dom. saving Household saving Corporate saving Foreign savings Domestic investment Prices Wholesale price inflation Consumer prices inflation Government finance Tax revenue Personal income tax Corporate income tax Customs duty Excise duty Non-tax revenue Revenue expenditure Capital expenditure Net market borrowing Fiscal deficit
Source: GoI, Anand Rathi Research
(INR bn.) (US$ bn.) (%) (%) (%) (%) (%) (%) (%) (US$) (growth, %) (growth, %) (growth, %) (growth, %) (growth, %) (growth, %) (growth, %) (% of GDP) (% of GDP) (% of GDP) (% of GDP) (% of GDP) (%) (%) (% of GDP) (growth, %) (growth, %) (growth, %) (growth, %) (growth, %) (% of GDP) (% of GDP) (US$ bn.) (% of GDP)
32,392 721 7.5 0.0 10.3 9.1 5.2 23.5 3.6 662 8.4 9.1 5.2 12.2 8.6 4.6 19.7 32.2 23.3 6.6 0.3 32.5 6.5 3.8 9.4 19.0 30.1 18.5 9.2 5.7 11.9 3.5 10.2 3.9
37,065 837 9.5 5.2 9.3 11.1 9.0 15.3 8.3 757 8.2 9.1 5.2 7.0 11.2 2.1 7.3 33.1 23.2 7.5 1.2 34.3 4.4 4.4 9.9 13.6 22.5 12.9 12.2 -5.4 11.9 1.8 21.5 4.0
42,840 946 9.7 3.7 12.7 10.2 8.2 16.1 3.8 843 11.5 12.5 7.3 9.4 9.1 12.6 19.7 34.4 22.9 8.0 1.0 36.3 5.4 6.7 11.1 34.1 42.5 32.7 5.7 8.3 12.0 1.6 24.4 3.3
49,479 1,230 9.2 4.7 9.5 10.5 9.8 14.8 9.7 1,080 8.5 9.0 6.3 6.0 8.8 6.5 12.0 36.4 22.6 8.7 1.3 38.1 4.7 6.2 12.0 36.7 33.7 20.6 5.1 23.0 12.0 2.4 32.7 2.6
55,744 1,214 6.7 1.6 3.9 9.8 6.8 -1.7 16.7 1,052 2.7 2.7 2.8 1.2 7.8 3.0 5.9 32.5 22.6 8.4 2.4 35.6 8.4 9.1 10.9 3.3 10.6 -4.1 -12.1 -5.3 14.2 1.6 50.9 6.0
61,621 1,297 7.0 -0.5 8.3 8.5 4.4 4.3 8.5 1,109 9.5 10.0 5.4 6.4 11.0 16.0 27.0 32.5 24.1 7.9 2.4 35.1 3.6 12.6 10.3 17.9 19.5 -15.4 -6.1 15.7 14.7 1.9 83.9 6.7
70,668 1,625 6.5 3.6 7.6 6.7 6.3 12.8 3.8 1,370 6.1 5.9 6.4 4.0 9.1 2.0 14.0 34.3 25.2 8.1 2.1 36.7 6.9 8.8 11.1 10.0 25.0 35.0 30.0 19.2 13.9 2.1 82.6 5.6
80,200 1,956 9.0 3.4 10.2 9.8 6.5 16.2 3.5 1,627 7.2 7.2 8.0 13.1 12.6 4.2 18.0 37.9 26.3 8.5 0.9 39.2 4.5 3.6 12.4 22.0 30.0 25.0 25.0 11.4 13.2 2.1 73.8 4.3
38
12 March 2010
Macro Snapshot
AR Estimate (Unit) FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12
Money and finance Bank deposits Bank deposits Bank credit Credit-deposit ratio Bank investments Money supply (M3) Money supply (M3) Equity market capitalisation Key rates Repo rate Reverse repo rate Prime lending rate Weighted average call rate 364-day T-bill yield 10-year G-sec yield Foreign trade Goods exports Goods exports Goods imports Goods imports Oil imports Trade balance Trade balance External sector Current account Trade balance Invisible balance Invisible balance Software Private transfer Net FDI Portfolio investment Commercial borrowing Short-term loans Capital account balance Overall balance Foreign Exchange Rupee per US dollar - average Rupee per US dollar - year end Rupee per euro Rupee per 100 yen Foreign exchange assets Net forex purchase by RBI
Source: GoI, RBI, Anand Rathi Research
(% of GDP) (growth, %) (growth, %) (ratio, %) (growth, %) (growth, %) (% of GDP) (US$ bn.) (%) (%) (%) (%) (%) (%) (US$ bn.) (growth, %) (US$ bn.) (growth, %) (US$ bn.) (US$ bn.) (% of GDP) (% of GDP) (% of GDP) (% of GDP) (US$ bn.) (US$ bn.) (US$ bn.) (US$ bn.) (US$ bn.) (US$ bn.) (US$ bn.) (% of GDP) (% of GDP) (INR) (INR) (INR) (INR) (US$ bn.) (US$ bn.)
51.6 11.2 26.2 65.3 6.4 12.3 69.5 377.8 6.00 4.75 10.75 4.66 5.59 6.79 83.5 30.7 111.5 42.5 29.8 -28.0 -3.9 -0.3 -4.7 4.3 31.2 16.9 20.5 3.7 9.3 5.2 3.8 3.9 3.6 44.95 43.76 56.55 41.65 141.5 20.8
55.9 23.9 38.0 72.7 -1.8 21.2 73.6 682.5 6.50 5.50 10.75 5.58 6.48 7.46 103.1 23.4 149.1 33.8 44.0 -46.1 -5.5 -1.2 -6.2 5.0 42.0 22.7 24.5 3.0 12.5 2.5 3.7 3.0 1.8 44.28 44.61 53.88 39.14 151.6 8.1
60.0 24.1 28.1 75.1 9.3 21.3 77.3 782.8 7.75 6.00 12.50 7.06 7.07 7.93 126.3 22.5 185.1 24.1 57.1 -58.8 -6.2 -1.0 -6.5 5.5 52.2 29.0 29.8 7.7 7.1 16.1 6.6 4.8 3.9 45.29 43.60 58.11 38.80 199.2 26.8
63.7 22.5 22.3 75.0 22.6 21.4 81.2 1276.8 7.75 6.00 12.75 6.02 7.52 7.82 163.0 29.1 249.8 35.0 79.7 -86.8 -7.1 -1.3 -7.4 6.2 75.7 36.9 41.7 15.9 27.4 22.6 15.9 8.7 7.5 40.24 39.99 56.99 35.29 309.7 78.2
67.9 20.2 17.5 73.3 20.3 18.6 85.5 672.1 5.00 3.50 12.50 6.94 5.05 7.08 182.9 12.2 290.7 16.4 91.3 -107.7 -8.9 -2.4 -9.8 7.4 89.9 43.5 44.6 17.5 -14.0 7.9 -1.9 0.6 -1.7 45.92 50.95 65.13 46.09 252.0 -34.9
71.6 16.5 15.1 72.4 18.2 16.3 89.9 1274.9 4.75 3.25 12.00 3.25 4.25 8.00 163.0 -10.9 268.0 -7.8 78.0 -105.0 -8.1 -2.4 -8.9 6.5 84.7 39.1 52.0 25.0 29.9 5.5 2.5 4.8 2.5 47.50 45.00 66.98 51.13 280.0 -3.0
72.1 15.5 16.2 72.9 29.1 14.0 89.3 1719.7 5.50 4.00 12.50 4.00 5.75 7.00 185.6 13.9 298.3 11.3 79.8 -112.7 -6.9 -2.1 -7.8 5.7 93.3 44.6 54.6 26.5 14.8 12.5 7.5 4.4 2.3 43.50 42.00 57.42 45.79 308.6 7.5
72.5 14.2 17.8 75.2 10.5 16.5 91.7 2085.2 7.00 5.00 13.00 5.25 6.00 6.50 232.6 25.3 346.0 16.0 83.8 -113.4 -5.8 -0.9 -6.4 5.5 108.3 51.8 60.1 28.2 19.0 17.0 9.0 4.4 3.5 41.00 40.00 51.25 41.00 364.3 33.4
39
12 March 2010
40
Appendix 1
Analyst Certification The views expressed in this research report accurately reflect the personal views of the analyst(s) about the subject securities or issuers and no part of the compensation of the research analyst(s) was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report. The research analysts, strategists, or research associates principally responsible for the preparation of Anand Rathi Research have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues. Anand Rathi Ratings Definitions Analysts ratings and the corresponding expected returns take into account our definitions of Large Caps (>US$1bn) and Mid/Small Caps (<US$1bn) as described in the Ratings Table below. Ratings Guide Large Caps (>US$1bn) Mid/Small Caps (<US$1bn) Buy >20% >30% Hold 5-20% 10-30% Sell <5% <10%
Anand Rathi Research Ratings Distribution (as of 12 Jan 10) Buy Anand Rathi Research stock coverage (116) 61% % who are investment banking clients 4%
Hold 10% 0%
Sell 29% 0%
Other Disclosures This report has been issued by Anand Rathi Financial Services Limited (ARFSL), which is regulated by SEBI. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities ("related investments"). ARFSL and its affiliates may trade for their own accounts as market maker / jobber and/or arbitrageur in any securities of this issuer(s) or in related investments, and may be on the opposite side of public orders. ARFSL, its affiliates, directors, officers, and employees may have a long or short position in any securities of this issuer(s) or in related investments. ARFSL or its affiliates may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any entity mentioned in this report. This research report is prepared for private circulation. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security's price or value may rise or fall. Past performance is not necessarily a guide to future performance. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. This document is intended only for professional investors as defined under the relevant laws of Hong Kong and is not intended for the public in Hong Kong. The contents of this document have not been reviewed by any regulatory authority in Hong Kong. No action has been taken in Hong Kong to permit the distribution of this document. This document is distributed on a confidential basis. This document may not be reproduced in any form or transmitted to any person other than the person to whom it is addressed. If this report is made available in Hong Kong by, or on behalf of, Anand Rathi Financial Services (HK) Limited., it is attributable to Anand Rathi Financial Services (HK) Limited., Unit 1211, Bank of America Tower, 12 Harcourt Road, Central, Hong Kong. Anand Rathi Financial Services (HK) Limited. is regulated by the Hong Kong Securities and Futures Commission. Anand Rathi Financial Services Limited and Anand Rathi Share & Stock Brokers Limited are members of The Stock Exchange, Mumbai, and the National Stock Exchange of India. 2010 Anand Rathi Financial Services Limited. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of Anand Rathi Financial Services Limited. Additional information on recommended securities/instruments is available on request.

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

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

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India I Equities

Economics Theme Report

India EcoTrix Mar 10

India EcoTrix Mar 10 Drain liquidity at your own risk

Macro theme and investment ideas

Anand Rathi Research

India EcoTrix Mar 10

Key macro forecasts

6.5 6.9 8.8 5.6 16.2 13.9 11.3 2.1 42

9.0 4.5 3.6 4.3 17.8 25.3 16.0 0.9 40

India EcoTrix Mar 10 Liquidity From overhang to hangover

India EcoTrix Mar 10

Anand Rathi Research

India EcoTrix Mar 10 Liquidity From overhang to hangover

Liquidity From overhang to hangover

Policy support for adequate liquidity

India EcoTrix Mar 10 Liquidity From overhang to hangover

Subdued growth outlook for FY11

India EcoTrix Mar 10 Liquidity From overhang to hangover

Anand Rathi Research

India EcoTrix Mar 10 Liquidity From overhang to hangover

Series with 99-00 base

Series with 04-05 base

India EcoTrix Mar 10 Liquidity From overhang to hangover

Fig 5 Turnaround in infra and industrial capex in FY11

Primacy of growth to prevail

Anand Rathi Research

India EcoTrix Mar 10 Liquidity From overhang to hangover

Anand Rathi Research

India EcoTrix Mar 10 Liquidity From overhang to hangover

Fig 6 Non-food inflation largely driven by base effect

Anand Rathi Research

India EcoTrix Mar 10 Liquidity From overhang to hangover

Fig 8 Rise in food prices largely in line with supply

Food in personal consumption

Anand Rathi Research

India EcoTrix Mar 10 Liquidity From overhang to hangover

Anand Rathi Research

India EcoTrix Mar 10 Liquidity From overhang to hangover

Fig 10 Narrowing divergence for edible oil prices

(Price index, Apr-98=100)

Iron and Steel-International

Anand Rathi Research

India EcoTrix Mar 10 Liquidity From overhang to hangover

Balanced rise in liquidity supply and demand

Anand Rathi Research

India EcoTrix Mar 10 Liquidity From overhang to hangover

India EcoTrix Mar 10 Liquidity From overhang to hangover

Net financial assets

Saving balance of government administration

Anand Rathi Research

India EcoTrix Mar 10 Liquidity From overhang to hangover

Fig 16 Overall government savings remain positive

Administration Non-departmental enterprise

Departmental enterprise Overall government savings

Source: GOI and Anand Rathi Research.

Anand Rathi Research

India EcoTrix Mar 10 Liquidity From overhang to hangover

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

Anand Rathi Research

India EcoTrix Mar 10 Liquidity From overhang to hangover

Capital account balance