A Perspective on India

A CHALLENGING 2008 After four consecutive years of strong gains, Indian equity markets have shown signs of a slowdown in 2008. The downturn could be attributed to a combination of factors, including weakening global sentiment and concerns regarding domestic inflation and growth. Globally, there has been a reassessment of the risk premiums attached to equities as an asset class in light of weakening growth and uncertainty about the extent of the impact to credit markets. In India, recent data has pointed toward a moderation in industrial production and rising inflationary pressures. Positive foreign institutional investor (FII) flows, combined with strong inflows from domestic insurance companies and mutual funds, were all large contributors for capital inflow and clearly led to momentum buying in certain sectors. However, as liquidity flows have begun to decline, a reversal of last year’s trends has begun to take place. Many of the sectors that had moved ahead of fundamentals last year due to momentum buying, such as consumer goods and information technology, have not sustained investor interest. This year, as trends have begun to reverse, many investors are focusing more on fundamentals.

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INDIAN ECONOMY Key implications—demand and investment Economic growth in India has been above trend for the past few years and has been aided by the availability of capital, low domestic interest rates, and strong FII flows. These factors have helped push domestic consumption and investment in recent years. The Reserve Bank of India (RBI) began to tighten rates over the last couple of years in order to moderate strong credit growth and avoid a bubble scenario. Rising rates and input costs appear to have impacted growth in interest rate sensitive sectors and RBI’s efforts to contain credit growth have clearly had an impact. The slowdown in industrial production numbers is an indication of the same trend. However, we should keep in mind that the composition of the index of industrial production is outdated and that India is predominantly a service-led economy.
73.1 -37.4 MSCI India Index 17.4 -6.5 FII flows** (US$ billion) -3.8 -24.5 BSE IT 34.7 -14.6 BSE FMCG 149.4 -47.6 BSE Power 92.2 -63.1 BSE Realty 81.0 -47.2 BSE Bankex 117.5 -52.1 BSE SmallCap 89.4 -47.3 BSE MidCap 75.4 -34.0 S&P CNX Nifty 64.7 -34.4 BSE Sensex 2007 YTD 2008* % Change All returns in USD. *As of 31 July 2008. **FII flows as of 30 June 2008.

At this stage, the Indian economy is facing headwinds in terms of inflationary pressures and policy responses (fiscal and monetary) to tame increasing prices. We expect economic growth and consumer demand to be impacted by recent price increases and higher borrowing costs. The expected wage increases as a result of the Sixth Pay Commission recommendation and farm loan waiver could boost consumption, but are likely to worsen the fiscal deficit. CORPORATE INDIA Key implications—earnings growth In recent years, strong economic fundamentals and readily available capital boosted the confidence of Indian companies, which have delivered earnings growth of nearly 30%. Growing confidence was also reflected in the sharp rise in the number of overseas acquisitions made by leading companies as they sought to increase their global

footprint. As a result, Indian stocks have traded at a premium due to consistently superior return on equity and better growth prospects. Return on Equity (ROE) Trend (%), 1995–2007

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Following an 8.8% growth in the first quarter of 2008, the Indian economy grew by 7.9% in the second quarter owing to moderation in industrial output. In our view, domestic consumption and improvement in farm output are likely to support GDP growth. While consensus estimates for GDP growth in fiscal year 2009 are being revised to around 7–8%, India is likely to remain one of the fastest-growing economies in the world, despite the downshift in global economic growth. India GDP Growth (% YOY), 1991–2008
Source: Bloomberg, 8 July 2008. Source: Citigroup, May 2008.

While RBI tightened domestic liquidity and also restricted overseas borrowings, Indian companies benefited from strong FII flows (cheaper money through primary/secondary market offerings). As a result, rising demand due to increasing disposable incomes together with strong economic growth boosted the bottom line. Given the recent monetary tightening and lack of FII flows, Indian companies are likely to face some difficulties raising capital for their expansion. However, the government and central bank have recently undertaken steps to improve access to capital by relaxing overseas borrowing terms, which should also help in tempering the weak rupee. The latter is likely to help the export competitiveness for India given that other Asian currencies have been appreciating against the U.S. dollar. Oil remains a key factor given that oil imports account for close to 75% of India’s crude oil requirements. The fluctuations in oil prices will affect India’s balance of payments and put further pressure on the rupee, but the large foreign exchange market (forex) reserves and strong invisibles should provide a buffer. Crude Oil Prices, 2002–2008
175 225 275 325 375 425 475 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 0 25 50 75 100 125 150 WTI US$ Per Barrel (RS) CRB Food Index (LS) CRB Commodity (LS)

0 5 10 15 20 25 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007E India EM World Asia Pacific ex-Japan
Source: FactSet, MSCI, Morgan Stanley Research, June 2008.

5.3 1.3 5.1 5.9 7.3 7.3 7.8 4.8 6.5 6.0 4.4 5.8 3.8 8.5 7.5 9.4 9.6 9.0 0 1 2 3 4 5 6 7 8 9 10 FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04

FY05 FY06 FY07 FY08E

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India’s Fixed Income Markets The growth of local currency debt markets can play a crucial role in a developing country’s economic performance and financial stability. The pressing needs of India’s large fiscal deficit have fueled a thriving market for government securities, commonly termed “G-Secs.” In contrast, the country’s corporate debt market is widely regarded as small, illiquid and lagging in development. In the early 1990s, India launched a series of debt market reforms with the decision to cease administering interest rates and using adhoc treasury bills to automatically monetise central government debt. Consequently, India converted to a market-determined interest rate environment where the RBI conducts monetary policy through its benchmark repo rate, cash reserve requirements and open market operations. Subsequent RBI reforms have included the use of additional types of government securities, plus efforts to consolidate numerous small, illiquid issues. The central bank also elongated the yield curve of government debt—a key development for the valuation of other fixed income securities—by progressively introducing longer maturity issues. It currently issues long-term debt with maturities from five to 30 years, as well as short-term debt in the form of 91-, 182- and 364-day Treasury bills.
Source: CapitalLine, Morgan Stanley Research, June 2008.

FIIs gained access to the G-Sec market in 1997, and during the present decade, this market has continued to mature through a series of government, central bank, regulatory and exchange initiatives: • 2001: NSE launches value-at-risk system for measuring risk in G-Secs • 2002: NSE creates benchmark NSE Government Securities Index • 2003: Retail trading in G-Secs commences • 2003: NSE introduces trading in interest rate futures • 2005: Electronic order matching platform launches • 2006: Short sales permitted • 2006: Passage of the Government Securities Act permits stripping of G-Secs (actual implementation of STRIPS is planned for 2008/2009) Some of these initiatives have been less successful than others. Compared to India’s active equity derivatives market, the development of bond-related derivatives, which can improve market liquidity and risk management, has been minimal. The NSE currently offers interest rate futures contracts on notional T-bills, zero-year zero-coupon bonds and 10-year coupon-bearing bonds. The RBI continues to study ways to further this market’s growth. India’s corporate bond market also lags far behind the G-Sec market in overall development—a trend India shares with several other Asian emerging markets. Borrowing from banks tends to be the more popular route for Indian corporate financing. Additional factors such as disclosure requirements, plus the overall cost and length of the issuance process, favour private placements over public issues. Developing Asia: Debt Securities as a % of GDP As of 31 December 2007 The balance sheets of Indian companies are currently in good shape, with the help of strong cash flows, low debt-equity ratios, and newlyadded capital stock. But margins are expected to moderate due to changes in the macroeconomic environment as well as the fact that 30% year-on-year growth was not sustainable and was cyclical

in nature. Corporate India Balance Sheets, 1994–2007
-10 -5 0 5 10 15 20 25 30 35 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 Cash to Total Assets (LS) YoY Change in Debt (LS) Debt to Equity (RS) 0 50 100 150 China India Indonesia South Korea Malaysia Philippines Thailand Corporate Debt Securities as a % of GDP Government Debt Securities as a % of GDP Sources: Asia Bond Monitor (ABM), April 2008; Asian Development Bank; AsianBondsOnline (ABO) website; and Morgan Stanley Capital International Inc. “Developing Asia” is defined as countries included in the MSCI Emerging Markets Asia Index. Corporate debt securities include those issued by financial institutions. India data is as of 30/06/07.

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Source: PricewaterhouseCoopers estimates (using UN population projections), March 2008.

OUTLOOK In the near term, India is likely to encounter some turbulence due to various factors, such as policy responses to rising inflation ahead of national elections, absence of FII flows until the global scenario improves, and earnings growth moderation. While these factors would impact market sentiment in the near term, we believe that India remains an attractive country for a variety of reasons: • Structural economic drivers such as positive demographics and

high savings rates should drive long-term economic growth. • The economy is primarily driven by domestic consumption and investment, providing relative insulation from global slowdown. - Although domestic consumption is likely to be impacted by increased prices and borrowing costs, the Sixth Pay Commission recommendation and farm loan waiver are positives. - The government’s infrastructure spending and capital expenditure (capex) plans of corporate India are likely to sustain the investment cycle. Capex could slow down if the demand situation deteriorates and global capital flows moderate further. • Strong forex reserves and a relatively low external debt-to-GDP ratio should mitigate the impact of the current account deficit. • India, we believe, is likely to be one of the fastest-growing economies in the world, despite the expected near-term slowdown. • Corporate margins are expected to moderate in this environment to a sustainable level, making stock picking more relevant. While there can be no assurance, we expect earnings growth to be in the range of 15–20% over the next three to five years. We believe that the recent volatility in the equity markets has been revealing attractive opportunities in India for long-term, bottom-up investors. Current valuations appear to have already factored in lower growth prospects and we believe Indian markets appear attractive. In our view, Indian equity markets are well positioned from a long-term perspective given their strong fundamentals.
17 7 17 3 Indonesia 10 5 10 3 Turkey 6 5 6 6 Australia 17 10 17 7 Mexico 8 9 8 7 Korea 88 (Rank 3) 22 (Rank 4) 88 (Rank 3) 7 (Rank 12) India 17 17 17 8 Russia 26 15 26 8 Brazil 9 10 9 9 Spain 9 10 9 10 Canada 10 13 10 14 Italy 14 15 14 17 France 14 15 14 18 UK 14 20 14 22 Germany 129 51 129 23 China 19 28 19 32 Japan 100 100 100 100 U.S. 2050 2007 2050 2007 GDP in PPP terms GDP at market exchange rates in US$ terms Country (Indices with U.S. = 100)

Projected Relative Size of Economies in 2007 and 2050 (U.S. = 100) India Projected to Become the Third Largest Economy in 2050.
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Important Information
All investments are subject to certain risks. Generally, investments offering the potential for higher returns are accompanied by a higher degree of risk. Stocks and other equities representing an ownership interest in a corporation have historically outperformed other asset classes over the longer term but tend to fluctuate more dramatically over the shorter term. Small or relatively new companies can be particularly sensitive to changing economic conditions due to factors such as relatively small revenues, limited product lines, and small market share. Smaller-company stocks have historically exhibited greater price volatility than larger-company stocks, particularly over the short term. Bond and other debt obligations are affected by changes in interest rates and the creditworthiness of their issuers. High-yield, lower-rated (“junk”) bonds generally have greater price swings and higher default risks. Foreign investing, especially in developing countries, has additional risks such as currency and market volatility and political or social instability. The information contained in this piece is as of its date, unless otherwise indicated, and is not a complete analysis of every material fact regarding the market and any industry sector, a security, or a portfolio. Statements of fact cited by the manager have been obtained from sources considered reliable but no representation is made as to the completeness or accuracy. Because market and economic conditions are subject to rapid change, opinions provided are valid only as of the date of the material. The manager’s analysis of issues, market sectors, and of the economic environment may have changed since the date of the material. References to particular securities are only for the limited purpose of illustrating general market or economic conditions, and are not recommendations to buy or sell a security or an indication of the author’s or any managed account’s holdings. The manager’s opinions are intended solely to provide insight into how the manager analyses securities and are not a recommendation or individual investment advice for any particular security, strategy, or investment product. Any performance quoted is historical, and, of course, past performance does not guarantee future results and results may differ over future time periods. This publication is for professional investors, institutional investment consultants or institutional investors. It is not meant for the general public. For more information, please contact Franklin Templeton Institutional directly. This article reflects the analysis and opinions of Franklin Global Advisers, an affiliate of Franklin Templeton Institutional, as of

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