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Asia Economics Flash

June 3, 2010
Goldman Sachs Global Economics, Commodities and Strategy Research at https://360.gs.com

Tushar Poddar tushar.poddar@gs.com +91 22 6616 9042

India: The assurance of domestic demand
 After the market volatility in May, we take a pulse check on the health of the Indian economy. Domestic demand continues to accelerate as evidenced by a slew of macro and micro indicators from the PMI, credit growth to auto sales and infrastructure build-out. With demand remaining strong, we think core inflation will likely remain elevated through FY11, and maintain our above-consensus inflation forecast of 7.5%. This would prompt further action by the Reserve Bank of India to withdraw accommodation. We persist with our view that effective policy rates may rise by 300 bp in 2010. Indeed, effective short-term policy rates have risen by some 200 bp year-to-date, with the recent liquidity tightening playing a large role. Government long bond yields have fallen sharply due to the success of the telecom spectrum auctions and the flight to safety, but may have troughed as the good news on the fiscal financing is priced in. The current account deficit is set to widen due to strong domestic and weak external demand, and we increase our deficit projection to 3% of GDP for FY11 from 2.5% earlier. Our 3, 6 and 12-month USD/INR forecasts are unchanged, as we believe that stronger growth and higher rates will drive the INR stronger, and due to our expectation of EUR appreciation against the USD. In the near term, however, there are risks to our views if the global risk aversion continues and if the EUR remains weak relative to the USD. The macro fundamentals remains favourable for corporate earnings, but valuations are rich, and therefore, our strategists maintain a market weight on the Indian equity market. Key risks to our domestic demand and market views—a sharp slowdown in the global economy and rising risk aversion leading to massive capital outflows; the central bank falling substantially behind the curve; and a poor monsoon.

Recent macro and micro data continue to suggest strength in domestic demand. The May HSBC Markit PMI came in at 59, the fastest pace of expansion in over two years; GDP growth for the January-March quarter was at a robust 8.6% yoy and 13.6% qoq annualized, even with lower government spending; industrial production numbers continue to be solid; and bank credit growth has increased to over 17% yoy as on May 7. The normal onset of the monsoons in the Southern coast of Kerala earlier this week, is also a key positive for domestic demand.
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Goldman Sachs Global Economics, Commodities and Strategy Research

Asia Economics Flash

Exhibit 1: The PMI suggests that domestic demand continues to accelerate
Index 65

60

55

50 PMI 45 PMI: Output PMI: New orders PMI: Employment 40

Source: CEIC, GS Global ECS Research.

At the micro level, key sectors such as autos and infrastructure continue to show rapid expansion. The pace of road construction has averaged about 10 km a day since the start of the year, compared to the 2009 pace of 6 km a day. Container activity in ports continues to be strong, rising 25% yoy on average in 2010 thus far. Electricity production continues to increase—and the outlook is bright, with our utilities analyst expecting total output to increase by 15,000 MW in 2010, compared to 9,600 MW in 2009. Structurally, India is on the path to reduce its power deficit over the next three years. The auto sector has shown impressive growth year to date (see Exhibit 2), and the outlook remains positive. Our auto analyst expects demand for commercial vehicles to growth by 20%-25%, and for light commercial vehicles by over 30%. With banks keen to lend, and order books for auto companies full, we think it is difficult to see a slowdown in the auto space. Exhibit 2: Motor vehicle sales have galloped ahead
% chg yoy, 6mma 50 Motor Vehicle Sales

40

Motor Vehicle Sales MVS: Passenger Vehicle

30

MVS: Two Wheelers

20

10

0

‐10

Source: CEIC, GS Global ECS Research.

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Goldman Sachs Global Economics, Commodities and Strategy Research

Asia Economics Flash

At the start of summer, we see upside risks to our GDP growth forecast of 8.2% for FY11, despite weak external demand and fiscal policy in retrenchment mode. The upside to domestic demand comes from easy financial conditions, even with the withdrawal of monetary accommodation, continued capacity expansion, especially in the infrastructure sectors, and robust household and corporate balance sheets aiding spending. With domestic demand remaining strong, we think pressures on core inflation will continue through FY11. Though headline prices may benefit from the recent pullback in commodity prices, food prices have not come off as much as policymakers expected, and food price inflation still running over 16% yoy currently. The more important upward pressure on inflation will continue to be the strength in demand and the closing of the output gap, and our FY11 average forecast for inflation remains at 7.5% (see India: Four reasons why we think inflation will be sticky, Asia Economics Analyst 10/07, April 8, 2010 ). Exhibit 3: Mind the gap! The output gap has closed exerting pressure on core prices
% chg qoq, sa 6 5 4 3 2 0.00 1 -0.01 0 -1 -2 -3 -0.02 -0.03 -0.04 -0.05 WPI core inflation Output gap based on the Industrial Production Index (RHS) %, 3mma 0.05 0.04 0.03 0.02 0.01

Source: CEIC, GS Global ECS Research.

We think the Reserve Bank of India (RBI) will continue to withdraw the extraordinary monetary accommodation, due to inflation running significantly above its normal comfort range of 5%-6%, and well above its medium-term target of 3%-4%. The recent external uncertainty has, we think, delayed the next rate hike till the next policy meeting on July 27. We, however, continue to hold our long-standing call of a 300 bp increase in effective policy rates in 2010. There has already been about 200 bp of effective tightening, largely due to recent liquidity tightening. The effective policy rate has moved from the floor of the corridor (reverse repo) to the ceiling (repo), forcing the RBI to move into liquidity injection mode. Last week, the RBI had to institute a special temporary liquidity facility. This is mainly due to outflows from the system from the 3G auction receipts, and portfolio outflows and therefore likely to be temporary. However, with demand for credit picking up pace, we think that going forward, effective policy rates will trend towards the repo rather than the reverse repo. We expect interest rate hikes to be more back-loaded, and forecast three more rate hikes in 2010. We closed our 2s-5s OIS INR flattener trade, essentially flat on the trade, due to the negative carry. The reason was primarily due to the lack of a near-term catalyst for the 2-year leg to move higher, as the RBI is likely to pause till end-July. It’s the 5-year leg which did the majority of the move in the last few weeks due to the global risk aversion, and the improved fiscal financing outlook. Although we still essentially believe that the curve will flatten, the risk-reward is higher now after the big move and we have one eye on the large negative carry.
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Goldman Sachs Global Economics, Commodities and Strategy Research

Asia Economics Flash

The fiscal financing situation has improved significantly with the unexpectedly large windfall from the telecom spectrum auction receipts. Instead of the budget expectations of about US$9 billion in proceeds, the government may end up netting close to US$22 billion in the 3G and broadband wireless auctions, thus alleviating fiscal financing pressures. Additional positives for fiscal financing include oil prices having come off significantly due to the global bout of risk aversion, helping contain the subsidy bill, and a possible increase in the foreign investor limit for government securities from US$5 billion currently to US$10 billion. Along with the flight to quality, these reasons led to a significant rally in the benchmark 10-year bond yields from above 8% in the beginning of May to a trough of 7.4% by May 24. We think government long bond yields may have bottomed as the good news has been priced in. There are spending pressures on the government in part due to cash payments to oil companies for losses incurred last year, increased social outlays partly from the Right to Education Act, and potentially increased security spending related to the Maoist disturbances. With inflation remaining sticky, rate hikes up ahead, and spending pressures on the government, we think upward pressure on yields may increase gradually. We retain our target rate of 8%-8.25% for the 10-year by end-FY11. India’s current account deficit is set to widen in FY11 due to the strength in domestic demand and weakness in external demand. We now estimate that the current account deficit may rise to 3% of GDP in FY11 from a forecasted 2% of GDP in FY10. Non-oil import demand has continued to outpace export demand, a trend which we think will continue as the domestic economy grows faster than its trading partners and sucks in capital goods and raw materials for its infrastructure growth. Thus, India will contribute positively at the margin to global rebalancing.

Exhibit 4: Strong domestic demand will increase the current account deficit
India: Current A/C Balance
% of GDP 4.0 3.0 2.0 1.0 0.0 ‐1.0 ‐2.0 ‐3.0 ‐4.0 ‐5.0 ‐6.0 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11F 2011/12F Income and transfers Net exports balance Current a/c balance % of GDP 4.0 3.0 2.0 1.0 0.0 ‐1.0 ‐2.0 ‐3.0 ‐4.0 ‐5.0 ‐6.0

Source: CEIC, GS Global ECS Research.

Our long-term outlook for the INR remains one of strength, driven by higher growth, rising interest rates, and continued capital inflows. Therefore, our 3, 6 and 12-month USD/INR forecasts are unchanged at 44, 43.4, and 43. This is predicated on our forecast that the EUR will appreciate to 1.35 against the USD over a 3-12 month horizon. The short-term outlook for the INR will depend overwhelmingly on appetite for global risk. If there is another bout of risk reduction, then the INR could be disproportionately hit due to the rising current account deficit and dependence on capital inflows, and if the EUR remains weak relative to the USD.

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Goldman Sachs Global Economics, Commodities and Strategy Research

Asia Economics Flash

Exhibit 5: The INR has depreciated recently on a trade-weighted basis
USD/INR 48.0 47.5 47.0 46.5 46.0 45.5 45.0 44.5 44.0 43.5 43.0
13‐May‐10 15‐May‐10 17‐May‐10 19‐May‐10 21‐May‐10 23‐May‐10 11‐May‐10 27‐May‐10 25‐May‐10 1‐May‐10 3‐May‐10 5‐May‐10 7‐May‐10 15‐Apr‐10 17‐Apr‐10 19‐Apr‐10 21‐Apr‐10 23‐Apr‐10 25‐Apr‐10 27‐Apr‐10 29‐Apr‐10 9‐May‐10

TWI Index 20.8 20.9 21.0 USD/INR INR TWI (RHS) Depreciation 21.1 21.2 21.3 21.4 21.5 21.6 21.7 21.8

Source: CEIC, GS Global ECS Research.

Notwithstanding the external uncertainties, we believe the macro fundamentals are favourable for Indian corporates. With growth remaining robust, pricing power in the hands of corporates, the RBI’s removal of accommodation more back-loaded, and long bond yields having come off, the outlook for company earnings remains favourable. However, as our strategists have pointed out, valuations are high on a relative and absolute basis. They therefore remain market weight on Indian equities. There are several risks to our views. First, a sharp slowdown in the global economy and rising risk aversion leading to large capital outflows. This could impair external funding for corporates, and lead to a slowdown in capex plans. Second, the RBI falling substantially behind the curve, allowing a build-up of inflationary expectations and then having to engineer a slowdown by sharply tightening monetary policy. Third, a poor monsoon curbing domestic demand and raising already high food prices. Key indicators to watch through the summer—the monsoons for its impact on demand and food prices; and credit growth to gauge the strength of domestic demand—both consumption and the capex cycle.

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Goldman Sachs Global Economics, Commodities and Strategy Research

Asia Economics Flash

I, Tushar Poddar, hereby certify that all of the views expressed in this report accurately reflect personal views, which have not been influenced by considerations of the firm's business or client relationships.

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