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India: Livin’ on a prayer?
Emerging Markets Economics Asia
Contributors Robert Prior-Wandesforde +65 6212 3707 firstname.lastname@example.org Devika Mehndiratta +65 6212 3707 email@example.com
A look ahead to 2011-12
Without wishing to pour cold water on what is a very favourable long-term growth story, we believe India’s macroeconomic fundamentals will disappoint the consensus in a number of respects next year. • First, we think the main drivers of economic growth, including interest rates, the exchange rate, oil prices and world trade will turn from positive to negative influences on activity in the not too distant future. We have cut our 2011/12 GDP growth forecast to a bottom-of-the-range 7.7%. • Second, while the year-on-year rate of Wholesale Price Inflation is set to fall further in the next few months, it might bottom in early 2011 at around 6%. Our estimate suggests WPI inflation will trend higher through the rest of next year if commodity prices rise from current levels. We wouldn’t be surprised if sequential rates of WPI inflation have already troughed. • Third, a combination of more dovish comments from the RBI and falling yearon-year inflation rates has led most to believe that policy rates are at or very close to a peak. This has, however, been the consensus view for some time and we believe further upside rate surprises are in store. Our forecast is for a total of 75bp repo and reverse repo rate hikes by around the middle of 2011. • Fourth, domestic liquidity conditions may ease somewhat, but we expect them to remain reasonably tight as lending growth continues to outpace the increase in deposits. So what does this mean for markets? For equities, the onus will likely be on companies to drive a positive wedge between the top and bottom lines of their profit and loss accounts. If this fails, then investors will have to hope that nothing comes along to stem the flow of liquidity emanating from the US. As for the bond market, our macroeconomic view presents something of a mixed bag. However, on balance, the fixed income team is modestly constructive. An important point to bear in mind is that the 10-year bond yield is highly likely to flatten or fall before policy rates have peaked. With the majority of the rate rises now behind us, the pace of tightening slowing and domestic liquidity easing a little, we should be at or close to the top in yields. Our foreign exchange analysts are looking for the Indian rupee to appreciate further over the coming 12 months, targeting a rate of INR42 against the USD. This is, however, largely a function of a weak USD view and the team is cognisant of the domestic risks surrounding the rupee. In particular, deterioration in global risk sentiment would likely hit the rupee harder than most other Asian currencies given the country’s high current account deficit and equity-focused foreign inflows.
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6 7. while economic activity is extremely insensitive to higher rates.” At the same time.000 15.8 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Source: Credit Suisse.4 7.000 19.2 8. domestically focused economy where growth is pretty much guaranteed to remain strong. however. higher short-term interest rates and an ample supply of bonds have weighed heavily on sentiment.000 17. bond yields in India have moved in the same direction as domestic equities over the last 18 months (Exhibit 1). CEIC Exhibit 2: … which has been very unusual in Asia 100 50 0 -50 -100 -150 -200 -250 -300 India China Tai Malay HK Korea Sing Thai Phil Indo * Since June 2009 Source: Credit Suisse.8 7. and could in any case reflect the pricing power of companies. those investing in India’s government bond markets have generally proved more cautious as rising inflation.000 20.2 7.19 November 2010 A tale of two asset classes Judging by the super-charged performance of Indian equities over the last 18 months.000 16. As a result. The typical macro view of those that have been pouring money into the market might run something like this: “India is a large.000 18.0 14. investors would appear to be nothing if not relaxed. While inflation is high and interest rates have risen. the BLOOMBERG PROFESSIONALTM service Change in 10y bond yield (bps)* Change in equity market (%)* India: Livin’ on a prayer? 2 . the former is now heading down.000 Sensex equity price index (LHS) 10 year bond yield (RHS) % 8.000 6. Exhibit 1: Indian bonds have sold off as equities have strengthened … Index 22.0 7.000 21. CEIC.
Calendar Q3 GDP numbers have still to be released and won’t be until 30 November. This might sound like a straightforward exercise. But that’s not to say that a near-term collapse in equities is inevitable If global liquidity remains strong. for example. Prod. Indian government bonds have been behaving more rationally in the context of the country’s macroeconomic fundamentals than the equity market. however. CEIC * 3 month-on-3 month annualised rate Source: Credit Suisse. (% 3m-on-3m ann)* 20 15 10 5 0 -5 -10 08 09 10 -10 08 09 10 * 3 month-on-3 month annualised rate for industrial production excluding capital goods Source: Credit Suisse. There are. rising slightly to 8. 1. Exhibit 3: Industrial slump … % 25 Exhibit 4: … only partly reflects capital goods % 20 15 10 5 0 -5 Ex. IP (% y-o-y) Ex. The trouble. That is the intention of this report. housing activity. employment or unemployment to consider. Cap. while decent high-frequency data are few and far between. Cap.4% in 2011/12. Prod. In our view. (% y-o-y) Ind. it is useful to begin by establishing just how the economy has performed in recent months. then current valuations would be easier to justify and the market should continue to perform well. no up-to-date measures of retail sales. Economic growth – Standing strong? From industry. So how likely is such a scenario to play out? Consensus forecasts would suggest that this is precisely what will happen.19 November 2010 The contrasting performance of the two markets no doubt partly reflects the level of foreign participation in Indian bonds relative to equities. is that history tells us that the consensus can often be wrong and it is important to consider the risks surrounding these views.3% in 2010/11. while inflation falls sharply and interest rates remain broadly flat from here. but this is actually not the case in India.to service-sector-led growth By way of background. GDP growth is expected to average 8. which will examine the likely development of India’s key macroeconomic fundamentals in turn over the next 12-18 months. inflation comes down and policy interest rates stop rising. economic growth holds up. CEIC India: Livin’ on a prayer? 3 . IP (% 3m-on-3m ann)* Ind. Foreigners play a much more important role in the latter than the former and have been seeking to escape the low growth/yield environment of the developed world in favour of the stronger activity and higher nominal yields associated with the emerging market universe. Hefty restrictions and regulations on overseas investment in Indian bonds has meant that global liquidity has found a more rewarding home in equities as well as the fixed income instruments of countries other than India (Exhibit 2). Such an environment could be good news for bonds as well.
despite the softening in the industrial sector. we have seasonally adjusted the production numbers and calculated the 3 month-on-3 month annualised rate (Exhibit 3). October-December could see year-on-year growth reach nearly 9%.19 November 2010 Industrial production is the only “top tier” monthly measure of activity in the country. It is. But even this has failed to present a particularly clear picture in recent times. Exhibit 5: PMI points to 9-10% growth in GDP ex.5% average increase in the series over last ten years. (RHS) 12 11 10 9 8 7 6 220 200 180 160 140 120 100 80 D&B Survey (LHS) % y-o-y 12 11 10 9 8 7 6 GDP ex. which represents about 9% of the total index. then GDP growth should be holding up reasonably well. below the 6. CEIC * Weighted average of manufacturing and services PMI Source: Credit Suisse. In order to try and look through the volatility in the year-on-year rate and gain a more timely indication of what is going on. which have also dropped back in recent times (although they too tend to be volatile). With this in mind and assuming the agricultural sector has continued to recover from the drought-related drop in output at the end of last year. This fairly downbeat impression of industrial sector activity is supported by secondtier indicators such as cement dispatches and power demand. Nevertheless. Agriculture … Index % y-o-y Exhibit 6: … while the same is true of the Dun & Bradstreet survey Index 65 60 55 50 45 40 06 07 Combined PMI (LHS)* GDP ex. agric. to 6% in June. mortgage disbursements and telephone subscriptions. We expect real GDP to have risen 7. In India: Is economic activity stalling? 29 October. real bank lending. agric. all of which provide a reasonably upbeat impression of services activity. including rail freight. for example. This certainly appears to be the message of Exhibits 5 and 6. But what is happening in the much larger service sector of the economy? Luckily things look better here. Markit. (RHS) 08 09 10 03 04 05 06 07 08 09 10 Source: Credit Suisse. The production of capital goods. Thanks partly to an easy base comparison. then the slowdown hasn’t been as abrupt (Exhibit 4). as year-on-year growth has swung widely from 15% in April.5% year-on-year in the July-September quarter on the basis of a 7. insurance premium collections. Devika Mehndiratta took a close look at a whole series of service-related measures. air traffic. which show the weighted average of the manufacturing and service sector PMIs and the results of Dun & Bradstreet’s India survey. has accounted for much of the recent volatility in overall industrial production and if we exclude this component. a 3 month-on-3 month annualised growth rate of 5% in September is not particularly impressive.9% quarter-on-quarter seasonally adjusted annualised increase. back to 15% in July and down to little more than 4% in September. CEIC India: Livin’ on a prayer? 4 . This suggests that the sector has suffered a sharp downturn in its underlying growth rate since the beginning of this year.
19 November 2010 What next? In order to provide a longer-term outlook for the economy. The explanatory. oil prices. social & personal services Source: Credit Suisse India: Livin’ on a prayer? 5 . Our intention here was to establish an underlying measure of GDP that would best pick up the impact of fundamental macroeconomic drivers (we have compared our indicator with overall GDP growth in Exhibit 7). agriculture & community services Total GDP 00 01 02 03 04 05 06 07 08 09 10 Source: CEIC. social & personal services”. Exhibit 7: Total GDP growth has been more stable than our underlying measure recently % y-o-y 14 12 10 8 6 4 2 0 98 99 GDP ex. or right hand side. real and nominal interest rates and various measures of the rupee exchange rate. Credit Suisse Exhibit 8: Model does a good job in explaining India’s underlying GDP growth % y-o-y 14 12 10 8 6 4 2 99 00 01 Actual GDP* Credit Suisse Model 02 03 04 05 06 07 08 09 10 * GDP excluding agriculture and community. or left hand side. variables we tried in the equation were world trade. variable in the equation was GDP. The dependent. and we have conducted our own investigation by constructing a multipleregression equation designed to explain changes in output over the last ten years. which are closely linked to government spending. excluding both “agriculture” and “community. These are often hotly disputed in India. we need to determine the fundamental drivers of GDP growth and their relative importance.
19 November 2010 Exhibit 8 shows the fit of the equation. year-on-year world trade growth picked up from -18% in calendar Q1 2009 to 22% in Q2 2010 ─ enough to add 2 percentage points to our measure of Indian GDP. There are a number of important conclusions to come from the analysis: • A 10% rise in world trade. which we have defined as the weighted-average import growth of India’s five main export partners. World trade growth. To put this in perspective.94 and passes all the standard statistical tests. For those surprised by the size of this impact. We found that a 1% appreciation in the rupee cuts growth by 0. is equivalent to 40% of the total rise in the growth rate over the period.5% to GDP growth as we have defined it here. investment spending. Looking ahead. was the second strongest it has ever been in the latest data point for calendar Q2 and looks very likely to slow from here. Our foreign exchange India: Livin’ on a prayer? 6 . at USD85/barrel.2% within six months. in turn. With high indebtedness comes a higher sensitivity to interest rates. thanks partly to the country’s relatively high inflation rate. We tried bank deposit rates. 27 October).2-0. This shows a dramatic increase in the share of outstanding bank loans as a percentage of GDP over the last decade or so. • Both the level and change in India’s trade-weighted exchange rate impacts activity according to the equation. as we have defined it here. A 1% rise in the PLR typically cuts GDP growth by 0. the repo rate and the Prime Lending Rate (PLR) as explanatory factors in the equation. with the nominal and real rate important. jobs and hence private consumption are also affected.1%-0. with further negative effects. with the last of these dominating the other two. are 15% above their recent lows. with the real trade-weighted index up around 10% over the last year.3 percentage points within 18 months. This is actually bigger than the impact we estimated on exports alone (see “Currency appreciation: What it means for Asia”. • Both real and nominal interest rates have a powerful impact as well. typically adds 0. the worry is that all of the factors mentioned above will start detracting from economic growth in the not too distant future. Exhibit 9: India is likely to be much more interest rate sensitive than it was % GDP 50 45 40 35 30 25 20 15 10 5 0 * All scheduled banks lending for business in India Source: Credit Suisse. We estimate that a 10% rise in the oil price cuts growth by 0.4% after a year. albeit a fairly small one. This. oil prices have a negative relationship with GDP. probably reflecting the fact that many exporters respond to a stronger rupee by squeezing profit margins. which has R-squared of 0. it is worth taking a look at Exhibit 9. In so doing. Oil prices appear to have broken into a new higher range and. adding up to more than 1 percentage point coming through over an 18-month period. The rupee has also been appreciating. CEIC Stock of bank lending* 50 53 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 • Not surprisingly.
7% 7.4% 8. with primary goods at 6.2%. creating a break in the series.3% 8. So far this year. previous 8. Finally.4% 8. while the interest rate picture has been muddied by a recent RBI requirement for commercial banks to publish a base rate rather their prime rate. recent data have finally provided some better news on the inflation front. it is hard to imagine that some of the central bank’s rate rises have not been passed on by the banks or will be in due course.4%. In Exhibit 12 we have shown the 3 month-on-3 month annualised change in the seasonally adjusted WPI. Inflation – Panic over? Despite the strength of the economic recovery to date. Our first stab at 2012/13 growth is 7. but there looks to be more to it than that. Manufacturing is down to just 1. Inflation is also now falling. which in turn bodes well for further drops in the year-on-year rate over the next few months. while average growth in 2012/13 may be even weaker than in the previous year given the low base. while CPI inflation has also been coming off from very high levels – Exhibit 11. Exhibit 10: Indian GDP growth revisions & consensus comparisons Actual/Consensus* 2008/09 2009/10 2010/11 2011/12 2012/13 6. With this in mind.7% 7. Apart from establishing which factors matter most for growth and how powerful the effects tend to be. new 8.5% (Exhibit 10). with the Wholesale Price Index (WPI). then we should expect overall GDP growth to surprise the consensus on the downside in 2011/12. putting us at the bottom of the consensus range. the Cash Reserve Ratio has risen 100bps. with the repo and reverse repo rates up 150bps and 200bps. It is tempting to suggest that the fall simply reflects base effects (the impact of very strong numbers last year falling out of the annual comparison).4% 7. we have decided to cut the 2011/12 projection to 7. This was just 3% in September and October.4%.0% Credit-Suisse. our equation can also provide a rough guide as to when they will impact activity. social and personal services”. If we include trend-like assumptions for “agriculture” and “community.7% from 8%. The timing varies from series to series.5% * Actual numbers for 2007/08 and 2008/09 with forecasts from Consensus Economics thereafter Source: Credit Suisse 2. but the overall message is that activity looks set to start softening from around the middle of next year. respectively.6% and fuel at 5. Price rises in the three main components of the WPI have all slowed considerably in 3 month-on-3 month annualised terms since the peak in February.19 November 2010 team expects the currency to continue to strengthen. while we are happy to leave our 2010/11 overall GDP growth forecast unchanged at 8. India’s key price measure. India: Livin’ on a prayer? 7 . pushing up the real interest rate. dropping back in year-on-year terms.4% Credit-Suisse.
which explains why we could find a statistically significant role for international food commodity prices in this equation. was that fact that real consumer spending (defined as private plus government consumption) also appears to have a powerful impact. India: Livin’ on a prayer? 8 . It is often argued that food prices are purely a function of supply-side factors. with the key points as follows: i) Primary goods (20% of the aggregate WPI): Food makes up two-thirds of the primary goods component. fuel and manufacturing.5% to primary goods prices after a year and a bit. but our analysis would suggest that demand is also highly influential. we have estimated a separate equation for the same three WPI components – primary. More interesting. a 1% rise in the rupeedenominated IMF food series apparently adds almost exactly the same amount to the WPI primary index. with a 1% rise in consumption adding 1. Specifically. Each equation was estimated on the basis of quarterly data from the beginning of 2000. We will return to this issue in the next section. however.19 November 2010 Exhibit 11: Wholesale and consumer price inflation are finally falling % y-o-y 20 18 16 14 12 10 8 6 4 2 0 -2 95 96 97 98 99 00 01 Source: Credit Suisse Industrial workers CPI Wholesale prices 02 03 04 05 06 07 08 09 10 Exhibit 12: Wholesale price rises have softened considerably in recent months % 20 15 10 5 0 -5 -10 05 Source: Credit Suisse Wholesale prices: 3m-on-3m annualised Wholesale prices: y-o-y 06 07 08 09 10 Modeling inflation In order to understand what has driven these falls as well as to help determine how inflation will develop from here.
according to the equation (grey line in Exhibit 12). there is a 20% rise in the level of oil. while metal. if we assume that commodity prices flatten out at current levels in rupee terms and consumer spending expands at a trend-like pace then.8% projections.6% after a year. For example.5% in the final quarter of calendar 2011. we once again found a role for consumption. The overriding message to come from this study is that international commodity price developments are key to all aspects of wholesale price inflation in the country. Exhibit 13: WPI scenarios with different commodity price assumptions % y-o-y 12 10 8 6 4 2 0 00 01 Actual headline WPI Forecast WPI with 20% rise in commodity prices Forecast WPI with flat commodity prices Forecast 02 03 04 05 06 07 08 09 10 11 Source: Credit Suisse. Indeed.5% average WPI rate for the current fiscal year and 6. it is comfortably the least volatile component of the three. This gives an 8. We have decided to take the average of the two scenarios described above as our own central forecast. it is important to emphasise that the accuracy of the forecasts depends crucially on whether the commodity price assumption is roughly correct. the equations suggest that headline WPI inflation will fall to around 5% early next year and then flatten out around this level (blue line in Exhibit 12). with the rupee and consumer demand playing important supporting roles. the equation suggests that a 10% rise in rupee-denominated international metal prices should be expected to add 0. the standard deviation of WPI manufacturing inflation has been less than half that of primary goods and one-quarter of that of fuel. As such.5% in 2011/12 – upward revisions from our previous 7.9% and 4. The fall before the rise As for the future. for example. before rising to 8. As always. If. iii) Manufacturing (65% of the aggregate WPI): While manufacturing prices account for two-thirds of the overall WPI index. it seems to us that the consensus forecast of Indian WPI inflation is not yet consistent with the widespread view that commodity prices will continue to head higher from here.3% to the manufacturing component. Consumption growth was statistically significant as well ─ a 1% increase typically boosts the fuel index by 0. India: Livin’ on a prayer? 9 . with a 10% rise in the oil price adding nearly 4% to the fuel component within 12 months. the recent drop in price pressures can be attributed to a combination of the strengthening currency. since the beginning of 2000. CEIC It is not without risks. food and oil commodity prices were also important drivers. however. On the basis of the equations. then the headline rate would only fall to 7% in the January-March quarter of 2011. sub-par consumer demand and stable oil prices. This is not a bad representation of the consensus view as well as that of the Reserve Bank of India (RBI).19 November 2010 ii) Fuel (15% of the aggregate WPI): The rupee-denominated world oil price was the dominant influence here. In explaining movements in this series. metal and food commodity prices over the next six months.5%-0.
5%-12% at present – modestly below what would be considered normal. Meanwhile. but on the basis of available corporate lending and mortgage rate figures.5%-13%? Most economists would tell us that the normal or neutral rate (the cost of capital) should be equal to trend economic growth (the return on capital). This is more aggressive than the consensus forecast. we continue to expect an additional 75bps in repo and reverse repo rate hikes by around the middle of next year (Exhibit 14). which saw the two key policy rates hiked a further 25bps each. while ideally we should also take into account the cost of equity as well as corporate bond and External Commercial Borrowing (ECB) rates. At the time of the 16 September meeting. the central bank wrote that. data limitations make it very hard to be precise here. Exhibit 14: We expect another 75bps of rate hikes.” What’s normal? The first statement raises an important question – how can a policy interest rate of around 6% possibly represent something “close to normal” for an economy where trend nominal GDP growth is generally thought to be around 12. we estimate that the weighted-average lending rate is something in the order of 11. for example. the statement accompanying the 2 November meeting. “based purely on current growth and inflation trends. which appears to be for little or nothing more in the way of rate rises from India’s central bank. Unfortunately. add that. but at a slower pace % 10 9 8 7 6 5 4 3 2 01 02 03 04 Repo rate CRR Repo rate F'cs 05 06 07 08 09 10 11 Source: Credit Suisse. It did. Policy rates – Enough’s enough? While continuing to raise policy interest rates. “in an uncertain world. A much better representation is given by an interest rate charged by commercial banks. More rises to come Notwithstanding this estimate. effectively ruling out a December hike.” The repo and reverse repo rates were raised to 6% and 5%. the Reserve Bank believes that the likelihood of further rate actions in the immediate future is relatively low”. suggested that. CEIC India: Livin’ on a prayer? 10 . “the tightening that has been carried out … has taken the monetary situation close to normal” adding that. the RBI has adopted a more dovish tone in its last two policy statements. at that meeting. however.19 November 2010 3. respectively. “the role of normalisation as a motivation for further actions is likely to be less important” and “current and expected macroeconomic conditions will be the more important considerations going forward. A large part of the answer reflects the fact that the policy rate is a very poor proxy for the cost of capital. we need to be prepared to respond appropriately to shocks that may emanate from either the global or domestic environment.
After all. Subburao. First. the RBI may well deem it appropriate for interest rates to be above normal. Just because the bank has signaled rates are close to normal and another hike is unlikely to be imminent. Second. CEIC India: Livin’ on a prayer? 11 . While it is certainly true to say that the link has become closer since the current RBI Governor. At the very least. the food price component of the WPI has risen by a staggering 84% since January 2005 (Exhibit 16). Exhibit 15 shows a far-from-perfect historical relationship between the policy rate and WPI inflation – the correlation between the two series has been just 0. Exhibit 15: Weak relationship between policy rate and WPI inflation % y-o-y 12 10 8 6 4 2 0 -2 01 02 03 04 WPI inflation (LHS) Policy interest rate (RHS)* % 10 9 8 7 6 5 4 3 05 06 07 08 09 10 11 *Average of repo and reverse repo rates Source: Credit Suisse. we believe the consensus may have read too much into the RBI’s recent statements. effectively imposing a huge and deeply unpopular tax on the poor. hiking interest rates will give the impression that the problem is being taken seriously. it is not clear whether this is anything more than a coincidence. Dr. our analysis suggests that food prices are influenced by consumer demand. took charge. Even if the consensus view of inflation is correct.09 since 2001. Against this background policymakers are under severe pressure to tackle the issue.19 November 2010 Our relatively hawkish rate view largely reflects two factors. CEIC Exhibit 16: Wholesale food prices up more than 80% in less than six years Index* 190 180 170 160 150 140 130 120 110 100 90 05 06 Headline WPI Food component of W PI 07 08 09 10 * Indexed such that January 2005=100 Source: Credit Suisse. which in turn is impacted by interest rates. there is a good likelihood that WPI inflation will start moving higher from the April-June quarter of next year. Although higher interest rates are widely thought to be an ineffectual tool in this regard. we are not convinced by the argument that falling inflation will inevitably put paid to the chances of further interest rate increases. we believe the RBI and key political figures won’t be satisfied until the level of food prices fall for a period. doesn’t necessarily mean that interest rates have peaked. as we argued in the previous section. In any case. After all.
We think not. wage growth and skilled labour shortages. but unlike the case with usual bank lending. FX intervention (purchase) by the central bank creates domestic liquidity if unsterilized. while consumer price measures are dominated by food.19 November 2010 Finally. we would be very surprised if the central bank wasn’t looking closely at a whole range of different variables.7% of outstanding bank deposits. some market participants have asked if the RBI might cut the Cash Reserve Ratio (CRR). around 1. Second. Exhibit 17: Banks’ net lending to/borrowing from the RBI INR bn* 1400 600 -200 -1000 Jan-01 Feb-02 Mar-03 Apr-04 May-05 Jun-06 Aug-07 Sep-08 Oct-09 Nov-10 * A -ve (+ve) number indicates that banks were net borrowers from (lenders to) the RBI. it would send a wrong signal with regard to the central bank’s monetary policy stance. the RBI must recognise that WPI and CPI inflation. in our view. our sense is that the magnitude of tightness should ease somewhat in coming months. As a result.3bn as of 30 October. the vast majority of which point to the need for further rate tightening and above-normal interest rates. 4. while a CRR cut would be a quick and easy solution to ease liquidity pressures. Source: Credit Suisse Why did liquidity turn so tight in the first place? • Government finances. it got locked up as an increase in the central government’s cash surplus (held with the RBI) and is estimated by the RBI to be worth INR777. as well as the current account deficit. although liquidity is very difficult to forecast in India. Barring the recent spurt in foreign equity inflows in October and November in response to the Coal India IPO. The large one-off revenues to the central government from 3G telecom and broadband license auctions in June gave a one-off spurt to bank credit growth. this money did not really come back to the banking system in the form of additional deposits. which remains one of tightening (see above). That is. and 12 India: Livin’ on a prayer? . which have very little to do with what is happening in India. all of which are at or close to the highs of 2007. • FX liquidity has been modest. are far from perfect indicators of underlying price pressures in the country. overall foreign inflows (taking both the current account deficit and net capital inflows together) have been modest. These include survey-based measures of capacity utilisation. First. which exceeds 3% of GDP and has been expanding rapidly. Domestic liquidity – Set to ease? Triggered by the extreme tightness in banking system liquidity since October and with comments from the RBI that it does not want liquidity to be excessively tight. The former is largely a function of international commodity price developments. Instead. as measured in India.
In RBI’s view. Exhibit 18: Banks’ deposits and lending INRbn. this should help to bring back some of the money that is currently locked out of the banking system.19 November 2010 on top of that. Additionally. Unless capital inflows surprise on the upside. while it was widely expected that liquidity would ease post the allotment of Coal India IPO shares. But we doubt that this would take us back to an excess liquidity situation. Barring October (we estimate the RBI bought around USD3. Magnitude of liquidity deficit likely to reduce but… The currently large magnitude of the deficit in banking liquidity (banks are net lenders to the RBI to tune of around INR1000bn) should reduce in coming months. this possibly reflects a shift away from deposits to currency given low real interest rates on bank deposits (effectively. the central bank has hardly intervened in the FX market since the beginning of this financial year (April 2010). While the current magnitude of tightness in banking liquidity should ease. In line with what we were expecting (India: Fiscal update – the good and the bad. It took parliamentary approval in August to spend an extra (compared to original budget estimates for the full year) INR500bn and earlier this week the government obtained approval to spend another INR200bn. Interestingly. this hasn’t materialized yet. (6m change in banks’ deposits) – (6m change in banks’ lending and investment in gov. The large Coal India Ltd IPO (worth USD3bn) in October was an additional factor for tight banking system liquidity – it led to investors’ application money getting locked up in a few hands until the actual allotments of shares were made earlier this month. in gov bonds 30 25 20 15 10 5 0 % 12m change in currency over that in deposits Sep-04 Sep-06 Sep-00 Sep-02 Sep-08 Source: Credit Suisse. 16 August 2010). The central bank has raised the cash reserve ratio by 100bps since February 2010.5bn) and probably early November. the government is taking advantage of its one-off extra revenues by loosening its purse strings. this has led to a decline in the money multiplier). CEIC Source: Credit Suisse. modest FX liquidity is likely to keep reserve money growth under check. banks’ deposit growth should see some pickup in response to the recent increase in deposit rates. From a liquidity perspective. India: Livin’ on a prayer? Sep-10 Oct-04 Oct-02 Oct-08 Oct-06 Oct-10 13 . This is another likely factor behind the recent moderating trend in bank deposits (Exhibit 19) – growth in bank deposits came off from 16% yearon-year to 13% in the six months to September. the central bank has anyway followed a relatively hands-off approach. it’s still likely to remain generally tight. The key reason for this is that we continue to expect net foreign inflows under the balance of payments to be modest (given an elevated current account deficit). • Pick up in currency demand. CEIC • CRR hikes and IPOs. bonds) Exhibit 19: Currency versus deposits (12m change in currency/12m change in bank deposits)*100 3000 2000 1000 0 -1000 -2000 -3000 Oct-00 Change in banks' deposits minus change in banks' lending and inv.
we believe India’s macroeconomic fundamentals will disappoint the consensus in a number of different respects next year. So what might this all mean for markets? It seems to us that the Indian economy has to perform very well if it is to meet the elevated expectations of foreign institutional investors in the equity market. Exhibit 20: Government spending growth is not particularly soft % y-o-y 80 60 40 20 0 -20 -40 Sep-02 Source: Credit Suisse. and we believe further upside rate surprises are likely. So while extra government spending is likely to help ease current liquidity tightness. it’s not clear how quickly and to what extent.7%. it may not turn out to be as significant as many are expecting. • Second. After the government received parliamentary approval in July to spend an extra INR500bn. many expected the locked up liquidity with the government (in the form of extra 3G telecom auction revenues) to come back in to the banking system quickly through extra government spending. This has been the consensus view for some time.19 November 2010 Also. It is also clear that plenty of money has been attracted to the market on the basis of what are perceived to be very positive macro drivers. but we expect them to remain reasonably tight. however. • Domestic liquidity conditions may ease somewhat. 14 India: Livin’ on a prayer? . • We think the main drivers of economic growth. the exchange rate. But at least as far as available data through September suggest. while the year-on-year rate of Wholesale Price Inflation is set to fall further in the next few months. oil prices and world trade will turn from positive to negative influences on activity in the not too distant future. Our estimates suggest WPI inflation will trend higher through the rest of next year if commodity prices rise from current levels. while extra government spending should help ease liquidity. Our forecast is for a total of 75bp repo and reverse repo rate hikes by around the middle of 2011. We have cut our 2011/12 GDP growth forecast to a bottom-ofthe-range 7. CEIC Government spending Trend growth Sep-04 Sep-06 Sep-08 Sep-10 Mission impossible? Without wishing to pour cold water on what is a very favourable long-term growth story. including interest rates. it might bottom in early 2011 at around 6%. While we recognise that the performance of the quoted corporate sector is not purely a function of India’s macroeconomic fundamentals. • A combination of more dovish comments from the RBI and falling year-on-year inflation rates has led most to believe that policy rates are at or very close to a peak. there doesn’t seem to have been any notable increase in spending in that quarter (ending September) (Exhibit 20). We wouldn’t be surprised if sequential rates of WPI inflation have already troughed. the links are reasonably close.
our macroeconomic view presents something of a mixed bag. the pace of tightening slowing and domestic liquidity at least easing a little. In particular. If this fails. while the prospect of more policy rate rises is not. are looking for the Indian rupee to appreciate further over the coming 12 months. On balance. An important point to bear in mind is that we think the 10-year bond yield is highly likely to flatten or fall before policy rates have topped out (Exhibit 21). then investors will have to hope that nothing comes along to stem the flow of liquidity emanating largely from the US. Downside growth surprises and at least a short-lived fall in inflation are good news. As for the government bond market. however. This is. then the onus would be on domestically oriented companies to drive a positive wedge between the top and bottom lines of their profit and loss account. With the majority of the rate rises now behind us. largely a function of a weak USD view and the team is very much cognisant of the risks surrounding the rupee. CEIC Our foreign exchange analysts. deterioration in global risk sentiment could hit the rupee harder than most other Asian currencies given the country’s high current account deficit and equity-focused foreign inflows. Exhibit 21: Bond yields likely to fall well before the policy rate does % % Policy rate (LHS)* 10 year bond yield (RHS) 11 10 9 8 7 6 5 4 9 8 7 6 5 4 3 01 02 03 04 05 06 07 08 09 10 * Average of repo and reverse repo rate Source: Credit Suisse. the fixed income team is inclined to be modestly positive. India: Livin’ on a prayer? 15 .19 November 2010 If our non-consensus views are correct. we think we should be at or close to the peak in yields. forecasting a rate of INR42 against the US dollar by this time next year.
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