india macro quarterly_oct 11

8/3/2019 India Macro Quarterly_Oct 11

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Return of Global UncertaintyA sense of dj vu

INDIA MACRO QUARTERLYOctober 2011


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11 October, 2011

INDIA MACRO QUARTERLY

YES ECOLOGUE 3

Contents Page No.

Global: Return of uncertainty...5Fears of recession weigh on financial marketsGreece: More pain in the offing

Resolution to Euro troubles: Painfully slowCentral Bank Policy: Options limited?

India: Growth to hover around trend..8Domestic consumption: Slowing but India looking inward for growth?Exports: Vulnerability to mountServices: To remain largely resilient

Structural factors keep inflation sticky......11Headline Inflation close to double digits: 19 months and countingFDI in retail: Still waiting in the wings

Core inflation momentum decelerates: The sole silver liningIndia caught in a wage-price spiral?...13

Rural wages: Powering the consumption storyUrban wage increases: Not far behindBreaking the back of wage-price spiral

Fiscal slippage unavoidable in FY12......17Expenditure remains strong while revenue continue to disappointDisinvestment target hinges on market sentimentExpectation on fiscal slippage for FY12

RBI to infuse primary liquidity through OMOs......20Domestic asset growth will be key for balance sheet expansionLiquidity deficit to deteriorate in H2 FY12

External risks contained....22BoP risks manageableFX cover to compensate for a mild deterioration in external debt

Bonds to suffer in the short term from additional market borrowing ...24Supply pressure strikes earlyOutlook

Global factors back on INR radar...27Why does Dollar movement become important?What about RBI intervention?Outlook

Vulnerabilities and policy space in case of stress....30Impact on external sector, growth, and inflationPolicy response

Annexure......33

Key Macro Numbers and Forecasts.........34


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Global: Return of uncertainty

Three years since the global financial crisis, the world economy is at the brink oftipping back into a recession. Events in the last two months, on both sides of theAtlantic, have belied expectations of optimists, who at the start of the year werehopeful of economic recovery that began in 2010 to gain further momentum in2011. The event that triggered a turnaround in sentiment was the unprecedenteddowngrade of USs AAA credit rating by one notch to AA+ by Standard & Poorsin August. The prolonged political drama which culminated in US debt limit

being raised at the eleventh hour came without a credible long term plan of debtreduction and hence justified the sovereign downgrade. A visible slowdown inthe US as the debt drama unfolded coincided with growing fears of a Greekdefault amidst renewed stress in other Euro zone peripheral economies. As thevery sanctity of the Euro monetary union began to be questioned with anintensification of debate on a solution for Greece, the speed and the scale ofturmoil in financial markets as confidence eroded, offered market players a senseof dj-vu, as many drew parallels with the period following the collapse ofLehman Brothers in 2008.

Fears of recession weigh on financial markets

Dented investor sentiment due to renewed jitters in the Euro zone over debt

sustainability has led to a sharp correction in financial markets in the last twomonths. A sharp correction across all asset classes pervaded, as a loss inconfidence triggered huge sell offs. Commodity prices declined as concerns overstrength of demand gathered pace. Crude oil (Brent) has corrected by 8% sinceearly August declining briefly below USD 100 per barrel recently, the level lastseen earlier this year in February. Correction in metal prices has led copper andaluminium prices on LME flirting close to one year lows. High beta currencies toohave taken a beating. Mimicking the sharp depreciation in Rupee (close to 6% inSeptember), Asian currencies in September recorded their biggest monthlycorrection since the Asian financial crisis in 1997. Euro is trading close to a nine

Chart1: Significant exposure to Greece, heightens

banking sector risks in Euro zone

Chart2: CDS soar to record high, as risky assets are

battered

Source: Thomson Reuters, YES BANK Limited Source: Bloomberg, YES BANK Limited

0 10 20 30 40 50 60

France

Germany

UK

Portugal

US

Netherlands

Italy

Austria

Banks Exposure to Greece (USD bn)

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1600

Sep-10

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PIIGS 5Y CDS

PIIGS 5Y govt bond spread with Germany

(bps)

Global economy at present is at the brink of tipping back into a recession Speed and scale of turmoil in financial markets reminiscent of the period post Lehman collapse Real economic growth has evidently slowed down in advanced economies, with a likelihood of a soft

landing in EMEs Despite desperate attempts to rescue Greece, a credible solution still remains out of sight With interest rates close to zero and high level of debt, advanced economys central banks are running

out of policy options to spur economic growth

Global economy at thebrink of tipping back intoa recession

Downgrade of USsovereign credit ratingfollowed by fears of aGreek default

led to sharp volatilityin financial markets

Erosion in investor

confidence has led to asharp selloff in all assetclasses

Commodity prices havecorrected; Brent crudebriefly falling belowUSD 100 pb


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month low against the USD and an all time low against the Yen. Since Augustbeginning, DJIA has declined close to 6%. Nikkei, DAX and Sensex have pared amuch greater 12%, 9% and 10% of their respective values. This has beenaccompanied by a surge in Credit Default Swaps (CDS), with 5 year CDS onGermany doubling since beginning of the year, to touch a record high of 118 bpson 3rd October, 2011. Recently, with US funds shutting off lending to Europeanbanks to limit their exposure to European sovereign debt, ECB announced aDollar based liquidity operation in unison with other major central banks, to offerunlimited amounts of USD liquidity operations to European Banks. The move wastriggered by heightened banking concerns in the region reflected in a sharpplunge in European banking stocks and 3 month Euribor rate soaring to 1.61% inearly August, the highest level since Mar-09. Additionally, the Markit iTraxxsenior financial index which expresses the cost of insuring the debt of 25 Europeanbanks and insurers, slumped accompanied by CDS of several European bankstopping post Lehman record highs.

Real economic growth softens visibly

Real economy growth indicators had begun to show a synchronized softnessglobally since Q2 2011 (see chart3), facing headwinds from elevated commodityprices, slowdown in consumption and ripple effect of regional economicweakness in one market spilling over to the other. The ongoing stress in thefinancial markets and unfavorable effects on financing conditions are likely tofurther dampen the pace of economic growth. GDP growth in US dropped to aseven quarter low of 0.4% in Q1 2011 and continued to remain depressed in Q2,expanding at a mere 1.3%. GDP in Euro zone stalled in Q2 2011, expanding by atepid 0.2%, led by a sharp dip in Germanys growth.

PMI for both manufacturing and services sector too have plunged, dipping incontraction phase in several economies, as new businesses dry up. PMI for EZ andUK display a loss of manufacturing momentum, with that of US, China, India

dropping to multi-month lows, edging precariously close to threshold level of 50(see chart4). Services too have followed suit, with PMI services for UK, US and EZexpanding at a weak pace. A sharp drop in services PMI in China and India, whereservices account for close to 45% and 60% of the GDP respectively, reinforces thelikelihood of soft landing in EMEs. Sign of a moderation in growth in other ASEANeconomies is visible from dampened export demand in Singapore, China, Thailandand Taiwan.

Greece: More pain in the offing

As Greece continues to grapple with limited cash reserves, the survival of thenation now hinges on the next tranche of aid. In an attempt to secure the

Chart3: Synchronized softness in global GDP Chart4: PMI trend lower in several economies

Source: Bloomberg, YES BANK Limited Source: Bloomberg, YES BANK Limited

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Global GDP Growth (%YoY)

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Japan

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PMI Manufacturing

China UK

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India

Equity markets losesignificant value.

while, CDS spreads

surge to record highs

Heightened bankingconcerns in EZ, force ECBto set up Dollar swaplines

Growth in Q2 2011indicates a synchronizedglobal weakness

mayhem in financialmarket runs the risk offurther slowing economicgrowth

PMI, both manufacturingand services, haveplunged in severaleconomies

Greeces survival hingeson next tranche of aid


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continued backing of international creditors (i.e Troika) and in a bid to keep itselfsolvent, the Greek government recently approved USD 8.8 bn of austeritymeasures including taxes on lower incomes, firing of state workers, wage cuts andreduction in pensions. Through the austerity measures, Greece attempts to securethe sixth tranche of bailout loan of EUR 8 bn from the EUR 109 bn bailout packageagreed by EU leaders on July 21, 2011. Despite the ambitious deficit reductionprogramme, Greek government announced that it would only be able to reduce itsfiscal deficit to 6.8% of GDP in 2011, falling short of the 6.5% target previouslydrawn upon by the Troika. As late as October 4, 2011 EU finance ministers agreedto delay Greeces receipt of aid till it enforced stricter measures and decided toreview the involvement of private sector in the bailout, which had earlier agreedto a 21% write down on their holding in Greek debt. It seems that Greece willperhaps have to wait longer for the next installment of aid to flow, while itembraces more austerity measures and proves its credibility to cut deficit further.

Resolution to euro troubles: Painfully slow

To resolve the Greek crisis and minimize the impact of a potential Greek defaulton banks, the EU commission has recommended a coordinated capital injection toEuropean banks. Trichet, ECB governor, made a call to all European banks andsupervisors recently to do what all is necessary to address the need forcapitalization. This is perhaps a signal of more action to come on the part of theEuropean policy makers to step up aid to banks and push private investors toaccept bigger losses on Greek bond holdings. While there is clear skepticismamong market participants over the size of the EFSF at EUR 440-billion beingsufficient to bailout the region, the recent vote by several European parliaments(including heavy weight Germany) to expand powers of EFSF (to enable ECB tobuy bonds in secondary market and recapitalize banks) was well received by themarkets. German Chancellor Angela Merkel recently indicated that the use of theFund should be limited as the last line of resort to defend the Euro. However, itremains to be seen how the logjam in Euro zone politics pans out to curtail theregions growing debt crisis amidst populist anger and turbulence in financialmarkets.

Central bank policy: Options limited?

With a recession like scenario unfolding, Central Banks globally have returned yetagain to a crisis fighting mode to support economic growth and stabilize financialmarkets. Three years since the Lehman collapse, monetary policy in advancedeconomies is now caught in the classic Keynesian liquidity trap, as interest ratesclose to zero leave limited or no room for further cuts to spur growth. On thefiscal front, stimulus programs in the aftermath of the global meltdown have leftbehind a legacy of unsustainable debt levels on both sides of the Atlantic.

On 6th October, 2011 the ECB announced that it would reintroduce purchase ofcovered bonds and provide yearlong loans for banks to support liquidity inmarkets. The BoE, on the same day, boosted its asset purchase program by GBP 75bn, to GBP 275 bn to avert a recession in the economy. Both central banks haveresorted to deploying old policy tools. The policy decisions follow the FederalReserves Operation Twist announced last month, which aims to replace USD400 bn of short term securities by long term securities in a move to reduceborrowing costs further and lower unemployment. With global growthmomentum under threat, additional easing in the form of Fed announcing a QE-3and ECB cutting rates cannot be ruled out, but clearly, central bankers are rapidlyrunning out of policy options to spur economic growth.

Despite the ambitious

austerity measures,reduction in fiscal deficitchallenging for Greece

Policy makers urgeRecapitalization ofEuropean banks

as EFSF, largelyinsufficient if crisisspreads to othereconomies

It remains to be seen howlogjam in EZ politicspans out to curtail the

crisis

With monetary policystuck in a Keynesianliquidity trap

coupled with mountinglevels of debt on thefiscal side

central banks arerunning out of policyoptions to stir economicgrowth


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India: Growth to hover around trend

In a quarter since our last update ( A Mid-Cycle Correction within Strong SecularGrowth Story, 20-May-11), in which we focused on a deliberated growth-inflationtradeoff being embraced by the RBI, the Indian economy has begun to displayincipient signs of moderation in growth albeit in pockets. However despite RBIhiking policy rate 12 times since March 2010, inflation continues to remain elevatedwith a strong likelihood of headline printing above 9% even in the next 2-3 months.More so, the situation in the global markets has been least supportive at a timewhen domestic policy challenges have surmounted. The vulnerable global economy

has the potential to translate into not only a weaker export growth for India, butalso impair critical investment inflows necessary to put the country on a highergrowth trajectory. While private consumption remians key for domestic growth, webelieve that it is time that India overthrows its complacency over consumptionauto-driving the economy. Much needed policy reforms to stir deferred investmentsinto action and to alleviate supply bottlenecks are required, to ensure that aneclectic mix of investment and consumption drives growth.

Domestic consumption: Slowing but India looking inward for growth?

With domestic consumption accounting for close to 70% of GDP, India enjoys thecomfort of looking inward for driver of economic growth. As pointed out in asection later (see India Caught In a Wage-Price Spiral?) strong rural demandbuoyed by steep wage increases has kept consumption demand ticking with nosymptom of a marked slowdown despite RBI hiking rates aggressively in the lastyear and a half. In our last quarterly report, we had pointed out the likelihood ofconsumption slowing down in FY12 due to re-pricing of credit at retail levelaligning with the policy stance of the RBI. The incipient signs of this moderationwere evident in the latest GDP figures for Q1 FY12 as private consumptiongrowth decelerated to 6.3%, compared to FY11 growth of 8.6% (see chart5). Otherhigh frequency variables also point to a moderation in consumer demand. On atrend basis, (12 month moving average) IIP consumer durable goods indicate aclear downturn. In addition, sale of passenger cars has plunged since thebeginning of the fiscal year (see chart6). Deployment of bank credit to personalloans on an incremental basis has also slowed in FY12. While we expect

Chart5: Private consumption indicates nascent signs ofmoderation

Chart6: as reflected in automobile sales

Source: CEIC, YES BANK Limited Source: CEIC, YES BANK Limited

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Private Consumption (% YoY)

IIP Consumer Goods (% YoY, RHS)

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Auto sales

Personal Vehicle Sales (3mma, %YoY)

3 Wheeler Sales (3mma, %YoY)

2 Wheeler Sales (3mma, %YoY)

Domestic private consumption displays nascent signs of moderation; but to remain supportive Investment climate remains weak; urgent need to hasten reform process to spur investment activity Export growth likely to ease in H2 FY12 Strength in agriculture and services sector to limit the downside in FY12 GDP growth We lower our GDP growth forecast to 7.7% from 7.9% earlier as we envisage a sharper slowdown in

industrial growth than perceived earlier

While growth has begunto display incipient signsof moderation

inflation continues toremain elevated, despiteRBI hiking rates 12 timessince March 2010

Consumption growthhasbegun to show signs of

easing

Car sales plunge; credit topersonal loans onincremental basis lower


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consumption to moderate further, the impact of past policy action is likely toremain limited to only urban consumption.

Investment sentiment weak; warrants need for hastening reforms

The investment climate in the economy has been adversely affected due toelevated level of commodity prices, policy inertia and rise in cost of financing. The

average gross fixed capital formation growth has declined to 5.4% in the last threequarters compared to 15% in the preceding three quarters. Growth in proposedindustrial investment is currently hovering close to a two year low (see chart7)

For sustainability of growth, acceleration in investments is imperative. With amajority of key bills and policy reforms still waiting in the wings, investmentdecisions have been deferred. Fast tracking of reforms will facilitate in attractinggreater private and foreign investment.

Exports: Vulnerability to mount

With global growth entering a soft patch - a visible slowdown in US and EZgrappling to avert a sovereign default, vulnerabilities to Indias export growth

have mounted. Since the beginning of FY12, exports on a monthly basis haveaveraged close to USD 27 bn compared to USD 20 bn in the previous fiscal year,clocking a spectacular growth rate of over 50% on a YoY basis.

Indian exports have bucked the recent trend of a slowdown in its Asian peers (seechart8). Yearly export growth in Taiwan and Singapore almost grounded to a haltin the month of August. Exports of these two economies serve as a bell-weatherfor Indian exports as witnessed in the recovery post Lehman crisis. The latestreading for Indian exports (for August) show incipient signs of cooling off;tracking though belatedly the slowdown in other Asian economies. Goingforward, amidst an easing demand in domestic economy coupled with the end ofDEPB benefits and a high base effect kicking in December onwards, the pace ofgrowth of Indian exports is likely to witness a correction.

Government spending: To offer limited support

Government spending is likely to offer limited support in FY12. The UnionBudget FY12 made a provision for a meager 3.4% growth in total expenditurecompared to 18.7% in FY11. With FY12 being the final year of the current five yearplan period, growth in plan expenditure is expected to be at 11.8%. The burden ofadjustment hence has fallen on non-plan expenditure, which is expected tocontract for the first time in the last thirteen years by 0.7%. However, due to anunder-budgeting of the subsidy burden, we expect actual expenditure of thegovernment to be higher than that budgeted.

Chart7: Investment sentiment suffersproposedindustrial investment at a 2 year low

Chart8: Indian exports buck the Asian trend tillnowlikely to suffer going forward

Source: CEIC, YES BANK Limited Source: Bloomberg, YES BANK Limited

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Trend (3mma, %YoY)

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Asian Exports

TaiwanSingapore non oilChinaThailandIndia

(%YoY, 3mma)

however, slowdownconfined to urbanconsumption

Growth in proposedindustrial investment at a2 year low

warrants the urgentneed to hasten reformprocess

India has bucked thetrend of a slowdown inAsian export growth.

slowdown in globalgrowth, easing domesticdemand and withdrawalof DEPB to weigh onexports, going forward

Minimal increase inbudgeted totalexpenditure to limit govtspending in FY12


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Agriculture: Another year of strong growth

Agriculture sector in FY11 clocked a growth rate of 6.6% owing to a favourablebase, close to normal monsoon and a record output of food grains.With an aboveaverage monsoon rains boosting the production of both rice and wheat this year,it is expected that India will achieve a record production of agri crops yet again in

FY12, as there is a strong correlation between food grains output and actualrainfall as a percentage of long period average (see chart9). In addition, a latewithdrawal of monsoon would also aid the sowing of Rabi seeds. We peg FY12agriculture growth at 3.5% owing to an adverse base effect, but with an upsidebias to our estimate.

Services: To remain largely resilientSome moderation due to lagged impact of slowdown in industrial activity

Being a services sector driven economy, India stands to benefit from the relativeresilience of the sector. In the aftermath of the FY09 global financial crisis, theslowdown in the Indian economy was largely led by industries and agriculturewith services growth holding up relatively well.

Despite a track record of proven resilience in previous downturns, services cannotgrow single handedly and are bound to witness some moderation at a time whenmanufacturing growth is receding. The latest PMI reading for services plummetedto a two and a half year low, falling below the 50 level. Banking and real-estateservices are likely to be negatively impacted by the current high rates of interest.Community, Social and Personal Services which is closely related to Governmentfinal consumption expenditure have already begin to moderate owing torestrained government expenses in a bid to keep fiscal exchequer under check.

Industry: To lead the moderation in GDP growth

There are clear signs of a slowdown in the economic activity since the beginningof FY12. IIP growth in the April-July FY12 clocked a growth of 5.8% against 9.7%

in the same period a year ago. The new IIP series on revised base of 2004-05,though offers a wider coverage, but is as volatile as the older series. Within IIP,the slowdown has been particularly sharpfor mining and manufactuing sectors.While the former suffers owing to regulatory and environmental restrictions,interest rates hikes have weighed on the latter. Based on the YTD trend, we reviselower our FY12 industry growth forecast to 6.7% from 7.2% earlier.

FY12 outlook: For FY12, we estimate a GDP growth of 7.7%, lower than ourearlier estimate of 7.9%, as we envisage a sharper slowdown in industrial growththan perceived earlier.

Chart9: Above normal monsoon in FY12 to aidagricultural output

Chart10: Resilience in services to limit the downside inGDP growth


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Agriculture Industry Services

Above normal monsoon

in Jul-Sept, and a latewithdrawal to ensure astrong agri growth inFY12

Services to remainbroadly resilient, as in2008.

.though somemoderation likely

Industrial growth underpressure; weak growth in

mining andmanufacturing sectors

We lower our FY12 GDPforecast to 7.7% from7.9% earlier


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Structural factors keep inflation sticky

Headline inflation close to double digits: 19 months and counting

Indian economy recorded a rapid annual growth averaging over 8% in the periodfrom 2003-08 accompanied by an average inflation rate of slightly below 5%. Sincethe crisis, while growth has returned to its trend rate of 8%, inflation has beenpersistently higher close to double digits for the last 19 months. During thisperiod, the underlying drivers of inflation shifted from primary food to primarynon-food to the more generalized non-food manufacturing, indicating emergence

of strong demand side pressures in the economy. In addition, elevated globalcommodity prices especially crude oil exacerbated price pressures.

Food inflation continues to remain elevated: Due to structural factors andinadequate policy response

Despite two successive years of normal monsoon, food inflation is currently closeto 10%. Though it has declined from a peak of above 20% in early last year, thecurrent level remains unacceptably high. Abysmally low levels of investment inthe agriculture sector, with gross capital formation in agriculture sector as apercent of total capital formation in the economy languishing below 3%, remains akey constraint for enhancing agricultural supply (see table 1). While supply sideconstraints have had a role to play in keeping inflation elevated, strong demand

side pressures have only added to the woes. The consumption basket, accordingto the NSSO survey, indicates a growing bias for consumption of so called proteinrich items that have led to higher inflation of non-cereal food items.

FDI in retail: Still waiting in the wings

The much awaited opening up of FDI in multi-brand retail seems to have gotprolonged. According to media reports, FDI in retail has got pushed to the nextfiscal year due to lack of political will and consensus among political parties. Thepolicy is widely expected to help in easing food inflation in the economy. The gapbetween farm gate prices of agricultural commodities and their retail prices inIndia is currently amongst the highest in world, due to long chain of

Chart11: Inflation continues to remain close to doubledigits for 18 months

Table1: Poor investment in agriculture sector aggravatesupply constraints


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FY09 FY10 FY11WPI Inflation (% YoY)

Average monthly WPIsince Apr-05 = 6.29%

Year

Gross Capital

Formation in

Agr as a % of

Total

FY05 2.56

FY06 2.66

FY07 2.54

FY08 2.69

FY09 3.09FY10 2.97

WPI inflation continues to remain close to double digits for almost 19 months While food inflation has eased, the current level remains unacceptably high at around 10% Supply constraints amidst strong demand side pressures keep inflation elevated The much awaited opening of FDI in multi brand retail likely to have been pushed to FY13 Headline WPI inflation to moderate albeit at a slow pace in the coming months The sharp correction in sequential momentum of core inflation should give RBI some comfort We expect WPI inflation in the range of 6.5-7% by Mar-12

Inflation has remainedclose to double digits inlast 18 months

justifying RBIs anti-inflationary stance

Supply bottlenecks inagriculture sector coupledwith strong demand

has meant food

inflation remainingelevated

FDI in multi-brand retailpostponed to next year


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intermediaries and inefficient mechanism of price discovery in the agriculturalsector. Opening up of FDI in the sector by ushering in professional expertise andwiping out middlemen is expected to reduce the gap between wholesale and retailprices and improve supply side inefficiencies in the sector.

Petrol Deregulation: Adds to inflation woes

Since deregulation in June 2010, petrol prices have been revised up 6 times byclose to 30%, with Brent crude price firming up by close to 50% during the sameperiod. While the frequent upward revisions to petrol prices has pushed analready elevated level of headline inflation higher, it has reduced the underrecoveries of the oil marketing companies, thereby lowering the subsidy burden ofthe government in turn. While the deregulation of petrol prices was a move longawaited, the government has not followed suit with diesel, kerosene and LPGprices, which are a bigger drain on the exchequer.

Headline WPI inflation: Moderation albeit at a slow pace in the coming months

While we believe that inflation saw its peak in August, it is expected that theheadline inflation will remain above 9% till November, since-

(i) Pass-through of high global commodity prices to domestic prices remainsincomplete(ii) Current administered electricity prices are yet to reflect increase in input

prices, even as many states have initiated increases(iii)The recent weakness in Rupee (driven by global risk aversion), if persists,

could add to inflationary pressures

Core Inflation Momentum decelerates: The sole silver lining

As the headline WPI inflation, core inflation continues to remain sticky above 7%.However, the sequential momentum in core has corrected from an average ofclose to 140 bps in Q4 FY11 to 50 bps in Q1 FY12 (see chart12). In three out of thefour last inflation readings, sequential momentum has clocked close to 0.40%, in

line with its historical average (0.37%), indicating incipient signs of stabilization inthe same. While it may take a few more months for core inflation to print below7%, the slowdown in sequential gains close to long period average should giveRBI some comfort on inflation front.

WPI Inflation to ease to 6.5-7% by Mar-12We expect inflation to ease to 6.5-7% by March end (see chart13), due to-(i) A favorable base effect(ii) Impact of past monetary action panning out(iii)The recent correction in global commodity prices

Chart12: Sequential momentum in core inflationcorrects sharply since Q4FY11 Chart13: Inflation to ease to 6.5-7% by March 2012


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EstimatedWPI trajectory

could have helped toease inflation byimproving supply chain

Deregulation of petrolprices has put upwardpressure on an alreadyelevated inflation level

WPI inflation expected toremain above 9% tillNovember

Sharp correction insequential momentum of

core inflation positive

We expect inflation todecline to 6.5-7% by Mar-12


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India caught in a wage-price spiral?

Wage-Price Spiral: A reality?

In the last two years, consumption in the Indian economy has remained resilientdespite inflation remaining above 9%, at almost twice its accepted threshold levelaccording to RBI. Private final consumption in the Indian economy has trendedhigher since the 1990s with a visible pickup in its pace of acceleration since 2005(see chart14). Even as the global economy struggled to expand during thefinancial crisis of 2008, consumption growth in India bottomed out at strongannual growth of 7.3% in FY10, highlighting the strength of domestic demand andits imperviousness to the global downturn. In the last few years, domesticdemand has found support in governments fiscal stimulus spending and otherreforms including higher public spending (especially in rural areas), cuts inindirect taxes, farm loan waiver package and a pay commission meting outgreater salaries to government employees. The direct and indirect impact of theseand other policies on rising wages, which inturn has helped to keep demandbuoyant, contributed to higher inflation as supply responses failed to keep trackwith the powering demand. We believe that India is currently experiencing theclassic wage-price spiral, in which prices and wages chase one another, makinginflation adopt a more structural nature in the economy.

Rural wages: Powering the consumption storyNREGA: Inducing structural changes

On the rural side of the economy, evidence of origin of a wage-price spiral can betraced to two channels - hikes in minimum support prices and expenditure onsocial security schemes such as the NREGA. NREGA, the UPA governmentsflagship programme initiated in 2005, guarantees rural labourers employmentopportunities at a minimum wage rate in non-farm activities. The success of thesocial scheme has not only pushed non-farm wages higher (by guaranteeing awage higher than the minimum wage in many states) but has also granted ahigher wage bargaining capacity to labourers employed in agriculture sector, byoffering them alternate employment opportunities in the non-farm sector. Data on

Chart 14: Private consumption in India ticking higheron a trend basis

Table2: Steep gains in rural wages in last three years

Source: CEIC, YES BANK Limited Source: Labour Bureau GOI, CEIC, YES BANK Limited

2

3

4

5

6

7

8

9

10

FY97

FY98

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

Private Consumption (% pa)

Private Consumption Trend (% pa, 5 yr ma) Agri Non-agri

FY06 5.5 3.3

FY07 6.9 4.3

FY08 8.1 7.1

FY09 11.6 10.2

FY10 16.9 14.5

FY11 19.5 16.8

Average rural daily wages (%YoY)

Private consumption in India rising on a trend basis; cushioned impact of the global financial crisis NREGA and sharp revisions in agricultural MSPs fuel rural wages Evolving dietary patterns exacerbate price pressures by lifting demand for protein rich items

Wages witness a strong growth in corporate and government sector in the last few years Higher wages stimulating demand in the absence of adequate supply response keeps inflation elevated The wage-price spiral has hardened inflationary expectations Need for fiscal policy to complement monetary policy to break the back of the wage-price spiral

Private consumption inIndia rising on a trendbasis

Government policies andother reforms haveboosted incomes

We believe India iscurrently experiencingthe classic wage-pricespiral

The success of NREGAhas meant higher wagesfor both farm and non-farm labour


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11 October, 2011


YES ECOLOGUE14

average rural daily wages of men for both farm and non-farm work corroborate thesame. We find that during FY09-11 agri and non agri wages rose cumulatively by48% and 41% respectively compared to a modest 6.8% and 4.9% cumulative hike inthe preceding three year period (see table). A similar trend is also seen in wages ofrural casual labourers employed in public works. According to NSSO Employmentand Unemployment rounds of 2007-08 and 2009-10, wages of casual workers roseby close to 22% in the two year period. Higher wages implying greater purchasingpower and a strong demand, have added to inflationary pressures in the economy.

Minimum Support Prices: See sharp upward revisions

However, NREGA stand alone is not solely responsible for contributing to thewage-price spiral. A collective rise in the price of agricultural inputs, rural wagesand international prices of primary commodities have underpined strong upwardrevisions to Minimum Support Prices for crops. In a three year period of FY09-11,agriculture sector has witnessed increases in MSPs to the tune of 40% or more forseveral crops (see chart15). Higher MSPs translate into higher rural purchasingpower and feed into inflation by keeping demand conditions robust. Withrevisions in NREGA wages and MSP both being indexed to inflation, the

cyclicality of wages and prices chasing one another gets further reinforced.

Evolving Dietary Patterns: Exacerbate price dynamics

The wage-price spiral has been exacerbated also by changes in dietary patternsespecially in the rural economy. From NSSO Household ConsumptionExpenditure Surveys, we find that while the share of monthly per capita incomespent on food has declined, within food products, there is a clear bias for greaterexpenditure on protein and nutrient rich items. As a share of total expenditure onfood, expenditure on pulses, egg, fish & meat and vegetables & fruits has risenbetween FY05 and FY08 (see table3). On inflation front, price pressures have alsobeen more prounounced in protein rich items and fruits & vegetables (see chart16)

Source: NSSO Employment and Unemployment Rounds

Year Male Female Person

2009-10 (` )* 94.63 86.655 91.07

2007-08 (` ) 76.02 70.66 74.45

Growth (%) 24.5 22.6 22.3

Wages of Casual Labour in Public Works

*average of wages of casual labour in public

works under NREGA and in public works other

than NREGA public works

Chart15: Sharp upward revision to MSPs of several

agricultural crops

Chart16: Price pressures more pronounced in protein

rich food items


0

10

20

30

40

50

60

70

80 Gains in Minimum Support Prices

FY06-FY08

FY09-FY11

100

120

140

160

180

200

220

240

Aug-05

Dec-05

Apr-06

Aug-06

Dec-06

Apr-07

Aug-07

Dec-07

Apr-08

Aug-08

Dec-08

Apr-09

Aug-09

Dec-09

Apr-10

Aug-10

Dec-10

Apr-11

Aug-11

WPI Inflation Index

Pulses

Fruits

Milk

Egg, Meat, Fish

verified byEmployment andUnemployment rounds ofNSSO

Sharp revision in MSPsfor crops has meanthigher rural purchasingpower

The evolution of dietarypatterns has led to

higher price pressuresin protein rich items,fruits and vegetables


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11 October, 2011


YES ECOLOGUE 15

Urban Wage Increases: Not far behind

The pace of wage increases in urban india have been as robust as those witnessedin rural. Despite having a favourable demographics, India has suffered from adearth of skilled talent because of its limited investment in educationalinfrastructure. With global companies having set base in India, there has been a

growing wrestle for acquiring the requisite talent, which in turn has meant highersalaries and incentives for employees. To authenticate the same, we use capitalinedatabase of Indian companies to calculate the employee expense (of which wages,salaries and bonuses are a bulk component) of BSE 500 companies. Our analysis isrestricted to a subset of about 150 companies due to limitations of dataavailability, but nevertheless offer a broad gauge of the corporate sector. We findthat since FY06 the annual gains in corporate wages has outpaced the annualgrowth of nominal GDP in every year (see chart17), except in FY10, when growthin corporate wages declined to 15.5% while nominal GDP growth remained closeto FY09 level, supported by a higher inflation above 9%. Not only has the privatecorporate sector been a testimony to strong wage hikes, government sector too hasreceived a bigger share of the pie. According to Department of Labour,

Government of Delhi data, minimum wages for unskilled, semi-skilled and skilledworkers have witnessed a cumulative hike of 50%, 58% and 63% in FY10-FY11. Ontop of a 33% hike in minimum wages of unskilled workers in FY10, Delhigovernment hiked wages by another 15% in FY11 citing inflation as the primaryreason (see table4).

Breaking the back of wage-price spiral

Inflation inertia sets in?

With strong upward revision in wages feeding into inflation and vice versa, anelevated level of inflation in the economy has been accompanied by a hardeningof inflationary expectations. According to RBIs quarterly survey, inflationexpectations for present and future (both 3 month and 1 year) continue to hover

close to record high levels, indicating expectations of high intransient inflation(see chart18). Given the nature of inflationary expectations to feed on themselves,RBI in its annual monetary policy raised two pertinent questions that monetarypolicy confronts in a situation of wage-price spiral.

Amidst a wage-price spiral and continued cost push and demand side pressures on

domestic prices, monetary policy confronts two key questions. First, will the recent signs

of weakening activity persist and restrain wage price and demand side pressures on

manufacturing inflation? Second, are there other factors that might put further pressure

on prices and wages and keep inflation high, thus feeding further on inflation

expectations? A judgement on the answers to these questions will influence the calibration

Table3: Evolving dietary patterns exacerbate the wage-price spiral

Chart17: Annual gains in corporate wages beat nominalGDP growth

Source: NSSO, MOSPI, YES BANK Limited Source: Capitaline, CEIC, YES BANK Limited

Rural 2004-05 2007-08

Item Group

Cereals 32.9 30.9

Pulses 5.9 6.2

Milk & milk products 15.3 14.8

Egg, fish and meat 6.2 6.4

Vegetables & Fruits 14.3 15.6

Sugar, salt, spices and edible oil 17.3 15.6

Beverages, refreshments and processed food 8.1 10.6

Source: NSSO

Expenditure as a % of MPCE

14

17

20

23

FY06 FY07 FY08 FY09 FY10 FY11

Corporate Sector Wage growth (% YoY)

Non Farm GDP Growth (% YoY)

Corporate wages keeppace with rural trends.

Wage growth in Indiancorporate sector outpacesthe growth in nominalGDP

Government employeesalso enjoy sharp upwardrevision to wages

Wage-price spiral hashardened inflationaryexpectations in theeconomy.

RBI visibly concernedabout the policychallenge that a wage-price spiral poses


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11 October, 2011


YES ECOLOGUE16

of the monetary policy stance

Need for fiscal policy to complement monetary policy

Since the Annual Policy in May, growth in the economy has begun to show signsof moderation albeit in pockets. Clearly, the interest rate sensitive sectors ofconstruction, auto production and investment are slowing down at a faster clip. Inaddition, the pace of sequential momentum in core inflation has corrected fromclose to 140 bps in Q4 FY11 to 50 bps in Q1 FY12. With a full impact of past policyaction and the more aggressive rate hikes in this fiscal (150 bps since May)panning out gradually, the monetary policy induced moderation in growth willhelp to break the inertial inflation dynamics and alter inflationary expectationsgoing forward. While we believe that RBIs rate tightening in the current cycle isnow over, the greater task of breaking the back of wage-price spiral completelynow rests on expenditure driven fiscal correction and government policies toenhance agri supply response.

Table4: Government salaries witness exorbitantupward revisions in FY10-11

Chart18: Wage-price spiral leads to hardening ofinflationary expectations

Source: Labour Bureau GOI, Indiastat, YES BANK LimitedSource: CEIC, YES BANK Limited

Unskilled Semi Skilled Skilled

2000 3.0 2.8 2.6

2001 6.6 6.2 5.6

2002 3.4 3.2 2.9

2003 4.4 4.1 3.8

2004 2.8 2.7 2.5

2005 6.4 6.0 5.5

2006 7.4 7.0 6.5

2007 6.1 5.8 5.4

2008 4.7 4.5 4.2

2009 8.3 7.9 7.4

2010 34.2 42.7 48.0

2011 15.3 15.1 14.9

Increase in Minimum Wages for Unskilled, Semi Skilled

and Skilled Government employees in Delhi (%YoY)

3

5

7

9

11

13

15

Jun-07

Dec-07

Jun-08

Dec-08

Jun-09

Dec-09

Jun-10

Dec-10

Jun-11

Current 3M Ahead 1Y Ahead

RBI's Household Inflation Expectations Survey

With the rate tighteningcycle now over

there is a greater rolefor fiscal policy to play inbreaking the back of awage price spiral


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11 October, 2011


YES ECOLOGUE 17

Fiscal slippage unavoidable in FY12

We had earlier highlighted the possibility of a fiscal slippage in FY12 and called fora fiscal deficit to GDP ratio of 5.5% vis--vis the budgeted target of 4.6% (for detailssee our earlier report:Analyzing the impact of fuel price hike, 27-Jun-11) on the back ofovershooting of the subsidy bill and loss in indirect tax revenue due to duty cuts onfuel prices. Over the last few months, risks to fiscal slippage have mounted further.Economic growth is now showing signs of moderation and governments

disinvestment target for FY12 is at risk both of them can potentially providefurther upside risk to fiscal deficit. Despite the emergence of upside risks, we nowexpect (for reasons mentioned below), the FY12 fiscal deficit to GDP ratio to come at5.1% vis--vis 5.5% expected earlier.

Expenditure remains strong while revenue continue to disappoint

According to latest data (as of Aug-11), the fiscal situation has deteriorted on bothexpenditure and revenue account. On FYTD basis (Apr-Aug), total expenditurecame at 37.5% of the budget target while net tax revenue collections came at 23.1%of the budget target (after adjusting for the expected shortfall due to announcedduty cuts in June). Hence so far in FY12, while expenditure has overshot its long-term average, tax revenue has disappointed (see chart 19).

For the period Apr-Aug, gross tax revenue growth came at 12.2% on a YoY basis.This is less than half the growth seen during the corresponding period of FY11 (seetable 5). Barring service tax collections, all other sources of tax revenue have beenshowing deceleration in growth momentum. A moderation in real economicacitivity on the back of monetary policy tightening by the RBI explains lowergrowth in corporate tax, customs and excise collections. Additionally, the cut inexcise and customs duties for fuel items would also start impinging upon indirecttax collections. Going forward, tax collections are likely to be under further pressureas FY12 GDP growth moderates towards 7.7% (for details see - India Growth: Tohover around trend).

Chart19: FY12 fiscal deficit at risk? Table5: Growth in tax collection moderates

Source: Budget documents, CEIC, YES BANK Limited Source: Budget documents, CEIC, YES BANK Limited

28%

30%

32%

34%

36%

38%

40%

18% 20% 22% 24% 26% 28% 30% 32%

RatioofApr-AugExpendituretoFY

Expenditure

Ratio of Apr-Aug Tax Revenue to FY Tax Revenue

FY01-FY11 Average

FY12FY09 FY10 FY11 FY12

Gross Tax revenue 25.0 -11.6 27.3 12.2

Corporate tax 45.9 2.5 18.4 -12.7

Income Tax 35.8 8.1 14.0 12.6

Customs 17.0 -34.1 59.8 27.1

Excise 6.6 -24.5 43.3 17.9

Service Tax 28.7 -2.3 13.8 37.0

Others 17.4 -2.0 -28.9 -3.3

YoY Growth over Apr-Aug (%)

Moderation in GDP growth and duty cuts announced earlier in the year to put tax revenue target at risk Low market appetite and uncertain environment can result in lower disinvestment receipts Expenditure management to become complicated as subsidy bill overshoots budget targets The government recently announced additional borrowing worth ` 529 bn for H2 FY12 to compensate for

the shortfall in other sources of financing the deficit We expect the government to lower the pressure on fiscal deficit and market borrowing by cutting

expenditure and deferring part of the subsidy payment to FY13 We now expect FY12 fiscal deficit to GDP ratio to come at 5.1% vis--vis 5.5% expected earlier

Fiscal slippage risks havemounted over the last fewmonths

Between Apr-Aug, whileexpenditure has overshotits long-term average, taxrevenue has disappointed

Except service taxcollections, all othersources of tax revenuehave been showingdeceleration in growthmomentum


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11 October, 2011


YES ECOLOGUE18

Subsidy to put further drain on resources

The government has so far disbursed 63% of food subsidy, 52% of fertilizer subsidy,and 89% of oil subsidy over the period Apr-Aug FY12. On the issue of oil subsidy,the current disbursal of 89% is misleading as most of the payment made by thegovernment has been account of clearing of FY11 dues. Assuming that oil prices

will average around USD 100-110 pb level for the entire year (the prospect offurther quantitative easing by central banks in developed economies couldpotentially offset the negative impact on oil prices emanating from the risk of aslowdown in global growth momentum), we expect oil subsidies to come around `500 bn (about ` 300 bn higher than budgted target for FY12).

The government could potentially reduce the underrecoveries (currently expectedover ` 1000 bn in FY12), and hence the oil subsidy bill, if further upwardadjustments are made in prices of diesel, kerosene, and LPG. However, it would bepolitically difficult to pass such a hike as the expected inflation moderation processwill get further delayed.

Disinvestment target hinges on market sentiment

The government kick started the FY12 disinvestment program with the PowerFinance Corporation FPO in May-11, which resulted in a collection of ` 11.4 bn.Since then, there has been no offer from the governments side to divest its stake inkey PSUs. This puts the ambitious ` 400 bn FY12 disinvestment target at risk. Weakequity market sentiment (the BSE Sensex is down almost 16% on a FYTD basis) hasbeen the primary reason behind the delay in continuing with the divestmentprocess. Recently the government lifted a curb on investment banks handling itsdisinvestment program to allow them to participate in similar programs from non-state companies in similar sector (the limitation introduced in Feb-11 had led tolower interest in PSU share sales).

While this may improve participation by investment banks, the success of the

disinvestment program, among other things, is crucially dependent upon marketconditions and investor appetite, which remains weak due to uncertainty regardingsovereign debt concerns in Europe. As such, it would be extremely challenging forthe government to exceed even FY11 disinvestment proceeds (around ` 230 bn).

Expectation on fiscal slippage for FY12

Taking into account the above mentioned factors, the table below summarizes ourexpectation for FY12 fiscal slippage coming from various quarters. The totalslippage in FY12 is likely to touch ` 1000 bn this can add 1.1% to the budgetedfiscal deficit target of 4.6%.

Chart20: Subsidy payment carries upside risks Chart21: Equity sentiment crucial for disinvestments

Source: CEIC, YES BANK Limited Source: Ministry of Disinvestments, CEIC, YES BANK Limited

0

10

20

30

40

50

60

70

80

90

100

0

50

100

150

200

250

300

350

400

450

Food Fertilizer Oil

Subsidy Payments (Apr-Aug FY12)

In INR bn As % of Budge te d Target (RHS)

-60

-40

-20

0

20

40

60

80

100

0

50

100

150

200

250

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12*

Disinvestment Receipts (INR bn) Sensex (annual %, RHS)

Under recoveries arelikely to exceed ` 1000 bnin FY12

we expect fuel subsidybill to come around ` 500bn vis--vis the budgetedtarget of ` 236 bn

FY12 disinvestment targetof ` 400 bn could be atrisk

as the weak marketsentiment couldpotentially lower investorappetite


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11 October, 2011


YES ECOLOGUE 19

This would not only impact governments credibility, but also increase the risk of anegative outlook by international rating agencies. As such, the government in ouropinion, is likely to take extreme measures to curb the extent of fiscal slippage by asmuch as possible. The potential impact of fiscal slippages on overall deficit can bemanaged through a combination of the following:

Defer part of the subsidy payment to FY13: (i) Food Subsidy Bill can beintroduced in FY13, and (ii) Since part of FY11 fuel subsidy bill was paid inFY12, the same can be done for FY12 fuel subsidy bill. This can reduce thepotential slippage in FY12 by around ` 350 bn (0.4% of GDP).

Curtail expenditure: The finance ministry has been indicating towards thispossibility for some time now. During FY11, actual expenditure by thegovernment was lower by` 177 bn compared to the revised estimates. As such,belt tightening by the finance ministry can help in reducing total expenditureby ` 200-300 bn during the course of FY12 (approximately 0.3% of GDP).

On a net basis, the government through the above mentioned ways can bring downthe potential slippage to around 0.5% of GDP (see table 6), resulting in a fiscaldeficit to GDP ratio of 5.1% in FY12.

How does it affect the arithmetic of financing?

In a surprise move, the government announced last week that it would borrowadditional ` 529 bn through dated securities in H2 FY12, pushing the H2 FY12 grossborrowing up to ` 2200 bn. According to newswire reports, this additionalborrowing would be a substitution for a shortfall in other sources of financing:

Lower cash surpluses in FY12 than previously anticipated (` 160 bn vs. ` 330bn)

Expected outflow from small savings (` 350 bn)As such, the additional borrowing does not address the possibility of fiscal slippagein FY12. According to our revised estimates, a likely scenario of a net fiscal slippage

of 0.5% of GDP would require further` 450 bn in financing. This could be a sourceof concern for the bond market as the onus of further additional borrowing couldonce again fall upon market borrowings amid weak support from other sources offinancing.

Table6: Sources of fiscal slippage in FY12 Chart22: Increasing reliance on market borrowings

Source: Budget documents, YES BANK Limited Source: RBI, YES BANK Limited

Food 200 200 0

Fuel 270 150 120

Tax Revenue 360 0 360

Disinvestment 200 0 200

Total 1030 350 680

Estimated

Slippage in FY12

Amount that can be

deferred to FY13

Potential Slippage

in FY12

(In ` bn)

0

20

40

60

80

100

120

Last 10Y Average Last 5Y Average FY12 (Revised)

Share of market borrowings in fiscal deficit (%)

Fiscal slippage in FY12can be managed by

deferring part of thesubsidy payment toFY13

and curtailingexpenditure under plancategory

We expect FY12 fiscaldeficit to GDP ratio tocome at 5.1%

Despite the ` 529 bnadditional borrowing, weexpect additional funding

requirement of about `450 bn in FY12


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11 October, 2011


YES ECOLOGUE20

RBI to infuse primary liquidity through OMOs

The effect of RBIs stance on monetary policy, liquidity, and fx intervention amidthe overall macroeconomic framework, are reflected in its balance sheet. This hasimportant implications for key monetary variables like reserve money, deposits,credit, money supply, etc.

Growth in RBIs monetary base has moderated to 16.9% YoY (as of 30-Sep-11) from21.5% (as of 1-Oct-10). While the moderation in reserve money growth wasanticipated, incremental expansion in currency in circulation has been somewhat

lower than we had been expecting earlier.

Currency leakage to be the key driver for RBI liabilities

The demand for currency is determined by a number of factors such as income,price level, the opportunity cost of holding currency, i.e., the interest rate oninterest bearing assets and the availability of alternative instruments fortransactions. While these are structural variables impacting currency demand, theimpact of cyclical and one-off variable cannot be ignored for a country like India. Assuch, we decided to model currency demand on real growth, inflation, interest rate,government expenditure (ex interest payments) and cash rich activity sectors(proxied by share of construction sector in overall GDP). The chart below shows theelasticities of various explanatory variables with respect to currency demand (all

variables were significant and had the expected signs). The estimates suggest thatthe incremental growth in currency demand is likely to be around 14.5% in FY12vis--vis 19.1% in FY11.

The CRR balances would move upwards with status quo on the rate side and apickup in deposit growth (by 18%). This would imply a 15.5% growth in reservemoney in FY12 from the liability side of RBIs balance sheet.

Domestic asset growth will be key for balance sheet expansion

Moving to the asset side of the balance sheet, we continue to see a substantial

Table7: OMO support to continue in FY12 via domesticasset creation

Chart23: Inflation and growth are major determinantsof currency demand

Changes in key items in RBI's Balance Sheet (` bn)

FY10 FY11 FY12*

Reserve Money 1,583 1,906 2,000

Liabilities

Currency 1,104 1,532 1,384

CRR Balances 473 394 613

Assets

Domestic 1,380 1,455 2,000-2,200

Out of which LAF 287 833 200-400

Out of which OMOs 755 672 700-900Foreign -418 933 600


-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

GDP Inflation

(WPI)

Interest Rate

(1Y CorpYield)

Government

Expenditure(ex int.)

Share of

Constructionin GDP

Elasticities with respect to Currency in Circulation (%)

Rising interest rates and moderation in GDP growth will help in moderating growth in currency incirculation

With the possibility of creating foreign assets being low, the RBI is likely to rely on domestic assetcreation for expanding its balance sheet Expansion of domestic assets would primarily happen through OMOs and LAF

We expect reserve money to grow by 15.5% in FY12 vis--vis 17.2% in FY11 We expect liquidity deficit to worsen in H2 FY12 and exceed ` 1000 bn from Nov-Dec

Growth in reserve moneyhas moderated

as rising interest ratesand a moderation in realeconomic activity has ledto a deceleration incurrency leakage

We expect growth incurrency in circulation tomoderate to 14.5% inFY12 from 19.1% in FY11


21/36

11 October, 2011


YES ECOLOGUE 21

growth in RBIs domestic assets, which is likely to come about through an increasein RBIs credit to government. With BoP surplus likely to remain modest in FY12,there will be a greater reliance on expanding domestic assets in order to match theincrease in liabilities under the monetary base. Increase in domestic assets wouldcome about through repo borrowing under LAF, MSF borrowing under LAF (thenew facility introduced in the FY12 Annual Policy under which banks cantemporarily dip to the extent of 1% on SLR for additional borrowing from the RBI ata rate which would be 1% higher than the prevailing repo rate), OMOs (OpenMarket Operations) by RBI, and the WMA (Ways and Means Advances throughwhich the government borrows temporarily from the RBI). Assuming that thegovernment would not dip into WMA on a net basis in FY12 (as indicated in theUnion Budget) and liquidity deficit under repo would have limited room to worsenvis--vis Mar-11 levels; most of the increase in RBIs domestic assets is likely tocome in the form of MSF borrowing and OMOs.

On the foreign asset side, limited fx intervention (generating not more than ` 200bn) amidst an expectation of a stronger Dollar in the second half of the year andwith an expectation of 3% investment return on RBIs reserves, net foreign assets

could potentially increase by ` 600 bn.

Liquidity deficit to deteriorate in H2 FY12

The manner in which changes in the monetary base (primary liquidity) unfoldduring the rest of the fiscal year would have a crucial bearing on secondaryliquidity in the domestic money market. Our liquidity model suggests significanttightening of liquidity conditions from Q3 FY12 onwards as currency leakage picksup on seasonal demand. The average deficit over Q3-Q4 FY12 is likely to be close to` 1 trillion despite the assumption on OMOs as:

The government has been continuously dipping into the WMA with RBI andhas frequently breached its WMA limit this year (see chart25). This hastriggered the issuance of short-term cash management bills (CMBs) on a regularbasis. We expect the government to remain in a deficit mode on an averagebasis for the rest of the year as pace of revenue collection lags the outflows onaccount of expenditure. While CMBs are liquidity neutral from a long-termperspective, the issuances can potentially provide some skew in the short-term.

The government has so far collected only ` 11.4 bn from disinvestments. Whilethe likelihood of achieving the ` 400 bn budgeted target seems remote, we areconvinced about divestment attempts in the rest of the year imparting shortterm skew in money market liquidity conditions.

Chart24: Liquidity deficit to worsen in H2 FY12 Chart25: WMA limit has been frequently breached in

FY12 so far

Source: CEIC, Budget Documents, YES BANK Limited Source: CEIC, RBI, YES BANK Limited

-130,000

-110,000

-90,000

-70,000

-50,000

-30,000

-10,000

10,000

30,000

Apr

May Jun Ju

l

Aug Sep Oc

t

Nov Dec Jan Feb M

ar

FY11 FY12Month end liquidity (` cr)

0

100

200

300

400

500

600

Apr-11

Ma-

11

Jun-

11

Jul-11

Aug-11

Sep-11

Oct-11

Nov-

11

Dec-11

Jan-12

Feb-

12

Mar-

12

W MA Bo rr ow in g (IN R b n) F Y12 WMA Li mi t (INR b n)

Foreign asset creation inFY12 likely to remainsubdued on account ofreduced fx intervention

and moderate BoPsurplus

Reliance on OMOs tocontinue in FY12

we expect close to `700-900 bn of bondpurchases through RBIsOMO

The new MSF facility islikely to be utilized bybanks in H2 FY12

Liquidity deficit toworsen in H2 FY12 due toseasonal leakage ofcurrency from thebanking system


22/36

11 October, 2011


YES ECOLOGUE22

External risks contained

Merchandise trade has seen improvement

Indias merchandise trade maintained a sterling performance in FY12, a trendwhich is in contrast to its Asian peers. Moreover, robustness in external trade hasalso so far defied any pressure whatsoever emerging from a slowdown in globalgrowth (see chart 26).

Between Apr-Aug, exports reached a level of USD 134.5 bn, a growth of 54.2%while the imports were USD 189.4 bn with a growth of 40.4% and a trade deficit of

USD 54.9 bn, during the same period. In FY12, engineering goods, oil, andelectronics have contributed immensely to the surge in export growth. As regardsto imports, apart from oil, precious metals, machinery, electronics, and chemicalshave been the key driver. Ongoing diversification both in terms of geography andproduct mix, have contributed largely to Indias resilience in merchandise trade (seeAppendix for details).

However, going forward, export growth is likely to stutter as traditionalstrongholds - the US and the EU - continue to hobble in economic uncertainties. Theglobal jitters could have a knock-on effect on other markets, such as South Americaand Southeast Asia, which are increasingly emerging as attractive destinations forIndian exports. This is corroborated by the HSBC PMI data for August, whichshowed that the pace of new orders for Indian manufacturers decelerated to the

slowest in 29 months as export orders contracted at a record pace. Import growth isalso likely to follow suit as domestic growth moderates and oil price cools off onglobal growth concerns amid financial instability.

BoP risks manageable

After registering a BoP surplus of USD 13 bn in FY11, the surplus on BoP is likely tomoderate in FY12 to around USD 11 bn (we are revising lower our expectation forFY12 BoP surplus from USD 17 bn earlier on account of increased globaluncertainty (see table below).

Chart26: Exports continue their relativeoutperformance Table8: BoP surplus in FY12 likely to moderate

Source: CEIC, Bloomberg, YES BANK Limited

*Estimate; **Includes errors and omissions

Source: CEIC, YES BANK Limited

30

35

40

45

50

55

60

65

-40

-20

0

20

40

60

80

Aug-06

Feb-07

Aug-07

Feb-08

Aug-08

Feb-09

Aug-09

Feb-10

Aug-10

Feb-11

Aug-11

India Exports (% YoY, 3mma)

Asia Exports (% YoY, 3mma)

Global PMI (RHS)

FY11 FY12*

Trade Balance -130.5 -158Invisibles 86.2 100

Current Account -44.3 -58.0

(as % of GDP) -2.6 -2.9

FDI 7.1 20Portfolio 30.3 14Loans 27.8 30Others -5.5 5

Capital Account 59.7 69.0

(as % of GDP) 3.5 3.5

Overall BoP** 13.1 11.0(as % of GDP)** 0.8 0.6

Highlights of BoP (USD bn)

Engineering goods, oil, and electronics have supported the robust export growth in FY12 so far Global growth slowdown to provide the key downside risk to export growth in the coming months Risks on current account deficit manageable as long as average crude oil stays below USD 110 pb level We expect BoP surplus of USD 11 bn in FY12 vis--vis USD 13 bn in FY11 FX reserves continue to provide adequate cover in the short-term and debt service payments in FY12

remain manageable

Merchandise tradecontinues its robustperformance in FY12

however globalslowdown and expiry ofDEPB benefits wouldmoderate growth inexports

We expect FY12 BoPsurplus at USD 11 bn vis--vis USD 13 bn in FY11


23/36

11 October, 2011


YES ECOLOGUE 23

Downward revision in overall BoP notwithstanding, we believe that the funding ofcurrent account deficit (of around 2.9% of GDP in FY12) would still be manageable.Although portfolio flows are unlikely to match FY11 levels, we are fairly optimisticon FDI and ECB inflows, which have so far remained extremely robust.

Increase in global risk aversion, while being negative for capital account, can

actually help reduce the deficit on current account through a reduction in oil importbill and an increase in remittances. On the capital account side, policy impetus likeFDI reforms, relaxation in ECB limits (the RBI in consultation with the governmenthas recently increased the ECB limit under automatic route to USD 750 mn fromUSD 500 mn earlier), hike in NRI deposit rates, and further relaxation of FII debtownership are likely to buffer the impact of any shortfall in portfolio inflows.However, a full blown financial crisis can potentially turn the capital account (andhence the BoP) into a deficit as it did in FY09.

FX cover to compensate for a mild deterioration in external debt

Indias external debt stood at USD 316.9 bn at end-June 2011, increasing by USD46.6 bn (17.2%) over end-June 2010 level of USD 270.3 bn. The rise in external debtwas mainly due to higher commercial borrowings and short-term trade credits,which is in line with high growth of the economy and strong domestic demand. Theshare of ECBs in total external debt continued to be the highest at 29.4% as of end- June 2011, followed by short-term debt (21.6%), NRI deposits (16.7%) andmultilateral debt (15.6%). The changing composition of debt in favour of ECBs isalso an indication of maturing market economy and the increasing role of thecorporate sector in the domestic economy.

Despite the increase in absolute terms, Indias external debt has remained withinmanageable limits. This is indicated by external debt to GDP ratio of 17.3% and debtservice ratio of 4.2% in FY11 compared to 18.0% and 5.5% in FY10 respectively.

However, there has been a mild deterioaration in certain parameters like the share

of short-term debt in total debt and fx reserves respectively, with the latterexceeding the former for the first time in 7-years. Additionally, the fx cover forimports is likely to fall below 9-months in FY12.

Although these long term concerns have been lingering on for a while and requirepolicy thought and action, we would not be overly worried about them from ashort-term perspective as FX reserves continue to provide more than adequatecover in the short-term (according to the Greenspan-Guidotti rule, reserves shouldequal short-term external debt) and debt service payment of USD 22.9 bn in FY12remain manageable.

Chart27: Risk has different impact on components ofBoP

Chart28: Key short-term debt ratios deteriorating

Source: CEIC, Bloomberg, YES BANK Limited Source: CEIC, YES BANK Limited

-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

Oil Transfers FDI FII ECB

5Y Correlation with VIX Index

0

5

10

15

20

25

30

90

100

110

120

130

140

150

Jun-

04

Jun-

05

Jun-

06

Jun-

07

Jun-

08

Jun-

09

Jun-

10

Jun-

11

Total Debt/FX Reserves (%)

Short-Term Debt/Total Debt (%, RHS)

Short-Term Debt/FX Reserves (%, RHS)

Although portfolio flowsare unlikely to matchFY11 levels, FDI and ECBinflows, would help in

funding the 2.9% currentaccount gap

Policymakers havestarted relaxing norms forFII debt and ECB inflows

External debt outstandingincreased by 17.2%between June-10 andJune-11

Debt/GDP ratio and debtservice ratio remainmanageable

as fx reserves continueto provide adequatesupport


24/36

11 October, 2011


YES ECOLOGUE24

Bonds to suffer in the short term from additional market borrowing

Since our last quarterly report (A Mid-Cycle Correction within Strong Secular GrowthStory, 20-May-11), the 10Y g-sec yield (currently trading above 8.70%) moved withinthe range of 8.20-8.50% over the next three months. Over the same period, the 3M T-Bill yield added about 40 bps and is now trading close to 8.40%. The inversion ofthe g-sec curve was preceded by the OIS curve (5Y-1Y), where curve inversion hasreached an all time high level (see chart below).

Aggressive monetary policy action

Aggressive monetary policy action by the RBI since May-11 has been the primedriver of curve inversion (although the impact of global factors on OIS curveinversion cannot be ignored). The table below summarizes the quarterly change inthe repo rate along with the average month-over-month change in the WPI and coreWPI (proxied by the Manufacturing ex Food Index). Both WPI and core WPIsuffered from increased sequential momentum over Q3-Q4 FY11, which was areflection of the pass-through of higher input prices to output prices amid stronggrowth conditions resulting in adequate pricing power.

Monetary policy tightening started at a modest pace as the initial drivers of inflationwere largely supply side variables (food, fuel, and minerals), with core inflationcontributing just 30% to the increase in WPI inflation between Apr-10 and Nov-10

(Monetary Policy Response to Recent Inflation in India - Speech by Deepak Mohanty,RBI). Since Dec-10, the sequential momentum in core inflation picked upsubstantially and reached a high of 1.3% MoM (on a seasonally adjusted basis) inFeb-11. Moreover, the period between Dec-10 till Apr-11 was characterized bysignificant upward revisions to preliminary data, with average revision per monthcoming at 105 bps (see our latest inflation report August WPI Inflation: WorriesLinger, 16-Sep-11).

As such, RBIs aggressive response came on the back of a shift in drivers of inflationamid significant upward revision to preliminary data. However, both these factors

Table9: Aggressive tightening followed a pickup ininflation momentum Chart29: OIS curve flattening has reached a record

WPI(QuarterlyAverage)

Core WPI(QuarterlyAverage)

Change inRepo Rate

(MoM sa, %) (MoM sa, %) (bps)

Q4 FY10 0.78 0.46 25

Q1 FY11 0.41 0.45 25

Q2 FY11 0.45 0.29 75

Q3 FY11 1.38 0.83 25

Q4 FY11 0.84 1.16 50

Q1 FY12 0.37 0.22 75Q2 FY12* 0.35 0.22 75

*July-Aug 2011

Source: CEIC, Bloomberg, YES BANK Limited Source: Bloomberg, YES BANK Limited

-150

-100

-50

0

50

100

150

200

2502

3

4

5

6

7

8

9

10

Sep-07

Mar-08

Sep-08

Mar-09

Sep-09

Mar-10

Sep-10

Mar-11

Sep-11

Repo (%)

Reverse Repo (%)

OIS 5Y-1Y (bps, Inverted, RHS)

Aggressive monetary tightening prevented a bond rally in Q2 FY12 While sequential momentum in core inflation has decelerated, output gap is gradually closing We expect the RBI to have ended its monetary tightening Fiscal slippage in FY12 can potentially create the need for further additional borrowing However, fiscal risks likely to be mitigated through RBI OMOs and supportive global conditions We expect the 10Y g-sec yield to move towards 8.80% in the near term and moderate towards 8.00-8.20%

by end-Mar-12

Aggressive monetarypolicy action by the RBIsince May-11 has been

the prime driver of curveinversion

Pass-through of higherinput prices to outputprices amid stronggrowth conditions hadput pressure oninflation in H2 FY11

however, sequentialmomentum in inflationover last 3-4 monthsshows significantmoderation


25/36

11 October, 2011


YES ECOLOGUE 25

have decreased in importance over the last 4-5 months - while sequentialmomentum in inflation has moderated significantly and stabilized at comfortablelevels, magnitude of revision to preliminary data has also come off. Domesticgrowth has started showing evidence of a moderation with the impact of recentaggressive tightening yet to play out completely. With output gap closing, the RBIis likely to have ended its rate tightening cycle. Hence we expect the repo rate tostay at 8.25% for the rest of the fiscal year. Adverse global economic and financialconditions necessitate the maintenance of status quo for assessing the impact of theglobal contagion via feeble economic growth and volatile and uncertain financialconditions.

Fiscal policy to gain importance

With interest rate policy unlikely to be a key driver of market rates in the short tomedium term, the focus would now shift to other drivers, viz., fiscal policy andliquidity conditions.

On the fiscal front, we expect a slippage to 5.1% of GDP vis--vis the budgetedtarget of 4.6% (see the fiscal section for details). This would create additional

funding requirement of about ` 450 bn. In the absence of any surprise on therevenue front and less likelihood of generation of any substantial internal savings,the burden of financing would fall upon market borrowings.

Supply pressure strikes early

Last week the government announced that it will borrow `2200 bn through datedsecurities in H2 FY12. This is higher than the budgeted amount by ` 529 bn. As aresult, the FY12 gross borrowing will now be ` 4700 bn against the budgeted targetof ` 4171 bn. The announcement of additional borrowing at the start of H2borrowing calendar caught the market by surprise as expectations regarding anysuch event was relegated to the last quarter of the financial year. The bond marketsold off, with the 10Y yield rising by 10 bps after the announcement.

The chart below highlights the monthly distribution of gross and net borrowings inH2 FY12. Key highlights of the announced borrowing plan are listed below: In contrast to the usual practice, the calendar is not front loaded it is evenly

loaded from a gross borrowing perspective and back loaded from a netborrowing perspective

Borrowings would be concluded by Feb-12 From a duration perspective (see table below for details), the supply is going to

be sizeable compared to H1, especially considering the absence of issuances inthe less than 5Y segment

Chart30: Budgeted H2 borrowing likely to becompleted by Feb-12

Table10: Supply of duration in H2 FY12 to be sizeable

Source: RBI, Budget Documents, YES BANK Limited Source: Bloomberg, YES BANK Limited

0

100

200

300

400

500

600

Oct Nov Dec Jan Feb Mar

Gross NetG-Sec Supply in H2 FY12 ( ` bn)

Month 5-9 Y 10-14 Y 15-19 Y More than 20Y

Oct-11 90-120 150-180 70-100 60-80

Nov-11 120-160 200-240 60-80 60-80

Dec-11 90-120 140-170 50-70 30-40

Jan-12 90-120 150-180 40-60 50-70

Feb-12 120-160 180-220 40-60 40-60

Mar-12 0 0 0 0

Month-wise supply of duration ( ` bn)

Share in

Borrowing (%) 23.2-30.9 37.3-45.0 11.8-16.8 10.9-15.0

With output gapgradually closing, weexpect the RBI to haveended its rate tightening

cycle

Fiscal slippage to 5.1% ofGDP in FY12 wouldcreate additional fundingrequirement of ` 450 bn

H2 FY12 borrowingrequirement has alreadyincreased by ` 529 bn

Supply of duration in H2is going to be sizeable


26/36

11 October, 2011


YES ECOLOGUE26

The increase in supply at the start of H2 is a concern as the additional borrowinghas been on the back of a substitution effect (see fiscal section above for details).This puts the supply-demand gap under further pressure as we anticipate actualfiscal slippages to result in close to` 450 bn of further additional borrowing in Mar-12 (see table below).

Outlook

The supply outlook in dated securities is clearly negative for the bond market. Assuch, the yield on the 10Y g-sec is likely to remain under pressure and movetowards 8.80% in the near-term.

However, there are a few positive factors on the horizon that will have a beraing onthe bond market over the next 6-months. The timing and the manner in which thesefactors unfold, would help in curbing the pressure on the bond market.

We believe the market is still positioned for one more rate hike in Oct-11.However, looking at the significant reduction in sequential momentum of coreinflation amid emerging signs of growth moderation, we expect the RBI to haveended its monetary policy tightening.

The recent decline in oil prices have been on account of increasing threat of aglobal slowdown amid heightened concerns of a global financial crisis. Anyfurther sustained decline would help in lowering WPI inflation by a highermargin than anticipated.

Our supply-demand gap in the bond market indicates a fair degree of excesssupply in FY12. The situation of excess supply worsens if we take into accountthe need for further borrowing in Mar-12. However, the actual supply pressureis likely to be significantly lower as RBI starts buying securities under its openmarket operations (OMOs). Our analysis on RBIs balance sheet expansionindicates a need for ` 700-900 bn of primary liquidity infusion through theOMO route (see the monetary section above for details).

Hence, while the first two factors would curb the pressure on the bond market fromthe monetary policy side, the third factor would help in taking the pressure off fromthe fiscal side. As such, we expect the yield on the 10Y g-sec to move towards 8.00-8.20% by Mar-12.

Table11: Supply-demand gap to potentially worsen inFY12

Chart31: Moderation in oil price to support bonds

*Includes additional borrowing of `529 bn;

** Includes additional borrowing of `979 bn

Source: RBI, Budget Documents, YES BANK Limited Source: Bloomberg, YES BANK Limited

FY11 FY12* FY12**

Total Supply 4,323 5,115 5,565

Central Government 3,653 4,115 4,565

State Government 1,000 1,000 1,000

MSS -330 0 0

Total Demand 3,687 4,612 4,612

Banks 1,415 2,862 2,862

Insurance Cos. 900 1,000 1,000

Others 700 750 750

RBI 672 0 0

Supply-Demand Gap 636 503 953

G-Sec Supply Pressure ( ` bn)

20

40

60

80

100

120

140

160

5

6

7

8

9

10

Se

p-06

Ma

r-07

Se

p-07

Ma

r-08

Se

p-08

Ma

r-09

Se

p-09

Ma

r-10

Se

p-10

Ma

r-11

Se

p-11

10Y g-sec yield (%) Oil (USD pb, RHS)

Additional borrowingannounced in Sep-11 hasbeen on the back ofsubstitution effect

10Y yield to movetowards 8.80% in the nearterm

however yield is likely

to moderate towards 8.00-8.20% by Mar-12

as RBI stops furtherrate tightening and usesthe OMO route to addressliquidity concerns

Global backdrop is alsolikely to provide supportto bonds in the comingmonths


27/36

11 October, 2011


YES ECOLOGUE 27

Global factors back on INR radar

INR has been tracking the trend in Asia

In the month of Sep-11, USDINR moved up by nearly three big figures (from 46 to49), after rising by nearly two big figures (from 44 to 46) in Aug-11. While we hadbeen expecting Rupee weakness on acount of a slight deterioration in the domesticmacro backdrop (see INR underperformance to correct, 4-Aug-11 and Global factors

hasten Rupee depreciation, 26-May-11), the extent of the movement caught everyoneby surprise. However, we should note that INR has outperformed other Asiancurrencies like the KRW and IDR and rapid movement in Sep-11 has been areflection of a broad based Dollar strength (the DXY Index gained 6.0% in Sep-11)on account of a pick up in global risk aversion.

Why does Dollar movement become so important?

Dollar being the base currency has an important impact on Rupee. However, theimpact of Dollar movement on Rupee is not uniform the degree of impact isdependent upon investor risk appetite and positioning. More importantly, theoverall BoP dynamics is a crucial determinant in explaining the degree of impact.For e.g., a high BoP surplus would generally be associated with lower degree of

impact of Dollar movement on Rupee. As BoP surplus reduces (or turns into adeficit), the impact of Dollar movement on Rupee gets amplified (see chart below).

For FY12, the BoP surplus is likely to extremely modest at 0.6% of GDP (downfrom 0.8% in FY11). As such, Rupees sensitivity to Dollar movements is likely tobe higher in such an environment. The current uncertain global economic andfinancial environment is likely to result in increased volatility in Dollar movementsand thereby add to Rupees vulnerability.

Chart32: Rupees sensitivity to Dollar increase during

times of lower BoP surplus

Chart33: Reduction in USD liquidity caused the initial

stress for Rupee

Source: CEIC, YES BANK Limited Source: Bloomberg, YES BANK Limited

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

-2

0

2

4

6

8

FY06 FY07 FY08 FY09 FY10 FY11 FY12*

BoP (as % of GDP)

INR elasticity wrt DXY (RHS)

38

40

42

44

46

48

50

52

542

4

6

8

10

12

14

16

Sep-06

Mar-07

Sep-07

Mar-08

Sep-08

Mar-09

Sep-09

Mar-10

Sep-10

Mar-11

Sep-11

Dollar Liquidity (USD bn) USDINR (Inverted, RHS)

Shortage of USD liquidity triggered the weakness in Rupee Risk aversion and Dollar strength further added to Rupee depreciation Weak Rupee has raised concerns regarding inflation management A 10% depreciation in Rupee if sustained, would add close to 40 bps to WPI inflation We expect RBI to actively consider fx intervention if depreciation pressure on Rupee escalates OMOs/CRR cuts can be