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Politics

Contagion Fears

Europe Braced for Grexit Chaos BY MEERA SELVA

Greece is not the only euro zone country with large debts and a population tired of austerity. Voters in countries like Portugal and Italy will be watching to see how it fares.

The Euro star sculpture outside the former ECB building in Frankfurt. Source: DPA

The sight of a smartly dressed Greek man crying, slumped to the floor in despair after trudging between four banks trying to withdraw a pension on behalf of his wife, has become the symbol of the countrys despair.

It has also, in many ways, become a warning to many other countries in the euro zone: follow the path Greece has taken and your pensioners too will wait anxious and exhausted outside banks trying to access their money.

The first question on everyones minds is: what will happen to Greece? Will it have its debts restructured, will it leave the euro? The second question is: what happens then to other countries in Europe, in particular Portugal and Italy, which also have large debts, sluggish growth and unstable politics.

Any choice that European leaders make this week will have consequences for the euro, and the politics of E.U. member states.

There is a possibility of political contagion, especially if the European Central Bank and the IMF come back to the table and recognize the new Greek mandate. It will be natural for other anti-austerity movements to say, well why cant we get the same terms, James Wood-Collins, chief executive of London-based Record Currency Management, told Handelsblatt Global Edition.

The alternative scenario is that Greece trickles out of the euro. The interesting point to look for is if there is a chain of circumstances that dispels the idea that joining the euro zone is irreversible.

The situation in Greece is so unappealing that voters in Italy, Spain and Portugal will not vote in droves for it in their own country.

Holger Schmieding Chief economist at Berenberg Bank

As European leaders meet later on Tuesday, for yet another summit, to discuss Greece, currency traders are wondering how to react. So far things have been relatively calm. The euro had drifted down to $1.0969 on Monday, but had risen to $1.1025 on Tuesday. Stock markets too were relatively steady, given the political turmoil in Europe.

The market reaction has been quite muted so far, Nick Stamenkovic, a macro strategist at securities broker RIA Capital Markets in Scotland, told Handelsblatt Global Edition. We are not in the same position as 2011 and 2012. The European Central Bank has firewalls in place, and European banks have reduced their exposure to Greece.

Another reason markets are calm at the moment is that Greece is so tiny: it accounts for less than 2 percent of the euro zone. It can collapse into a black hole, and its impact on the world economy, at least for a week or two, would be negligible. But other countries are bigger, and only the most complacent trader could believe that Greek events will not eventually change the nature of the whole euro zone.

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The two most vulnerable countries at the moment are Italy and Portugal, both of which have debt to GDP ratios of over 130 percent.

Portugal in particular, looks similar to Greece last year. It has an unpopular center-right government, losing ground in the polls to the center-left Socialist party, led by a firebrand leader Antonio Costa, who called Monday for far reaching reforms in the way the euro zone operated.

Portugal, like Greece and Ireland, had to avail of a bailout, getting loans of 78 billion ($108 billion) from the European Union and the International Monetary Fund in 2011. It successfully exited its bailout progam last year.

However, the tough austerity that it was forced to impose as a condition of the bailout is deeply unpopular.

The country will vote in October, and Mr. Costas Socialists, who have taken a firm anti-austerity stance, are currently enjoying strong support, currently polling at 36.9 percent.

From an economic point of view, Portugal has the largest imbalance after Greece; weak competitiveness and a number of problems, Antonio Roldan Mones, a London-based analyst at political risk consultancy Eurasia group, told Handelsblatt Global Edition.

But there is a fundamental difference, he said. There is a full political commitment from all parties that will take part in the upcoming elections, to remain in the euro zone and do whatever it takes to stay in. Having said that, if you open the door to leaving the euro and the euro zone becomes a less credible entity, and it becomes possible to leave and possibly re-enter after devaluing, things will change.

Portugals main weakness is that much of its debt, which is now over 278 billion, is held by foreign investors. If they decide to sell, spooked by a possible Socialist win in October, or the wider state of the euro zone, its economy looks shaky.

Italy, too, presents a looming problem. It makes up one sixth of the euro-zone economy and it has debts of over 2 trillion, making it the third largest sovereign bond market in the world. Unemployment is just below 13 percent and youth unemployment is over 40 percent.

Its second and third largest opposition parties have, from opposite ends of the political system, come out in favor of Greeces decision to vote No in Sundays referendum.

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Giorgos Chatzifotiadis, 77, cries after trying to withdraw money from a bank. Source AFP

Beppo Grillo, leader of Italys anti-austerity, anti-establishment Five Star Movement, wrote on his blog over the weekend that the Greek vote meant that now Merkel and bankers will have food for thought.

Matteo Salvini, head of the xenophobic Northern League, now the third most popular party in Italy, said the no vote reinforced the sovereignty of Greece.

What is clear is that the best protections a country can have against contagion is growth. Spain is a classic case. It has borne the weight of austerity measures for years, and Podemos, a movement that arose from the anti-austerity protests of 2011, organized itself into a political party in early 2014.

By January of this year, the group was polling as Spains most popular party, but its growth has been curtailed since then. The strong Spanish economy, now growing at around 4 percent, is partly responsible, as is the fact that Podemos has close links with Syriza and Spanish voters do not see the Greek scenario as an appealing one.

I dont think the Greek story helps Podemos. Even if there is a generous deal for Greece, people see the economic suffering, the bank closures. In the context of a fast growing economy I dont think people will vote for Podemos, said Mr. Roldan Mones.

For now, things appear calm. Many believe the real moment the euro zone was in danger was during the crisis of 2011 and 2012. Now the European Stability Mechanism has a 500 billion rescue fund and the European Central Bank has a 1 trillion quantitative easing program. It also has the ability to implement Outright Monetary Transactions or OMTs, which allow it to buy government bonds. Banks too are in better shape than they were.

Holger Schmieding, chief economist at Berenberg Bank, said the strength of the euro zones biggest countries helped. This Greek crisis hits Europe at a time when core Europe is in decent shape. All signs point to economic upswing led by domestic demand. This crisis is a serious

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challenge but the economy can cope with it. The situation in Greece is so unappealing that voters in Italy, Spain and Portugal will not vote in droves for it in their own country, he told Handelsblatt Global Edition.

Mr Wood-Collins argues that while the euro still has plenty of safe havens, including the German bund, to reassure investors, a Grexit will take the currency into uncharted waters. At the moment, there are no mechanisms to hedge against the possibility of a country leaving the euro, but if there is demand, companies such as his could create new products, including a type of redenomination swap that would allow funds and companies to hedge their exposure to the euro.

He cites an example of an Italian manufacturer, that may hold all its assets domestically but have a euro-demoninated debts. If Italy were to leave the euro zone and reintroduce the lira, the debts would weigh heavily on the balance sheets against a weaker lira. A swap would allow the company to link up with another entity, say an Italian pension fund whose liabilities are to Italian pensioners but which holds euro investments, which would like to swap out its Italian liabilities.

That is a class of instrument people were talking about three or four years ago. It didnt take off at that stage as banks struggled to get people interested in both sides. If Greece leaves the euro zone, the risks of other countries becomes more real and we may well see demand for those instruments return. Then we have a market mechanism that puts a price on the likelihood of a country leaving. This creates a parallel interest rate market that will provide an indication as to how people perceive risks, he said.

European leaders are well aware that markets will create parallel currencies if the euro appears unsustainable. One of the best ways to stop this happening is to create a proper fiscal union, with common insurance funds to protect banking deposits, and for countries to more closely align their welfare states and social policies. The heads of all the main E.U. institutions including the European Commission and ECB have already published a document calling for this new level of integration. The chaos in Greece may, unexpectedly strengthen their hand.

Even if Greece leaves the single currency, it may actually increase the prospect of further integration in the euro, with France and Germany pushing for more integration, said RIA Capitals Mr. Stamenkovic. I can see a scenario where euro-zone countries push for banking integration and political integration, to stop this happening again in the future.

Meera Selva is an editor with Handelsblatt Global Edition and has covered economics and politics in Britain, Africa and Berlin. To contact the author: [email protected]

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Please see important disclaimer and disclosures at the end of the document

ECONOMICS

25 June 2015

Important Notice: The circumstances in which this publication has been produced are such that it is not appropriate to characterise it as independent

investment research as referred to in MiFID and that it should be treated as a marketing communication even if it contains a research recommendation.

This publication is also not subject to any prohibition on dealing ahead of the dissemination of investment research. However, SG is required to have

policies to manage the conflicts which may arise in the production of its research, including preventing dealing ahead of investment research.

Extract from a report

Asian Themes

Chinas decade of debt restructuring Over the coming decade, the Chinese economy will go through a phase of intense reform.

Debt restructuring will be part of the transformation and has already begun in earnest.

What debt will be restructured? The state sector, including state-owned enterprises (SOEs)

and local government financing vehicles (LGFVs), is the cause of Chinas deteriorating

economic efficiency and the main culprit for the mounting debt problem.

Why now? Until today implicit state guarantees have helped China avoid a systemic financial

crisis, but they are now being weakened by financial market liberalisation. In particular, the

deterioration in local government financing conditions could trigger a domino effect in terms of

credit risk. The time to worry about a hard landing was not before, perhaps is not yet, but will be

soon, if without debt restructuring.

How will the debt be restructured? The big strategy is emerging, and so far it consists of

three elements lowering interest rates, extending durations and recapitalising. The first

two elements are the backbone of the debt-to-bond swap programme for local governments,

and the last element offers hope for SOEs, which will benefit more from a steady bull market

than from a crazy one.

What impact will this have?

- Economic growth will not accelerate, because debt growth will be more under control.

The debt restructuring process will be accompanied by more discipline in local government

borrowing and more emphasis on investment efficiency, which in turn implies further

deceleration in investment and overall economic growth in the near term.

- Monetary policy will stay modestly accommodative, but there will be no QE or currency

devaluation. Policymakers will try to cap interest rate levels during the restructuring phase,

but relative to economic growth, credit conditions will no longer be as loose. Barring

scenarios of extreme economic difficulty, we see no chance of any QE or active currency

devaluation, since such a programme would severely impede the development of Chinas

capital markets, which are of great importance to RMB internationalisation.

- Credit risk will be lower for some, but higher for others. The debt restructuring is also a

process of formalising explicit state guarantees, while scaling back implicit state

guarantees. Central government will move part of the credit risk that is currently backed by

local governments and SOEs onto its own balance sheet, but will also draw a clearer line

between the state and the corporate sector. Hence, credit spreads will widen.

- A hard landing is more likely if debt restructuring lags financial market liberalisation. If a

crisis looms large, the Chinese government should still be able to speed up restructuring

and come up with an extensive bail-out programme. However, such a decision may not

come easily and its impact may not be as powerful as that of the successful banking

restructuring that took place in the early 2000s. The financial system is much more open,

complex and sizeable, and further liberalisation will only add to the uncertainties.

China

Wei Yao

(33) 1 57 29 69 60 [email protected]

This document is being provided for the exclusive use of ABHINAV BHANDARI (Reliance Capital Asset Management Limited )

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Asian Themes

25 June 2015 2

Time to face the debt

It is now a widely-shared view that Chinas debt has grown too fast since the Great

Recession, and that its debt level is now high. To recap, we estimate that total non-financial

sector debt, including government, household and non-financial corporate debt, reached

230% of GDP at end-2014, up by about 10ppt from end-2013 and by almost 70ppt since end-

2008. However, two-thirds of this debt has been considered government debt, directly or

contingently, which makes it possible for the government to suppress risk discoveries.

Debt by itself is not necessarily a problem, but if the borrowed funds go to finance

investments that generate diminishing returns, it is. There is evidence in both macro and

corporate-level data to suggest a weakening debt-servicing capacity. And the big borrowers

SOEs and LGFVs are also the weakest links.

Debt is a problem

One common argument that plays down the severity of Chinas debt problem is that assets

have grown almost equally as fast as debt, and so leverage (as measured by, for example, the

debt-to-asset ratio) has not deteriorated meaningfully. This argument holds that newly created

or enhanced assets, such as infrastructure, may have failed to generate near-term returns,

thus causing a liquidity problem, but will eventually prove to be efficient. While we sympathise

with this logic, we do not think that it necessarily dispels all the concerns with regard to

Chinas current situation.

First, the asset quality is probably questionable. Constructing a balance sheet for the

Chinese economy is extremely difficult (not least due to incomplete flow of funds data), and so

we are unable to adequately assess the pace of Chinas asset expansion. If we assume that

asset growth has indeed been in lockstep with debt growth, at 20% per annum for six years,

we can deduce that there will have been a 30% decline in the ratio of GDP to total assets,

which is conceptually akin to return on assets (ROA) for corporates. That, we reckon, raises

some legitimate questions about the quality of the asset growth.

Chart 1: Further deterioration in investment efficiency Chart 2: Estimate of Chinas debt-servicing ratio, 2014

Debt load

(% of GDP)

Average int rate

(% pa)

Average

maturity (yr)

Total nonfinancial corporate debt 185 6.1 4.5

SOE central 50 4.0 5

SOE local 50 5.0 5

Non-LGB local govt debt 35 6.5 5

Private corporates 50 9.0 3

Interest payment 11.3

Principal payment, no roll-over 37.3

Total debt service cost 48.6

Source: NBS, CEIC, SG Cross Asset Research/Economics Source: PBoC, CBRC, CEIC, SG Cross Asset Research/Economics.

Second, economic efficiency has unequivocally declined. The assets that were created

between 2009 and 2014 have not yet started to generate better economic returns after five

years. An update of our calculation of the incremental capital output ratio (ICOR) shows that

investment efficiency, measured by the amount of investment in previous years needed to

2

2.5

3

3.5

4

4.5

5

5.5

6

2000 2002 2004 2006 2008 2010 2012 2014

Incremental Capital Output Ratio(calculated as the av erage change in inv estment ov er the past f iv e y ears div ided by the change in current

y ear GDP)


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Asian Themes

25 June 2015 3

generate one unit of output, has deteriorated further (Chart 1). The ICOR approached 5.5 in

2014, up sharply from less than 2.5 before the Great Recession. As a comparison, the long-

term average for other developing economies in Asia stands at between 3 and 4.

Third, the value of the assets is elusive. The previous two points suggest that the book value

of Chinas assets that can justify the debt growth does not seem be in line with the declining

return. Moreover, when liquidity stress builds up, more assets are put up for sale and their

prices are more likely to be depressed. In a sign of heightened liquidity stress, Chinas debt

service burden has grown steadily along with its debt load. Two years ago, we estimated that

the debt service ratio of the non-financial corporate sector (including LGFVs) was close to

40% of GDP, similar to the levels seen in a number of economies at a time when they were

headed for serious financial and economic crises1. Now, this same debt-servicing ratio stands

at close to 50% of GDP and the interest payment alone is about 11% of GDP (Chart 2), up

from 9% in 2012 as we had calculated. And this is happening despite a decline in general

borrowing costs.

The three slices of macro-level data point to a rising debt service burden accompanied by a

deteriorating debt servicing capacity and a diminishing marginal return on investment.

Debt with the state

On the surface it appears that most of the debt has been taken out by non-financial

corporates and local governments, while households and the central government each owe

about 20% of GDP. The latest hint dropped by the authorities suggests that the amount of

debt for which local governments are deemed to bear direct responsibility was CNY16tn at

end-2014, equivalent to 25% of GDP. That leaves the count of corporate debt at 165% of

GDP.

However, most of the corporate debt is also related to the state. SOE debt amounts to

close to 100% of GDP while the debt taken out by LGFVs (previously) and guaranteed by local

governments is equivalent to 10-15% of GDP; this means that private corporate debt actually

stands at only 50-55% of GDP.

Chart 3: The state is the biggest borrower Chart 4: The state is behind most lenders

Source: PBoC, MoF, NBS, CEIC, SG Cross Asset Research/Economics. * CNY16tn to be officially

recognised as local government debt, but only a small portion in LGBs

Source: PBoC, SAFE, CEIC, SG Cross Asset Research/Economics.

1 Drehmann, M. & Juselius M., Do debt service costs affect macroeconomic and financial stability? BIS Quarterly

Review, September 2012.

Central Govt 20

Local Govt* 25

Central SOEs 50

Local SOEs 50

LGFVs 10-15

Private corp 50-55

Households 20

Estimates of China's total nonfinancial debt by borrower (end- 2014, % of GDP)

Bank loans 130

Corporate bonds

20

Govt bonds 20

Shadow banking

50

External debt 10

Estimates of China's total nonfinancial debt by lender (end- 2014, % of GDP)

Policy & state-owned banks account for 65% of total banking assets

and own 60% of domestic bonds


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Asian Themes

25 June 2015 4

The domestic financial system funds over 95% of all debt and is also dominated by

state-owned institutions. Policy and state-owned banks account for over 60% of total

banking, and own close to 60% of all domestic non-financial bonds. Even in the shadow

banking system, a majority of the big players, including trust and security firms, have state-

owned institutions as their big shareholders. The financial market as a whole has long

accepted the notion that those state-owned (or backed) corporates carry the credibility of the

state. In that sense, one could say that government debt direct and contingent combined

could be 155-160% of GDP, or over two-thirds of Chinas total non-financial debt.

This fact that both the creditors and the debtors are either controlled or greatly

influenced by the government could explain, to a large extent, why the scenario of an

imminent banking and economic crisis has failed to materialise so far. The government is

able to suppress risk discoveries in the financial system and has indeed been doing so, both

intentionally and unintentionally. For evidence of this, we need look no further than bank non-

performing loan (NPL) ratios (still lower than 1.5%), which are widely deemed too low to be

true, and the very few cases of bond defaults so far.

Pockets of vulnerability

Thus the state sector not only carries most of the debt but is also the very source of the

inefficiency. Two recent studies based on firm-level data, one by the IMF2 and the other by

the HKMA3, provide further evidence of this. Based on the data of listed non-financial firms,

both papers concluded that the SOEs, especially those in the real estate sector and industries

with substantial over-capacity, represent a clear pocket of vulnerability. Building on the

method used in this research, we analyse a sample of LGFVs that have issued corporate

bonds and find that their situation appears even more dismal than the two papers indicated.

SOEs weaker than private

The two papers unveil a number of valuable findings, particularly with regard to SOEs, which

we summarise below.

The leverage of the SOEs, especially those in real estate, construction, mining

and utilities, has risen more quickly. Measured by debt-to-equity (D/E) or debt-to-

asset (D/A) ratios, the leverage of listed corporates is not high. But this is attributable

to the persistent and significant deleveraging efforts of private-owned firms since

2008.

Profitability has generally declined since the global financial crisis, measured by

ROA (=EBIT/total assets). Highly leveraged firms (mostly SOEs) have fared worse

than average (5-6%) by 1.5-2ppt.

The debt-servicing capacity of SOEs is weaker, even though they benefit from

lower effective interest rates. Among SOEs, local SOEs are more vulnerable. The

HKMA paper also pointed out that subsidised interest rates have only led to falling

investment efficiency and higher leverage than otherwise.

2 Chivakul, M. and Lam, W.R., Assessing Chinas Corporate Sector Vulnerabilities, IMF Working Paper, WP/15/72,

March 2015.

3 Zhang, W., Han, G., Ng, B. and Chan, S., Corporate Leverage in China: Why Has It Increased Fast in Recent Years and

Where do the Risks Lie? HKIMR Working Paper No.10/2015, April 2015.


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Asian Themes

25 June 2015 5

Given that the dataset the two papers used only covered listed firms which are, on average,

probably stronger than non-listed firms, the findings probably represent an above-average

performance for Chinas entire corporate sector. However, the performance gaps between the

state-owned and the private-owned firms and between central and local SOEs are also clearly

evidenced by the data provided by the statistical bureau (Charts 5 & 6).

Chart 5: SOEs underperform the private sector Chart 6: Local SOEs still less profitable

Source: MoF, NBS, CEIC, SG Cross Asset Research/Economics Source: MoF, NBS, Bloomberg, CEIC, SG Cross Asset Research/Economics

LGFVs worse still

LGFVs have issued over CNY5tn in corporate bonds, according to the domestically widely

accepted bond market classification. We look into the bond covenants available on

Bloomberg and find 249 issuers with sufficient data for our analysis. While we only get a

snapshot of the latest situation, it is not a pretty picture.

Leverage of LGFVs is generally high, with the average D/E ratio close to 200% and

the median at around 150%.

Profitability is very low, with ROA at only 2%. Nearly 80% of LGFVs in the sample

have negative cash flows. Since LGFVs are mostly operating in the infrastructure

space, the lack of short-term return is partially understandable.

Debt-servicing capacity is simply dismal. The effective interest rate of these LGFVs

is already very low, at less than 2.5%, probably implying a big share of non-interest

bearing debt (e.g. accounts payable). Even so, half of the LGFVs still have an interest

rate coverage ratio of less than one, which generally points to a situation of financial

stress. The corresponding debt-at-risk accounts for close to 60% of total debt in the

sample.

Also, in this case, we think that the sample represents the better performers among all the

LGFVs. First, the financial positions of the LGFVs in our sample are probably no worse than

the average level of all the LGFVs that have issued bonds, because there is no statistically

significant difference in the yields between bonds issued by LGFVs with and without available

financial data. Second, bond-issuing LGFVs are of a higher quality than those who have not

issued bonds, because only LGFVs that have met the standards set by the planning agency

have access to bond financing.

The dismal financial situation of the LGFVs is probably the reason that the government has

begun restructuring debt with the debt-to-bond swap programme for local governments.

0

5

10

15

20

25

30

35

40

2000 2002 2004 2006 2008 2010 2012 2014

State-owned

Private-owned

Loss-making enterprises as % of total industrial enterprises by ownership

0

2

4

6

8

10

12

14

16

2009 2010 2011 2012 2013 2014

Central SOEs Local SOEs Return on Equity, %

A-share average: 13.7 (2013)


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Asian Themes

25 June 2015 6

Denial is no longer viable

As the growth deceleration intensifies and financial market liberalisation accelerates, denying

the debt problem is becoming an increasingly unviable strategy. The Chinese government may

be able to keep papering over the debt problem by continuing to offer implicit credit

guarantees to everyone for another year or two. However, developments in the past year

suggest that top policymakers are now willing to face up to the problem and work on a

deleveraging plan. One recent announcement in this direction came from Premier Li, who

told a roomful of international and domestic media in March this year that allowing credit

events to occur and leaving them to the market to work out will be necessary to address the

moral hazard problem.

Market pricing of interest rates is at the core of interest rate liberalisation, which

policymakers are keen to push through. That is simply impossible without the existence of

risk. Besides installing a deposit insurance scheme, which implicitly admits the possibility of

bank restructuring, onshore bond defaults have started to emerge alongside the acceleration

of interest rate liberalisation. By the time of this publication, we have counted four credit

events in the onshore secondary bond market, including one SOE, and close to a dozen

private placement bond defaults (Table 1). While in a few default cases (e.g. Chaori and

Zhongsen) investors were eventually paid, the occurrence of these credit events have kick-

started risk revaluation in the bond market (Chart 7). We think that, due to its signalling effects,

the bond market will continue to be a cautious test ground for the government.

Table 1: Defaults in China domestic bond market

Company

name Sector Ownership

Default

date

Issue

date

Size

(CNY mn) Maturity

Coupon

rate

Default

detail

Public issuance

Chaori Solar

energy Private Mar14 Mar12 1000 5yr 8.98%

Interest, but

repaid later

Cloud Live

(Xiangeqing)

IT

(catering) Private Apr15 Apr12 480 5yr 6.78%

Interest &

principal

Baoding

Tianwei

Electrical

equipment SOE Apr15 Apr11 1500 5yr 5.7% Interest

Zhuhai

Zhongfu

Containers

packaging Private May15 May12 590 3yr 5.28% Principal

Private placement

Xuzhou

Zhongsen

Construction

materials

Private, SOE

as guarantor Mar14 Mar13 180 3yr 10%

Interest, but

repaid later

Zhejiang

Huatesi* Polyester Private Jul14 Jan13 60 2yr 11%

Interest &

principal

Huzhou

Jintai

Plating

technology Private Jul14

Jul12 15 3yr 9% Interest &

principal Jul12 15 3yr 11%

Tianlian

Binhai

Composite

materials

Private, SOE

as guarantor Jul14 Jan13 50 2yr 9%

Interest &

principal

Huazhu

Shoes Clothing

Private, SOE

as guarantor Aug14 Aug13 80 3yr 10% Interest

Dongfei

Mazuoli Machinery

Private, LGFV

as guarantor Jan15 Jan13 110 2 yr 9.5%

Interest &

principal

Anhui NBO Machinery Private, SOE

as guarantor Feb15 Feb13 60 3yr 9.8%

Interest &

principal

Suqian Zhifu Leather Private, SOE

as guarantor Feb15 Feb13 150 3yr 9.5%

Interest &

principal

Inner

Mongolia

Hengda

Highways Private, LGFV

as guarantor Apr15 Apr13 200 3yr 10.2%

Interest &

principal

Jiangsu

Dahong Textile

Private, LGFV

as guarantor Apr15 Apr13 300 3yr 10%

Interest &

principal

Source: Caixin, Financial Times, Wallstreetcn, Yicai, SG Cross Asset Research/Economics. * Huatesi asked for bankruptcy protection in March 2015.


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Asian Themes

25 June 2015 7

The fiscal reform will also bring more credit risk to the fore. The fiscal reform has started

to limit local governments ability to extend credit guarantees at a time of slowing domestic

growth and tightening global liquidity. Local governments have played a critical role along the

credit risk chain. They extend credit guarantees to LGFVs, local SOEs and even some private

companies that are deemed local champions, and it is also a common practice for LGFVs and

local SOEs to provide credit guarantees to small and medium-size private enterprises. As this

critical domino chain of local governments in Chinas credit risk situation begins to wobble,

there could be significant ramifications for broad financial market stability. Such a chain

reaction seems to have begun: SOEs and LGFVs are the guarantors in a majority of private

placement bond default cases but have failed to provide credit protection as promised (Table

1).

Chart 7: Credit spreads start to widen Chart 8: The NPL cycle has finally begun

Source: China bond, CEIC, SG Cross Asset Research/Economics Source: CBRC, CEIC, SG Cross Asset Research/Economics

Apart from reform, the pressure exerted by the multi-year growth deceleration is already

weighing on commercial banks, whose NPLs have doubled since 2012 (Chart 8), indicating

that private sector debt restructuring has begun and that the process so far is rightly being left

to market mechanisms. Consequently, for the first time Chinese loan officers are prioritising

containing credit risk over growing loan books, and this has gotten in the way of the

transmission of monetary policy easing.

Restructuring now

Since top policymakers now accept the new normal of structural growth deceleration and are

committed to reform, credit risk will surely rise from here. The only question is how fast. As

financial market liberalisation progresses, the governments ability to control its speed will

gradually diminish. Then we will have more reason to worry about a hard landing. The

combined effect of retreating state guarantees and rising risk aversion can be a nasty surprise

to policymakers, and the real estate sector, which directly and indirectly contributes 30% of

total output, could add to the worry.

We think that the chance of avoiding a painful deleveraging hinges on whether the

government can restructure the non-performing assets sufficiently before the credit risk

gets out of control. We think this is achievable, since the firms that borrow and underperform

the most are government firms, but the restructuring must start now and move fast.

0

20

40

60

80

100

120

140

160

180

1/2013 5/2013 9/2013 1/2014 5/2014 9/2014 1/2015 5/2015

AAA+ v s. AA+

AA+ v s. AA-

1-year corporate bond credit spreads, bps

0

0.5

1

1.5

2

2.5

Foreign

Rural commercial

City commercial

Shareholding

State-owned

Bank NPLs by type of bank, CNY tn


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DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES AND

ANALYST CERTIFICATIONS.

CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION

Client-Driven Solutions, Insights, and Access

India Economics: El Nio, India monsoons and implications for interest rates

Normal monsoon key to further easing Monsoon still plays an important role in determining the policy rate

outlook in India. Our base case is for a moderate rainfall deficiency,

forecasting CPI inflation for Jan16 and Mar16 at 5.8% and 5.7% respectively.

RBI is likely to stay on hold and only cut rates again next fiscal year. However,

our analysis shows that a 'normal' monsoon could shave inflation projections

by 40-50bps, potentially allowing the RBI to shift the timing of a rate cut to 4Q

of the current financial year. A very poor monsoon, on the other hand can add

170bps to headline CPI. But the impact could be lower if the government

steps in with adequate measures to boost the availability of certain food items.

We examine linkages between El Nio patterns, rainfall in India,

agricultural production and CPI inflation. Here are the key findings.

o The probability of a sub-par monsoon is 85% in an El Nio year, while the

probability of an excess monsoon in an El Nio year is zero.

o There is a strong correlation between agricultural production and rainfall

since 2001, specially for foodgrain, pulses and oilseeds. For protein

products, a delicate demand and supply balance means a small supply

shortfall can cause prices to surge. Food Inflation seems to have become

more persistent for certain commodities including pulses.

o There is limited evidence of second-round effects from headline to core

inflation in recent years. Our analysis suggests that the tendency of core

inflation reverting to headline, though it was very high during 2002 to

2011, has reduced significantly during 2012 to 2015.

o Exhibit 1 summarizes our key findings and shows how a weak monsoon

could impact CPI inflation.

Exhibit 1: RBI should have limited space to cut rates this year (CS base case) unless monsoon is 'normal'

Source: Credit Suisse

Research Analysts

Deepali Bhargava

65 62125699

[email protected]

01 July 2015

Economics Research

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India Economics: El Nio, India monsoons and implications for interest rates 2

Exploring the link between rainfall, agriculture production and inflation Evaluating the risk to CPI inflation from monsoons is critical given the initial projections by

the India meteorological department of a below 'normal' monsoon; RBIs new inflation

mandate to contain inflation around 4% +/- 2; and our view that RBI is likely to keep rates

on hold for an extended period of time. In analyzing the likely impact that the monsoon

may have on inflation this year, we explore three linkages:

Global weather anomalies such as El Nio and rainfall in India;

Rainfall and agriculture production; and

Agriculture production and inflation.

El Nio and rainfall in India

An El Nio year has tended to coincide with rainfall deficiency in India 85% of the time in

the past 144 years. We looked at the data from 1871 to 2014 and concluded the following:

1) Probability of a normal (slightly negative) to deficient1 monsoon in India is 85% in the

years with an El Nio occurrence. India has also never had an excess2 monsoon

during these years.

2) Probability of rainfall being "normal" to "excess" is 85% in the years with a La Nina

weather pattern.

3) Probability of a normal monsoon in India is relatively high (40%) in the years when

there was no El Nio or La Nina.

Exhibit 2: Probability of El Nio resulting in normal(-ve) to deficient rains is 85%

0% 20% 40% 60% 80% 100%

El Nino

La Nina

Other

Deficient Normal(slightly negative) Normal(slightly positive) Excess

Probability of El Nino/La Nina resulting in monsoon anomalies (1871 to 2014)

Source: Gadgil and Kumar (The Asian monsoon agriculture and economy), Credit Suisse

1 According to the IMD parameters, below 90 percent of long-period average is defined as deficient.

2 We have classified rainfall as deficient, normal (slightly negative), normal (slightly positive) or excess monsoon, when the rainfall deviation from long-period average is below -10%, between -10% to zero, between zero and +10%, or above +10% respectively

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How poor rainfall affects agriculture production

Given the composition (see Exhibit 3 and Exhibit 4) of agriculture production in India,

which is dominated by livestock products, cereals and fruits & vegetables, we think there

are two ways in which rainfall can impact agricultural production:

Exhibit 3: Cereals are less than 1/3rd

of total agricultural production

Exhibit 4: 1/5th

of total agricultural output constitutes milk

Cereals18% Pulses

3%Oilseeds

6%

Sugar4%

Fruits and vegetables

17%

Other Agri crops14%

Livestock products

25%

Forest and fishery13%

Share in value of output of agriculutal products (2010-11)

Milk67%

Meat 18%

Eggs3% Others

12%

Share in value of output of livestock products (2010-11)

Source: Department of Agriculture and Cooperation, Credit Suisse Source: Department of Agriculture and Cooperation, Credit Suisse

1) Direct output contraction: Growth in the production of agricultural crops depends upon

acreage and yield. Progress of monsoon impacts acreage significantly while other

factors also impact yield.

2) Fodder availability and livestock products: The delay in the monsoon also cause sub-

par milk production as fodder availability decreases.

The link between lower rainfall and lower food grain production is still very strong

The chart below suggests a strong positive correlation between rain deficiency and food

grain production since 2001. This suggests that India's agricultural production is still highly

dependent on the quality of rainfall, probably reflecting domestic structural constraints in

the sector. Interestingly, the correlation between the two series was weak prior to 2001,

but this may have simply reflected low volatility in the rainfalls.

Exhibit 5: High impact of rainfall deficiency on food grain production since 2001

-30

-20

-10

0

10

20

30

40

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Deviation in rainfall from normal (normalised) Foodgrain production (%yoy,rhs)

Source: CEIC, Credit Suisse

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The impact on yields has a positive correlation for cereals, pulses, and oil seeds

(about 27% of total agricultural production)

We looked at the relationship between yields and rainfall for the key agriculture

commodities as charted below. While the trend increase in yields over time likely reflects

use of better yielding crop varieties and fertilizers, the de-trended crop yield series

suggests inter-annual fluctuations in yields could reflect variations in the rainfalls for Kharif

(summer crops) food grain and oilseeds. This means that about 27% of agriculture

production (cereals, pulses and oilseeds) does seem to be highly correlated with rainfall

anomalies. On the other hand, we found a lack of correlation between rainfall and rabi

(winter crop) food grain.

Exhibit 6: Impact of rains on oilseed yield very high Exhibit 7: Impact of rains on kharif grain yield high

y = 1.0399x + 1.5553R = 0.58

-30

-20

-10

0

10

20

30

40

50

60

-20 -10 0 10 20 30 40

Change in annual rainfall (%yoy)

Change

in y

ield

(%

yoy)

Oilseeds

y = 0.4616x + 1.399R = 0.49

-20

-15

-10

-5

0

5

10

15

20

25

-20 -10 0 10 20 30 40


Change

in y

ield

(%

yoy)

Foodgrain kharif


Exhibit 8: Impact of rains on pulses yield low Exhibit 9: Impact of rains on rabi grain yield v.low

y = 0.4008x + 1.2064R = 0.31

-20

-15

-10

-5

0

5

10

15

20

-20 -10 0 10 20 30 40


Change

in y

ield

(%

yoy)

Pulses

y = 0.054x + 1.582R = 0.02

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

-20 -10 0 10 20 30 40Change in annual rainfall (%yoy)

Change

in y

ield

(%

yoy)

Foodgrain Rabi


Fragile structural demand-supply balance for milk and pulses could be exacerbated

by the seasonal impact

Apart from the direct impact, monsoon performance is also likely to have an indirect

impact on livestock products (with 67% coming from milk) by affecting the availability of

key inputs for cattle such as fodder. This is because of the delicate structural demand-

supply balance of milk. While milk production has grown at an average of 4% in the last

three years, it hasnt been able to break above trend growth. This together with a sharp

increase in per capital consumption (14% cumulative from 2000 to 2012) leaves the

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demand-supply balance still precarious and susceptible to seasonal shocks. For example,

in 2012, when India faced a far-less alarming rainfall situation, the deficit in dry fodder was

40%, green fodder 36% and fodder concentrate supplies 57%.

Exhibit 10: Intake of milk, eggs has risen significantly Exhibit 11: Demand-Supply balance of pulses fragile

0

5

10

15

20

25

30

35

40

45

40

45

50

55

60

65

70

1993-94 1999-00 2004-05 2009-10 2011-12

Annual per capital consumption of milk (litres) and eggs

Milk (Rural, lhs) Milk (Urban, lhs)

Eggs (Rural,rhs ) Eggs (Urban, rhs)

Total pulses (mn tons) 2010-11 2011-12 2012-13 2013-14

Production18.2 17.1 18.3 19.8

Domestic Use20.8 20.4 22.2 23.1

Domestic demand-supply gap-2.6 -3.3 -3.8 -3.3

Imports2.8 3.5 4.0 3.5

Average WPI inflation(% yoy)6 5 40 -13

Demand and Supply Balance for Pulses

Source: Department of Agriculture and Cooperation, Credit Suisse Source: NCAER, Credit Suisse

Similarly, the balance is fragile for pulses as well. Given that production of pulses is likely

to fall by 4.3%yoy to 18.43 million tons (MT) in 2014-15, we think pulses are likely to

contribute to higher inflation if the monsoon disappoints. The actual impact will depend on

the spatial distribution since production of pulses is concentrated in a few states (namely

Andhra Pradesh, Madhya Pradesh, Maharashtra, Rajasthan and UP).

The link between rainfall/production and inflation

Poor monsoon and food inflation spikes

In this section, we analyze the following to establish the impact of monsoons on India CPI

inflation: 1) if a deficient rainfall year is associated with a spike in inflation, 2) how

persistent and generalized inflationary pressures could be after the initial surge, 3) where

could CPI be under various rainfall scenarios.

Exhibit 12: Monsoon anomaly does seem to explain CPI variation

-30

-20

-10

0

10

20

30

40

Jun-8

9

May-9

0

Apr-

91

Mar-

92

Feb-9

3

Jan-9

4

Dec-9

4

Nov-9

5

Oct-

96

Sep-9

7

Aug-9

8

Jul-99

Jun-0

0

May-0

1

Apr-

02

Mar-

03

Feb-0

4

Jan-0

5

Dec-0

5

Nov-0

6

Oct-

07

Sep-0

8

Aug-0

9

Jul-10

Jun-1

1

May-1

2

Apr-

13

Mar-

14

Feb-1

5

CPI (industrial workers) food inflation (%, 3m over 3m saar)

Deficient rains and oil price spike

Normal (slightly -ve) rains

Asian Financial Crisis currency depreciation

Moderate El Nino and drought


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The periods of deficient rainfall seem to be associated with spikes in CPI food inflation

(Exhibit 12), though the magnitude of spikes during 2009, 1997/8 may have been

exaggerated by other factors such as currency depreciation and oil price spikes.

Food inflation has also been more persistent for pulses and certain vegetables

(8.4% of the CPI basket)

Moreover, the food price shocks seem to have become more persistent in recent years.

This also corresponds with clearly rising demand and changing demand patterns around

this time. Exhibit 13 and Exhibit 14 illustrate the sustained prices that prevailed in 2009. As

shown below, prices of one of the key pulses Tur, and important vegetable, Onion were

27% and 44% higher respectively in the period post the drought (Jan-Mar quarter)

compared to pre-drought (Apr-Jun) prices. This wasnt the case in 2002 and 2004 where

the prices of all commodities shown below fell even below the pre-drought levels.

One way to address persistence in certain commodities would be government

intervention similar to what we saw in 2014 when monsoon was deficient as well.

Measures announced by the government included amending the Essential Commodities

Act to deter hoarding and black marketing, steps to improve drinking water supply and

boost availability of fodder to save livestock, and releasing buffer stocks in the market.

The measures helped contain volatility and spike in prices of commodities like cereals

and vegetables.

Exhibit 13: Persistent pulse prices Exhibit 14: Persistent vegetable prices

0

1000

2000

3000

4000

5000

6000

7000

8000

2400

2500

2600

2700

2800

2900

3000

3100

Apr-Jun Jul-Sep Oct-Dec Jan-Mar

Tur prices (INR/quintal)

2002-03

2004-05

2009-10 (rhs)

0

200

400

600

800

1000

1200

1400

1600

1800

Apr-Jun Jul-Sep Oct-Dec Jan-Mar

Onion prices (INR/quintal)

2002-03

2004-05

2009-10

Source: GoI, Credit Suisse Source: GoI, Credit Suisse

The second round impact from headline to core inflation has declined significantly

in recent years

We investigate the possibility of core inflation reverting to headline. If core inflation is

reverting to headline, this would indicate a worrying development of second-round effects

from food price shocks causing aggregate inflation expectations to rise. This would result

in core inflation catching up with headline inflation, something which the RBI would

definitely be uncomfortable with. We analyze this for five-year duration periods starting

1997 and the results depicted in Exhibit 15 suggest that the tendency of core inflation

reverting to headline, though was very high during 2002 to 2011, has reduced significantly

in the recent most period from 2012 to 2015.

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Exhibit 15 Tendency of core reverting to headline has gone down implying less second round effects from headline to core inflation We estimate the equation

core i,t

core i,t-12 = I + i (

core i,t-12 -

headline i,t-12 ) + i,t from year 1997 with 5-year intervals

where is plotted below

If core inflation reverts to headline, we expect a negative coefficient i on the wedge between headline and core.

-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

1997-2001 2002-2006 2007-2011 2012-2015

Lower the value, higher the tendency of core to revert to headline


Second-round effects became evident post November 2009 around the time global

commodity prices rebounded. While food inflation averaged 20% YoY during Nov09-

Mar10, non-food manufacturing products inflation rose from 0.14% in November 2009 to

3.5% in March 2010 suggesting more generalization of the inflation process. Hence, we

think second-round effects are more evident and direct when the supply shock or the price

shock is fuel inflation led rather than food led.

Putting the pieces together: Mapping out the inflation outlook and monetary policy

After accounting for the above linkages, we estimate the likely CPI trajectory for Jan and

March16 in our four3 rainfall scenarios. The key results are as follows:

1) Deficient rainfall does seem to be associated with spikes in food inflation, likely through

farm production disruptions. The risk of rainfall deficiency is considerable in the years

with the El Nio weather pattern.

2) While the difference in impact on inflation from normal and moderate monsoons is not

very significant; the difference could be substantial between moderate and very severe

monsoons. Government measures could help contain volatility and a spike in inflation

in cereals and certain vegetables, though pulses and oilseeds could continue to be

vulberable given unavailability of buffer stocks.

3) Our CPI forecasts assume a moderate deficiency (0 to -5% of LPA) and we place our

Jan16 and Mar16 inflation estimates at 5.8% and 5.7% respectively. A poor monsoon

could risk our GDP forecast of 8.1% for the current fiscal year, but we think the risks to

higher inflation would far outweigh the concerns on lower agricultural growth. As such,

we expect the RBI to refrain from cutting rates again this FY to establish credibility of

its new inflation target regime (see India: Improving growth inflation mix).

3 For this analysis, we have classified rainfall as normal, moderate, severe and very severe if the deviation from long- period

average is 0 to 10%, 0 to -5%, -5 to -10%, and

01 July 2015


4) A 'normal' (positive) monsoon will likely shift the inflation trajectory lower by 40-50bps

(Exhibit 16 and Exhibit 17). In this alternative scenario, we could see additional rate

cuts by the RBI this year. However, this is unlikely to be the case given the prediction

of an El Nio weather pattern.

Exhibit 16: RBI could have space to cut rates if monsoon is 'normal'

Exhibit 17: Severe to very severe monsoon deficiency is a risk to inflation

4.5 5 5.5 6 6.5 7 7.5 8

Normal

Moderate

Severe

Very severe

CPI estimates (%yoy) for Jan'16 under various rainfall scenarios

4.5 5 5.5 6 6.5 7 7.5 8 8.5

Normal

Moderate

Severe

Very severe

CPI estimates (%yoy )for Mar'16 under various rainfall scenarios

Source: Credit Suisse Source: Credit Suisse

Exhibit 18: Conclusion: RBI may have limited space to cut rates this year unless monsoon is 'normal'

Source: Credit Suisse

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Markets Research

Has Indias capex cycle finally begun to lift?

After years of dormancy, there are tantalizing signs that Indias capex may finally be turning up, as reflected in capital goods production and sales, lending to infrastructure, commercial vehicle sales, and rising order books in the roads sector

Prima facie, this appears at odds with weak credit growth, but we see bank credit as a lagging, not leading, indicator of capex in this cycle

Instead, we expect the early stages of the capex pickup to be financed by non-bank sources that have experienced greater monetary transmission; indeed, corporate bond and FDI flows together were higher than bank credit to the corporate sector in 2014

These non-bank sources of financing are being complemented by government-funded cash contracts in the transportation sector (the EPC model) on the back of higher budgetary allocations

We attribute the capex upturn to three factors: continued alleviation of implementation bottlenecks (reflected in stalled projects reducing for a sixth consecutive quarter in Apr-June), some easing of monetary conditions over the last few months, and a frontloading of government capital expenditures

That said, any pickup is expected to be modest, constrained eventually by impaired assets in banks and residual implementation bottlenecks such as land acquisition.

Indias stability-but-no-growth pact (with apologies to the EU)

Ever since India stood exposed during the taper-tantrum of 2013, a significant macroeconomic adjustment has occurred. The central government fiscal deficit has been reduced by another 1% of GDP over the last three years, and a new monetary policy regime is in place, predicated on keeping real rates positive, after years of negative rates led to widespread disintermediation of financial savings. Fiscal and monetary tightening, combined with the sharp oil price decline, ensured that inflation has fallen dramatically over the last year, creating space for monetary easing long before anyone thought possible. Furthermore, these same forces have induced the current account deficit (CAD), which was tracking close to 5% of GDP during the taper tantrum, to collapse to a 1% handle. Unsurprisingly, the BoP has been in a strong surplus over the last six quarters, and the RBI has been quick to build FX reserve buffers, fortifying India against global shocks, as manifested in the outperformance of the India rupee compared to its EM peers.

But even as stability has returned, growth has not followed suit. The new GDP series suggests an economy that is galloping along, but the data do not sync with the reality on the ground over the last few quarters. Until recently, a variety of high-frequency indicatorsearnings, IP, PMIs, imports reflected growths soft underbelly. Indeed, the production side of the new GDP series showed that, based on gross value added, growth actually slowed to 6.1%oya in 1Q from 6.8% in 4Q15.(see, Making sense of India's growth disconnect, Sajjid Chinoy, June 12, 2015).

Page 1 of 9Economics Web Note

7/2/2015https://markets.jpmorgan.com/research/email/gtt7e087/GPS-1750002-0.html

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Why capex matters so much

But more than disappointing growth, the bigger lament has been the lack of investment growth. The new GDP series does not have enough back data to reflect how dramatically this phenomenon has changed over the last decade. So we use the old GDP series, which has a much longer history. Between 2003-4 and 2007-8, gross fixed capital formation grew a stunning 15.7% a year on average. In contrast, over the last 12 quarters of data it has grown a paltry 1.6% a year!

Corporate investment rose from 5% of GDP to nearly 18% before the global financial crisis, but has since fallen to half that level. In fact, overall investment is deceptively high because it reflects a surge in household and valuables investment, including the surge in gold hoarding by households. In short, the composition of investment has turned adverse, with unproductive gold accumulation replacing productive corporate investment. Why does this matter? Because it was the capacity-creating investment-led growth that drove GDP growth to nearly 9% but kept core inflation below 5% pre-crisis. And it was the consumption-led growth that caused core inflation to average 9% even as growth itself moderated to 6% post crisis (per the old GDP series).



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Infrastructure and capex: that stirring feeling

The post-crisis slide in Indias long-term growth fundamentals makes the quality of growth --infrastructure and private investment -- almost more important than the quantity of growth. And here is where we see tantalizing signs of life, particularly on infrastructure investment, after years of dormancy.

Cap goods production picks up smartly...

So whats the evidence? For starters, capital goods production within IP has picked up smartly over the last few months. Admittedly, this sectors output is lumpy and volatile, cautioning against over-interpreting a few data points. But, strikingly, over the last three months, capital goods production growth has stabilized around 10%oyaa pace and consistency not seen since the spring of 2011. And this is not on account of base effects the sequential momentum of cap goods production also has accelerated in recent months. That said, we remain cautious: there have been a few instances over the last few years where momentum rose for a few months only to fall back.

...as do sales of capital goods producers...

Adding credence to the production data is the fact that sales of capital goods producers have also firmed up in both nominal and real terms over the last few months. Growth of real sales of capital goods companies within the BSE 100 has also stabilized around the 10-11% oya marksimilar to cap goods production in IP. This suggests that the cap goods production rebound is more signal than noise.

...and commercial vehicle sales...

Other proximate indicators help reinforce our impressions. Commercial vehicle sales have also picked up smartly in recent months. The year-on-year increase since last May is misleading because it was being underpinned by large and favourable base effects. But sequential sales momentum has firmed up the last three months, partly reflecting replacement demand on the back of large price discounts. Still, it adds to the evidence that something is stirring on the ground.



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...and lending to the infrastructure sector

Several commentators have cited weakening credit growth as a sign that a capex turnaround is not imminent and, in fact, that growth may be getting weaker. But the devil is in the details. For starters, nominal credit growth to the infrastructure sector has accelerated, albeit modestly, from a low of 5.1% in December to 7.1% by April. But, there are two more fundamental issues to consider. First, its important to separate nominal versus real effects, because working capital requirements have reduced with the collapse in wholesale price inflation. Recall, lending to infrastructure also expanded 7.5% a year ago, when core WPI inflation was 4.6 percentage points higher. Thus 7.1% growth in nominal lending to infrastructure implies a significant acceleration in real credit growth. This pickup is particularly noticeable since February, with real credit growth accelerating to 7.5% oya from February to April, after averaging 5.2% in 2014.

But even as lending to infrastructure may have picked up, there is a legitimate concern that broader credit growth continues to stagnate. However, unlike earlier growth cycles, we believe credit growth will be a lagging, not leading, indicator of activity in this cycle given elevated levels of non-performing assets and capital constraints in public sector banks that has made them averse to grow their book and thereby impeded monetary transmission. Instead, we discuss below how any pick-up in capex, in the early part of the cycle, is likely to be financed by non-bank sources this time around.

Order books in the road sector are thickening

It is also encouraging that the outlook for some infrastructure sectors seems to have improved. This is perhaps most visible in the roads sector. In FY15, the National Highway Authority of India (NHAI) awarded contracts for 3,000 kms of road construction, almost double the FY14 total. And NHAI plans to award 7500-9000 kms over the next year, with the roads allocation increased by 174%. (See, IndiaCement :Dissecting the demand side Roads:How big is the opportunity? Gunjan Prithyani, June 19, 2015). Given implementation bottlenecks on the ground, one can justifiably be skeptical about how many of these awards will translate into activity. But, importantly, the NHAI has recently changed policy to only award projects after environmental clearances are in place and 90% of land acquisition



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has been completed, which suggests that the translation from awards to construction is likely to pick-up in the coming months.

One way to corroborate this is by looking at the order book of Larsen & Toubro which is the best proxy for Indias infrastructure sector -- and whose order book is higher than the next 10 firms in the engineering & construction sector. As the chart below shows, the stock of orders have increased sharply by 28% at the end of the 2015 financial year (March 2015). There are some caveats in order: A quarter of these orders are from the Middle East but, interestingly, that order book has slowed. So the healthy rise in aggregate orders actually suggests that domestic orders are growing even more strongly- particularly transmission & distribution and transportation infrastructure. (See Larsen&Toubro:Robustearningsgrowthinstore,premisedonuptickinlocalexecution&absenceofivemarginsurprisesinMiddleEast, Sumit Kishore, June 11, 2015)

But how is this being financed?

To the extent that capital goods production is picking up and order books are rising, the next question is how will these expenditures be financed? India has traditionally been largely a bank-financed economy. But, weighed down by impaired assets and capital constraints, public sector banks which account for 70% of all assets have been reluctant to grow their asset books. As a consequence they have been reluctant to cut lending rates with the weighted average lending rate being cut by only 25-30 bps against policy rate cuts of 75 bps. Instead, public sector banks have cut deposit rates, increasing their net interest margins to rebuild capital.

So how will the capex cycle be financed? Other sources of funding for the corporate sector have gradually become more important. Wholesale rates have fallen materially over the last nine months, as monetary policy eased. Despite some retracement over the last two months, the AAA five-year corporate bond yield has tumbled 75 bps since September. As a result, firms, at the margin, are moving away from loans to corporate bonds. The table shows the flow of funds to the corporate sector, comparing the April-December periods for the last four years to avoid financial year-end seasonality. Two trends stand out: First, there is a secular increase in non-bank sources of financing as non-bank markets have developed. The 2013 pickup in bank credit is an aberration, a temporary re-



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intermediation into bank lending on the back of the interest rate defense that caused wholesale, but not bank lending, rates to spike. Otherwise, bank lending as a source of new corporate financing has diminished steadily.

Second, within the broader uptrend, the reliance on corporate bonds and commercial paper is strongly correlated with the direction of the rate cycle because of much quicker transmission of policy rates into their yields. Corporate bonds and CPs become a much more attractive source of financing in the run-up to and during an easing cycle, because their yields quickly reflect rate cuts and rate cut expectations. Between April and December 2014, corporate bond issuance constituted almost 25% of corporate funding vs. a 16% average in the previous three years. In fact, corporate bonds and FDI together accounted for about 43.3% of corporate funding, slightly higher than credit offtake! Therefore, both for cyclical and secular reasons, non-bank sources of financing are becoming increasingly important at the margin. We therefore believe that the early stages of any capex cycle could increasingly be financed by these sources.

Complementing this is the fact that in the transportation sector, at least, most capex is happening on the back of government-funded cash contracts (the EPC model) from higher budgetary allocations in the roads, railways, urban, instead of the erstwhile BOT (Build-Operate-Transfer) model.

A confluence of forces at work



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So whats driving the turn in the capex cycle? We believe three complementary forces are at play. First, implementation bottlenecks on the ground continue to abate albeit slowly. This is proxied by the fact that the ratio of stalled projects has reduced for a sixth consecutive quarter in the April-Jun quarter (see chart). While much still needs to be done especially on reforming land acquisition progress on speeding up environmental clearances and reform of the regulatory architecture of coals and minerals seems to have helped at the margin.

Second, the government seems to have stepped up capital expenditures sharply in recent months. Between March and May, for instance, capex spending by the government surged 138% in nominal terms and 126% in real terms. Undoubtedly some of this spike is due to a base effectcapex spending was very weak in the corresponding months of 2014 because the full-year budget was delayed to July after the new government came to power. But even adjusting for base effects, capex spending has been impressive. The authorities clearly are front-loading capex to catalyze private investmentas reflected in rising NHAI orders, for example. Our only caveat is that, with the overall budget envelope not changing, more capex spending now just means less capex spending later. But to the extent that it can help jumpstart private capex, the bunching would have been worth it.

Finally, monetary conditionsa weighted average of real corporate bond yields and the real effective exchange ratehave eased in recent months after peaking last November. This is both on account of policy rate cuts and some depreciation of the REER in April and May.

All told, the combination of implementation bottlenecks abating, some easing of monetary conditions and frontloading of public sector investment seems to have colluded to give capex a boost.



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Statutory Health Warning: any lift to be modest

We believe the capex cycle has bottomed and is showing signs of stirring, but we do not claim that the lift is going to be dramatic because significant headwinds remain. Even as firms are able to tap non-bank sources of financing, banks risk aversion linked to their capital constraints will eventually become a binding constraint. Second, while implementation bottlenecks are easing, land acquisition remains an impediment for many infrastructure projects. Third, even as we suspect that roads, power, railway, and defense sectors are likely to get a second wind, investment in commodity-intensive sectors is likely to remain weak amidst depressed global commodity markets. But these headwinds are known. For now, however, cautious optimism is warranted that the much-awaited capex cycle, lying dormant for many years may finally be shaking off some of its slumber.

Sajjid Z Chinoy(91-22) [email protected] Chase Bank, N.A., Mumbai Branch Toshi Jain(91-22) [email protected] Chase Bank, N.A., Mumbai Branch

www.jpmorganmarkets.com

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7GROUND VIEW GROUND VIEW 1 - 31 July 2015 1 - 31 July 2015 6

India has cumulatively added ~130GW in

generation capacity in the last eight years

and with a targeted addition of 120GW (CEAs

revised estimate at 150GW including renewa-

bles) in the 12th plan, India would add ~220GW

over 10 years between FY08 and FY17. This

compares very favourably to the previous plans

in the 8th, 9th, and 10th five-year plans, a

much-lower 63GW was added cumulatively.

While India has managed to add decent pow-

er-generation capacity in the last 10 years, other

inputs such as coal, transmission capacity, and dis-

tribution reforms have failed to keep up the pace.

The current government is focusing on: (1) increas-

ing coal production and (2) correcting transmission

and distribution constraints to give back the power

sector its mojo. The following pages detail the

planned spending on inter-state and intra-state

transmission networks and the consequent winners

and losers.

Why is the government so focused on transmission system?

R E N E W E D F O C U S O N T R A N S M I S S I O N

An important event that contributed to the re-

newed focus on establishing a robust and reliable

transmission system that can withstand the differ-

ent load profiles across the country was the north-

ern region blackout in CY12 after a grid failure.

Two severe power blackouts affected most of north-ern and eastern India on 30th and 31st July 2012. The day 1 blackout affected over 300mn people and was briefly the largest power outage in history, counting number of people affected, beating In-dias own 2001 record, also in northern India, when 230mn people were affected. The day-2 blackout remains the largest power outage in history and affected over 620mn people, about 9% of the world population or half of Indias population, spread across 22 states in northern, eastern, and northeast India. An estimated 32GW of generating capacity was taken offline. The blackouts were a major embarrassment to the government of India, which faced widespread criticism for not overhauling Indias power grid.

Even as Coal India missed its FY15 target, it has re-portedly been given a production target of 550mn tonnes for FY16. The company produced 494mn tonnes of coal in FY15 while its offtake was 489mn tonnes. For the first two months of FY16, Coal Indias production has increased 12% and as per the coal secretary, it would not only meet its target for FY16, but even exceed it by 10%

Capacity addition in India (incl. renewables) (MW)

0

20000

40000

60000

80000

100000

120000

140000

160000

180000

8th Plan 9th Plan 10th Plan 11th Plan 12th Plan 13th Plan

The reforms ushered in by the Electricity Act,

2003, led to the private sector strongly adding

new generation capacity over 2010-15; the private

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sector now accounts for ~40% of the genera-

tion capacity in India. While large capacity was

added in the last five years, a major portion of it

is underutilized because of: (1) paucity of fuel and

transmission botllenecks and (2) lack of offtake by

SEBs. The government has already started working

on increasing coal Indias production and is now

focusing on removing transmission bottlenecks.

While electricity reforms brought in strong addi-

tions in generation capacity, a similar increase has

not yet happened in transmission, despite the

sector being opened up to the private sector from

CY11 (inter-state transmission).

Private sector capacity now at ~40% of installed capacity in India

Power Sector

Generation 40%

Trans Line 60%

Tower pkg. 60% Transformers 50%

Conductors 25% Others 50%

Others 15%

Sub station 40%

Transmission 20% Distribution 40%

Normative spending in various segments of the power sector driven by capacity addition

From 2011, the government decided that it would award all future transmission projects on tariff-based bidding. Until then Power Grid was given all projects on a nomination basis (cost-plus model) where the company earned a fixed RoE (15.5% in the 11th and 12th plan).

Source: CEA

Source: PhillipCapital India Research

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Transmission Distribution

Generation Capacity

Generating Transformer

Sending 765 KV

Receiving 765 KV

400 KV 220 or 132 KV

33 KV 11 KV

765 KV Generating system Transmission Cap requirement

Distribution Cap requirement

MW MVA 22 KV to 765 kv

765 KV to 400 kv

400 KV to 220 kv or 132 kv

220 kv to 132 kv or 33kv

33kv to 11kv

11kv to 433kv

660 805 1080 1080 1620 2430 6210 4860 9720 14580

9.4 22.1

400 KV generating system Sending 400 kv

Receiving 400 KV

Transmission Cap requirement

33 KV 11 KV Distribution Cap requirement

MW MVA 22 KV to 400 kv 400 to 220 kv or 132 kv

33kv to 11kv

11kv to 433kv

500 610 811 811 1622 1622 3244 4866

3.2 9.7

220 KV generating system Sending 220 KV

Receiving 400 KV

Transmission Cap requirement

33 KV 11 KV Distribution Cap requirement

MW MW 22 KV to 400 kv 220 kv to 132 kv

33kv to 11kv

11kv to 433kv

200 244 500 500 1000 1000 2000 3000

5 15

Assessment of transformation capacity wt reqmnt wt avg require-ment

wt avg

765 KV generating system-1 phase system-6 transformation

0.5 9.4 4.7 22.1 11.045


0.35 3.2 1.1 9.7 3.4062


0.15 5 0.75 15 2.25

6.6 16.7

Every MW of new generation capacity needs around 7MVA of transmission capacity

Plan Transmission Lines Transformation

Generation (MW)

(ckm) Ckm/MW (MW) MVA/MW

VI 42584 52,034 0.82 46621 1.1

VII 63636 79,455 0.80 75,322 1.2

VIII 85795 117,376 0.73 125,042 1.5

IX 105045 152,269 0.69 181,942 1.7

X 132329 198,407 0.67 257,639 1.9

XI 199877 257,481 0.78 409,551 2.0

XII (Till April, 15) 268602 364,921 0.74 591,380 2.2

Generation and transmission capacity addition over the plan periods

However, today India has only 2.2MVA of transmis-

sion capacity per megawatt of generation capacity

this is far below the required 7MVA and largely

explains the congestion that is visible in the in-

terstate transmission of power across the country.

While Power Grid has done a good job in terms

of adding transmission capacity, it has clearly not

been sufficient. Understanding this need, the gov-

ernment opted to open the sector to the private

sector, but this has had mixed results. Source: CEA

To ensure uninterrupted flow of power 1MW of new generation capacity needs ~7MVA of transformation capacity

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On 30th and 31st July, India saw two severe blackouts due to grid disturbances. These blackouts affected northern, eastern and northeast India and affected more than 300mn people. Due to high load and poor monsoons, the northern Region was drawing too much power from the neighbouring western and eastern grids. On the other hand, because of rains, the western-region demand was lesser than nor-mal and it was under-drawing. This situation led to a very skewed load-generation balance among the regions. The two blackouts exposed the inherent and hitherto hidden fragility of Indias electricity grid.

Analysis of the grid failure highlighted multiple reasons: a) Skewed load generation balance across regional grids b) Grid indiscipline, including over-drawing and under-drawing c) Depleted reliability margins d) Failure of defence mechanisms e) Absence of primary response from generators f) Insufficient visibility and situational awareness at load-despatch centresg) Inadequate appreciation of transfer capability vis--vis transmission capacity

The blackouts brought into sharp focus the importance of investments in T&D infrastructure and ensuring grid discipline. To prevent fu-ture grid collapses, the government took various measures such as extensive audit of the protection system, stern action against utilities in case of deviation from schedule, and strengthening of the State Load Despatch Centre.

Plan T&D as proportion of generation (x)

I Plan 1.3

II Plan 0.8

III Plan 0.6

Three Year Plan 0.8

IV Plan 0.9

V Plan 0.7

Annual Plan 0.8

VI Plan 0.5

VII Plan 0.5

Annual Plan 0.4

Annual Plan 0.3

VIII Plan 0.5

IX Plan 0.7

X Plan 0.7

XI Plan 0.5

Recommended 1.0

Spending on T&D vs. generation signifi-cant underinvestment

Other than Indias first five-year plan, the ratio of spending on T&D to generation has been appallingly lower than required.

765 substation operating in India

July 2012 grid failure: What went wrong?

Source: CEA

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S T A T U S O F T R A N S M I S S I O N S E C T O R

How transmission in India stacks up right now?

India currently has two transmission systems

Interstate Transmission System (ISTS) and

Intra-state Transmission System (Intra-STS). Al-

together, these systems make up 305,000ckms

of transmission lines(>220kv), 13,500MW of

high-voltage direct current (HVDC) terminals, and

591,000MVA of transformation capacity.

Description 10th Plan end

11th plan addition

11th plan end

Current (Apr,15)

12th plan addition

12th Plan end

13th plan addition

13th Plan end

Transmission Lines (>220kv) ckm

HVDC Bipole lines 5872 3,560 9,432 9,432 7,440 16,872 10,600 27,472

765kv 2184 3,066 5,250 18,650 27,000 32,250 22,200 54,450

400kv 75722 31,097 106,819 136,264 38,000 144,819 30,000 174,819

220kv 114629 21,351 135,980 149,828 35,000 170,980 85,714 256,694

Total 198407 59,074 257,481 304,742 107,440 364,921 148,514 513,435

HVDC terminal

HVDC back-to-back 3000 - 3,000 3,000 - 3,000 - 3,000

HVDC Bipole terminals 5000 1,750 6,750 10,500 12,750 19,500 15,000 34,500

Total- HVDC Terminal Capacity, MW 8200 1,550 9,750 1

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