India Outlook for FY 10

8/14/2019 India Outlook for FY 10

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India Outlook FY10

Rocky Roadto Recovery


2/45

Index Growth fears to be allayed by policy response and faster global recovery 3

FY09 saw a dramatic turnaround in global and domestic conditions post the Lehman collapse that

shattered the relatively robust working of the economy in the first half. Uncertain global conditions

along with evolving domestic conditions make a point forecast for GDP growth in FY10 virtually

impossible and hence we approach the growth forecasting issue from several alternative dimensions.

Inflation is expected to remain benign 16Reversal in global commodity prices led to swift decline in price pressures since end of last year. We

expect inflation to tread into the negative zone, however the threat of structural deflation remains

distant. Favourable base effect, along with moderate global commodity prices would keep inflation at

benign levels in FY10.

Expansive fiscal policy to continue 18Expansive fiscal policy has become the order of the day, as governments world over try to shore up

economic growth. The initiation of fiscal measures in India since late last year has been prompt,

however they have led to a deterioration of the fiscal parameters. We expect the fiscal deficit to touch

7% in FY10 on account of further increase in plan expenditure.

Softer interest rates to stay 23Changing global and domestic conditions warranted the adoption of an accommodative monetary

policy since September last year. In its fight against the global crisis monetary policy has acted as a

first line of defense for RBI. We expect a softer interest rate regime to continue with a downward bias

on rates.

Though easing of rates have had an expected impact on yields till Q3 FY09, the same is not true sincethen as fears of excess supply of government issuances have dominated sentiment. Considering the

market sentiment towards the problem of excess supply and RBIs response thereof, on an average we

expect the 10Y yield to lie in the range 6.5-7.0% over the next few months. However, in the medium to

long term yields should start reflecting macro fundamentals of benign inflation and moderate growth

when the market recognizes the balance in demand-supply. We expect yields to head towards 6% at

that point.

Near term risks to undermine INR, strength to return on benign BoP outlook 33FY10 is likely to see a more balanced BoP as a narrowing trade deficit helps to improve the current

account and capital account doesnt deteriorate significantly from current levels. In the medium to long

run, Rupee would take cues from the overall benign BoP outlook along with a weakening of the dollar

against the major currencies. In the near term, however, the Rupee will be at depreciated levels as riskappetite remains largely on the sidelines and dollar trades firmly. Further, with event risks lurking in the

near term, the downward pressure on the domestic currency can get exacerbated.


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FY09 The year of two halvesGDP falters after 5 years of plus 8% growth

The year FY09 can actually be called the year of

two halves, where the relatively robust working

of the economy in the first half was shattered by

the impact of the global meltdown post the

Lehman collapse.

In the early part of the year, the ongoing cyclical

moderation was accentuated by rapid tightening

of monetary policy to counter record inflation

levels. This softening up of the economy made

us susceptible to the global shock.

Under the impact of the crisis, growth fell,

liquidity tightened and in response governments

initiated expansive monetary and fiscal policies.Source: CEIC, ICICI Bank Research

IIP Precursor to the deteriorating conditions

Growth of industrial production had started

indicating the slowdown since last fiscal.

The sharp drop in IIP growth in October gave

credence to the worst fears that industrial

production has virtually stalled leading to rapid

build-up of inventories across different industry

segments.

The average growth of IIP declined sharply in

Q3 FY09 to 0.4% compared to 8.4% in Q3 FY08.

The Dec08 and Jan09 figures are also in the

red indicating that the pain has not eased yet. However, there are some nascent signs of

stabilizing in sectors like cement, steel and auto.Source: CSO, ICICI Bank Research

Inflation Does a U-turn As growth momentum started faltering in the

beginning of last year, inflation reared its ugly

head on the back of steep increase in global

metal and fuel prices. Inflation zoomed into the

double-digit zone peaking at near 13% level in

early August09.

Rising inflation was essentially contributed by

increase in manufacturing articles prices (basemetals, edible oil) and fuel prices (increase in

regulated prices of petrol, diesel and LPG).

The peak in inflation was also accompanied with

fiscal and monetary tightening measures, which

led to strained liquidity and high interest rates

thus accelerating the cyclical downfall. Source: Bloomberg, ICICI Bank Research

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Jun-08

Sep-08

Dec-08

GDP Growth(% YoY)

0

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14

Jan-0

8

Feb-0

8

M

ar-0

8

Apr-0

8

M

ay-0

8

Jun-0

8

Jul-08

Aug-0

8

Sep-0

8

Oct-08

Nov-0

8

Dec-0

8

Jan-0

9

Feb-0

9

M

ar-0

9

WPI(% YoY)

-2

0

2

4

6

8

10

12

14

16

Oct-05

Dec-05

Feb-06

Apr-06

Jun-06

Aug-06

Oct-06

Dec-06

Feb-07

Apr-07

Jun-07

Aug-07

Oct-07

Dec-07

Feb-08

Apr-08

Jun-08

Aug-08

Oct-08

Dec-08

Feb-09

IIP

Growth 3 month MA

(% YoY)


4/45

FY09 The year of two halvesPolicy rates Switching modes

The monetary tightening measures took the

form of CRR and repo rate being raised by 250

bps and 225 bps respectively to 9% each.

With evolving global conditions, the months of

September October saw a dramatic tightening

of money markets with call rates jumping to

20% levels.

The situation necessitated a change in policy

stance and since then RBI has reduced the CRR

by 400 bps to 5% and repo rate by 350 bps to

5.5%.

Moving in sync with policy rates, the overnight

call rate and bond yields eased significantly

from the stressed levels of October.Source: Bloomberg, ICICI Bank Research

Virtual paralysis in the external sector The downward growth momentum and falling

external demand in the face of global recession

has started to reflect in the external trade data.

Export growth has remained in the negative for

the fifth consecutive month.

Export growth averaged 22.7% in H1 FY09 while

it has averaged 12.2% between Oct08-Feb09.

Average import growth has fallen to 3.2%

between Oct-Feb09 from 38.7% in H1 FY09.

The trade deficit, which had ballooned in the

earlier part of the year, has started to ease on

account of falling imports.

Source: CSO, ICICI Bank ResearchAnalysing the growth outlook for FY10 A conceptual framework

Uncertainties about the prognosis of global recovery and inability to fathom the dent in sentiments would

make a point forecast for GDP growth in FY10 virtually impossible and hence we approach the growth

forecasting issue from several alternative dimensions.

Our broad thought is to look at GDP growth from both demand side and supply side as well as from the

perspective of how the long-term structural factors would play out. We start off with an analysis of the

savings-investment trends and try to arrive at growth estimates through the productivity of these

investments, as reflected in ICOR.

The demand side approach concentrates on the drivers of consumption and investment demand. Weidentify the possible trends in consumption that could emerge in FY10 and also discuss how the quantum

of investment would be conditioned by both business sentiment and availability of finance. In supply side

analysis we focus on the outlook for agriculture, industry and services. All through our analysis, we are

aware that the outlook for FY10 would have to be conditioned for extreme volatility. So simultaneously we

undertake a historical exercise of trying to gauge how much different components of GDP respond in

slowdown years. These approaches lead us to construct 3 possible scenarios for growth in FY10.

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Jan-07

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Jul-07

Sep-07

Nov-07

Jan-08

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ar-08

M

ay-08

Jul-08

Sep-08

Nov-08

Jan-09

M

ar-09

CRR Repo rate(%)

-20

-10

0

10

20

30

40

50

Feb-0

6

Jun-0

6

Oct-0

6

Feb-0

7

Jun-0

7

Oct-0

7

Feb-0

8

Jun-0

8

Oct-0

8

Feb-0

9

-16

-14

-12

-10

-8

-6

-4

-2

0

Exports growth (3m MA) Trade balance (RHS) (USD bn)(% YoY)


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Savings & Investment structural determinantsParadigm shift in savings propelled growth Savings and Investment are the traditional

structural determinants of growth; more so in a

developing economic set up.

The structural shift of the economy is visible

with average savings rate rising to 33.6% in the

last five years from 24% in the prior five year.

While household savings account for almost

70% of gross domestic savings, its share has

fallen from close to 90% in 1990s.

The share of private corporate savings has

increased markedly from close to 14% in FY02

to 23% in FY07. Of equal importance is the fact

that public sector has turned into a net saver

from being a net dissaver in FY03.Source: CSO, ICICI Bank Research

...and led the upsurge in investment The shift in trajectory of Indias growth path has

been a result of the turnaround in investment

growth from negative and single digit levels.

In a scenario of rising domestic savings,

availability of capital is easier which fuels

investment demand.

The financing of investment shows that

domestic savings accounts for roughly 96-99%

of total investment indicating that the reliance

on external sources of financing is minimal.

The trend in investment growth shows its erratic

nature before FY03 but since then the stability in

investment growth has been remarkable.Source: CSO, ICICI Bank Research

The data suggest that a slowdown year impacts private and public sector savings while household

savings remain stable. With sluggish growth expected in FY09 and FY10 private corporate sector

savings as a proportion of GDP would fall - historically, the fall has been less than 1%. However, in

FY09 and FY10 the fall could be higher since the ratios are at elevated levels initially.

With falling corporate and public savings we expect gross domestic savings as a percentage of GDP to

fall to near 32% levels in FY10 from the high of 37.7% in FY08.

HH savings

to GDP (%)

Change from

previous year

Pvt corporate

savings to GDP

(% )

Chan ge from

previous

year

Pub lic sector

savings to

GDP (%)

Chan ge from

previous year

GDCF to

GDP (%)

Change from

previous year

FY 95 20.5 1.4 3.8 0.0 2.6 1.2 25.5 3.0

FY 98 19.4 1.7 4.7 -0.3 2.0 -0.4 25.3 1.3

FY 01 23.6 0.5 4.2 -0.7 -1.9 -1.0 24.3 -1.6

FY 03 25.2 1.1 4.2 0.5 -0 .7 1.5 25.2 2.4

FY 07 26.1 -0.3 8.5 0.4 3.5 0.7 35.9 0.4

H ou se h o ld S av in g s P r iv at e C o rp o r a te sa vin g s P u b lic se c to r s a vin g s C a pit a l f o rm a tio n

Benchmark years Slowdown years

0

5

10

15

20

25

30

35

40

1996-97

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

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3

4

5

6

7

8

9

10

11Savings as a % of GDP Real GDP growth (RHS)

Real GDP growth between 7.5-

9.4% when savings between 30-

35% of GDP

Real GDP growth between 4-6% when

savings ranged between 22-23% of GDP

(%) (%)

-5

0

5

10

15

20

25

30

1996-9

7

1997-9

8

1998-9

9

1999-0

0

2000-0

1

2001-0

2

2002-0

3

2003-0

4

2004-0

5

2005-0

6

2006-0

7

2007-0

8

2

3

4

5

6

7

8

9

10

11Investment growth Savings growth Real GDP growth (RHS)(%) (%)


6/45

Productivity gains catalyze investment into growthProductivity of investment dips in slowdown The impact of investments on overall GDP

growth is conditioned by the productivity of

those investments.

Productivity gains on the back of technological

progress and entrepreneurial innovations have

been reflected in the incremental capital output

ratio (ICOR - a measure of how much capital is

needed to produce an additional unit of output).

Between 2000-06 Indias ICOR averaged 4,

lower than that of China at 4.3 and Brazil at 5.1.

ICOR has tendency to rise in a slowdown year.

During the slowdown of FY03 ICOR jumped to

6.9 from 4.5 in the previous year. ICOR for FY09

based on advanced estimates is at 5.3 from 4.2

in FY08. Source: RBI, ICICI Bank ResearchEfficiency loss to be offset by investment We have tried to simulate the implied

investment growth for a given level of GDP

growth and ICOR for FY10.

The table on the right shows, the assumed GDP

growth for FY10 and the ICOR levels expected

to prevail in FY10, different combinations of

which yield an implied investment growth.

Analysis for FY10 shows that for the GDP to

grow by 6.5% and with assumed ICOR at 6,

investment would have to grow by 12%. Withinvestment growth already moderating to near

8.5% levels in FY09 such a scenario in FY10

seems fraught with difficulties. Implied investment rateSource: ICICI Bank Research

Safe-haven component may pose a challenge Flight to quality a natural response of the

household investor in bad times leading to a

rise in the safe haven components

Changes in household assets shows that

slowdown years are marked by a rise in

deposits and LIC funds indicating the risk

averse nature of households. We expect the share of financial savings in total

savings to decline, as households would turn

averse to risky assets. This could potentially

thwart the productivity of investable funds.

During previous slowdown years share of

financial savings in total savings has dropped

between 5-7% while that of physical savings has

increased by a similar amount.Source: RBI, ICICI Bank Research

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0

20

40

60

80

100

120

FY97

FY98

FY99

FY00

FY01

FY02

FY03

FY08

Proportion in change HH assetsDeposits Currency LIC PPF Shares & Debentures Others

(%)

During slowdown years proportion of LIC & deposits rises

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10

FY93

FY94

FY95

FY96

FY97

FY98

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09AE

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10

11

ICOR rises sharply during slowdown years

ICOR GDP (RHS) (% YoY)

5 5.5 6

5.5 -21 -13 -6

6 -14 -5.5 36.5 -7 2.3 127 0 10.2 20

GDP

Growth in

FY10

ICOR levels


7/45

Demand side developments in past slowdownsConsumption growth falters in slowdown Moving on from the savings investment

approach we look at the consumption investment angle in the demand side of the

growth dynamics.

The chart on the right shows the scatter plot of

consumption growth in the year t vis--vis the

previous year t-1. The points on above the 45

degree line represent a slowdown in year t vis-

-vis in year t-1.

The highlighted points indicate consumption

growth in a slowdown year vis--vis the

previous year. This analysis reveals that private

consumption growth could fall by 3 - 5% points

from the previous year and could make a

significant difference to the forecast for FY10. *Highlighted years are slowdown years FY98, FY01, FY03Source: CEIC, ICICI Bank ResearchInvestment growth follows a volatile trend The share of investment rose from 23% of GDP

in FY03 to 32% in FY08. Improving corporate

balance sheets was a big contributor to this.

The chart on the right shows the scatter plot of

investment growth in the present year t vis--vis

the previous year t-1. Absence of a particular

pattern corroborates with the erratic nature of

investment growth.

It is interesting to note that in 2 out of 3 cases

poor investment growth actually preceded aslowdown year rather than following it. Theimplications for FY10 would depend on how

deeply entrenched is the investment

deceleration.

*Highlighted years are slowdown year FY98, FY01, FY03

Source: CEIC, ICICI Bank ResearchGDP growth deviates from its upward trend The chart on the right shows the scatter plot of

GDP growth in the year t vis--vis the previous

year t-1. The points above the 45 degree line

represent a slowdown in year t vis-a-vis in year

t-1.

With most of the points falling to the right of the

45 degree line, we see that growth has been onan uptrend.

In a slowdown year as expected GDP growth

drops sharply compared to the previous year,. A

similar pattern for consumption growth seems

to indicate that the projection of GDP growth for

FY10 would depend critically on how

consumption responds. *Highlighted years are slowdown years FY98, FY01, FY03Source: CEIC, ICICI Bank Research

Y(t) = 0.2208Y(t-1) + 3.8163

R2

= 0.0581

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2 3 4 5 6 7 8 9

Private Consumption growth (t)

Private

Consum

ption

grow

th

(t-1)

Y(t) = -0.0651Y(t-1) + 10.103

R2= 0.0042

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22

-5 - 2 1 4 7 10 13 16 19 22

Investment growth (t)

Investm

entgrow

th

(t-1)

Y(t) = 0.3961Y(t-1) + 3.6819

R2= 0.1698

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2 3 4 5 6 7 8 910

GDP growth (t)

GDP

grow

th

(t-1)


8/45

Criticality of consumption to the overall growthThe story of consumption evolution Consumption accounts for 70% of GDP and its

significant expansion has been promoted by the

emerging middle class and ably supported by a

transformation in rural India.

The chart here shows the stable and rising

consumption growth. The quarters of a fall in

growth are largely associated with a bad

monsoon.

The 15 consecutive quarters of more than 5%

consumption growth has not been at the

expense of domestic savings, but primarily

because of the rising disposable incomes.

Maintaining a healthy consumption growth will

be critical for overall GDP growth in FY10. Source: CEIC, ICICI Bank ResearchConsumption Sustainers Rural demand to remain resilient (~57%

workforce in agriculture). Agriculture &

government services remain unaffected and to

benefit from govt measures. State pay

commission to infuse purchasing power

Faster rising affordability on the back of falling

prices

Lower interest rates to boost consumption

Favorable wealth effect a surge in income

levels over the past years to provide a cushion

during this period of slowdown

Long term structural factors intact -

demographic advantage, rising middle class and

fast rising skilled labour

Potential pitfalls in consumption growth Falling industrial output and uncertain global

environment to reduce employment

opportunities in near term

Lagged effect of downturn on services could

feed into employment uncertainty

On the back of uncertain job climate and falling

availability of credit consumers might be forced

to defer discretionary purchases

With a sharp reversal in equity and real estate

markets, more and more consumers would feel

the pinch and this erosion of wealth could havean adverse impact on a particular segment

Global risk aversion to weigh down on

consumer sentimentPay Commission impact to linger on Governments measures centre & state pay

commission, employment programs would

help to mitigate pressure on consumption.

The table shows that there was a staggered

impact of the 5th pay commission on the wage

expenses for the centre and the state lasting till

FY01. Wages and salaries of the centre as a %of GDP rose from 2.7% to 3.3% while that of the

state rose to a high of 7.2% on account of the

5th pay commission.

Thus taking into account a similar rise of the

wage bill for the centre and state, the 6th pay

commission would give an income boost of

upto 1.4% of GDP. Source: RBI, ICICI Bank Research

0

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8

9

10

Jun-00

Dec-00

Jun-01

Dec-01

Jun-02

Dec-02

Jun-03

Dec-03

Jun-04

Dec-04

Jun-05

Dec-05

Jun-06

Dec-06

Jun-07

Dec-07

Jun-08

Dec-08

Private Consumption growth(% YoY)

Central Government

INR bn % to GDP INR bn % to GDP

1996-97 371 2.7 912 6.7

1997-98 500 3.3 996 6.5

1998-99 572 3.3 1156 6.6

1999-00 648 3.3 1357 7

2000-01 661 3.1 1508 7.2

2001-02 640 2.8 1525 6.7

2002-03 706 2.9 1588 6.5

2003-04 735 2.7 1847 6.7

2004-05 808 2.6 1847 5.9

2005-06 906 2.5 2069 5.8

2006-07 941 2.3 2131 5.1

2007-08 1005 2.1 2259 4.8

2008-09 1357 2.5 2700 4.9

2009-10^ 1561 2.6 3300 5.5

^ : Assuming similar impact as of 5th Pay commission and nominal

GDP growth of 10%

Note - Data for state govt post 2005-06 is calculated assuming similar

growth as for central govt over the subsequent years

Wages, salaries and pension

* :Non-plan revenue expenditure of the States going to social,economic and administrative services

State Governments

(Consolidated)*


9/45

Lower prices and rates to provide further reliefHow much will falling prices matter?

As mentioned earlier affordability could outpace

the fall in income

Inflation as measured by WPI has convincingly

reversed its tract after growing at double digits

last year. We expect negative inflation to prop

up this year for a few months, before prices

start rising again.

However, falling inflation could also have anadverse impact wherein consumers would defer

purchases in anticipation of further fall in prices.

The current fall in prices is a phenomenon

driven by the statistical base effect, and hence

this is expected to wane at the latter part of the

year, diluting its impact on consumer behavior. Source: Bloomberg, ICICI Bank ResearchAuto sales correlate well with WPI trends To substantiate the above point we analysed the

trend of auto sales growth with the headline

inflation figure.

The graph shows clearly that an inverse relation

exists between falling prices and auto sales

growth and the correlation between auto sales

and WPI lagged by 3 months is close to 0.5.

Auto sales is a component of leveraged

spending by the consumers. Hence we feel that

the impact of falling prices on auto sales could

be coming through the interest rate channel -phases of falling prices are also associated with

easing interest rates.Source: Bloomberg, ICICI Bank Research

Falling rate could support leveraged spending Private consumption, has an inverse

relationship with interest rates adjusted for

inflation.

However the relationship works with a lag. As

per economic logic, lower rates help to

stimulate demand as cost of credit reduces and

this is reflected in the high correlation of 0.7.

We have used the 1-year prime lending rateadjusted for inflation for the purpose of analysis.

The relationship is sensitive to the use of the

PLR and it weakens significantly on taking the 1-

year deposit rate (correlation falls to 0.4).

With PLR rates expected to fall in FY10, we

could see a potential upside for consumption. Source: RBI, ICICI Bank Research

0

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4

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12

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Apr

M

ay

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan

Feb

M

ar

Inflation

FY08 FY09

(% YoY)

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3

4

5

6

7

8

9

10

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

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3

4

5

6

7

8

9

10Correlation of -0.74(%)(% YoY) Private Consumption Real Interest rates (t-2) (RHS)

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-15

-5

5

15

25

35

M

ar-00

Sep-00

M

ar-01

Sep-01

M

ar-02

Sep-02

M

ar-03

Sep-03

M

ar-04

Sep-04

M

ar-05

Sep-05

M

ar-06

Sep-06

M

ar-07

Sep-07

M

ar-08

Sep-08

M

ar-09

0

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4

6

8

10

12

14

Auto Sales 3 Month MA

WPI lagged by 3 months (inverted, RHS)

(% YoY) (% YoY)

Falling inflation to prop up auto sales


10/45

Investment and exports could be a drag on growthFalling rates to shore up investment From the demand side, analysing investment

demand will be complementary to the analysis

that we have done for consumption demand.

We analyze the impact of lower rates on

investment and it indeed does have a positive

relation. Lower rates reduces cost of funds

relative to potential returns and this helps

encourage more investment. Lower rates would

also help to make some projects more viable.

In case of consumption the mechanism works

through a lag, for investment though counter

intuitive the relation holds in the immediate

period. However, a depressed business

sentiment could delay this impact. Source: CEIC, ICICI Bank Researchbut financing could be an area of concern In the recent past the proportion of foreign

flows helping finance investment had increased

markedly.

The freezing of global financial markets post the

Lehman collapse led to ripple effects in India

adversely affecting the foreign flow of funds.

In an environment where investment grows, its

financing would increasingly depend on bank

credit. However with the proportion of bank

credit to total financing rising to 60%, its

sustainability remains questionable in the future. Other sources of foreign flows such as FDI

which have seen a spurt in FY09 might not be

forthcoming in FY10 thus worsening the outlook

for FY10. Source: RBI, ICICI Bank ResearchExternal sector to shave off GDP growth

The share of external sector (exports and

imports) has risen from 17% in 1991 to 36%

recently. With imports been much higher than

exports, net exports usually has been a negative

contributor towards GDP growth

Looking at the trend of contribution of net

exports to GDP growth since FY01, we see thatit could shave off between 0.5-3.5% points from

the overall GDP growth.

With a high probability of stagnating exports

being counteracted by declining imports,

negative contribution of net export to GDP

growth would be muted in FY10.Source: CEIC, ICICI Bank Research

-6

-4

-2

0

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4

6

8

10

12

2001

2002

2003

2004

2005

2006

2007

2008

Contribution of Net exports to GDP growth

GDP growth

(%)

0

2

4

6

8

10

12

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

-5

0

5

10

15

20

25Correlation of -0.8(%) Real interest rate Investment (RHS) (% YoY)

FY08* FY09*FY08*INR bn

FY09* INRbn

A) Bank credit to the industry 45 60 2249 2932B) Flow from non banks 55 40 1509 980B.1. Domesstic Sources 25 19 1259 9331. Public issues 7 3 344 136

2. Gross pvt placements 6 8 323 391

3. CP's subscribed by non banks 6 4 314 200

4.Others 6 4 278 207

B.2. Foreign Sources 30 20 1487 9811. ECB/FCCB 13 6 630 276

2. ADR/GDR 5 1 250 47

3. Short term credit 8 3 416 1234. FDI to India 4 11 191 536

Toral Credit (A + B) 100 100 4995 4847* as reported by RBI in the Macro & Monetary Development Jan'09

Sources of financing as % o f total credit to industry


11/45

Analyzing past slowdowns from the supply sideWide variations in agriculture growth

Moving on from the demand side analysis of

GDP to the supply side analysis, we try toinvestigate the probable paths of agriculture,

industry and services growth in FY10.

Agriculture growth suffers from sharp volatility

owning to exogenous factors. A scatter plot is

used to depict agriculture growth in year t vis--

vis the previous year t-1. Points above the 45

degree line represent slowdown in year t

compared to year t-1. The negative slope of the

regression line could indicate severe base

effects. Poor agriculture growth generally

accentuates the slowdown but is generally not

caused by an industrial slowdown. *Highlighted years are slowdown years FY98, FY01, FY03Source: CEIC, ICICI Bank ResearchIndustrial growth may be affecting with a lag The graph on the right shows industrial growth

in year t vis-a-vis in year t-1. The upward

sloping regression line indicates that a good

production year is followed by a better one.

Points above the 45-degree line represent

slowdown in year t compared to year t-1.

However not in all slowdown years, do we see a

moderation in industrial growth. Probably

slower industrial growth in one particular year

impacts other segments of the supply side with

a lag and GDP growth contracts with a lag.

With a sharp drop in industrial growth in FY09, it

is possible to have a somewhat better industrial

growth number in FY10. *Highlighted years are slowdown years FY98, FY01, FY03Source: CEIC, ICICI Bank Research

Message from past industrial growth cycles We looked at the movement of IIP growth in the

slowdown phase of FY01 and FY98.

IIP growth fell for 14 months prior to reaching

the trough during the slowdowns of FY98 and

FY03. While in the case of FY01 we see

sideways movement of IIP growth for upto 10

months after reaching the trough, in case of

FY98, IIP growth shows some semblance ofrecovery in the subsequent months.

In the current phase too IIP has been in a

downtrend for a similar time, but we would

have to wait to conclude if the trough has been

hit. The pace of recovery in FY10 would depend

on inventory adjustment, global factors and

business sentiment, among other things.Source: CSO, ICICI Bank Research

Y(t) = -0.7346Y(t-1) + 5.2377

R2

= 0.5435

-10

-8

-6

-4

-2

0

2

4

68

10

12

-8 -6 -4 - 2 0 2 4 6 8 10

12

Agriculture growth (t)

Agriculture

grow

th

(t-1)

Y(t) = 0.4957Y(t-1) + 3.2765

R2

= 0.2488

0

2

4

6

8

10

12

0 2 4 6 810

12

Industry growth (t)

Industry

grow

th

(t-1

)

-2

0

2

4

6

8

10

12

14

t-1

t-3

t-5

t-7

t-9

t-11

t-13 t

t+

2

t+

4

t+

6

t+

8

t+

10

IIP

Slowdown of FY98 Slowdown of FY01 Current Slowdown

(% YoY)

t - month of lowest growth


12/45

Will service sector be able to hold on?Service sector has defied growth cycles The chart here shows a scatter plot

representation of service sector growth in year tvis--vis that in year t-1. Points above the 45

degree line represent slowdown in year t

comapred to year t-1.

In a slowdown phase, the drop in service sector

growth in one year has not been rapid except in

one instance. However that occurred in the time

of the tech bubble burst and therefore

understandable.

Extending this logic further, FY10 service sector

growth seems to be less at risk, but the extent

of global meltdown would pose significant

challenges.*Highlighted years are slowdown years FY98, FY01, FY03

Source: CEIC, ICICI Bank ResearchGovernment expenditure to aid recovery We looked at the community, social and

personal services segment, which essentially

reflects the government revenue expenditure

and has a correlation of close to 80% with the

same. Q3 growth of 17.3% YoY reflects the

same.

The chart clearly shows that while its share in

GDP is at a modest 13-14%, its contribution to

GDP doubled in Q3 FY09 to 2.05% from 1.08%

in Q2 FY09.

Going forward this sector could hold the key fora robust service sector growth as stress on

fiscal stimulus remains.Source: CEIC, ICICI Bank Research

Trade, hotel and transport could be at risk Trade, hotels and transport segment of services

has not only gained importance in terms of

share in GDP but its contribution to GDP has

also witnessed marked improvement. Its

contribution to GDP rose from 1.5% in 1997 to

3% in 2007 before falling to 1.8% in Q3 FY09.

However the heterogeneity of this sector could

pose a problem in terms of analyzing its future

growth path. While poor global conditions and

heightened security concerns post the terror

attacks could adversely affect the trade and

hotels segment, domestic demand for

communication services still remains strong.Source: CSO, ICICI Bank Research

Y(t) = 0.5788Y(t-1) + 3.0906

R2

= 0.3372

3

4

5

6

7

8

9

10

11

12

3 4 5 6 7 8 910

11

12

Services growth (t)

Servicesgrow

th

(t-1

)

-1

-0.5

0

0.5

1

1.5

2

2.5

3

Dec-98

Dec-99

Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

6

9

12

15

18

21Community, Social & Personal Services

Contribution to GDP growth Share in GDP (RHS)

(%)(% YoY)

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

Dec-98

Dec-99

Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

18

21

24

27

30Trade, Hotels and Communications

Contribution to GDP growth Share in GDP (RHS)

(%)(% YoY)


13/45

How vulnerable is India to the global crisis?The vulnerability indicators

Source: McKinsey, CEIC, ICICI Bank Research

Having discussed the sectoral composition ofthe GDP, it would be useful to see this in the

context of vulnerability of the sectors.

We have defined sectors with maximum

domestic linkages and easy supply of credit as

the least affected sectors as the risk stemming

from a global downturn is minimal. Sectors that

have greater exposure to external sector and

face credit constraints along with an overhang

of supply are deemed worst affected.

The moderately affected sectors are the ones

facing demand constraints, however cred

availability remains strained.

It is interesting to note that while the worst

affected sectors account for 42% of the GDP,

they contributed roughly 55% of the GDPgrowth in FY08.

* The vulnerability classification is by McKinsey

Vulnerability risk to the global crisis stand evenly balanced for India

Source: IIF, Ecowin, ICICI Bank Research

Based on a host of parameters different countries have been ranked according to their vulnerability to the

global crisis with the rank 1 given to the least vulnerable country. Countries are then judged as highly

vulnerable or least vulnerable using the average score of the ranks for different parameters.

Such an exercise has yielded the result that vulnerability risk to a global crisis is evenly balanced for India

compared to its peer group.

Worst affected

sectors - 42%

Least affected sectors -

30%

Moderately affected

sectors - 29%

Share in GDP

Worst affected

sectors - 55%

Least affected sectors -

20%

Moderately affected

sectors - 25%

Proportion of Contribution to GDP growth in FY08

Agriculture, Forestry & logging, Fishing, Public

administration & defence services, Other

services

Mining & Quarrying, Registered ,Trade, Hotels &

Restaurants, Banking & insurance, Business

Services

Railways, Transport by other means, Storage,

Communications, Unregistered Manufacturing

Region

External

debt

Forex

reserves

Short term

debt

Short

term debt

Equity

markets

Domestic

credit

Fiscal

deficit

Current

Account

Balance

Average

score

(% GDP) (% debt) (% reserves)

(% total

debt)

(% change

since Jan'08) (% GDP) (% GDP) (% GDP)

China 2 1 1 12 10 11 4 2 5.4

Indonesia 4 8 7 3 7 2 6 6 5.4

Brazil 1 11 4 4 2 6 7 8 5.4

India 6 4 2 5 8 5 8 9 5.9

Russia 8 5 6 6 12 4 12 3 7.0

South Korea 10 6 10 11 3 10 3 7 7.5

S Africa 5 7 9 8 1 12 11 12 8.1


14/45

Looking ahead to FY10

Source: CEIC, ICICI Bank Research

Having analysed growth dynamics through different appraoches, we now try to construct probable

scenarios that could emerge in FY10.

The trends of the GDP components show that consumption has had a more stable past than the widely

fluctuating investment. However the India growth story with plus 8% growth over the last five years,

has been fuelled by a surge in investment growth led by healthier corporate balance sheets, capacity

expansions and enhanced productivity.

While during a slowdown average rate of consumption growth has slipped only by 1-1.2%, investment

growth falls by a greater amount of about 4% compared to the long term average.

Consumption growth has a tendency to dip in years with a bad monsoon and the lowest consumption

growth of 2.6% too occurred in a drought year.

With lack of fiscal room available in previous years, we see that average government consumption

growth during slowdown years is only marginally higher compared to the long term average. Howeverthere is reason to believe that the trend would not hold in the current slowdown phase with the

government boosting the economy through doses of higher expenditure.

Challenging times ahead

While growth in FY09 is expected to fall below

the 7% level, the challenges seem to multiply in

FY10.

With a dismal global backdrop and poor

domestic conditions the FY10 seems to be a lot

more difficult year than FY09.

For GDP growth in FY10 to reach near 6-6.5%

levels, consumption would have to grow by 5-7% and investment would have to grow by 7-

10%. This would be plausible if the government

measures to boost consumption growth seep

into the system rapidly and early signs of pick-

up in demand encourage capacity expansion

plans. Source: CEIC, ICICI Bank Research

24

710

12

3

5

70

2

4

6

8

Consumption

(% YoY)

GDP

(% YoY)

Investment (% YoY)

Scenarios for FY10 GDP

All possible scenarios

Growth rates (%) GDP

Private

consumption

Govt

consumption Investment Exports Imports

Avg growth in last 13

years 6.93 5.81 5.51 10.21 14.37 15.51

Avg growth last 5

years 8.92 7.01 4.76 15.76 15.03 22.12vg growt ur ng

slowdown 5.11 4.60 6.59 6.44 12.55 9.71

Minimum 3.77 2.67 -0.35 -4.10 -2.33 -2.44

Maximum 9.69 8.67 13.23 21.99 31.40 45.58

FY08 9.00 8.30 6.90 13.80 7.50 7.60FYTD 6.80 6.50 13.20 10.00 15.50 25.30


15/45

Constructing growth scenarios for FY10The bareminimum

Global headwinds: Export growth

contraction continues

for most part of FY10

Outflow of foreign

funds on worsening

global condition and

rating downgrade

Domesticconditions: Corporate savings

led collapse in gross

domestic savings

Cost and availability

of credit continue to

remain a sore point

for consumers and

corporates

Tight consumer

lending, employment

uncertainty and

adverse wealth effect

to weigh on private

consumption Inventory build-up

stalled by uncertain

consumption outlook

Investment projects

shelved with no

intention of adding

new projects

Financial instability

due to global

developments

Depressed asset

prices keep business

and consumersentiment down

Political uncertainty

worsens post

elections

Signs ofrecovery,domesticfundamentalssupport

Propelled bypolicy pushGlobal headwinds Export growth

falters but manages

positive growth of 2%

Some FDI inflows

but FIIs and ECB

lenders remain on the

sidelines

Domesticconditions: GDS does not drop

below 32% of GDP

Gap in investment

financing partially

bridged by

government initiatives

and partly by RBIs

liquidity providing

measures

Discretionary

purchases deferred,

rural spending helps

maintain growth of

consumption around6%

Inventory

drawdown in H1

paves way for a build-

up later

Investment pipeline

to be completed as

per schedule but fresh

proposals would not

be forthcoming

Sentiment improves

in H2 FY10 on the

back of globaldevelopments

Election results

throw up at least a

stable government

Aided by globalrecovery

Global headwinds: Global economy

sees some recovery

by 2009 end

FDI continues, FIIs

search for relative

valuation and some

appetite for ECBs

revive

Export growth

recovers in H2 FY10

Domesticconditions: Bank credit flows

helps to revive

investment

investment growth

does not drop below

7%

The recovery

process is swift with

the crisis not

spreading to other

sectors Retail credit

resumes providing

impetus to

consumption

Business and

consumer sentiment

recovers quickly

Inventory

adjustment is promp

and this fuels capacit

expansion and fresh

projects

Election resultsthrow no surprises

and new govt

committed towards

further reforms

Shorterglobalrecession,proactivepolicy action

GDP growthof 5.5 - 6% GDP growthof 6 - 6.5% GDP growthof 7 7.5%


16/45

Inflation Diverging trendsMoney Supply Inflation link breaks down Historically money supply growth and inflation

have depicted positive correlation of 0.65%.

While inflation peaked at near 13% levels in

Aug08, money supply growth dipped at that

time from 22% levels in the previous months to

around 20% levels. Correlation of money supply

and inflation turned inverse in the period of

Jan07 and Feb09.

Our forecast of negative inflation in the first few

months of FY10 confirms that this inverse

correlation will continue. However, any rapid

monetary growth to finance fiscal deficit would

have potential long-term inflationary bias.Source: Bloomberg, ICICI Bank Research

CPI and WPI paint different inflation scenario With the rise in WPI last year, the consumer

price index also rose, however the drop in the

WPI off late has not been mirrored by the CPI.

While WPI averaged 3.2% in Feb09, the CPI

reading for Feb09 was at 9.63%. It is expected

that CPI would fall, however only with a lag.

The differing weights for food, fuel and metals

between CPI and WPI are the main reason for

this divergence. While food prices have been

moving up and account for 47-57% of CPI fuel

prices, which are falling account for only 3-7%

of CPI.

Source: CEIC, ICICI Bank ResearchPrimary articles inflation still elevated

While headline inflation figure has been edging

down rapidly since Oct last year, driven by fall

in fuel and manufacturing good prices, the

primary articles inflation has not eased as much.

The high MSPs set by the government for rice,

wheat, urad and tur have been precluding the

fall in food prices.

Higher prices of food articles also have anindirect impact on WPI through higher prices of

manufactured items. The sensitivity of policymaking to primary article

prices would deter any strong reaction to

negative headline inflation numbers.Source: Bloomberg, ICICI Bank Research

10

15

20

25

30

35

40

45

M

ar-91

M

ar-92

M

ar-93

M

ar-94

M

ar-95

M

ar-96

M

ar-97

M

ar-98

M

ar-99

M

ar-00

M

ar-01

M

ar-02

M

ar-03

M

ar-04

M

ar-05

M

ar-06

M

ar-07

M

ar-08

M

ar-09

0

2

4

6

8

10

12

14

16

18M3 Inflation (RHS)(% YoY) (% YoY)

Correlation of 0.65

0

2

4

6

8

10

12

Feb-07

Apr-07

Jun-07

Aug-07

Oct-07

Dec-07

Feb-08

Apr-08

Jun-08

Aug-08

Oct-08

Dec-08

Feb-09

0

2

4

6

8

10

12

14

CPI WPI (RHS)(% YoY) (% YoY)

0

2

4

6

8

10

12

14

Apr-0

8

M

ay-0

8

Jun-0

8

Jul-08

Aug-0

8

Sep-0

8

Oct-08

Nov-0

8

Dec-0

8

Jan-0

9

Feb-0

9

M

ar-0

9

Whole Index Primary Index(% YoY)


17/45

Structural deflation is not a serious threatRecessions need not always be deflationary Historically, the notion of deflation has been

associated with periods of recession due to the

Great Depression experience.

To analyse the same we empirically study the

relationship between inflation rates and GDP

growth of 22 countries over the period 1960-

2005.

Our results point to no clear link between

inflation and GDP growth. While we found 31

cases where low inflation occurred with periods

of positive GDP growth, 22 cases of high

inflation occurred in periods of recession.Source: World Bank, IFS, ICICI Bank Research

Indias vulnerability to deflation relatively low

An index of Deflation Vulnerability constructed

by IMF shows that the deflationary risks have

increased in the global economy, particularly in

the G 7 countries. Higher the value of the index,

the more the deflationary pressures.

Japan is the only country, which has very high

risks while 13 other countries (out of 35) display

moderate risk of deflation. For India, the index

suggests minimal deflationary risk.

The deflationary risks for the global economy as

a whole (GDP weighted) has increased to 0.34 in

2009 from 0.32 in 2003. This rise in risks is

primarily driven by negative output gaps and

low asset prices. Source: IMF, ICICI Bank ResearchInflation expected to average close to 2-3% On the basis of a simple statistical exercise

assuming primary, manufacturing and fuel

indices to closely mirror the trend in the past

five years, we have tried to forecast the weekly

inflation figures for FY10.

As per our analysis inflation would enter the

negative zone over the next few weeks and

remain in the red for most part of 2009. This fallin the year on year inflation is essentially on

account of the base effect.

Our forecast chart of the inflation figures for

FY10 is a statistical exercise to reflect the base

effect. However going forward as commodity

prices pick up from the abysmally low levels, we

expect inflation to average about 3% in FY10. Source: Bloomberg, ICICI Bank Research


18/45

Overview and comparison of fiscal deficitIndia fares poorly in comparison

Expansion of fiscal deficit has become a global

theme as governments across the world are

trying to cushion the falling economic growth.

Among the developed countries, US, UK, and

Japan are expected to record extremely high

deficit numbers over the next two years as

governments in these countries provide

stimulus in a phased manner. Russia has

slipped from surplus to deficit mode rapidly. Indias performance on the fiscal parameter has

deteriorated because of stimulus measures,

populist expenditure, and high commodity

prices in the recent past.Source: IMF, ICICI Bank Research

Combined fiscal deficit looks onerous

The combined fiscal deficit of the government is

budgeted to be close to 8.5% of GDP in FY10.

However, we expect centers deficit to touch 7%

due to 1% increase in plan expenditure and

approx. INR 300 bn of tax cuts announced post

the interim budget. Considering about 1%

stimulus by the new government in FY10, the

deficit could touch 8%. These correspond to

two likely scenarios A and B, for the FY10 deficit

(for details see the bond market section). Hence

the combined deficit could lie between 10.5-

11.5% under the two different scenarios

considered above.

Off-balance sheet items, which are expected to

be less in FY10, could potentially add another

0.7% (compared to the 2.4% in FY09). Source: RBI, ICICI Bank ResearchPost election, deficits carry an upward bias Historical data suggests that on an average,

fiscal deficit has a tendency to rise post the

general elections, the last election being a

pleasant exception. Bulk of the increase in fiscal deficit in FY09

(increase of INR 1932 bn) has come from anincrease in the primary deficit of the center as

interest payments are expected to have risen by

approximately INR 19 bn only. The upward risk to fiscal deficit in FY10 would

emanate from a higher than expected primary

deficit.

Source: RBI, Parliament of India, ICICI Bank Research

-11 -9 -7 -5 -3 -1 1 3 5

Australia

Canada

Germany

Japan

UK

US

Brazil

Russia

India

China

Government balance as % of GDP

2008 2009 2010

0

2

4

6

8

10

12

FY82

FY84

FY86

FY88

FY90

FY92

FY94

FY96

FY98

FY00

FY02

FY04

FY06

FY08

FY10E

Fiscal deficit (as % of GDP) Center State

-2

0

2

4

6

8

10

FY8

2

FY8

4

FY8

6

FY8

8

FY9

0

FY9

2

FY9

4

FY9

6

FY9

8

FY0

0

FY0

2

FY0

4

FY0

6

FY0

8

FY1

0

BE

Fiscal deficit Primary deficit Revenue deficit

(as % of GDP)

General elections


19/45

Fiscal stimulus and deficitsFiscal stimulus varies across countries

In most countries discretionary fiscal stimulus

has so far focused on 2009, with the 2010

amounts generally representing phasedimplementation of programs initiated in 2009.

According to the IMF, for the G20 as a whole

fiscal stimulus would amount to 1.8% of GDP in

2009 and 1.3% of GDP in 2010.

Difference in the size of stimulus comes

primarily from two sources ability of the

government (i.e., the level of the deficit at which

they entered the recession) and the presence of

in-built automatic stabilizers in each economy.Source: IMF, ICICI Bank Research

Indias fiscal stimuli has so far been prompt

Fiscal stimulus in India was introduced in late

2008 and as elsewhere, it came in the form of

both an increase in expenditure as well as a cut

in taxes.

So far, a total of INR 500 bn increase in

combined government expenditure has been

earmarked under the two different stimulus

measures along with tax cuts to the tune of INR

375-400 bn.

Although not a part of any fiscal stimulus, but

schemes like the farm debt waiver and sixth

commission payouts could very well reduce theneed for aggressive fiscal stimulus.

Source: Press releases, ICICI Bank ResearchHigh deficit to support growth

Except FY09, the government had been curbing

fiscal largesse since the introduction of the

FRBM Act by trying to maintain a somewhat

counter cyclical fiscal policy structure.

Although the direction of causality between

deficit and growth is far from clear, but

nevertheless a higher deficit (or a lower surplus)

is beneficial in times of slowing economic

activity as government spending substitutes the

fall in private spending in order to sustain

aggregate demand.

Hence, a higher deficit need not always be a

macro risk (through rise in interest rates and

crowding out). It can very well be a much-

needed growth booster. Source: RBI, ICICI Bank Research

0.0

0.5

1.0

1.5

2.0

2.5

-10 -8 -6 -4 -2 0

Average government balance as % of GDP (2008-10)

Averageannounce

dfisca

lim

pluse

as

%o

fGDP(2008

-10)

India

UK Japan

Brazil

Canada

Germany Russia

Australia

China

US

S u m m a r y o f a n n o u n c e d f i sc a l s ti m u l u s m e a s u r es i n In d i a I N R b nFirst stimulus package

Increase in plan expenditure 200

Reduction in CENVAT 87

Infrastructure promotion through IIFCL 100

Scheme for textile and SMEs 14

Second stimulus package

Increase in state government expenditure 300

Increase in tax-free bond limit for IIFCL 300

Special credit line and liquidity support through SPV for NBFCs 250

FII investment in corporate debt increased to USD 15 bn from 6 bn

ECB relaxation

OthersTax cuts announced post interim budget 300

0

2

4

6

8

10

12

FY

82

FY

84

FY

86

FY

88

FY

90

FY

92

FY

94

FY

96

FY

98

FY

00

FY

02

FY

04

FY

06P

FY

08RE

FY

10BE

2

3

4

5

6

7

8

9

Real GDP Fiscal defict (inverted, RHS)(% YoY) (% of GDP)


20/45

Assessing the determinants of deficit in FY10Indirect tax revenues to be impacted further

As part of tax reforms, indirect taxes (customs

and excise) were reduced substantially since

mid 1990s resulting in fall in collections vis--vis

nominal growth.

The reduction in indirect tax rates (as a part of

fiscal stimuli) and the expected slowdown in

nominal growth to around 10% would impact

revenues from indirect taxes in FY10.

This would have an adverse impact on the tax-

to-GDP ratio, which is already depicting signs of

fatigue.

Source: RBI, ICICI Bank Research

Bleak year for direct tax revenues?

Share of direct tax revenue in gross tax revenue

is expected to increase from 55% to 57% in

FY10 we see upside risks to these estimates,

as the new government is likely to implement

stimulus measures through a reduction in

indirect tax rates (revenues from which are

generally more sensitive to slack in economic

activity).

Driven by a slightly higher fall in indirect tax

revenue, during 1997-98, tax-to-GDP ratio fell by

0.5% as nominal growth dropped from 15.7% to6.3% - this could be repeated to a lesser extent

in FY 10 as the ratio could slip towards 8% from

the expected 8.6% in FY09.Source: RBI, ICICI Bank Research

Pressure from subsidies to come off

The plunge in global commodity prices will act

as blessing for the off-balance sheet deficit that

is expected to drop from about 2.4% in FY09 to

about 0.7% in FY10.

Cash subsidy bill for the government is also

expected to come down (driven by a drop in

fertilizer subsidies) from its decade high level of

INR 1292 bn in FY09 to INR 1009 bn in FY10.

If a faster than expected recovery in global

economy escalates commodity prices, then

chance of a rise in FY10 estimate of cash

subsidy later on in the year cannot be ruled out. Source: RBI, ICICI Bank Research

5

10

15

20

25

30

35

40

45

50

FY91

FY92

FY93

FY9

4

FY9

5

FY9

6

FY9

7

FY9

8

FY9

9

FY0

0

FY0

1

FY0

2

FY0

3

FY0

4

FY0

5

FY0

6

FY0

7

14

15

16

17

18

19

20

21

22

23

24

Customs/ Imports Excise/ Industrial output (RHS)(%) (%)

6

8

10

12

14

16

18

20

FY

82

FY

84

FY

86

FY

88

FY

90

FY

92

FY

94

FY

96

FY

98

FY

00

FY

02

FY

04

FY

06

FY0

8

FY1

0BE

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

Nominal GDP Tax revenue (RHS)(% YoY) (% of GDP)

0

100

200

300

400

500

600

700

800

FY

01

FY

02

FY

03

FY

04

FY

05

FY

06

FY

07

FY

08

FY

09RE

FY

10BE

0

200

400

600

800

1000

1200

1400

Subsidies FoodFertilizerPetroleumOthers Total (RHS)(INR bn) (INR bn)


21/45

Assessing the determinants of deficit in FY10Can higher expenditure be avoided?

Although the Indian economy has undergone

structural changes over the last two decades, a

crude analysis suggests that the correlation

between nominal growth and government

expenditure falls substantially during times of

slowdown (which implies increased government

expenditure) the average correlation

coefficient lies close to 0.4 compared to close

to 0.2 observed during expansion phases.

Higher government expenditure acts as a

natural stress reliever and is a preferred form of

fiscal stimulus, considering the relatively higher

value of fiscal multiplier over the tax multiplier.Source: RBI, ICICI Bank Research

How productive is increased expenditure?

According to the interim budget, revenue

expenditure for the government is expected to

rise above 14% of GDP in FY10 from close to

12% in FY09. This is in contrast to the fall in capital

expenditure, which is expected to drop to about

1.7% of GDP in FY10 from about 1.8% in FY09. The moderation in capital expenditure is a

concern, as it is not helping in enhancing the

productive capacity of the economy, whereas

the increase in revenue expenditure is justreflective of the increase in government

consumption through the implementation of

various stimulus measures. Source: RBI, ICICI Bank ResearchRising deficits imply larger interest payments

The difference between the gross fiscal and

primary deficit has increased by close to 2%

over the last decade primarily due to rising

interest payments.

Total interest payments are expected to

increase by INR 328 bn in FY10 this happens

to be highest single year increase.

However, what is more worrying is the

likelihood of interest payments (as percentage

of revenue receipts) rising for the second

consecutive year in FY10 after the improvement

seen since FY02.Source: RBI, ICICI Bank Research

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

Slowdown Expansion

Correlation between Growth in Nominal GDP & Expenditure

Growth in Nominal GDP & Revenue

During a slowdown phase expenditure rises but revenue

falls

8

9

10

11

12

13

14

15

FY82

FY84

FY86

FY88

FY90

FY92

FY94

FY96

FY98

FY00

FY02

FY04

FY06

FY0

8R

E

FY1

0B

E

1

2

3

4

5

6

7

8Expenditures as % of GDP Revenue Capital (RHS)

0

500

1000

1500

2000

2500

FY

81

FY

83

FY

85

FY

87

FY

89

FY

91

FY

93

FY

95

FY

97

FY

99

FY

01

FY

03

FY

05

FY

07

FY

09RE

20

25

30

35

40

45

50

55

Interest Payments - size as % of revenue receipts (RHS)(INR bn)


22/45

Issues in financing the deficitHeavy reliance on market borrowings

Since FY99, major part of the financing of the

fiscal deficit has been borne by market

borrowings. Net market borrowings (as % of fiscal deficit)

increased from the budgeted 75% to 80% in

FY09 this is expected to touch a record 93% in

FY10. Since there are significant upside risks to the

budgeted fiscal deficit estimate, this share could

even go higher however since short-term

borrowings have not been considered in the

FY10 interim budget, a part of the increase in

deficit could potentially be offset through this.


might increase the onus on banks

The share of market borrowing in financing the

fiscal deficit has picked up after FY05.

G-sec holdings by banks (as % of outstanding)

have somewhat moderated in the four years till

FY07, with increased participation seen from

PFs and LIC.

However, with the fiscal deficit rising once again

in FY09 and FY10, the incremental appetite for

g-secs is likely to come more from the banks

side given their huge deposit base.

Source: RBI, ICICI Bank ResearchElevated yields to pose further problem

The moderation in average rate of interest on

domestic government liabilities has been

beneficial in bringing down the interest cost (as

% of receipts) after FY04.

However, there would be two factors acting

against the interest costs this year (i) the

increase in magnitude of the deficit per se will

result in higher interest costs, and (ii) buoyancy

in bond yields is expected to continue and since

majority of the financing would be through

market loans, the interest cost for the

government runs the risk of carrying an upward

bias.Source: RBI, ICICI Bank Research

Y e a rMark e tL o a n s

S m a l lS av in gs S PFs

Spec i a lDepos i t s

FY91 - FY95 (avg.) 10.86 10.85 11.63 11.53

FY96 - FY00 (avg.) 12.39 11.62 11.62 10.93

FY01 12.99 11.6 10.54 9.87

FY02 12.83 11.61 9.09 10.5

FY03 12.11 11.56 8.53 8.82

FY04 11.11 10.88 7.39 7.94

FY05 9.87 9.37 7.99 7.65

FY06 10.07 8.9 7.46 7.25

FY07 8.9 8.91 7.63 6.85

FY08 9.45 8.33 7.83 5.67

Average In teres t Rates on Outs tanding Domest i cL iab i l i ti es o f the Cen t re (%)

-20%

0%

20%

40%

60%

80%

100%

FY82

FY84

FY86

FY88

FY90

FY92

FY94

FY96

FY98

FY00

FY02

FY04

FY06

FY08RE

FY10BE

Financing of fiscal defict External sources Net market borrowings

Draw down of cash balances Others

3

4

5

6

7

8

9

FY91

FY92

FY93

FY94

FY95

FY96

FY97

FY98

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

40

45

50

55

60

65

70

75Fiscal deficit as % of GDP Banks' holding of G-Secs as % of

outstanding stock (RHS)


23/45

Monetary policy response so farLiquidity seems to be the prime concern

Even before the fiscal stimulus across the world

gained traction, deployment of monetary policy

happened in both conventional and non-

conventional forms. While growth concerns prompted easing of

policy rates, liquidity concerns and financial

stability seems to be the principal objective

behind the use of non-conventional methods. Policies dealing with toxic assets, capital

injection programs, and creditor protection in

case of further deterioration have not been

needed in the Indian context.

Source: IMF, ICICI Bank Research

RBI does the most aggressive policy easing

In the fight against the ongoing crisis, monetary

policy from the RBI indeed acted as the first

line of defense. Even before fiscal policy was considered as a

possible tool, financial stability and growth

concerns prompted the RBI to cut policy rates

aggressively - the repo and reverse repo rates

were pruned by 400 bps and 250 bps to 5% and

3.5% respectively in less than five months. Apart from this CRR and SLR were also brought

down by 400 bps and 100 bps to 5% and 24%respectively.

Source: Bloomberg, ICICI Bank Researchand infuses liquidity as well

The spillover from the ongoing global financial

crisis resulted in an unprecedented tightening of

liquidity conditions after the collapse of Lehman

Brothers, which was exacerbated by seasonal

tax outflows and fx intervention by the RBI. Since Sep-08, RBI released about INR 4300 bn

liquidity in FY09 through various measures. Further support came through in the form of a

100 bps cut in the SLR, and measures to

counter the shortage in fx liquidity (e.g., Dollar

swap line for banks, increase in rates for NRI

deposits, resumption of SMO, etc.)Source: RBI, ICICI Bank Research

Establish/

Increase

DepositInsurance

Wholesale

BorrowingGuarantees

Strengthe

ned

LiquidityMeasures

Re-

Capitalization Plans

Asset

PurchasePlans

Developed Countr iesAustralia x x x x

Canada x x x

Germany x x x x x

France x x x

Italy x x x

Japan x x x

UK x x x x x

US x x x x x

EM Countr iesBrazil x x

Russia x x x x x

India x

China x

South Korea x x x x

Conta inmentOverv iew o f po l i cy measures

Resolut ion

Measure/ Facility Size (INR bn)

CRR cuts 1600

MSS unwinding 631

Term repo facility 600

Increase in export credit refinance 255

Special refinance facility 385Refinance facility for SIDBI/NHB/EXIM 160

Liquidity facility for NBFCs 250

OMO purchases 466

Total 4347

Actual/ Potential release of liquidity since Sep-08

3

4

5

6

7

8

9

10

M

ar-05

Sep-05

M

ar-06

Sep-06

M

ar-07

Sep-07

M

ar-08

Sep-08

M

ar-09

Policy rates Repo Reverse Repo CRR(%)


24/45

Quantitative Easing and the RBICentral banks expanding their balance sheets

Various policy initiatives taken by the central

banks are resulting in an expansion of their

balance sheets.

Since Sep-08, the Fed started increasing its

balance sheet size through purchases of assets

of different types and maturities. Similarly, the

BoE has also increased its balance sheet size by

implementing various schemes like the Asset

Purchase Facility. Monetization of government debt through

buying of treasuries and corporate bonds by

Fed, BoE, BoJ, SNB, etc. would further lead to

an expansion in their balance sheet size.Source: Bloomberg, CEIC, ICICI Bank Research

RBIs version of QE

Although RBI has not bought any private

securities from the market, the effect of the

ongoing monetization of government deficit

would be reflected in its balance sheet. OMOs till date have been the preferred route of

monetization of deficit since possibility of

private placement has been shrouded in

mystery. Stock of Rupee securities held with the

RBI increased by INR 383 bn in FY09. Changes in other parts of the balance sheet

would most likely be of little significance inFY10.

Source: CEIC, ICICI Bank ResearchMoney multiplier spikes up

Money multiplier has lied between 4.5 5.0 for

most part of last seven years. However, the aggressive amount of monetary

easing in the form of cuts in the CRR (which was

pruned by 400 bps in just about three months)

resulted in a sharp spike in the money

multiplier, thereby pushing it to an all time high. Since the RBI could resort to further CRR cuts if

required, money multiplier could possibly stay

in a higher range in FY10. Any effort to expand

RBI balance sheet would result in liquidity

infusion unlike other countries where this

transmission mechanism has failed.Source: CEIC, ICICI Bank Research

3.7

3.9

4.1

4.3

4.5

4.7

4.9

5.1

5.3

Mar-

99

Mar-

00

Mar-

01

Mar-

02

Mar-

03

Mar-

04

Mar-

05

Mar-

06

Mar-

07

Mar-

08

4

5

6

7

8

9

10

11

Money Mu ltiplier CRR (%, inverted, RHS)

50

100

150

200

250

300

M

ay-06

Aug-06

Nov-06

Feb-07

M

ay-07

Aug-07

Nov-07

Feb-08

M

ay-08

Aug-08

Nov-08

Feb-09

700

900

1100

1300

1500

1700

1900

2100

2300

BoE's asset size Fed's asset size (RHS)(GBP bn) (USD bn)

6000

7000

8000

9000

10000

11000

12000

13000

14000

15000

16000

Mar-06

Jun-06

Sep-06

Dec-06

Mar-07

Jun-07

Sep-07

Dec-07

Mar-08

Jun-08

Sep-08

Dec-08

Mar-09

RBI's Assets - FCA Gold Rupee securities (incl T-Bills) Others(INR bn)


25/45

Forecasting key monetary variables



Source: CEIC, ICICI Bank Research Source: CEIC, ICICI Bank ResearchMeasures of money supply could carry an upside risk in FY10

Although net foreign exchange assets and net non-monetary liabilities of RBI were the major

drivers of M0 in FY09, their significance would reduce dramatically in FY10 as no significant net

foreign inflows are expected (see our BoP forecast below for details). RBIs credit to the

government gained importance in FY09 because of the temporary immunity from FRBM leading to

the start of monetization of fiscal deficit and also because of the depletion of the MSS stock. Both

these trends are expected to gather pace in FY10.

The impact of this expansion would get reflected in net bank credit to government, which wouldfinally affect M3. In our opinion, the expansion in net bank credit to government would offset the

decline in bank credit to the commercial sector on the back of falling nominal growth in FY10.

This expansion in M3 will eventually be reflected in an increase in aggregate deposits of the

banking system.

-5000

-3000

-1000

1000

3000

5000

7000

9000

11000

13000

15000

M

ar-99

M

ar-00

M

ar-01

M

ar-02

M

ar-03

M

ar-04

M

ar-05

M

ar-06

M

ar-07

M

ar-08

M

ar-09

Sources of M0 - Net RBI credit to govt NFA of RBI NNML of RBI(INR bn)

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

M

ar-99

M

ar-00

M

ar-01

M

ar-02

M

ar-03

M

ar-04

M

ar-05

M

ar-06

M

ar-07

M

ar-08

M

ar-09

Components of M0(INR bn)

Currency in circulation Bankers' deposit with RBI

-10000

0

10000

20000

30000

40000

50000

60000

M

ar-99

M

ar-00

M

ar-01

M

ar-02

M

ar-03

M

ar-04

M

ar-05

M

ar-06

M

ar-07

M

ar-08

M

ar-09

Sources of M3 - Net bank credit to govt Bank credit

to comm sector NFA of banks NNML of banks

(INR bn)

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

50000

M

ar-99

M

ar-00

M

ar-01

M

ar-02

M

ar-03

M

ar-04

M

ar-05

M

ar-06

M

ar-07

M

ar-08

M

ar-09

Components of M3 - Currency with public Demand

dep with banks Time dep with banks

(INR bn)


26/45

Path of key monetary and credit ratiosInvestments to increase as

The pick-up in credit-to-M3 ratio since FY05 was

associated not only with a higher growth for the

economy, but also with an improvement in

financial deepening.

Going forward, although we expect the ratio of

aggregate deposits-to-M3 to remain around

80%, credit-to-M3 ratio is likely to moderate to

below 60% (for reasons enumerated above).

The effect of this decline would be somewhat

offset by an increase in the investment-to-M3

ratio that can be expected to almost touch 26%

in FY10.


credit offtake is expected to moderate

As growth slows down further, credit demand

would moderate further at the same time the

supply of credit would also come down as

banks are expected to become more risk

averse. The fall in the credit-deposit ratio would also be

driven by deposit growth, which can be

expected to remain buoyant on the face of RBIs

monetization.

Investment-deposit ratio could turn marginallyhigher as banks are expected to increase their

holding of excess SLR.Source: RBI, ICICI Bank Research

Structure of RBI balance sheet to get altered

FY10 could end up being a unique year as

temporary immunity from the FRBM act will

allow RBI to monetize governments fiscal

deficit.

Since BoP is expected to remain close to zero

next year, the result would be an expansion of

net domestic assets of the RBI vis--vis its netforeign assets.

We expect the ratio of RBIs NDA-to-NFA, which

started increasing in FY09, to become positive

and increase further in FY10.

The increase in this ratio would be vital for

providing cushion to the economy suffering

from a withdrawal in economic activity. Source: CEIC, ICICI Bank Research

0.70

0.72

0.74

0.76

0.78

0.80

0.82

Mar-99

Mar-00

Mar-01

Mar-02

Mar-03

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

0.20

0.25

0.30

0.35

0.40

0.45

0.50

0.55

0.60

0.65Ratios - Deposits/M3 Credit/M3 (RHS) Investments/M3 (RHS)

0

20

40

60

80

100

120

140

FY82

FY84

FY86

FY88

FY90

FY92

FY94

FY96

FY98

FY00

FY02

FY04

FY06

FY08

FY10E

-10

0

10

20

30

40

50

60

70

Incremental ratios Credit-DepositInvestment-Deposit (inverted, RHS)

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

Mar-

00

Mar-

01

Mar-

02

Mar-

03

Mar-

04

Mar-

05

Mar-

06

Mar-

07

Mar-

08

Mar-

09

Ratio of NDA to NFA of RBI


27/45

Framework for analyzing monetary policy stance


Source: RBI, ICICI Bank ResearchLiquidity provision to remain key for RBI in FY10

We have envisaged two plausible on-balance sheet deficit scenarios - A and B for FY10, wherein A

corresponds to 7% of GDP and B corresponds to 8% of GDP (for details see the fiscal section).

RBIs pump priming carries the potential to keep growth in M3 and deposits at a robust level. The

only monetary variable that can be expected to moderate would be credit.

On the supply side, credit growth is expected to come off as banks generally become more cautious

in their lending activities, while on the demand side fall in input costs and a overall slowdown in

activity would tend to dampen demand for credit. Apart from sounding concerned on growth, RBI has become extremely cautious about financial

stability and hence liquidity management would continue to enjoy paramount importance. Since we expect FY10 BoP to remain close to zero, currency with the public would become the most

important driver of liquidity. Any possible sell side intervention by the RBI in the beginning of the year

would possibly be offset by a reverse transaction later (please refer to our Rupee view below).

Management of liquidity would come in the form of bond purchases under OMO and a depletion of

the MSS stock.

CRR would be deployed only if liquidity conditions begin to tighten despite these efforts.

Additionally we expect 50-100 bps cut in the repo and reverse repo rates.

FY 07 FY 0 8 FY 0 9S c en A S c en B

A . D r iv e r s o f L iq u id ity 623 2040 -416 -111 7 -1117RBI's net purchase from ADs 1190 3121 227 0 0

Currency with the public -698 -846 -993 -1167 -1167

Centre's surplus cash balances with RBI -12 -266 300 0 0

Others 142 31 50 50 50

B. M a n a g e m en t o f L iq u id ity -243 -1177 2 861 279 8 3197Change in LAF balances 364 212 576 776 676

Change in net OMO 7 135 466 1142 1641

Change in MSS outstanding -339 -1054 796 880 880

Liquidity impact of CRR changes -275 -470 1023 0 0

C . Ba n k Reser v es (A + B) 3 80 86 3 244 5 168 1 208 0

F Y 1 0R B I 's L iq u id i ty M an agem en t O p er a t io n s ( I NR b n )

(+) indicates injection and (-) indicates absorption

INR bn % INR bn % INR bn % INR bn % INR bn %

MO 1360 24 2194 31 595 6.4 561 6 1010 10

M3 5807 21 6964 21 7512 19 7497 16 3502 20

Aggregate Deposits 5029 24 5802 22 6320 20 5927 15 7763 20

Credit 4241 28 4173 22 5167 22 4011 14 4870 17

FY10 (Scen B)Changes in Key monetary variables

FY07 FY08 FY09 FY10 (Scen A)


28/45

Fundamental factors affecting bond yieldsEffect of monetary policy on bonds diluted

Although we expect further policy easing from

the RBI, but it is likely to be of less significance

for bond yields as long as supply concerns

continue to dominate sentiment.

The effect of aggressive policy easing was

limited only till Q3 FY09 after which the 10Y g-

sec yields climbed up by more than 180 bps. Although, the 10Y benchmark bond yield barely

stayed within the LAF corridor over the last two

years, its average spread above the repo rate

stayed at just 12 bps between Dec-06 to Dec-08.

Source: Bloomberg, CEIC, ICICI Bank Research

as 10Y stays much above policy rates

The average spread of 10Y bond yield over the

repo rate increased to about 72 bps in Q4 FY09,

while the current spread would be close to 200

bps. Such a high level of spread with the policy rate

is not very common Data since Jun-00 suggests that the 10Y bond

yield has stayed 150 bps above the repo rate

only 2% of the time. However, if we consider the entire LAF width

(which currently is at 150 bps) as the spread,then the frequency turns out to be 16%.

Source: Bloomberg, ICICI Bank ResearchEffect of inflation and oil could also ease

Apart from policy rates, inflation and oil price

are other traditionally important drivers of bond

yields.

With both staying low for the time being, the

high level of long-term correlation with bond

yields can be expected to moderate in FY10.

However, there is a slim possibility that theglobal economy starts to recover in early 2010,

and with the ongoing monetization in most of

the countries inflation could become a possible

threat thereafter this could restore the long

term correlation to higher levels once again.Source: Bloomberg, ICICI Bank Research

-1.00

-0.75

-0.50

-0.25

0.00

0.25

0.50

0.75

1.00

Mar-

00

Mar-

01

Mar-

02

Mar-

03

Mar-

04

Mar-

05

Mar-

06

Mar-

07

Mar-

08

Mar-

09

1Y rolling correlation of 10Y G-Sec yield with WPI and Oil price

Frequency (%)

Above 50 bps 52

Above 100 bps 20

Above 150 bps 2

Greater than 1/3 LAF 50

Greater than 2/3 LAF 34

Greater than LAF 16

* Data since Jun-00

Spread of 10Y G-Sec above reporate*

3

4

5

6

7

8

910

11

M

ar-01

M

ar-02

M

ar-03

M

ar-04

M

ar-05

M

ar-06

M

ar-07

M

ar-08

M

ar-09

Repo Rate Reverse Repo Rate 10Y G-Sec Yield(%)


29/45

Bond market outlook


Source: RBI, CEIC, ICICI Bank Research Source: RBI, ICICI Bank ResearchRBI actions to tackle excess supply and the outlook for bonds

In the first part of FY10, fundamental factors might play a very limited role in determining bond yields.

We have noticed that in the last quarter of FY09 excess supply emerged as the key factor which kept

sentiment at bay. Even in FY10, the overall supply of g-secs could potentially lie between INR 3900-

5000 bn this would be about 23%-58% higher than the net supply in FY09.

The overall demand-supply balance does not look that threatening because of heavy OMO purchase by

RBI in H1. Such a trend is expected to continue in H2 as well.

However, since fiscal slippage is expected to be much higher (1.5-2.5% of GDP), market is factoring ina risk of the supply-demand balance getting

Documents

India Outlook for FY 10