What We Are Reading Vol.82

Emerging Markets Research
9 July 2015
Asia Themes: India
Assembling the building blocks

Increasing fiscal revenue is supporting the governments medium term agenda of
raising infrastructure investment. The focus is likely to be on urbanisation,
clearing supply bottlenecks through better logistics, stronger infrastructure and
ending power and coal shortages, which can raise Indias trend growth rate.
Railways, highways, ports and urban infrastructure projects are likely to be

prioritised. Along with coal and power, we estimate that the government could
spend an additional USD190bn in the next five years on these sectors.
Our input output analysis on value addition indicates that Indias potential
growth rate could rise by more than 1.4pp on this investment. This implies that
India could be enjoying close to double-digit real GDP growth by FY20, even if
only 75% of the planned infrastructure investments are realised.
For urbanisation, the governments smart cities initiative will complement the
planned creation of several greenfield cities across the country. Higher
investment in urban projects should also improve productivity in next five years.
The government is targeting 24x7 power availability across the country by

2019. We believe that the first obstacle of fuel availability has been resolved, and
the nations power deficit is shrinking, a trend that looks set to continue, based
on planned capacity additions.
The highways construction programme could see additional spending of INR2trn

in the next five years, which should strengthen connectivity and fundamentally
lower underlying inflation pressures. Railways and ports may see potential
additional investments of INR5trn and INR1trn respectively in capacity building,
which should further improve economic connectivity and reduce the cost of
doing business in India.
We believe execution risks will persist in India, given lack of clarity on land
acquisition rules, issues of NPAs in the banking sector, and generally poor
demand conditions, both domestically and globally. Headwinds for growth may
also increase if the logistical improvements are not coordinated, which may
render some investments to be unproductive.
PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 23
Rahul Bajoria
+65 6308 3511
rahul.bajoria@barclays.com
Barclays Bank, Singapore
Siddhartha Sanyal
+91 22 6719 6177
siddhartha.sanyal@barclays.com
Barclays Bank, India
www.barclays.com
Barclays | Asia Themes: India
INFRASTRUCTURE AND GROWTH

Infrastructure spending ramp up likely
Narendra Modis government
is prioritising urbanisation to
drive growth
After slightly more than a year in office, the Narendra Modi-led administration is laying out
its key policy areas. At the heart of the governments growth model is a push for greater
urbanisation in India. Calling urbanisation an opportunity rather than a threat, the
government has outlined a structured approach to increase the share of the urban
population through greater connectivity, universal access to basic facilities, and boosting
manufacturing and services activity. The government, enjoying a fiscal windfall in the wake
of lower oil prices, is prioritising infrastructure investment and has outlined five key areas.
Urbanisation With the smart cities initiative in place, along with marquee projects like
the Delhi-Mumbai Industrial corridor (DMIC), we estimate that the government will
spend an additional INR2trn on urban projects above previous trend levels.
Power and coal With coal production rising and the government aiming for universal
power access, we estimate that an additional INR2trn may be spent in these areas.
Highways The government has a 30km/day road construction goal, and is looking to
add 10,000km to the highway network, which could involve investment of INR2trn.
Railways A key focus area, we think the government could increase spending on the
rail network by INR5.0trn on capacity enhancement projects.
Ports and freight corridors Along with the highway and railway networks, projects to
enhance connectivity are being prioritised for ports and waterways. Port-related
investments could rise by INR1trn and improve the last mile of transport links, which is
expected to boost exports.
The government may spend an
additional INR12trn in next 5
years on infrastructure
In the next five years, we estimate that the government could spend more than INR12trn
(~USD190bn, or ~8.5% of GDP) in the above five areas above levels based on past trends. If
executed successfully, we think the government will be able to crowd-in private
investment, and create a long term boost to the economys growth potential. Without these
extra initiatives, we estimate that the government would only have channelled roughly 1%
of GDP per annum towards investments in these sectors. In this report, we examine the
governments infrastructure push and the possible impact on long-term growth.
FIGURE 1
Our estimates show that planned Infra spending may boost growth in the next five years
Projects (INR bn)
FY16
FY17
FY18
FY19
FY20
Electricity
16
23
31
171
Urban infrastructure projects
30
30
38
53
285
Railways
44
110
132
154
558
Highways
50
67
100
117
571
Ports
10
17
21
21
285
Logistics/efficiency gains
322
644
966
1289
Potential increase in value added
143
562
959
1343
3159
Value added (INR bn)
FY16
FY17
FY18
FY19
FY20
Potential scenario (100%)
143
562
959
1343
3159
Potential scenario (75% realisation)
110
507
885
1254
2762
Value added (% of nominal GDP)
FY16
FY17
FY18
FY19
FY20
0.10
0.35
0.53
0.67
1.40
Potential scenario (75% realisation)
0.08
0.32
0.49
0.62
1.22
Source: CEIC, Barclays Research
9 July 2015
Additional spending could raise GDP growth rate to 10%

We estimate that the combined effects of the rise in infrastructure investment could generate
~USD50bn in additional value-added (1.4% of nominal GDP) by FY20, under an optimistic
scenario that assumes full realisation of the spending. One of our scenarios is based on a more
realistic 75% completion rate of infrastructure spending by 2020. At this rate of realisation, we
estimate that ~USD44bn (1.2% of nominal GDP) in value-added could be created by FY20,
which could quicken the pace of real GDP growth by about 1.4pp and push real GDP growth
very close to 10% by FY20.
Critical infrastructure spending

could significantly boost
growth potential, raising it to
double digit levels
Even without a big infrastructure spending boost, we expect the economy to expand by a
respectable 8.1 % pa on average during the next five years. In our 75% potential scenario,
increased investment in the foundations of a stronger economy, ie, power availability, logistics
and connectivity, and urban infrastructure, would have the biggest impact, as this should also
facilitate higher private investment in other sectors of the economy, particularly FDI.
FIGURE 2
Investments in mining, power and transport projects to rise significantly
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
3.5
3.0
FY94
FY98
FY02
FY10
FY06
FY14
FY18E
GCF: Mining, power & transport (% of GDP)

Among several key projects, the governments focus is on implementing the industrial corridors
between Delhi-Mumbai and Amritsar-Kolkata, critical coal linkages in eastern India, expanding
solar and renewable energy, and an upgrading of urban infrastructure. All of these areas are ripe
to draw in private investment.
Delhi Mumbai Industrial

corridor a key project
FIGURE 3
Infrastructure spending could boost GDP growth by 1.4pp
FIGURE 4
Considerable scope for growth outperformance
Real GDP (%)
FY16
FY17
FY18
FY19
FY20
11
Status quo baseline
7.80
8.00
8.20
8.30
8.40
10
9
Potential growth
scenario
(75% realisation)
7.90
8.39
8.80
9.05
9.84
Difference from
baseline (pp)
0.10
0.439
0.60
0.75
1.44
8
7
6
Forecast
5
4
FY05
FY08
FY11
Status quo baseline

9 July 2015
FY14
FY17
FY20
URBANISATION AND SMART CITIES

Growing smartly Smart cities to lead the way
Urban India contributes
roughly 63% of total GDP
Urban areas have powered Indias growth over the past two decades and now generate
c63% of Indias GDP up from c45% in 1990. We believe Indias large population and low
GDP per capita indicate that urbanisation trends have significant scope to accelerate further.
To facilitate this, the quality of urbanisation needs to be paid attention considered as well.
One of the cornerstone projects initiated by Narendra Modi in his first year is the Make in
India program. Behind the ambition of becoming a manufacturing champion, lies a
structured approach to increasing urbanisation.
Cities in India are growing

rapidly, and could generate 7075% of GDP by 2020
Indian cities are growing rapidly, but they are also expanding in an unorganised manner.
Decades of internal migration have pressured the existing infrastructure systems. In the
absence of structured planning and poor execution of actual projects, the quality of living
has been declining in many of Indias cities. Under the moniker of smart cities, the
government wants to create new urban clusters, which are expected to be both a driver of
growth and reduce the burden on existing cities. Even if past trends are maintained, we
estimate that 35% of Indias population could live in cities by 2020 and contribute 70-75%
of its GDP.
Indias urbanisation has increased, but development has been uneven

India has been urbanising, but
in an uneven manner
Indias urbanisation rate, as per the 2011 census, stood at 31.6%, up from 27.8% in 2001,
with only seven provinces reporting a higher than national average in this period. While
Western and Southern India have been urbanising quickly, progress in Northern and Eastern
India has been slower. It is in these two regions that we think PM Modis smart cities
concept could have the greatest impact through reinvigorating urbanisation and
industrialisation trends in these states. In this context, we think the dedicated freight
corridor planned for Eastern India has potential to correct the countrys urbanisation
imbalance, though the greenfield urban clusters under construction or planned have a
strong Western India bias. Little progress is visible in terms of planning more urban clusters
in Eastern or Northern India.
FIGURE 5
Share of GDP produced from urban regions
FIGURE 6
Urban India powered the last decades growth acceleration*
%
90
85
% YoY
Urban
Rural
8.0
84
7.0
80
76
78
1.8
6.0
5.0
75
70
65
63
3.0
60
2.0
55
1.0
-
50
United
States
Western
Europe
Latin
America
China
India
Source: McKinsey Global Institute (2012), Ministry of Urban Development

(MoUD), Barclays Research
9 July 2015
2.6
4.0
65
2.0
1.8
5.7
1.6
1.4
2.3
2.7
3.4
1950-51 - 1970-71 - 1980-81 - 1990-91 - 2000-01 1970-71

1980-81
1990-91
2000-01
2009-10
Note: *Chart shows contribution to total GDP growth.
Source: RBI, MoUD, Barclays Research
Smart cities From policy to action

Smart cities initiative is largely
aimed at planned urbanisation
One of the key themes of Prime Minister Narendra Modis election campaign was the use of
urbanisation as a catalyst for growth. Apart from resolving infrastructure bottlenecks, the
government plans to set up 100 smart cities, which involves upgrading the infrastructure in
existing tier 1 and tier 2 cities, and setting up new urban clusters to manage the pace and
quality of urbanisation. For instance, among the facilities proposed for these cities are such
things are the availability of underground parking, adequate digital connectivity, smart
power grids, piped gas networks, adequate public transport and environmentally-friendly
surroundings to enhance quality of life.
Several greenfield cities are

under construction in India
According to a report by the McKinsey Global Institute in 2010 (Urbanisation in India), in the
next 20 years India could have 68 cities with a population of more than one million up
from 42 in 2010. Some interesting case studies for the smart cities under construction in
India are New Raipur (Chhattisgarh), Dholera Investment region (Gujarat) and Lavasa
(Maharashtra), which are cities being constructed from scratch with plans to integrate
technology in day-to-day management of their infrastructure.
Naya Raipur A smart city in the making since 2008

Naya Raipur (New Raipur) is an administrative capital being built in Central India, in the state of Chhattisgarh. Construction
began in 2008. Administrative capitals are not a new thing in India, and many states have constructed such cities previously
(ie, Bhubaneswar, Gandhinagar, and Chandigarh). Built over 80sqkm, the city has already seen INR40bn of investment, and
it is expected to have more than half a million resident by 2030. The city is also expected to house the prestigious Indian
Institute of Management (IIM) and Indian institute of Technology (IIT), which should help to boost its appeal. The city also
possesses one of the best rated cricket stadiums in India.
DMIC itself will have 7 urban

clusters, which will be built
from scratch
The proposed Delhi-Mumbai industrial corridor, which could be Indias largest infrastructure
project, includes plans for seven new city townships across the states it passes through to
promote urbanisation of these areas. Similar projects in Andhra Pradesh (Amravati), Gujarat
(Dholera), Rajasthan (Neemrana) and in the North East are expected to get underway in the
next few years.
FIGURE 9
Several Greenfield cities/urban clusters already under-way
City
State
Partner Country
FIGURE 10
Brownfield city up gradation, a major part of the smart cities
initiative
City
Ajmer
Dholera
Gujarat
Japan
Kochi smart city
Kerala
Allahabad
Lavasa
Maharashtra
Shimla
Naya Raipur
Chhattisgarh
Varanasi
Andhra Pradesh
Singapore
Maharashtra
Japan
Gujarat
Nagpur
Maharashtra
Delhi
Shendra Bidkin
GIFT city
Dighi
Source: Various media sources, MoUD, Barclays Research
9 July 2015
Partner Country
Brownfield projects
Greenfield projects
Amravati
State
Vizag
Pondicherry
Rajasthan
US
Uttar Pradesh
US
Himachal Pradesh
France
Uttar Pradesh
Japan
Andhra Pradesh
US
Tamil Nadu
France
Maharashtra
France
Delhi NCR
Spain
Source: Various media sources, MoUD, Barclays Research
Electricity sector powering up

Power infrastructure being
planned alongside
urbanisation
To make the planned smart cities and industrial/manufacturing clusters viable, the
government has set an ambitious target of providing 24x7 electricity access to every
household by 2019. In order to achieve this target, the government needs to take significant
steps not just in generation, but also in the transmission and distribution of power.
FIGURE 11
High growth needs considerable addition in power capacity
Power capacity (%, CAGR)
25
CG
20
15
RJ
OD
10
WB
AP
0
6.0
HR
KR
UP
PN
MP
GJ
MH
TN
JH
7.0
8.0
9.0
10.0
GSDP (% growth between FY06-FY15)

Government is targeting 24x7

power access by 2019
Access to reliable electricity supply remains a major issue for India, with only 75% of the
population having access to power. An increase in generating capacity and improvement in
fuel availability goes a long way in solving the problems of power availability. But
transmission and distribution still remain a challenge. Indias power consumption still
remains low, as Indias per capita GDP is still very low. While there has been considerable
capacity augmentation in the last 10 years, the sector has been plagued by issues of
distribution, and fuel shortages, which are being unclogged gradually.
Power capacity addition is

impressive, but utilisation is
not
India has been adding ~20GW per year of electricity capacity for last 3-4 years, and this
trend may slow down in coming years, especially in conventional generation capacity like
coal and gas. Indias per capita power consumption has risen considerably in last two
decades, but still remains considerably below its peers, both in the region and globally.
FIGURE 12
Net capacity addition has been rising significantly
25
FIGURE 13
Bulk of power generation capacity is coal based
(12m rolling
sum, GW)
Others
14%
FY 15
20
15
Hydro
16%
10
5
0
May-05
May-07
Thermal
Others
May-09
9 July 2015
Thermal
70%
May-11
May-13
May-15
Hydro
Power additional capacity
Coal linkages Coal India sets a one billion target

An early success of the
government has been in
improving fuel availability for
the power sector, particularly
coal
A key focus area for the government for 24x7 power access is an increase in coal
production. With the government setting an aggressive target of 1 billion tonnes of coal
production for Coal India, the state monopoly, efforts to modernise existing coal mines and
improve connectivity through rail and road routes have been intensified. Together with
projects in the power sector, we estimate that the government will invest an additional
INR2.0trn in the next five years on capacity enhancement. Construction has already begun
on the three proposed rail links in central India (Tori-Shivpur-Kathutia, Jharghuda-Barpali
and Mand-Raigarh), which, when completed, could raise coal mining output considerably
(see Figure 15). If the higher output is achieved, this would significantly reduce the risk of
fuel shortages for the power sector, as well as potentially improve both domestic growth
and reduce the import bill, which has been increasing in the past few years.
FIGURE 14
Three new railway links could help coal output rise by 270mt, or more than 50% of current production
Rail line
Tori- Shivpur Kathuthia
(MandRaigargh)
Potential
coal
movement
(mt)
Remarks / Our expectations
70-80
Nearly 35% land acquisition is complete, and construction work has

started in some parts. Our equity research expects a single line to be
ready by FY17, although the full line may not be completed even by
FY20.
Expected completion
date by government
Distance
covered
(km)
June 2016 for single line & Dec

2017 for double line
Phase 1:
44kms
Phase II:
49kms
First phase of the project will be

commissioned by Sept' 17
Phase I:
74kms
Phase II:
62kms
100
Jun-16
53kms
90-100
JharsgudaBarpalli
The land acquisition process is ongoing, and execution SPVs have

been formed. Our equity research thinks the projects are still in
initial planning phase, and may not add significantly to coal traffic
by FY20
Land acquisition is ongoing slowly, but execution is picking up, and
this line may be completed by end of FY17
Source: Coal India, Barclays Equity Research
Critical rail linkages could

boost coal output significantly
At the same time, captive coal mining (i.e. coal mines used by private power producers) is
expected to play a much bigger role, as the success of the recent coal auctions have
removed a bottleneck, and helped to ease raw material supply pressures. The availability of
fuel has also improved, and similar initiatives are being launched to restart gas-based power
plants, with the government taking a lead role in ensuring gas supply is available.
FIGURE 15
Coal India aggressive production targets
FIGURE 16
Coal production is picking up pace
1,000
908
900
774
800
600
500
462
494
548
522
598
563
20
15
10
5
678
661
700
757
25
612
-5
-10
-15
400
-20
FY14
FY15
Production (mt)
FY16
(CE)
FY17
(CE)
FY18
(CE)
FY19
(CE)
Barclays equity research estimates
CE is Company estimates; Source: Coal India, Barclays Equity Research
9 July 2015
FY20
(CE)
-25
May-08
Feb-10
Nov-11
IP: Coal (% y/y)
Aug-13
May-15
IP: Coal (% y/y, 3mma)
Source: Haver Analytics, Barclays Research
Urban planning and suburban rail networks

Urban renewal projects were
funded aggressively by the
government in this years
budget
Along with the planned increases in the capacity of the road and rail networks, urban
decongestion is a major priority area. In the past two decades, a policy focus has been on
building Intra-city railway networks. Since 2000, MRT networks have been constructed in
New Delhi and the greater NCR region, as well as in Mumbai, Bangalore, Gurgaon, Jaipur
and, recently, in Chennai. Similar projects are underway in six other cities, while the systems
already operating are being expanded. The upgrading of existing infrastructure is a major
part of the smart city initiative, with MRT construction planned for a further 9-13 cities.
7 Indian cities have MRT

networks, another 6 cities have
MRTs under construction
The total length of the existing MRT networks in operation across India amounts to 236km,
with 550km of new lines under construction, and a further 600km under consideration.
While the total investment envisaged under the MRT construction programme is around
INR5trn in the next five years, we do not expect all of these plans to materialise, given that
execution risks are high. In short, we expect delays to persist in this infrastructure sector.
In next five years, another 10

cities may start MRT projects
Nonetheless, we do expect a ramp up in spending programs on urban renewal, as the

governments focus increasingly shifts from tier-1 to tier 2 cities. Budgetary support for the
development of metro rail lines was increased to USD1.38bn from cUSD1bn in FY15 (a 37%
rise). We expect the government to increase spending on urban projects by INR2.0trn in the
next five years. Many of the planned metro lines, including in Vijaywada, Nagpur, Vizag and
Pune, have already been earmarked for budgetary funding for the first time. Others such as
Ahmedabad and Lucknow have also received budgetary support. We believe more cities will
be added to the MRT project list in the upcoming budgets.
Urban clusters need better

connectivity, concessional and
FDI funding is likely to be
encouraged
The government has indicated that it will look to create larger urban clusters in tier-2 and
tier-3 cities, given that existing metropolitan cities continue to struggle with inadequate
infrastructure. Such new cities could relieve the pressure on the larger cities, and create
alternative centres of growth. Apart from MRT networks, critical projects for urban renewal
are being prioritised, particularly for Mumbai. In particular, the Trans harbour link project (a
22.5km six lane bridge) has been approved, with 80% of funding likely to come from Japan
International Cooperation Agency (JICA). The government in Maharashtra is also working
on a coastal freeway project, which should help to ease traffic congestion in the Mumbai
and bring about productivity gains.
FIGURE 17
MRT/Subway networks are operational in seven cities, with Delhi having the largest network
Project
State
Comment
Bangalore
Karnataka
First stretch opened on 20 October 2011, and since then more sections have been added to the
network. Phase 1 construction is well underway, and the tendering process for phase 2 is
expected to pick up once phase 1 is complete.
Kolkata
West Bengal
The first metro network in India, it is now being expanded, although construction is slow given
land acquisition issues. The line will have an underground section below the River Hooghly.
New Delhi
New Delhi
Delhi Metro is the flagship metro system in India and is the 13th largest MRT network in the
world. It also connects with the neighbouring cities of Gurgaon, Ghaziabad and Noida, is being
expanded with the construction of more lines and extensions of current lines.
Jaipur
Rajasthan
The Jaipur metro is being implemented in two phases comprising of 12km and 23km stretches.
The first phase started operation recently, while the second phase is yet to be bid out. The
second phase is envisaged to be contracted on a PPP basis (phase 1 was on an EPC basis).
Gurgaon
Haryana
The first privately owned metro rail in India is operational, and phase 2 is under construction
Mumbai
Maharashtra
One lineis operational, three other lines are yet to be ordered. The expected cost of the three
other lines is in excess of INR700bn. Mumbai Monorail is already operational in parts.
Chennai
Tamil Nadu
Phase 1 contracts have been awarded and a 10 km stretch was recently opened. Phase 2
expansion contracts may take more time as the required detailed report is not yet ready, as the
city may also initiate a monorail project.
Source: Various news sources, DMRC, Ministry of Railways, Ministry of Urban Development, Barclays Research
9 July 2015
10
RAILWAYS, HIGHWAYS AND PORT CONNECTIVITY

Railways a path less taken
Railway infrastructure is
expansive in India, but it is also
overused
Indias railways have experienced systematic underinvestment and overuse for the past
three decades. Railway revenues as a percentage of GDP have declined on a trend basis to
just above 1% in FY14. Even in terms of adding capacity, Indias track record has been
disappointing. And since independence, most railway investment has focused on changing
the type of lines (from medium gauge to broad gauge to accommodate larger bigger
trains), without paying much attention to expanding the network. In fact, India had a
significant head start over China in terms of legacy railway assets, but over last three
decades China has made up that deficit and overtook Indias total railway network in 2006.
Share of railways in the

economy has fallen
considerably over time
In a White Paper published in 2015, the railway ministry noted that railways have faced
chronic underinvestment, and its share of transport investment under the five year plans
has fallen from 56% (1985-90) to 30% in (2007-2012). This is due in part to the
governments to focus on improving the highways and road infrastructure, but it is also due
to lack of revenue generation within Indian Railways, which has long subsidised passenger
traffic through funds raised by hauling freight.
Government raised allocation

for railways investments by the
biggest amount in this budget
Given the persistent underinvestment, Indias railroads face considerable congestion, which
has degraded the systems ability to speed up existing freight and passenger movement,
and also increase the number of trains in service. Existing investment projects will take 7-10
years to complete and will cost up to USD63bn, without additional funding from the
government. Historically it has proved difficult to accelerate investments, given Indian
Railways stressed finances, which are mainly the result of the large losses INR250bn per
year (~USD4bn) on its passenger service, given that tariffs remain historically low.
Private investment is not likely

to play a big part in railways,
barring port connectivity links
Private investment in railways is a relatively new concept in India. In recent years, the
government has provided the scope for private investors to manage and build tracks,
particularly for port connectivity. Of this, roughly 1,000 km of track has been commissioned,
while another 1,500 km is under construction or has been sanctioned for construction. The
liberalisation of railways for foreign investment was initiated in 2014, but so far, there has
been little in terms of realised investment.
FIGURE 20
Railways has shrunk in proportion to the economy
FIGURE 21
China overtook Indias railway infrastructure in 2006
68
2.40
66
2.20
64
2.00
62
1.80
60
1.60
58
56
1.40
54
1.20
1.00
FY84
52
FY89
FY94
FY99
FY04
FY09
Railway revenues (% of GDP)

9 July 2015
rail track
kms ('000)
FY14
50
1982
1987
1992
1997
China
2002
2007
2012
India
Source: World Bank, Barclays Research
13
Railways now focusing on completing legacy projects

Focus is on expediting
completion of legacy projects,
and increasing track capacity
Railways are a major investment focus for the Modi government. In its first full budget, the
government allocated a significantly higher sum of money to the railways. But it did not
announce a single new project, focusing instead on expediting the completion of 357 legacy
projects worth over INR1.8trn (USD28bn). This focus is critical, in our opinion, as the trend
of announcing key projects and then not allocating the necessary resources to complete
them has been an issue. As the government described it, spreading the resources too
thinly has created considerable bottlenecks; therefore, shifting the focus to enhancing
capacity through project completions is a welcome step, in our view.
Financing of railway
investments will be a mix of
internal revenues, budgetary
support and debt securities
In terms of financing, the government has increased budgetary support and also raised
tariffs for goods and passengers in order to raise funds. In addition, promised investments
from Life Insurance Co of India of INR1.5trn, captive funding from coal miners for freight
linkages and private investment (both domestic and foreign) should ensure a significant
increase in investments, potentially to INR8.5trn (USD130bn) over next five years.
Railways internal revenue

generation likely to improve
with falling fuel costs
Prospectively, if the operating ratio of railways improves further (projected at 88.5% in

FY15-16), and foreign investments are seen in high-speed rail corridors, internal financing
constraints are likely to ease considerably. We expect the government to spend roughly
INR5trn (USD79bn) over and above the historical trends, which would be roughly three
times the investment seen in the previous five years. This implies that as the railway
network expands and operates with more efficiency, its impact on GDP growth, and
consequently GDP size, will be significant.
According to analysis by the governments Chief Economic Adviser, Arvind Subramanian,
every unit of investment in railroads boosts output in other sectors by as much as 7.4x. We
believe the funding available for railways has improved drastically, and with focus on
cutting costs and involving the private sector, the governments efforts to revive investment
is likely to pay-off, especially with improving fiscal dynamics.
FIGURE 22
Progress in railway expansion since independence has been
slow and modest
70,000
FIGURE 23
Lack of internal revenue generation hurts railways ability to
invest in asset creation
kms
60,000
100
50,000
96
95
40,000
Impact of 6th
pay commission
92 92 91
90
30,000
85
20,000
80
10,000
75
95 95 95
91
90
94
91
89
83
79
76
Source: Ministry of Railways, Barclays Research
2013-14
FY16F
FY15
FY14
FY13
FY12
FY11
FY10
FY09
60
FY08
-multiple
tracks
FY07
gauge
FY06
gauge
FY05
65
gauge
FY04
double
FY03
Narrow
FY01
Medium
FY02
70
Broad
1950-51
9 July 2015
98
Operating ratio (%)

Source: Ministry of Railways, Barclays Research
14
DMIC and freight corridors

Delhi-Mumbai Industrial Corridor (DMIC) is perhaps Indias largest infrastructure project and aims to rejuvenate Indias
manufacturing sector. The DMIC envisages the creation of a dedicated freight corridor that would triple industrial output
and quadruple exports in the region in a decade.
FIGURE 24
Freight corridors
Source: DFCCIL, Barclays Equity Research
As part of the DMIC, India is also building Dedicated Freight Corridors (DFCs), specific rail links to connect various points from
Delhi to Mumbais Jawaharlal Nehru Port Trust (JNPT), to spur activity and improve logistics. The construction of the freight
corridor is estimated to cost over INR45bn and work is progressing at a satisfactory pace. Along with the western corridor,
India is also investing in an Eastern corridor, which will run from Ludhiana (Punjab) to Dankuni (West Bengal), tracking the
eastern industrial corridor. Once completed by the end of FY18-FY19, the Western DFC will add capacity to increase freight
movement from 50mn mt to 161mn mt by FY22, and 284mn mt by FY37 according the Dedicated Freight Corridor Corp of
India. The Eastern DFC is expected to increase traffic from 55mn mt to 153mn mt by FY22, and 251mn mt by FY37.
FIGURE 25
Traffic estimates for western and eastern dedicated freight corridors
284
300
251
241
250
203
200
161
214
182
153
150
100
50
50
55
0
Existing
FY22
FY27
Western DFC (mmt)
FY32
FY37
Eastern DFC (mmt)
Source: DFCCIL, Barclays Equity Research
9 July 2015
15
Highways Reviving the NDA1 legacy

Along with railways, outlays for
road construction have been
increased significantly
The Modi government is prioritising connectivity in railways and highways to boost

economic activity. Highway construction, which had gathered significant pace under NDA
and UPA1 governments, slowed sharply in recent years. However, with renewed focus and
by changing the projects from an ownership (BOT) model to a construction project (EPC)
model, the governments tendering process and the pace of construction is improving. This
is further aided by a considerable improvement in the fiscal position, which allows the
government to transfer some of its higher revenues to the highway construction project.
For faster execution, the

government has abandoned
the PPP model for EPC based
construction contracts
The government is focusing on three key areas in the highway sector. First, a significant
amount of energy is being devoted to removing the bottlenecks on existing projects.
According to the ministry of highways, almost one-third of the projects sanctioned during
2011-14 are either behind the schedule or have run into disputes. This means speeding up
current projects is a major priority for the government.
Major focus is on widening of

roads and existing highway
networks
Second, the government is focusing on expanding the current network of roads by

increasing the number of lanes, from two to up to eight, to increase capacity on existing
routes and key national highways. Third, the government is focusing on improving
connectivity by taking up critical linkage projects in northeastern and eastern India, and
along the countrys borders. The government has set a target of awarding contracts for
10,000 km of roads to be tendered in FY16, up 25% from the previous fiscal year, and the
target is likely to increase in the coming years.
New capacity is being added in

Eastern and North Eastern
India
An additional INR2trn of
spending is likely on highways
Overall, the government intends to spend roughly INR5trn in the next five years on road and
highway construction, with a target increase the pace of road construction to 30 km/day,
by March 2016. It intends to sustain it until the end of 2019, and we believe the government
will spend roughly INR2trn over and above previous estimates. In order to cut costs, the
government is also switching to construction of roads made from concrete, rather than
bitumen. This will improve the lifecycle of new roads, and for this, the government has
launched a centralised cement purchase program (www.inampro.nic.in), through which
construction projects can buy cement at 20-30% below market prices. This should help to
reduce both costs and graft, by making procurement of raw materials more centralised and
transparent.
FIGURE 29
Recent dip in state highways is due to their reclassification
as national highways
FIGURE 30
Significant number of expansion projects will increase the
number of multiple-lane highways in coming years
180,000
45,000
160,000
40,000
140,000
35,000
120,000
30,000
100,000
25,000
80,000
20,000
60,000
15,000
40,000
19330
19128
10,000
20,000
0
1951
5,000
1961
1971
1981
National highways (kms)

Source: MoRTH, Barclays Research
9 July 2015
40658
1991
2001
2011
2014
State highways (kms)
0
Single lane
Double lane
Four to eight lanes
National highway breakdown (kms)

Data as per 2012-13 Source: MoRTH, Barclays Research
17
Ports and waterways Providing last mile connectivity

India is planning on upgrading
12 major sea ports, along with
internal waterways
A key priority area for the government is to upgrade Indias port infrastructure, to provide
last mile connectivity, particularly for exporters. Under its Sagar Mala (Oceans garland)
project, the government plans to modernise, expand or construct 200 commercial ports,
including 12 major sea ports, as well as upgrade 101 inland waterways in order to promote
cheaper and alternative transportation for both goods and passengers. This blue revolution
project is largely focused on eastern India around the River Ganga belt, which accounts for
40% of Indias economic activity.
Work on expansion has

already begun in JNPT, Indias
largest port
Work has begun on modernising of key ports, including Mumbais JNPT, and more projects
are likely to be taken up in coming months. In addition, large satellite ports are likely to be
constructed around existing ports the JNPT, and the ports in Mundra port and Kochin to
ad capacity and ease constraints in these ports. This will be supplemented by investment in
private ports, such as the recent announcement of Vizhinjam port in Kerala, an estimated
investment of INR40bn. As part of the overall initiative, the ports ministry plans to create 12
new greenfield cities around these major ports, designating them as special coastal
economic zones that will have last-mile connectivity with roadways and railways.
Major ports are likely to be

connected to the freight
corridors, thus boosting
logistics considerably
These projects are will be connected to economic corridors, such as the DMIC, and should
help with the last-stage shipment of goods, largely expected to be for export purposes. The
total cost of the upgrade has not been disclosed, but road and rail construction projects,
along with expansion of JNPT, already amounts to a total investment of more than USD1bn,
with the final cost likely to be several times that figure. Once finished, the sector is likely to
see investments of INR1trn more than previously planned. Project funding is likely to be
done through a development cess on cargo handled, and also through concessionaire
funding from international and national agencies.
FIGURE 32
Indias port upgrades are integrated with its dedicated freight corridors
DMIC 's freight corridor connects

key ports with manufacturing
clusters
India's eastern states have low

urbanisation. EDFC will help
increase urbanisation
Ludhiana
Delhi
Kandla
Haldia
Mumbai
Paradip
JNPT
Vizag
Marmagao
Major government ports Ennore
Mangalore
Chennai
Cochin
Freight and industrial corridor

Industrial corridor
Tuticorin
Source: DFCCIL, Ministry of Shipping, Barclays Research
9 July 2015
19
Top of Mind
Issue 36
China leverage: how big a risk?

El
Kenneth Ho and Kinger Lau address equity

margin financing and other credit-related
threats to Chinas growth and financial stability
The explosion in margin financing behind the recent astonishing
run-up in Chinese A shares is a new twist on China credit
concerns, a long-standing grey swan for Chinese and global
growth. As of the beginning of June, the balance of margin
financing outstanding was RMB2.2tn, an estimated 12% of the
free float market cap of marginable stocks and 3.5% of GDP
easily the highest in the history of global equity markets. And
these estimates do not take into account hidden leverage
from other types of borrowing (i.e., consumer loans and trust
products) where proceeds were used to invest in stocks, which
we estimate at RMB 1tn to RMB 1.5tn, assuming effective
system-wide leverage of 2.2x.
We estimate that a significant portion of the hidden leverage
has now been unwound and the reported official margin
balance has dropped to RMB1.5tn. This unwinding has
contributed to a dramatic correction in Chinese equity markets,
erasing a sizable portionthough not allof the stock gains
this year. While a range of market-supporting policies (banning
of selling from large stakeholders for a period of six months,
suspending IPOs, relaxing the forced selling requirement of
underwater margin positions, among others) finally halted the
sell-off on July 9, questions remain about whether the equity
market turmoil could threaten other Chinese assets, economic
growth and broader financial market stability.
Some damage, but likely contained
We think an aggressive policy response will need to be
maintained for the government to keep stability in the A-shares
market, which has been dominated by retail investors who tend
to be less influenced by fundamentals. Without such a
response, a further correction in A-shares is likely, and we
could see continued moderate spillovers to other assets. For
example, some corporate credit spreads have already begun to
widen. Recent commodity price sell-offs may also be related to
China equity developments, although there are clearly other
fundamental drivers also behind the commodity weakness.
systemic risk in the financial sector is likely to remain wellcontained. The PBOC has contributed to a RMB260bn injection
into the brokerage houses to support their liquidity, which
should, in turn, help support the market. The PBOC has many
tools and resources to prevent these developments from
turning into a broader financial crisis, in our view.
Silver lining
Looking beyond recent events in the equity market, there are
perhaps some reasons to be less concerned about China credit
than in the past. Of course, China still has an enormous amount
of debt; its debt buildup since the global financial crisis ranks in
the 97th percentile of debt-to-GDP changes over the past 50
years (see our January 26, 2015, China credit conundrum
publication). But limited external indebtedness, a strong current
account position and USD4tn of foreign exchange reserves all
suggest that policymakers have a number of tools to tackle
credit problems. And, in fact, the credit rebalancing process has
begun, with a notable slowdown in total social financing (TSF)
growth since 2013, as policymakers reined in the riskier
segments of the shadow banking sector.
Further, the property price slump and an abrupt removal of
moral hazard riskstwo key credit-related risks in recent
yearshave been receding. The average change in primary
market residential prices rebounded month on month in May
2015, the first sequential uptick since April 2014. Although
housing prices are still down 5.6% year on year, the sequential
improvement and easier credit conditions should help remove
tail risk concerns. And despite the first default by a State
Owned Enterprise (SOE) in the domestic corporate bond
market this year, we expect only a gradual increase in credit
stresses. The governments push to develop the municipal
bond market should help ease the refinancing of debts by local
government-related entities, once again reducing tail risk.
Credit rebalancing has begun

China nominal GDP and total social financing (a broad measure of
credit in the economy), % yoy
Nominal GDP growth

Total Social Financing growth
40
30
20
A first for global equities

Margin trading balance as a share of free-floating market cap, %
10%
8%
10
China
Taiwan
NYSE
Korea
0
03
04
05
06
07
08
09
10
11
12
13
14
15
Source: PBOC, China National Bureau of Statistics.
6%
4%
2%
0%
02 03 04 05 06 07 08 09 10 11 12 13 14 15
Source: Wind, Bloomberg, Goldman Sachs Global Investment Research.
However, economic spilloversat least at this stageare likely

to remain muted. Estimates of Chinese wealth related to the
equity markets are relatively smallaround 6% if we look at
equities as a share of the household balance sheetand equity
markets are generally still well above 2014 levels. Moreover,
Goldman Sachs Global Investment Research
The extreme equity market volatility remains a risk to watch,

but a combination of a strong external position and proactive
government policies suggest that systemic credit risks can be
contained. However, the bumpy downshift in growth will likely
continue. And as policymakers work through Chinas
imbalances, macro and market volatility will likely remain high.
Kenneth Ho, Asia Credit Strategist

Kinger Lau, Chief China Equity Strategist
Email:
Tel:
Email:
Tel:
kenneth.ho@gs.com
+852-2978-7468
kinger.lau@gs.com
+852-2978-1224
Goldman Sachs (Asia) L.L.C.

Goldman Sachs (Asia) L.L.C.
China's Stock Market Pain Is Indias Financial Gain

by Santanu Chakraborty, July 24, 2015
The tumult in Chinas stock markets has turned into a blessing for Indian shareholders. International
investors are pulling out of China, fueling record outflows through the Shanghai-Hong Kong exchange
link, amid a $2.8 trillion plunge in mainland equity values since June 12. Theyve plowed $705 million into
India over the same period, sparking a world-beating 7 percent gain in the benchmark S&P BSE Sensex
index.
Chinas interventionist response to the rout -- including unprecedented trading restrictions -- has
prompted foreigners to shift their equity exposure to India, according to hedge fund Alexander Alternative
Capital LLC. The $2 trillion economy, which got a fresh boost from tumbling crude prices this month, is
less exposed than its emerging-market peers to slowing growth in China, Aquarius Investment Advisors
Pte. says.
The recent travails in China make India seem like an oasis of calm in terms of volatility, Jonathan
Schiessl, the head of equities at the U.K.-based Ashburton Investments, which oversees $12 billion, said
in an e-mail. The fund has cut its exposure to China by 1 percent in the past month to invest in Indian
equities and raise its cash position, he said.
Gains in Indian shares over the past six weeks mark a turnaround from the preceding four months, when
Chinas bull market and doubts over Prime Minister Narendra Modis economic policies kept foreigners
away. The Sensex tumbled 11 percent from this years peak on Jan. 29 through June 12, making it the
worlds worst performer after Egypt.
IMF Forecast
Those concerns have been allayed by the biggest jump in indirect tax receipts in May since 2011, which
gives Modi ammunition to boost expenditure. A 12 percent decline in Brent crude prices this month has
also pared government subsidy bills in a country that imports about three-quarters of its oil.
Indias economy expanded 7.5 percent in the March quarter, beating Chinas 7 percent growth, while the
International Monetary Fund predicts India will outpace its neighbor in the current fiscal year.
The longer-term growth outlook is also stronger in India because of its superior demographics, according
to Franklin Templeton Templeton Investments. More than 62 percent of the nations 1.2 billion people are
between age 15 and 59, government data show. Chinas pool of workers in this age group is expected to
shrink by 61 million by 2030, according to United Nations. Thats about the equivalent of losing the
combined working populations of the U.K. and France.
India is in a phase in which multiple engines of growth can drive GDP from 7-8 percent to 9-10 percent in
the next five years, said Sukumar Rajah, who manages about $9 billion as chief investment officer of
Asian Equity at Franklin Templeton in Singapore. For China, we expect growth to decelerate over the
next few years partly because it doesnt benefit from demographic trends the way that India does.
State Intervention
Templeton is overweight India and underweight Chinese shares in Hong Kong relative to benchmark
indexes, Rajah said. Hes bullish on Indian industrial companies such Larsen & Toubro Ltd. amid signs of
increased spending on infrastructure. The Hang Seng China Enterprises Index declined 0.8 percent at
1:19 p.m. in Hong Kong on Friday after a private gauge of Chinese manufacturing unexpectedly fell to the
lowest level in 15 months. Indias Sensex lost 0.3 percent in Mumbai trading, poised for a weekly decline.
For overseas money managers, Chinas meddling has raised concern about the governments promise to
enact the free-market reforms needed to make mainland shares eligible for MSCI Inc.s benchmark
indexes. Measures to end the rout include a ban on selling by major shareholders, halting initial public
offerings and allowing more than 1,400 companies to suspend trading.
The intervention puts a wet blanket on Chinas indices being included in the MSCI gauges, said Michael
Corcelli, chief investment officer of Alexander Alternative in Miami. The steps are bad for China and
definitely good for India, he said.
Deficient Rainfall
Indias stocks rally may unravel if the strengthening El Nino weather pattern weakens monsoon rains,
said Anil Ahuja, the Singapore-based chief executive officer of hedge fund IPEplus Advisors. The JuneSeptember rainfall, which was 16 percent above a 50-year average at the end of last month, is now 7
percent below normal, according to the weather office. The monsoon waters more than half of Indias
farmland and a shortfall can stoke food prices.
The Sensex gauge trades at 15.9 times 12-month projected profits, compared with a five-year mean of
14.4, data compiled by Bloomberg show. The Hang Seng China Enterprises is valued at 8 times.
A weak monsoon has not been priced in, Ahuja said. Valuation multiples are high versus long-term
averages. If earnings dont begin to justify valuations soon, investors will start to move away. Indian
earnings are projected to grow about seven times faster than China over the next 12 months. Profits at
Sensex companies will climb 30 percent, versus 4.3 percent for the Hang Seng China Enterprises Index,
analyst estimates compiled by Bloomberg show.
Indias recent outperformance could be because it has a steady macro-economic picture and is relatively
insulated from any slowdown in China compared with other emerging markets such as South Korea and
Brazil, said A.S. Thiyaga Rajan, a Singapore-based senior managing director at Aquarius. India could
see greater interest, now that it is projected to be the fastest-growing major economy.
The story behind sudden boom in distressed assets

business
Anand Adhikari and Mahesh Nayak
July 16, 2015
On the 10th of every month, State Bank of India's headquarters at Nariman Point in South Mumbai plays host to
some eager guests. Heads of several of India's 15 asset reconstruction companies (ARCs) make a beeline to
review the 'for sale' bad loans that India's largest bank would be willing to hawk for a price. A similar exercise
takes place at some of India's largest banks, though not necessarily with such regularity.
Till fairly recently, such meetings
were infrequent and resulted in
one-off transactions. But, of late,
the intensity of deals emerging out
of such exchanges is soaring. And
that, in turn, is giving rise to an
unprecedented boom in India's
distressed assets business. In the
first decade of the existence of
ARCs, banks sold all of Rs 87, 049
crore of bad loans for Rs 19,308
crore. But in the past two years
alone, ARCs have bought bad
assets worth Rs 1,02,068 crore for
Rs 43,243 crore. Last year, SBI
alone had shed assets worth Rs
12,500 crore, Bank of India Rs
2,844 crore and Central Bank of
India Rs 1,119 crore. These
include SBI's Rs 1,600 crore loan
in Bharati Shipyard to Edelweiss
ARC, Rs 900 crore Hotel
Leelaventure loan to JM Financial
ARC and Rs 1,500 crore loan in
Corporate Power to ARCIL.
Several factors are driving this flourishing trade in bad assets. But the biggest trigger
came in November 2013 when Reserve Bank of India Governor Raghuram Rajan, in
a strongly worded exhortation, asked the banking system to clean up its act. "You
can put lipstick on a pig but it doesn't become a princess. So dressing up a loan and
showing it as restructured and not provisioning for it when it stops paying, is an
issue," he had said. Until then, scared to bell the cat, banks had been ever-greening
their bad loans - and slipping deeper into the abyss. What alarmed Rajan was that the
gross and net non-performing assets (NPAs) in the banking system had hit an
alarming 4 .2 per cent and 2.2 per cent, respectively, by September 2013 when Rajan
came in, against an average of 2.6 per cent and 1.2 per cent, respectively, between
2009 and 2013.
Under Rajan's stewardship, the RBI has announced a host of measures that have
fuelled distressed asset sale business. Early last year, the central bank allowed the
banks to sell even the loans where the principal or interest was overdue by 60 days
rather than 90 days, earlier. In essence, it allowed banks to start selling assets early if
they felt the loan was non-redeemable. Other factors are also responsible. ARCs are
betting heavily on the proposed new bankruptcy law which will give them a greater
leeway (including sale of whole or part of the company and change of management
or promoter) to revive the distressed assets. Four, in general, the industry believes
that the Indian economy has seen through the worst of the slowdown and things can
only look up from here. And, those who have the cash are happy to buy distressed
assets since they come at a significant discount to an identical greenfield project.
For over 10 years, it was only ARCIL, backed by SBI and ICICI, which was active
in buying loans from its sponsor banks. But a majority of new ARCs have been set
up after 2008/09. Among the newest, Edelweiss ARC which was set up in 2009, has
worked up a portfolio of over Rs 20,000 crore. At the second spot is ARCIL with a
portfolio of Rs 11,000 crore. The top five ARCs make for nearly 90 per cent of the
accounts under management. Essentially, that means the ARC takes over the asset, or
company, and tries to revive it by managing it better, instead of trying to recover
money by selling off parts of it. Not everybody is chasing assets under management
(AUMs) though. "We look at it as an investment business. We are not in the AUM
game," grins Eshwar Karra, CEO of Phoenix ARC, Kotak Group, formed in 2004.
Karra deals with only sub-Rs100-crore loans, with a focus on turning around the
companies and sold quickly instead of volumes
The big reason why ARCs remain enthusiastic is because sale of bad loans will only
intensify. Banks, after all, are sitting on a pile of bad debts. Of the Rs 70 lakh crore
that the banking system has given in advances, nearly Rs 7.7 lakh crore is believed to
be classified as 'stressed assets' that have defaulted on their payments. Of this, Rs3.1
lakh crore is already defined as gross NPAs on which there has been a default. A lot
of that is likely to be made available to ARCs for sale. So, while the banks are being
pushed by the regulator to clean up their books, ARCs see an opportunity of making
big bucks like their counterpart asset management companies (AMCs) and hedge
funds in the US
Globally, the distressed assets market began to emerge in the

late 80s and early 90s in the US. In fact, most of the modern
day private equity firms - KKR, WL Ross and JC Flower - owe
their existence to early successes in the distressed assets
business. By now, the US is also a major market for the
ancillary industry around distressed assets, including trade in
bonds of distressed companies and turnaround funds which buy
completely broke companies, take over their managements,
turn them around and then sell them. In Asia, the distress
industry grew post the East Asian currency crisis in the late
90s. Early distress investors, such as Clearwater, Cerberus
Capital, GE and Loan Star Funds, have made significant gains
from such junk assets. Over the years, hedge funds have
become rich and powerful enough to intervene in sovereign
debt as Argentina is beginning to discover in the bitter dispute
between two New York hedge funds Gramercy Funds
Management LLC and Elliott Management Corp. In fact,
Elliott even impounded an Argentine Navy vessel for nonpayment, while the Argentine President Cristina Fernandez de
Kirchner has vowed never to negotiate with the fund calling it "vultures".
A Hard Job
Despite the enthusiasm around distressed assets, it is not a job
for the faint hearted.
ARCs are a breed born out of the Securitisation and
Reconstruction of Financial Assets and Enforcement of
Security Interest (SARFAESI) Act of 2002. The objective, says
former finance minister Yashwant Sinha, "was to enable the
banks to acquire the
securities which had
been pledged and sell
them without the
interference of the
courts". Sinha adds:
"We did away under
this Act with the
jurisdiction of civil
courts and gave a huge
power to the banks to deal with the issue of NPAs."
Not everything has panned out exactly as planned. Several legal and
regulatory hurdles have meant that ARCs were unable to exercise the
kind of freedom to turn around these bad assets. "We have such a
decrepit system for enforcing securities. In theory, it should be easier to
enforce a pledge to sell a company and kick the management out, but
most company managements will not go easily, and buyers don't want
to get into this trouble. He will buy only if you are giving it to him 100
per cent in an uncontentious manner," says Harsh Pais, Partner,
Trilegal, a Delhi-based law firm.
Take the case of Bharati Shipyard. A year after Edelweiss ARC bought Bharati Shipyard's Rs 4,570 crore loan
from 12 of its 23 bankers, there awaited a surprise. As many as nine winding up petitions appeared out of the
blue in the Bombay High Court thwarting the attempts of Edelweiss to turn around the cash-strapped ship
building firm. Surprisingly, insurance giant Life Insurance Corporation (LIC) was also one of the petitioners
despite being a secured creditor.
Yet, Edelweiss group chairman and CEO Rashesh Shah remains bullish. Shah, who began his career with the
ICICI group when it was still a development finance institution and had not turned into a bank, believes he
knows how to deal with stressed assets. "Very often a distressed company is still viable, but it is just that it is
indebted," says Shah.
Last year, SBI and Bank of India jointly sold a
loan of a distressed commercial mall in upmarket
Bangalore. Phoenix ARC and Edelweiss ARC
acquired the loans at different points in time from
three banks and they agreed to work together to
revive the Mall. It was a semi-finished mall with a
loan outstanding of Rs 400 crore. The project also
had ready tenants on papers, but because of lack
of funds, the mall's work was suspended
indefinitely. The banking channel refused to lend
and non-banking financial institutions (NBFCs)
were circumspect. The two ARCs acted swiftly by
bringing in an additional Rs 70 crore to complete
the project. "The stalled mall had no value, but by
infusing additional funds, we will increase the
value of the fully occupied mall to Rs600 crore
based on the annual lease rental income of over
Rs 60 crore," says Shah. If it goes according to
plan, both Edelweiss and Phoenix ARC will make
supernormal profits in this distressed asset. The
lending banks, too, will get their money back.
Phoenix ARC's Karra says resolution works for
him as the company boasts the highest 70 per cent redemption record of security receipts issued to banks in
exchange of bad assets. Shah is, however, looking at the restructuring route by working with promoters
alongside: "We see this as a resolution business, while many of our peers are looking at it as a recovery
business," he says, adding: "Resolution business is more of aggregating debt, fresh infusion of capital,
identification of non-core assets, and bringing in a strategic partner. This requires a good mix of financing
background, investment banking capabilities and also an understanding of the equity market." Edelweiss ARC
is manned by IDBI Bank's former executive director Siby Antony.
Sale of loan to ARCs, however, is the last resort for banks. Unlike retail defaulters where banks are known to
hire musclemen for quick recovery, corporate loan recovery is a different ball game. At times, there are labour
unions demanding their pound of flesh; statutory authorities like income tax to excise jump in to claim their
dues; employees approach the court for bankruptcy proceedings. But in most cases it is the deposed
promoters/management that pose the biggest hurdle in a revival.
Sitting at the Edelweiss House in a Mumbai suburb, Antony is strategising to push the Bharati Shipyard
winding up petition out of his way. Bharati has promised to repay the unsecured creditors in 12-15 months.
Antony has also engaged with Bharati Shipyard's promoters PC Kapoor and Vijay Kumar, and other lending
banks which did not sell their loans.
Not far away from Edelweiss' suburban headquarters is the 17th floor office of
P.K. Malhotra, Deputy Managing Director (Stressed Assets Management) of
State Bank of India. Malhotra, a veteran of banking with over three decades of
experience, cannot seem to hide his smile. SBI had even hired consultant
Alvarez & Marsal to turn around Bharati, but with no success. In fact, a
corporate debt restructuring could not save Bharati. Malhotra, who spends most
of his time identifying the bad loans for auction, is making sure that the bank
has exercised all its options before parting with the loan. Banks' options start
with a CDR package, suggesting one time settlement, exiting non-core assets,
infusing additional funds, bringing in strategic investors and then suggesting
complete takeover by another player.
For Malhotra, keeping bad loans in

SBI's books is like feeding a white
elephant. The ARC route gives the
bank 15 per cent (earlier 5 per
cent) of the negotiated sale amount as upfront cash, while the
remaining stays in the book as investment in security receipts
(SRs), which gets redeemed over a period of five to eight years,
depending on the ARCs' ability to recover. Past records show that
ARCs returned 50 per cent of the SRs issued to banks. Clearly,
Bharati is off Malhotra's back today. It is now the headache for
Antony. The company founded by two technocrat-cumentrepreneurs from IIT Kharagpur - Kapoor and Kumar - has been
making huge losses for the last three years.
Any setbacks, such as that of Bharati's, haven't deterred top ARCs
from buying big. ARCIL, the oldest ARC, bought another whopper
of a deal in April this year. It acquired the Rs 3,000 crore bad loans
of Corporate Power, a company belonging to Nagpur-based
Abhijeet Group.
For almost two years, its bankers had been negotiating with
potential buyers, such as SREI, JSW, NTPC, TATA and the
Adanis, to sell the loan, but with little success. SREI Infra was the
first to show interest, but the deal couldn't go through because
bankers were not ready for a major haircut. They believed that the
company could be revived as its 1,080 MW power plant installed by BHEL (no Chinese equipment, stresses a
banker) had a captive coal mine. "The plant was near the pit head. The coal was of good quality. The
transportation cost was minimal," says the representative of a lender. There was an interest for complete buyout,
but negotiations fell through midway. The reasons were the uncertainty over the mines as it came under CBI
investigations for irregular allotment of coal mines (see The Big Asset Sale).
There are success stories too. Edelweiss claims to put Electrotherm (India), a leader in induction furnace, on a
revival path. Edelweiss bought Rs 1,500 crore of the Rs 3,400 crore debt from over half-a-dozen banks. "We
converted a part of the debt into equity," says Antony, whose ARC now holds a 10 per cent stake in the unit.
Today, Electrotherm, which has been a loss-making unit since March 2012, has seen its revenues jump from Rs
659 crore in 2013/14 to Rs1,829 crore in 2014/15. "I have to ensure 18 per cent IRR (internal rate of return)
otherwise there is no business in the bad assets," says Antony.
Bankers' Dilemma
The sale of large NPAs, such as Bharati and Corporate Power, indicate a clear change in the banks' approach
towards selling bad loans.
Earlier, banks sold only the written-off bad loans which were practically dead assets. They also sought a high
price. Now, with the RBI on their case, banks are in a bind, even as there is no respite from bad loans. For
public sector unit (PSU) banks, the government has stopped liberal funding of capital every year. The only
option now is to generate cash by selling bad loans to ARCs.
Take for instance the case of SBI, which sold the biggest chunk of bad loans of around Rs 12,000 crore in its
history in 2014/15. "This has helped us to clean our balance sheet. The transfer to ARC will also generate some
return for us in the future," hopes Malhotra. This is true for the banking sector at large. ARCs, says SBI,
remains the most pro-active. In fact, it has made sale of bad assets like an assembly line activity. The bank's
monthly sale of NPAs (quarterly earlier) say a lot about SBI's seriousness to clean the books. "We have
substantially improved our information inputs to ARCs," says Malhotra. SBI allows three weeks to ARCs to do
their due diligence before accepting the bids. (See SBI's Sale To ARCs).
Undoubtedly, the big shift in SBI's approach is the sale of fresh NPAs, such as the Hotel Leela-venture
exposure of Rs 4,200 crore. It was put up for sale within three months of declaring it as an NPA. The sale to JM
Financial ARC, however, came as a big surprise to the promoters of the luxury hotel chain. The bank reasons
that there was no hope of generating cash in the next four to five years.
Patron RBI
Much of the credit for the
excitement in the distressed
assets business must go to the
RBI. "Most of the changes have
come from the regulator, which
is also in response to the build
up of NPAs in the system," says
Nikhil Shah, Managing Director
at Alvarez & Marsal. ( See The
Push Has Come From The RBI).
In the past 18 months, the RBI
has introduced a slew of
reforms, including hiking the
initial investment by ARCs from
5 per cent of the acquisition
amount to 15 per cent, to
discourage ARCs from relying
heavily on the management fee
model for their survival.
In the 5:95 model, ARCs used to
buy a bad loan at a discount
from banks' book value by
paying just 5 per cent upfront in
cash, while the balance was in
the form of security receipts
issued by them. ARCs also get a
management fee of 1.5 per cent every year on the overall AUM they manage. In the 5:95 scenario, ARCs were
content playing the management fee model because on an investment of Rs 5 (on a Rs 100 loan), they were
earning Rs 1.5, which meant a 30 per cent rate of return on the investment of Rs 5 (see Route To Recovery).
Ever since the RBI mandated the cash composition to 15 per cent (15:85 model) in August last year, ARCs have
a greater stake in moving from the 'management fee' model to the 'investment model' as the 1.5 per cent
management fee only amounts to 10 per cent rate of return on a cash investment of 15 per cent. This gives the
ARCs more of an incentive to actually turn around the company and make it profitable, instead of just passively
earning profits through management fees. It also ensures that they work harder.
Restructure, Resolve and

Deliver
ARCs have no magic wand to
revive a sick unit. They mostly
use the bilateral route by
working alongside the promoter
to de-leverage the business. "We
are financial restructuring
specialists. We are not business
restructuring experts," says
Eshwar Karra, CEO of Phoenix
ARC. Players like ARCIL and
Edelweiss are playing in big
loans where dozens of banks are
involved. Loan aggregation is a
huge challenge and the
resolution strategy centres
around restructuring of loans to revive a unit.
JM Financial, which bought the Leelaventure loan, is in a bind. Loss-making Leela is asset-rich with well-run
hotel properties. JM is still in dialogue with the company's management, which is asking for certain concessions
in interest and repayment terms from JM Financial. Meanwhile, Leela has also approached the government to
provide concessions to the hotel industry, in terms of loan refinancing. "We have represented to the government
for longer term loan for hotel industry by including existing hotels in the refinancing scheme. We are awaiting
response," says Vivek Nair, Chair-man and Managing Director, Hotel Leelaventure.
Three months ago, JM had put out an advertisement for the sale of Hotel Leela's Chennai and Goa properties to
reduce the debt burden. "They are yet to zero in on the sale. In this difficult environment selling a large hotel
property is very difficult," says a banker. In May this year, the company decided to mobilise Rs 1,000 crore
through equity or debt. "Ultimately, Hotel Leela will be a strategic sale to a big hotel chain," says a rival ARC
official. JM Financial refused to participate in the story.
Edelweiss ARC, on its part, is arranging Rs 600 crore from high networth individuals (HNIs) to complete its
order for delivering a couple of ships to Bharati Shipyard. Unlike banks, Edelweiss ARC has the flexibility to
reduce the interest rates drastically, whereas banks cannot lend below their base rates. Similarly, Edelweiss
could convert part of Bharati's debt into equity, whereas such decisions by banks would come under scrutiny.
ARCs actually have no such worries. "Our short-term plan is to revive the company in 24-30 months," says
Antony. There are some who say new investors (generally private equity) demand priority over existing lenders
as they are taking a bigger risk. "This preference is not acceptable to those banks who have not sold their loans,"
says a market observer.
While ARCs try to identify and take only those assets which can be made viable, it does not always play out
that way. The oldest, ARCIL finally got the Corporate Power loan at a hefty discount, but the entire economics
of the project has now turned on its head. The coal mine was re-auctioned recently to another player. Now, the
coal mine advantage does not exist any more. Another big negative is the location of the unfinished plant. The
Corporate Power plant is in Chandwa in Latehar district of Jharkhand, which is a Naxalite-affected region. "We
are working towards a resolution. We have to finish it. We have to get coal linkages. We have to also get the
power purchase agreement (PPA) revised," says an official of ARCIL.
"Banks generally have factory buildings or land as security, but what about the other assets in a business which
are not subject to security, such as business licenses, contracts, customers, employees, etc.? How do you
transfer these assets under SARFAESI? There is a big hurdle in transferring the continuity of the business," says
Haigreve Khaitan, Partner at Khaitan & Company.
In cases where an ARC decides to opt for the asset-stripping route without the consent of the promoters, there is
lot of resistance. ARCIL has struggled to sell Tulip Star Hotel (erstwhile Centaur near Mumbai's Juhu beach)
for many years. The company has successfully challenged the SARFAESI notice of ARCIL in the past. Board
for Industrial and Financial Reconstruction (BIFR) is yet another escape route where, after the failure of a
corporate debt restructuring (CDR), promoters can immediately approach the board. "Once you take a
SARFAESI action, BIFR action gets abated. But practically, it doesn't happen," admits an ARC official.
Many ARC heads say that the legal system is the joker in the pack that spoils the recovery process. Globally,
AMCs are set up to resolve NPAs. They have the backing of a judiciary to help in repossession and sale of
assets. The reality in the Indian context is that you cannot throw a promoter out of the company. Shah's biggest
learning in a short period is: "You cannot be adversarial with banks and promoters. You have to find a win-win
deal involving the ARCs, banks and promoters." There are currently 20 lakh recovery cases pending in Lok
Adalats, Debt Recovery Tribunals (DRTs) and SARFAESI. According to the RBI, Rs 1,73,100 crore worth of
money is locked in courts with the recovery record at Rs 31,100 crore as on March 31, 2014. (see Resolution
Through Courts).
The Bankers Guide
Bankers hold a grudge against ARCs that they are unable to turn around the stressed assets despite a lot of
flexibility in restructuring a loan. "ARCs have limited financial muscle, which leaves little scope for revival,"
says the head of a PSU bank. ARCs have spent barely Rs 3,400 crore to acquire total assets of Rs 1.89 lakh
crore of book value till date. If all the NPAs do find themselves in the market, that's another Rs 3.10 lakh crore
which require at least Rs 22,500 crore of capital from ARCs by the 15:85 principle. That's the kind of money
ARCs do not have today because of various reasons: they are not allowed to go public for now and there is no
secondary market for security receipts.
ARCs find it difficult to access funding for basic needs like working capital. The selling banks cannot lend,
while non-bank entities, such as private equity, demand 18-20 per cent interest with priority in repayment over
existing debt. This leaves the responsibility of a haircut on debt on the capital-starved ARCs. CRISIL points out
in its recent study that an ARC had to arrange for working capital for a textile company (name withheld) when
banking channels shut their doors on it. Similarly, another ARC arranged funds for a mid-sized developer to
complete the project.
There are some who suggest that the ARC game play has changed with a higher initial contribution at 15 per
cent for them. "This requires an integrated approach (involving) support from PE firms, distressed funds and
turnaround specialists, among others," says Hari Hara Mishra of a Delhi-based ARC
"There have been a couple of transactions in the recent past where foreign institutions were interested in ARCs.
For example, KKR showed interest in International Asset Reconstruction Company (IARC) and Hong Kongbased SSG Capital in Delhi-based ACRE. For global players, investing in ARCs enable them to take an
exposure in the growing distressed market and, this may prove to be a win-win for both. "These global investors
provide transfer of technical knowledge, information and capabilities, which is going to equip ARCs to handle
complex cases. This will also provide access to global network in terms of investments and industry
knowledge," says Munesh Khanna, Partner (Corporate Finance) at PWC.
"Foreign capital must come here because ARCs are starved of capital. The track record of ARCs has been
abysmal in terms of return on equity," says Vinayak Bhuguna, CEO and Managing Director of ARCIL. The
return on equity is barely double digit. So the performance has to go up to attract foreign capital. Currently, the
capacity of ARCs to take up more fresh bad loans is also limited because of their low capital base. According to
a report on ARC business in India by turnaround specialist Alvarez & Marsal, the current capitalisation of all
ARCs put together is around Rs 3,000 crore. "With the cash component increased to 15 per cent of acquisition,
the net worth of ARCs would be sufficient to acquire only Rs20,000 crore of stressed assets. Assuming ARCs
acquire the NPAs at a discounted norm of 60 per cent of the book value, all ARCs put together can garner Rs
33,300 crore of NPAs," says the report.
The recent RBI move to allow banks to take 51 per cent equity by converting their debt will be a game changer.
"This will work as a threat for defaulters. It will force promoters to come to the table," says Birendra Kumar,
Managing Director and CEO at IARC. If that happens, a lot of stressed assets will not reach the ARC stage.
Skeptics, however, say banks are not in the business of running a hotel or an airline. "Banks will enjoy a
provision arbitrage for 18 months after converting their debt into equity. But after 18 months, they also have to
sell the company to investors. If they don't sell, the banks will have to mark to market the value of their equity
periodically," says Khanna
More Gaps to Plug
Either way, there's miles to go before ARCs have sound sleep. One of their biggest bugbear is that banks do not
follow a consortium approach of selling and, therefore, ARCs have to resort to a time-consuming process of
dealing with each bank separately. Bharati and Hotel Leela are good examples of the consortium approach
where SBI took a lead, but in most cases, ARCs have to run after individual banks. This process could take as
much as 6-12 months. "Big banks like SBI and ICICI, which are in big loans, can take a lead in bringing
together all lending banks in a defaulting company," says an ARC official
Last week, ARCs raised another issue with Union Finance Secretary Hasmukh Adhia - that of joint bidding by
ARCs. They suggested joint bidding would spread the risk in a large account. In Hotel Leela, Kotak's Phoenix
actually bought a small quantity of loan from a bank, which declined the JM offer because of valuation.
Similarly, private equity players should be encouraged to buy stressed assets. Global private equity player KKR
has already shown interest in acquiring a controlling stake in IARC. If the deal goes through, IARC will have
access to KKR's management bandwidth and its war chest of funds.
Raman Singh of Bank of India, who deals in stressed assets, says ARCs' track record shows a recovery of 10-12
per cent of the book value and 50 per cent of the acquisition cost. This indicates half the SRs are as good as junk
The outstanding SRs currently stand at close to Rs 50,000 crore. And, more will get added along the way. If
ARCs succeed, banks will also get their money, which is the objective of promoting specialised ARCs to
recover bad loans in the economy. But if they fail to recover loans, it's merely a book entry of transfer of a junk
asset from a bank to an ARC. It is in the interest of everybody- the government, the banks, the legal system and
the ARCs - to make the system work so that the NPA monster can be tamed
20 July 2015
Asia Pacific/India
Equity Research
Investment Strategy
Research Analysts
Neelkanth Mishra
91 22 6777 3716
neelkanth.mishra@credit-suisse.com
Prateek Singh
91 22 6777 3894
prateek.singh@credit-suisse.com
India Market Strategy

STRATEGY
The surge of the states

Figure 1: State governments enable private investment and were too small
Ravi Shankar
91 22 6777 3869
ravi.shankar@credit-suisse.com
Other contributors
Anantha Narayan
91 22 6777 3730
anantha.narayan@credit-suisse.com
Arnab Mitra
91 22 6777 3806
arnab.mitra@credit-suisse.com
Jatin Chawla
91 22 6777 3719
jatin.chawla@credit-suisse.com
Lokesh Garg
91 22 6777 3743
lokesh.garg@credit-suisse.com
Sunil Tirumalai
91 22 6777 3714
sunil.tirumalai@credit-suisse.com
Nitin Jain
91 22 6777 3851
nitin.jain.2@credit-suisse.com
Rohit Kadam, CFA
91 22 6777 3824
rohit.kadam@credit-suisse.com
Vaibhav Jain
91 22 6777 3968
vaibhav.jain@credit-suisse.com
Akshay Saxena
91 22 6777 3825
akshay.saxena@credit-suisse.com
Source: Credit Suisse research
Indian state too small, but growing. Government services for citizens
and businesses are primarily provided by state governments. They employ
12 mn people, supporting more than a fifth of Indias middle class. We
disagree with the popular opinion that it is wasteful. States with more govt
employees have higher per capita GDP; e.g., Bihar has a third of the police
force vs. the national average, and the worst per capita GDP. A state must
enable/facilitate the private sector to operate: a stunted state fails in that
role. This is changing now (e.g. education, police) as states get more funds.
States fiscal size growing rapidly. Combined (centre + state) spending is
budgeted to rise 13.4% YoY, in line with recent years, but the mix of
spending has changed sharply: states together are to spend 65% more than
the centre in FY16 vs. just 6% more in FY11. Nearly half of the increase in
spending comes from their own revenues, as tax collection efficiency is
improving across states helped by VAT/computers, and GST should help.
Consumption stays supported; fiscal stress may emerge. With
government services finally improving, so does Indias medium-term growth
outlook, and the market P/E multiple. Near term, over the next two years
implementation of 7th Pay Commission could increase the states combined
salary bill by Rs2 tn. States pension bill is also rising (Rs2.2 tn), as is social
welfare spend (5x NREGA at Rs1.6 tn), up 1.9x since FY12. These could
stress state fiscal deficits, as well as inflation. From the markets
perspective, consumption should be boosted.
DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST
CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do
business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a
conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in
making their investment decision.
CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS
BEYOND INFORMATION
Client-Driven Solutions, Insights, and Access
20 July 2015
Focus charts
Figure 2: Slight pickup in total govt expenditure in FY16b
30%
Central + State Govt. Receipts & Expenditure Growth
25%
Figure 3: States to spend 65% more than Centre in FY16

24
21
1.7x
Rs tn
1.6x
18
1.5x
20%
15
1.4x
15%
12
1.3x
1.2x
5%
1.1x
1.0x
0%
10%
1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016b
Receipts YoY
Expenditure YoY
0.9x
1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015r
State
Centre (net)
Ratio (RHS)
Source: RBI, Budget documents, Credit Suisse estimates
Figure 4: State governments' capex split (FY15b)
Figure 5: State governments revenue expenses (FY15b)
Medical
4%
General
Services
7%
Welfare
9%
Others
6%
Urban
Power
Development
4%
5%
Rural
Development
10%
Agriculture
23%
Roads &
Bridges
19%
Energy
9%
Rural
Development
10%
Others
6%
Education
20%
Interest
Payment
11%
Health
6%
Pensions
10%
Welfare
8%
Agriculture
9%
Urban
Development
13%
Administration
11%
Split for FY15b; FY16b States' Revenue Expenditure: Rs 18tn
Split for FY15b; FY16b States' Capital Expenditure: Rs 3.4tn

Source: Budget documents, Credit Suisse estimates
Figure 6: High state govt. employment drives high GDP
Figure 7: State spend on salaries to shoot up post 7 CPC
40
35
30
25
20
15
10
5
0
200
150
100
50
0
HP UT DL TN PU KA KE HA MH AS RA AP OR GU MP JH CH WB UP BI
State Empl. Per '000 People (incl. Quasi)
GSDP Per Capita (Rs '000)
th
8
INR tn
7
An increase of Rs 2tn if all states
6
implement 7th CPC recommendations
5
4
3
2
1
0
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Total state spend on salaries (INR tn)
Source: 6th CPC Report, Credit Suisse estimates
Figure 8: Share of increased net transfers in FY16b
Figure 9: Incremental spending to boost consumption
BI
3%
RJ
4%
GU
4%
HP
3%
KE
4%
TR Others
2% 9%
UP
20%
CG
4%
JH
5%
WB
14%
MP
12%
AS
6%
OR
7%
Beneficiaries of Rs 1.6tn increase in net transfers in FY16

Urban Dev
2%
Water
3%
Health
6%
Police
6%
Pay Comm.
Rural Dev
7%
7%
Welfare
8%
Roads
2%
40%
30%
20%
10%
0%
YoY (RHS)
Source: MOSPI, Census 2011, Credit Suisse estimates
AR
3%
50%
Others
1%
Education
24%
Pension
18%
Interest
16%
Categories of states' incremental spend in FY16: Rs 3.3tn

20 July 2015
The surge of the states

States fiscal size growing rapidly
Despite combined (state + centre) FY16 fiscal deficit target being the fourth lowest since
1980, combined spending is budgeted to rise 13.4% YoY. Growth is only marginally above
the recent trends, but the mix of spending has changed sharply: states together are to
spend 65% more than the Centre in FY16, vs. just 6% more in FY11.
Share of states spend up

sharply since FY11
Nearly half of the rise in state spending comes from states own revenue sources, a sixth
from a small rise in fiscal deficits from a low 2.1% in FY11. Around 37% of the increase
comes from higher central transfers: in FY15 a number of schemes were shifted from
Central Plan to State Plan, and in FY16 direct tax sharing was increased from 32% to 42%.
with nearly half the rise

coming from their own
revenue sources
There is limited scope for central transfers to increase further, though there could be some
more discretion given to state governments on fund allocation between and within schemes.
But states own revenue sources are likely to improve further. VAT adoption as well as
computerisation has improved the tax collection efficiency of states, with 1 pp of GDP
improvement in collections since 2010. GST implementation could provide another boost.
Tax collection efficiency

improving in states; could
improve further with GST
Indian state too small, but growing

Government services that citizens and businesses need are primarily provided by state
governments: education, police, urban administration, utilities, public works, and the like.
They therefore together are ~60% of total government employment, and support more
than a fifth of Indias middle class families. Not surprisingly, states spend 20-25% of their
budgets on salaries, and only 15% of their spending is capex.
State governments support

more than a fifth of Indias
middle class
The commonly-held view that states high revenue expenditure is wasteful is incorrect, in
our view. We find that states that have more government employees have higher per
capita GDP. A possible reason for this: the governments role is to enable the private
sector to operate, by providing law and order, educated workforce, urban amenities, etc.
For example, against the national average of 1.38 police per 000 population (among the
lowest globally), Bihar has 0.55, and lags on GSDP per capita too.
States with more

government employees
have higher per capita GDP
But this is changing as states get more funding: employment in education and police, the
two largest categories of state workers, is rising steadily. Poorer states are also spending
more on rural development. A concern is the rising pension bill (Rs2.2 in FY16b), and high
social welfare spend (5x NREGA), up 1.9x since FY12
Consumption stays supported

We see three key implications of the above changes for the market: (1) A larger state is
necessary for medium-term growth prospects and good for the broader market multiple.
There is visible catch up with the world on measurable metrics like school enrolment and
policing, even though weak educational outcomes suggest quality needs improvement.
A larger state is good for

medium-term growth
prospects
(2) Given high employment, implementation of the 7th Pay Commission recommendations
could increase the combined salary bill of states by Rs2 tn (1.3% of GDP) if all states
implemented it in FY17. This clearly affects consumption and likely inflation too.
7th Pay Commission could

raise the salary bill of states
by Rs2 tn (more, including
pensions)
(3) FY16b state spending should be up 16% YoY (Rs3.3 tn), with nearly two-thirds in
directly consumption boosting areas like education (teacher salaries), pensions, and social
welfare: the productivity impact could take longer to show up. Slippage on targets should
be lower this year, as budgeted central transfers dont seem overstated. Kerala,
Chhattisgarh, Odisha, MP and UP are the states likely to see the fastest growth.
20 July 2015
Financial summary
Figure 10: A list of key stocks that benefit
Stock
Hindustan Unilever Ltd

Maruti Suzuki India Ltd
Zee Entertainment
LIC Housing Finance Ltd
Havells India Ltd
Voltas
Kajaria Ceramics Limited
Rating
OUTPERFORM
OUTPERFORM
OUTPERFORM
OUTPERFORM
OUTPERFORM
OUTPERFORM
OUTPERFORM
CMP
Target price
Upside Market cap
(Rs)
(Rs)
(US$ bn)
FY16
FY17
936
4,180
382
463
301
315
783
975
5,100
440
540
340
380
950
32
20
5.8
3.7
3.0
1.7
1.0
41
22
34
13
32
26
30
34
15
26
10
26
20
24
4%
22%
15%
17%
13%
21%
21%
P/E (x)
EPS growth (%)

FY16 FY17
18.6
52.4
11.3
29.6
19.9
20.6
14.1
20.7
44.6
28
32.8
24
27.4
24.7
Source: Company data, Credit Suisse estimates
Figure 11: States share of population and GDP

State code
State name
UP
MP
GU
WB
KA
AP
TL
MH
BI
TN
RJ
KE
OR
JH
CG
JK
UT
TR
HA
PU
HP
AS
AR
MN
MZ
NA
ME
SI
GO
Uttar Pradesh
Madhya Pradesh
Gujarat
West Bengal
Karnataka
Andhra Pradesh
Telangana
Maharashtra
Bihar
Tamil Nadu
Rajasthan
Kerala
Odisha
Jharkhand
Chhattisgarh
Jammu & Kashmir
Uttarakhand
Tripura
Haryana
Punjab
Himachal Pradesh
Assam
Arunachal Pradesh
Manipur
Mizoram
Nagaland
Meghalaya
Sikkim
Goa
Share of population (%)
Share of GDP (%)
16.5%
6.0%
5.0%
7.5%
5.1%
4.1%
2.9%
9.3%
8.6%
6.0%
5.7%
2.8%
3.5%
2.7%
2.1%
1.0%
0.8%
0.3%
2.1%
2.3%
0.6%
2.6%
0.1%
0.2%
0.1%
0.2%
0.2%
0.1%
0.1%
8.7%
4.4%
7.5%
6.8%
5.7%
4.5%
3.8%
14.4%
3.3%
8.3%
5.0%
3.9%
2.8%
1.7%
1.8%
0.9%
1.2%
0.3%
3.7%
3.1%
0.8%
1.6%
0.1%
0.1%
0.1%
0.2%
0.2%
0.1%
0.5%
Source:Planning Commission, Census 2011
20 July 2015
States' fiscal size growing rapidly

Changing seasonality of government expenditure has created volatility in economic
momentum: it slows the economy down in the March quarter but revives it in the June
quarter. But on a full year basis, the growth in combined expenditure of central and state
governments has remained in the 11-13% YoY bracket for the last five years, with the
13.4% YoY budgeted in FY16b being the highest (Figure 12).
Figure 12: Slight pickup in total govt expenditure in FY16b
th
Figure 13: FY16b total deficit target 4 lowest since 1980
30%
12%
25%
10%
20%
8%
15%
6%
10%
4%
5%
2%
as % of GDP
0%
0%
1980
1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016b
Receipts YoY
1988
1992
1996
2000
Union Fiscal Deficit
Expenditure YoY
Source: RBI, budget documents, Credit Suisse estimates
1984
2004
2008
2012
2016e
State Fiscal Deficit
State expenditure growing faster than at Centre

While total fiscal deficit has remained unchanged since FY11 (Figure 13), the mix has
changed as there has been an unprecedented sharp divergence in the pace at which
spending by state governments is growing, and the rate of growth of central government
expenditure (Figure 14). State governments together are budgeted to spend 65% more
than the Centre in FY16 (Figure 15), substantially higher than five years back.
Figure 14: State expenditure growing faster than Centre
25%
Figure 15: States to spend 65% more than Centre in FY16

24
Rs tn
1.7x
20%
21
1.6x
15%
18
1.5x
10%
15
1.4x
12
1.3x
1.2x
1.1x
1.0x
5%
0%
-5%
-10%
0
1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016b
Central Exp. (Net) Y/Y (%)
State Exp. Y/Y (%)
0.9x
1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015r
State
Centre (net)
Ratio (RHS)
20 July 2015
This increase in expenditure by state governments has not been due to a rise in deficits.
Even though deficit ratios have risen from the low levels seen in FY11, they are still below
levels seen in most of the last 35 years (Figure 16). FY16 deficit ratio is budgeted to be
2.6% (this is for a sample of 15 states that together constitute 88% of total state
expenditure)a 50 bp drop on the revised deficit of 3.1% in FY15 (2.2% was budgeted).
The final deficit in FY15 too is likely to be lower than the revised number, as has generally
been seen in prior years. Deficits contribution to the rise in spending has been minimal;
instead, states' spending has been supported by a rise in their own revenue sources (37%
of FY11-16 increase, Figure 17) as well as central transfers.
Figure 16: State deficits up from lows, but under control
Figure 17: Source of funds for rise in expenditure FY11-16
5.0%
Deficit
18%
4.5%
4.0%
Own Tax
37%
3.5%
3.0%
2.5%
2.0%
Central
Transfers
37%
1.5%
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016
States' fiscal deficit to GDP
(2016 data for 15 states)
Own non-Tax
8%
Increase in spend FY11-16: Rs12.9tn

States' improving tax collections: Better compliance

States' own tax collections shot up between 2010 and 2013 (Figure 18) and after a
slowdown in FY14, when they grew only 9%, picked up again in FY15, and are expected
to grow robustly in FY16b as well. While high inflation does boost states' tax collections,
as most state taxes are ad-valorem, state taxes as a % of GDP have risen sharply since
FY10 (Figure 19), suggesting that tax collection efficiency has improved.
Figure 18: Tax collection growth shot up in 2010-13
Figure 19: States' own tax collection efficiency improving

6.8%
25%
Standout increase in
states' own tax growth
20%
6.6%
6.4%
6.2%
15%
6.0%
5.8%
10%
5.6%
5%
5.4%
5.2%
0%
1986- 1989- 1992- 1995- 1998- 2001- 2004- 2007- 2010- 201389
92
95
98
01
04
07
10
13
16
States' Tax Revenue CAGR
5.0%
1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016b
Own Tax as % of GDP
20 July 2015
Many incorrectly attribute this increase in efficiency to just higher property taxes (booming
real-estate markets in many large cities) and to rising revenues from alcohol (i.e., state
excise). Sales taxes have driven nearly two-thirds of the increase (Figure 20) in states'
own tax collections. Among other things this has been driven by a steady increase in the
number of entities registered to pay sales taxes (Figure 21 shows data for 18 states): this
has helped taxes grow in excess of nominal GDP growth.
Figure 20: Sales taxes have driven two-thirds of increase
Others
11%
Figure 21: No. of sales tax assessees rising at 5-7% p.a.

5.6
Property Taxes
13%
State Excise
10%
Sales Tax
66%
# of Sales Tax Assessees in 18 states (some assumptions)
5.4
7%
5.2
6%
5.0
5%
4.8
4%
4.6
3%
4.4
2%
4.2
1%
4.0
0%
2010
2011
# of Assessees (mn)
Sources of increase in states' own taxes (FY10-15b): Rs 4.8tn

8%
2012
2013
Y/Y (%)
Source: CAG State Audit Reports, Credit Suisse estimates
Improving enforcement is being driven by computerisation (i.e., better information

management), lagged effects of VAT implementation, as well as transfers of best practices
between states. In our view, states should continue to grow tax collection faster than GDP,
given the large number of enterprises that are NOT still in the tax net (Figure 22), the
expected widening of the tax base with GST implementation, and also the significant
catch-up that can happen for states that still have low sales tax to GDP (Figure 23).
Figure 22: Only a fraction of enterprises pay sales tax
60
Mn
58.5
Figure 23: Sales tax as % of GDP could rise in many states

7%
6%
50
5%
40
4%
30
3%
20
2%
10
1%
5.4
1.7
1.1
Service Tax
Assessees
Regd. companies
0
# of enterprises in
India
Sales Tax
Assessees
Source: CAG Reports, Economic Census, Credit Suisse estimates
0%
WB
BI
MH OR JH MP CG RJ
Sales tax as % of GSDP (2010)
UP GU KA AP* KE TN
Increase during 2010-15 (pp)
20 July 2015
The surge in central transfers is likely behind us

As per the constitution most of tax collection responsibilities (income tax, corporation tax,
customs duties, service tax, etc.) lie with the central government (as it should from an
efficiency perspective), but most tasks of dispensing government services (law and order,
healthcare, education, civic amenities, rural roads, electrification, etc.) are with state
governments. This necessitates significant transfers of taxes from the centre to the state.
These transfers are of four types: (1) Direct tax sharing/devolution: a fixed share of all
taxes collected by the centre automatically go to the statesevery five years the Finance
Commission, a constitutional body, revises this ratio; (2) Grants: the Finance Commission
also recommends some grants to weaker states, though the centre can choose to provide
grants to specific states for disaster relief, repair of roads, etc; (3) Contribution to state
plan: for schemes like education and health; and (4) Assistance for Centrally
Sponsored Schemes (CSS): the centre can choose to spend on areas that are state
subjects, and route funds through the state budget.
Transfers to the states have risen at 18% CAGR from FY10-16b, and particularly sharply
in the past two years (Figure 24): in FY15 all the central schemes on state subjects where
the centre by-passed state governments and provided funds directly to autonomous
bodies, were converted to schemes under state plans. This was just an accounting change
and total spending in the economy did not rise: just control moved to the states.
Then in FY16, as per the recommendations of the Fourteenth Finance Commission (FFC),
there was a sharp increase in states direct share of tax revenues: from 32% to 42%,
though this was offset by a Rs745 bn drop in Central Assistance for State Plan: untied
funds and funds for eight small schemes were discontinued.
Figure 24: Rise in % of Central taxes transferred to states
Figure 25: More increase in transfer to states is unlikely
Rs Tn
9
60%
18% CAGR FY10-16b
8
7
Central schemes
transferred to State Plan
Central Plan
16%
Others
2%
Interest
32%
55%
50%
Salaries
16%
3
45%
2
1
0
40%
2010
2011
Tax Sharing
2012
Grants
2013
2014
State Plan
2015r
CSS
2016b
% of Taxes
Subsidies
17%
Defence
17%
FY16 Central Expenditure ex-state transfers: Rs 14.4tn

Going forward, a further increase in transfers is unlikely, given that the remaining
expenditure at the central level is primarily on interest payments, defence, centrally
administered subsidies and salaries (Figure 25). Much of Central Plan expenditure is also
on central subjects like roads and railways (Figure 26), and areas that are constitutionally
state subjects are much smaller.
though there could be more discretion for states

In FY16b, most funds are to be transferred to states via direct tax transfers and
contribution to 66 schemes under the state plan (Figure 27). While states have full
autonomy to spend on these schemes as they wish, they do not have the freedom to use
these funds elsewhere, i.e., the funds are still tied to these specific schemes. Recently a
panel of chief ministers recommended that the government delink 46 of these schemes,
letting the states choose which schemes they want to participate in.
20 July 2015
Given the significant diversity in infrastructure and social requirements between states
(e.g., UP needs roads whereas Karnataka needs irrigation; TN and Kerala need old-age
homes given the high average age whereas UP and Bihar need kindergartens and more
primary schools given low literacy rates and a high fertility rate), more freedom would
improve the productivity of this expenditure.
Figure 26: Most Central Plan spend is on central subjects
Energy
6%
Urban Dev
5%
Others
3%
Figure 27: Most transfers via direct sharing + State plans

CSS
3%
Roads
23%
North East
Welfare
7%
State Plan
24%
Industry
7%
Education
8%
Economic
Services
10%
Railways
20%
Social Services
11%
FY16 Central Plan Outlay ex-state transfers: Rs 2.4tn

Grants
12%
Tax Sharing
61%
Total FY16b Transfer to States: Rs 8.6 Tn

Discretion for states necessary

Given the size of Indias population (a sixth of humanity), each of the states is as large as
most countries (Figure 28): this necessitates a federal system of governance, as it is near
impossible for the centre to manage all changes in every state.
Figure 28: States in India are country-sized
Figure 29: Low development level/Wide income disparity
Source: Census 2011, IMF World Economic Outlook
Source: Census 2011, IMF World Economic Outlook
20 July 2015
Not only are the states large, they also have very disparate productivity levels (Figure 29),
and are very poor. The richest state in India is Goa, which in per capita GDP (not PPP
adjusted) is at the same level as Paraguay. The second richest, Delhi, is like Indonesia,
and the third richest, Sikkim, is like Egypt. The rest of the country is more like sub-Saharan
Africa. To rise from such low levels, ground level productivity drivers must improve.
Figure 30: Connections & availabilitydifferent challenges
Figure 31: Some need kindergartens, other old age homes
Source: Census 2011
Source: Census 2011
The states also have very different infrastructure requirements: some states need to invest
in electrifying their households (Figure 30), as the share of households that are electrified
is abysmally low, whereas those that have gone through that process need to prioritise
investments in capex to bring down distribution losses (e.g. Gujarat). Similarly, while the
northern states, given higher fertility rates need more primary schools, the southern states,
with average age in the early to mid-thirties, need more old-age homes.
This adjustment to physical and social infrastructure necessitates planning and
expenditure by state governments: their improving ability to spend is thus very positive for
Indias medium-term growth prospects.
10
20 July 2015
Consumption stays supported

Some improvement in social indicators
For India the most important measures of socio-economic development are at low levels,
and, while there is visible improvement, that is so for most under-developed economies.
So is this increase in spending by state governments having any impact?
As education and police are the two largest areas of employment for state governments,
we compare changes in India to those elsewhere. That on both literacy levels (Figure 63)
and on the enrolment ratio in primary schools (Figure 64) India is faring better than even
other developing countries suggests that some of these changes are having an impact.
Figure 63: Literacy growth better even if on a low base
Figure 64: Enrolment has improved dramatically
Adult Literacy
100%
90%
80%
70%
60%
50%
2005
2015e
Net Primary Enrolment Rate

1.6%
100%
1.4%
95%
1.2%
90%
1.0%
85%
0.8%
80%
0.6%
75%
0.4%
70%
0.2%
65%
0.0%
60%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
-0.5%
2002
10yr CAGR (RHS)
Source: UNESCO, Credit Suisse estimates
2012
10yr CAGR (RHS)
Source: UNESCO, Credit Suisse estimates
In particular the enrolment ratio is now in a range prevalent in most countries globally,
even the developed ones, and the growth is much faster than in other developing markets
even though current ratios are higher, suggesting a low base is not the only reason.
Figure 65: Educational outcomes weak across states
Figure 66: Indias police-to-people growth among fastest
80%
30%
70%
20%
60%
10%
50%
7.0
Police per '000 people
10.0%
6.0
8.0%
5.0
6.0%
4.0
4.0%
0%
3.0
2.0%
40%
-10%
2.0
0.0%
30%
-20%
1.0
-2.0%
0.0
-4.0%
20%
-30%
HP KE PU AP HA UT WBMH OR TN CG KA BI GU IN RJ JH MP UP
Std V Reading Levels in Dec. 2014
Change 2010-14 (% points, RHS)
Source: ASER 2014 (Pratham), Credit Suisse estimates
2008
2013
5-yr CAGR (RHS)
Source: UNODC, Credit Suisse estimates
20
20 July 2015
However, this is not yet showing up in educational outcomes, suggesting that while states
have rapidly expanded schools and teachers, the quality and processes may have
suffered. Most states seem to have seen a sharp drop in reading and arithmetic
proficiency (Standards III and V): very likely that the new schools and teachers are part of
the student base, but arent learning as much as they should. Worryingly, this problem
exists even in the developed states. This clearly will be the next challenge for states.
Similarly, the improvement in the police-to-people ratio in India has been among the
fastest in the world (in Figure 66, Brazil is an outlier), even though a 2% p.a. pace may
seem slow given the large gap that needs to be bridged.
High salary burden: Big 7th Pay Commission impact

Figure 67: States employ the bulk of government staff
State employees (57%)
Quasi (Central)
25%
State
25%
Quasi (State)
17%
Central
18%
Figure 68: State spending on salaries to shoot up

50%
INR tn
45%
An increase of Rs 2tn if all states

implement 7th CPC recommendations
40%
35%
30%
25%
20%
15%
10%
1
Local Bodies
15%
5%
0%
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Split of all India government employees in 2012

Source: MOSPI Statistical Yearbook, Credit Suisse estimates
Total state spend on salaries (INR tn)
YoY (RHS)
While the economic impact of changes to state governments administrative services may
be longer term, their large staff strength has a significant regular presence in the economy.
Given that most of the government services are provided by state governments, they also
have the bulk of government staff on their rolls (Figure 67), with total employment at 12 mn
and rising. Including quasi-state and local government employment (e.g. state transport
corporations), they employ more than a fifth of the urban middle class.
th
Figure 69: Salaries may rise by 29% post 7 CPC

Change in pay post 7th CPC for lowest pay band
50,000
Figure 70: State govt salary spend growth tracks centres

50%
40%
40,000
30%
30,000
20%
20,000
10%
10,000
0%
-10%
Pre 7th CPC in 2016
Basic Pay
Grade Pay
Post 7th CPC in 2016

Other Allowances
Source: 6th CPC Report, Credit Suisse estimates
DA
1998
2000
2002
2004
Central Govt Spend (2-yr CAGR)
2006
2008
2010
2012
State Govt Spend (2-yr CAGR)
Source: RBI, Brochure on Pay and Allowances , CS research
21
20 July 2015
Not surprisingly, states spend 20-25% of their budget on salaries, with their FY16b salary
bill likely to add up to Rs5.2n (Figure 68), nearly 3.6% of GDP. At the time of
implementation of the once-in-a-decade pay revisions for government employees, this
proportion shoots up, and then trends down in the intervening years as salary increases
lag overall spending growth.
The 7th Pay Commission is effective 01-Jan-2016, and the Central Pay Commissions
(CPC) report is expected by October 2015. Given the near-formulaic nature of increases
seen thus far, it seems likely that the recommended increase would be 29% (Figure 69).
States have their own pay commissions, but these generally adopt the central pay
commissions recommendations, as seen in the near-synchronous changes in the salary
burden of the centre and the states (Figure 70): we use a two-year CAGR to smoothen out
the impact of arrears. This pay commission is likely to submit its recommendations well in
advance (unlike the 6th CPC that was accepted nearly 2.7 years after it became effective
on 01-Jan-2006), and some of the states like MP have already started provisioning for the
increases, as arrears create significant pressures on state budgets.
It is clear from Figure 67 that generally all states do not implement the pay commission
recommendations at the same time, else the increase in the overall salary bill would have
been ~40% in any one year. It is very likely that this time as well not all of the Rs2 tn
increase would be seen in the same year.
Fiscal stresses and election calendar affect timing

While the salary increase is to be effective 01-Jan-2016, only two states (Madhya Pradesh
and Gujarat) have provisioned for an increase in FY16b. All others, like the centre, have
not. The state-wise timing would be driven by two main factors: the states fiscal ability to
absorb the cost, and when state elections are due. A sharp jump in compensation helps
gather votes, and given the large number of employees, this voter base becomes
important (some believe that the 2009 victor for the UPA in the general elections was
affected by the 6th CPC).
Some states are less well prepared fiscally to absorb the pay commission impact
Given stringent fiscal targets, states with stretched finances (Figure 71) or those where
these increases are a meaningful part of spending (Figure 72) are likely to delay the
increase until they can: employee agitations would then be necessary to trigger the
implementation of the pay commission.
Figure 71: States with high impact on deficits
Figure 72: Impact of salary increases varies across states
5.0%
12%
4.5%
11%
4.0%
10%
3.5%
9%
3.0%
2.5%
8%
2.0%
7%
1.5%
6%
1.0%
5%
0.5%
4%
0.0%
TL AP PU OR CG KE MP BI RJ UP HA TN KA JH GU WB MH
FY17 Fiscal Deficit/GSDP
FY17 Salary Spend increase as % of FY17 GSDP
PU MH AP WB KE HA OR TN RJ MP JH TL KA BI CG GU UP
FY17-16 Salary spend increase as % of FY16 Spending
22
20 July 2015
Impact of state elections calendar: TN, KE, WB, AS, GU, PB & UP may see it early
We use probable dates for next state elections to assess potential implementation dates.
For Bihar (elections later this year), the elections pre-date the 7th PC findings. On the other
hand, among major states, for Tamil Nadu, Kerala, West Bengal and Assam, where
elections are due in the middle of 2016, and in Gujarat, Punjab and UP (mid/end-2017) an
early implementation is likely. Other states may want to time it better depending on fiscal
preparedness or impact on elections.
Broad impact on the economy: Impact on inflation and possibly growth
A sudden 30-40% increase in compensation for more than a fifth of the urban middle class
is likely to show up in macroeconomic statistics. Particularly as the total quantum, once all
states have implemented it, would be more than 1% of GDP. While it is difficult to isolate
the impact of the pay commission, surges in inflation in 1998 and 2009 are noticeable
(Figure 73): the episode after the 5th PC was shorter, while that after the 6th PC was much
longer, though likely other factors played a role as well. There is likely to be some growth
impact, even if the fiscal multiplier of such spending is generally low; the final impact would
depend on the changes in fiscal deficits, i.e., how states go about funding this increase.
Looking back at external balances, a noticeable change is not discernible.
Figure 73: Inflation impact of pay commissions
40%
30%
6th PC likely played a

role in this surge
5th PC: Inflation impact
hard to isolate
20%
10%
0%
-10%
Jan-61 Feb-67 Mar-73 Apr-79 May-85 Jun-91 Jul-97 Aug-03 Sep-09
CPI (% YoY)
Figure 74: State governments liabilities

WB
PU
UP
KE
GO
AP
RJ
UT
BI
GU
KA
JH
MP
MH
TN
OR
HA
AS
CG
10%
15%
20%
25%
30%
35%
Outstanding Liabilities as % of FY15 GSDP (as of FY15 end)
Fiscal health of states

Given that high inflation supports high nominal GDP growth, solvency stresses are
uncommon among Indian states (Figure 74): only Punjab and WB were considered
stressed 1-2 years back. Yet, a large increase in the salary burden can potentially create
stresses on state government balance sheets. In particular as they also extend guarantees
(effectively off-balance sheet funding) in various sectors like power and irrigation, and
sometimes to State Finance Corporations as well.
FY16b impact: Spending up 16%

In this financial year, the impact of larger or improved administration, or even the 7 th PC
recommendations would not matter. Instead, for investors the important factor is a 16%
increase in total state spending (Figure 14 on Page 5). It is widely believed that state
governments lack the institutional capacity to spend quickly, and generally miss their
spending targets meaningfully. This fear is higher for some states than for others.
23
20 July 2015
Looking back at history, one finds that there is indeed a slippage in spending (Figure 75),
but it was generally in the ~2% range till FY11. This is not insignificant, but not large
enough to derail the growth impact. Since FY12 however, the slippage on FY targets has
increased sharply, and the root cause for this, in our view, has been the uncertainty on
receipts as the central governments fiscal mismanagement drove very large slippages on
transfers to states (Figure 76). This suggests the constraint is not the states ability to
spend quickly. This year, as budgeted estimates of central revenue are credible, if not
conservative, slippages against budgeted targets are likely to be insignificant.
Figure 75: Spending slippages are generally 2% of target
6%
Figure 76: High slippage since FY12 due to the centre

1.0
1.0%
INR tn
4%
Slippage has been worse than expected in last

4 years because of fiscal troubles at the centre
2%
0%
-2%
0.8
0.8%
0.6
0.6%
0.4
0.4%
0.2
0.2%
-4%
-6%
-8%
0.0
0.0%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015e
2012
States' Spending Slippage actual vs budgeted
2013
2014
2015
Revised vs Budgeted Transfers (INR tn)
as % of GDP
Source: Company data, Credit Suisse estimates
Over and above the growth in their own tax revenues, the big change for state
governments this year has been the change in transfers (see link). We estimate that UP,
WB, MP and Orissa are together more than half of the increase (Figure 77). Not
surprisingly, Orissa, MP and UP are the states likely to see the highest increases in
spending (Figure 78).
Figure 77: Share of increased net transfers in FY16
HP
3%
Others
TR 9%
2%
AR
3%
UP
20%
BI
3%
KE
4%
CG
4%
WB
14%
RJ
4%
GU
4%
JH
5%
AS
6%
OR
7%
MP
12%
Beneficiaries of Rs 1.6tn increase in net transfers in FY16

Figure 78: Growth in states total expenditure in FY16

KE
CG
OR
MP
UP
BI
GU
RJ
TN
AS
HP
PU
HA
AP
JK
JH
WB
KA
MH
UT
18%
18%
17%
16%
16%
16%
15%
15%
15%
15%
15%
14%
14%
14%
13%
12%
4%
0%
5%
10%
15%
27%
26%
21%
20%
25%
30%
YoY Increase in FY16/FY15
The YoY comparisons seem high given that the FY15 actual spending was curtailed by the
nearly Rs850 bn in slippages in transfers that the states did not know with just 1-2 months
left to go in the year (see link). Moreover, as state budgets are presented without getting
details of the significant central budget changes, many have not incorporated the higher
central transfers. To this extent there could be some slippage on spending targets.
24
20 July 2015
Headline seems consumption boosting, but

underlying more broad-based
Of the Rs3.3 tn in additional spending in FY16b, the near-term effects of nearly two-thirds
of it would just be to boost consumption (Figure 79). Spending on education and police are
budgeted to continue growth. For some discretionary categories like roads, rural
development and urban development, the growth could be higher than what official
numbers show (Figure 80). This is because due to the Rs850 bn shortage in central
transfers the final spend on these categories in FY15 would have been much lower than
even the revised FY15 numbers the states presented in their FY16 budget.
Figure 79: Incremental spending to boost consumption
Urban Dev
2%
Water
3%
Health
6%
Roads
2%
Others
1%
Education
24%
Police
6%
Pay Comm.
7%
Rural Dev
7%
Pension
18%
Welfare
8%
Interest
16%
Categories of states' incremental spend in FY16: Rs 3.3tn

Figure 80: Y/Y growth in spending for each category

Pension
Interest
Police
Education
Water
Health
Rural Dev
Welfare
Roads
Urban Dev
Admin
Agri
Power
-5%
0%
5%
10%
15%
20%
Budgeted Spending Increase (FY16b over FY15r)
Supportive of longer-term economy/market growth

Changes of this magnitude: improving ground-level governance, 30-40% increase in
compensation for 12 mn people, or a 16% growth in spending, can all have meaningful
implications for the broader market. We shortlist seven stocks from the larger basket,
using (1) sector; (2) geographical (i.e. state-wise) presence (it seems better to not have
one!); and (3) ongoing company/management strategy level changes. In the following
pages we cover implications for HUL, Maruti, LIC Housing Finance, Havells, Zee TV,
Voltas and Kajaria Ceramics.
25
ECONOMICS
15 July 2015
Important Notice: The circumstances in which this publication has been produced are such that it is not appropriate to characterise it as independent
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Extract from a report
Latam Themes
No second line of defence against a commodity-led slowdown
The sustained fall in Latam growth since 2010 shows that the region was unprepared to
face the onslaught of a commodity-led slowdown (see the Commodities Review report
"Cycles within supercycles"). In the absence of the required structural reforms, domestic
sources alone will be insufficient to lift growth and improve other macro indicators. As a
result, Latam ex-Mexico faces a prolonged period of weaker growth, lower current account
and fiscal balances and pressure on currencies and other asset classes over the longer
term, notwithstanding the near-term impact of the impending start of US monetary
tightening.
Latin America
Dev Ashish
(91) 80 2802 4381
dev.ashish@sgcib.com
(Also see our latest Commodities Review report "One swallow does not a summer make.")
The commodity price deceleration is affecting the macro economy severely. Except
for Mexico, most Latam countries are predominantly commodity exporters and are
facing deteriorating macro conditions due to lower commodity prices.
Domestic sources of growth have diminished. The falling share of manufacturing in

GDP and the erosion of domestic investment-funding sources (savings) have exposed
Latams overreliance on commodity demand and prices. (See also the Anchor Theme
#1 Growth Labour income and consumption to drive recovery from our latest
quarterly Global Economic Outlook report.)
Reforms matter, but cant entirely negate the impact of commodity. Notwithstanding
the recent sell-off in currency market, countries having proximity with the US or those
implementing credible reforms will eventually have better macro prospects. However,
Latam countries are still worse off on average with or without reforms.
Latam assets face long term challenges. Low commodity price environment and
resulting deterioration of macro indicators will keep Latam currencies weaker than
otherwise over the medium to longer term, notwithstanding the near-term impact of the
impending start of US monetary tightening.
Rising upside risk of tighter monetary policy. The impending start of a Fed tightening
cycle could lead to an upward bias to monetary policy rates compared with the last Fed
tightening cycle in 2004-06. (See also the Anchor theme #3 Monetary Policy Uneven
real policy impact from the Global Economic Outlook report for more discussion.)
Global growth recovery may not improve commodity prices

World growth, LHS
Commodity prices + IMF f orecasts
Commodity prices + model f orecasts
%
6
Latam macro indicators continue to worsen

%
%
40
30
20
10
Inf lation, LHS
Fiscal balance
Current account balance
-1
-2
-10
IMF and model
forecasts
-20
-30
-2
1993
1997
2001
2005
2009
2013
2017
-40
2
1
-1
% of GDP
Growth, LHS
-3
-4
2005
2007
2009
2011
2013
-5
Note: Weighted average for Argentina, Brazil, Chile, Colombia, Mexico and Peru.
Inflation average excludes Argentina.
Source: IMF WEO, Datastream, National sources, SG Cross Asset Research/Economics
Please see important disclaimer and disclosures at the end of the document
This document is being provided for the exclusive use of ABHINAV BHANDARI (Reliance Capital Asset Management Limited )
Latam Themes
Dismal 1990s and the commodity-led boom of the 2000s

Latin America faced several currency and debt crises and episodes of hyperinflation in the
1990s and early 2000s, leading to poor macroeconomic outcomes on average during the
1990s and until as recently as the early years of the 2000s. However, macro performance
improved dramatically in the last decade after the (predominantly) Chinese-demand-led boom
for commodity demand and prices. Between 2004 and 2008, most commodity prices surged
faster than during 1998 and 2003 (in fact most commodity prices declined on average
between 1997 and 2003 with the exception of crude oil prices). A look at the key numbers
shows the sharp change in Latam fortunes during these two periods.
Chart 1. Commodity prices are expected to remain low in the foreseeable future
2005=100
250
Commodity price index

Commodity Non-Fuel
Commodity Industrial Inputs
200
Crude Oil
Commodity Metals
150
100
IMF WEO
Apr-2015 forecasts
50
0
1980
1985
1990
1995
2000
2005
2010
2015
Source: IMF WEO, SG Cross Asset Research/Economics
Latam economies that were growing on average at 1.7% p.a. between 1998 and 2003
accelerated sharply to 4.8% during 2004-08. Over a similar timeframe, Latam inflation slowed
from 8.1% to 4.9%, fiscal balances improved from -3.8% of GDP to -1.1%, gross public debt
came down from 57.7% to 51.8%, the current account turned into surplus (+0.1% of GDP)
from the deficit of -2.2% of GDP and gross national savings a key factor in determining the
strength of economy as far as it ability to grow internally is concerned improved from 16.8%
to 20.9% of GDP.
A big shift since the slide in commodity prices

Things have changed since the 2008-09 financial crisis and more particularly since the end of
the commodity super-cycle. (Also see our latest Commodities Review report "One swallow
does not a summer make" for the latest commodity outlook and forecasts.) Macro indicators
during 2009-11 (2009 and 2010 being the sharp bust and bounce-back years and 2011 being
a relatively normal growth year) were worse than those in the boom years of 2004-08 on
average and growth deteriorated further and more seriously during 2012-14. In fact, as can be
seen in Chart 2, macro performance during 2009-11 was helped by the fiscal expansion and
bounce-back of commodity prices.
Growth and other macro indicators, however, came under more severe pressure in recent
years as commodity prices declined again. Non-fuel commodity prices were down -5.1%
between 2012 and 2014 (based on IMF WEO estimates), and prices of industrial inputs fell by
15 July 2015
Latam Themes
7.9% and the prices of metals by 10.5% while crude oil prices were down by 2.5% (a
significant development considering the average annual change since 1998 of over 17%).
Chart 2. Summary of Latam macro indicators, Latam currency and global commodity prices
1998-2003
2004-08
2009-11
2012-14*
GDP grow th (% pa)
1.7
4.8
3.5
2.3
CPI inflation (% pa)
8.1
4.9
4.6
4.7
Key Latam m acro indictors
Fiscal (% of GDP)*
-3.8
-1.1
-2.8
-3.1
Gross public debt (% of GDP)*
57.7
51.8
48.4
49.4
Current account (% of GDP)
-2.2
0.1
-1.3
-2.7
Gross savings (% of GDP)
16.8
20.9
20.1
18.9
Average change in com m odity prices

Non-Fuel (% pa)
-2.4
13.3
9.5
-5.1
Industrial Inputs (% pa)
-1.9
14.9
13.7
-7.9
Crude Oil (% pa)
11.2
27.9
7.7
-2.5
Metals (% pa)
-1.2
24.5
14.2
-10.5
Latam currency m ovem ent (negative m eans appreciation vs USD, %)

1997-03
2003-08
2008-11
2011-14
Since end 2013
ARSUSD
236.6
-6.4
26.2
64.0
38.1
BRLUSD
240.7
-49.7
-7.1
42.7
32.9
CLPUSD
69.7
-30.9
-6.4
12.7
18.6
COPUSD
185.0
-29.6
-5.6
1.4
32.0
MXNUSD
32.9
4.3
12.3
6.9
17.7
PENUSD
35.4
-14.8
-6.5
-0.2
12.8
* Not e: Values are f or Argent ina, Brazil, Chile, Colombia, M exico, Peru. Peru f iscal included f rom 2000.
Brazil and Peru gross debt included f rom 2000. Inf lat ion does not include Argent ina. IM F WEO and SG f orecast s.
Chart 3. Worsening macro indicators in Latam

Growth, LHS
Fiscal balance
%
8
Inflation, LHS
% of GDP
2
0
4
-1
-2
-3
0
-2
-4
2005
2007
2009
2011
2013
-5
Note: Weighted average for Argentina, Brazil, Chile, Colombia, Mexico and Peru. Inflation average excludes Argentina.
Source: IMF WEO, SG Cross Asset Research/Economics
Between 2012-14, Latam growth averaged 2.3% less than half the rate during 2004-08.
Inflation remains broadly unchanged (in fact it has started rising) and fiscal balance will be
close to the 2009-11 levels but considerably worse than in 2004-08. The current account
balance has deteriorated significantly. Finally, gross savings have slipped by close to 2.0%
15 July 2015
Latam Themes
since 2008 to 18.9% of GDP affecting the countrys domestic capability on capital formation
and in turn causing growth potential to suffer.
The cost of ignoring domestic growth channels

The dismal state of manufacturing
The commodity boom diverted attention from the falling share of manufacturing in GDP and
trade. The lack of manufacturing competiveness (Chinas emergence as a manufacturing
powerhouse in 2000s being a key reason) is now causing Latam countries to suffer in a world
that has seen low demand growth particularly after the 2008-09 financial crisis.
However, Mexico is proving to be an exception in this regard as the manufacturing share
remains high as a percentage of total exports in this country. Ironically, Mexicos high
dependence on manufacturing exports (primarily to the US) and its weak competitiveness
vis--vis China was one of the most crucial reasons for its sub-par trade growth
performance during the 2000s when the other countries in the region did well by exporting
commodities to the fast growing manufacturing hub China. The fact that Mexico remained a
manufacturing hub, nevertheless, should help it grow faster than the regional average in the
near future. Of course, there are many other reasons to this assumption that we discuss later
in the box on page 10. (See also the Anchor Theme #1 Growth Labour income and
consumption to drive recovery from our latest quarterly Global Economic Outlook report.)
Chart 4. Share of manufacturing either too low in Latam countries or contracted over the last
decade
Share of manufacturing in merchandise exports
% of total
90
80
Year 2000
70
Year 2013
60
50
40
30
20
10
0
Argentina
Brazil
Chile
Colombia
Mexico
Peru
Source: WTO, National sources, Datastream, SG Cross Asset Research/Economics
Domestic funding of investment is eroding

Low growth, and therefore lower income growth and lower fiscal balances have eroded gross
savings. Since 2010, the savings/GDP ratio in Latam has declined from 20.4% to 18.3% of
GDP. With the exception of Colombia, most country faces considerable funding challenges to
meet investment needs. This is most notable in Brazil, where savings have fallen to their
lowest level since record-keeping began (thanks to lower growth and higher inflation). In fact,
with Brazilian economy continuing to deteriorate in 2015, the savings-investment gap could
well be an enormous challenge to meet and would likely lead to further slide in investment
15 July 2015
Latam Themes
Despite a substantial fall

in
investment,
the
saving-investment gap
remains
alarmingly
growth that would perpetuate and deepen the stagflation. There is no escape from this
situation other than the policy or external demand-led big push.
Chart 5. Brazilian savings: a matter of serious concern
unstable in Brazil.
30
Gross national sav ings
% of GDP
50-country average
Chile
Brazil
Peru
Mexico
Argentina
Colombia
25
20
15
10
1990
1995
2000
2005
2010
Source: IMF WEO, SG Cross Asset Research/Economics, Note: 50 country average represents countries with highest GDP share in world.
Chart 6. Despite a substantial fall in investment, the savings-investment gap remains alarmingly
unstable in Brazil
% of GDP
Savings, 4Q MA
23
Investment, 4Q MA
21
19
17
15
Investment-saving gap too high in these periods
13
2001
2003
2005
2007
2009
2011
2013
2015
Source: IBGE, BCB, Datastream, SG Cross Asset Research/Economics
The dependency ratio for all Latam countries but Chile is expected to turn slightly better over
the next few years, adding a few basis points to trend growth. Brazil leads the pack as it has
the lowest dependency ratio and is still expected to improve on it in the near term. However, a
limited improvement in the participation rate could very well cancel out the advantages of a
declining dependency ratio.
15 July 2015
Latam Themes
Chart 7. Demographics remains Brazils critical advantage compared with regional peers
Population dependency ratio
58
56
2010
2015
2020
54
52
50
48
46
44
42
Argentina
Brazil
Chile
Colombia
Mexico
Peru
Source: UN population projections, SG Cross Asset Research/Economics
Chart 8. Drivers of potential growth in selected Latam countries

6.0%
Total factor productiv ity
Capital stock
Participation rate
Brazil
Working age population
Chile
Mexico
4.0%
2.0%
0.0%
-2.0%
Source: Feenstra, Robert C., Robert Inklaar and Marcel P. Timmer (2013), "The Next Generation of the Penn World Table" available for download at www.ggdc.net/pwt, Datastream, IMF WEO, UN
population division, National sources, SG Cross Asset Research/Economics
The wrong growth model: consumption vs investment

Domestically, in a number of Latam countries, growth over the past decade has been
consumption-oriented, supported by booming commodity prices. The industrial production
and investment growth have generally lagged consumption - (probably) one of the factors
leading to the surge in inflation despite low growth. The stable industrial production to retail
15 July 2015
Latam Themes
sales ratio in Mexico does explain, to some extent, the balanced consumption/investment
ratio and the stable inflation pattern there.
The
industrial
production
and the investment growth

have
generally
lagged
Chart 9. Supply-side is clearly struggling in Latam-ex-Mexico

2003 = 1.0
Ratio of industrial production to retail sales
1.1
consumption - (probably)
one of the factors leading to
1.0
the surge in inflation despite

low growth.
0.9
0.8
0.7
Brazil
Mexico
Chile
Colombia
0.6
0.5
2003
2005
2007
2009
2011
2013
2015
Source: National sources, Datastream, SG Cross Asset Research/Economics
Growth elasticity of commodity prices has declined

The IMFs world growth and commodity price forecasts suggest that growth elasticity of
commodity prices has declined substantially. Based on a simple model of commodity price
determination, we observe a considerable divergence between the IMF forecast of commodity
prices which is expected to fall on average over next 4-5 years and what the model
suggests given global growth forecasts.
Chart 10. Commodity prices could remain low even with moderately better global growth
prospects as supply-side dynamics are changing
World growth, LHS
Commodity prices + IMF forecasts
Commodity prices + model forecasts
%
6
%
40
IMF and model

forecasts
20
10
-10
-20
0
-1
30
-30
1993
1997
2001
2005
2009
2013
2017
-40
Source: IMG WEO, SG Cross Asset Research/Economics
The expected divergence (probably due to changes in supply-side dynamics) between world
growth and commodity prices implies that Latam cannot rely on commodity price
improvements, even in the wake of a recovery in the world growth. Given the likely path of the
commodity cycle, Latam growth will probably remain weak for several years unless positive
external and internal shocks add impetus to growth. Put simply, Latam must find and develop
15 July 2015
Latam Themes
domestic channels through structural reforms to raise its growth potential. Our estimate
shows that the decline in commodity prices has actually shaved off about one-third of Latams
growth potential. This, of course, does not take into account the indirect effects and other
structural and institutional factors that have also contributed to low growth in several countries
(for example in Argentina).
Chart 11. Commodity prices would shave-off one-third of Latam growth potential (= actual
average growth between 2003 and 2012)
Impac t of 10% pt fall in non- fuel
c ommodity pric e inflation vs 2003- 12
average of 9%
(t- statistic s)
Ac tual average growth

between 2003- 12
Argentina
2.50
2.4
7.2
Brazil
1.52
6.0
3.6
Chile
1.12
2.3
4.7
Colombia
1.46
3.8
4.8
Mexic o
0.75
1.1
2.7
Peru
1.90
4.1
6.5
Latam
1.23
4.4
3.6
Source: National sources, IMF WEO, SG Cross Asset Research/Economics
Low growth and BoP risk are pro-cyclical in Latam

Unlike most other countries, Latams external balances do not have a counter-cyclical
relationship with growth. In fact, growth depends a lot on the trade surplus and its impact on
the investment cycle (see discussion below). As a result, any deterioration in growth goes
hand-in-hand with balance-of-payment risk.
Chart 12. Pro-cyclical external balances: growth and current account balance falling together
%
% of GDP
1
Growth, LHS
-1
-2
-3
-2
2000
2002
2004
2006
2008
2010
2012
2014
-4
Note: Weighted average for Argentina, Brazil, Chile, Colombia, Mexico and Peru.
15 July 2015
Latam Themes
Export dependent investment cycle

Apart from the direct impact on growth and the current account, the commodity-led export
slowdown has also affected the investment cycle (likely not limited to the mining sector) and
this is potentially aggravating growth trends through employment and consumption channels
as well (as we find out in case of Brazil). Here again, the link between real export growth and
the investment cycle appears weaker at present for Mexico while it seems to have a direct and
proportional relationship in Brazil and Argentina. For the two mining-dependent countries
Chile and Peru the relationship is direct and more than proportional, implying a greater
investment decline in the event of a contraction in exports. While Colombian investment
growth has remained strong until now, we suspect that it has peaked and might follow a
weaker trajectory now, as suggested by export growth (Q3 14 being an exceptional quarter).
Chart 13a. Weaker investment growth in Brazil, Argentina, Chile and Peru in response to falling exports
40
% yoy
Argentina: real GFCF
40
Argentina: real exports
30
20
10
0
-10
-20
-30
2001
2003
2005
2007
2009
2011
2013
2015
% yoy
Brazil: real GFCF
40
Brazil: real exports
30
30
20
20
10
10
-10
-10
-20
2001
2003
2005
2007
2009
2011
2013
2015
% yoy
Chile: real GFCF

Chile: real exports
-20
2001
2003
2005
2007
2009
2011
2013
Chart 13b. Gross fixed capital formation appears stronger in Mexico, while it may have peaked in Colombia
40
% yoy
Colombia: real GFCF
30
Colombia: real exports
30
% yoy
40
Mexico: real GFCF

Mexico: real exports
20
20
Peru: real GFCF

Peru: real exports
30
20
10
10
10
0
-10
-10
-20
2001
% yoy
2003
2005
2007
2009
2011
2013
-20
2001
-10
2003
2005
2007
2009
2011
2013
-20
2001
2003
2005
2007
2009
2011
2013
2015
Mexico remains best placed among regional peers

Mexicos limited reliance on commodity exports and the high share of manufacturing in its
GDP and exports make it less vulnerable to low commodity prices over longer run
(notwithstanding the recent re-pricing of MXN post the sharp fall in oil prices amid concerns
about beginning of the Fed tightening cycle). Moreover, unlike other Latam countries,
Mexicos overdependence on the US (which is the market for approximately 80% of total
Mexican exports) may in fact be a blessing in disguise this time around. Finally, recent reforms
(see the box below) could improve the countrys growth potential substantially over the next
few years. Trade and growth will help improve other macro indicators too, making Mexico the
most attractive investment destination in the region.
15 July 2015
Latam Themes
Box 1
Mexican reforms
Potential growth to rise by 0.9%-1.4%
Over the past couple of years the Mexican Congress has passed reform legislations in several areas including energy, banking,
telecom and broadcasting, fiscal, anti-monopoly, education and political. Some of these reforms will have immediate
implications on growth while others will affect the economy over the longer run.
We estimate that these structural reforms could eventually lift Mexicos growth potential by 0.7% to 1.1% over the next 2-4
years (from the current level of between 2.4% to 2.7%) via supply-side impacts on the mining sector and demand-side
impacts on consumption and investment. Growth potential should improve another 0.2% to 0.3% later this decade and early
next thanks to improved productivity. (Also see the potential growth estimates, explanatory factors and discussion in the
Global Economic Outlook.)
The indirect impact of these reforms should generate higher employment growth (leading to higher income and consumption
growth), a better fiscal trajectory, lower inflation and eventually lower interest rates in Mexico.
Box Table: Recent reforms in Mexico
Sector
Reforms
Implications
Energy
Ends monopoly of state oil company PEMEX and

the Federal Electricity Commission, CFE. Allows
foreign investment in these areas. Regulatory
oversight to be strengthened.
Foreign investment to rise. To raise

potential growth by 0.2-0.3% point. To
improve employment growth as well.
Banking and
finance
Banking sector competitiveness and efficiency

improves. Improves contract enforcement and
investor's protection.
To double the credit/GDP ratio in about

a decade. To lift potential growth by 0.40.6%.
Telecom &
broadcasting
services
Aims to raise consumption and competition. To

reduce burden on consumers.
Could improve potential growth between

0.1-0.2% pt by raising consumption.
Existing larger firms will be affected.
Aims to raise taxes (income, dividend,

consumption, mining) and spending.
Implications ambiguous over longer-run

- both on growth and fiscal. Presents a
short-term downside risk.
Anti-monopoly
Education
Creates new regulators. Tougher laws.

To improve teaching quality. Greater supervision.
Long-term implications on growth and

productivity
Improves productivity in longer-run.
Political
Allows re-election of members of Congress and

more federal oversight of local elections.
Brings greater stability in the political

system and policy framework.
Taxes
Overall impact: to improve growth potential by 0.9% to 1.4% by end of this decade. Should help reduce fiscal
burden, inflation and interest rates.
Source: National sources, SG Cross Asset Research/Economics
Impact on Latam assets: US monetary tightening cycle and beyond

In an environment of low commodity prices, overreliance on external sources to meet current
account challenges and investment needs will keep Latam currencies weaker than otherwise
would have been the case over the medium to longer term (and beyond the near term
pressure due to the impending US monetary tightening cycle). Structural reforms, a strong
manufacturing base and US growth will eventually help Mexico notwithstanding the recent
depreciation of the Mexican peso and pressure on it in the near term. Among other countries,
Peru continues to enjoy a high level of foreign reserves to GDP ratio that has, so far,
benefitted the Peruvian nuevo sol (PEN) in relative terms. While the Argentine peso (ARS) is
the worst affected currency (mostly due to its own reason rather due to lower commodity
prices led slowdown), the Brazilian real (BRL) is heading for its worst time in more than a
15 July 2015
10
Latam Themes
decade. The Chilean peso (CLP) has depreciated more than 30% since 2012 amid dwindling
growth and a wide current account deficit. Finally, there remains significant pressure on the
currencies of even better managed economies like Colombia in the medium term (as seen in
the recent pressure on the Colombian peso). (Also see our Cross Asset Strategy report "The
global implications of lower oil prices.")
Chart 14. Peru has the highest official foreign exchange reserves to GDP ratio in Latam
% of GDP
35
Argentina
Brazil
Chile
Colombia
Mexico
Peru
30
25
20
15
10
5
2000
2002
2004
2006
2008
2010
2012
2014
Chart 15. MXN remains top performing Latam currency since 2012 despite recent sell-off, BRL
in red mark
Latam currency m ovement vs USD
Jan-12 = 1.0
BRL
1.2
CLP
COP
MXN
PEN
1.1
1.0
0.9
0.8
0.7
0.6
0.5
Jan-12
Jul-12
Jan-13
Jul-13
Jan-14
Jul-14
Jan-15
Jul-15
Source: Datastream, National sources, SG Cross Asset Research/Economics
Monetary policy in an era of lower commodity prices

The world has changed dramatically for Latam
The Feds monetary tightening in 2004-06 had little effect on Latam policy rates as the bulk of
Latam policy changes then can be explained by domestic inflation and growth concerns.
Moreover, there is little evidence to show that Latam currencies suffered during the last Fed
tightening cycle and hence it can be argued that Latam inflation at that time was
predominantly domestic.
Part of the above still holds true for 2015 when the Fed begins monetary tightening as
expected by our US economists. However, this time is different. Lower commodity prices
have dented Latam macro fundamentals severely in some cases and are exerting extreme
15 July 2015
11
Latam Themes
pressure on Latam assets. Under this scenario, there appears to be some upside risk to
Latam policy rates from the impending start of a Fed tightening cycle. This may or may not
result in excessive tightening in Brazil and Colombia, early tightening in Mexico, and no further
easing in Chile and Peru. However, as pressure on currency is being felt in these countries,
there could be a significantly stronger upward bias on monetary policy rates compared with
last Fed tightening cycle. (See also the Anchor theme #3 Monetary Policy Uneven real
policy impact from the Global Economic Outlook report for more discussion.)
Chart 16. Inflation not a problem in Latam-ex-Brazil, but has
risen in most of them ex-Mexico over past couple of years
Brazil
Colombia
% y oy
10
Mexico
Peru
Chile
Chart 17. Significantly stronger upward bias on monetary

policy rates given the low growth environment
16
Brazil
Colombia
Mexico
Peru
Chile
14
12
10
-2
-4
2004
2006
2008
2010
2012
0
2006
2014
2008
2010
2012
2014
Source: Datastream, National sources, SG Cross Asset Research/Economics
Conclusion: No defense against a commodity-led slowdown
The commodity price deceleration is affecting the macro economy severely. Except
for Mexico, most Latam countries are predominantly commodity exporters and are
facing deteriorating macro conditions due to lower commodity prices.
Domestic sources of growth have diminished. The falling share of manufacturing in

GDP and the erosion of domestic investment-funding sources (savings) have exposed
Latams overreliance on commodity demand and prices. (See also the Anchor Theme
#1 Growth Labour income and consumption to drive recovery from our latest
quarterly Global Economic Outlook report.)
Reforms matter, but cant entirely negate the impact of commodity. Notwithstanding
the recent sell-off in currency market, countries having proximity with the US or those
implementing credible reforms will eventually have better macro prospects. However,
Latam countries are still worse off on average with or without reforms.
Latam assets face long term challenges. Low commodity price environment and
resulting deterioration of macro indicators will keep Latam currencies weaker than
otherwise over the medium to longer term, notwithstanding the near-term impact of the
impending start of US monetary tightening.
Rising upside risk of tighter monetary policy. The impending start of a Fed tightening
cycle could lead to an upward bias to monetary policy rates compared with the last Fed
tightening cycle in 2004-06. (See also the Anchor theme #3 Monetary Policy Uneven
real policy impact from the Global Economic Outlook report for more discussion.)
15 July 2015
12
Have your cake and eat it

Democracy, it turns out, is good for growth after all
Jun 27th 2015 | From the print edition
Chinas blistering economic performance in recent years has brought advocates of democracy out in hives. GDP growth in
the one-party state, at an average of 10% over the past decade, has easily outpaced that of its democratic emergingmarket rivals. India saw annual growth of 6% over the same period; Brazil, just 2%. Some say that democracy is to blame
for Indias and Brazils slower progress. Politicians in such places cannot lay the foundations for long-term growth, the
argument goes, since voters want instant gratification. Are freedom and prosperity really at odds?
The idea is not new. In 1994 Torsten Persson of Stockholm University and Guido Tabellini, then of the University of
Brescia, published a paper that argued that in democracies, vote-hungry politicians divert resources away from people
who could use them more efficiently by lavishing spending on their constituents in the form of unemployment benefits and
pensions. This and political gridlock, another unfortunate aspect of democracy, both tend to slow growth. Another paper
published in 1994, by Robert Barro of Harvard University, analysed data from some 100 countries before concluding that
the effect of democracy on growth is weakly negative.
Democracys economic denigrators have not had it all their own way, however. In a paper published in 2008 Daron
Acemoglu of the Massachusetts Institute of Technology argued that in non-democracies, well-connected firms use
political power to shut out competition. Ukraine, an oligarchy, has a backward economy partly because investors have
typically been barred from large parts of the economy, such as the gas sector. That is not the only problem with
repressive regimes. When people have no political power, the risk of conflict rises: think, for example, of the protests in
Hong Kong last year. That may scare away investors. Autocracies also tend to skimp on schools and health care, which
pushes down on the productive potential of the economy.
Mr Acemoglu, along with three colleagues, has now come back to the question in a new paper. It notes that comparing
the economic impact of different political systems is tricky. The average free country, according to a classification by
Freedom House, an advocacy group, has a GDP per person of $17,000, four times that of the average unfree or partly
free country. That could be seen as an indicator in itself, but it also presents a problem. Economists have long reasoned
that poor countries should grow faster than rich ones, since they can boost growth dramatically with simple investments in
schools and roads, whereas rich nations have exhausted such easy gains. Given that authoritarian countries are poorer
than democracies, they should also grow faster. Add in all manner of economic and cultural differences, and disentangling
the effect of democracy itself is tough.
The paper also identifies another methodological problem. In the years leading up to a change in the political regimeie,
when a country goes from being an autocracy to a democracy (or vice versa)GDP growth stumbles. Small wonder: such
transitions often involve mass protests or violent coups. Alternatively, a flailing economy may itself make a change of
regime more likely. Researchers, though, have typically failed to account for the volatile behaviour of GDP in response to
such events.
Autocracies 1, democracies 1.2
The authors look at data for 175 countries from 1960 to 2010 and assess their degree of democracy based on an index
that measures things like free elections and checks on executive power. They then compare growth rates and political
freedom, having made adjustments for the odd behaviour of GDP during transitions and for the relative poverty of unfree
countries, among other distortions. They find that a permanent democratisationwhere there is no slide back into
autocracyleads to an increase in GDP per person of about 20% in the subsequent 25 years. When a given country is in
such a democratic state, it grows faster than when it is not (see chart). The authors reckon that higher investment in
schooling and health care and lower social unrest are the reason. There is also no clear evidence to suggest that poor
countries benefit less from democratisation, as many had assumed.
By now, sceptics will have spotted a problem. Some factors may help a country both to become more democratic and to
grow faster. Take South Koreas transition to democracy in 1988. In the subsequent five years its income per person grew
at an average annual rate of 6%. That makes political freedom look like an economic boon, but it is not so simple. In the
years leading up to the transition, university attendance grew rapidly. As the number of educated Koreans rose, calls for
democracy got louder. Yet better education may also have led to stronger economic growth in itself. That makes it hard to
tell whether democratisation causes growth, or growth causes democratisation.
To help solve this problem, the authors need a clean variable, one that runs from political system to economic outcome,
not the other way round. Their answer lies in the fact that democratisation in one country tends to make it likelier in a
nearby country, too. Tunisias revolution in 2010 was partly responsible for Egypts, for example, which soon followed.
Crucially, however, Tunisian politics had little effect on Egypts growth rate. That, the authors say, means the
democratisation of nearby countries can be used as a proxy for the democratisation of the country itself. This approach
yields similar results: democracies fuel growth.
Not everyone will be convinced. Historians will protest that trying to compress the infinite variety of global politics into a
few variables is a hopeless task. Each democracy and autocracy operates in a different way, after all. Democracy
advocates may not even get that excited: few fling themselves into the cause of self-determination in order to boost GDP.
But freedom and growth make for a pretty unbeatable combination.
How to preserve a startup culture as a company grows

by Adrienne Sanders | Jul 22, 2015
The intense atmosphere at startups can make conflicts difficult to resolve
Buzzing about which new startups will prosper and which will flop is a favorite pastime in Silicon Valley. But a new
companys prospects arent based on just what the company creates, says Stanford professor Lindred Greer. Theyre also
based on the people creating it and, more important, how they treat one another. Startup success is as much about
managing the people as it is about creating the product, says Greer, an organizational behavior professor at Stanford
Graduate School of Business.
Be Aware of Culture in Early Stage Startups
The culture of early stage startups forms the backbone of the culture the company will have in later years. Therefore,
paying attention early on to the type of culture you want to create is critical. One aspect of startup culture, Greer notes, is
the emphasis the founders put on equality. While egalitarian cultures can motivate workers and encourage a free flow of
ideas, they are often hard to maintain when companies scale and managers have to make hard decisions that go against
the grain of the egalitarian ethos. The first time someone has to be fired, the culture of equality may be shattered, Greer
says.
In order to preserve this culture as they grow, startups must find ways early on to balance the need to motivate workers
and give them a voice with competing organizational needs for structure and hierarchy, she says. To illustrate this point,
Greer offers an analogy about the fateful day a child discovers that Santa Claus is not real. There is no changing that
reality. But, says Greer, a parent has a choice between saying Tough luck Santa doesnt exist and Im sorry the man
in the red suit doesnt exist, but the holiday spirit does. Likewise, a founder can say, Tough luck. I can fire whomever I
want. Or, she can find a more respectful way to communicate this to the remaining employees and preserve the spirit of
equality while maintaining her position at the top of the organizational hierarchy.
Keep It Professional
Resolving conflicts at startups can be more difficult than at other types of companies, Greer says, because founding
members are often friends. Conflicts may be more personal and intense. Likewise, it may be difficult to keep
communication and interpersonal dynamics focused solely on work-related matters. Greer recommends that startup
teams designate a time and place in the office where people can talk through work issues in a professional frame of mind,
consciously choosing to set aside personal bonds.
Stay Humble
Founders who maintain a humble management style and share credit for successes will empower others. If you ask for
voice and opinions, show that you actually do something with it, Greer says. A founder who blindly pursues his vision
without feedback from others can lead the company into disaster.
Ice Cream Helps
Leaders who actively value team contributions tend to make themselves easily accessible to their subordinates. For
example, Greer interviewed one CEO who created a self-serve ice cream area at his company to promote more frequent
and spontaneous communication between management and employees.
Avoid Overlapping Skill Sets
Entrepreneurs often form companies with friends or classmates with whom they share interests, skills and personality
traits. But ignoring the need for true complementarity is the number one mistake startups make, at least in the early
phases, Greer says. Maintaining a high-performing startup is possible only when teams have complementary skill sets
without much overlap. If everyone is, say, a finance expert, who will run operations?
Provide Clarity
Ideally, each member of the team brings his or her own unique and needed contribution to the success of the enterprise,
but managers also need to provide guidance to teams. To avoid unnecessary confusion and competition, leaders should
clearly delineate who is responsible for which tasks.
Greer is testing this concept at the Atlanta Tech Village, a startup incubator in Georgias capital. Working with a group of
several founding startup teams, she advised half to clearly identify each members unique specific role in a forthcoming
task. Then she asked all the groups to build towers using marshmallows and sticks of spaghetti. The teams that received
an intervention about establishing clear roles, she discovered, built more stable towers. She is now tracking the groups
actual business performance over the next two months to see if it reflects the same results.
Ask Outsiders for Help
Company founders who surround themselves with a team of experts will help ensure there is a culture of respect for
employees. Doing so sheds light on how companies such as Apple and Google have succeeded despite more autocraticleaning founders. Those people were counterbalanced by very strong peers at the management team level that
complemented their personalities and helped them lead more effectively.

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Emerging Markets Research

Asia Themes: India

Assembling the building blocks

Railways, highways, ports and urban infrastructure projects are likely to be

The government is targeting 24x7 power availability across the country by

The highways construction programme could see additional spending of INR2trn

Barclays | Asia Themes: India

INFRASTRUCTURE AND GROWTH

Urban infrastructure projects

Potential increase in value added

Value added (INR bn)

Potential scenario (100%)

Potential scenario (75% realisation)

Value added (% of nominal GDP)

Potential scenario (100%)

Potential scenario (75% realisation)

Source: CEIC, Barclays Research

Barclays | Asia Themes: India

Additional spending could raise GDP growth rate to 10%

Critical infrastructure spending

GCF: Mining, power & transport (% of GDP)

Delhi Mumbai Industrial

Real GDP (%)

Status quo baseline

Status quo baseline

Potential scenario (75%)

Source: CEIC, Barclays Research

Barclays | Asia Themes: India

URBANISATION AND SMART CITIES

Cities in India are growing

Indias urbanisation has increased, but development has been uneven

Source: McKinsey Global Institute (2012), Ministry of Urban Development

1950-51 - 1970-71 - 1980-81 - 1990-91 - 2000-01 1970-71

Barclays | Asia Themes: India

Smart cities From policy to action

Several greenfield cities are

Naya Raipur A smart city in the making since 2008

DMIC itself will have 7 urban

Kochi smart city

Source: Various media sources, MoUD, Barclays Research

Source: Various media sources, MoUD, Barclays Research

Barclays | Asia Themes: India

Electricity sector powering up

Power capacity (%, CAGR)

GSDP (% growth between FY06-FY15)

Government is targeting 24x7

Power capacity addition is

Source: CEIC, Barclays Research

Barclays | Asia Themes: India

Coal linkages Coal India sets a one billion target

Tori- Shivpur Kathuthia

Remarks / Our expectations

Nearly 35% land acquisition is complete, and construction work has

June 2016 for single line & Dec

First phase of the project will be

The land acquisition process is ongoing, and execution SPVs have

Source: Coal India, Barclays Equity Research

Critical rail linkages could

Barclays equity research estimates

CE is Company estimates; Source: Coal India, Barclays Equity Research

IP: Coal (% y/y)

IP: Coal (% y/y, 3mma)

Source: Haver Analytics, Barclays Research