India Macro Quarterly

Return of Global Uncertainty A sense of dj vu
INDIA MACRO QUARTERLY

October 2011
11 October, 2011
Contents
Fears of recession weigh on financial markets Greece: More pain in the offing Resolution to Euro troubles: Painfully slow Central Bank Policy: Options limited?
Page No.
Global: Return of uncertainty...5
India: Growth to hover around trend..8

Domestic consumption: Slowing but India looking inward for growth? Exports: Vulnerability to mount Services: To remain largely resilient
Structural factors keep inflation sticky......11

Headline Inflation close to double digits: 19 months and counting FDI in retail: Still waiting in the wings Core inflation momentum decelerates: The sole silver lining
India caught in a wage-price spiral?...13

Rural wages: Powering the consumption story Urban wage increases: Not far behind Breaking the back of wage-price spiral
Fiscal slippage unavoidable in FY12......17

Expenditure remains strong while revenue continue to disappoint Disinvestment target hinges on market sentiment Expectation on fiscal slippage for FY12
RBI to infuse primary liquidity through OMOs......20

Domestic asset growth will be key for balance sheet expansion Liquidity deficit to deteriorate in H2 FY12
External risks contained....22

BoP risks manageable FX cover to compensate for a mild deterioration in external debt
Bonds to suffer in the short term from additional market borrowing ...24
Supply pressure strikes early Outlook
Global factors back on INR radar...27

Why does Dollar movement become important? What about RBI intervention? Outlook
Vulnerabilities and policy space in case of stress....30

Impact on external sector, growth, and inflation Policy response
Annexure......33 Key Macro Numbers and Forecasts.........34
YES ECOLOGUE
11 October, 2011
Global: Return of uncertainty

Global economy at present is at the brink of tipping back into a recession Speed and scale of turmoil in financial markets reminiscent of the period post Lehman collapse Real economic growth has evidently slowed down in advanced economies, with a likelihood of a soft landing in EMEs Despite desperate attempts to rescue Greece, a credible solution still remains out of sight With interest rates close to zero and high level of debt, advanced economys central banks are running out of policy options to spur economic growth Three years since the global financial crisis, the world economy is at the brink of tipping back into a recession. Events in the last two months, on both sides of the Atlantic, have belied expectations of optimists, who at the start of the year were hopeful of economic recovery that began in 2010 to gain further momentum in 2011. The event that triggered a turnaround in sentiment was the unprecedented downgrade of USs AAA credit rating by one notch to AA+ by Standard & Poors in August. The prolonged political drama which culminated in US debt limit being raised at the eleventh hour came without a credible long term plan of debt reduction and hence justified the sovereign downgrade. A visible slowdown in the US as the debt drama unfolded coincided with growing fears of a Greek default amidst renewed stress in other Euro zone peripheral economies. As the very sanctity of the Euro monetary union began to be questioned with an intensification of debate on a solution for Greece, the speed and the scale of turmoil in financial markets as confidence eroded, offered market players a sense of dj-vu, as many drew parallels with the period following the collapse of Lehman Brothers in 2008. Fears of recession weigh on financial markets Erosion in investor confidence has led to a sharp selloff in all asset classes Dented investor sentiment due to renewed jitters in the Euro zone over debt sustainability has led to a sharp correction in financial markets in the last two months. A sharp correction across all asset classes pervaded, as a loss in confidence triggered huge sell offs. Commodity prices declined as concerns over strength of demand gathered pace. Crude oil (Brent) has corrected by 8% since early August declining briefly below USD 100 per barrel recently, the level last seen earlier this year in February. Correction in metal prices has led copper and aluminium prices on LME flirting close to one year lows. High beta currencies too have taken a beating. Mimicking the sharp depreciation in Rupee (close to 6% in September), Asian currencies in September recorded their biggest monthly correction since the Asian financial crisis in 1997. Euro is trading close to a nine
Chart2: CDS soar to record high, as risky assets are battered
1600 1400 1200 1000 800 600 400
Germany
Global economy at the brink of tipping back into a recession
Downgrade of US sovereign credit rating followed by fears of a Greek default
led to sharp volatility in financial markets
Commodity prices have corrected; Brent crude briefly falling below USD 100 pb
Chart1: Significant exposure to Greece, heightens banking sector risks in Euro zone
Banks Exposure to Greece (USD bn) Austria Italy Netherlands US Portugal UK
(bps)
PIIGS 5Y CDS PIIGS 5Y govt bond spread with Germany
200
Jan-11 Sep-10 Nov-10 Jul-11 Mar-11 May-11 Sep-11
France 0 10 20 30 40 50 60
Source: Thomson Reuters, YES BANK Limited
Source: Bloomberg, YES BANK Limited
YES ECOLOGUE
11 October, 2011

Equity markets lose significant value. month low against the USD and an all time low against the Yen. Since August beginning, DJIA has declined close to 6%. Nikkei, DAX and Sensex have pared a much greater 12%, 9% and 10% of their respective values. This has been accompanied by a surge in Credit Default Swaps (CDS), with 5 year CDS on Germany doubling since beginning of the year, to touch a record high of 118 bps on 3rd October, 2011. Recently, with US funds shutting off lending to European banks to limit their exposure to European sovereign debt, ECB announced a Dollar based liquidity operation in unison with other major central banks, to offer unlimited amounts of USD liquidity operations to European Banks. The move was triggered by heightened banking concerns in the region reflected in a sharp plunge in European banking stocks and 3 month Euribor rate soaring to 1.61% in early August, the highest level since Mar-09. Additionally, the Markit iTraxx senior financial index which expresses the cost of insuring the debt of 25 European banks and insurers, slumped accompanied by CDS of several European banks topping post Lehman record highs. Real economic growth softens visibly Real economy growth indicators had begun to show a synchronized softness globally since Q2 2011 (see chart3), facing headwinds from elevated commodity prices, slowdown in consumption and ripple effect of regional economic weakness in one market spilling over to the other. The ongoing stress in the financial markets and unfavorable effects on financing conditions are likely to further dampen the pace of economic growth. GDP growth in US dropped to a seven quarter low of 0.4% in Q1 2011 and continued to remain depressed in Q2, expanding at a mere 1.3%. GDP in Euro zone stalled in Q2 2011, expanding by a tepid 0.2%, led by a sharp dip in Germanys growth. PMI for both manufacturing and services sector too have plunged, dipping in contraction phase in several economies, as new businesses dry up. PMI for EZ and UK display a loss of manufacturing momentum, with that of US, China, India dropping to multi-month lows, edging precariously close to threshold level of 50 (see chart4). Services too have followed suit, with PMI services for UK, US and EZ expanding at a weak pace. A sharp drop in services PMI in China and India, where services account for close to 45% and 60% of the GDP respectively, reinforces the likelihood of soft landing in EMEs. Sign of a moderation in growth in other ASEAN economies is visible from dampened export demand in Singapore, China, Thailand and Taiwan. Greece: More pain in the offing As Greece continues to grapple with limited cash reserves, the survival of the nation now hinges on the next tranche of aid. In an attempt to secure the
Chart4: PMI trend lower in several economies
65
Germany EZ
while, CDS spreads surge to record highs
Heightened banking concerns in EZ, force ECB to set up Dollar swap lines
Growth in Q2 2011 indicates a synchronized global weakness
mayhem in financial market runs the risk of further slowing economic growth
PMI, both manufacturing and services, have plunged in several economies
Greeces survival hinges on next tranche of aid
Chart3: Synchronized softness in global GDP

4 3 2 1 0 Global GDP Growth (%YoY) US UK Japan
PMI Manufacturing
60 55 50 45 40 35 China US ISM India UK EZ
-1
Sep-10 Jun-10 Mar-10 Dec-10 Mar-11 Jun-11
30
Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Sep-08 Nov-08 Sep-09 Nov-09 Sep-10 May-08 May-09 May-10 Nov-10 May-11 Mar-08 Mar-09 Mar-10 Mar-11 Jul-11
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11 October, 2011

continued backing of international creditors (i.e Troika) and in a bid to keep itself solvent, the Greek government recently approved USD 8.8 bn of austerity measures including taxes on lower incomes, firing of state workers, wage cuts and reduction in pensions. Through the austerity measures, Greece attempts to secure the sixth tranche of bailout loan of EUR 8 bn from the EUR 109 bn bailout package agreed by EU leaders on July 21, 2011. Despite the ambitious deficit reduction programme, Greek government announced that it would only be able to reduce its fiscal deficit to 6.8% of GDP in 2011, falling short of the 6.5% target previously drawn upon by the Troika. As late as October 4, 2011 EU finance ministers agreed to delay Greeces receipt of aid till it enforced stricter measures and decided to review the involvement of private sector in the bailout, which had earlier agreed to a 21% write down on their holding in Greek debt. It seems that Greece will perhaps have to wait longer for the next installment of aid to flow, while it embraces more austerity measures and proves its credibility to cut deficit further. Resolution to euro troubles: Painfully slow To resolve the Greek crisis and minimize the impact of a potential Greek default on banks, the EU commission has recommended a coordinated capital injection to European banks. Trichet, ECB governor, made a call to all European banks and supervisors recently to do what all is necessary to address the need for capitalization. This is perhaps a signal of more action to come on the part of the European policy makers to step up aid to banks and push private investors to accept bigger losses on Greek bond holdings. While there is clear skepticism among market participants over the size of the EFSF at EUR 440-billion being sufficient to bailout the region, the recent vote by several European parliaments (including heavy weight Germany) to expand powers of EFSF (to enable ECB to buy bonds in secondary market and recapitalize banks) was well received by the markets. German Chancellor Angela Merkel recently indicated that the use of the Fund should be limited as the last line of resort to defend the Euro. However, it remains to be seen how the logjam in Euro zone politics pans out to curtail the regions growing debt crisis amidst populist anger and turbulence in financial markets. Central bank policy: Options limited? With monetary policy stuck in a Keynesian liquidity trap With a recession like scenario unfolding, Central Banks globally have returned yet again to a crisis fighting mode to support economic growth and stabilize financial markets. Three years since the Lehman collapse, monetary policy in advanced economies is now caught in the classic Keynesian liquidity trap, as interest rates close to zero leave limited or no room for further cuts to spur growth. On the fiscal front, stimulus programs in the aftermath of the global meltdown have left behind a legacy of unsustainable debt levels on both sides of the Atlantic. On 6th October, 2011 the ECB announced that it would reintroduce purchase of covered bonds and provide yearlong loans for banks to support liquidity in markets. The BoE, on the same day, boosted its asset purchase program by GBP 75 bn, to GBP 275 bn to avert a recession in the economy. Both central banks have resorted to deploying old policy tools. The policy decisions follow the Federal Reserves Operation Twist announced last month, which aims to replace USD 400 bn of short term securities by long term securities in a move to reduce borrowing costs further and lower unemployment. With global growth momentum under threat, additional easing in the form of Fed announcing a QE-3 and ECB cutting rates cannot be ruled out, but clearly, central bankers are rapidly running out of policy options to spur economic growth.
Despite the ambitious austerity measures, reduction in fiscal deficit challenging for Greece
Policy makers urge Recapitalization of European banks
as EFSF, largely insufficient if crisis spreads to other economies
It remains to be seen how logjam in EZ politics pans out to curtail the crisis
coupled with mounting levels of debt on the fiscal side
central banks are running out of policy options to stir economic growth
YES ECOLOGUE
11 October, 2011
India: Growth to hover around trend

Domestic private consumption displays nascent signs of moderation; but to remain supportive Investment climate remains weak; urgent need to hasten reform process to spur investment activity Export growth likely to ease in H2 FY12 Strength in agriculture and services sector to limit the downside in FY12 GDP growth We lower our GDP growth forecast to 7.7% from 7.9% earlier as we envisage a sharper slowdown in industrial growth than perceived earlier In a quarter since our last update (A Mid-Cycle Correction within Strong Secular Growth Story, 20-May-11), in which we focused on a deliberated growth-inflation tradeoff being embraced by the RBI, the Indian economy has begun to display incipient signs of moderation in growth albeit in pockets. However despite RBI hiking policy rate 12 times since March 2010, inflation continues to remain elevated with a strong likelihood of headline printing above 9% even in the next 2-3 months. More so, the situation in the global markets has been least supportive at a time when domestic policy challenges have surmounted. The vulnerable global economy has the potential to translate into not only a weaker export growth for India, but also impair critical investment inflows necessary to put the country on a higher growth trajectory. While private consumption remians key for domestic growth, we believe that it is time that India overthrows its complacency over consumption auto-driving the economy. Much needed policy reforms to stir deferred investments into action and to alleviate supply bottlenecks are required, to ensure that an eclectic mix of investment and consumption drives growth. Domestic consumption: Slowing but India looking inward for growth? Consumption growth has begun to show signs of easing With domestic consumption accounting for close to 70% of GDP, India enjoys the comfort of looking inward for driver of economic growth. As pointed out in a section later (see India Caught In a Wage-Price Spiral?) strong rural demand buoyed by steep wage increases has kept consumption demand ticking with no symptom of a marked slowdown despite RBI hiking rates aggressively in the last year and a half. In our last quarterly report, we had pointed out the likelihood of consumption slowing down in FY12 due to re-pricing of credit at retail level aligning with the policy stance of the RBI. The incipient signs of this moderation were evident in the latest GDP figures for Q1 FY12 as private consumption growth decelerated to 6.3%, compared to FY11 growth of 8.6% (see chart5). Other high frequency variables also point to a moderation in consumer demand. On a trend basis, (12 month moving average) IIP consumer durable goods indicate a clear downturn. In addition, sale of passenger cars has plunged since the beginning of the fiscal year (see chart6). Deployment of bank credit to personal loans on an incremental basis has also slowed in FY12. While we expect
Chart6: as reflected in automobile sales
40 35 30 25 20 15 10 5 0 -5
Jul-10 Jan-11 Feb-11 Apr-10 Aug-10 Sep-10 Nov-10 May-10 Mar-11 Apr-11 Dec-10 May-11 Jun-10 Oct-10 Jun-11 Jul-11
While growth has begun to display incipient signs of moderation
inflation continues to remain elevated, despite RBI hiking rates 12 times since March 2010
Car sales plunge; credit to personal loans on incremental basis lower
Chart5: Private consumption indicates nascent signs of moderation

12 11 10 9 8 7 6
Dec-07 Dec-10 Dec-06 Dec-08 Dec-09 Jun-07 Jun-08 Jun-10 Jun-11 Jun-06 Jun-09
Private Consumption (% YoY) IIP Consumer Goods (% YoY, RHS)
30 25 20 15 10 5 0 -5 -10 -15
Auto sales
Personal Vehicle Sales (3mma, %YoY) 3 Wheeler Sales (3mma, %YoY) 2 Wheeler Sales (3mma, %YoY)
Source: CEIC, YES BANK Limited

8

YES ECOLOGUE
11 October, 2011

however, slowdown confined to urban consumption consumption to moderate further, the impact of past policy action is likely to remain limited to only urban consumption. Investment sentiment weak; warrants need for hastening reforms The investment climate in the economy has been adversely affected due to elevated level of commodity prices, policy inertia and rise in cost of financing. The average gross fixed capital formation growth has declined to 5.4% in the last three quarters compared to 15% in the preceding three quarters. Growth in proposed industrial investment is currently hovering close to a two year low (see chart7) For sustainability of growth, acceleration in investments is imperative. With a majority of key bills and policy reforms still waiting in the wings, investment decisions have been deferred. Fast tracking of reforms will facilitate in attracting greater private and foreign investment. Exports: Vulnerability to mount With global growth entering a soft patch - a visible slowdown in US and EZ grappling to avert a sovereign default, vulnerabilities to Indias export growth have mounted. Since the beginning of FY12, exports on a monthly basis have averaged close to USD 27 bn compared to USD 20 bn in the previous fiscal year, clocking a spectacular growth rate of over 50% on a YoY basis. Indian exports have bucked the recent trend of a slowdown in its Asian peers (see chart8). Yearly export growth in Taiwan and Singapore almost grounded to a halt in the month of August. Exports of these two economies serve as a bell-weather for Indian exports as witnessed in the recovery post Lehman crisis. The latest reading for Indian exports (for August) show incipient signs of cooling off; tracking though belatedly the slowdown in other Asian economies. Going forward, amidst an easing demand in domestic economy coupled with the end of DEPB benefits and a high base effect kicking in December onwards, the pace of growth of Indian exports is likely to witness a correction. Government spending: To offer limited support Government spending is likely to offer limited support in FY12. The Union Budget FY12 made a provision for a meager 3.4% growth in total expenditure compared to 18.7% in FY11. With FY12 being the final year of the current five year plan period, growth in plan expenditure is expected to be at 11.8%. The burden of adjustment hence has fallen on non-plan expenditure, which is expected to contract for the first time in the last thirteen years by 0.7%. However, due to an under-budgeting of the subsidy burden, we expect actual expenditure of the government to be higher than that budgeted.
Growth in proposed industrial investment at a 2 year low
warrants the urgent need to hasten reform process
India has bucked the trend of a slowdown in Asian export growth.
slowdown in global growth, easing domestic demand and withdrawal of DEPB to weigh on exports, going forward
Minimal increase in budgeted total expenditure to limit govt spending in FY12
Chart7: Investment sentiment suffersproposed industrial investment at a 2 year low

80 60 40 20 0 -20 -40 Industrial Investment (No. of Proposals, % YoY) Trend (3mma, %YoY)
Chart8: Indian exports buck the Asian trend till nowlikely to suffer going forward
(%YoY, 3mma) 60 40 20 0 -20 -40
Feb-09 Feb-10 Aug-08 Nov-08 Aug-09 Nov-09 Aug-10 Nov-10 Feb-11 May-09 May-10
Asian Exports Taiwan Singapore non oil China Thailand India
Sep-09
Mar-08
Sep-10
Sep-08
Mar-11
Mar-09
Mar-10

YES ECOLOGUE

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May-11
Aug-11
11 October, 2011

Agriculture: Another year of strong growth Agriculture sector in FY11 clocked a growth rate of 6.6% owing to a favourable base, close to normal monsoon and a record output of food grains. With an above average monsoon rains boosting the production of both rice and wheat this year, it is expected that India will achieve a record production of agri crops yet again in FY12, as there is a strong correlation between food grains output and actual rainfall as a percentage of long period average (see chart9). In addition, a late withdrawal of monsoon would also aid the sowing of Rabi seeds. We peg FY12 agriculture growth at 3.5% owing to an adverse base effect, but with an upside bias to our estimate. Services: To remain largely resilient Some moderation due to lagged impact of slowdown in industrial activity Services to remain broadly resilient, as in 2008. Being a services sector driven economy, India stands to benefit from the relative resilience of the sector. In the aftermath of the FY09 global financial crisis, the slowdown in the Indian economy was largely led by industries and agriculture with services growth holding up relatively well. Despite a track record of proven resilience in previous downturns, services cannot grow single handedly and are bound to witness some moderation at a time when manufacturing growth is receding. The latest PMI reading for services plummeted to a two and a half year low, falling below the 50 level. Banking and real-estate services are likely to be negatively impacted by the current high rates of interest. Community, Social and Personal Services which is closely related to Government final consumption expenditure have already begin to moderate owing to restrained government expenses in a bid to keep fiscal exchequer under check. Industry: To lead the moderation in GDP growth Industrial growth under pressure; weak growth in mining and manufacturing sectors There are clear signs of a slowdown in the economic activity since the beginning of FY12. IIP growth in the April-July FY12 clocked a growth of 5.8% against 9.7% in the same period a year ago. The new IIP series on revised base of 2004-05, though offers a wider coverage, but is as volatile as the older series. Within IIP, the slowdown has been particularly sharp for mining and manufactuing sectors. While the former suffers owing to regulatory and environmental restrictions, interest rates hikes have weighed on the latter. Based on the YTD trend, we revise lower our FY12 industry growth forecast to 6.7% from 7.2% earlier. FY12 outlook: For FY12, we estimate a GDP growth of 7.7%, lower than our earlier estimate of 7.9%, as we envisage a sharper slowdown in industrial growth than perceived earlier.
Above normal monsoon in Jul-Sept, and a late withdrawal to ensure a strong agri growth in FY12
.though some moderation likely
We lower our FY12 GDP forecast to 7.7% from 7.9% earlier
Chart9: Above normal monsoon in FY12 to aid agricultural output

120 100 80 200 60 180 40 20 0
FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11
Chart10: Resilience in services to limit the downside in GDP growth

14 12 Agriculture Industry Services
Actual Rainfall as a % of LPA Foodgrain Output (MT, RHS)
240
220
10 8 6 4 2
160
0 -2
140
-4 Dec-09 Dec-10 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Jun-10 Jun-11

YES ECOLOGUE
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11 October, 2011
Structural factors keep inflation sticky

WPI inflation continues to remain close to double digits for almost 19 months While food inflation has eased, the current level remains unacceptably high at around 10% Supply constraints amidst strong demand side pressures keep inflation elevated The much awaited opening of FDI in multi brand retail likely to have been pushed to FY13 Headline WPI inflation to moderate albeit at a slow pace in the coming months The sharp correction in sequential momentum of core inflation should give RBI some comfort We expect WPI inflation in the range of 6.5-7% by Mar-12 Headline inflation close to double digits: 19 months and counting Indian economy recorded a rapid annual growth averaging over 8% in the period from 2003-08 accompanied by an average inflation rate of slightly below 5%. Since the crisis, while growth has returned to its trend rate of 8%, inflation has been persistently higher close to double digits for the last 19 months. During this period, the underlying drivers of inflation shifted from primary food to primary non-food to the more generalized non-food manufacturing, indicating emergence of strong demand side pressures in the economy. In addition, elevated global commodity prices especially crude oil exacerbated price pressures. Food inflation continues to remain elevated: Due to structural factors and inadequate policy response Supply bottlenecks in agriculture sector coupled with strong demand Despite two successive years of normal monsoon, food inflation is currently close to 10%. Though it has declined from a peak of above 20% in early last year, the current level remains unacceptably high. Abysmally low levels of investment in the agriculture sector, with gross capital formation in agriculture sector as a percent of total capital formation in the economy languishing below 3%, remains a key constraint for enhancing agricultural supply (see table 1). While supply side constraints have had a role to play in keeping inflation elevated, strong demand side pressures have only added to the woes. The consumption basket, according to the NSSO survey, indicates a growing bias for consumption of so called protein rich items that have led to higher inflation of non-cereal food items. FDI in retail: Still waiting in the wings FDI in multi-brand retail postponed to next year The much awaited opening up of FDI in multi-brand retail seems to have got prolonged. According to media reports, FDI in retail has got pushed to the next fiscal year due to lack of political will and consensus among political parties. The policy is widely expected to help in easing food inflation in the economy. The gap between farm gate prices of agricultural commodities and their retail prices in India is currently amongst the highest in world, due to long chain of
Table1: Poor investment in agriculture sector aggravate supply constraints
Inflation has remained close to double digits in last 18 months
justifying RBIs antiinflationary stance
has meant food inflation remaining elevated
Chart11: Inflation continues to remain close to double digits for 18 months

12 WPI Inflation (% YoY) 10 8 6 4 2 0 -2
Dec Nov Feb Jun May Aug Mar Sep Oct Apr Jan Jul
FY09
FY10
FY11
Year
Average monthly WPI since Apr-05 = 6.29%
Gross Capital Formation in Agr as a % of Total 2.56 2.66 2.54 2.69 3.09 2.97
FY05 FY06 FY07 FY08 FY09 FY10

YES ECOLOGUE
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11 October, 2011

could have helped to ease inflation by improving supply chain intermediaries and inefficient mechanism of price discovery in the agricultural sector. Opening up of FDI in the sector by ushering in professional expertise and wiping out middlemen is expected to reduce the gap between wholesale and retail prices and improve supply side inefficiencies in the sector. Petrol Deregulation: Adds to inflation woes Since deregulation in June 2010, petrol prices have been revised up 6 times by close to 30%, with Brent crude price firming up by close to 50% during the same period. While the frequent upward revisions to petrol prices has pushed an already elevated level of headline inflation higher, it has reduced the under recoveries of the oil marketing companies, thereby lowering the subsidy burden of the government in turn. While the deregulation of petrol prices was a move long awaited, the government has not followed suit with diesel, kerosene and LPG prices, which are a bigger drain on the exchequer. Headline WPI inflation: Moderation albeit at a slow pace in the coming months While we believe that inflation saw its peak in August, it is expected that the headline inflation will remain above 9% till November, since(i) Pass-through of high global commodity prices to domestic prices remains incomplete (ii) Current administered electricity prices are yet to reflect increase in input prices, even as many states have initiated increases (iii) The recent weakness in Rupee (driven by global risk aversion), if persists, could add to inflationary pressures Core Inflation Momentum decelerates: The sole silver lining As the headline WPI inflation, core inflation continues to remain sticky above 7%. However, the sequential momentum in core has corrected from an average of close to 140 bps in Q4 FY11 to 50 bps in Q1 FY12 (see chart12). In three out of the four last inflation readings, sequential momentum has clocked close to 0.40%, in line with its historical average (0.37%), indicating incipient signs of stabilization in the same. While it may take a few more months for core inflation to print below 7%, the slowdown in sequential gains close to long period average should give RBI some comfort on inflation front. WPI Inflation to ease to 6.5-7% by Mar-12 We expect inflation to ease to 6.5-7% by March end (see chart13), due to(i) A favorable base effect (ii) Impact of past monetary action panning out (iii) The recent correction in global commodity prices
Deregulation of petrol prices has put upward pressure on an already elevated inflation level
WPI inflation expected to remain above 9% till November
Sharp correction in sequential momentum of core inflation positive
We expect inflation to decline to 6.5-7% by Mar12
Chart12: Sequential momentum in core inflation corrects sharply since Q4FY11

1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4
Jan-11 Nov-10 Feb-11 Aug-10 Apr-11 Sep-10 Jul-11 May-11 Aug-11 Dec-10 Mar-11 Oct-10 Jun-11
Chart13: Inflation to ease to 6.5-7% by March 2012

12 10 8 6 4 2 0 -2
Mar-09 Mar-10 Mar-11 Sep-11 Sep-09 Sep-10 Mar-12 Jun-09 Dec-09 Dec-10 Jun-11 Dec-11 Jun-10
Core Inflation MoM
Core Inflation (% YoY, RHS)
9.0 8.5 8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0
Estimated WPI trajectory
12
YES ECOLOGUE
11 October, 2011
India caught in a wage-price spiral?

Private consumption in India rising on a trend basis; cushioned impact of the global financial crisis NREGA and sharp revisions in agricultural MSPs fuel rural wages Evolving dietary patterns exacerbate price pressures by lifting demand for protein rich items Wages witness a strong growth in corporate and government sector in the last few years Higher wages stimulating demand in the absence of adequate supply response keeps inflation elevated The wage-price spiral has hardened inflationary expectations Need for fiscal policy to complement monetary policy to break the back of the wage-price spiral Wage-Price Spiral: A reality? In the last two years, consumption in the Indian economy has remained resilient despite inflation remaining above 9%, at almost twice its accepted threshold level according to RBI. Private final consumption in the Indian economy has trended higher since the 1990s with a visible pickup in its pace of acceleration since 2005 (see chart14). Even as the global economy struggled to expand during the financial crisis of 2008, consumption growth in India bottomed out at strong annual growth of 7.3% in FY10, highlighting the strength of domestic demand and its imperviousness to the global downturn. In the last few years, domestic demand has found support in governments fiscal stimulus spending and other reforms including higher public spending (especially in rural areas), cuts in indirect taxes, farm loan waiver package and a pay commission meting out greater salaries to government employees. The direct and indirect impact of these and other policies on rising wages, which inturn has helped to keep demand buoyant, contributed to higher inflation as supply responses failed to keep track with the powering demand. We believe that India is currently experiencing the classic wage-price spiral, in which prices and wages chase one another, making inflation adopt a more structural nature in the economy. Rural wages: Powering the consumption story NREGA: Inducing structural changes The success of NREGA has meant higher wages for both farm and nonfarm labour On the rural side of the economy, evidence of origin of a wage-price spiral can be traced to two channels - hikes in minimum support prices and expenditure on social security schemes such as the NREGA. NREGA, the UPA governments flagship programme initiated in 2005, guarantees rural labourers employment opportunities at a minimum wage rate in non-farm activities. The success of the social scheme has not only pushed non-farm wages higher (by guaranteeing a wage higher than the minimum wage in many states) but has also granted a higher wage bargaining capacity to labourers employed in agriculture sector, by offering them alternate employment opportunities in the non-farm sector. Data on
Table2: Steep gains in rural wages in last three years
Average rural daily wages (%YoY)
Private Consumption (% pa) 9 8 7 6 5 4 3 2 Private Consumption Trend (% pa, 5 yr ma)
Private consumption in India rising on a trend basis
Government policies and other reforms have boosted incomes
We believe India is currently experiencing the classic wage-price spiral
Chart 14: Private consumption in India ticking higher on a trend basis

10
Agri FY06 FY07 FY08 FY09 FY10 FY11 5.5 6.9 8.1 11.6 16.9 19.5
Non-agri 3.3 4.3 7.1 10.2 14.5 16.8
FY97
FY98
FY99
FY00
FY01
FY02
FY03
FY04
FY05
FY06
FY07
FY08
FY09
FY10
FY11
Source: Labour Bureau GOI, CEIC, YES BANK Limited
YES ECOLOGUE
13
11 October, 2011

average rural daily wages of men for both farm and non-farm work corroborate the same. We find that during FY09-11 agri and non agri wages rose cumulatively by 48% and 41% respectively compared to a modest 6.8% and 4.9% cumulative hike in the preceding three year period (see table). A similar trend is also seen in wages of rural casual labourers employed in public works. According to NSSO Employment and Unemployment rounds of 2007-08 and 2009-10, wages of casual workers rose by close to 22% in the two year period. Higher wages implying greater purchasing power and a strong demand, have added to inflationary pressures in the economy. Minimum Support Prices: See sharp upward revisions Sharp revision in MSPs for crops has meant higher rural purchasing power However, NREGA stand alone is not solely responsible for contributing to the wage-price spiral. A collective rise in the price of agricultural inputs, rural wages and international prices of primary commodities have underpined strong upward revisions to Minimum Support Prices for crops. In a three year period of FY09-11, agriculture sector has witnessed increases in MSPs to the tune of 40% or more for several crops (see chart15). Higher MSPs translate into higher rural purchasing power and feed into inflation by keeping demand conditions robust. With revisions in NREGA wages and MSP both being indexed to inflation, the cyclicality of wages and prices chasing one another gets further reinforced. Evolving Dietary Patterns: Exacerbate price dynamics The evolution of dietary patterns has led to The wage-price spiral has been exacerbated also by changes in dietary patterns especially in the rural economy. From NSSO Household Consumption Expenditure Surveys, we find that while the share of monthly per capita income spent on food has declined, within food products, there is a clear bias for greater expenditure on protein and nutrient rich items. As a share of total expenditure on food, expenditure on pulses, egg, fish & meat and vegetables & fruits has risen between FY05 and FY08 (see table3). On inflation front, price pressures have also been more prounounced in protein rich items and fruits & vegetables (see chart16)
Wages of Casual Labour in Public Works Year 2009-10 (` )* 2007-08 (` ) Growth (%) Male 94.63 76.02 24.5 Female 86.655 70.66 22.6 Person 91.07 74.45 22.3
verified by Employment and Unemployment rounds of NSSO
higher price pressures in protein rich items, fruits and vegetables
*average of wages of casual labour in public works under NREGA and in public works other than NREGA public works
Source: NSSO Employment and Unemployment Rounds
Chart15: Sharp upward revision to MSPs of several agricultural crops

80 70 60 50 40 30 20 10 0 FY06-FY08 FY09-FY11 Gains in Minimum Support Prices
Chart16: Price pressures more pronounced in protein rich food items

240 220 200 180 160 140 120 100
Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10
WPI Inflation Index Pulses Fruits Milk Egg, Meat, Fish

14
YES ECOLOGUE
11 October, 2011

Corporate wages keep pace with rural trends. Urban Wage Increases: Not far behind The pace of wage increases in urban india have been as robust as those witnessed in rural. Despite having a favourable demographics, India has suffered from a dearth of skilled talent because of its limited investment in educational infrastructure. With global companies having set base in India, there has been a growing wrestle for acquiring the requisite talent, which in turn has meant higher salaries and incentives for employees. To authenticate the same, we use capitaline database of Indian companies to calculate the employee expense (of which wages, salaries and bonuses are a bulk component) of BSE 500 companies. Our analysis is restricted to a subset of about 150 companies due to limitations of data availability, but nevertheless offer a broad gauge of the corporate sector. We find that since FY06 the annual gains in corporate wages has outpaced the annual growth of nominal GDP in every year (see chart17), except in FY10, when growth in corporate wages declined to 15.5% while nominal GDP growth remained close to FY09 level, supported by a higher inflation above 9%. Not only has the private corporate sector been a testimony to strong wage hikes, government sector too has received a bigger share of the pie. According to Department of Labour, Government of Delhi data, minimum wages for unskilled, semi-skilled and skilled workers have witnessed a cumulative hike of 50%, 58% and 63% in FY10-FY11. On top of a 33% hike in minimum wages of unskilled workers in FY10, Delhi government hiked wages by another 15% in FY11 citing inflation as the primary reason (see table4). Breaking the back of wage-price spiral Inflation inertia sets in? Wage-price spiral has hardened inflationary expectations in the economy. With strong upward revision in wages feeding into inflation and vice versa, an elevated level of inflation in the economy has been accompanied by a hardening of inflationary expectations. According to RBIs quarterly survey, inflation expectations for present and future (both 3 month and 1 year) continue to hover close to record high levels, indicating expectations of high intransient inflation (see chart18). Given the nature of inflationary expectations to feed on themselves, RBI in its annual monetary policy raised two pertinent questions that monetary policy confronts in a situation of wage-price spiral. Amidst a wage-price spiral and continued cost push and demand side pressures on domestic prices, monetary policy confronts two key questions. First, will the recent signs of weakening activity persist and restrain wage price and demand side pressures on manufacturing inflation? Second, are there other factors that might put further pressure on prices and wages and keep inflation high, thus feeding further on inflation expectations? A judgement on the answers to these questions will influence the calibration
Chart17: Annual gains in corporate wages beat nominal GDP growth
23 Corporate Sector Wage growth (% YoY) Non Farm GDP Growth (% YoY)
Wage growth in Indian corporate sector outpaces the growth in nominal GDP
Government employees also enjoy sharp upward revision to wages
RBI visibly concerned about the policy challenge that a wageprice spiral poses
Table3: Evolving dietary patterns exacerbate the wageprice spiral

Rural Item Group Cereals Pulses Milk & milk products Egg, fish and meat Vegetables & Fruits Sugar, salt, spices and edible oil Beverages, refreshments and processed food
Source: NSSO
2004-05 2007-08 Expenditure as a % of MPCE 32.9 30.9 5.9 6.2 15.3 14.8 6.2 6.4 14.3 15.6 17.3 15.6 8.1 10.6
20
17
14 FY06 FY07 FY08 FY09 FY10 FY11
Source: NSSO, MOSPI, YES BANK Limited
Source: Capitaline, CEIC, YES BANK Limited
YES ECOLOGUE
15
11 October, 2011

of the monetary policy stance With the rate tightening cycle now over Need for fiscal policy to complement monetary policy Since the Annual Policy in May, growth in the economy has begun to show signs of moderation albeit in pockets. Clearly, the interest rate sensitive sectors of construction, auto production and investment are slowing down at a faster clip. In addition, the pace of sequential momentum in core inflation has corrected from close to 140 bps in Q4 FY11 to 50 bps in Q1 FY12. With a full impact of past policy action and the more aggressive rate hikes in this fiscal (150 bps since May) panning out gradually, the monetary policy induced moderation in growth will help to break the inertial inflation dynamics and alter inflationary expectations going forward. While we believe that RBIs rate tightening in the current cycle is now over, the greater task of breaking the back of wage-price spiral completely now rests on expenditure driven fiscal correction and government policies to enhance agri supply response.
there is a greater role for fiscal policy to play in breaking the back of a wage price spiral
Table4: Government salaries upward revisions in FY10-11
witness
exorbitant
Chart18: Wage-price spiral leads to hardening of inflationary expectations

15 13 11 9 7 5 3 RBI's Household Inflation Expectations Survey Current 3M Ahead 1Y Ahead
Increase in Minimum Wages for Unskilled, Semi Skilled and Skilled Government employees in Delhi (%YoY) Unskilled 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 3.0 6.6 3.4 4.4 2.8 6.4 7.4 6.1 4.7 8.3 34.2 15.3 Semi Skilled 2.8 6.2 3.2 4.1 2.7 6.0 7.0 5.8 4.5 7.9 42.7 15.1 Skilled 2.6 5.6 2.9 3.8 2.5 5.5 6.5 5.4 4.2 7.4 48.0 14.9
Jun-07
Dec-07
Dec-08
Dec-09
Dec-10
Source: Labour Bureau GOI, Indiastat, YES BANK Limited
16
YES ECOLOGUE
Jun-11
Jun-08
Jun-09
Jun-10
11 October, 2011
Fiscal slippage unavoidable in FY12

Moderation in GDP growth and duty cuts announced earlier in the year to put tax revenue target at risk Low market appetite and uncertain environment can result in lower disinvestment receipts Expenditure management to become complicated as subsidy bill overshoots budget targets The government recently announced additional borrowing worth ` 529 bn for H2 FY12 to compensate for the shortfall in other sources of financing the deficit We expect the government to lower the pressure on fiscal deficit and market borrowing by cutting expenditure and deferring part of the subsidy payment to FY13 We now expect FY12 fiscal deficit to GDP ratio to come at 5.1% vis--vis 5.5% expected earlier We had earlier highlighted the possibility of a fiscal slippage in FY12 and called for a fiscal deficit to GDP ratio of 5.5% vis--vis the budgeted target of 4.6% (for details see our earlier report: Analyzing the impact of fuel price hike, 27-Jun-11) on the back of overshooting of the subsidy bill and loss in indirect tax revenue due to duty cuts on fuel prices. Over the last few months, risks to fiscal slippage have mounted further. Economic growth is now showing signs of moderation and governments disinvestment target for FY12 is at risk both of them can potentially provide further upside risk to fiscal deficit. Despite the emergence of upside risks, we now expect (for reasons mentioned below), the FY12 fiscal deficit to GDP ratio to come at 5.1% vis--vis 5.5% expected earlier. Expenditure remains strong while revenue continue to disappoint According to latest data (as of Aug-11), the fiscal situation has deteriorted on both expenditure and revenue account. On FYTD basis (Apr-Aug), total expenditure came at 37.5% of the budget target while net tax revenue collections came at 23.1% of the budget target (after adjusting for the expected shortfall due to announced duty cuts in June). Hence so far in FY12, while expenditure has overshot its longterm average, tax revenue has disappointed (see chart 19). For the period Apr-Aug, gross tax revenue growth came at 12.2% on a YoY basis. This is less than half the growth seen during the corresponding period of FY11 (see table 5). Barring service tax collections, all other sources of tax revenue have been showing deceleration in growth momentum. A moderation in real economic acitivity on the back of monetary policy tightening by the RBI explains lower growth in corporate tax, customs and excise collections. Additionally, the cut in excise and customs duties for fuel items would also start impinging upon indirect tax collections. Going forward, tax collections are likely to be under further pressure as FY12 GDP growth moderates towards 7.7% (for details see - India Growth: To hover around trend).
Table5: Growth in tax collection moderates
Fiscal slippage risks have mounted over the last few months
Between Apr-Aug, while expenditure has overshot its long-term average, tax revenue has disappointed
Except service tax collections, all other sources of tax revenue have been showing deceleration in growth momentum
Chart19: FY12 fiscal deficit at risk?

40%
Ratio of Apr-Aug Expenditure to FY Expenditure
FY01-FY11 Average 38% FY12 36% 34% 32% 30% 28% 18% 20% 22% 24% 26% 28% 30% 32%
YoY Growth over Apr-Aug (%) FY09 Gross Tax revenue Corporate tax Income Tax Customs Excise Service Tax Others
Ratio of Apr-Aug Tax Revenue to FY Tax Revenue
FY10 -11.6 2.5 8.1 -34.1 -24.5 -2.3 -2.0
FY11 27.3 18.4 14.0 59.8 43.3 13.8 -28.9
FY12 12.2 -12.7 12.6 27.1 17.9 37.0 -3.3
25.0 45.9 35.8 17.0 6.6 28.7 17.4
Source: Budget documents, CEIC, YES BANK Limited

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

17
11 October, 2011

Subsidy to put further drain on resources Under recoveries are likely to exceed ` 1000 bn in FY12 The government has so far disbursed 63% of food subsidy, 52% of fertilizer subsidy, and 89% of oil subsidy over the period Apr-Aug FY12. On the issue of oil subsidy, the current disbursal of 89% is misleading as most of the payment made by the government has been account of clearing of FY11 dues. Assuming that oil prices will average around USD 100-110 pb level for the entire year (the prospect of further quantitative easing by central banks in developed economies could potentially offset the negative impact on oil prices emanating from the risk of a slowdown in global growth momentum), we expect oil subsidies to come around ` 500 bn (about ` 300 bn higher than budgted target for FY12). The government could potentially reduce the underrecoveries (currently expected over ` 1000 bn in FY12), and hence the oil subsidy bill, if further upward adjustments are made in prices of diesel, kerosene, and LPG. However, it would be politically difficult to pass such a hike as the expected inflation moderation process will get further delayed. Disinvestment target hinges on market sentiment The government kick started the FY12 disinvestment program with the Power Finance Corporation FPO in May-11, which resulted in a collection of ` 11.4 bn. Since then, there has been no offer from the governments side to divest its stake in key PSUs. This puts the ambitious ` 400 bn FY12 disinvestment target at risk. Weak equity market sentiment (the BSE Sensex is down almost 16% on a FYTD basis) has been the primary reason behind the delay in continuing with the divestment process. Recently the government lifted a curb on investment banks handling its disinvestment program to allow them to participate in similar programs from nonstate companies in similar sector (the limitation introduced in Feb-11 had led to lower interest in PSU share sales). While this may improve participation by investment banks, the success of the disinvestment program, among other things, is crucially dependent upon market conditions and investor appetite, which remains weak due to uncertainty regarding sovereign debt concerns in Europe. As such, it would be extremely challenging for the government to exceed even FY11 disinvestment proceeds (around ` 230 bn). Expectation on fiscal slippage for FY12 Taking into account the above mentioned factors, the table below summarizes our expectation for FY12 fiscal slippage coming from various quarters. The total slippage in FY12 is likely to touch ` 1000 bn this can add 1.1% to the budgeted fiscal deficit target of 4.6%.
Chart20: Subsidy payment carries upside risks
450 400 350 300 250 200 150 100 50 0 Food Fertilizer Subsidy Payments (Apr-Aug FY12) Oil In INR bn As % of Budgeted Target (RHS) 100 90 80 70 60 50 40 30 20 10 0
we expect fuel subsidy bill to come around ` 500 bn vis--vis the budgeted target of ` 236 bn
FY12 disinvestment target of ` 400 bn could be at risk
as the weak market sentiment could potentially lower investor appetite
Chart21: Equity sentiment crucial for disinvestments

250 Disinvestment Receipts (INR bn) Sensex (annual %, RHS) 100 80 200 60 40 20 100 0 -20 -40 0
FY12* FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11
150
50
-60
Source: Ministry of Disinvestments, CEIC, YES BANK Limited
18
YES ECOLOGUE
11 October, 2011

This would not only impact governments credibility, but also increase the risk of a negative outlook by international rating agencies. As such, the government in our opinion, is likely to take extreme measures to curb the extent of fiscal slippage by as much as possible. The potential impact of fiscal slippages on overall deficit can be managed through a combination of the following: Defer part of the subsidy payment to FY13: (i) Food Subsidy Bill can be introduced in FY13, and (ii) Since part of FY11 fuel subsidy bill was paid in FY12, the same can be done for FY12 fuel subsidy bill. This can reduce the potential slippage in FY12 by around ` 350 bn (0.4% of GDP). Curtail expenditure: The finance ministry has been indicating towards this possibility for some time now. During FY11, actual expenditure by the government was lower by ` 177 bn compared to the revised estimates. As such, belt tightening by the finance ministry can help in reducing total expenditure by ` 200-300 bn during the course of FY12 (approximately 0.3% of GDP). On a net basis, the government through the above mentioned ways can bring down the potential slippage to around 0.5% of GDP (see table 6), resulting in a fiscal deficit to GDP ratio of 5.1% in FY12. How does it affect the arithmetic of financing? In a surprise move, the government announced last week that it would borrow additional ` 529 bn through dated securities in H2 FY12, pushing the H2 FY12 gross borrowing up to ` 2200 bn. According to newswire reports, this additional borrowing would be a substitution for a shortfall in other sources of financing: Lower cash surpluses in FY12 than previously anticipated (` 160 bn vs. ` 330 bn) Expected outflow from small savings (` 350 bn) As such, the additional borrowing does not address the possibility of fiscal slippage in FY12. According to our revised estimates, a likely scenario of a net fiscal slippage of 0.5% of GDP would require further ` 450 bn in financing. This could be a source of concern for the bond market as the onus of further additional borrowing could once again fall upon market borrowings amid weak support from other sources of financing.
Fiscal slippage in FY12 can be managed by
deferring part of the subsidy payment to FY13
and curtailing expenditure under plan category
We expect FY12 fiscal deficit to GDP ratio to come at 5.1%
Despite the ` 529 bn additional borrowing, we expect additional funding requirement of about ` 450 bn in FY12
Table6: Sources of fiscal slippage in FY12
Chart22: Increasing reliance on market borrowings

120 Share of market borrowings in fiscal deficit (%) 100 80 60 40 20 0 Last 10Y Average Last 5Y Average FY12 (Revised)
Estimated Slippage in FY12 Food Fuel Tax Revenue Disinvestment Total 200 270 360 200 1030
Amount that can be Potential Slippage deferred to FY13 in FY12 (In ` bn) 200 150 0 0 350 0 120 360 200 680
Source: Budget documents, YES BANK Limited

YES ECOLOGUE
Source: RBI, YES BANK Limited

19
11 October, 2011
RBI to infuse primary liquidity through OMOs

Rising interest rates and moderation in GDP growth will help in moderating growth in currency in circulation With the possibility of creating foreign assets being low, the RBI is likely to rely on domestic asset creation for expanding its balance sheet Expansion of domestic assets would primarily happen through OMOs and LAF We expect reserve money to grow by 15.5% in FY12 vis--vis 17.2% in FY11 We expect liquidity deficit to worsen in H2 FY12 and exceed ` 1000 bn from Nov-Dec In the absence of significant fx intervention, domestic asset creation will exceed growth in foreign assets Growth in reserve money has moderated The effect of RBIs stance on monetary policy, liquidity, and fx intervention amid the overall macroeconomic framework, are reflected in its balance sheet. This has important implications for key monetary variables like reserve money, deposits, credit, money supply, etc. Growth in RBIs monetary base has moderated to 16.9% YoY (as of 30-Sep-11) from 21.5% (as of 1-Oct-10). While the moderation in reserve money growth was anticipated, incremental expansion in currency in circulation has been somewhat lower than we had been expecting earlier. Currency leakage to be the key driver for RBI liabilities The demand for currency is determined by a number of factors such as income, price level, the opportunity cost of holding currency, i.e., the interest rate on interest bearing assets and the availability of alternative instruments for transactions. While these are structural variables impacting currency demand, the impact of cyclical and one-off variable cannot be ignored for a country like India. As such, we decided to model currency demand on real growth, inflation, interest rate, government expenditure (ex interest payments) and cash rich activity sectors (proxied by share of construction sector in overall GDP). The chart below shows the elasticities of various explanatory variables with respect to currency demand (all variables were significant and had the expected signs). The estimates suggest that the incremental growth in currency demand is likely to be around 14.5% in FY12 vis--vis 19.1% in FY11. The CRR balances would move upwards with status quo on the rate side and a pickup in deposit growth (by 18%). This would imply a 15.5% growth in reserve money in FY12 from the liability side of RBIs balance sheet. Domestic asset growth will be key for balance sheet expansion Moving to the asset side of the balance sheet, we continue to see a substantial
Table7: OMO support to continue in FY12 via domestic asset creation
Changes in key items in RBI's Balance Sheet (` bn) FY10 Reserve Money Liabilities Currency CRR Balances Assets Domestic Out of which LAF Out of which OMOs Foreign
20
as rising interest rates and a moderation in real economic activity has led to a deceleration in currency leakage
We expect growth in currency in circulation to moderate to 14.5% in FY12 from 19.1% in FY11
Chart23: Inflation and growth are major determinants of currency demand

1.6 1.4 1.2 1.0 0.8 Elasticities with respect to Currency in Circulation (%)
FY11 1,906 1,532 394 1,455 833 672 933
FY12* 2,000 1,384 613 2,000-2,200 200-400 700-900 600
1,583 1,104 473 1,380 287 755 -418
0.6 0.4 0.2 0.0 -0.2 GDP Inflation (WPI) Interest Rate Government Share of (1Y Corp Expenditure Construction Yield) (ex int.) in GDP

YES ECOLOGUE
11 October, 2011

growth in RBIs domestic assets, which is likely to come about through an increase in RBIs credit to government. With BoP surplus likely to remain modest in FY12, there will be a greater reliance on expanding domestic assets in order to match the increase in liabilities under the monetary base. Increase in domestic assets would come about through repo borrowing under LAF, MSF borrowing under LAF (the new facility introduced in the FY12 Annual Policy under which banks can temporarily dip to the extent of 1% on SLR for additional borrowing from the RBI at a rate which would be 1% higher than the prevailing repo rate), OMOs (Open Market Operations) by RBI, and the WMA (Ways and Means Advances through which the government borrows temporarily from the RBI). Assuming that the government would not dip into WMA on a net basis in FY12 (as indicated in the Union Budget) and liquidity deficit under repo would have limited room to worsen vis--vis Mar-11 levels; most of the increase in RBIs domestic assets is likely to come in the form of MSF borrowing and OMOs. On the foreign asset side, limited fx intervention (generating not more than ` 200 bn) amidst an expectation of a stronger Dollar in the second half of the year and with an expectation of 3% investment return on RBIs reserves, net foreign assets could potentially increase by ` 600 bn. Liquidity deficit to deteriorate in H2 FY12 The new MSF facility is likely to be utilized by banks in H2 FY12 The manner in which changes in the monetary base (primary liquidity) unfold during the rest of the fiscal year would have a crucial bearing on secondary liquidity in the domestic money market. Our liquidity model suggests significant tightening of liquidity conditions from Q3 FY12 onwards as currency leakage picks up on seasonal demand. The average deficit over Q3-Q4 FY12 is likely to be close to ` 1 trillion despite the assumption on OMOs as: The government has been continuously dipping into the WMA with RBI and has frequently breached its WMA limit this year (see chart25). This has triggered the issuance of short-term cash management bills (CMBs) on a regular basis. We expect the government to remain in a deficit mode on an average basis for the rest of the year as pace of revenue collection lags the outflows on account of expenditure. While CMBs are liquidity neutral from a long-term perspective, the issuances can potentially provide some skew in the short-term. The government has so far collected only ` 11.4 bn from disinvestments. While the likelihood of achieving the ` 400 bn budgeted target seems remote, we are convinced about divestment attempts in the rest of the year imparting short term skew in money market liquidity conditions.
Foreign asset creation in FY12 likely to remain subdued on account of reduced fx intervention and moderate BoP surplus
Reliance on OMOs to continue in FY12
we expect close to ` 700-900 bn of bond purchases through RBIs OMO
Liquidity deficit to worsen in H2 FY12 due to seasonal leakage of currency from the banking system
Chart24: Liquidity deficit to worsen in H2 FY12
Chart25: WMA limit has been frequently breached in FY12 so far

FY12
30,000 10,000 -10,000 -30,000
Month end liquidity (` cr)
FY11
600 WMA Borrowing (INR bn) 500 400 300 FY12 WMA Limit (INR bn)
-50,000 -70,000 -90,000 -110,000
200 100 0
Nov-11
Feb-12
May-11
Source: CEIC, Budget Documents, YES BANK Limited
Source: CEIC, RBI, YES BANK Limited
Aug-11
Mar-12
Jun-11
Dec-11
Oct-11
Apr-11
Sep-11
Nov
May
Aug
Jan-12
Mar
Apr
Jul-11
-130,000
Dec Sep Feb Jun Oct Jan Jul
YES ECOLOGUE
21
11 October, 2011
External risks contained

Engineering goods, oil, and electronics have supported the robust export growth in FY12 so far Global growth slowdown to provide the key downside risk to export growth in the coming months Risks on current account deficit manageable as long as average crude oil stays below USD 110 pb level We expect BoP surplus of USD 11 bn in FY12 vis--vis USD 13 bn in FY11 FX reserves continue to provide adequate cover in the short-term and debt service payments in FY12 remain manageable Merchandise trade has seen improvement Merchandise trade continues its robust performance in FY12 Indias merchandise trade maintained a sterling performance in FY12, a trend which is in contrast to its Asian peers. Moreover, robustness in external trade has also so far defied any pressure whatsoever emerging from a slowdown in global growth (see chart 26). Between Apr-Aug, exports reached a level of USD 134.5 bn, a growth of 54.2% while the imports were USD 189.4 bn with a growth of 40.4% and a trade deficit of USD 54.9 bn, during the same period. In FY12, engineering goods, oil, and electronics have contributed immensely to the surge in export growth. As regards to imports, apart from oil, precious metals, machinery, electronics, and chemicals have been the key driver. Ongoing diversification both in terms of geography and product mix, have contributed largely to Indias resilience in merchandise trade (see Appendix for details). However, going forward, export growth is likely to stutter as traditional strongholds - the US and the EU - continue to hobble in economic uncertainties. The global jitters could have a knock-on effect on other markets, such as South America and Southeast Asia, which are increasingly emerging as attractive destinations for Indian exports. This is corroborated by the HSBC PMI data for August, which showed that the pace of new orders for Indian manufacturers decelerated to the slowest in 29 months as export orders contracted at a record pace. Import growth is also likely to follow suit as domestic growth moderates and oil price cools off on global growth concerns amid financial instability. BoP risks manageable After registering a BoP surplus of USD 13 bn in FY11, the surplus on BoP is likely to moderate in FY12 to around USD 11 bn (we are revising lower our expectation for FY12 BoP surplus from USD 17 bn earlier on account of increased global uncertainty (see table below).
however global slowdown and expiry of DEPB benefits would moderate growth in exports
We expect FY12 BoP surplus at USD 11 bn vis-vis USD 13 bn in FY11
Chart26: Exports outperformance

80 60 40 20
continue
their
relative
65 60 55 50 45
Table8: BoP surplus in FY12 likely to moderate

Highlights of BoP (USD bn) FY11 FY12* Trade Balance -130.5 -158 Invisibles 86.2 100 Current Account -44.3 -58.0 (as % of GDP) -2.6 -2.9 FDI Portfolio Loans Others Capital Account (as % of GDP) Overall BoP** (as % of GDP)**
*Estimate; **Includes errors and omissions Source: CEIC, YES BANK Limited
YES ECOLOGUE
India Exports (% YoY, 3mma) Asia Exports (% YoY, 3mma) Global PMI (RHS)
0 -20 -40
40 35 30
7.1 30.3 27.8 -5.5 59.7 3.5 13.1 0.8
20 14 30 5 69.0 3.5 11.0 0.6
Aug-08
Aug-09
Aug-10
Source: CEIC, Bloomberg, YES BANK Limited

22
Aug-11
Feb-07
Feb-08
Feb-09
Aug-06
Aug-07
Feb-10
Feb-11
11 October, 2011

Downward revision in overall BoP notwithstanding, we believe that the funding of current account deficit (of around 2.9% of GDP in FY12) would still be manageable. Although portfolio flows are unlikely to match FY11 levels, we are fairly optimistic on FDI and ECB inflows, which have so far remained extremely robust. Increase in global risk aversion, while being negative for capital account, can actually help reduce the deficit on current account through a reduction in oil import bill and an increase in remittances. On the capital account side, policy impetus like FDI reforms, relaxation in ECB limits (the RBI in consultation with the government has recently increased the ECB limit under automatic route to USD 750 mn from USD 500 mn earlier), hike in NRI deposit rates, and further relaxation of FII debt ownership are likely to buffer the impact of any shortfall in portfolio inflows. However, a full blown financial crisis can potentially turn the capital account (and hence the BoP) into a deficit as it did in FY09. FX cover to compensate for a mild deterioration in external debt Indias external debt stood at USD 316.9 bn at end-June 2011, increasing by USD 46.6 bn (17.2%) over end-June 2010 level of USD 270.3 bn. The rise in external debt was mainly due to higher commercial borrowings and short-term trade credits, which is in line with high growth of the economy and strong domestic demand. The share of ECBs in total external debt continued to be the highest at 29.4% as of endJune 2011, followed by short-term debt (21.6%), NRI deposits (16.7%) and multilateral debt (15.6%). The changing composition of debt in favour of ECBs is also an indication of maturing market economy and the increasing role of the corporate sector in the domestic economy. Despite the increase in absolute terms, Indias external debt has remained within manageable limits. This is indicated by external debt to GDP ratio of 17.3% and debt service ratio of 4.2% in FY11 compared to 18.0% and 5.5% in FY10 respectively. However, there has been a mild deterioaration in certain parameters like the share of short-term debt in total debt and fx reserves respectively, with the latter exceeding the former for the first time in 7-years. Additionally, the fx cover for imports is likely to fall below 9-months in FY12. Although these long term concerns have been lingering on for a while and require policy thought and action, we would not be overly worried about them from a short-term perspective as FX reserves continue to provide more than adequate cover in the short-term (according to the Greenspan-Guidotti rule, reserves should equal short-term external debt) and debt service payment of USD 22.9 bn in FY12 remain manageable.
Chart28: Key short-term debt ratios deteriorating
150 140 130 120 110
-0.2
Although portfolio flows are unlikely to match FY11 levels, FDI and ECB inflows, would help in funding the 2.9% current account gap
Policymakers have started relaxing norms for FII debt and ECB inflows
External debt outstanding increased by 17.2% between June-10 and June-11
Debt/GDP ratio and debt service ratio remain manageable
as fx reserves continue to provide adequate support
Chart27: Risk has different impact on components of BoP

0.2 5Y Correlation with VIX Index
0.1
Total Debt/FX Reserves (%) Short-Term Debt/Total Debt (%, RHS) Short-Term Debt/FX Reserves (%, RHS)
30 25 20 15 10 5 0
0.0
-0.1
100
-0.3
90
Jun-04
Jun-05
Jun-08
Jun-09
Jun-10
Jun-06
Jun-07
-0.4 Oil Transfers FDI FII ECB
Source: CEIC, Bloomberg, YES BANK Limited

23
YES ECOLOGUE
Jun-11
11 October, 2011
Bonds to suffer in the short term from additional market borrowing

Aggressive monetary tightening prevented a bond rally in Q2 FY12 While sequential momentum in core inflation has decelerated, output gap is gradually closing We expect the RBI to have ended its monetary tightening Fiscal slippage in FY12 can potentially create the need for further additional borrowing However, fiscal risks likely to be mitigated through RBI OMOs and supportive global conditions We expect the 10Y g-sec yield to move towards 8.80% in the near term and moderate towards 8.00-8.20% by end-Mar-12 Since our last quarterly report (A Mid-Cycle Correction within Strong Secular Growth Story, 20-May-11), the 10Y g-sec yield (currently trading above 8.70%) moved within the range of 8.20-8.50% over the next three months. Over the same period, the 3M TBill yield added about 40 bps and is now trading close to 8.40%. The inversion of the g-sec curve was preceded by the OIS curve (5Y-1Y), where curve inversion has reached an all time high level (see chart below). Aggressive monetary policy action Aggressive monetary policy action by the RBI since May-11 has been the prime driver of curve inversion (although the impact of global factors on OIS curve inversion cannot be ignored). The table below summarizes the quarterly change in the repo rate along with the average month-over-month change in the WPI and core WPI (proxied by the Manufacturing ex Food Index). Both WPI and core WPI suffered from increased sequential momentum over Q3-Q4 FY11, which was a reflection of the pass-through of higher input prices to output prices amid strong growth conditions resulting in adequate pricing power. Monetary policy tightening started at a modest pace as the initial drivers of inflation were largely supply side variables (food, fuel, and minerals), with core inflation contributing just 30% to the increase in WPI inflation between Apr-10 and Nov-10 (Monetary Policy Response to Recent Inflation in India - Speech by Deepak Mohanty, RBI). Since Dec-10, the sequential momentum in core inflation picked up substantially and reached a high of 1.3% MoM (on a seasonally adjusted basis) in Feb-11. Moreover, the period between Dec-10 till Apr-11 was characterized by significant upward revisions to preliminary data, with average revision per month coming at 105 bps (see our latest inflation report August WPI Inflation: Worries Linger, 16-Sep-11). As such, RBIs aggressive response came on the back of a shift in drivers of inflation amid significant upward revision to preliminary data. However, both these factors
Aggressive monetary policy action by the RBI since May-11 has been the prime driver of curve inversion
Pass-through of higher input prices to output prices amid strong growth conditions had put pressure on inflation in H2 FY11
however, sequential momentum in inflation over last 3-4 months shows significant moderation
Table9: Aggressive tightening followed a pickup in inflation momentum

WPI (Quarterly Average) (MoM sa, %) Q4 FY10 Q1 FY11 Q2 FY11 Q3 FY11 Q4 FY11 Q1 FY12 Q2 FY12*
*July-Aug 2011 Source: CEIC, Bloomberg, YES BANK Limited
24
Chart29: OIS curve flattening has reached a record

10 -150 -100 -50 0 50 100 150 200 250
Mar-08 Mar-09 Mar-10 Mar-11 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11
YES ECOLOGUE
Core WPI (Quarterly Average) (MoM sa, %) 0.46 0.45 0.29 0.83 1.16 0.22 0.22
Change in Repo Rate (bps) 25 25 75 25 50 75 75
Repo (%) Reverse Repo (%) OIS 5Y-1Y (bps, Inverted, RHS)
9 8 7 6 5 4 3 2
0.78 0.41 0.45 1.38 0.84 0.37 0.35
11 October, 2011

have decreased in importance over the last 4-5 months - while sequential momentum in inflation has moderated significantly and stabilized at comfortable levels, magnitude of revision to preliminary data has also come off. Domestic growth has started showing evidence of a moderation with the impact of recent aggressive tightening yet to play out completely. With output gap closing, the RBI is likely to have ended its rate tightening cycle. Hence we expect the repo rate to stay at 8.25% for the rest of the fiscal year. Adverse global economic and financial conditions necessitate the maintenance of status quo for assessing the impact of the global contagion via feeble economic growth and volatile and uncertain financial conditions. Fiscal policy to gain importance With interest rate policy unlikely to be a key driver of market rates in the short to medium term, the focus would now shift to other drivers, viz., fiscal policy and liquidity conditions. On the fiscal front, we expect a slippage to 5.1% of GDP vis--vis the budgeted target of 4.6% (see the fiscal section for details). This would create additional funding requirement of about ` 450 bn. In the absence of any surprise on the revenue front and less likelihood of generation of any substantial internal savings, the burden of financing would fall upon market borrowings. Supply pressure strikes early H2 FY12 borrowing requirement has already increased by ` 529 bn Last week the government announced that it will borrow ` 2200 bn through dated securities in H2 FY12. This is higher than the budgeted amount by ` 529 bn. As a result, the FY12 gross borrowing will now be ` 4700 bn against the budgeted target of ` 4171 bn. The announcement of additional borrowing at the start of H2 borrowing calendar caught the market by surprise as expectations regarding any such event was relegated to the last quarter of the financial year. The bond market sold off, with the 10Y yield rising by 10 bps after the announcement. The chart below highlights the monthly distribution of gross and net borrowings in H2 FY12. Key highlights of the announced borrowing plan are listed below: In contrast to the usual practice, the calendar is not front loaded it is evenly loaded from a gross borrowing perspective and back loaded from a net borrowing perspective Borrowings would be concluded by Feb-12 From a duration perspective (see table below for details), the supply is going to be sizeable compared to H1, especially considering the absence of issuances in the less than 5Y segment
With output gap gradually closing, we expect the RBI to have ended its rate tightening cycle
Fiscal slippage to 5.1% of GDP in FY12 would create additional funding requirement of ` 450 bn
Supply of duration in H2 is going to be sizeable
Chart30: Budgeted H2 completed by Feb-12

600 500 400 300 200 100 0 Oct Nov
borrowing
likely
to
be
Table10: Supply of duration in H2 FY12 to be sizeable
G-Sec Supply in H2 FY12 ( ` bn)
Gross
Net
Month-wise supply of duration (` bn) ` Month 5-9 Y 10-14 Y 15-19 Y More than 20Y Oct-11 90-120 150-180 70-100 60-80 Nov-11 120-160 200-240 60-80 60-80 Dec-11 90-120 140-170 50-70 30-40 Jan-12 90-120 150-180 40-60 50-70 Feb-12 120-160 180-220 40-60 40-60 Mar-12 0 0 0 0 Share in Borrowing (%) 23.2-30.9 37.3-45.0 11.8-16.8 10.9-15.0
Dec
Jan
Feb
Mar
Source: RBI, Budget Documents, YES BANK Limited
YES ECOLOGUE
25
11 October, 2011

The increase in supply at the start of H2 is a concern as the additional borrowing has been on the back of a substitution effect (see fiscal section above for details). This puts the supply-demand gap under further pressure as we anticipate actual fiscal slippages to result in close to ` 450 bn of further additional borrowing in Mar12 (see table below). Outlook The supply outlook in dated securities is clearly negative for the bond market. As such, the yield on the 10Y g-sec is likely to remain under pressure and move towards 8.80% in the near-term. However, there are a few positive factors on the horizon that will have a beraing on the bond market over the next 6-months. The timing and the manner in which these factors unfold, would help in curbing the pressure on the bond market. We believe the market is still positioned for one more rate hike in Oct-11. However, looking at the significant reduction in sequential momentum of core inflation amid emerging signs of growth moderation, we expect the RBI to have ended its monetary policy tightening. The recent decline in oil prices have been on account of increasing threat of a global slowdown amid heightened concerns of a global financial crisis. Any further sustained decline would help in lowering WPI inflation by a higher margin than anticipated. Our supply-demand gap in the bond market indicates a fair degree of excess supply in FY12. The situation of excess supply worsens if we take into account the need for further borrowing in Mar-12. However, the actual supply pressure is likely to be significantly lower as RBI starts buying securities under its open market operations (OMOs). Our analysis on RBIs balance sheet expansion indicates a need for ` 700-900 bn of primary liquidity infusion through the OMO route (see the monetary section above for details). Hence, while the first two factors would curb the pressure on the bond market from the monetary policy side, the third factor would help in taking the pressure off from the fiscal side. As such, we expect the yield on the 10Y g-sec to move towards 8.008.20% by Mar-12.
Additional borrowing announced in Sep-11 has been on the back of substitution effect
10Y yield to move towards 8.80% in the near term
however yield is likely to moderate towards 8.008.20% by Mar-12
as RBI stops further rate tightening and uses the OMO route to address liquidity concerns
Global backdrop is also likely to provide support to bonds in the coming months
Table11: Supply-demand gap to potentially worsen in FY12

G-Sec Supply Pressure (` bn) ` Total Supply Central Government State Government MSS Total Demand Banks Insurance Cos. Others RBI Supply-Demand Gap
*Includes additional borrowing of `529 bn; ** Includes additional borrowing of `979 bn Source: RBI, Budget Documents, YES BANK Limited
26
Chart31: Moderation in oil price to support bonds

10 160 140 9 120 8 100 80 60 6 40 5 20
FY11 4,323 3,653 1,000 -330 3,687 1,415 900 700 672 636
FY12* 5,115 4,115 1,000 0 4,612 2,862 1,000 750 0 503
FY12** 5,565 4,565 1,000 0 4,612 2,862 1,000 750 0 953
10Y g-sec yield (%)
Oil (USD pb, RHS)
Sep-06
Sep-07
Sep-09
Sep-10
Sep-08
Mar-09
Mar-07
Mar-08
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YES ECOLOGUE
Mar-11
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11 October, 2011
Global factors back on INR radar

Shortage of USD liquidity triggered the weakness in Rupee Risk aversion and Dollar strength further added to Rupee depreciation Weak Rupee has raised concerns regarding inflation management A 10% depreciation in Rupee if sustained, would add close to 40 bps to WPI inflation We expect RBI to actively consider fx intervention if depreciation pressure on Rupee escalates OMOs/CRR cuts can be used to sterilize the impact of fx intervention on INR liquidity BoP surplus of USD 11 bn should provide support to Rupee We expect USDINR around 48.50-49.50 levels by Dec-11, and 45.00-46.00 levels by Jun-12
INR has been tracking the trend in Asia INR weakened as systemic USD liquidity deteriorated In the month of Sep-11, USDINR moved up by nearly three big figures (from 46 to 49), after rising by nearly two big figures (from 44 to 46) in Aug-11. While we had been expecting Rupee weakness on acount of a slight deterioration in the domestic macro backdrop (see INR underperformance to correct, 4-Aug-11 and Global factors hasten Rupee depreciation, 26-May-11), the extent of the movement caught everyone by surprise. However, we should note that INR has outperformed other Asian currencies like the KRW and IDR and rapid movement in Sep-11 has been a reflection of a broad based Dollar strength (the DXY Index gained 6.0% in Sep-11) on account of a pick up in global risk aversion. Why does Dollar movement become so important? Dollar being the base currency has an important impact on Rupee. However, the impact of Dollar movement on Rupee is not uniform the degree of impact is dependent upon investor risk appetite and positioning. More importantly, the overall BoP dynamics is a crucial determinant in explaining the degree of impact. For e.g., a high BoP surplus would generally be associated with lower degree of impact of Dollar movement on Rupee. As BoP surplus reduces (or turns into a deficit), the impact of Dollar movement on Rupee gets amplified (see chart below). For FY12, the BoP surplus is likely to extremely modest at 0.6% of GDP (down from 0.8% in FY11). As such, Rupees sensitivity to Dollar movements is likely to be higher in such an environment. The current uncertain global economic and financial environment is likely to result in increased volatility in Dollar movements and thereby add to Rupees vulnerability.
and global conditions triggered a risk-on mode
Impact of Dollar movement on Rupee gets amplified in case of low BoP surplus
Chart32: Rupees sensitivity to Dollar increase during times of lower BoP surplus
8 BoP (as % of GDP) INR elasticity wrt DXY (RHS) 6 1.6 1.4 1.2 1.0 0.8 2 0.6 0.4 0.2
Chart33: Reduction in USD liquidity caused the initial stress for Rupee
16 14 12 10 8 6 4 Dollar Liquidity (USD bn) 2
Mar-07 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Mar-08 Mar-09
38 40 42 44 46 48 50 USDINR (Inverted, RHS)

Mar-11 Mar-10 Sep-11
27
52 54
-2 FY06 FY07 FY08 FY09 FY10 FY11 FY12*
0.0
YES ECOLOGUE
11 October, 2011

What other factors explain the current weakness? Trade deficit has remained sizeable due to strong oil and gold imports Apart from the above mentioned factors, the modified basic balance (expressed by the sum of merchandise trade balance and portfolio flows) has been steadily deteriorating over the last 2-months. While a drop in FII inflows (on account of an increase in global risk aversion) partly explains the reason behind worsening of the modified basic balance, a pick up in the trade deficit has been the primary driver. Monthly trade deficit in Aug-11 at USD 14.1 bn remained close to its all time high. While we do not have the breakup of preliminary data, anecdotal evidence suggests the role of strong gold imports behind rising trade deficit. According to the World Gold Council, Indias consumer demand for gold has remained extremely buoyant, growing at 73% YoY in Q1 FY12 (of which 38% growth was in real terms). Additionally, the bunching up of outflows due to clearing of payments to Iran for oil purchased earlier in the year aggravated the problem. According to our estimates, close to USD 5.0-5.5 bn outflow happened during Aug-11, resulting in a temporary squeeze on Dollar liquidity in the system (see chart 32). What about RBI intervention? The sudden and rapid pace of Rupee depreciation has sparked concerns regarding imported inflation. According to available empirical estimates, a 10% depreciation of the exchange rate increases WPI inflation by 0.4% (in the short-term) to 0.9% (in the long-term). With WPI inflation running close to double digits, further upside risk to inflation through the mechanism of exchange rate pass-through would complicate monetary policy decision making for the RBI. On one hand, if the RBI chooses not to come in the way of Rupee depreciation by largely staying away from fx intervention, then the onus of controlling inflationary risks would fall upon interest rates. The interest rate channel has already been utlized to a large extent and further tightening could only be associated with diminishing returns amid emerging signs of domestic growth moderation. On the other hand, if the RBI intervenes in order to stabilize the exchange rate, as it actively did during Sep-Nov 2008 (when it sold a cumulative of USD 25.6 bn), then it could create problems for money market liquidity conditions. Liquidity could tighten beyond the 1% of NDTL levels as RBI sells Dollars and mops up Rupee liquidity from the system. This could impart instability to money markets. In order to offset the impact of intervention, the RBI will have to carry out sterlization operations to provide Rupee liquidity to the system. This can be
Payment to Iran for oil imported earlier were cleared in Aug-11
A 10% depreciation in Rupee if sustained, adds about 40 bps to WPI inflation
RBI is likely to intervene in fx, if Rupee depreciates further significantly
Chart34: Sudden and rapid depreciation in Rupee raises inflationary risks

52 50 48 46 44 42 40 38
Sep-09 Sep-11 Sep-05 Sep-06 Sep-07 Sep-08 Sep-10
Chart35: The RBI has so far remained away from the fx market
15 10 5 0 100 -5 95 90 85
Aug-04 Aug-07 Aug-08 Aug-09 Aug-10 Aug-05 Aug-06 Aug-11
YES ECOLOGUE
USDINR
WPI (% YoY, RHS)
12 10 8 6 4
RBI's Net Purchase of USD (In bn)
REER (RHS)
115 110 105
-10
2
-15
0
-20
-2
28
11 October, 2011

FX intervention is likely to be sterilized through OMO/CRR cuts achieved through a cut in CRR or through open market purchases of g-secs. Both these operations however run the risk of diluting the anti-inflationary stance of the central bank. Outlook Any delay in resolution of sovereign debt concerns in the EU can potentially increase risk aversion further and push INR towards 50 levels USDINR has breached our previous forecast of 45.50 and is currently trading around the 49 levels. The crisis in Eurozone can keep the Dollar funding problem from going away completely (the coordinated action by central banks in developed countries to re-establish their USD swap line with the Fed, notwithstanding). This could reduce INRs carry appeal despite RBI remaining one of the most hawkish central banks in the world. Any delay in resolution of sovereign debt concerns in the Eurozone can potentially increase risk aversion even further and push INR towards 50 levels (as it did in 2008-09). Going forward near term conventional and unconventional monetary policies in the EU and US are likely to provide support to the Dollar as: The latest Operation Twist by the Fed raises short term interest rates in the US (positive for USD) ECB is forced to cut policy rates and consider further asset purchases (negative for EUR, act as USD positive indirectly) BoE further builds up on its QE type operation (negative for GBP, act as USD positive indirectly) As such, Rupee is likely to remain under pressure, with meagre support from RBI intervention (below 50 levels). Hence we expect USDINR to trade around 48.5049.50 levels by Dec-11. However, with the government slowly moving out of policy inertia and policymakers looking for relaxing norms for inflows (through ECB, refinancing of Rupee loans, and debt purchases by FIIs), INR could possibly become one of the best performing currencies in the risk off mode. With the expectation of some stabilization of EU problems over the next 3-4 months, this would be positive for the Rupee. Hence we expect USDINR to trade around 45.50-46.50 levels by Mar12 and around 45.00-46.00 levels by Jun-12.
INR likely to remain under pressure in the near term and trade around 49 levels in this quarter
We expect INR to strengthen to around 45.50-46.50 levels by Mar12 and further to around 45.00-46.00 levels by Jun12
Chart36: Domestic equity markets have outperformed in the last two weeks
1.83 1.78 0.61 1.73 1.68 1.63 1.58 0.55 1.53 1.48 0.53 0.59 MSCI Index Ratios 0.63
India/ EM Asia India/ US (RHS)
Chart37: Valuations should soon start providing support

32 Sensex PE Ratio (%) 28 24 20 Sensex PB Ratio (%, RHS) 7 6 5 4 16 12 8 3 2 1 8
0.57
5-Sep
19-Sep
15-Aug
22-Aug
29-Aug
26-Sep
12-Sep
1-Aug
8-Aug
Sep-06
Sep-07
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YES ECOLOGUE
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11 October, 2011
Vulnerabilities and policy space in case of stress

The IMF has significantly downgraded global growth prospects for 2012 and 2013 The ongoing crisis in EU has raised the level of uncertainty in global financial markets In case of a stress scenario o While current account gap can benefit, overall BoP could deteriorate o Growth and inflation could likely moderate further While the RBI has ample room for accommodation, fiscal space is relatively constrained On the back of unprecedented monetary and fiscal stimulus globally, world GDP growth recovered to 5.1% in 2010 from -0.7% in 2009. However, outlook on world GDP growth for 2011 has been under constant scrutiny over the last few months as the nascent economic recovery has lost momentum amid return of volatility in global financial markets triggered by sovereign debt concerns in advanced economies. According to the Sep-11 WEO of the IMF, world GDP is expected to grow by 4.0% in 2011 and 2012 respectively vis--vis the previous estimate of 4.4% and 4.5% (as per the Apr-11 edition of the WEO). However, this presumes that European policymakers manage to contain the crisis in the euro area periphery, that US policymakers strike a judicious balance between support for the economy and medium-term fiscal consolidation, and that volatility in global financial markets does not escalate further. Both these assumptions will be put to test if The crisis in the euro area runs beyond the control of policymakers, notwithstanding the strong policy response agreed at the July-11 EU summit Activity in advanced economies, which is already softening, suffers further blows Either one of these eventualities would have serious repercussions for global growth and financial markets. In such a scenario, the emerging market economies, which have so far stayed away from signs of significant stress, both on the real economy as well as in the financial markets, can once again become vulnerable as they did in 2008-09. The write-up below attempt to make a preliminary assessment of the impact on the Indian economy under these stressed global macro conditions and comparing the same with the post Lehman experience. Impact on external sector Impact on the external sector would be visible on both the current and capital accounts, thereby putting the overall BoP under stress. In FY09, merchandise exports declined by approximately 30% (H2 over H1). On the imports front, H2 FY09 saw a decline of 36% vis--vis H1 FY09 of which 27%
Chart38: Current account deficit improved after the previous crisis
15 10 5 Trade Balance Invisibles (as % of GDP) Current Account
Outlook on world GDP growth for 2011 has been under constant scrutiny
due to rising sovereign debt concerns in Europe
EMEs can become vulnerable if the crisis in EU runs beyond the control of policymakers
Chart39: while capital account deteriorated

5 4 3 2
Foreign Investment (as % of GDP)
Loans
Capital Account
1
-5 -10 -15 Q1 FY09 Q2 FY09 Q3 FY09 Q4 FY09 Q1 FY10
0 -1 -2 Q1 FY09 Q2 FY09 Q3 FY09 Q4 FY09 Q1 FY10
Source: Labour Bureau GOI, CEIC, YES BANK Limited
30
YES ECOLOGUE
11 October, 2011

decline emanated from non-oil imports, while oil imports fell by a massive 52% over the same period due to a plunge in oil prices. The impact on services exports was initially mute, but eventually unfolded in the next financial year (services exports declined by 34% in FY10 compared to FY09). On a net basis, the initial aftershock of the global financial crisis in FY09 helped in lowering the current account gap the deficit came down to 2.1% of GDP over H2 FY09 from 2.5% of GDP over H1 FY09. On the capital account, the most perceptible impact was on portfolio flows. While portfolio flows were negative even before the collapse of Lehman Brothers in Sep08 (H1 FY09 saw an outflow of USD 5.5 bn), the outflows gathered pace with the intensification of the global financial crisis as FIIs pulled out USD 8.5 bn over H2 FY09. Other items under capital account like the FDI and access to external borrowings and trade credit also came under stress (see table below). On a net basis, the capital account deteriorated with the intensification of the global financial crisis. The average surplus of 1.9% of GDP under capital account in H1 FY09 slipped to an average deficit of 1.7% of GDP over H2 FY09. Current Scenario: While share of US and EU in Indias total exports has moderated from 34% in FY08 to just below 31% in FY11, the extent of diversificaion (to non US and EU centres) is not enough to avert the contagion from a second global recession in a short span of time. The deterioration in exports would not impact the current account negatively in stress scenario as moderation in imports would once again offset the overall impact. However, the capital account could once again become vulnerable to abrupt outflows, thereby putting the overall BoP under stress. Impact on growth Reflecting the slowdown in external demand, and the consequences of a reversal of capital flows, GDP growth began decelerating from Q3 FY09 onwards. While overall GDP growth remained below 6% in H2 FY09, the impact was exaggerated due to a contraction in agriculture output on the back of a monsoon failure in 2008. The actual impact on growth was concentrated on the industrial sector, which grew at a tepid pace of 2.4% over H2 FY09 compared to 6.6% over H1 FY09. The service sector remained somewhat resilient due to the prompt fiscal and monetary stimulus. Current Scenario: Under a stress scenario, Indias GDP growth can once again fall below 7% with momentum in the industrial sector already remaining weak. However, the agri GDP growth is likely to provide a buffer this time around unlike FY09, which suffered from drought year.
Chart41: Global commodity prices plunged after the intensification of the crisis
160 140 120 100 80
4 2 0 -2 -4 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09
The initial aftershock of the global financial crisis in FY09 helped in lowering the current account gap
while the capital account deteriorated
Overall BoP can become vulnerable in case of extreme stress due to capital outflows
In FY09, while growth decelerated, the impact was exacerbated due to drought in 2008
Under a stress scenario, Indias GDP growth can once again fall below 7% with momentum in the industrial sector already weak
Chart40: Industrial GDP was the worst hit during the previous crisis
14 12 10 8 6 Agriculture Industry (% YoY) Services Overall GDP
Brent (USD pb)
CRB Index (RHS)
500 450 400 350 300 250 200 150
60 40 20
Jul-08 Sep-08 Jan-08 Nov-08 Mar-08 Jan-09 May-08 Mar-09 May-09

YES ECOLOGUE

31
11 October, 2011

Impact on inflation WPI inflation corrected in FY09 as commodity prices crashed The initial decline in WPI inflation was a reflection of the crash in commodity prices after the intensification of the global financial crisis. Average price for Brent in H2 FY09 was lower by 58% vis-a-vis H1 FY09 The broader CRB Commodity Index fell by 43% in H2 FY09 over H1 FY09 As global commodity prices eased, headline WPI inflation moderated to an average rate of 6.1% over H2 FY09 from 10.1% over H1 FY09. Inflationary pressures further subsided as output gap closed, with core inflation declining to 0.3% in FY10 from 5.7% in FY09. Current Scenario: A global shock of similar proportion can potentially have a similar impact on the WPI inflation trajectory. However, this time commodity prices have not dropped as much as they did in FY09 this implies only a gradual moderation in inflation. Response to crisis In response to the global financial crisis, which intensified with the collapse of Lehman Brothers, policymakers responded promptly. The government provided fiscal stimulus to the extent of 4.5% of GDP over FY09 and FY10 The RBI cut the repo rate by 425 bps over 9-months following the collapse of Lehman Brothers in Sep-08 The RBI interevend in the fx market to curb volatility (the central bank sold USD 26 bn between Sep-08 and Dec-08) USD liquidity (through swaps) and INR liquidity (through cuts in reserve requirements and OMOs) was provided by the RBI in an active manner Current Scenario: In the event of a severe crisis, the RBI can be expected to reverse its monetary tightening in a swift manner. This would be possible as a severe crisis can be expected to significantly lower inflationary pressures. The repo rate and the CRR currently stand at 8.25% and 6.00% respectively both provide ample room for monetary accomodation, if required. Current fx reserves of around USD 315 bn are higher than USD 290 bn the level just before the collapse of Lehman Brothers. This provides RBI the necessary werewithal to stem excess volatility in Rupee if required. Apart from relaxing reserve requirements, the RBI can also take recourse to OMOs in an active manner for providing INR liquidity. Similarly, USD liquidity provisions can be reactivated if required. While the RBI seems comfortably placed for any contingency, the fiscal space appears constrained. However, the drop in commodity prices would help reduce the potential subsidy burden and provide some room for fiscal pump priming.
This time, moderation in commodity prices is likely to result in only a gradual moderation
Monetary and fiscal policies responded swiftly after the collapse of Lehman in 2008
In the current scenario, while the RBI seems comfortably placed for policy accommodation if required, the fiscal space appears constrained
Chart42: Both headline and core inflation eased after the crisis
14 12 10 8 6 4 2 0 -2 -4
Nov-08 May-08 May-09 Nov-09 Mar-08 Mar-09 Jul-08 Sep-08 Jul-09 Sep-09 Jan-09 Jan-08
Chart43: RBI provided ample accommodation during the crisis period

10 (%) Repo Rate Reverse Repo Rate
monetary
WPI (% YoY)
Core WPI (% YoY)

9 8 7 6 5 4 3 2
CRR
Nov-08
May-08
May-09
32
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11 October, 2011
Appendix
Exports of Principal Commodities (Share in Total) Commodity Group Primary Products Agriculture & Allied Products Ores & Minerals Manufactured Goods Leather & Manufactures Chemicals & Chemical Products Engineering Goods Textiles & Textiles Products Gems & Jewellery Others Petroleum Products Others FY91 23.8% 18.5% 5.3% 71.6% 8.0% 9.5% 12.4% 23.9% 16.1% 1.7% 2.9% 1.7% FY01 16.0% 13.4% 2.6% 77.1% 4.4% 13.2% 15.3% 25.3% 16.6% 2.3% 4.2% 2.8% FY11 13.9% 9.7% 4.2% 66.1% 1.5% 11.4% 13.2% 9.2% 11.8% 1.0% 16.5% 3.5%
Imports of Principal Commodities (Share in Total) Commodity Group Petroleum, Crude & Products Consumption Goods Capital Goods Export Related Items Pearls & Precious Stones Chemicals Others Miscellaneous Fertilizers Non Ferrous Metals, Ores, Scraps Iron & Steel Gold & Silver Others FY91 25.0% 2.3% 24.2% 15.3% 8.7% 5.3% 1.3% 33.1% 4.1% 6.1% 4.9% 0.0% 18.0% FY01 31.0% 2.9% 17.7% 15.9% 9.5% 4.8% 1.6% 32.5% 1.5% 2.6% 1.5% 8.2% 18.8% FY11 30.1% 2.5% 20.3% 14.1% 8.9% 4.2% 1.0% 33.0% 2.0% 3.8% 2.9% 9.6% 14.7%
Exports to Principal Regions (Share in Total) Region/Country OECD Countries US EU Asia & Oceania Others OPEC Eastern Europe Developing Countries Asia of which China Latin America Others FY90 55.9% 16.2% 24.9% 11.2% 3.6% 6.7% 0.0% 15.6% 13.2% 0.1% 0.4% 21.8% FY00 57.3% 22.8% 26.2% 5.8% 3.2% 10.6% 0.0% 28.4% 22.3% 1.5% 1.8% 3.7% FY10 35.9% 10.9% 20.2% 2.9% 2.0% 21.1% 0.1% 39.2% 29.8% 6.5% 3.5% 3.8%
Imports to Principal Regions (Share in Total) Region/Country OECD Countries US EU Asia & Oceania Others OPEC Eastern Europe Developing Countries Asia of which China Latin America Others FY90 60.2% 12.1% 33.3% 10.7% 4.2% 14.3% 0.0% 17.1% 12.5% 0.2% 0.0% 8.4% FY00 43.0% 7.2% 22.3% 7.5% 6.3% 25.9% 0.0% 29.2% 20.0% 2.6% 1.9% 1.9% FY10 32.6% 5.9% 13.3% 6.8% 6.7% 32.0% 0.0% 32.5% 25.6% 10.7% 3.6% 2.8%
YES ECOLOGUE
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11 October, 2011
Key Macro Numbers and Forecasts

INDIAN ECONOMY - ANNUAL MACRO TRACKER FY06 FY07 FY08 FY09 FY10 National Income Indicators Real GDP (%) 9.5 9.7 9.2 6.6 7.5 Agriculture (%) 5.2 3.7 4.7 1.6 0.2 Industry (%) 8.1 13.6 9.3 3.0 10.2 Services (%) 11.3 10.2 10.4 9.0 8.5 Inflation WPI Average (%) Monetary Sector Bank Credit (%) Bank Deposits (%) Reserve Money (%) Money Supply (%) External Sector Trade Balance (USD bn) Invisibles (USD bn) Current Account (USD bn) Current Account (as % of GDP) BoP (USD bn) Key Policy Rates Reverse Repo Rate (year end) Repo Rate (year end) CRR (year end) SLR (year end) Market Rates Call rate (average) 1year T-Bill (average) 10 year G-Sec (average) Exchange Rate (USDINR) Annual Average Year-end
* Estimated values Source: CSO, CGA, Reserve Bank of India; MinCom;YBL
FY11 8.5 6.6 7.9 9.4
FY12 E 7.7 3.5 6.7 9.2
4.4
6.6
4.7
8.1
3.9
9.6
8.5
30.8 18.1 20.8 17.0
28.1 23.8 22.4 21.3
22.3 22.4 23.9 21.7
17.5 19.9 9.0 19.3
16.9 17.2 16.7 17.1
21.4 15.8 17.2 16.0
18.0 18.0 15.5 15.5
-51.9 42.0 -9.9 -1.3 15.1
-61.8 52.2 -9.6 -1.2 36.6
-91.5 75.7 -15.8 -1.3 92.2
-119.5 89.9 -29.6 -2.3 -20.1
-118.4 78.9 -39.5 -2.7 13.4
-130.5 86.2 -44.3 -2.6 13.1
-158.0 100.0 -58.0 -2.9 11.0
6.50 5.50 5.00 25.00
7.50 6.00 6.00 25.00
7.75 6.00 7.50 25.00
5.00 3.50 5.00 24.00
5.00 3.50 5.75 25.00
6.75 5.75 6.00 24.00
8.25 7.25 6.00 24.00
5.56 5.97 7.11
7.05 7.02 7.77
5.71 7.50 7.90
7.00 7.15 7.58
3.33 4.37 7.20
5.73 6.56 7.91
44.27 44.62
45.22 43.48
40.27 40.11
46.00 50.73
47.46 44.91
45.57 43.50
46.00
34
YES ECOLOGUE
11 October, 2011
YES BANK LIMITED

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11 October, 2011
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YES ECOLOGUE

India Macro Quarterly - Oct 11

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Return of Global Uncertainty A sense of dj vu

INDIA MACRO QUARTERLY

Global: Return of uncertainty...5

India: Growth to hover around trend..8

Structural factors keep inflation sticky......11

India caught in a wage-price spiral?...13

Fiscal slippage unavoidable in FY12......17

RBI to infuse primary liquidity through OMOs......20

External risks contained....22

Global factors back on INR radar...27

Vulnerabilities and policy space in case of stress....30

Annexure......33 Key Macro Numbers and Forecasts.........34

INDIA MACRO QUARTERLY

Global: Return of uncertainty

Global economy at the brink of tipping back into a recession

Downgrade of US sovereign credit rating followed by fears of a Greek default

led to sharp volatility in financial markets

PIIGS 5Y CDS PIIGS 5Y govt bond spread with Germany

Source: Thomson Reuters, YES BANK Limited

Source: Bloomberg, YES BANK Limited

INDIA MACRO QUARTERLY

while, CDS spreads surge to record highs

Growth in Q2 2011 indicates a synchronized global weakness

PMI, both manufacturing and services, have plunged in several economies

Greeces survival hinges on next tranche of aid

Chart3: Synchronized softness in global GDP

60 55 50 45 40 35 China US ISM India UK EZ

Source: Bloomberg, YES BANK Limited

Source: Bloomberg, YES BANK Limited

INDIA MACRO QUARTERLY

Policy makers urge Recapitalization of European banks

as EFSF, largely insufficient if crisis spreads to other economies

coupled with mounting levels of debt on the fiscal side

INDIA MACRO QUARTERLY

India: Growth to hover around trend

While growth has begun to display incipient signs of moderation

Car sales plunge; credit to personal loans on incremental basis lower

Chart5: Private consumption indicates nascent signs of moderation

Private Consumption (% YoY) IIP Consumer Goods (% YoY, RHS)

Source: CEIC, YES BANK Limited

Source: CEIC, YES BANK Limited

INDIA MACRO QUARTERLY

Growth in proposed industrial investment at a 2 year low

warrants the urgent need to hasten reform process

India has bucked the trend of a slowdown in Asian export growth.

Minimal increase in budgeted total expenditure to limit govt spending in FY12

Chart7: Investment sentiment suffersproposed industrial investment at a 2 year low

Asian Exports Taiwan Singapore non oil China Thailand India

Source: CEIC, YES BANK Limited

Source: Bloomberg, YES BANK Limited

INDIA MACRO QUARTERLY

.though some moderation likely

We lower our FY12 GDP forecast to 7.7% from 7.9% earlier

Chart9: Above normal monsoon in FY12 to aid agricultural output

Chart10: Resilience in services to limit the downside in GDP growth

Actual Rainfall as a % of LPA Foodgrain Output (MT, RHS)

Source: CEIC, YES BANK Limited

Source: CEIC, YES BANK Limited

INDIA MACRO QUARTERLY

Structural factors keep inflation sticky

Inflation has remained close to double digits in last 18 months