India Outlook For FY 10

India Outlook FY10
Rocky Road
to Recovery
Index
• Growth fears to be allayed by policy response and faster global recovery 3
FY09 saw a dramatic turnaround in global and domestic conditions post the Lehman collapse that
shattered the relatively robust working of the economy in the first half. Uncertain global conditions
along with evolving domestic conditions make a point forecast for GDP growth in FY10 virtually
impossible and hence we approach the growth forecasting issue from several alternative dimensions.
• Inflation is expected to remain benign 16

Reversal in global commodity prices led to swift decline in price pressures since end of last year. We
expect inflation to tread into the negative zone, however the threat of structural deflation remains
distant. Favourable base effect, along with moderate global commodity prices would keep inflation at
benign levels in FY10.
• Expansive fiscal policy to continue 18

Expansive fiscal policy has become the order of the day, as governments world over try to shore up
economic growth. The initiation of fiscal measures in India since late last year has been prompt,
however they have led to a deterioration of the fiscal parameters. We expect the fiscal deficit to touch
7% in FY10 on account of further increase in plan expenditure.
• Softer interest rates to stay 23

Changing global and domestic conditions warranted the adoption of an accommodative monetary
policy since September last year. In its fight against the global crisis monetary policy has acted as a
‘first line of defense’ for RBI. We expect a softer interest rate regime to continue with a downward bias
on rates.
Though easing of rates have had an expected impact on yields till Q3 FY09, the same is not true since
then as fears of excess supply of government issuances have dominated sentiment. Considering the
market sentiment towards the problem of excess supply and RBI’s response thereof, on an average we
expect the 10Y yield to lie in the range 6.5-7.0% over the next few months. However, in the medium to
long term yields should start reflecting macro fundamentals of benign inflation and moderate growth
when the market recognizes the balance in demand-supply. We expect yields to head towards 6% at
that point.
• Near term risks to undermine INR, strength to return on benign BoP outlook 33
FY10 is likely to see a more balanced BoP as a narrowing trade deficit helps to improve the current
account and capital account doesn’t deteriorate significantly from current levels. In the medium to long
run, Rupee would take cues from the overall benign BoP outlook along with a weakening of the dollar
against the major currencies. In the near term, however, the Rupee will be at depreciated levels as risk
appetite remains largely on the sidelines and dollar trades firmly. Further, with event risks lurking in the
near term, the downward pressure on the domestic currency can get exacerbated.
FY09 – The year of two halves
GDP falters after 5 years of plus 8% growth (% YoY) GDP Growth
• The year FY09 can actually be called the year of 11
two halves, where the relatively robust working 10
of the economy in the first half was shattered by 9
the impact of the global meltdown post the 8
Lehman collapse. 7
6
• In the early part of the year, the ongoing cyclical
5
moderation was accentuated by rapid tightening
4
of monetary policy to counter record inflation 3
levels. This softening up of the economy made
2
us susceptible to the global shock.
D e c -0 4
M a r -0 5
J u n -0 5
S e p -0 5
D e c -0 5
M a r -0 6
J u n -0 6
S e p -0 6
D e c -0 6
M a r -0 7
J u n -0 7
S e p -0 7
D e c -0 7
M a r -0 8
J u n -0 8
S e p -0 8
D e c -0 8
• Under the impact of the crisis, growth fell,
liquidity tightened and in response governments
initiated expansive monetary and fiscal policies.
Source: CEIC, ICICI Bank Research
IIP – Precursor to the deteriorating conditions
(% YoY) IIP
• Growth of industrial production had started 16 Growth 3 month MA
indicating the slowdown since last fiscal. 14
• The sharp drop in IIP growth in October gave 12
credence to the worst fears that industrial 10
production has virtually stalled leading to rapid 8
build-up of inventories across different industry 6
segments. 4
• The average growth of IIP declined sharply in 2
Q3 FY09 to 0.4% compared to 8.4% in Q3 FY08. 0
The Dec’08 and Jan’09 figures are also in the -2
red indicating that the pain has not eased yet.
O ct-05
Dec-05
Feb-06
Apr-06
Ju n -06
Au g -06
O ct-06
Dec-06
Feb-07
Apr-07
Ju n -07
Au g -07
O ct-07
Dec-07
Feb-08
Apr-08
Ju n -08
Au g -08
O ct-08
Dec-08
Feb-09
• However, there are some nascent signs of
stabilizing in sectors like cement, steel and auto.
Source: CSO, ICICI Bank Research
Inflation – Does a U-turn (% YoY) WPI
• As growth momentum started faltering in the 14
beginning of last year, inflation reared its ugly 12
head on the back of steep increase in global
10
metal and fuel prices. Inflation zoomed into the
double-digit zone peaking at near 13% level in 8
early August’09. 6
• Rising inflation was essentially contributed by 4
increase in manufacturing articles prices (base
2
metals, edible oil) and fuel prices (increase in
regulated prices of petrol, diesel and LPG). 0
J a n -0 8
F e b -0 8
M a r-0 8
A p r-0 8
M a y -0 8
J u n -0 8
J u l-0 8
A u g -0 8
S e p -0 8
O c t-0 8
N o v -0 8
D e c -0 8
J a n -0 9
F e b -0 9
M a r-0 9
• The peak in inflation was also accompanied with

fiscal and monetary tightening measures, which
led to strained liquidity and high interest rates Source: Bloomberg, ICICI Bank Research
thus accelerating the cyclical downfall.
3
FY09 – The year of two halves
Policy rates – Switching modes (%) CRR Repo rate
• The monetary tightening measures took the 10
form of CRR and repo rate being raised by 250 9

bps and 225 bps respectively to 9% each.
8
• With evolving global conditions, the months of
September – October saw a dramatic tightening 7
of money markets with call rates jumping to
20% levels. 6
• The situation necessitated a change in policy 5

stance and since then RBI has reduced the CRR
4
by 400 bps to 5% and repo rate by 350 bps to
J a n -0 7
M a r-0 7
M a y -0 7
J u l-0 7
S e p -0 7
N o v -0 7
J a n -0 8
M a r-0 8
M a y -0 8
J u l-0 8
S e p -0 8
N o v -0 8
J a n -0 9
M a r-0 9
5.5%.
• Moving in sync with policy rates, the overnight
call rate and bond yields eased significantly
from the stressed levels of October. Source: Bloomberg, ICICI Bank Research
Virtual paralysis in the external sector Exports growth (3m MA) Trade balance (RHS) (USD bn)
(% YoY)
• The downward growth momentum and falling 50 0
external demand in the face of global recession -2
40
has started to reflect in the external trade data.
30 -4
• Export growth has remained in the negative for -6
the fifth consecutive month. 20
-8
• Export growth averaged 22.7% in H1 FY09 while 10 -10
it has averaged –12.2% between Oct’08-Feb’09. 0 -12
Average import growth has fallen to –3.2% -10
-14
between Oct-Feb’09 from 38.7% in H1 FY09.
-20 -16
• The trade deficit, which had ballooned in the
F e b -0 6
J u n -0 6
O c t-0 6
F e b -0 7
J u n -0 7
O c t-0 7
F e b -0 8
J u n -0 8
O c t-0 8
F e b -0 9
earlier part of the year, has started to ease on
account of falling imports.
Analysing the growth outlook for FY10 – A conceptual framework

Uncertainties about the prognosis of global recovery and inability to fathom the dent in sentiments would
make a point forecast for GDP growth in FY10 virtually impossible and hence we approach the growth
forecasting issue from several alternative dimensions.
Our broad thought is to look at GDP growth from both demand side and supply side as well as from the
perspective of how the long-term structural factors would play out. We start off with an analysis of the
savings-investment trends and try to arrive at growth estimates through the productivity of these
investments, as reflected in ICOR.
The demand side approach concentrates on the drivers of consumption and investment demand. We
identify the possible trends in consumption that could emerge in FY10 and also discuss how the quantum
of investment would be conditioned by both business sentiment and availability of finance. In supply side
analysis we focus on the outlook for agriculture, industry and services. All through our analysis, we are
aware that the outlook for FY10 would have to be conditioned for extreme volatility. So simultaneously we
undertake a historical exercise of trying to gauge how much different components of GDP respond in
slowdown years. These approaches lead us to construct 3 possible scenarios for growth in FY10.
4
Savings & Investment – structural determinants
Paradigm shift in savings propelled growth…
(%) Savings as a % of GDP Real GDP growth (RHS) (%)
• Savings and Investment are the traditional 40 Real GDP growth between 7.5-
11
Real GDP growth between 4-6% when
structural determinants of growth; more so in a 35
savings ranged between 22-23% of GDP
9.4% when savings between 30- 10
35% of GDP
developing economic set up. 30 9
• The structural shift of the economy is visible 8

25
with average savings rate rising to 33.6% in the 7
20
last five years from 24% in the prior five year. 6
15
5
• While household savings account for almost
10 4
70% of gross domestic savings, its share has
5 3
fallen from close to 90% in 1990’s.
0 2
• The share of private corporate savings has
1 9 9 6 -9 7
1 9 9 7 -9 8
1 9 9 8 -9 9
1 9 9 9 -0 0
2 0 0 0 -0 1
2 0 0 1 -0 2
2 0 0 2 -0 3
2 0 0 3 -0 4
2 0 0 4 -0 5
2 0 0 5 -0 6
2 0 0 6 -0 7
2 0 0 7 -0 8
increased markedly from close to 14% in FY02
to 23% in FY07. Of equal importance is the fact
that public sector has turned into a net saver
from being a net dissaver in FY03. Source: CSO, ICICI Bank Research
...and led the upsurge in investment
(%) Investment growth Savings growth Real GDP growth (RHS) (%)
• The shift in trajectory of India’s growth path has 30 11
been a result of the turnaround in investment 25 10
growth from negative and single digit levels. 9
20
• In a scenario of rising domestic savings, 8
availability of capital is easier which fuels 15 7
investment demand. 10 6
• The financing of investment shows that 5

5
domestic savings accounts for roughly 96-99% 4
0
of total investment indicating that the reliance 3
on external sources of financing is minimal. -5 2
1 9 9 6 -9 7
1 9 9 7 -9 8
1 9 9 8 -9 9
1 9 9 9 -0 0
2 0 0 0 -0 1
2 0 0 1 -0 2
2 0 0 2 -0 3
2 0 0 3 -0 4
2 0 0 4 -0 5
2 0 0 5 -0 6
2 0 0 6 -0 7
2 0 0 7 -0 8
• The trend in investment growth shows its erratic
nature before FY03 but since then the stability in
investment growth has been remarkable.
H o u s e h o ld S a v in g s P r iv a t e C o r p o r a t e s a v in g s P u b lic s e c to r s a v in g s C a p it a l f o r m a t io n
P vt c o rp o ra te C h a n g e fro m P u b lic sec to r
H H sa vin g s C h a n g e fro m sa vin g s to G DP p revio u s sa vin g s to C h a n g e fro m G DC F to C h a n g e fro m
to G DP (% ) p revio u s yea r (% ) yea r G DP (% ) p revio u s yea r G DP (% ) p revio u s yea r
FY 95 20.5 1.4 3.8 0.0 2.6 1.2 25.5 3.0
FY 98 19.4 1.7 4.7 -0.3 2.0 -0.4 25.3 1.3
FY 01 23.6 0.5 4.2 -0.7 -1.9 -1.0 24.3 -1.6
FY 03 25.2 1.1 4.2 0.5 -0.7 1.5 25.2 2.4
FY 07 26.1 -0.3 8.5 0.4 3.5 0.7 35.9 0.4
Benchmark years Slowdown years
• The data suggest that a slowdown year impacts private and public sector savings while household
savings remain stable. With sluggish growth expected in FY09 and FY10 private corporate sector
savings as a proportion of GDP would fall - historically, the fall has been less than 1%. However, in
FY09 and FY10 the fall could be higher since the ratios are at elevated levels initially.
• With falling corporate and public savings we expect gross domestic savings as a percentage of GDP to
fall to near 32% levels in FY10 from the high of 37.7% in FY08.
5
Productivity gains catalyze investment into growth
Productivity of investment dips in slowdown
ICOR GDP (RHS) (% YoY)
• The impact of investments on overall GDP 10 11
growth is conditioned by the productivity of 9 10
those investments. ICOR rises sharply during slowdown years 9
8
• Productivity gains on the back of technological 8
7
progress and entrepreneurial innovations have 7
6
been reflected in the incremental capital output 6
ratio (ICOR - a measure of how much capital is 5
5
needed to produce an additional unit of output). 4 4
• Between 2000-06 India’s ICOR averaged 4, 3 3
lower than that of China at 4.3 and Brazil at 5.1. 2 2
ICOR has tendency to rise in a slowdown year.
FY 93
FY 94
FY 95
FY 96
FY 97
FY 98
FY 99
FY 00
FY 01
FY 02
FY 03
FY 04
FY 05
FY 06
FY 07
FY 08
FY 09 AE
During the slowdown of FY03 ICOR jumped to
6.9 from 4.5 in the previous year. ICOR for FY09
based on advanced estimates is at 5.3 from 4.2 Source: RBI, ICICI Bank Research
in FY08.
Efficiency loss to be offset by investment
• We have tried to simulate the implied
investment growth for a given level of GDP ICOR levels
growth and ICOR for FY10. 5 5.5 6
• The table on the right shows, the assumed GDP GDP 5.5 -21 -13 -6
growth for FY10 and the ICOR levels expected Growth in 6 -14 -5.5 3
to prevail in FY10, different combinations of FY10 6.5 -7 2.3 12
which yield an implied investment growth.
7 0 10.2 20
• Analysis for FY10 shows that for the GDP to
grow by 6.5% and with assumed ICOR at 6,
investment would have to grow by 12%. With
investment growth already moderating to near
8.5% levels in FY09 such a scenario in FY10 Implied investment rate
seems fraught with difficulties.
Source: ICICI Bank Research
Safe-haven component may pose a challenge (%) Proportion in change HH assets

Deposits Currency LIC PPF Shares & Debentures Others
• Flight to quality a natural response of the 120
During slowdown years proportion of LIC & deposits rises
household investor in bad times leading to a
100
rise in the ‘safe haven’ components
80
• Changes in household assets shows that
slowdown years are marked by a rise in 60
deposits and LIC funds – indicating the risk
40
averse nature of households.
20
• We expect the share of financial savings in total
savings to decline, as households would turn 0
averse to risky assets. This could potentially
-20
thwart the productivity of investable funds.
FY 97
FY 98
FY 99
FY 00
FY 01
FY 02
FY 03
FY 08
• During previous slowdown years share of

financial savings in total savings has dropped Source: RBI, ICICI Bank Research
between 5-7% while that of physical savings has
increased by a similar amount.
6
Demand side developments in past slowdowns
Consumption growth falters in slowdown
9
• Moving on from the savings – investment
P r iv a te C o n s u m p tio n g r o w th (t-1 )
Y(t) = 0.2208Y(t-1) + 3.8163
approach we look at the consumption – 8
R2 = 0.0581
investment angle in the demand side of the 7
growth dynamics.
6
• The chart on the right shows the scatter plot of
consumption growth in the year ‘t’ vis-à-vis the 5
previous year ‘t-1’. The points on above the 45
degree line represent a slowdown in year t vis- 4
à-vis in year t-1. 3
• The highlighted points indicate consumption
2
growth in a slowdown year vis-à-vis the
9
previous year. This analysis reveals that private Private Consumption growth (t)
consumption growth could fall by 3 - 5% points
from the previous year and could make a *Highlighted years are slowdown years – FY98, FY01, FY03
significant difference to the forecast for FY10. Source: CEIC, ICICI Bank Research
Investment growth follows a volatile trend 22
• The share of investment rose from 23% of GDP 19
Y(t) = -0.0651Y(t-1) + 10.103
In v e s tm e n t g r o w th (t-1 )
R2 = 0.0042
in FY03 to 32% in FY08. Improving corporate 16
balance sheets was a big contributor to this. 13
• The chart on the right shows the scatter plot of 10
investment growth in the present year t vis-à-vis 7
the previous year t-1. Absence of a particular 4
pattern corroborates with the erratic nature of 1
investment growth. -2
• It is interesting to note that in 2 out of 3 cases -5
poor investment growth actually preceded a
-5
-2
10
13
16
19
22
slowdown year rather than following it. The Investment growth (t)
implications for FY10 would depend on how
*Highlighted years are slowdown year – FY98, FY01, FY03
deeply entrenched is the investment Source: CEIC, ICICI Bank Research
deceleration.
GDP growth deviates from its upward trend
10
• The chart on the right shows the scatter plot of Y(t) = 0.3961Y(t-1) + 3.6819
GDP growth in the year t vis-à-vis the previous 9
R2 = 0.1698
year t-1. The points above the 45 degree line 8
G D P g r o w th (t-1 )
represent a slowdown in year t vis-a-vis in year 7

t-1.
6
• With most of the points falling to the right of the
45 degree line, we see that growth has been on 5
an uptrend. 4
• In a slowdown year as expected GDP growth 3
drops sharply compared to the previous year,. A 2
similar pattern for consumption growth seems
2
10
to indicate that the projection of GDP growth for GDP growth (t)
FY10 would depend critically on how
*Highlighted years are slowdown years – FY98, FY01, FY03
consumption responds. Source: CEIC, ICICI Bank Research
7
Criticality of consumption to the overall growth
The story of consumption evolution
(% YoY) Private Consumption growth
• Consumption accounts for 70% of GDP and its 10
significant expansion has been promoted by the 9
emerging middle class and ably supported by a 8
transformation in rural India. 7
6
• The chart here shows the stable and rising
5
consumption growth. The quarters of a fall in 4
growth are largely associated with a bad 3
monsoon. 2
• The 15 consecutive quarters of more than 5% 1
consumption growth has not been at the 0
J u n -00
D ec -00
J u n -01
D ec -01
J u n -02
D ec -02
J u n -03
D ec -03
J u n -04
D ec -04
J u n -05
D ec -05
J u n -06
D ec -06
J u n -07
D ec -07
J u n -08
D ec -08
expense of domestic savings, but primarily
because of the rising disposable incomes.
Maintaining a healthy consumption growth will
be critical for overall GDP growth in FY10. Source: CEIC, ICICI Bank Research
Consumption Sustainers Potential pitfalls in consumption growth

• Rural demand – to remain resilient (~57% • Falling industrial output and uncertain global
workforce in agriculture). Agriculture & environment to reduce employment
government services remain unaffected and to opportunities in near term
benefit from govt measures. State pay • Lagged effect of downturn on services could
commission to infuse purchasing power feed into employment uncertainty
• Faster rising affordability on the back of falling • On the back of uncertain job climate and falling
prices availability of credit consumers might be forced
• Lower interest rates to boost consumption to defer discretionary purchases
• Favorable wealth effect – a surge in income • With a sharp reversal in equity and real estate
levels over the past years to provide a cushion markets, more and more consumers would feel
during this period of slowdown the pinch and this erosion of wealth could have
• Long term structural factors intact - an adverse impact on a particular segment
demographic advantage, rising middle class and • Global risk aversion to weigh down on
fast rising skilled labour consumer sentiment
Pay Commission impact to linger on Wages, salaries and pension
State Governments
• Government’s measures – centre & state pay Central Government

INR bn % to GDP INR bn
(Consolidated)*
% to GDP
commission, employment programs – would 1996-97 371 2.7 912 6.7
1997-98 500 3.3 996 6.5
help to mitigate pressure on consumption. 1998-99 572 3.3 1156 6.6
1999-00 648 3.3 1357 7
• The table shows that there was a staggered 2000-01 661 3.1 1508 7.2
2001-02 640 2.8 1525 6.7
impact of the 5th pay commission on the wage 2002-03 706 2.9 1588 6.5
expenses for the centre and the state lasting till 2003-04
2004-05
735
808
2.7
2.6
1847
1847
6.7
5.9
FY01. Wages and salaries of the centre as a % 2005-06 906 2.5 2069 5.8
2006-07 941 2.3 2131 5.1
of GDP rose from 2.7% to 3.3% while that of the 2007-08 1005 2.1 2259 4.8
state rose to a high of 7.2% on account of the 2008-09
2009-10^
1357
1561
2.5
2.6
2700
3300
4.9
5.5
5th pay commission. * : Non-plan revenue expenditure of the States going to social,
economic and administrative services
• Thus taking into account a similar rise of the ^ : Assuming similar impact as of 5th Pay commission and nominal
GDP growth of 10%
wage bill for the centre and state, the 6th pay Note - Data for state govt post 2005-06 is calculated assuming similar
growth as for central govt over the subsequent years
commission would give an income boost of
Source: RBI, ICICI Bank Research
upto 1.4% of GDP.
8
Lower prices and rates to provide further relief
How much will falling prices matter?
(% YoY) Inflation
• As mentioned earlier affordability could outpace 14
FY08 FY09
the fall in income 12
• Inflation as measured by WPI has convincingly
10
reversed its tract after growing at double digits
last year. We expect negative inflation to prop 8
up this year for a few months, before prices
6
start rising again.
• However, falling inflation could also have an 4
adverse impact wherein consumers would defer
2
purchases in anticipation of further fall in prices.
• The current fall in prices is a phenomenon 0
Jul
Oct
Apr
M ar
M ay
N ov
Dec
S ep
Feb
Aug
Jun
Jan
driven by the statistical base effect, and hence
this is expected to wane at the latter part of the Source: Bloomberg, ICICI Bank Research
year, diluting its impact on consumer behavior.
Auto sales correlate well with WPI trends (% YoY) (% YoY)
Auto Sales 3 Month MA
• To substantiate the above point we analysed the 35 WPI lagged by 3 months (inverted, RHS)
0
trend of auto sales growth with the headline 25 2
inflation figure.
4
• The graph shows clearly that an inverse relation 15
exists between falling prices and auto sales 5 6
growth and the correlation between auto sales 8
and WPI lagged by 3 months is close to –0.5. -5
10
• Auto sales is a component of leveraged -15
12
spending by the consumers. Hence we feel that Falling inflation to prop up auto sales
the impact of falling prices on auto sales could -25 14
be coming through the interest rate channel -
M a r -0 0
S e p -0 0
M a r -0 1
S e p -0 1
M a r -0 2
S e p -0 2
M a r -0 3
S e p -0 3
M a r -0 4
S e p -0 4
M a r -0 5
S e p -0 5
M a r -0 6
S e p -0 6
M a r -0 7
S e p -0 7
M a r -0 8
S e p -0 8
M a r -0 9
phases of falling prices are also associated with
easing interest rates.
Source: Bloomberg, ICICI Bank Research
Falling rate could support leveraged spending (% YoY) Private Consumption Real Interest rates (t-2) (RHS) (%)
• Private consumption, has an inverse 10 10
Correlation of -0.74
relationship with interest rates adjusted for 9 9
inflation. 8 8
• However the relationship works with a lag. As 7 7
per economic logic, lower rates help to 6 6
stimulate demand as cost of credit reduces and 5 5
this is reflected in the high correlation of –0.7.
4 4
• We have used the 1-year prime lending rate 3 3
adjusted for inflation for the purpose of analysis.
2 2
The relationship is sensitive to the use of the
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
PLR and it weakens significantly on taking the 1-

year deposit rate (correlation falls to –0.4).
• With PLR rates expected to fall in FY10, we
could see a potential upside for consumption. Source: RBI, ICICI Bank Research
9
Investment and exports could be a drag on growth
Falling rates to shore up investment…
(%) Real interest rate Investment (RHS) (% YoY)
• From the demand side, analysing investment 12 25
Correlation of -0.8
demand will be complementary to the analysis
10 20
that we have done for consumption demand.
• We analyze the impact of lower rates on 8 15
investment and it indeed does have a positive
6 10
relation. Lower rates reduces cost of funds
relative to potential returns and this helps 4 5
encourage more investment. Lower rates would
2 0
also help to make some projects more viable.
• In case of consumption the mechanism works 0 -5
through a lag, for investment though counter
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
intuitive the relation holds in the immediate
period. However, a depressed business
sentiment could delay this impact. Source: CEIC, ICICI Bank Research
…but financing could be an area of concern Sources of financing as % of total credit to industry
FY08* FY09* INR
• In the recent past the proportion of foreign
FY08* FY09* INR bn bn
flows helping finance investment had increased A) Bank credit to the industry 45 60 2249 2932
markedly. B) Flow from non banks 55 40 1509 980
• The freezing of global financial markets post the B.1. Domesstic Sources 25 19 1259 933
Lehman collapse led to ripple effects in India 1. Public issues 7 3 344 136
2. Gross pvt placements 6 8 323 391
adversely affecting the foreign flow of funds.
3. CP's subscribed by non banks 6 4 314 200
• In an environment where investment grows, its 4.Others 6 4 278 207
financing would increasingly depend on bank B.2. Foreign Sources 30 20 1487 981
credit. However with the proportion of bank 1. ECB/FCCB 13 6 630 276
credit to total financing rising to 60%, its 2. ADR/GDR 5 1 250 47
3. Short term credit 8 3 416 123
sustainability remains questionable in the future. 4. FDI to India 4 11 191 536
• Other sources of foreign flows such as FDI Toral Credit (A + B) 100 100 4995 4847
which have seen a spurt in FY09 might not be * as reported by RBI in the Macro & Monetary Development Jan'09
forthcoming in FY10 thus worsening the outlook
for FY10. Source: RBI, ICICI Bank Research
External sector to shave off GDP growth (%) Contribution of Net exports to GDP growth
12
• The share of external sector (exports and GDP growth
10
imports) has risen from 17% in 1991 to 36%
recently. With imports been much higher than 8
exports, net exports usually has been a negative 6
contributor towards GDP growth 4
• Looking at the trend of contribution of net 2
exports to GDP growth since FY01, we see that 0
it could shave off between 0.5-3.5% points from -2
the overall GDP growth. -4
• With a high probability of stagnating exports -6
being counteracted by declining imports,
2001
2002
2003
2004
2005
2006
2007
2008
negative contribution of net export to GDP

growth would be muted in FY10.
10
Analyzing past slowdowns from the supply side
Wide variations in agriculture growth
12
• Moving on from the demand side analysis of Y(t) = -0.7346Y(t-1) + 5.2377
10
R2 = 0.5435
GDP to the supply side analysis, we try to 8
A g r ic u ltu r e g r o w th (t-1 )
investigate the probable paths of agriculture, 6
industry and services growth in FY10. 4
• Agriculture growth suffers from sharp volatility 2
owning to exogenous factors. A scatter plot is 0
-2
used to depict agriculture growth in year t vis-à-
-4
vis the previous year t-1. Points above the 45
-6
degree line represent slowdown in year t
-8
compared to year t-1. The negative slope of the
-10
regression line could indicate severe base
-8
-6
-4
-2
10
12
effects. Poor agriculture growth generally Agriculture growth (t)
accentuates the slowdown but is generally not *Highlighted years are slowdown years – FY98, FY01, FY03
caused by an industrial slowdown. Source: CEIC, ICICI Bank Research
Industrial growth may be affecting with a lag

12
• The graph on the right shows industrial growth
in year t vis-a-vis in year t-1. The upward Y(t) = 0.4957Y(t-1) + 3.2765
10 R2 = 0.2488
sloping regression line indicates that a good
In d u str y g ro w th (t-1 )
production year is followed by a better one. 8

Points above the 45-degree line represent
slowdown in year t compared to year t-1. 6
• However not in all slowdown years, do we see a
4
moderation in industrial growth. Probably
slower industrial growth in one particular year 2
impacts other segments of the supply side with
a lag and GDP growth contracts with a lag. 0
0
10
12
• With a sharp drop in industrial growth in FY09, it Industry growth (t)
is possible to have a somewhat better industrial
*Highlighted years are slowdown years – FY98, FY01, FY03
growth number in FY10.
Message from past industrial growth cycles
(% YoY) IIP
• We looked at the movement of IIP growth in the 14
Slowdown of FY98 Slowdown of FY01 Current Slowdown
slowdown phase of FY01 and FY98. 12
t - month of lowest growth
• IIP growth fell for 14 months prior to reaching 10
the trough during the slowdowns of FY98 and 8
FY03. While in the case of FY01 we see
6
sideways movement of IIP growth for upto 10
months after reaching the trough, in case of 4
FY98, IIP growth shows some semblance of 2
recovery in the subsequent months. 0
• In the current phase too IIP has been in a -2
downtrend for a similar time, but we would
t
t-1
t-3
t-5
t-7
t-9
t-1 1
t-1 3
t+ 2
t+ 4
t+ 6
t+ 8
t+ 1 0
have to wait to conclude if the trough has been

hit. The pace of recovery in FY10 would depend
on inventory adjustment, global factors and Source: CSO, ICICI Bank Research
business sentiment, among other things.
11
Will service sector be able to hold on?
Service sector has defied growth cycles
12
• The chart here shows a scatter plot Y(t) = 0.5788Y(t-1) + 3.0906
11
representation of service sector growth in year t R2 = 0.3372
10
S e rv ic e s g ro w th (t-1 )
vis-à-vis that in year t-1. Points above the 45
degree line represent slowdown in year t 9
comapred to year t-1. 8
• In a slowdown phase, the drop in service sector 7
growth in one year has not been rapid except in 6
one instance. However that occurred in the time 5
of the tech bubble burst and therefore
4
understandable.
3
• Extending this logic further, FY10 service sector
10
11
12
growth seems to be less at risk, but the extent Services growth (t)
of global meltdown would pose significant *Highlighted years are slowdown years – FY98, FY01, FY03
challenges.
Government expenditure to aid recovery
(% YoY) Community, Social & Personal Services (%)
• We looked at the community, social and 3
Contribution to GDP growth Share in GDP (RHS)
21
personal services segment, which essentially 2.5
reflects the government revenue expenditure 18
2
and has a correlation of close to 80% with the
1.5
same. Q3 growth of 17.3% YoY reflects the 15
same. 1
12
• The chart clearly shows that while its share in 0.5
GDP is at a modest 13-14%, its contribution to 0
9
GDP doubled in Q3 FY09 to 2.05% from 1.08% -0.5
in Q2 FY09.
-1 6
• Going forward this sector could hold the key for
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
a robust service sector growth as stress on
fiscal stimulus remains.
Trade, hotel and transport could be at risk (% YoY) Trade, Hotels and Communications (%)
4.5 30
Contribution to GDP growth Share in GDP (RHS)
• Trade, hotels and transport segment of services 4
has not only gained importance in terms of
3.5 27
share in GDP but its contribution to GDP has
3
also witnessed marked improvement. Its
2.5
contribution to GDP rose from 1.5% in 1997 to 24
3% in 2007 before falling to 1.8% in Q3 FY09. 2
1.5
• However the heterogeneity of this sector could 21
1
pose a problem in terms of analyzing its future
growth path. While poor global conditions and 0.5
heightened security concerns post the terror 0 18

Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
attacks could adversely affect the trade and

hotels segment, domestic demand for
communication services still remains strong.
12
How vulnerable is India to the global crisis?
The vulnerability indicators
Share in GDP Proportion of Contribution to GDP growth in FY08
Least affected sectors - Least affected sectors -

30% 20%
Worst affected Worst affected

sectors - 42% sectors - 55%
Moderately affected Moderately affected

sectors - 29% sectors - 25%
Source: McKinsey, CEIC, ICICI Bank Research
• We have defined sectors with maximum

domestic linkages and easy supply of credit as
the least affected sectors – as the risk stemming
Agriculture, Forestry & logging, Fishing, Public
administration & defence services, Other
from a global downturn is minimal. Sectors that
services have greater exposure to external sector and
face credit constraints along with an overhang
Mining & Quarrying, Registered ,Trade, Hotels &
Restaurants, Banking & insurance, Business
of supply are deemed worst affected.
Services • The moderately affected sectors are the ones
facing demand constraints, however credit
Railways, Transport by other means, Storage,
availability remains strained.
Communications, Unregistered Manufacturing
• It is interesting to note that while the worst
affected sectors account for 42% of the GDP,
• Having discussed the sectoral composition of they contributed roughly 55% of the GDP
the GDP, it would be useful to see this in the growth in FY08.
context of vulnerability of the sectors. * The vulnerability classification is by McKinsey
Vulnerability risk to the global crisis stand evenly balanced for India
Current
External Forex Short termShort Equity Domestic Fiscal Account Average
Region debt reserves debt term debt markets credit deficit Balance score
(% total (% change
(% GDP) (% debt) (% reserves) debt) since Jan'08) (% GDP) (% GDP) (% GDP)
China 2 1 1 12 10 11 4 2 5.4
Indonesia 4 8 7 3 7 2 6 6 5.4
Brazil 1 11 4 4 2 6 7 8 5.4
India 6 4 2 5 8 5 8 9 5.9
Russia 8 5 6 6 12 4 12 3 7.0
South Korea 10 6 10 11 3 10 3 7 7.5
S Africa 5 7 9 8 1 12 11 12 8.1
Source: IIF, Ecowin, ICICI Bank Research
Based on a host of parameters different countries have been ranked according to their vulnerability to the
global crisis with the rank 1 given to the least vulnerable country. Countries are then judged as highly
vulnerable or least vulnerable using the average score of the ranks for different parameters.
Such an exercise has yielded the result that vulnerability risk to a global crisis is evenly balanced for India
compared to its peer group.
13
Looking ahead to FY10
Private Govt
Growth rates (%) GDP consumption consumption Investment Exports Imports
Avg growth in last 13
years 6.93 5.81 5.51 10.21 14.37 15.51
Avg growth last 5

years 8.92 7.01 4.76 15.76 15.03 22.12
Avg growth during
slowdown 5.11 4.60 6.59 6.44 12.55 9.71
Minimum 3.77 2.67 -0.35 -4.10 -2.33 -2.44
Maximum 9.69 8.67 13.23 21.99 31.40 45.58
FY08 9.00 8.30 6.90 13.80 7.50 7.60
FYTD 6.80 6.50 13.20 10.00 15.50 25.30
• Having analysed growth dynamics through different appraoches, we now try to construct probable
scenarios that could emerge in FY10.
• The trends of the GDP components show that consumption has had a more stable past than the widely
fluctuating investment. However the India growth story with plus 8% growth over the last five years,
has been fuelled by a surge in investment growth led by healthier corporate balance sheets, capacity
expansions and enhanced productivity.
• While during a slowdown average rate of consumption growth has slipped only by 1-1.2%, investment
growth falls by a greater amount of about 4% compared to the long term average.
• Consumption growth has a tendency to dip in years with a bad monsoon and the lowest consumption
growth of 2.6% too occurred in a drought year.
• With lack of fiscal room available in previous years, we see that average government consumption
growth during slowdown years is only marginally higher compared to the long term average. However
there is reason to believe that the trend would not hold in the current slowdown phase with the
government boosting the economy through doses of higher expenditure.
Challenging times ahead Scenarios for FY10 GDP
• While growth in FY09 is expected to fall below 8

the 7% level, the challenges seem to multiply in
FY10. 6
• With a dismal global backdrop and poor GDP

All possible scenarios
domestic conditions the FY10 seems to be a lot (% YoY) 4
more difficult year than FY09.

2
• For GDP growth in FY10 to reach near 6-6.5%
levels, consumption would have to grow by 5- 0 7
7% and investment would have to grow by 7- 2 5
4
10%. This would be plausible if the government 7 3 Consumption
Investment (% YoY) 10 (% YoY)
measures to boost consumption growth seep 12
into the system rapidly and early signs of pick-

up in demand encourage capacity expansion
plans.
14
Constructing growth scenarios for FY10
The bare Propelled by Aided by global

minimum policy push recovery
Global headwinds: Global headwinds Global headwinds:

• Export growth • Export growth • Global economy
contraction continues falters but manages sees some recovery
for most part of FY10 positive growth of 2% by 2009 end
• Outflow of foreign • Some FDI inflows • FDI continues, FIIs
funds on worsening but FIIs and ECB search for relative
global condition and lenders remain on the valuation and some
rating downgrade sidelines appetite for ECBs
Domestic Domestic revive
conditions: conditions: • Export growth
• Corporate savings • GDS does not drop recovers in H2 FY10
led collapse in gross below 32% of GDP Domestic
domestic savings • Gap in investment conditions:
• Cost and availability financing partially • Bank credit flows
of credit continue to bridged by helps to revive
remain a sore point government initiatives investment –
for consumers and and partly by RBI’s investment growth
corporates Signs of liquidity providing Shorter does not drop below
• Tight consumer recovery, measures global 7%
lending, employment domestic • Discretionary recession, • The recovery
uncertainty and fundamentals purchases deferred, proactive process is swift with
adverse wealth effect support rural spending helps policy action the crisis not
to weigh on private maintain growth of spreading to other
consumption consumption around sectors
• Inventory build-up 6% • Retail credit
stalled by uncertain • Inventory resumes providing
consumption outlook drawdown in H1 impetus to
• Investment projects paves way for a build- consumption
shelved with no up later • Business and
intention of adding • Investment pipeline consumer sentiment
new projects to be completed as recovers quickly
• Financial instability per schedule but fresh • Inventory
due to global proposals would not adjustment is prompt
developments be forthcoming and this fuels capacity
• Depressed asset • Sentiment improves expansion and fresh
prices keep business in H2 FY10 on the projects
and consumer back of global • Election results
sentiment down developments throw no surprises
• Political uncertainty • Election results and new govt
worsens post throw up at least a committed towards
elections stable government further reforms
GDP growth GDP growth GDP growth

of 5.5 - 6% of 6 - 6.5% of 7 – 7.5%
15
Inflation – Diverging trends
Money Supply Inflation link breaks down
(% YoY) M3 Inflation (RHS) (% YoY)
• Historically money supply growth and inflation 45 18
have depicted positive correlation of 0.65%. 40 16
Correlation of 0.65 14
• While inflation peaked at near 13% levels in 35
Aug’08, money supply growth dipped at that 12
30 10
time from 22% levels in the previous months to
around 20% levels. Correlation of money supply 25 8
and inflation turned inverse in the period of 20
6
Jan’07 and Feb’09. 4
15 2
• Our forecast of negative inflation in the first few
months of FY10 confirms that this inverse 10 0
M a r-91
M a r-92
M a r-93
M a r-94
M a r-95
M a r-96
M a r-97
M a r-98
M a r-99
M a r-00
M a r-01
M a r-02
M a r-03
M a r-04
M a r-05
M a r-06
M a r-07
M a r-08
M a r-09
correlation will continue. However, any rapid
monetary growth to finance fiscal deficit would
have potential long-term inflationary bias.
CPI and WPI paint different inflation scenario

(% YoY) CPI WPI (RHS) (% YoY)
• With the rise in WPI last year, the consumer 12 14
price index also rose, however the drop in the
WPI off late has not been mirrored by the CPI. 10 12
• While WPI averaged 3.2% in Feb’09, the CPI 10

8
reading for Feb’09 was at 9.63%. It is expected 8
that CPI would fall, however only with a lag. 6
6
• The differing weights for food, fuel and metals 4
4
between CPI and WPI are the main reason for
2 2
this divergence. While food prices have been
moving up and account for 47-57% of CPI fuel 0 0
prices, which are falling account for only 3-7%
F e b -0 7
A p r-0 7
J u n -0 7
A u g -0 7
O c t-0 7
D e c -0 7
F e b -0 8
A p r-0 8
J u n -0 8
A u g -0 8
O c t-0 8
D e c -0 8
F e b -0 9
of CPI.

Primary articles inflation still elevated
(% YoY) Whole Index Primary Index
• While headline inflation figure has been edging 14
down rapidly since Oct last year, driven by fall 12
in fuel and manufacturing good prices, the
10
primary articles inflation has not eased as much.
8
• The high MSPs set by the government for rice,
wheat, urad and tur have been precluding the 6
fall in food prices. 4
• Higher prices of food articles also have an 2
indirect impact on WPI through higher prices of
0
manufactured items.
A p r-0 8
M a y -0 8
J u n -0 8
J u l-0 8
A u g -0 8
S e p -0 8
O c t-0 8
N o v -0 8
D e c -0 8
J a n -0 9
F e b -0 9
M a r-0 9
• The sensitivity of policymaking to primary article

prices would deter any strong reaction to
negative headline inflation numbers.
16
Structural deflation is not a serious threat
Recessions need not always be deflationary
Growth
• Historically, the notion of deflation has been Inflation
<0 0-2 2-5 5-8 8-10 10-12 12+
associated with periods of recession due to the 0-1 1 10 15 6 0 0 0
Great Depression experience. 1-2 5 23 31 16 5 0 1
• To analyse the same we empirically study the 2-5 11 50 186 92 20 8 1
relationship between inflation rates and GDP 5-10 18 26 115 54 18 10 1
growth of 22 countries over the period 1960- 10-15 12 21 43 33 8 3 0
2005. 15-20 6 11 19 10 5 3 1
• Our results point to no clear link between 20-30 19 11 15 10 5 3 3
inflation and GDP growth. While we found 31 30+ 22 8 19 13 4 4 0
cases where low inflation occurred with periods
of positive GDP growth, 22 cases of high
inflation occurred in periods of recession.
Source: World Bank, IFS, ICICI Bank Research
India’s vulnerability to deflation relatively low

Deflation Vulnerability Index
• An index of Deflation Vulnerability constructed Countries 2009 Q4 2008 Q4 2003 Q1 1998 Q4
by IMF shows that the deflationary risks have Japan 0.71 0.64 0.86 0.5
increased in the global economy, particularly in United States 0.53 0.47 0.27 0
the G 7 countries. Higher the value of the index, Germany 0.38 0.23 0.54 0.15
the more the deflationary pressures. Italy 0.38 0.38 0.23 0
• Japan is the only country, which has very high France 0.36 0.36 0.5 0.21
risks while 13 other countries (out of 35) display China 0.27 0.23 0.18 0.43
moderate risk of deflation. For India, the index Russia 0.27 0.18 0 0.25
suggests minimal deflationary risk. Canada 0.2 0.2 0.53 0.13
United Kingdom 0.13 0.27 0.2 0
• The deflationary risks for the global economy as
Brazil 0.11 0 0.5 0.27
a whole (GDP weighted) has increased to 0.34 in
India 0.11 0.09 0.09 0.1
2009 from 0.32 in 2003. This rise in risks is
primarily driven by negative output gaps and
Source: IMF, ICICI Bank Research
low asset prices.
Inflation expected to average close to 2-3% WPI inflation (% YoY)
15
• On the basis of a simple statistical exercise Actual Forecast
assuming primary, manufacturing and fuel 12
indices to closely mirror the trend in the past 9
five years, we have tried to forecast the weekly
inflation figures for FY10. 6
• As per our analysis inflation would enter the 3

negative zone over the next few weeks and 0
remain in the red for most part of 2009. This fall
in the year on year inflation is essentially on -3
account of the base effect. -6
•
N o v-07
Jan -08
M ar-08
M ay-08
Ju l-08
S ep -08
N o v-08
Jan -09
M ar-09
M ay-09
Ju l-09
S ep -09
N o v-09
Jan -10
M ar-10
Our forecast chart of the inflation figures for

FY10 is a statistical exercise to reflect the base
effect. However going forward as commodity
prices pick up from the abysmally low levels, we Source: Bloomberg, ICICI Bank Research
expect inflation to average about 3% in FY10.
17
Overview and comparison of fiscal deficit
India fares poorly in comparison 2008 2009 2010
• Expansion of fiscal deficit has become a global China

theme as governments across the world are India
trying to cushion the falling economic growth. Russia
Brazil
• Among the developed countries, US, UK, and
Japan are expected to record extremely high US
UK
deficit numbers over the next two years as
governments in these countries provide Japan
stimulus in a phased manner. Russia has Germany
slipped from surplus to deficit mode rapidly. Canada

Australia
• India’s performance on the fiscal parameter has
deteriorated because of stimulus measures, -11 -9 -7 -5 -3 -1 1 3 5
populist expenditure, and high commodity Government balance as % of GDP
prices in the recent past.
Combined fiscal deficit looks onerous

• The combined fiscal deficit of the government is Fiscal deficit (as % of GDP) Center State
12
budgeted to be close to 8.5% of GDP in FY10.
However, we expect center’s deficit to touch 7% 10
due to 1% increase in plan expenditure and
approx. INR 300 bn of tax cuts announced post 8
the interim budget. Considering about 1%
6
stimulus by the new government in FY10, the
deficit could touch 8%. These correspond to 4
two likely scenarios A and B, for the FY10 deficit
(for details see the bond market section). Hence 2
the combined deficit could lie between 10.5- 0
11.5% under the two different scenarios
FY 82
FY 84
FY 86
FY 88
FY 90
FY 92
FY 94
FY 96
FY 98
FY 00
FY 02
FY 04
FY 06
FY 10 E
FY 08
considered above.
• Off-balance sheet items, which are expected to
be less in FY10, could potentially add another
0.7% (compared to the 2.4% in FY09). Source: RBI, ICICI Bank Research
Post election, deficits carry an upward bias

Fiscal deficit Primary deficit Revenue deficit
• Historical data suggests that on an average, 10
(as % of GDP)
fiscal deficit has a tendency to rise post the 8
general elections, the last election being a
pleasant exception. 6
• Bulk of the increase in fiscal deficit in FY09 4
(increase of INR 1932 bn) has come from an
increase in the primary deficit of the center as 2
interest payments are expected to have risen by 0
approximately INR 19 bn only. General elections
-2
• The upward risk to fiscal deficit in FY10 would
FY 82
FY 84
FY 86
FY 88
FY 90
FY 92
FY 94
FY 96
FY 98
FY 00
FY 02
FY 04
FY 06
FY 10 BE
FY 08
emanate from a higher than expected primary

deficit.
Source: RBI, Parliament of India, ICICI Bank Research

18
Fiscal stimulus and deficits
Fiscal stimulus varies across countries
• In most countries discretionary fiscal stimulus 2.5
Average announced fiscal impluse

has so far focused on 2009, with the 2010 China
amounts generally representing phased 2.0
as % of GDP (2008-10)
implementation of programs initiated in 2009. US
Australia
1.5
• According to the IMF, for the G20 as a whole
fiscal stimulus would amount to 1.8% of GDP in Germany Russia
1.0
2009 and 1.3% of GDP in 2010.
UK Japan Canada
• Difference in the size of stimulus comes
0.5
primarily from two sources – ability of the
India Brazil
government (i.e., the level of the deficit at which
0.0
they entered the recession) and the presence of
-10 -8 -6 -4 -2 0
in-built automatic stabilizers in each economy.
Average government balance as % of GDP (2008-10)
India’s fiscal stimuli has so far been prompt Summary of announced fiscal stimulus measures in India INR bn
• Fiscal stimulus in India was introduced in late First stimulus package
2008 and as elsewhere, it came in the form of Increase in plan expenditure 200
both an increase in expenditure as well as a cut Reduction in CENVAT 87
in taxes. Infrastructure promotion through IIFCL 100
Scheme for textile and SMEs 14
• So far, a total of INR 500 bn increase in
combined government expenditure has been Second stimulus package
earmarked under the two different stimulus Increase in state government expenditure 300
measures along with tax cuts to the tune of INR Increase in tax-free bond limit for IIFCL 300
375-400 bn. Special credit line and liquidity support through SPV for NBFCs 250
FII investment in corporate debt increased to USD 15 bn from 6 bn
• Although not a part of any fiscal stimulus, but ECB relaxation
schemes like the farm debt waiver and sixth
commission payouts could very well reduce the Others
need for aggressive fiscal stimulus. Tax cuts announced post interim budget 300
Source: Press releases, ICICI Bank Research

High deficit to support growth
(% YoY) Real GDP Fiscal defict (inverted, RHS) (% of GDP)
• Except FY09, the government had been curbing 12 2
fiscal largesse since the introduction of the
3
FRBM Act by trying to maintain a somewhat 10
counter cyclical fiscal policy structure. 4
8
• Although the direction of causality between 5
deficit and growth is far from clear, but 6
6
nevertheless a higher deficit (or a lower surplus) 4
is beneficial in times of slowing economic 7
activity as government spending substitutes the 2 8
fall in private spending in order to sustain
0 9
aggregate demand.
FY 82
FY 84
FY 86
FY 88
FY 90
FY 92
FY 94
FY 96
FY 98
FY 00
FY 02
FY 04
FY 06 P
FY 08 RE
FY 10 BE
• Hence, a higher deficit need not always be a

macro risk (through rise in interest rates and
crowding out). It can very well be a much-
needed growth booster. Source: RBI, ICICI Bank Research
19
Assessing the determinants of deficit in FY10
Indirect tax revenues to be impacted further Customs/ Imports Excise/ Industrial output (RHS)
(%) (%)
• As part of tax reforms, indirect taxes (customs 50 24
and excise) were reduced substantially since 45 23
mid 1990s resulting in fall in collections vis-à-vis 40 22
nominal growth. 35
21
• The reduction in indirect tax rates (as a part of 20

30
fiscal stimuli) and the expected slowdown in 19
25
nominal growth to around 10% would impact 18
20
revenues from indirect taxes in FY10. 17
15 16
• This would have an adverse impact on the tax-
10 15
to-GDP ratio, which is already depicting signs of
5 14
fatigue.
FY 91
FY 92
FY 93
FY 94
FY 95
FY 96
FY 97
FY 98
FY 99
FY 00
FY 01
FY 02
FY 03
FY 04
FY 05
FY 06
FY 07
Bleak year for direct tax revenues?
(% YoY) Nominal GDP Tax revenue (RHS) (% of GDP)
• Share of direct tax revenue in gross tax revenue 20 9.5
is expected to increase from 55% to 57% in 9.0
18
FY10 – we see upside risks to these estimates,
16 8.5
as the new government is likely to implement
8.0
stimulus measures through a reduction in 14
indirect tax rates (revenues from which are 7.5
12
generally more sensitive to slack in economic 7.0
10
activity). 6.5
8 6.0
• Driven by a slightly higher fall in indirect tax
revenue, during 1997-98, tax-to-GDP ratio fell by 6 5.5
FY 82
FY 84
FY 86
FY 88
FY 90
FY 92
FY 94
FY 96
FY 98
FY 00
FY 02
FY 04
FY 06
0.5% as nominal growth dropped from 15.7% to
FY 10 BE
FY 08
6.3% - this could be repeated to a lesser extent
in FY 10 as the ratio could slip towards 8% from
the expected 8.6% in FY09.
Pressure from subsidies to come off (INR bn) Subsidies Food Fertilizer Petroleum Others Total (RHS) (INR bn)
• The plunge in global commodity prices will act 800 1400
as blessing for the off-balance sheet deficit that 700 1200

is expected to drop from about 2.4% in FY09 to 600
1000
about 0.7% in FY10. 500
800
• Cash subsidy bill for the government is also 400
expected to come down (driven by a drop in 600
300
fertilizer subsidies) from its decade high level of
400
INR 1292 bn in FY09 to INR 1009 bn in FY10. 200
100 200
• If a faster than expected recovery in global
economy escalates commodity prices, then 0 0
chance of a rise in FY10 estimate of cash
FY 01
FY 02
FY 03
FY 04
FY 05
FY 06
FY 07
FY 08
FY 09 RE
FY 10 BE
subsidy later on in the year cannot be ruled out.
20
Assessing the determinants of deficit in FY10
Can higher expenditure be avoided?
Correlation between Growth in Nominal GDP & Expenditure
• Although the Indian economy has undergone 0.6 Growth in Nominal GDP & Revenue
structural changes over the last two decades, a
0.4
crude analysis suggests that the correlation
between nominal growth and government
0.2
expenditure falls substantially during times of
slowdown (which implies increased government 0.0
expenditure) – the average correlation
coefficient lies close to –0.4 compared to close -0.2
to 0.2 observed during expansion phases.
During a slowdown phase expenditure rises but revenue
• Higher government expenditure acts as a -0.4
falls
natural stress reliever and is a preferred form of
-0.6
fiscal stimulus, considering the relatively higher
Slowdown Expansion
value of fiscal multiplier over the tax multiplier.

How productive is increased expenditure?
Expenditures as % of GDP Revenue Capital (RHS)
• According to the interim budget, revenue 15 8
expenditure for the government is expected to 14 7
rise above 14% of GDP in FY10 from close to
13 6
12% in FY09.
12 5
• This is in contrast to the fall in capital
expenditure, which is expected to drop to about 11 4
1.7% of GDP in FY10 from about 1.8% in FY09. 10 3
• The moderation in capital expenditure is a 9 2
concern, as it is not helping in enhancing the
productive capacity of the economy, whereas 8 1
FY 82
FY 84
FY 86
FY 88
FY 90
FY 92
FY 94
FY 96
FY 98
FY 00
FY 02
FY 04
FY 06
FY 08 RE
FY 10 BE
the increase in revenue expenditure is just
reflective of the increase in government
consumption through the implementation of
various stimulus measures. Source: RBI, ICICI Bank Research
Rising deficits imply larger interest payments (INR bn) Interest Payments - size as % of revenue receipts (RHS)
• The difference between the gross fiscal and 2500 55
primary deficit has increased by close to 2% 50
over the last decade primarily due to rising 2000
45
interest payments.
1500 40
• Total interest payments are expected to
increase by INR 328 bn in FY10 – this happens 1000 35
to be highest single year increase.
30
• However, what is more worrying is the 500
25
likelihood of interest payments (as percentage
of revenue receipts) rising for the second 0 20
consecutive year in FY10 after the improvement
FY 81
FY 83
FY 85
FY 87
FY 89
FY 91
FY 93
FY 95
FY 97
FY 99
FY 01
FY 03
FY 05
FY 07
FY 09 RE
seen since FY02.
21
Issues in financing the deficit
Heavy reliance on market borrowings…
Financing of fiscal defict External sources Net market borrowings
• Since FY99, major part of the financing of the Draw down of cash balances Others
100%
fiscal deficit has been borne by market
borrowings. 80%
• Net market borrowings (as % of fiscal deficit) 60%
increased from the budgeted 75% to 80% in
FY09 – this is expected to touch a record 93% in 40%
FY10. 20%
• Since there are significant upside risks to the
0%
budgeted fiscal deficit estimate, this share could
even go higher – however since short-term -20%
FY 82
FY 84
FY 86
FY 88
FY 90
FY 92
FY 94
FY 96
FY 98
FY 00
FY 02
FY 04
FY 06
borrowings have not been considered in the
FY 08 RE
FY 10 BE
FY10 interim budget, a part of the increase in
deficit could potentially be offset through this.
…might increase the onus on banks
Fiscal deficit as % of GDP Banks' holding of G-Secs as % of
• The share of market borrowing in financing the 9 75
outstanding stock (RHS)
fiscal deficit has picked up after FY05. 70
8
• G-sec holdings by banks (as % of outstanding)
65
have somewhat moderated in the four years till 7
FY07, with increased participation seen from 60
PFs and LIC. 6
55
• However, with the fiscal deficit rising once again 5
50
in FY09 and FY10, the incremental appetite for
g-secs is likely to come more from the bank’s 4 45
side given their huge deposit base.
3 40
FY 91
FY 92
FY 93
FY 94
FY 95
FY 96
FY 97
FY 98
FY 99
FY 00
FY 01
FY 02
FY 03
FY 04
FY 05
FY 06
FY 07
Elevated yields to pose further problem Average Interest Rates on Outstan din g Domestic
• The moderation in average rate of interest on Liabilities of the Centre (%)
domestic government liabilities has been Market S mall S pecial
beneficial in bringing down the interest cost (as Y ear Loans Savings S PFs Deposits
% of receipts) after FY04. FY91 - FY95 (avg.) 10.86 10.85 11.63 11.53
• However, there would be two factors acting FY96 - FY00 (avg.) 12.39 11.62 11.62 10.93
against the interest costs this year – (i) the FY01 12.99 11.6 10.54 9.87
increase in magnitude of the deficit per se will FY02 12.83 11.61 9.09 10.5
result in higher interest costs, and (ii) buoyancy FY03 12.11 11.56 8.53 8.82
in bond yields is expected to continue and since FY04 11.11 10.88 7.39 7.94
majority of the financing would be through FY05 9.87 9.37 7.99 7.65
market loans, the interest cost for the FY06 10.07 8.9 7.46 7.25
government runs the risk of carrying an upward FY07 8.9 8.91 7.63 6.85
bias. FY08 9.45 8.33 7.83 5.67
22
Monetary policy response so far
Liquidity seems to be the prime concern Over view o f p o lic y mea su r es
C o n tain m en t Reso lu tio n
• Even before the fiscal stimulus across the world Establish/ Strengthe
gained traction, deployment of monetary policy Increase Wholesale ned Re- Asset
Deposit Borrowing Liquidity Capitalizati Purchase
happened in both conventional and non- Insurance Guarantees Measures on Plans Plans
conventional forms. Develo p ed C o u n tr ies
Australia x x x x
• While growth concerns prompted easing of Canada x x x
Germany x x x x x
policy rates, liquidity concerns and financial France x x x
stability seems to be the principal objective Italy
Japan
x x
x
x
x x
behind the use of non-conventional methods. UK x x x x x
US x x x x x
• Policies dealing with toxic assets, capital
injection programs, and creditor protection in E M C o u n tr ies
Brazil x x
case of further deterioration have not been Russia x x x x x
India x
needed in the Indian context. China x
South Korea x x x x

RBI does the most aggressive policy easing…
(%) Policy rates Repo Reverse Repo CRR
• In the fight against the ongoing crisis, monetary 10
policy from the RBI indeed acted as the “first
line of defense”. 9
• Even before fiscal policy was considered as a 8

possible tool, financial stability and growth 7
concerns prompted the RBI to cut policy rates
6
aggressively - the repo and reverse repo rates
were pruned by 400 bps and 250 bps to 5% and 5
3.5% respectively in less than five months. 4
• Apart from this CRR and SLR were also brought 3
down by 400 bps and 100 bps to 5% and 24%
M a r-05
S ep -05
M a r-06
S ep -06
M a r-07
S ep -07
M a r-08
S ep -08
M a r-09
respectively.
…and infuses liquidity as well

Actual/ Potential release of liquidity since Sep-08
• The spillover from the ongoing global financial
Measure/ Facility Size (INR bn)
crisis resulted in an unprecedented tightening of
liquidity conditions after the collapse of Lehman CRR cuts 1600
Brothers, which was exacerbated by seasonal MSS unwinding 631
tax outflows and fx intervention by the RBI. Term repo facility 600
• Since Sep-08, RBI released about INR 4300 bn Increase in export credit refinance 255
liquidity in FY09 through various measures. Special refinance facility 385
• Further support came through in the form of a Refinance facility for SIDBI/NHB/EXIM 160
100 bps cut in the SLR, and measures to Liquidity facility for NBFCs 250
counter the shortage in fx liquidity (e.g., Dollar
OMO purchases 466
swap line for banks, increase in rates for NRI
deposits, resumption of SMO, etc.)
Total 4347
23
Quantitative Easing and the RBI
Central banks expanding their balance sheets
(GBP bn) BoE's asset size Fed's asset size (RHS) (USD bn)
• Various policy initiatives taken by the central 300 2300
banks are resulting in an expansion of their 2100
balance sheets. 250
1900
• Since Sep-08, the Fed started increasing its
200 1700
balance sheet size through purchases of assets
of different types and maturities. Similarly, the 1500
BoE has also increased its balance sheet size by 150 1300
implementing various schemes like the Asset 1100
Purchase Facility. 100
900
• Monetization of government debt through
50 700
buying of treasuries and corporate bonds by
M ay-06
Aug-06
N ov-06
Feb-07
M ay-07
Aug-07
N ov-07
Feb-08
M ay-08
Aug-08
N ov-08
Feb-09
Fed, BoE, BoJ, SNB, etc. would further lead to
an expansion in their balance sheet size.
Source: Bloomberg, CEIC, ICICI Bank Research
RBI’s version of QE (INR bn) RBI's Assets - FCA Gold Rupee securities (incl T-Bills) Others
• Although RBI has not bought any private 16000
securities from the market, the effect of the 15000
ongoing monetization of government deficit 14000
would be reflected in its balance sheet. 13000
12000
• OMOs till date have been the preferred route of
11000
monetization of deficit since possibility of
private placement has been shrouded in 10000
9000
mystery. Stock of Rupee securities held with the
RBI increased by INR 383 bn in FY09. 8000
7000
• Changes in other parts of the balance sheet
6000
would most likely be of little significance in
Mar-06
Jun-06
Sep-06
Dec-06
Mar-07
Jun-07
Sep-07
Dec-07
Mar-08
Jun-08
Sep-08
Dec-08
Mar-09
FY10.
Money multiplier spikes up

Money Multiplier CRR (%, inverted, RHS)
• Money multiplier has lied between 4.5 – 5.0 for 5.3 4
most part of last seven years. 5.1 5
• However, the aggressive amount of monetary 4.9
6
easing in the form of cuts in the CRR (which was 4.7
pruned by 400 bps in just about three months) 7
4.5
resulted in a sharp spike in the money 8
multiplier, thereby pushing it to an all time high. 4.3
9
• Since the RBI could resort to further CRR cuts if 4.1
required, money multiplier could possibly stay 3.9 10
in a higher range in FY10. Any effort to expand
3.7 11
RBI balance sheet would result in liquidity
Mar-99
Mar-00
Mar-01
Mar-02
Mar-03
Mar-04
Mar-05
Mar-06
Mar-07
Mar-08
infusion unlike other countries where this

transmission mechanism has failed.
24
Forecasting key monetary variables
(INR bn) Sources of M0 - Net RBI credit to govt NFA of RBI NNML of RBI (INR bn) Sources of M3 - Net bank credit to govt Bank credit
15000 60000
to comm sector NFA of banks NNML of banks
13000
50000
11000
9000 40000
7000 30000
5000
3000
20000
1000 10000
-1000
0
-3000
-5000 -10000
M ar-99
M ar-00
M ar-01
M ar-02
M ar-03
M ar-04
M ar-05
M ar-06
M ar-07
M ar-08
M ar-09
M ar-99
M ar-00
M ar-01
M ar-02
M ar-03
M ar-04
M ar-05
M ar-06
M ar-07
M ar-08
M ar-09
Source: CEIC, ICICI Bank Research Source: CEIC, ICICI Bank Research
(INR bn) Components of M0 (INR bn) Components of M3 - Currency with public Demand
10000 50000 dep with banks Time dep with banks
Currency in circulation Bankers' deposit with RBI
9000 45000
8000 40000
35000
7000
30000
6000
25000
5000
20000
4000 15000
3000 10000
2000 5000
1000 0
M ar-99
M ar-00
M ar-01
M ar-02
M ar-03
M ar-04
M ar-05
M ar-06
M ar-07
M ar-08
M ar-09
M ar-99
M ar-00
M ar-01
M ar-02
M ar-03
M ar-04
M ar-05
M ar-06
M ar-07
M ar-08
M ar-09
Source: CEIC, ICICI Bank Research Source: CEIC, ICICI Bank Research
Measures of money supply could carry an upside risk in FY10

• Although net foreign exchange assets and net non-monetary liabilities of RBI were the major
drivers of M0 in FY09, their significance would reduce dramatically in FY10 as no significant net
foreign inflows are expected (see our BoP forecast below for details). RBI’s credit to the
government gained importance in FY09 because of the temporary immunity from FRBM leading to
the start of monetization of fiscal deficit and also because of the depletion of the MSS stock. Both
these trends are expected to gather pace in FY10.
• The impact of this expansion would get reflected in net bank credit to government, which would
finally affect M3. In our opinion, the expansion in net bank credit to government would offset the
decline in bank credit to the commercial sector on the back of falling nominal growth in FY10.
• This expansion in M3 will eventually be reflected in an increase in aggregate deposits of the
banking system.
25
Path of key monetary and credit ratios
Investments to increase as…
Ratios - Deposits/M3 Credit/M3 (RHS) Investments/M3 (RHS)
• The pick-up in credit-to-M3 ratio since FY05 was 0.82 0.65
associated not only with a higher growth for the 0.60

0.80
economy, but also with an improvement in 0.55
financial deepening. 0.78 0.50
• Going forward, although we expect the ratio of 0.45
aggregate deposits-to-M3 to remain around 0.76
0.40
80%, credit-to-M3 ratio is likely to moderate to
0.74 0.35
below 60% (for reasons enumerated above).
0.30
• The effect of this decline would be somewhat 0.72
offset by an increase in the investment-to-M3 0.25
ratio that can be expected to almost touch 26% 0.70 0.20
Mar-99
Mar-00
Mar-01
Mar-02
Mar-03
Mar-04
Mar-05
Mar-06
Mar-07
Mar-08
Mar-09
in FY10.
…credit offtake is expected to moderate

Incremental ratios Credit-Deposit Investment-Deposit (inverted, RHS)
• As growth slows down further, credit demand 140 -10
would moderate further – at the same time the 120 0
supply of credit would also come down as 10
banks are expected to become more risk 100
20
averse. 80
30
• The fall in the credit-deposit ratio would also be 60
driven by deposit growth, which can be 40
expected to remain buoyant on the face of RBI’s 40
50
monetization. 20 60
• Investment-deposit ratio could turn marginally 0 70
higher as banks are expected to increase their
FY 82
FY 84
FY 86
FY 88
FY 90
FY 92
FY 94
FY 96
FY 98
FY 00
FY 02
FY 04
FY 06
FY 10 E
FY 08
holding of excess SLR.
Structure of RBI balance sheet to get altered

Ratio of NDA to NFA of RBI
• FY10 could end up being a unique year as 1.4
temporary immunity from the FRBM act will 1.2
allow RBI to monetize government’s fiscal
1.0
deficit.
0.8
• Since BoP is expected to remain close to zero
0.6
next year, the result would be an expansion of
net domestic assets of the RBI vis-à-vis its net 0.4
foreign assets. 0.2
• We expect the ratio of RBI’s NDA-to-NFA, which 0.0
started increasing in FY09, to become positive -0.2
and increase further in FY10.
Mar-00
Mar-01
Mar-02
Mar-03
Mar-04
Mar-05
Mar-06
Mar-07
Mar-08
Mar-09
• The increase in this ratio would be vital for

providing cushion to the economy suffering
from a withdrawal in economic activity. Source: CEIC, ICICI Bank Research
26
Framework for analyzing monetary policy stance
Changes in Key monetary variables
FY07 FY08 FY09 FY10 (Scen A) FY10 (Scen B)
INR bn % INR bn % INR bn % INR bn % INR bn %
MO 1360 24 2194 31 595 6.4 561 6 1010 10
M3 5807 21 6964 21 7512 19 7497 16 3502 20
Aggregate Deposits 5029 24 5802 22 6320 20 5927 15 7763 20
Credit 4241 28 4173 22 5167 22 4011 14 4870 17

RBI's L iq u id ity M a n a g em en t O p er a tio n s (IN R b n )
FY 07 FY 08 FY 09 FY 10
S c en A S c en B
A. Dr iver s o f L iq u id ity 623 2040 -416 -1117 -1117
RBI's net purchase from ADs 1190 3121 227 0 0
Currency with the public -698 -846 -993 -1167 -1167
Centre's surplus cash balances with RBI -12 -266 300 0 0
Others 142 31 50 50 50
B. M a n a g em en t o f L iq u id ity -243 -1177 2861 2798 3197

Change in LAF balances 364 212 576 776 676
Change in net OMO 7 135 466 1142 1641
Change in MSS outstanding -339 -1054 796 880 880
Liquidity impact of CRR changes -275 -470 1023 0 0
C . Ba n k Reser ves (A+ B) 380 863 2445 1681 2080

(+) indicates injection and (-) indicates absorption

Liquidity provision to remain key for RBI in FY10
• We have envisaged two plausible on-balance sheet deficit scenarios - A and B for FY10, wherein A
corresponds to 7% of GDP and B corresponds to 8% of GDP (for details see the fiscal section).
• RBI’s pump priming carries the potential to keep growth in M3 and deposits at a robust level. The
only monetary variable that can be expected to moderate would be credit.
• On the supply side, credit growth is expected to come off as banks generally become more cautious
in their lending activities, while on the demand side fall in input costs and a overall slowdown in
activity would tend to dampen demand for credit.
• Apart from sounding concerned on growth, RBI has become extremely cautious about financial
stability – and hence liquidity management would continue to enjoy paramount importance.
• Since we expect FY10 BoP to remain close to zero, currency with the public would become the most
important driver of liquidity. Any possible sell side intervention by the RBI in the beginning of the year
would possibly be offset by a reverse transaction later (please refer to our Rupee view below).
• Management of liquidity would come in the form of bond purchases under OMO and a depletion of
the MSS stock.
• CRR would be deployed only if liquidity conditions begin to tighten despite these efforts.
Additionally we expect 50-100 bps cut in the repo and reverse repo rates.
27
Fundamental factors affecting bond yields
Effect of monetary policy on bonds diluted…
(%) Repo Rate Reverse Repo Rate 10Y G-Sec Yield
• Although we expect further policy easing from 11
the RBI, but it is likely to be of less significance 10
for bond yields as long as supply concerns
9
continue to dominate sentiment.
8
• The effect of aggressive policy easing was
7
limited only till Q3 FY09 after which the 10Y g-
sec yields climbed up by more than 180 bps. 6
• Although, the 10Y benchmark bond yield barely 5

stayed within the LAF corridor over the last two 4
years, its average spread above the repo rate 3
stayed at just 12 bps between Dec-06 to Dec-08.
M ar-01
M ar-02
M ar-03
M ar-04
M ar-05
M ar-06
M ar-07
M ar-08
M ar-09
Source: Bloomberg, CEIC, ICICI Bank Research
…as 10Y stays much above policy rates
• The average spread of 10Y bond yield over the Spread of 10Y G-Sec above repo
repo rate increased to about 72 bps in Q4 FY09, rate*
while the current spread would be close to 200 Frequency (%)
bps. Above 50 bps 52
• Such a high level of spread with the policy rate Above 100 bps 20
is not very common Above 150 bps 2
• Data since Jun-00 suggests that the 10Y bond
Greater than 1/3 LAF 50
yield has stayed 150 bps above the repo rate
Greater than 2/3 LAF 34
only 2% of the time.
Greater than LAF 16
• However, if we consider the entire LAF width
(which currently is at 150 bps) as the spread, * Data since Jun-00
then the frequency turns out to be 16%.
Effect of inflation and oil could also ease

1Y rolling correlation of 10Y G-Sec yield with WPI and Oil price
• Apart from policy rates, inflation and oil price 1.00
are other traditionally important drivers of bond 0.75
yields. 0.50
• With both staying low for the time being, the 0.25
high level of long-term correlation with bond
0.00
yields can be expected to moderate in FY10.
-0.25
• However, there is a slim possibility that the
global economy starts to recover in early 2010, -0.50
and with the ongoing monetization in most of -0.75
the countries inflation could become a possible -1.00
threat thereafter – this could restore the long
Mar-00
Mar-01
Mar-02
Mar-03
Mar-04
Mar-05
Mar-06
Mar-07
Mar-08
Mar-09
term correlation to higher levels once again.
28
Bond market outlook
Estimation of supply-demand situation for G-Secs in FY10 FY09 FY10
(INR bn) Scenario A Scenario B
A. SLR demand by banks* 1940 2175 2754
B. Demand from all PFs 150 175 175
C. Demand from LIC and other insurance companies 500 550 550
D. Demand from RBI 466 1098 1621
E. Total demand (A+B+C+D) 3056 3998 5100
F. Announced government borrowing 2620 3086 3086
G. Additional government borrowing 0 902 1504
H. Change in MSS outstanding -796 -790 -790
I. SDL issuance 700 800 1200
J. Oil bonds (adjusted for RBI's SMO) 345 0 50
K. Fertilizer bonds 300 0 50
L. Total supply (F+G+H+I+J+K) 3169 3998 5100
Excess supply (D-J) 113 0 0
* Assuming SLR mainained at 28.5%
Borrowing summary (INR bn) Change

(INR bn) Demand-supply gap for G-Secs 10Y yield (inverted, RHS) (%)
FY09 FY10
400 5.0
H1 Gross borrowing 1,060 2,410 127%
200 5.5 Maturities (dated) 440 331
Net borrowing 620 2,079 235%
0 6.0
MSS 110 -330
6.5 OMO 0 -800
-200
7.0 Net increase in supply 730 949 30%
-400
7.5
-600
8.0 H2* Gross borrowing 1550 1,208 -22%
-800 Maturities (dated) 0 200
8.5 Net borrowing 1550 1007 -35%
-1000 9.0 MSS -475 -110
-1200 9.5 OMO -545 -550
Jul
Oct
Apr
M ay
N ov
D ec
Feb
S ep
Ju n
Jan
Aug
Net increase in supply 529 347 -34%

* Figures are expectations for H2 FY10
Source: RBI, CEIC, ICICI Bank Research Source: RBI, ICICI Bank Research
RBI actions to tackle excess supply and the outlook for bonds
• In the first part of FY10, fundamental factors might play a very limited role in determining bond yields.
We have noticed that in the last quarter of FY09 excess supply emerged as the key factor which kept
sentiment at bay. Even in FY10, the overall supply of g-secs could potentially lie between INR 3900-
5000 bn – this would be about 23%-58% higher than the net supply in FY09.
• The overall demand-supply balance does not look that threatening because of heavy OMO purchase by
RBI in H1. Such a trend is expected to continue in H2 as well.
• However, since fiscal slippage is expected to be much higher (1.5-2.5% of GDP), market is factoring in
a risk of the supply-demand balance getting jeopardized once again. RBI has so far shown little
inclination towards private placement, in which case the effective management of the problem of
excess supply would come only via OMO purchases.
• Considering the market sentiment towards the problem of excess supply and RBI’s response thereof,
on an average we expect the 10Y yield to lie in the range 6.5-7.0% over the next few months. However,
in the medium to long term yields should start reflecting macro fundamentals of benign inflation and
moderate growth when the market recognizes the balance in demand-supply. We expect yields to
head towards 6% at that point.
29
Behaviour and outlook on key spreads
RBI could influence the long-short spread
(bps) Spread of 10Y G-Sec over 3M T-Bill
• Since Sep-08, the combination of rate cut 500
expectations from the RBI, and medium term Average spread = 116 bps
inflation concerns, which later got replaced by 400
Min spread = -47 bps
concerns about issuances, contributed to a 300
steepening of the yield curve in India. Max spread = 453 bps
• There could be some near-term bias for this 200
spread to remain at elevated levels as RBI can 100

be expected to announce further rate cuts, but
going forward, RBI’s purchase of more longer 0
dated bonds through OMO while issuing a
-100
higher percentage of short-to-medium term
M ar-04
S ep-04
M ar-05
S ep-05
M ar-06
S ep-06
M ar-07
S ep-07
M ar-08
S ep-08
M ar-09
securities can put a cap on this spread.

Swaps to outperform bonds? (bps) Spread of 5Y G-Sec over 5Y OIS
• Swaps outperformed bonds (by approximately 200
24 bps) during the down move in rates in Q3 150
FY09, as well as during the up move in rates in Average spread = 19 bps
Q4 FY09. 100
• This led to a widening in the bond swap spread 50

to a record high level. 0
• While monetary policy expectations and RBI’s
-50
commitment to maintain ample liquidity would
support swaps more than bonds, supply -100
Min spread = -143 bps Max spread = 167 bps
concerns will have a greater negative influence -150
on bonds – hence the spread should remain
M ar-02
S ep-02
M ar-03
S ep-03
M ar-04
S ep-04
M ar-05
S ep-05
M ar-06
S ep-06
M ar-07
S ep-07
M ar-08
S ep-08
M ar-09
elevated.
Corporate bond spreads to moderate further (bps) 5Y AAA Corp Bond - 5Y G-Sec 3M MIBOR - 3M OIS (RHS) (bps)
• The worsening of liquidity conditions post the 450 600
fallout of Lehman raised the risk premium – as 400
Avg FY05 to FY08 = 89 bps Avg in FY09 = 247 bps 500
evident in the high TED spreads in the US. 350
Avg FY05 to FY08 = 89 bps Avg in FY09 = 273 bps 400
• This unusually high level of risk aversion 300
permeated the thin corporate bond market and 250 300
manifested itself in historically high levels of 200 200
spread with the g-sec – at one instance the 150
100
spread of 5Y AAA corporate bond over 100
corresponding g-sec rose above 400 bps. With 0
50
ample liquidity, the spread should moderate
0 -100
further in FY10.
M ar-04
S ep-04
M ar-05
S ep-05
M ar-06
S ep-06
M ar-07
S ep-07
M ar-08
S ep-08
M ar-09
• Apart from this, strains were so visible in the

form of an explosion in offshore CDS spreads
for some of the large Indian corporates. Source: Bloomberg, ICICI Bank Research
30
Auction dynamics to hold key in FY10
Q4 FY09 sets the tone for lack of interest…
FY09 devolvements as % of notified Q1 Q2 Q3 Q4
• Excess supply has dampened buying interest at 25%
the regular auctions, resulting in total

devolvement on PDs to the tune of INR 108 bn 20%
in FY09 with most noticeable lack of interest
found in the long dated securities. 15%
• Devolvement in Q1, Q2, and Q3 had two
important characteristics – (i) they were not very 10%
high in percentage terms and (ii) they were
localized in a particular segment.
5%
• This is where Q4 differed in which not only were
the share of devolvement higher, but they were
0%
also spread across various segment of the
5-9 yrs 10-14 yrs 15-19 yrs 20+ yrs
curve.
…impacting even the popular benchmarks
(%) 6.05% 2019 security Cut-off yield Bid/Notified ratio (RHS)
• The new 10Y benchmark (6.05% 2019 security), 7.2 5.0
which was issued slightly earlier than 7.0 4.5
anticipated, also saw tepid response.
6.8 4.0
• The sell off in bonds in Q3 FY09 resulted in an
almost 100 bps increase in the cut-off yield for 6.6 3.5
the new 10Y bond in just about four auctions – 6.4 3.0
the cut-off yield for the 91 day T-Bill increased
by about 20 bps in the same period. 6.2 2.5
• Similarly, the received bid-to-notified ratio has 6.0 2.0

also declined from 4.5 in the first auction to 1.79 5.8 1.5
in the last auction for the new 10Y bond in FY09.
6-M ar
13-M ar
20-M ar
6-Feb
13-Feb
20-Feb
27-Feb
30-Jan
RBI trying to mange duration risk in FY10

% share of gross borrowing H1 FY09 H1 FY10 OMO in Q4 FY09
• Keeping in mind the huge increase in 60
government borrowing and the associated
upside risks, RBI has assured that the 50
management would be done in the most non-
40
disruptive manner.
• Apart from MSS unwinds and OMO purchases 30
RBI has also decided to act on the shape of the
curve by increasing issuances in the short 20
segment of the bond market while reducing
issuances in the longer segment. 10
• A flatter yield curve could result if RBI tries to

0
reduce duration risk by focusing aggressively at
5-9 yrs 10-14 yrs 15-19 yrs 20+ yrs
the longer end for OMO purchases.
31
Other determinants of interest rates
Rising bond yields unsupportive of growth (% YoY) GDP 10Y G-Sec Yield (RHS) (%)
• Policy response in FY10 is likely to be geared 12 13
towards controlling the upside risk to bond 12
10
yields. 11
• This would be important because a combination 8 10
of falling growth and rising bond yields could 9
spawn instability within the system. 6
8
• Although the government has attained 4 7
immunity from the FRBM Act in FY09 and FY10, 6
rising bond yields in a falling growth 2
5
environment would tend to have an adverse
0 4
impact on interest payment costs for the
M ar-99
M ar-00
M ar-01
M ar-02
M ar-03
M ar-04
M ar-05
M ar-06
M ar-07
M ar-08
M ar-09
government.

Can put unwarranted pressure on other rates (%) SBI PLR SBI 3-5Y Deposit Rate 10Y G-Sec Yield
• Since market linked interest rates normally 14
serve as a benchmark for other rates in the 13
economy, it is natural for the government and 12
the RBI to become uncomfortable if yields start 11
moving in a direction opposite to what 10
fundamentals would warrant. 9
• Lending rates react to bond yields with a slightly 8
greater lag than borrowing rates – moreover 7
their elasticity is also lower.
6
• Rising bond yields makes the adjustment of 5
lending and borrowing rates delayed.
M ar-99
M ar-00
M ar-01
M ar-02
M ar-03
M ar-04
M ar-05
M ar-06
M ar-07
M ar-08
M ar-09
Correlation with US yields merits mention

• A simple regression on last ten years data 14.0
suggests that almost 54% of the movement in y = 1.77x - 0.0923
12.0
domestic 10Y bond yield is explained by the US R2 = 0.54%
10Y yield.
India 10Y yield
10.0
• This association stems from the importance of
8.0
monetary policy by the Fed in US and its
repercussion on the global economy as well as 6.0
other markets like commodities and equities
4.0
• Going forward, US yields would carry a natural
upward bias due to huge supply in 2009 – but 2.0
aggressive purchase of treasuries by the Fed
1.5
2.5
3.5
4.5
5.5
6.5
7.5
could provide intermittent succor.

US 10Y yield
32
Tracing INR trajectory in 2008
53 USD/INR
Relatively stable The worsening C/A
51 Rupee moves as
situation due to
record high oil prices
49 depreciation pressure
due to outflows puts pressure on the
Re, but start of
47 balanced by overall
SMOs limit the fall,
dollar weakness along The intensification of the
45 with belief of a soft resulting in only a financial crisis exerted a strong
mild depreciation
landing for Indian outflow pressure, which together
43 economy with refinancing issues and
deteriorating BoP caused Rupee
41
to weaken sharply
39
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08
Jul-08
Aug-08
Sep-08
Oct-08
Nov-08
Dec-08
Jan-09
Feb-09
Mar-09
Apr-09
Oil spoils picture for Rupee in H1-08

(USD bn) Trade balance Oil imports (RHS, inverted scale) (USD bn)
• In the past year, months with higher oil imports 0 0
registered a higher trade deficit & vice versa. -2 2
• With the first half of the year, seeing a sustained -4
uptrend in global energy prices, dollar demand 4
by Indian oil companies saw a sharp increase, -6
6
resulting in a depreciation of the currency. -8
• Further, the domestic currency came under -10
8
pressure as talks that global crude oil would
-12 10
cross USD 200 a barrel (in the future) gave rise
to concerns of a significant deterioration in the -14 12
country’s current account position.
J a n -08
Feb -08
M a r-08
A p r-08
M a y -08
J u n -08
J u l-08
A u g -08
S ep -08
O c t-08
N o v -08
D ec -08
J a n -09
Feb -09
• As India’s crude oil prices came down to USD
44pb from USD 133pb, oil imports came down
to USD 4.04bn in Feb09 from USD 10.96bn in Source: Bloomberg, ICICI Bank Research
Aug08.
…but RBI SMO mutes the impact (INR cr) (%)
Weekly purchase of oil bonds by RBI for SMO
5000 4
• As dollar demand by oil companies soared RBI Weekly change in USD/INR (appreciation(+)/depreciation(-))
3
started with Special Market Operations (SMO), 4000
Phase I Phase II Phase III 2
to contain the depreciation pressure on the
currency. Under this, RBI bought oil bonds from 3000 1
these companies (ceiling Rs 10 bn a day) and in 0
2000 -1
return supplied them with dollars.
-2
• These operations did have the desired impact 1000
-3
on the Rupee as periods, which saw RBI
purchasing oil bonds, did largely corresponded 0 -4
1 3 -J u n -0 8
4 -J u l-0 8
2 5 -J u l-0 8
1 5 -A u g -0 8
5 -S e p -0 8
2 6 -S e p -0 8
1 7 -O c t-0 8
7 -N o v -0 8
2 8 -N o v -0 8
1 9 -D e c -0 8
9 -J a n -0 9
3 0 -J a n -0 9
2 0 -F e b -0 9
1 3 -M a r -0 9
3 -A p r -0 9
to periods of Rupee appreciation.

• Of the INR 759 bn worth of oil bonds issued by
the government in FY09, RBI has purchased INR
419.97 bn via SMOs. There is no target for FY10. Source: RBI, Bloomberg, ICICI Bank Research
33
INR - a victim of financial meltdown in H208
INR reacts sharply to massive outflows in H2
(USD mn)
USD/INR FII flows (RHS)
• The year 2008 began with the FII flows reversing 53 1100
their trend (net inflows 2007 USD 19.5bn), which 51 800
continued for most part of the year.
49 500
• Even though there were substantial FII outflows 47 200
in H1’08, the Rupee did not depreciate sharply
45 -100
as a weak dollar cushioned the impact.
43 -400
• However, the Rupee reacted adversely to the
strong FII outflow pressure following the 41 -700
intensification of the financial crisis in Sep’08. 39 -1000
J a n -0 8
F e b -0 8
M a r -0 8
A p r -0 8
M a y -0 8
J u n -0 8
J u l-0 8
A u g -0 8
S e p -0 8
O c t-0 8
N o v -0 8
D e c -0 8
J a n -0 9
F e b -0 9
M a r -0 9
A p r -0 9
• Oct’08 was the worst as FII outflows amounted
to an astronomical USD –4.04 bn, and the INR
weakened sharply by 6%, despite the massive
central bank intervention (USD 18.67 bn).
Increasing macroeconomic risks bring…
• The twin bogey of fiscal deficit and current
15
Current account balance (as % of GDP)
account deficit dogged the Rupee outlook for 2007 2008 2009 F
most part of FY09. This was further accentuated 10
by the risk of failure to roll over external debt
especially short-term trade credit. 5
• The significant deterioration in global economic 0

conditions brought to the forefront vulnerability
of many of the developing economies due to -5
their macroeconomic imbalances, fuelling
-10
downgrade concerns. As a result, EM currency
B ra z il
T u rke y
H u n g ary
In d ia
K o re a
In d o n e sia
R u ssia
C h in a
P o la n d
T h a ila n d
S o u th
A fric a
basket came under immense pressure.

• S&P, in Jan’09, put India on negative watch and
with fiscal balances likely to deteriorate further,
the possibility of a downgrade to junk cannot be
ruled out.
…EM currencies under pressure, incl. INR
(%)
• Emerging market currencies suffered heavily in 20
Change in currency vs. USD 2007 2008 2009YTD
2008, first on account of the strong outflow 10
Appreciation
pressure and then due to the increasing
0
concerns over rising current account deficits,
fiscal imbalances and short term external debt. -10
• The Korean won and Brazilian Dollar were the -20

worst hit, each depreciating by more than 30% -30
in 2008. The Indian Rupee was not far behind, -40
Depreciation
weakening close to 24% last year.
-50
• In 2009, Rupee has suffered far less than many
B r a z il
H u n g a ry
K o rea
In d ia
R u s s ia
C h in a
P o la n d
T h a ila n d
S o u th
A f r ic a
of its peers such as Polish Zloty, Ruble. This

reflects the relatively stronger economic
fundamentals along with RBI intervention. Source: Bloomberg, ICICI Bank Research
34
Risks to India’s current account balanced
Trends in India’s current account position
(USD bn) Invisibles Trade balance Current account
• India’s current account has been in deficit 30
mostly, as invisibles were unable to finance 20
entirely the shortfalls on the trade side. Even
then, the CAD was largely at manageable levels 10
(generally less than 1.2% of GDP since 1997). 0
• The current account briefly turned positive -10

(FY02-FY04), helped by a relatively stable trade
-20
balance and growth in invisibles on account of
software services related flows and remittances. -30
• Current account has been worsening since then -40
Q3FY98
Q3FY99
Q3FY00
Q3FY01
Q3FY02
Q3FY03
Q3FY04
Q3FY05
Q3FY06
Q3FY07
Q3FY08
Q3FY09
(Apr-Dec 09 at USD -22.3 bn), as strong import
demand (both oil and non oil) widened trade
balance, while invisibles remained modest. Source: RBI, ICICI Bank Research
Increased trade linkages together with…

Exports plus imports (as a percentage of GDP)
• With global economy facing one of its worst 40
contractions since World War II, countries with
high dependence on trade would receive a 35
much severe blow than others.
30
• This does put to jeopardy, the prospects of
India’s export sector as India’s trade linkages
25
with ROW have seen a marked increase over
the decade. India’ two-way trade (exports and
20
imports as a proportion of GDP) has risen from
25% in FY00 to around 38% in FY08.
15
• Even then India’s external openness as gauged
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
by this is much less than of many of its peers.
For Asians economies such as South Korea,
Singapore, the two-way trade is more than
100%, implying a greater dependence on trade.
…shrinking global trade to impact external
(%YoY)
sector 45 Export growth Import growth
• According to WTO, the contraction in global 35
demand would cause exports to decline in 2009
by nearly 9% in volume terms (for developed 25
economies 10%, developing countries 2-3%). 15
• Global exports could receive a severe blow 5
should protectionism emerge on a large scale. -5
According to World Bank, 17 of the G20
countries imposed 47 trade restrictions between -15
the Nov and Apr G20 meeting. -25
•
FY 81
FY 83
FY 85
FY 87
FY 89
FY 91
FY 93
FY 95
FY 97
FY 99
FY 01
FY 03
FY 05
FY 07
FY 09e
India might not be as severely affected as others

as it has a relatively small part to play in global
trade. Its share in global exports and imports in
2008 was a mere 1.1% and 1.8% respectively. Source: CEIC, ICICI Bank Research
35
Exports under pressure
Regional diversification could aid exports
(%) Share in total exports
• India’s dependence on the US has been 25
FY01 FY06 FY08
decreasing, with its share in overall exports
20
declining from around 21% in FY01 to 12% in
FY08. At the same time, exports to GCC and 15
other markets have been expanding. UAE is
currently the third largest export destination. 10
• Despite the diversification of export markets, 5
prospects of the export sector look shaky, as
not only the developed economies but also 0
EM’s are to see a sharp decline in demand.
E u ro zo n e
S in g a p o r e
UK
C h in a
UAE
Hong
Japan
US
ko n g
• The government response in the form of duty
drawback benefits for certain items, credit line
to EXIM bank. – has been able to arrest the
collapse but a recovery is not yet in sight. Source: Commerce Ministry of India, ICICI Bank Research
But steep fall in the value of crude and iron ore exports signals the adverse impact…
%Growth %Growth %Growth %Growth (Apr- %Share (Apr-

Commodity
(Nov 08) (Oct 08) (Sep 08) Nov 08) Nov 08)
PETROLEUM -23.0 4.0 36.1 36.75 18.27
GEMS & JEWELLERY -8.7 -1.3 72.2 12.43 11.55
MACHINERY AND INSTRUMENTS -57.7 63.2 58.4 84.56 5.91
TRANSPORT EQUIPMENTS -196.5 35.2 27.3 36.96 5.96
IRON & STEEL -36.0 23.2 67.8 51.08 3.08
IRON ORE -58.8 -76.0 -19.8 4.18 2.3
READYMADE GARMENTS 10.4 10.1 43.9 9.93 4.01
COTTON -8.1 3.8 2.8 54.12 2.51
PLASTIC PRODUCTS -1.8 -6.1 0.0 12.88 1.87
MANMADE YARN,FABRICS 16.3 19.1 1.8 23.88 1.82
CHEMICALS 33.3 63.2 83.3 62.01 2.1
Source: Commerce Ministry of India, ICICI Bank Research
…of global recession on export industry
• In Feb’09, total value of exports declined by – (%) World GDP growth India export growth (RHS) (%)
4.5 35
21.7%YoY to USD 11.91 bn. The fall in exports
4.0 30
was exaggerated by a steep fall in petroleum
products (accounts for 18.2% of exports), which 3.5 25
primarily reflects the steep fall in energy prices. 3.0
20
2.5
• Despite the export diversification, foreign Possible 15
2.0
demand for Indian manufactured goods tends to trajectory 10
decline during periods of global slowdown. 1.5
for exports 5
1.0
• The correlation coefficient between global 0.5 0
growth and Indian export growth, is quite strong
0.0 -5
at 87% (from the start of the decade).
1993
1995
1997
1999
2001
2003
2005
2007
2009
• Commerce Ministry expects Indian exports to

be around USD 170-175 bn in FY10. Source: Bloomberg, World Bank, ICICI Bank Research
36
Oil prices, domestic slowdown to ease imports
%Growth %Growth %Growth %Growth (Apr- %Share (Apr-
Commodity
(Nov 08) (Oct 08) (Sep 08) Nov 08) Nov 08)
PETROLEUM -23.0 4.0 36.1 36.75 18.27
GEMS & JEWELLERY -8.7 -1.3 72.2 12.43 11.55
MACHINERY AND INSTRUMENTS -57.7 63.2 58.4 84.56 5.91
TRANSPORT EQUIPMENTS -196.5 35.2 27.3 36.96 5.96
IRON & STEEL -36.0 23.2 67.8 51.08 3.08
IRON ORE -58.8 -76.0 -19.8 4.18 2.3
READYMADE GARMENTS 10.4 10.1 43.9 9.93 4.01
COTTON -8.1 3.8 2.8 54.12 2.51
PLASTIC PRODUCTS -1.8 -6.1 0.0 12.88 1.87
MANMADE YARN,FABRICS 16.3 19.1 1.8 23.88 1.82
CHEMICALS 33.3 63.2 83.3 62.01 2.1
Source: Commerce Ministry of India, ICICI Bank Research
Non oil imports at risk by domestic slowdown

(%) Non-oil imports growth GDP growth (RHS) (%)
• While petroleum and its products account for bulk 60 Correlation 0.61 12
of India’s imports, other important imports of the
50
country include machinery, gems, electronics etc. 10
40
• Imports of many of these non-oil commodities 30
8
depend upon domestic growth prospects. Periods
20 6
of a relatively high economic growth have seen a
surge in non-oil imports, while the reverse is true 10
4
when domestic activity slows down. 0
2
-10
• The degree of responsiveness of non-oil imports
to GDP is quite high, as the elasticity of demand is -20 0
D e c -9 8
D e c -9 9
D e c -0 0
D e c -0 1
D e c -0 2
D e c -0 3
D e c -0 4
D e c -0 5
D e c -0 6
D e c -0 7
D e c -0 8
at 2.4% (from 1997).
• India’s non-oil imports have started to moderate
in response to the slowdown in domestic demand
(Feb’09 non-oil imports contracted by 10.2%YoY).
Source: Bloomberg, RBI, ICICI Bank Research
Oil import bill to decline on price effect (mn tons)
Total volume of crude oil imports (USD bn)
16 14
• Since FY05, India’s oil import bill has increased at Total value of crude oil imports (RHS)
a rapid pace, of around 40% (FY08 USD 79bn, 14 12
FY09e USD 88bn). During this time, however, 12
10
crude oil imports, in volume terms, have seen 10
only a modest increase of around 8.5%. 8
8
• The sharp increase in India’s crude oil basket had 6
6
driven the oil import bill to record highs. With 4

4
global energy prices declining rapidly, oil import
2 2
bill has also fallen sharply (USD 4.1 bn in Feb’09).
0 0
• With oil prices expected to remain subdued in
J a n -0 7
M a r -0 7
M a y -0 7
J u l-0 7
S e p -0 7
N o v -0 7
J a n -0 8
M a r -0 8
M a y -0 8
J u l-0 8
S e p -0 8
N o v -0 8
2009 (av USD 55pb), the oil import bill is likely to

be around USD 60 bn in FY10. This excludes any
impact of the KG Basin gas production. Source: CEIC, Bloomberg, ICICI Bank Research
37
Uncertain outlook for invisibles in FY10
Global meltdown could risk remittance flows
(USD bn) Remittances Growth (RHS) (%)
• India benefited vastly from the oil boom in the 45 Adverse impact of
120
Middle East and the Technology revolution. The 40 Oil Price Gulf crisis along
Dot com bubble
100
share of private transfers to total GDP has risen Shocks burst and global
35 with recession in US
slowdown 80
steadily from 2.8% in FY01 to 3.7% in FY08. 30 Oil Price
60
• According to World Bank, in 2007 India received 25
Shock
the highest remittance flows. North America and 40
20
Middle East account for the bulk of remittance 15
20
inflows (44% and 24% respectively). 10 0
• Although data is yet to confirm, there is 5 -20
increasing fear that the burden of layoffs in 0 -40
developed countries could fall on migrant
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
workers. This together with the fall in the
income of oil workers in the Gulf region could
slow down remittance flows into India. Source: Bloomberg, ICICI Bank Research
A weak Rupee could offset the moderation
(USD bn) (%)
Total private transfers
• Apart from global macroeconomic conditions, 14
Quarterly Change in USD/INR (RHS)
10
exchange rate movements and interest rate 8
D e p re c ia t io n
12
differentials also determine remittance flows. 6
10
4
• Despite the ongoing global meltdown, there are 8 2
indications that the recent Rupee weakness had 0
6
led to an increase in inflows. -2
4
• Even the hike in interest rate ceilings on NRI -4
2 -6
deposits since Sep’08 (175 bps for NRE and 100
bps for FCNR (B) deposits), has boosted inflows. 0 -8
D e c -9 4
D e c -9 6
D e c -9 8
D e c -0 0
D e c -0 2
D e c -0 4
D e c -0 6
D e c -0 8
• Despite these facts, FY10 is likely to see a more
subdued growth in invisible flows, as gloomy
world outlook dominates other positive factors.
Risks to core balance emerging (USD bn) Core Trade Balance Oil Imports
30
• While India’s overall trade balance has been
negative, its core trade balance (merchandise 25
and software service exports less non oil
imports) has been strictly positive. 20
• The IT sector boom has led to a surge in 15

software related flows (USD 5.8bn in FY01 to
10
USD 29 bn in FYTD09). While NASSCOM has
not given any estimates for FY10, cutback in 5
tech budgets and depreciation of non-dollar
0
currencies can pose negative surprises.
D e c -0 3
J u n -0 4
D e c -0 4
J u n -0 5
D e c -0 5
J u n -0 6
D e c -0 6
J u n -0 7
D e c -0 7
J u n -0 8
D e c -0 8
• We are worried by the sharp drop in the core

trade balances for Dec’08 quarter, but feel that
the situation could improve going forward.
Source: RBI, Bloomberg, ICICI Bank Research
38
Global recovery to script the fate of capital flows
Decline in global capital flows could hit India
Private financial flows to Emerging Market economies (USD bn)
• Turning to the capital account side of BoP, while 2006 2007 2008e 2009f
record high capital flows in FY08 (USD 108 bn) Total Private flows 564.9 928.6 465.8 165.3
had led to a sharp Rupee appreciation, the Equity investment 222.3 296.1 174.1 194.8
reverse was true in FY09, as capital flows fell Private Creditors 342.6 632.4 291.7 -29.5
sharply (Apr-Dec USD 16 bn). Latin America 51.5 183.6 89.0 43.1
Equity investment 28.9 81.5 48.4 42.0
• Globally as well, private capital flows have Private Creditors 22.6 102.1 40.7 1.0
nearly halved in the last two years. According to Emerging Europe 226.3 392.8 254.2 30.2
the International Institute of Finance (IIF), net Equity investment 50.2 81.1 50.3 48.6
capital flows to EM’s are likely to be an abysmal Private Creditors 176.2 311.7 203.9 -18.4
USD 165bn in 2009 from USD 466bn last year. Emerging Asia 258.9 314.8 96.2 64.9
• Emerging Europe followed by Emerging Asia Equity investment 122.6 112.9 57.9 85.7
Private Creditors 136.3 201.9 38.2 -20.8
are likely to be the two worst hit regions from
the sharp reduction in net flows during 2007-09. Source: IIF, ICICI Bank Research
FII flows at mercy of global liquidity position

• The sharp decline in capital flows seen over the Monthly FII flows (12M MA, USD bn) G5 liquidity index (RHS)
2.2 200
past few months is likely to be due to a
1.8
contraction in liquidity in developed markets. 150
1.4
• According to our G5 liquidity index (measures 1.0
100
changes in G5 money supply), G5 liquidity was
0.6 50
expanding till as late as Mar’08 and started to
0.2
moderate post that. It contracted towards the 0
end of 2008, as massive global deleveraging -0.2
-50
pressures emerged (index fell to –20 in Dec’08). -0.6
-1.0 -100
• In the ongoing financial crisis, liquidity apart,
J u n -0 4
O c t-0 4
F e b -0 5
J u n -0 5
O c t-0 5
F e b -0 6
J u n -0 6
O c t-0 6
F e b -0 7
J u n -0 7
O c t-0 7
F e b -0 8
J u n -0 8
O c t-0 8
F e b -0 9
investor perception of risk is an important driver
of FII flows. So, while we might see an up tick in
G5 liquidity (due to the various central bank
actions) elevated levels of risk could continue to
Source: Reuters Ecowin, SEBI, ICICI Bank Research
keep FII flows at bay.
Even FDI flows could be hampered (USD bn)
FDI Flows Inflows Outflows Net
• Since FY07, FDI inflows have been increasing, 15
reflecting the strong economic fundamentals
12
along with opening up of the economy. Indian
firms have also stepped up their foreign 9
investment, causing some FDI outflow.
6
• According to official estimates, Apr- Jan FDI
inflows stood at USD 23.9 bn, lower than the 3
USD 34.3 bn received in FY08.
• Govt. has been clearing several FDI proposals in 0
Q 1FY 96
Q 3FY 97
Q 1FY 99
Q 3FY 00
Q 1FY 02
Q 3FY 03
Q 1FY 05
Q 3FY 06
Q 1FY 08
Q 3FY 09
recent months (March around 30 cleared

amounting to Rs 1042 cr). Even then, FDI flows
could moderate in FY10 as PE funds and foreign
companies slowdown their investments. Source: RBI, ICICI Bank Research
39
Balance of Payment outlook for FY10
FY10f
(USD bn) FY07 FY08 FY09f
Optimistic Pessimistic
1 Merchandise -61.8 -91.6 -119.0 -89.0 -119.0
- Exports 128.9 166.2 169.0 171.0 160.0
- Imports 190.7 257.8 288.0 260.0 279.0
Non oil imports 121.0 160.0 187.0 185.0 193.0
Oil imports 58.0 79.0 88.0 60.0 71.0
2 Invisibles 52.2 74.6 84.0 85.0 80.0
Total Current Account -9.6 -17.0 -35.0 -4.0 -39.0
1 Foreign Investment 14.8 45.0 6.0 25.0 6.0
- FDI 7.7 15.4 20.0 20.0 8.0
- Portfolio Investment 7.1 29.6 -14.0 5.0 -2.0
2 Loans 24.5 41.9 7.0 8.0 4.0
3 Banking Capital 1.9 11.8 0.0 4.0 1.0
4 Other capital 4.2 9.5 -4.0 1.0 0.0
Total Capital Account* 45.2 108.0 9.0 38.0 11.0
Overall Balance of Payments 37.6 93.4 -26.0 34.0 -28.0
(* includes errors and omissions)
A more balanced BoP on the cards

• In light of the considerable uncertainty surrounding global economic and financial conditions, we
decided to come out with two plausible scenarios for our FY10 BoP forecasts, taking into account two
extreme scenarios that can serve as benchmarks for the coming year.
• Coming to the specifics of our BoP forecast, we think that exports are likely to remain muted as global
growth is expected to recover only towards the end of 2009. While some growth in exports can be
expected towards the end of FY10, a more prolonged global recession can change that. Imports on the
other hand, are expected to decline, as subdued oil prices (in the range of USD 55-60 a barrel), sharply
bring down the oil import bill, and the domestic slowdown leads to only a modest rise in the non-oil
import component. The overall trade deficit is likely to narrow against this background.
• On the invisible side, some moderation can be expected in remittance flows, but a weaker currency
along with the recent hikes in NRI deposit rates are more likely to ensure a steady inflow. While
software service receipts, the other major component of invisibles are showing signs of moderation,
they are unlikely to see a very sharp drop. On the whole, we see net invisible receipts stable at around
USD 80 - USD 85 bn. However, we acknowledge the possibility of substantial downward risks to this.
• On the capital flows side, we think that FII flows could surprise us, both on the upside as well as the
downside. On one hand, a further deterioration in global financial conditions would result in elevated
levels of risk aversion, keeping the FII outflow pressure intact. This can get intensified, particularly in
the near term, if India’s sovereign rating is downgraded. On the other hand, signs of global recovery
could see a spurt in risk appetite, aiding capital flows to emerging markets. We however, have taken a
more conservative view on FII flows, and see FII flows around USD –2 bn - USD 5 bn.
• Some respite could be provided by FDI inflows, as one off deals could take place. However, these
would not amount to a very significant sum, keeping the overall capital account around neutral levels.
• We don’t expect a large inflow or outflow in other components of the capital account, such as ECBs,
trade credits etc, and see loans (ECBs plus trade credits) to be around USD 4 bn to USD 8bn.
• On the whole, we think that in FY10 a more balanced BoP is likely as current account sees some
improvement on the back of a narrowing trade deficit and the capital account does not see any
significant deterioration from current levels. However, our BoP outlook has not budgeted for any oil
discovery in the KG basin and a development of the same could result in a positive surprise.
• This rather benign outlook for BoP prompts us to forecast an appreciation path for rupee in the
medium to long term. 40
Risks of external vulnerability exaggerated
India ranks low on external vulnerability
(%)
Total debt to GDP ST debt to total debt
• Moving away from BoP, investors are 160
Total ST debt to FX reserves Total FX reserves to total debt
positioning for a potential risk to the currency, 140
arising from the country’s external vulnerability. 120
• Difficulty in accessing international capital 100
markets, particularly for shorter maturities, 80
together with unfavorable currency movements 60
has raised refinancing concerns and possibility
40
of a sovereign default by some of the countries.
20
• Poland and Hungary are the most vulnerable, in 0
terms of all the external vulnerability indicators.
B r a z il
H u n g ary
R u s sia
In d ia
M a la y sia
P o la n d
M e x ic o
T h a ila n d
S o u th
Ko rea
• India is much better placed than many of its
peers, with a relatively small debt to GDP ratio.
More importantly, its ST debt to total debt and
Source: Reuters Ecowin, Ministry of Finance, ICICI Bank Research
ST debt to FX reserves is amongst the lowest.
Near term risks on external debt overdone (USD bn) (As of Dec'08)
• Recently there were concerns that India could 100
Short term debt by residual maturity
90.0 Components of ST debt by residual maturity
face some liquidity issues in meeting its external
debt obligations, particularly in the near term. 80
• Of the USD 43.8 bn of trade credits as per ST

Short term debt by
60
debt by residual maturity, USD 28.1 bn has been 43.8 original maturity
disbursed during Apr-Nov’08 (RBI data), leaving
40 31.8
a balance of roughly USD 15 bn.
• Outflow risk for NRI deposits is small as nearly 20 7.8
2.9
85% of these are for maintenance purposes. 2.2 1.4 0.1
The outflow risk for even the part of the 0
T o ta l
C o m m erc ia l
E xt lia b o f
D ep o sits
c red its
deposits meant for investment purposes is low O th ers

FII In v
Bo rro w in g s
S o v ereig n
T ra d e
b a n kin g
sy stem
N RI
d eb t
due to India’s strong fundamentals.
• Repayment due on ECBs over the next one year
at USD 7 bn is also relatively small. Source: Ministry of Finance, ICICI Bank Research
Near term FCCB redemptions pressure trivial (USD bn) Outstanding amount of FCCBs maturing in
6
• Borrowing via the issuance of FCCBs had been a
preferable route for Indian firms. Total FCCBs 5
approved shot up from 77 in FY07 to 113 in
FY08. However, this dropped sharply to only 7 4
during Apr-Aug’08 (none since Sep), reflecting
the difficulty in raising capital via this route. 3
• In the ongoing global meltdown, it is quite likely 2
that FCCBs maturing in the near term (USD 1.29
bn in FY10 as per Bloomberg) come for 1
redemption as their conversion price is much
higher than the market price. 0
• Last Nov, RBI decided to consider premature FY10 FY11 FY12 FY13
buyback of FCCBs by Indian firms. It has Source: Bloomberg, ICICI Bank Research
extended the deadline for this to 31st Dec’09.
41
Risk appetite & dollar moves to impact INR
Short term INR dynamics affected by risk
• Our Global Risk Index (GRI), has been able to 53
USD-INR Global Risk Index (RHS)
4
successfully map periods of increasing and
51
falling risk appetite. 3
• Selling Rupee is a favorable trade in the off 49
Risk Aversion
2
shore market, when risk aversion runs high. 47
1
• The index peaked last October (3.91) as global 45
financial meltdown gathered pace. 0
43
Correspondingly, the Rupee saw one of its
worst performances, depreciating by over 8%. 41 -1
• While the index is currently (1.21) substantially 39 -2

off its peak, it is still well above its historical
Apr-07
Jun-07
Aug-07
Oct-07
Dec-07
Feb-08
Apr-08
Jun-08
Aug-08
Oct-08
Dec-08
Feb-09
Apr-09
average (0.1 from May’96), possibly signaling
Rupee weakness to remain in the near term.
Source: Bloomberg, Reuters Ecowin, ICICI Bank Research
Fate of Asians and major crosses linked
• Currencies normally tend to move in the same 1
6M rolling correlation between DXY and ADXY
direction, as overall dollar weakness (strength) 0.8
imply stronger (weaker) major crosses, which in 0.6
turn spills over to the other EM currencies. 0.4
• The 6M rolling correlation between ADXY 0.2
(index of 10 Asian currencies) and DXY (dollar 0
-0.2
trade weighted index) has generally been
-0.4
around -0.9. Last summer, this correlation broke
-0.6
down (–0.1) as a worsening European economic -0.8
outlook aided the dollar while the Asians, still -1
largely unaffected from the crisis traded firmly.
A p r -0 0
A p r -0 1
A p r -0 2
A p r -0 3
A p r -0 4
A p r -0 5
A p r -0 6
A p r -0 7
A p r -0 8
• With Dollar as the preferred safe haven
currency, currencies, both majors and Asians,
are likely to under-perform in the near term.
Rupee moves to be in sync with Asian basket
6M rolling correlation between USD-INR and AXJ
• Since Asian currencies tend to move together, 1
movements in Rupee have largely followed 0.8
those of the Asians. The correlation between the 0.6
Rupee and our trade weighted Asian currency 0.4
Index excluding Japan (AXJ) has been strongly 0.2
positive (generally above 0.8). 0
-0.2
• Generally, any sustained deviation in this
correlation gets corrected through the NDF -0.4
-0.6
market as has been observed in Sep’08.
-0.8
• In the coming year, we think that in the EM
A p r -0 6
J u l-0 6
O c t-0 6
J a n -0 7
A p r -0 7
J u l-0 7
O c t-0 7
J a n -0 8
A p r -0 8
J u l-0 8
O c t-0 8
J a n -0 9
A p r -0 9
space, relatively strong fundamentals of Asians,

would aid a faster recovery of their currencies,
including Rupee.
42
RBI intervention – a choice between ability & willingness
Reserves deplete as central banks intervene (%)
(USD bn) Change in FX reserves during Sep -Dec'08
• In the aftermath of the Lehman bankruptcy, 20 Change in currency between Sep - Dec'08 (RHS) 5
emerging market economies faced huge 0 0
outflow pressure, which pummeled their
-20 -5
domestic currencies.
-40 -10
• In the period Sep- Oct’08, Russian central bank
heavily used its FX reserves (declined by a -60 -15
massive USD 131 bn) to preserve the value of -80 -20
its currency (depreciated by 19%). -100 -25
• Korea was a close second, seeing a fall in its FX -120 -30
reserves close to USD 38 bn with its currency -140 -35
depreciating by 15%. Russia India Indonesia South Thailand Malaysia Poland
• The drop in India’s FX reserves was USD 30bn, Korea
with the Rupee weakening by close to 11%. Source: Reuters Ecowin, Bloomberg, ICICI Bank Research
FX reserves – not a restraint for intervention

(USD bn) Change in foreign currency assets
• Change in India’s FX reserves during any given 40
Total Due to valuation change
period is the cumulative effect of the actual 30
inflow/outflow and valuation gain/loss, on the 20
Estimates
major currencies that form the reserves. 10
• In 2007, India added a record USD 96 bn to its 0
FX reserves, of which valuation effects -10
accounted for only USD 10.5
-20
• The picture changed in 2008, as foreign -30
currency assets have depleted by USD 56 bn
-40
during Jul-Dec’08. Of this, USD 33bn is due to a
Q 1 FY 07
Q 2 FY 07
Q 3 FY 07
Q 4 FY 07
Q 1 FY 08
Q 2 FY 08
Q 3 FY 08
Q 4 FY 08
Q 1 FY 09
Q 2 FY 09
Q 4 FY 09
Q 3 FY 09
valuation change (depreciation of currencies vs.
USD) and the rest is dollar outflows.
• In this light, the drop in FX reserves in FY09 is
not so alarming and we think that it will not act
as a severe constraint on intervention in FY10. Source: RBI, Bloomberg, ICICI Bank Research
INR liquidity could modulate intervention call (USD bn) Average monthly LAF balances Net intervention by RBI (RHS) (USD bn)
800 28
• RBI’s intervention action in the FX market gets
600 21
reflected in the domestic INR liquidity dynamics.
• While the central bank intervened heavily in 400 14
2007 to contain Rupee appreciation, 200 7

intervention in 2008 (particularly H2) was to
0 0
stem the depreciation pressures on the Rupee.
-200 -7
• The surge in the dollar demand, in the aftermath
of the Lehman crisis, saw RBI intervene to the -400 -14
tune of USD 18.67 bn in Oct’08. This also -600 -21

corresponded to a sharp fall in domestic
J u l-0 0
J a n -0 1
J u l-0 1
J a n -0 2
J u l-0 2
J a n -0 3
J u l-0 3
J a n -0 4
J u l-0 4
J a n -0 5
J u l-0 5
J a n -0 6
J u l-0 6
J a n -0 7
J u l-0 7
J a n -0 8
J u l-0 8
J a n -0 9
liquidity with avg. LAF shortfall of INR 400 bn.

• The need to maintain ample INR liquidity could
Source: Bloomberg, RBI, ICICI Bank Research
weigh on RBI’s intervention strategy in FY10.
43
FY10 Rupee outlook
REER movement to guide intervention
decision (USD bn) Net intervention by RBI REER (6 country, 1993-94 base, RHS)
15 120
• RBI’s intervention decisions are not only
affected by the volatility in USD/INR, but also by 10
115
the movement in effective exchange rate. 5
110
• The Rupee has started to depreciate not just 0
against the dollar but also its other major -5 105
trading partners as REER has fallen below 100 -10
(99.24 as of 19th Feb’09) from as high as 115. 100
-15
• Any further fall in rupee against dollar from here -20 95
on would skew the valuation towards excessive
M a y -0 3
S e p -0 3
J a n -0 4
M a y -0 4
S e p -0 4
J a n -0 5
M a y -0 5
S e p -0 5
J a n -0 6
M a y -0 6
S e p -0 6
J a n -0 7
M a y -0 7
S e p -0 7
J a n -0 8
M a y -0 8
S e p -0 8
J a n -0 9
depreciation if the other crosses were not
moving simultaneously. Such an outcome could
warrant intervention from RBI.
• However, any generalized dollar strength would Source: RBI, ICICI Bank Research
effectively reduce the need for any intervention.
FY10 Rupee View – Near term risks to undermine Rupee, but strength to return in long term
Overall Rupee moves will depend on several factors, such as
• Capital flows – In the near term, possibility of sporadic capital outflows could not be ruled out, keeping
the currency under pressure. However, over the medium to long term, we could see capital flows
trickling into the economy as financial conditions stabilize. This would in turn be supportive of a
stronger domestic currency.
• Risk aversion - While short-term Rupee dynamics are often driven by investor perception of risk, this
relationship seems to have weakened in recent times. Reemergence of this relationship could exert
downward pressure on rupee in the near term. This is based on our assessment that certain risk events
can still materialize in the next quarter.
• Event risks (Political uncertainty, sovereign downgrade) – Among event risks, the uncertainty
surrounding the forthcoming general elections, along with, the risk of a ratings downgrade, as fiscal
position deteriorates, would severely dampen investor confidence, causing the currency to depreciate.
• Oil prices – With global demand contracting severely, oil prices should remain muted. This would not
only help to improve the current account but also bring down the dollar demand by oil companies,
easing the depreciation pressure on the Rupee.
• Dollar View – In the near term, we think that the Dollar will trade firmly, benefiting from its safe haven
currency status. However, in the long term as global economy shows signs of recovery Dollar strength
is likely to wane. This would have a positive influence on rupee.
• RBI Intervention – Intervention by the central bank holds the key to the extent to which Rupee can
depreciate in the future. We believe that the central bank is unlikely to be constrained by falling FX
reserves. Apart from the stated goal of arresting sharp rupee movements, domestic liquidity conditions
together with the level of REER would be the guiding principles for the central bank.
Assimilating the views stemming from the above factors, our bias is towards a weaker rupee in the near
term. The trading range on INR could extend to 53 levels in June quarter. However, the overall benign BoP
scenario and depreciation of dollar against other crosses would make the conditions ripe for a rebound in
rupee in the medium to long term. Our target for March end 2010 stands at 47 levels. Risks to the view
arise from a faster than anticipated global recovery, which could prevent the possibility of near term
depreciation.
44
Treasury Research Group
Economics Research
Samiran Chakraborty Chief Economist (+91-22) 2653-7548 samiran.chakraborty@icicibank.com
Ruchi Singh Economist (+91-22) 2653-6280 ruchi.singh@icicibank.com
Shubhra Mittal Economist (+91-22) 2653-6760 shubhra.mittal@icicibank.com
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India Outlook For FY 10

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India Outlook For FY 10

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India Outlook FY10

• Inflation is expected to remain benign 16

• Expansive fiscal policy to continue 18

• Softer interest rates to stay 23

• The peak in inflation was also accompanied with

form of CRR and repo rate being raised by 250 9

• The situation necessitated a change in policy 5

Analysing the growth outlook for FY10 – A conceptual framework

• The structural shift of the economy is visible 8

• The financing of investment shows that 5

Safe-haven component may pose a challenge (%) Proportion in change HH assets

• During previous slowdown years share of

represent a slowdown in year t vis-a-vis in year 7

Consumption Sustainers Potential pitfalls in consumption growth

• Government’s measures – centre & state pay Central Government

PLR and it weakens significantly on taking the 1-

negative contribution of net export to GDP

Industrial growth may be affecting with a lag

production year is followed by a better one. 8

have to wait to conclude if the trough has been

heightened security concerns post the terror 0 18

attacks could adversely affect the trade and

Source: CSO, ICICI Bank Research

Least affected sectors - Least affected sectors -

Worst affected Worst affected

Moderately affected Moderately affected

Source: McKinsey, CEIC, ICICI Bank Research

• We have defined sectors with maximum

Avg growth last 5

Source: CEIC, ICICI Bank Research

Challenging times ahead Scenarios for FY10 GDP

• While growth in FY09 is expected to fall below 8

• With a dismal global backdrop and poor GDP

domestic conditions the FY10 seems to be a lot (% YoY) 4

more difficult year than FY09.

into the system rapidly and early signs of pick-

The bare Propelled by Aided by global

Global headwinds: Global headwinds Global headwinds:

GDP growth GDP growth GDP growth

CPI and WPI paint different inflation scenario

• While WPI averaged 3.2% in Feb’09, the CPI 10

Source: CEIC, ICICI Bank Research

• The sensitivity of policymaking to primary article

India’s vulnerability to deflation relatively low

• As per our analysis inflation would enter the 3

Our forecast chart of the inflation figures for

• Expansion of fiscal deficit has become a global China

stimulus in a phased manner. Russia has Germany

slipped from surplus to deficit mode rapidly. Canada

Combined fiscal deficit looks onerous

Post election, deficits carry an upward bias

emanate from a higher than expected primary

Source: RBI, Parliament of India, ICICI Bank Research

Average announced fiscal impluse

Source: IMF, ICICI Bank Research

Source: Press releases, ICICI Bank Research

• Hence, a higher deficit need not always be a

• The reduction in indirect tax rates (as a part of 20

as blessing for the off-balance sheet deficit that 700 1200

subsidy later on in the year cannot be ruled out.

Source: RBI, ICICI Bank Research

Source: RBI, ICICI Bank Research

seen since FY02.