19 November 2010

Economics Research
http://www.credit-suisse.com/researchandanalytics

India: Livin’ on a prayer?

Emerging Markets z Economics z Asia

Contributors A look ahead to 2011-12

Robert Prior-Wandesforde Without wishing to pour cold water on what is a very favourable long-term
+65 6212 3707
growth story, we believe India’s macroeconomic fundamentals will disappoint
robert.priorwandesforde@credit-suisse.com
the consensus in a number of respects next year.
Devika Mehndiratta
+65 6212 3707 • First, we think the main drivers of economic growth, including interest rates,
devika.mehndiratta@credit-suisse.com the exchange rate, oil prices and world trade will turn from positive to negative
influences on activity in the not too distant future. We have cut our 2011/12
GDP growth forecast to a bottom-of-the-range 7.7%.
• Second, while the year-on-year rate of Wholesale Price Inflation is set to fall
further in the next few months, it might bottom in early 2011 at around 6%.
Our estimate suggests WPI inflation will trend higher through the rest of next
year if commodity prices rise from current levels. We wouldn’t be surprised if
sequential rates of WPI inflation have already troughed.
• Third, a combination of more dovish comments from the RBI and falling year-
on-year inflation rates has led most to believe that policy rates are at or very
close to a peak. This has, however, been the consensus view for some time
and we believe further upside rate surprises are in store. Our forecast is for a
total of 75bp repo and reverse repo rate hikes by around the middle of 2011.
• Fourth, domestic liquidity conditions may ease somewhat, but we expect them
to remain reasonably tight as lending growth continues to outpace the
increase in deposits.
So what does this mean for markets? For equities, the onus will likely be on
companies to drive a positive wedge between the top and bottom lines of their
profit and loss accounts. If this fails, then investors will have to hope that
nothing comes along to stem the flow of liquidity emanating from the US.
As for the bond market, our macroeconomic view presents something of a
mixed bag. However, on balance, the fixed income team is modestly
constructive. An important point to bear in mind is that the 10-year bond yield is
highly likely to flatten or fall before policy rates have peaked. With the majority
of the rate rises now behind us, the pace of tightening slowing and domestic
liquidity easing a little, we should be at or close to the top in yields.
Our foreign exchange analysts are looking for the Indian rupee to appreciate
further over the coming 12 months, targeting a rate of INR42 against the USD.
This is, however, largely a function of a weak USD view and the team is
cognisant of the domestic risks surrounding the rupee. In particular,
deterioration in global risk sentiment would likely hit the rupee harder than most
other Asian currencies given the country’s high current account deficit and
equity-focused foreign inflows.

ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER
IMPORTANT DISCLOSURES, PLEASE REFER TO https://firesearchdisclosure.credit-suisse.com.
 19 November 2010

A tale of two asset classes

Judging by the super-charged performance of Indian equities over the last 18 months,
investors would appear to be nothing if not relaxed. The typical macro view of those that
have been pouring money into the market might run something like this: “India is a large,
domestically focused economy where growth is pretty much guaranteed to remain strong.
While inflation is high and interest rates have risen, the former is now heading down, and
could in any case reflect the pricing power of companies, while economic activity is
extremely insensitive to higher rates.”
At the same time, however, those investing in India’s government bond markets have
generally proved more cautious as rising inflation, higher short-term interest rates and an
ample supply of bonds have weighed heavily on sentiment. As a result, bond yields in
India have moved in the same direction as domestic equities over the last 18 months
(Exhibit 1).

Exhibit 1: Indian bonds have sold off as equities have strengthened …

Index %
22,000 Sensex equity price index (LHS) 8.2
21,000 10 year bond yield (RHS) 8.0
20,000 7.8
19,000
7.6
18,000
7.4
17,000
16,000 7.2

15,000 7.0
14,000 6.8
Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10
Source: Credit Suisse, CEIC

Exhibit 2: … which has been very unusual in Asia

100
50
0
-50
-100
-150 Change in 10y bond yield (bps)*
-200 Change in equity market (%)*
-250
-300
India China Tai Malay HK Korea Sing Thai Phil Indo
* Since June 2009
Source: Credit Suisse, CEIC, the BLOOMBERG PROFESSIONALTM service

India: Livin’ on a prayer? 2

 19 November 2010

The contrasting performance of the two markets no doubt partly reflects the level of foreign
participation in Indian bonds relative to equities. Foreigners play a much more important
role in the latter than the former and have been seeking to escape the low growth/yield
environment of the developed world in favour of the stronger activity and higher nominal
yields associated with the emerging market universe. Hefty restrictions and regulations on
overseas investment in Indian bonds has meant that global liquidity has found a more
rewarding home in equities as well as the fixed income instruments of countries other than
India (Exhibit 2).
In our view, Indian government bonds have been behaving more rationally in the context
of the country’s macroeconomic fundamentals than the equity market. But that’s not to
say that a near-term collapse in equities is inevitable If global liquidity remains strong,
economic growth holds up, inflation comes down and policy interest rates stop rising, then
current valuations would be easier to justify and the market should continue to perform
well. Such an environment could be good news for bonds as well.
So how likely is such a scenario to play out? Consensus forecasts would suggest that this
is precisely what will happen. GDP growth is expected to average 8.3% in 2010/11, rising
slightly to 8.4% in 2011/12, while inflation falls sharply and interest rates remain broadly
flat from here. The trouble, however, is that history tells us that the consensus can often
be wrong and it is important to consider the risks surrounding these views. That is the
intention of this report, which will examine the likely development of India’s key
macroeconomic fundamentals in turn over the next 12-18 months.

1. Economic growth – Standing strong?

From industry- to service-sector-led growth
By way of background, it is useful to begin by establishing just how the economy has
performed in recent months. This might sound like a straightforward exercise, but this is
actually not the case in India. Calendar Q3 GDP numbers have still to be released and
won’t be until 30 November, while decent high-frequency data are few and far between.
There are, for example, no up-to-date measures of retail sales, housing activity,
employment or unemployment to consider.

Exhibit 3: Industrial slump … Exhibit 4: … only partly reflects

capital goods
% Ind. Prod. (% y-o-y) % Ex. Cap. IP (% y-o-y)
25 Ind. Prod. (% 3m-on-3m ann)* 20 Ex. Cap. IP (% 3m-on-3m ann)*
20 15
15
10
10
5
5
0 0

-5 -5
-10 -10
08 09 10 08 09 10
* 3 month-on-3 month annualised rate * 3 month-on-3 month annualised rate for industrial production
Source: Credit Suisse, CEIC excluding capital goods
Source: Credit Suisse, CEIC

India: Livin’ on a prayer? 3

 19 November 2010

Industrial production is the only “top tier” monthly measure of activity in the country. But
even this has failed to present a particularly clear picture in recent times, as year-on-year
growth has swung widely from 15% in April, to 6% in June, back to 15% in July and down
to little more than 4% in September. In order to try and look through the volatility in the
year-on-year rate and gain a more timely indication of what is going on, we have
seasonally adjusted the production numbers and calculated the 3 month-on-3 month
annualised rate (Exhibit 3). This suggests that the sector has suffered a sharp downturn in
its underlying growth rate since the beginning of this year.
The production of capital goods, which represents about 9% of the total index, has
accounted for much of the recent volatility in overall industrial production and if we exclude
this component, then the slowdown hasn’t been as abrupt (Exhibit 4). Nevertheless, a 3
month-on-3 month annualised growth rate of 5% in September is not particularly
impressive. It is, for example, below the 6.5% average increase in the series over last ten
years. This fairly downbeat impression of industrial sector activity is supported by second-
tier indicators such as cement dispatches and power demand, which have also dropped
back in recent times (although they too tend to be volatile).
But what is happening in the much larger service sector of the economy? Luckily things look
better here. In India: Is economic activity stalling? 29 October, Devika Mehndiratta took a
close look at a whole series of service-related measures, including rail freight, air traffic, real
bank lending, insurance premium collections, mortgage disbursements and telephone
subscriptions, all of which provide a reasonably upbeat impression of services activity.
With this in mind and assuming the agricultural sector has continued to recover from the
drought-related drop in output at the end of last year, then GDP growth should be holding
up reasonably well, despite the softening in the industrial sector. This certainly appears to
be the message of Exhibits 5 and 6, which show the weighted average of the
manufacturing and service sector PMIs and the results of Dun & Bradstreet’s India survey.
We expect real GDP to have risen 7.5% year-on-year in the July-September quarter on
the basis of a 7.9% quarter-on-quarter seasonally adjusted annualised increase. Thanks
partly to an easy base comparison, October-December could see year-on-year growth
reach nearly 9%.

Exhibit 5: PMI points to 9-10% growth Exhibit 6: … while the same is true of
in GDP ex. Agriculture … the Dun & Bradstreet survey
Index % y-o-y Index % y-o-y
D&B Survey (LHS)
65 Combined PMI (LHS)* 12 220 12
GDP ex. agric. (RHS)
GDP ex. agric. (RHS) 11 200 11
60
180
10 10
55 160
9 9
50 140
8 8
120
45 7
100 7
40 6 80 6
06 07 08 09 10 03 04 05 06 07 08 09 10
* Weighted average of manufacturing and services PMI Source: Credit Suisse, CEIC
Source: Credit Suisse, Markit, CEIC

India: Livin’ on a prayer? 4

 19 November 2010

What next?
In order to provide a longer-term outlook for the economy, we need to determine the
fundamental drivers of GDP growth and their relative importance. These are often hotly
disputed in India, and we have conducted our own investigation by constructing a multiple-
regression equation designed to explain changes in output over the last ten years.
The dependent, or left hand side, variable in the equation was GDP, excluding both
“agriculture” and “community, social & personal services”, which are closely linked to
government spending. Our intention here was to establish an underlying measure of GDP
that would best pick up the impact of fundamental macroeconomic drivers (we have
compared our indicator with overall GDP growth in Exhibit 7). The explanatory, or right
hand side, variables we tried in the equation were world trade, oil prices, real and nominal
interest rates and various measures of the rupee exchange rate.

Exhibit 7: Total GDP growth has been more stable than our underlying measure
recently
% y-o-y
14 GDP ex. agriculture & community services

12 Total GDP

10
8
6
4
2
0
98 99 00 01 02 03 04 05 06 07 08 09 10
Source: CEIC, Credit Suisse

Exhibit 8: Model does a good job in explaining India’s underlying GDP growth
% y-o-y
14
Actual GDP*
12 Credit Suisse Model
10

2
99 00 01 02 03 04 05 06 07 08 09 10
* GDP excluding agriculture and community, social & personal services
Source: Credit Suisse

India: Livin’ on a prayer? 5

 19 November 2010

Exhibit 8 shows the fit of the equation, which has R-squared of 0.94 and passes all the
standard statistical tests. There are a number of important conclusions to come from
the analysis:
• A 10% rise in world trade, which we have defined as the weighted-average import
growth of India’s five main export partners, typically adds 0.5% to GDP growth as we
have defined it here. To put this in perspective, year-on-year world trade growth picked
up from -18% in calendar Q1 2009 to 22% in Q2 2010 ─ enough to add 2 percentage
points to our measure of Indian GDP. This, in turn, is equivalent to 40% of the total rise
in the growth rate over the period.
• Both real and nominal interest rates have a powerful impact as well. We tried bank
deposit rates, the repo rate and the Prime Lending Rate (PLR) as explanatory factors in
the equation, with the last of these dominating the other two. A 1% rise in the PLR
typically cuts GDP growth by 0.4% after a year, with further negative effects, adding up to
more than 1 percentage point coming through over an 18-month period. For those
surprised by the size of this impact, it is worth taking a look at Exhibit 9. This shows a
dramatic increase in the share of outstanding bank loans as a percentage of GDP over the
last decade or so. With high indebtedness comes a higher sensitivity to interest rates.

Exhibit 9: India is likely to be much more interest rate sensitive than it was
% GDP
50
45 Stock of bank lending*
40
35
30
25
20
15
10
5
0
50 53 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07
* All scheduled banks lending for business in India
Source: Credit Suisse, CEIC

• Not surprisingly, oil prices have a negative relationship with GDP, albeit a fairly small one.
We estimate that a 10% rise in the oil price cuts growth by 0.1%-0.2% within six months.
• Both the level and change in India’s trade-weighted exchange rate impacts activity
according to the equation, with the nominal and real rate important. We found that a 1%
appreciation in the rupee cuts growth by 0.2-0.3 percentage points within 18 months.
This is actually bigger than the impact we estimated on exports alone (see “Currency
appreciation: What it means for Asia”, 27 October), probably reflecting the fact that many
exporters respond to a stronger rupee by squeezing profit margins. In so doing,
investment spending, jobs and hence private consumption are also affected.
Looking ahead, the worry is that all of the factors mentioned above will start detracting
from economic growth in the not too distant future. World trade growth, as we have
defined it here, was the second strongest it has ever been in the latest data point for
calendar Q2 and looks very likely to slow from here. Oil prices appear to have broken into
a new higher range and, at USD85/barrel, are 15% above their recent lows. The rupee has
also been appreciating, with the real trade-weighted index up around 10% over the last
year, thanks partly to the country’s relatively high inflation rate. Our foreign exchange

India: Livin’ on a prayer? 6

 19 November 2010

team expects the currency to continue to strengthen. Finally, while the interest rate picture
has been muddied by a recent RBI requirement for commercial banks to publish a base
rate rather their prime rate, creating a break in the series, it is hard to imagine that some of
the central bank’s rate rises have not been passed on by the banks or will be in due
course. So far this year, the Cash Reserve Ratio has risen 100bps, with the repo and
reverse repo rates up 150bps and 200bps, respectively. Inflation is also now falling,
pushing up the real interest rate.
Apart from establishing which factors matter most for growth and how powerful the effects
tend to be, our equation can also provide a rough guide as to when they will impact activity.
The timing varies from series to series, but the overall message is that activity looks set to
start softening from around the middle of next year.
If we include trend-like assumptions for “agriculture” and “community, social and personal
services”, then we should expect overall GDP growth to surprise the consensus on the
downside in 2011/12, while average growth in 2012/13 may be even weaker than in the
previous year given the low base. With this in mind, while we are happy to leave our
2010/11 overall GDP growth forecast unchanged at 8.4%, we have decided to cut the
2011/12 projection to 7.7% from 8%, putting us at the bottom of the consensus range. Our
first stab at 2012/13 growth is 7.5% (Exhibit 10).

Exhibit 10: Indian GDP growth revisions & consensus comparisons

Actual/Consensus* Credit-Suisse, previous Credit-Suisse, new
2008/09 6.7% - -
2009/10 7.4% - -
2010/11 8.3% 8.4% 8.4%
2011/12 8.4% 8.0% 7.7%
2012/13 - - 7.5%
* Actual numbers for 2007/08 and 2008/09 with forecasts from Consensus Economics thereafter
Source: Credit Suisse

2. Inflation – Panic over?

Despite the strength of the economic recovery to date, recent data have finally provided
some better news on the inflation front, with the Wholesale Price Index (WPI), India’s key
price measure, dropping back in year-on-year terms, while CPI inflation has also been
coming off from very high levels – Exhibit 11.
It is tempting to suggest that the fall simply reflects base effects (the impact of very strong
numbers last year falling out of the annual comparison), but there looks to be more to it
than that. In Exhibit 12 we have shown the 3 month-on-3 month annualised change in the
seasonally adjusted WPI. This was just 3% in September and October, which in turn
bodes well for further drops in the year-on-year rate over the next few months. Price rises
in the three main components of the WPI have all slowed considerably in 3 month-on-3
month annualised terms since the peak in February. Manufacturing is down to just 1.2%,
with primary goods at 6.6% and fuel at 5.4%.

India: Livin’ on a prayer? 7

 19 November 2010

Exhibit 11: Wholesale and consumer price inflation are finally falling
% y-o-y
20 Industrial workers CPI
18
16 Wholesale prices
14
12
10
8
6
4
2
0
-2
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: Credit Suisse

Exhibit 12: Wholesale price rises have softened considerably in recent months
% Wholesale prices: 3m-on-3m annualised
20
Wholesale prices: y-o-y
15

10

-5

-10
05 06 07 08 09 10
Source: Credit Suisse

Modeling inflation
In order to understand what has driven these falls as well as to help determine how
inflation will develop from here, we have estimated a separate equation for the same three
WPI components – primary, fuel and manufacturing. Each equation was estimated on the
basis of quarterly data from the beginning of 2000, with the key points as follows:
i) Primary goods (20% of the aggregate WPI): Food makes up two-thirds of the primary
goods component, which explains why we could find a statistically significant role for
international food commodity prices in this equation. Specifically, a 1% rise in the rupee-
denominated IMF food series apparently adds almost exactly the same amount to the WPI
primary index. More interesting, however, was that fact that real consumer spending
(defined as private plus government consumption) also appears to have a powerful impact,
with a 1% rise in consumption adding 1.5% to primary goods prices after a year and a bit.
It is often argued that food prices are purely a function of supply-side factors, but our
analysis would suggest that demand is also highly influential. We will return to this issue
in the next section.

India: Livin’ on a prayer? 8

 19 November 2010

ii) Fuel (15% of the aggregate WPI): The rupee-denominated world oil price was the
dominant influence here, with a 10% rise in the oil price adding nearly 4% to the fuel
component within 12 months. Consumption growth was statistically significant as well ─ a
1% increase typically boosts the fuel index by 0.5%-0.6% after a year.
iii) Manufacturing (65% of the aggregate WPI): While manufacturing prices account for
two-thirds of the overall WPI index, it is comfortably the least volatile component of the
three. Indeed, since the beginning of 2000, the standard deviation of WPI manufacturing
inflation has been less than half that of primary goods and one-quarter of that of fuel. In
explaining movements in this series, we once again found a role for consumption, while
metal, food and oil commodity prices were also important drivers. For example, the
equation suggests that a 10% rise in rupee-denominated international metal prices should
be expected to add 0.3% to the manufacturing component.
The overriding message to come from this study is that international commodity price
developments are key to all aspects of wholesale price inflation in the country, with the
rupee and consumer demand playing important supporting roles. On the basis of the
equations, the recent drop in price pressures can be attributed to a combination of the
strengthening currency, sub-par consumer demand and stable oil prices.

The fall before the rise

As for the future, if we assume that commodity prices flatten out at current levels in rupee
terms and consumer spending expands at a trend-like pace then, the equations suggest
that headline WPI inflation will fall to around 5% early next year and then flatten out
around this level (blue line in Exhibit 12). This is not a bad representation of the
consensus view as well as that of the Reserve Bank of India (RBI).

Exhibit 13: WPI scenarios with different commodity price assumptions

% y-o-y
Actual headline WPI Forecast
12
Forecast WPI with 20% rise in commodity prices
10
Forecast WPI with flat commodity prices
8

0
00 01 02 03 04 05 06 07 08 09 10 11
Source: Credit Suisse, CEIC

It is not without risks, however. If, for example, there is a 20% rise in the level of oil, metal
and food commodity prices over the next six months, then the headline rate would only fall
to 7% in the January-March quarter of 2011, before rising to 8.5% in the final quarter of
calendar 2011, according to the equation (grey line in Exhibit 12). As such, it seems to us
that the consensus forecast of Indian WPI inflation is not yet consistent with the
widespread view that commodity prices will continue to head higher from here.
We have decided to take the average of the two scenarios described above as our own
central forecast. This gives an 8.5% average WPI rate for the current fiscal year and 6.5%
in 2011/12 – upward revisions from our previous 7.9% and 4.8% projections. As always, it
is important to emphasise that the accuracy of the forecasts depends crucially on whether
the commodity price assumption is roughly correct.

India: Livin’ on a prayer? 9

 19 November 2010

3. Policy rates – Enough’s enough?

While continuing to raise policy interest rates, the RBI has adopted a more dovish tone in
its last two policy statements. At the time of the 16 September meeting, for example, the
central bank wrote that, “the tightening that has been carried out … has taken the
monetary situation close to normal” adding that, “the role of normalisation as a motivation
for further actions is likely to be less important” and “current and expected macroeconomic
conditions will be the more important considerations going forward.” The repo and reverse
repo rates were raised to 6% and 5%, respectively, at that meeting.
Meanwhile, the statement accompanying the 2 November meeting, which saw the two key
policy rates hiked a further 25bps each, suggested that, “based purely on current growth
and inflation trends, the Reserve Bank believes that the likelihood of further rate actions in
the immediate future is relatively low”, effectively ruling out a December hike. It did,
however, add that, “in an uncertain world, we need to be prepared to respond
appropriately to shocks that may emanate from either the global or domestic environment.”

What’s normal?
The first statement raises an important question – how can a policy interest rate of around
6% possibly represent something “close to normal” for an economy where trend nominal
GDP growth is generally thought to be around 12.5%-13%? Most economists would tell
us that the normal or neutral rate (the cost of capital) should be equal to trend economic
growth (the return on capital).
A large part of the answer reflects the fact that the policy rate is a very poor proxy for the
cost of capital. A much better representation is given by an interest rate charged by
commercial banks, while ideally we should also take into account the cost of equity as well
as corporate bond and External Commercial Borrowing (ECB) rates. Unfortunately, data
limitations make it very hard to be precise here, but on the basis of available corporate
lending and mortgage rate figures, we estimate that the weighted-average lending rate is
something in the order of 11.5%-12% at present – modestly below what would be
considered normal.

More rises to come

Notwithstanding this estimate, we continue to expect an additional 75bps in repo and
reverse repo rate hikes by around the middle of next year (Exhibit 14). This is more
aggressive than the consensus forecast, which appears to be for little or nothing more in
the way of rate rises from India’s central bank.

Exhibit 14: We expect another 75bps of rate hikes, but at a slower pace
%
10
Repo rate CRR Repo rate F'cs
9
8
7
6
5
4
3
2
01 02 03 04 05 06 07 08 09 10 11
Source: Credit Suisse, CEIC

India: Livin’ on a prayer? 10

 19 November 2010

Our relatively hawkish rate view largely reflects two factors. First, we believe the
consensus may have read too much into the RBI’s recent statements. Just because the
bank has signaled rates are close to normal and another hike is unlikely to be imminent,
doesn’t necessarily mean that interest rates have peaked. After all, the RBI may well
deem it appropriate for interest rates to be above normal.
Second, we are not convinced by the argument that falling inflation will inevitably put paid
to the chances of further interest rate increases. Exhibit 15 shows a far-from-perfect
historical relationship between the policy rate and WPI inflation – the correlation between
the two series has been just 0.09 since 2001. While it is certainly true to say that the link
has become closer since the current RBI Governor, Dr. Subburao, took charge, it is not
clear whether this is anything more than a coincidence. In any case, as we argued in the
previous section, there is a good likelihood that WPI inflation will start moving higher from
the April-June quarter of next year.
Even if the consensus view of inflation is correct, we believe the RBI and key political
figures won’t be satisfied until the level of food prices fall for a period. After all, the food
price component of the WPI has risen by a staggering 84% since January 2005 (Exhibit
16), effectively imposing a huge and deeply unpopular tax on the poor. Against this
background policymakers are under severe pressure to tackle the issue. Although higher
interest rates are widely thought to be an ineffectual tool in this regard, our analysis
suggests that food prices are influenced by consumer demand, which in turn is impacted
by interest rates. At the very least, hiking interest rates will give the impression that the
problem is being taken seriously.

Exhibit 15: Weak relationship between policy rate and WPI inflation
% y-o-y %
WPI inflation (LHS)
12 10
Policy interest rate (RHS)*
10 9
8 8
6 7
4 6
2 5
0 4
-2 3
01 02 03 04 05 06 07 08 09 10 11
*Average of repo and reverse repo rates
Source: Credit Suisse, CEIC

Exhibit 16: Wholesale food prices up more than 80% in less than six years
Index*
190 Headline WPI
180
Food component of W PI
170
160
150
140
130
120
110
100
90
05 06 07 08 09 10
* Indexed such that January 2005=100
Source: Credit Suisse, CEIC

India: Livin’ on a prayer? 11

 19 November 2010

Finally, the RBI must recognise that WPI and CPI inflation, as measured in India, are far
from perfect indicators of underlying price pressures in the country. The former is largely a
function of international commodity price developments, which have very little to do with
what is happening in India, while consumer price measures are dominated by food.
As a result, we would be very surprised if the central bank wasn’t looking closely at a
whole range of different variables, the vast majority of which point to the need for further
rate tightening and above-normal interest rates, in our view. These include survey-based
measures of capacity utilisation, wage growth and skilled labour shortages, all of which are
at or close to the highs of 2007, as well as the current account deficit, which exceeds 3%
of GDP and has been expanding rapidly.

4. Domestic liquidity – Set to ease?

Triggered by the extreme tightness in banking system liquidity since October and with
comments from the RBI that it does not want liquidity to be excessively tight, some market
participants have asked if the RBI might cut the Cash Reserve Ratio (CRR). We think not.
First, while a CRR cut would be a quick and easy solution to ease liquidity pressures, it
would send a wrong signal with regard to the central bank’s monetary policy stance, which
remains one of tightening (see above). Second, although liquidity is very difficult to
forecast in India, our sense is that the magnitude of tightness should ease somewhat in
coming months.

Exhibit 17: Banks’ net lending to/borrowing from the RBI

INR bn*

1400

600

-200

-1000
Jan-01 Feb-02 Mar-03 Apr-04 May-05 Jun-06 Aug-07 Sep-08 Oct-09 Nov-10

* A -ve (+ve) number indicates that banks were net borrowers from (lenders to) the RBI.
Source: Credit Suisse

Why did liquidity turn so tight in the first place?

• Government finances. The large one-off revenues to the central government from 3G
telecom and broadband license auctions in June gave a one-off spurt to bank credit
growth, but unlike the case with usual bank lending, this money did not really come back
to the banking system in the form of additional deposits. Instead, it got locked up as an
increase in the central government’s cash surplus (held with the RBI) and is estimated
by the RBI to be worth INR777.3bn as of 30 October. That is, around 1.7% of
outstanding bank deposits.
• FX liquidity has been modest. FX intervention (purchase) by the central bank creates
domestic liquidity if unsterilized. Barring the recent spurt in foreign equity inflows in
October and November in response to the Coal India IPO, overall foreign inflows (taking
both the current account deficit and net capital inflows together) have been modest, and

India: Livin’ on a prayer? 12

 19 November 2010

on top of that, the central bank has anyway followed a relatively hands-off approach.
Barring October (we estimate the RBI bought around USD3.5bn) and probably early
November, the central bank has hardly intervened in the FX market since the beginning
of this financial year (April 2010).
• Pick up in currency demand. This is another likely factor behind the recent moderating
trend in bank deposits (Exhibit 19) – growth in bank deposits came off from 16% year-
on-year to 13% in the six months to September. In RBI’s view, this possibly reflects a
shift away from deposits to currency given low real interest rates on bank deposits
(effectively, this has led to a decline in the money multiplier).

Exhibit 18: Banks’ deposits and Exhibit 19: Currency versus deposits
lending
INRbn, (6m change in banks’ deposits) – (6m change in (12m change in currency/12m change in bank
banks’ lending and investment in gov. bonds) deposits)*100

3000 Change in banks' deposits 30 % 12m change in currency

minus change in banks' over that in deposits
2000 lending and inv. in gov bonds 25
1000 20

0 15

-1000 10

-2000 5

-3000 0

Sep-04

Sep-06
Sep-00

Sep-02

Sep-08

Sep-10
Oct-00

Oct-02

Oct-04

Oct-08
Oct-06

Oct-10

Source: Credit Suisse, CEIC Source: Credit Suisse, CEIC

• CRR hikes and IPOs. The central bank has raised the cash reserve ratio by 100bps
since February 2010. The large Coal India Ltd IPO (worth USD3bn) in October was an
additional factor for tight banking system liquidity – it led to investors’ application money
getting locked up in a few hands until the actual allotments of shares were made earlier
this month. Interestingly, while it was widely expected that liquidity would ease post the
allotment of Coal India IPO shares, this hasn’t materialized yet.

Magnitude of liquidity deficit likely to reduce but…

The currently large magnitude of the deficit in banking liquidity (banks are net lenders to
the RBI to tune of around INR1000bn) should reduce in coming months. In line with what
we were expecting (India: Fiscal update – the good and the bad, 16 August 2010), the
government is taking advantage of its one-off extra revenues by loosening its purse
strings. It took parliamentary approval in August to spend an extra (compared to original
budget estimates for the full year) INR500bn and earlier this week the government
obtained approval to spend another INR200bn. From a liquidity perspective, this should
help to bring back some of the money that is currently locked out of the banking system.
Additionally, banks’ deposit growth should see some pickup in response to the recent
increase in deposit rates.
But we doubt that this would take us back to an excess liquidity situation. While the current
magnitude of tightness in banking liquidity should ease, it’s still likely to remain generally tight.
The key reason for this is that we continue to expect net foreign inflows under the balance of
payments to be modest (given an elevated current account deficit). Unless capital inflows
surprise on the upside, modest FX liquidity is likely to keep reserve money growth under check.

India: Livin’ on a prayer? 13

 19 November 2010

Also, while extra government spending should help ease liquidity, it’s not clear how quickly
and to what extent. After the government received parliamentary approval in July to spend
an extra INR500bn, many expected the locked up liquidity with the government (in the form
of extra 3G telecom auction revenues) to come back in to the banking system quickly
through extra government spending. But at least as far as available data through September
suggest, there doesn’t seem to have been any notable increase in spending in that quarter
(ending September) (Exhibit 20). So while extra government spending is likely to help ease
current liquidity tightness, it may not turn out to be as significant as many are expecting.

Exhibit 20: Government spending growth is not particularly soft

% y-o-y Government spending
80 Trend growth

60

40

20

-20

-40
Sep-02 Sep-04 Sep-06 Sep-08 Sep-10

Source: Credit Suisse, CEIC

Mission impossible?
Without wishing to pour cold water on what is a very favourable long-term growth story, we
believe India’s macroeconomic fundamentals will disappoint the consensus in a number of
different respects next year.
• We think the main drivers of economic growth, including interest rates, the exchange
rate, oil prices and world trade will turn from positive to negative influences on activity in
the not too distant future. We have cut our 2011/12 GDP growth forecast to a bottom-of-
the-range 7.7%.
• Second, while the year-on-year rate of Wholesale Price Inflation is set to fall further in the
next few months, it might bottom in early 2011 at around 6%. Our estimates suggest WPI
inflation will trend higher through the rest of next year if commodity prices rise from current
levels. We wouldn’t be surprised if sequential rates of WPI inflation have already troughed.
• A combination of more dovish comments from the RBI and falling year-on-year inflation
rates has led most to believe that policy rates are at or very close to a peak. This has
been the consensus view for some time, however, and we believe further upside rate
surprises are likely. Our forecast is for a total of 75bp repo and reverse repo rate hikes
by around the middle of 2011.
• Domestic liquidity conditions may ease somewhat, but we expect them to remain
reasonably tight.
So what might this all mean for markets? It seems to us that the Indian economy has to
perform very well if it is to meet the elevated expectations of foreign institutional investors
in the equity market. While we recognise that the performance of the quoted corporate
sector is not purely a function of India’s macroeconomic fundamentals, the links are
reasonably close. It is also clear that plenty of money has been attracted to the market on
the basis of what are perceived to be very positive macro drivers.

India: Livin’ on a prayer? 14

 19 November 2010

If our non-consensus views are correct, then the onus would be on domestically oriented
companies to drive a positive wedge between the top and bottom lines of their profit and
loss account. If this fails, then investors will have to hope that nothing comes along to
stem the flow of liquidity emanating largely from the US.
As for the government bond market, our macroeconomic view presents something of a
mixed bag. Downside growth surprises and at least a short-lived fall in inflation are good
news, while the prospect of more policy rate rises is not. On balance, the fixed income
team is inclined to be modestly positive. An important point to bear in mind is that we think
the 10-year bond yield is highly likely to flatten or fall before policy rates have topped out
(Exhibit 21). With the majority of the rate rises now behind us, the pace of tightening
slowing and domestic liquidity at least easing a little, we think we should be at or close to
the peak in yields.

Exhibit 21: Bond yields likely to fall well before the policy rate does
% %
9 Policy rate (LHS)* 11
10 year bond yield (RHS)
8 10
9
7
8
6
7
5
6
4 5
3 4
01 02 03 04 05 06 07 08 09 10
* Average of repo and reverse repo rate
Source: Credit Suisse, CEIC

Our foreign exchange analysts, are looking for the Indian rupee to appreciate further over
the coming 12 months, forecasting a rate of INR42 against the US dollar by this time next
year. This is, however, largely a function of a weak USD view and the team is very much
cognisant of the risks surrounding the rupee. In particular, deterioration in global risk
sentiment could hit the rupee harder than most other Asian currencies given the country’s
high current account deficit and equity-focused foreign inflows.

India: Livin’ on a prayer? 15

 EMERGING MARKETS ECONOMICS AND FIXED INCOME STRATEGY
Kasper Bartholdy
Head of Strategy and Economics
+44 20 7883 4907
kasper.bartholdy@credit-suisse.com

LATIN AMERICA ECONOMICS

Alonso Cervera Carola Sandy Casey Reckman Lorraine White
Head of Non-Brazil +1 212 325 2471 +1 212 325 5570 +1 212 538 4311
Latin America Economics carola.sandy@credit-suisse.com casey.reckman@credit-suisse.com lorraine.white@credit-suisse.com
+52 55 5283 3845 Argentina, Peru, Colombia Venezuela, Panama, El Salvador Research Analyst
alonso.cervera@credit-suisse.com
Mexico, Chile
Nilson Teixeira Nilto Calixto Leonardo Fonseca Daniel Lavarda Tales Rabelo
Head of Brazil Economics +55 11 3841 6345 +55 11 3841 6348 +55 11 3841 6352 +55 11 3841 6353
+55 11 3841 6288 nilto.calixto@credit-suisse.com leonardo.fonseca@credit-suisse.com daniel.lavarda@credit-suisse.com tales.rabelo@credit-suisse.com
nilson.teixeira@credit-suisse.com Brazil Brazil Brazil Brazil

EASTERN EUROPE, MIDDLE EAST & AFRICA ECONOMICS

Berna Bayazitoglu Sergei Voloboev Ivailo Vesselinov
Head of EMEA Economics +44 20 7888 3694 +44 20 7883 8057
+44 20 7883 3431 sergei.voloboev@credit-suisse.com ivailo.vesselinov@credit-suisse.com
berna.bayazitoglu@credit-suisse.com Russia, Ukraine, Lebanon Kazakhstan, Israel, Romania
Turkey, South Africa

Jacqueline Madu Gergely Hudecz Natig Mustafayev Alexey Pogorelov

+44 20 7883 4216 +44 20 7883 9589 +44 20 7888 1065 +7 495 967 8772
jacqueline.madu@credit-suisse.com gergely.hudecz@credit-suisse.com natig.mustafayev@credit-suisse.com alexey.pogorelov@credit-suisse.com
Egypt, GCC, Nigeria Czech Republic, Hungary, Poland Russia

NON-JAPAN ASIA ECONOMICS

Dong Tao Christiaan Tuntono
Head of Non-Japan Asia Economics +852 2101 7409
+852 2101 7469 christiaan.tuntono@credit-
dong.tao@credit-suisse.com suisse.com
China, Korea Hong Kong, Taiwan
Robert Prior-Wandesforde Devika Mehndiratta Santitarn Sathirathai Kun Lung Wu
+65 6212 3707 +65 6212 3483 +65 6212 5675 +65 6212 3418
robert.priorwandesforde@credit-suisse.com devika.mehndiratta@credit-suisse.com santitarn.sathirathai@credit-suisse.com kunlung.wu@credit-suisse.com
India, Indonesia India, Philippines Malaysia, Singapore, Thailand, Vietnam

STRATEGY
Igor Arsenin Paul Fage Ashish Agrawal Helen Parsons, CFA Saad Siddiqui
Head of Latin America Strategy Head of EMEA Strategy Asia Strategy +1 212 538 8889 +44 20 7888 9464
+1 212 325 6437 +44 20 7883 7994 +65 6212 3405 helen.parsons@credit-suisse.com saad.siddiqui@credit-suisse.com
igor.arsenin@credit-suisse.com paul.fage@credit-suisse.com ashish.agrawal@credit-suisse.com Strategy Strategy

Ray Farris Olivier Desbarres Daniel Katzive

Head of FX Strategy +65 6212 3367 +1 212 538 2163
+44 20 7888 2529 olivier.desbarres@credit-suisse.com daniel.katzive@credit-suisse.com
ray.farris@credit-suisse.com FX Strategy FX Strategy
Disclosure Appendix
Analyst Certification
Robert Prior-Wandesforde and Devika Mehndiratta each certify, with respect to the companies or securities that he or she analyzes, that (1) the views expressed in this report accurately reflect his or
her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views
expressed in this report.

Disclaimer
References in this report to Credit Suisse include all of the subsidiaries and affiliates of Credit Suisse AG operating under its investment banking division. For more information on our structure, please
use the following link: https://www.credit-suisse.com/who_we_are/en/.
This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such
distribution, publication, availability or use would be contrary to law or regulation or which would subject Credit Suisse AG or its affiliates (“CS”) to any registration or licensing requirement within such
jurisdiction. All material presented in this report, unless specifically indicated otherwise, is under copyright to CS. None of the material, nor its content, nor any copy of it, may be altered in any way,
transmitted to, copied or distributed to any other party, without the prior express written permission of CS. All trademarks, service marks and logos used in this report are trademarks or service marks or
registered trademarks or service marks of CS or its affiliates.
The information, tools and material presented in this report are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to
buy or subscribe for securities or other financial instruments. CS may not have taken any steps to ensure that the securities referred to in this report are suitable for any particular investor. CS will not
treat recipients of this report as its customers by virtue of their receiving this report. The investments and services contained or referred to in this report may not be suitable for you and it is
recommended that you consult an independent investment advisor if you are in doubt about such investments or investment services. Nothing in this report constitutes investment, legal, accounting or
tax advice, or a representation that any investment or strategy is suitable or appropriate to your individual circumstances, or otherwise constitutes a personal recommendation to you. CS does not
advise on the tax consequences of investments and you are advised to contact an independent tax adviser. Please note in particular that the bases and levels of taxation may change.
Information and opinions presented in this report have been obtained or derived from sources believed by CS to be reliable, but CS makes no representation as to their accuracy or completeness. CS
accepts no liability for loss arising from the use of the material presented in this report, except that this exclusion of liability does not apply to the extent that such liability arises under specific statutes or
regulations applicable to CS. This report is not to be relied upon in substitution for the exercise of independent judgment. CS may have issued, and may in the future issue, other reports that are
inconsistent with, and reach different conclusions from, the information presented in this report. Those reports reflect the different assumptions, views and analytical methods of the analysts who
prepared them and CS is under no obligation to ensure that such other reports are brought to the attention of any recipient of this report.
CS may, to the extent permitted by law, participate or invest in financing transactions with the issuer(s) of the securities referred to in this report, perform services for or solicit business from such
issuers, and/or have a position or holding, or other material interest, or effect transactions, in such securities or options thereon, or other investments related thereto. In addition, it may make markets in
the securities mentioned in the material presented in this report. CS may have, within the last three years, served as manager or co-manager of a public offering of securities for, or currently may make
a primary market in issues of, any or all of the entities mentioned in this report or may be providing, or have provided within the previous 12 months, significant advice or investment services in relation
to the investment concerned or a related investment. Additional information is, subject to duties of confidentiality, available on request. Some investments referred to in this report will be offered solely
by a single entity and in the case of some investments solely by CS, or an associate of CS or CS may be the only market maker in such investments.
Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Information, opinions
and estimates contained in this report reflect a judgement at its original date of publication by CS and are subject to change without notice. The price, value of and income from any of the securities or financial
instruments mentioned in this report can fall as well as rise. The value of securities and financial instruments is subject to exchange rate fluctuation that may have a positive or adverse effect on the price or
income of such securities or financial instruments. Investors in securities such as ADR’s, the values of which are influenced by currency volatility, effectively assume this risk.
Structured securities are complex instruments, typically involve a high degree of risk and are intended for sale only to sophisticated investors who are capable of understanding and assuming the risks
involved. The market value of any structured security may be affected by changes in economic, financial and political factors (including, but not limited to, spot and forward interest and exchange
rates), time to maturity, market conditions and volatility, and the credit quality of any issuer or reference issuer. Any investor interested in purchasing a structured product should conduct their own
investigation and analysis of the product and consult with their own professional advisers as to the risks involved in making such a purchase.
Some investments discussed in this report may have a high level of volatility. High volatility investments may experience sudden and large falls in their value causing losses when that investment is
realised. Those losses may equal your original investment. Indeed, in the case of some investments the potential losses may exceed the amount of initial investment and, in such circumstances, you
may be required to pay more money to support those losses. Income yields from investments may fluctuate and, in consequence, initial capital paid to make the investment may be used as part of that
income yield. Some investments may not be readily realisable and it may be difficult to sell or realise those investments, similarly it may prove difficult for you to obtain reliable information about the
value, or risks, to which such an investment is exposed.
This report may provide the addresses of, or contain hyperlinks to, websites. Except to the extent to which the report refers to website material of CS, CS has not reviewed any such site and takes no
responsibility for the content contained therein. Such address or hyperlink (including addresses or hyperlinks to CS’s own website material) is provided solely for your convenience and information and
the content of any such website does not in any way form part of this document. Accessing such website or following such link through this report or CS’s website shall be at your own risk.
This report is issued and distributed in Europe (except Switzerland) by Credit Suisse Securities (Europe) Limited, One Cabot Square, London E14 4QJ, England, which is regulated in the United
Kingdom by The Financial Services Authority (“FSA”). This report is being distributed in Germany by Credit Suisse Securities (Europe) Limited Niederlassung Frankfurt am Main regulated by the
Bundesanstalt fuer Finanzdienstleistungsaufsicht ("BaFin"). This report is being distributed in the United States and Canada by Credit Suisse Securities (USA) LLC; in Switzerland by Credit Suisse AG;
in Brazil by Banco de Investimentos Credit Suisse (Brasil) S.A; in Mexico by Banco Credit Suisse (México), S.A. (transactions related to the securities mentioned in this report will only be effected in
compliance with applicable regulation); in Japan by Credit Suisse Securities (Japan) Limited, Financial Instruments Firm, Director-General of Kanto Local Finance Bureau (Kinsho) No. 66, a member of
Japan Securities Dealers Association, The Financial Futures Association of Japan, Japan Securities Investment Advisers Association; elsewhere in Asia/ Pacific by whichever of the following is the
appropriately authorised entity in the relevant jurisdiction: Credit Suisse (Hong Kong) Limited, Credit Suisse Equities (Australia) Limited, Credit Suisse Securities (Thailand) Limited, Credit Suisse
Securities (Malaysia) Sdn Bhd, Credit Suisse AG, Singapore Branch, and elsewhere in the world by the relevant authorised affiliate of the above. Research on Taiwanese securities produced by Credit
Suisse AG, Taipei Branch has been prepared by a registered Senior Business Person. Research provided to residents of Malaysia is authorised by the Head of Research for Credit Suisse Securities
(Malaysia) Sdn Bhd, to whom they should direct any queries on +603 2723 2020. This research may not conform to Canadian disclosure requirements.
In jurisdictions where CS is not already registered or licensed to trade in securities, transactions will only be effected in accordance with applicable securities legislation, which will vary from jurisdiction
to jurisdiction and may require that the trade be made in accordance with applicable exemptions from registration or licensing requirements. Non-U.S. customers wishing to effect a transaction should
contact a CS entity in their local jurisdiction unless governing law permits otherwise. U.S. customers wishing to effect a transaction should do so only by contacting a representative at Credit Suisse
Securities (USA) LLC in the U.S.
This material is not for distribution to retail clients and is directed exclusively at Credit Suisse's market professional and institutional clients. Recipients who are not market professional or institutional
investor clients of CS should seek the advice of their independent financial advisor prior to taking any investment decision based on this report or for any necessary explanation of its contents. This
research may relate to investments or services of a person outside of the UK or to other matters which are not regulated by the FSA or in respect of which the protections of the FSA for private
customers and/or the UK compensation scheme may not be available, and further details as to where this may be the case are available upon request in respect of this report.
CS may provide various services to US municipal entities or obligated persons ("municipalities"), including suggesting individual transactions or trades and entering into such transactions. Any services
CS provides to municipalities are not viewed as “advice” within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. CS is providing any such services and
related information solely on an arm’s length basis and not as an advisor or fiduciary to the municipality. In connection with the provision of the any such services, there is no agreement, direct or
indirect, between any municipality (including the officials, management, employees or agents thereof) and CS for CS to provide advice to the municipality. Municipalities should consult with their
financial, accounting and legal advisors regarding any such services provided by CS. In addition, CS is not acting for direct or indirect compensation to solicit the municipality on behalf of an unaffiliated
broker, dealer, municipal securities dealer, municipal advisor, or investment adviser for the purpose of obtaining or retaining an engagement by the municipality for or in connection with Municipal
Financial Products, the issuance of municipal securities, or of an investment adviser to provide investment advisory services to or on behalf of the municipality.
Copyright © 2010 CREDIT SUISSE AG and/or its affiliates. All rights reserved.
Investment principal on bonds can be eroded depending on sale price or market price. In addition, there are bonds on which
investment principal can be eroded due to changes in redemption amounts. Care is required when investing in such instruments.
When you purchase non-listed Japanese fixed income securities (Japanese government bonds, Japanese municipal bonds, Japanese government guaranteed bonds, Japanese corporate bonds) from
CS as a seller, you will be requested to pay purchase price only.