India Fixed Income: RBI policy guidance and liquidity measures in focus

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1 3M 6M 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 19Y 24Y 30Y In Focus: For private circulation only : RBI policy guidance and liquidity measures in focus Gilts have pared all the gains witnessed post 50 bps rate cut and FII debt limit hike (%) Yield curve 28-Sep Oct-15 Current 7 th Pay Commission (SePC) has fuelled inflation and fiscal concerns, thereby raising bar higher for further monetary accommodation RBI likely to pause on rates tomorrow, though Governor s commentary on SePC and liquidity will be closely watched Gilts under pressure on Fed rate hike concerns and impact of SePC among others. 10Y yield likely to trade in % in Dec-2015, however, OMO purchase and new benchmark issuance likely to put downward pressure on 10Y yield by March December Fed rate hike bets have increased sharply We expect the Fed to initiate rate liftoff in December. Meanwhile, as assured by Yellen recently, after the initial hike, policy tightening is likely to be very gradual, thereby providing some relief to markets th Pay Commission (SePC) poses upside risk to CPI The SePC recommended a 23.6% increase in wage and pension bill including ~139% hike in House Rent Allowance. We estimate that the first round impact of 7 th Pay Commission on CPI given HRA hike is likely to be ~40 bps. Source: Reuters, ICICI Bank Research We have revised our inflation projections post Pay Commission which would be partly offset by various factors The impact of SePC on demand side inflation pressures is likely to be offset by factors such as subdued commodity prices, weak rural demand, low capacity utilization and Government measures. The inflation impact is likely to be lower versus 6 th Pay Commission which was accompanied by a fiscal stimulus package. On balance, we believe that CPI risks posed by SePC has raised the bar higher for further monetary accommodation. Fiscal situation remains under pressure We expect Government to cut expenditure in FY2016 given weak divestment collections, to meet fiscal deficit target of 3.9% of GDP. However, we are more concerned regarding fiscal impact of SePC on FY2017 fiscal by ~0.5% of GDP, which poses a risk towards fiscal consolidation by 0.4% of GDP. In this regard, Government would be required to take steps to reduce subsidies by expanding DBT coverage, implement GST, corporate tax rationalization and aggressive divestment strategy (like SUUTI stake sales). OMO purchases likely to be key trigger for lower yield We believe that weakness in capital flows is likely to lead the RBI to expand balance sheet using creation of domestic assets. In the rest of the current fiscal, we expect an OMO purchases of at least INR 400 bn to be conducted. Source: MOSPI, ICICI Bank Research November 30, 2015 Kanika Pasricha kanika.pasricha@icicibank.com Sumeet Agrawal sumeet.agrawal@icicibank.com Please see important disclaimer at the end of this report RBI s guidance on SePC and liquidity easing to be closely tracked We expect RBI to pause on rates tomorrow, after it frontloaded 50 bps rate cut in September. Meanwhile, Governor s comments regarding impact of SePC will be watched, to form policy expectations. Further, the fixed income markets would watch for cues on RBI s comfort with OMO purchases. Bond markets likely to remain under pressure in the near term The benchmark bond yield is currently trading at 7.77%, up ~25 bps, compared to levels hit post 50-bps rate cut and FII debt limit hike. This is attributable to factors like (a) Fed rate hike concerns, (b) SePC fuelling fiscal and inflation concerns, (c) Possibility of rise in borrowing given lackluster gold bond issuance, (d) Risk of discom bond issuance on Gsec and SDLs (e) Elevated pulses inflation and (f) Impact of unseasonal rains on food supply. 10Y yield likely to trade in % in Dec-2015, however, OMO purchases and new benchmark issuance likely to put downward pressure on 10Y yield by Mar-2015.

2 December Fed rate hike bets have increased sharply The latest FOMC minutes highlighted that the necessary conditions for a rate hike could well be met by the time of the next meeting. This led to an increase in market bets for a December rate hike have increased to ~74% from 33% at the time of September meeting. We continue to expect the Fed to initiate rate liftoff in December. Meanwhile, as assured by Yellen recently, after the initial hike, policy tightening is likely to be very gradual, thereby providing some relief to markets. 7 th Pay Commission (SePC) poses upside risk to CPI We have revised our inflation projections post Pay Commission The SePC recommended a 23.6% increase in wage and pension bill, including ~139% hike in House Rent Allowance. The impact on inflation would be attributable to 2 factors: Rise in demand on pay hikes and Hike in House Rent allowance. We estimate that the first round impact of 7 th Pay Commission on FY2017 CPI given HRA hike is likely to be ~40 bps. (Details in Annexure) Apart from this, the impact will also be on account of rise in consumer demand. However, this is likely to be offset by factors such as: Subdued global commodity prices, weakness in rural demand, low capacity utilization and Government measures to control food inflation. Source: MOSPI, ICICI Bank Research Fiscal accounts in H1FY2016 Fiscal component FY2016 (BE) FY2016 (BE) over FY2015 (% YoY) (INR bn) (% YoY) Receipts Gross taxes States' share Total taxes (Net to Centre) Non taxes Non-debt capital receipts (INR bn) Disinvestment Expenditure Revenue Capital Fiscal deficit Fiscal deficit (% of GDP) 3.9 April-Sep FY2016 ^using GDP growth of 11.5% YoY in FY2016 Source: Budget documents, ICICI Bank Research Moreover, the inflation impact is likely to be lower compared to 6 th Pay Commission, which was also accompanied by increased arrears and fiscal stimulus measures such as sharp increase in rural employment scheme allocations, farm debt waiver and corporate tax allowances among others. On balance, we are revising higher our FY2017 CPI projections, given that core inflation pressures are likely to rise on implementation of the 7 th Pay Commission recommendations. CPI is expected to broadly move in the 5-6% range in the next fiscal, with March-2017 projection of ~5.5% YoY. This is likely to pose a challenge for the Central Bank in achieving it end FY2017 CPI goalpost of 5.0% YoY. The Central Bank may choose to undermine the partial statistical increase in housing inflation on HRA hike and instead track CPI ex housing in order to assess demand-side inflation pressures. In conclusion, the bar for further monetary accommodation has been raised higher. Fiscal situation remains under pressure During April-Sep FY2016, the Government registered fiscal deficit of 68.1% of budgeted levels vis-à-vis 82.6% during same period in FY2015. The improvement in tax revenues on the back of pick up in direct tax collections provided the crucial support. Further, quality of spending remains healthy given the focus on capex led by roads and railways sectors. However, given the sluggish divestment collections, we expect the Government to cut expenditure in FY2016, to meet fiscal deficit target of 3.9% of GDP. Divestment target for the fiscal has been set at INR 695 bn, of which only ~INR 130 bn has been achieved till date. While there have been talks regarding accelerating the pace of stake sales, the Finance Ministry has indicated the possibility of a shortfall on this account. 2

3 FY1997 FY1999 FY2001 FY2003 FY2005 FY2007 FY2009 FY2011 FY2013 FY2015 FY th Pay Commission likely to make fiscal consolidation challenging (%) Fiscal deficit as % of GDP th Pay Commission 6th Pay Commission Consolidation roadmdap Source: Budget documents, ICICI Bank Research Sluggish FII flows have led us to revise down BoP projections and raised OMO purchase prospects Source: SEBI, ICICI Bank Research Source: Budget documents, ICICI Bank Research However, we are more concerned regarding fiscal impact of SePC on FY2017 fiscal by ~0.5% of GDP, which poses a risk towards fiscal consolidation by 0.4% of GDP. In this regard, Government would be required to take steps such as: Reduce subsidies by expanding DBT coverage, Implement GST, Corporate tax rationalization and Aggressive divestment strategy (like SUUTI stake sales). OMO purchases likely to be key trigger for lower yield We believe that weakness in capital flows is likely to lead the RBI to expand balance sheet using creation of domestic assets. In the rest of the current fiscal, we expect an OMO purchases of at least INR 400 bn to be conducted. The detailed analysis is as follows: From an RBI balance sheet perspective, Governor Rajan indicated post April policy that the reserve money growth should at least be in line with nominal GDP growth. We project nominal GDP growth at ~10% in FY2016. This implies that the reserve money (or RBI s balance sheet) is required to increase by ~INR 2000 bn in the current fiscal. The Central Bank s balance sheet increases through 2 channels: Creation of (1) Foreign assets (FX intervention) and (2) Domestic assets (Open market operations) The quantum of primary liquidity injection by the RBI through the FX route is estimated using balance of payments. Given the sluggish FII inflows (USD 1 bn FYTD), we have revised down our BoP projection for FY2016 by USD 7 bn to USD 24 bn. This implies that RBI s balance sheet will rise in the current fiscal by ~INR 1600 bn, through creation of foreign assets. The gap between required rise in reserve money (INR 2000 bn) and BoP projection for the fiscal (~INR 1600 bn), is likely to be plugged through OMO purchases. Meanwhile, the Central Bank has already conducted net contraction in domestic assets i.e. implemented OMO sales to the tune of INR 320 bn. In conclusion, the RBI will be required to conduct OMOs worth at least INR 400 bn in the rest of this fiscal in order to support systemic liquidity situation. 3

4 3M 6M 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 19Y 24Y 30Y Oct-2015 CPI spiked on unfavourabe base effect Inflation (new base =100) (% YoY) Weight (%) Oct-14 Sep-15 Oct-15 Headline Food Cereals Vegetables Protein Pulses Fuel and light Core Pan, tobacco & intoxicants Housing Clothing Services Transport ex-transport Source: CEIC, ICICI Bank Research Discom bond issuance of ~INR tn expected in next 2 years (INR bn) FY12 FY13 FY14 FY15E Total 2,452 3,043 3,732 4,753 SEB debt Haryana Rajasthan Tamil Nadu Uttar Pradesh Bihar Jharkhand Andhra Pradesh (including Telangana) Total for distressed states 1,516 2,002 2,588 3,356 Source: CEIC, ICICI Bank Research RBI s guidance on SePC and liquidity easing to be closely tracked We expect RBI to pause on rates tomorrow, after it frontloaded 50 bps rate cut in September. Post policy, the October CPI reading was released, which was higher than our and RBI s expectations at 5.0% YoY versus prior of 4.4% YoY. While, price pressures were subdued across major sub-components, however, CPI in pulses spiked to record high of 42% YoY and contributed ~1 percentage point to inflation. Hence, the RBI is likely to wait and watch for inflation trends in the coming months before considering further policy action. Meanwhile, Governor s comments regarding impact of SePC will be watched, to form policy expectations. Further, the fixed income markets would watch for cues on RBI s comfort with OMO purchases amid tight liquidity conditions. Discom bond issuance to increase sharply on UDAY implementation Under the new scheme Ujwal Discom Assurance Yojna, or UDAY in order to bail out the State Electricity Boards (SEBs). As per the proposed scheme, ~75% of the SEB debt will be transferred to State Governments, which would issue non-slr securities in lieu of the same. If the 8 states distressed with SEB issues (i.e. Haryana, Rajasthan, Tamil Nadu, Uttar Pradesh, Bihar, Jharkahnd, Andhra Pradesh and Telangana), come on board, the additional bond issuance is expected to be INR 2.5 tn, (75% of current outstanding debt). This is substantial given the net borrowing by State Governments of ~INR 2.4 tn in FY2015. Also, as these Discom bonds will be issued at 25 bps premium over the prevailing SDL, there will be demand for these bonds by non-slr regulated entities like insurance companies and provident funds. (~50% of ownership in SDLs). This is likely to be an adverse impact on demand for SDLs and Gsec. We believe that the bond issuances would be similar to the recently issued Special SDL s wherein the bonds were not converted into marketable securities at one go. Hence, we expect the market impact of the huge SEB bond issuance to be limited and calibrated as banks would remain less incentivized to sell these converted loans (bonds) at loss. That said, down move in yields would induce banks to exit these bonds. Bond markets likely to remain under pressure in the near term The benchmark bond yield is currently trading at 7.77%, up ~25 bps, compared to levels hit post 50-bps rate cut and FII debt limit hike. This is attributable to factors like (a) Fed rate hike concerns, (b) SePC fuelling fiscal and inflation concerns, (c) Possibility of rise in borrowing given lackluster gold bond issuance, (d) Risk of discom bond issuance on Gsec and SDLs (e) Elevated pulses inflation and (f) Impact of unseasonal rains on food supply. Gilts have pared all the gains witnessed post 50 bps rate cut and FII debt limit hike (%) 8.2 Yield curve 28-Sep Oct-15 Current Source: Reuters, ICICI Bank Research 10Y yield likely to trade in % in Dec-2015, however, OMO purchases and new benchmark issuance likely to put downward pressure on 10Y yield by Mar

5 Annexure Calculation of impact on housing CPI: The CPI manual indicates that housing CPI is calculated in the following way, with 75% weight provided to self-occupied houses and 25% to rented dwellings. Of the total rented dwellings, ~11% is provided by the Government and PSUs to their employees and which would witness a 140% hike since Jan Determination of Housing CPI Item weight Description (%) House rent-self owned 74.4 House rent-rented 24.9 Hotel lodging charges 0.2 Other consumer rent hiring charges for furniture etc 0.4 Impact = Weight of Govt in rented dwellings* Weight of rented dwellings in housing CPI calculation* Weight of housing in CPI* Hike in HRA =11%*25%*10%*140% = 38 bps Rental Equivalent Approach is adopted to impute the rent of owner occupied houses In case of concessional or subsidized dwellings, the rent actually paid by the family for the dwelling along with any allowance foregone in lieu of the accommodation given to him/her is taken as rent payable per month. For example, a Government employee is residing in a government accommodation for which the Government charges a license fee of say, Rs.250 per month and if the government employee foregoes house rent allowance normally admissible to him/her, say of Rs.5000 per month, then the total rent payable for the purpose of house rent enquiry is calculated as Rs.5250 ( ). 5

6 Gross SDL issuances on a fiscal year basis are on a rising trend and amounted ~INR 2.7 tn (~USD 42 bn) in FY2015 Market borrow ings by S tate Governments (` bn) FY2012 FY2013 FY2014 FY2015 Gross borrowing Redemption Net borrowing Source: RBI, ICICI Bank Research Ownership pattern of SDLs (Long-term investors are the prime buyers) Provident funds 15.8% FIIs 0.0% Corporates 0.3% Ownership of SDLs Others 3.9% RBI 0.0% Financial institutions 0.4% Mutual funds 0.4% Insurance companies 33.2% Primary dealers 0.2% Source: RBI, ICICI Bank Research PSU banks 35.5% Private sector banks 5.8% Regional rural banks 1.6% Cooperative banks 3.1% 6

7 Ownership pattern of Central Government Gsec (RBI and Banks are the prime buyers) Corporates 1.3% Provident funds 7.6% FIIs 3.7% Ow nership of Gsec Others 3.0% RBI 13.5% Financial institutions 1.9% Mutual funds 2.1% PSU banks 22.7% Insurance companies 20.9% Primary dealers 0.3% Cooperative banks 2.6% Regional rural banks 0.8% Private sector banks 19.9% Source: RBI, ICICI Bank Research 7

8 ICICI Bank: ICICI Bank Towers, Bandra Kurla Complex, Mumbai Phone: (+91-22) Treasury Research Group Economics Research Sunandan Chaudhuri Senior Economist (+91-22) Kamalika Das Economist (+91-22) (ext 6280) Kanika Pasricha Economist (+91-22) Samir Tripathi Economist (+91-22) Niharika Tripathi Economist (+91-22) (ext 6943) Sagrika Gogia Economist (+91-22) (ext 2180) Treasury Desks Treasury Sales (+91-22) Currency Desk (+91-22) Gsec Desk (+91-22) FX Derivatives (+91-22) /43 Interest Rate Derivatives (+91-22) Commodities Desk (+91-22) Corporate Bonds (+91-22)

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