Market Strategy Monthly. Treasury Research Group For private circulation only

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1 Monthly Treasury Research Group For private circulation only March 29, 2013 Executive Summary Global outlook: Policy induced gradual recovery The key theme for the markets through 2013 includes the gradual recovery in global growth prospects, easy monetary policy by the G-4 central banks and continued emphasis on fiscal restraint across the developed world. In the US, fiscal policy risk is countered by easy monetary policy. Meanwhile, Eurozone is likely to under perform US with respect to economic growth prospects. In the EZ, the debate remains on the right mix of fiscal consolidation and growth enhancing measures. Markets are likely to trade ranged in near-term on Italian political uncertainty and Cyprus bailout concerns. State of the Indian economy: Uncertainty to instill caution in the near term Going into the end of this fiscal year we believe Q4 marks a change in the trajectory for our growth prospects albeit to a modest degree. Going ahead, we expect growth to recover and the situation on the external sector to improve. However, in the near term, domestic political fragility and global uncertainties especially in the Eurozone will keep markets cautious. Currency: Rupee to trade choppy but remain ranged in FY2014 The recent turn of events on the global and domestic front have added to market uncertainty, be it the noise around Cyprus bailout, concerns over UPA Government s stability and cautious rate guidance by the RBI. While Rupee gains look to be limited in the current environment, we do not expect INR to weaken sharply as capital inflows are likely to remain healthy especially given the Government s commitment towards capital account liberalisation. Rates: Markets maintain caution though OMOs to support Bond yields have witnessed upward pressure and OIS curve has bull steepened since end February. The announcement of gross borrowing numbers, uncertainty regarding bond swap program and RBI s cautious forward guidance has weighed on gilts. Overall, we expect benchmark yields to range 7.60%-8.10% in FY2014, with the timing of an expected 25 bps rate cut in H1 FY2014 and OMOs to determine the trajectory for yields. Inflation: Fuel price hikes pose risk to inflation while core to moderate WPI inflation print rose to 6.84% YoY in February from an over 3-year low in the previous month, mainly on account of administered fuel price hikes. Core inflation though has declined to lowest level since March Going forward, we expect WPI inflation to average 7% YoY in FY2014 versus 7.3% YoY in FY2013, with inflation projected to rise from 6.2% YoY in March 2013 to 7.6% YoY in March Feature: Enhancing India s export competitiveness- need of the hour Looking at India s widening trade deficit, it has become extremely important to analyse the underlying reasons for India s unimpressive export performance. Since a significant part of India s exports are manufactured, in this feature we dwell into the key reasons that have led to the erosion of India s manufacturing competitiveness, resulting in our weak export performance. We also look into the lessons India can learn from its Asian peers that have successfully transformed into export hubs. 1

2 Global Overview Samir Tripathi The key theme for the markets through 2013 includes the gradual recovery in global growth prospects, easy monetary policy by the G-4 central banks and continued emphasis on fiscal restraint across the developed world Labour market and housing sector point toward incremental improvement in economic activity Fiscal policy remains the key risk to the US economic outlook Easy monetary policy to support economic activity Global outlook: Policy induced gradual recovery In the very near term, the development in Eurozone, especially from Cyprus and Italy weighed on market sentiment and reversed some of the gains from late 2012 and early From the fundamental perspective, the key themes for the markets through the course of 2013 include, the gradual recovery in global growth prospects, easy monetary stance by the G-4 central banks and continued emphasis on fiscal restraint across the developed world. On the growth front, we are relatively more optimistic on the US economy as compared to Eurozone, which is likely to remain in recession throughout US economic recovery gaining traction In the US, the fiscal uncertainty on account of sequestration, which is likely to result in automatic spending cuts to the tune of USD 85 bn through financial yearend 2013 (i.e. September 2013) has weighed on market sentiment. However, despite the fiscal worries, the economic momentum for US has surprised on the upside. In this regard, the incremental improvement in the labour market conditions on the one hand and bottoming out of the housing sector on the other provide the key evidence of the overall improvement in economic activity. In the labour market, non-farm payrolls (NFP) added 236K jobs in February 2013, significantly better than market expectations of an increase of 165K. Meanwhile, unemployment rate improved to 7.7% in February from 7.9% in the previous month. Similarly, the housing sector data prints too point toward a robust recovery. S&P/Case-Shiller house price index climbed by 8.1% YoY in January 2013, after rising 6.8% YoY in December These improved real estate prices are partly on account of historically low interest rates on the one hand and partly the reviving confidence in the housing sector. Overall, this revival is likely to persist and we expect the US economy to grow in the range of % through the course of However, for our growth expectation to materialize, US political authorities should act promptly to raise the debt ceiling and agree on a credible medium-term fiscal consolidation plan with special emphasis on entitlement programs and tax reform. Given that fiscal related issues pose downside risk to US economic activity, the Fed is likely to continue with its monetary stimulus program, at least through the remainder of In the latest policy meeting, Fed chairman Bernanke reiterated that the central bank would continue to buy longer-term US Treasury securities at the rate of USD 45 bn/month and the Agency MBS at USD 40 bn/month. These actions are aimed toward maintaining downward pressure on longer-term interest rates, supporting mortgage markets and to help make broader financial conditions more accommodative. These measures are likely to support economic activity in However beyond 2013, Fed will have to start thinking in terms of reversal of the ultra easy policy stance in a calibrated manner, such that there is least disruption. 2

3 Eurozone to under perform US on economic growth performance Proactive policy stance by the ECB has reduced the tail risk from Eurozone financial system Besides fiscal consolidation, policymakers should emphasize improved growth measures Eurozone on a slow growth trajectory The Eurozone is marred by weaker growth prospects, and we expect Eurozone to remain in recession through The weakness is likely to be more pronounced in the peripheral economies i.e. Italy, Spain, Portugal and Greece. Also, the recessionary pressures in the peripheral economies are likely to weigh on French and German economic activity and the core economies are likely to post muted growth prospects. While the growth prospects have been bad, it would have been worse if not for the proactive monetary stance adopted by the ECB. The ECB s LTRO s (Long term refinancing operation) and the OMT program (Outright monetary transaction) have reduced the scope of tail risk materializing in the Eurozone, however monetary tools too have limitation in terms of stimulating the real economy. Monetary transmission becomes difficult in a scenario where economic agents are deleveraging. Therefore, while the accommodative monetary policy stance will continue, greater emphasis is placed on the fiscal and structural reforms process. In the past, the political leadership has put greater importance on fiscal reforms. Infact, the Euro area-wide general government deficit has declined from 4.2% of GDP in 2011 to 3.5% of GDP in 2012 and is projected to reduce further to 2.8% of GDP in Governments should build on this progress with a view to further restoring confidence in the sustainability of public finances. However, what is required is a shift toward comprehensive structural reform program, which gives equal emphasis to fiscal consolidation and economic growth enhancing measures. This point is broadly emphasized by the election results from Italy, wherein 57% of Italians voted for parties that explicitly oppose fiscal austerity. The outgoing Prime Minister Mario Monti mustered less than 10% of votes in both houses, suggesting that the focus of structural reforms should looked beyond narrow fiscal consolidation measures and should also emphasize better growth prospects as well. We expect risk assets to trade sideways in the near term Market outlook Choppy near term In the immediate near term, besides the political uncertainty in Italy, the markets are also driven by Cyprus bailout concerns. Cyprus has reached an agreement with the Troika, which will result in release of a EUR 10 bn bailout package. However, the restructuring of the Cyprus banking sector and imposition of haircut on the unsecured deposits (i.e. above EUR 100,000) has dented the confidence and increased vulnerability of the banking sector in the Eurozone economy. As a result of these developments, we expect risk assets to trade sideways in the near term, after posting stellar performance during early

4 State of the Indian Economy The last quarter has served as a turning point of sorts for the economy. On mostly all parameters this quarter has witnessed a change in trajectory, which we believe indicates nascent recovery Although the headline Q3 GDP print was fairly dismal, the pick up in growth rates of both consumption and investment demand is encouraging Sensitivity to twin deficits has increased significantly for monetary policy making as well Uncertainty to instill caution in the near term Kamalika Das As we head into the end of the fiscal year 2013, we note that the last quarter has served as a turning point of sorts for the economy. On mostly all parameters this quarter has witnessed a change in trajectory, which we believe indicates nascent recovery. The Government s statistical wing had pegged the year s GDP growth at 5% YoY and the Q3 actual print came in at 4.5% YoY thereby cementing expectations that the full year growth will indeed be what the Advance Estimates suggest. However, be that as it may, we expect GDP growth to have recovered some lost ground in Q4 although more meaningful momentum is unlikely to be witnessed till a few more months have passed. Although the headline GDP print was fairly dismal, what is actually encouraging is the pick up in growth rates of both consumption and investment demand. Being a domestic demand driven economy, robust consumption demand is vital to keep the growth path alive. Several factors have influenced consumption demand primarily, slower income growth and persistently high inflation levels. Going ahead in the next fiscal with a recovery, income levels are likely to improve and inflation in average terms is expected to be lower than what it was this fiscal. The scenario for capital formation is less certain at the moment. The investment climate in all probability depends not only on the level of interest rates prevailing in the country but also on the macroeconomic stability, policy stance and sentiment. Hence, apart from the 100 bps rate cut that the RBI has already administered over the fiscal year, a firm commitment from the Government to continue with its reform and policy agenda (such as more projects granted approvals through CCI) would have a salutary effect on investment demand. On the external front also the fourth quarter is likely to be significant turning point. Balance of payments data for Q3 showed a surge in current account deficit as % of GDP at a record level of 6.7% in the wake of a 5.4% in Q2. However, a substantial recovery has been seen in Q4 in the trade data and the trade deficit in February has shrunk sharply as compared to the highs seen in Q3. This is expected to lead to an improvement in CAD in the last quarter. Incidentally, the sensitivity to twin deficits has increased significantly for monetary policy making as well. RBI has now repeatedly pointed out that although the fiscal scenario shows some promise but the elevated levels of current account remains a cause for concern. Some recovery seen in domestic demand Wedge between CPI and WPI increasing sharply (% YoY) Q1 FY2006 Q3 FY2006 Q1 FY2007 Q3 FY2007 Q1 FY2008 Q3 FY2008 Q1 FY2009 Q3 FY2009 Q1 FY2010 Q3 FY2010 Q1 FY2011 Q3 FY2011 Q1 FY2012 Q3 FY2012 Q1 FY2013 Q3 FY2013 Real GDP (market price) Private consumption Gross fixed capital formation (ppt) Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 CPI-WPI Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Source: CEIC, ICICI Bank Research Source: CEIC, ICICI Bank Research 4

5 The Central Bank has strongly communicated the stance that it deems high inflation levels as a very credible threat to growth prospects currently Systemic liquidity deficit continues to be tight in the wake of advance tax outflows but we expect this to correct a bit as Government spending starts coming in Domestic political fragility and events in the Eurozone will keep markets cautious and keep policy stance uncertain support. IIP shows an encouraging up tick As far as inflation is concerned, the RBI in its last monetary policy meeting flagged concerns about the widening wedge between WPI and CPI and said that room for additional policy easing is limited after the 25 bps repo rate cut. The Central Bank has strongly communicated the stance that it deems high inflation levels as a very credible threat to growth prospects currently and will act broadly in accordance with this stance. The divergence between WPI and CPI are primarily attributable to food inflation. WPI has started to trend downward on a strong decline in core inflation but the diesel price reforms will keep an upward pressure on the fuel index. As far as other high frequency macro indicators are concerned, industrial production grew by a much more than expected 2.4% YoY in January. Although a more robust recovery in manufacturing is still some way off but we expect some measure of improvement to continue. The Union budget had been closely watched and the Finance Minister seems to have delivered on his commitment to reduce fiscal deficit as % of GDP to acceptable levels. However, although the headline looks creditable but the quality of fiscal mix has taken a backseat as consolidation was achieved through a very sharp cut in plan expenditure. The oil companies continuing price increase for diesel will be very important as it will help take some burden off the subsidy bill. In the context of subsidies, the food security bill will be watched closely. The cabinet has passed it and the Parliament is likely to debate it as soon as it is in session again. The passage of the bill will consequently add to the food subsidy bill. On the monetary front, systemic liquidity deficit continues to be tight in the wake of advance tax outflows but we expect this to correct a bit as Government spending starts coming in. Bond yields continue to be elevated in anticipation of the start of the borrowing program and both the stock markets and the Rupee have witnessed very choppy movement lately, buffeted by both domestic and international developments. The political backdrop also remains considerably fragile at the moment following the recent exit of DMK, which was a key UPA ally. Uncertainties now hinge around SP, which provides much needed outside support to the UPA. Along with this, how the crisis in Cyprus pans out will also be watched carefully as this has injected a considerable amount of vulnerability into the Eurozone lately. Thus over the next month or so, global developments along with how our domestic political alliances work out will be key for asset market trajectories and also for overall macroeconomic growth as our recovery in some sense is still predicated on the Government s commitment to continue to provide Budgeted subsidy bill for FY2014 looks credible Mining Manufacturing Electricity IIP (% YoY) Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Source: CEIC, ICICI Bank Research (in INR bn) FY 2013 BE FY 2013 RE Source: CEIC, ICICI Bank Research FY 2014 BE Fertiliser Subsidy Food Subsidy Petroleum Subsidy BE: Budgeted estimate, RE: Revised estimate 5

6 Forex Strategy Since the start of this year the Rupee has made several attempts to rise towards but has been pushed back on unexpected developments The most recent in the series of events is the noise around Cyprus bailout, concerns over UPA s stability and cautious rate guidance by the RBI While DMKs exit caused a stir, there were further jitters on rumours of possible pull-out by SP Cyprus has managed to strike a last minute deal, but it has come with several riders, which has sent tremors across Eurozone Rupee again derailed from its appreciation path Rupee to trade choppy but remain ranged in FY2014 Surbhi Ogra Since the start of this year the Rupee has made several attempts to rise towards but has been pushed back on unexpected developments, both global and domestic. The most recent in the series of events is the noise around Cyprus bailout, concerns over UPA s stability and cautious rate guidance by the RBI. Factors that have weighed on INR in recent days RBI rate cut fails to spread cheer: While the RBI cut repo rate by 25 bps to 7.5% in its March meeting, it dampened expectations of further rate cuts in its policy statement, stating that headroom for further monetary easing remains quite limited. Such a hawkish stance by RBI prompted the market to pare its rate cut expectations for FY2014. DMK s exit causes political stir: Owing to UPA s lukewarm reaction to DMK s demand for a tougher resolution against Sri Lanka, the party withdrew support from the Government. Meanwhile, there were some jitters following rumours of a possible pull out by the Samajwadi Party from the UPA. Global risk sentiment hit on Cypriot bailout concerns: Cyprus accounts for 0.2% of Eurozone GDP, so a bailout request by the nation in June last year did not trouble the markets much, as it hardly posed a systemic risk. After a wait of 9 months, the nation finally got a bailout but there was one detail that shook the global markets, as for the first time in the Eurozone crisis depositors were made to contribute towards the recapitalisation of banks. Cyprus proposed to tax its savings accounts as part of a EUR 10 bn bailout by the European Union. This caused a stir in the financial markets for creating a dangerous precedent for other countries in the region. While Cyprus managed to strike a last minute deal with the EU-IMF-ECB troika to get a EUR 10 bn bailout package, in exchange it had to agree to shut down its second largest bank, Laiki. The nation has assured safety to the uinsured deposits i.e. deposits less than EUR 100,000 by creating a good bank out of the Bank of Cyprus. However, in an unprecedented decision, uninsured deposits will be used to recapitalise the banking system. Moreover, senior bondholders will also have to take a hit. In the latest development, Cyprus has placed strict controls to prevent a The Cyprus bailout issue has weighed on global risk sentiment underscoring the fall in Euro USDINR Political uncertainty in Italy and Spain, Euro t k Budget falls short of market expectations DMK quits UPA and RBI douses rate cut expectations EURUSD Jan 8-Jan 15-Jan 22-Jan 29-Jan 5-Feb 12-Feb 19-Feb 26-Feb 5-Mar 12-Mar 19-Mar 1-Jan 8-Jan 15-Jan 22-Jan 29-Jan 5-Feb 12-Feb 19-Feb 26-Feb 5-Mar 12-Mar 19-Mar 26-Mar Source: Trade Ministry, ICICI Bank Research Source: Bloomberg, ICICI Bank Research 6

7 Rupee is having to deal with increased volatility on the back of rising interlinkages with the global economy Ramification of the recent On analysing the possible impact of the latest developments, one gets further events would add further confirmation that currency movements are likely to remain choppy. Firstly, the uncertainty to the global DMK issue. On the face of it there has been no apparent harm from DMK s exit, and domestic markets, causing Rupee to be but it does make the Government a bit vulnerable, given increased reliance on choppy outside support. This could considerably slow down the pace of planned reforms. Parliamentary approval is pending for reforms in the pension and insurance sector, along with the tax reforms with the DTC and GST hanging in the balance. Secondly, the RBI has added another degree of uncertainty in its For a more predictable INR policy stance, which will keep markets guessing and add to Rupee volatility. trajectory, support will Thirdly, the Cyprus issue just goes to confirm what we have long believed that have to come from the Eurozone debt crisis is unlikely to get resolved any time soon. Just as one domestic policymakers feels that the Eurozone debt crisis has slipped to the background, a new issue crops up. Thus market would keep getting hit intermittently with negative surprises from Eurozone. The only silver lining is the safety net that has been given by the ECB of unlimited liquidity support. While Rupee gains looks to be limited in the current environment, we do not expect INR to weaken sharply as capital inflows are likely to remain healthy given the Government s commitment towards capital account liberalisation Increasing global interlinkages have caused more swings in USDINR bank run. While Eurozone officials have tried to downplay the case of Cyprus as being one-off, one can already see its tremors across Eurozone. Rupee to deal with increased volatility The currency markets are known to be fairly volatile but the increasing interlinkages between the global and domestic economy have led to a sharp rise in the number of factors that can have an impact on a currency. It is this continuous barrage of events that underscores the recurring swings being seen in Rupee. Thus, the currency is unable to conform to one direction for long, as has been seen in case of Rupee over the last few quarters. Currency outlook: Choppy but ranged On the global front, there is little one can do other than watch the events unfold. For a more predictable INR trajectory, support will have to come from domestic policymakers. While the Government remains committed in its intent to support growth and boost investment, market is looking for execution. Meanwhile, with several state elections this year and the General elections next year, political dynamics will be a key input towards shaping market sentiment. While, noise around DMK s exit has receded, it does not look to be the end of further political disturbances. While Rupee gains looks to be limited in the current environment, we do not expect INR to weaken sharply as capital inflows are likely to remain healthy especially given the Government s commitment towards capital account liberalisation. Thus we expect USDINR to trade choppy but remain ranged. Healthy capital flows would help to cap the losses in Rupee (%) 6 % change between weekly high-low of USDINR (USD bn) 8 Net FII inflows Debt Equity Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Source: Bloomberg, ICICI Bank Research Source: Bloomberg, ICICI Bank Research 7

8 Fixed Income Strategy Kanika Pasricha Bond yields have witnessed upward pressure and OIS curve has bull steepened since end February Heavy gross borrowing estimate for FY2014 and uncertainty regarding the bond swap program has weighed on gilts The RBI s cautious rate RBI s cautious forward rate guidance As per our expectations, the Central Bank guidance has limited reduced the repo rate by 25 bps to 7.50% in the Meeting on 19 future expectation of rate th March. However, the policy guidance is fairly cautious, with the RBI stating that while cuts growth has decelerated significantly, the headroom for further monetary easing remains quite limited (amidst inflation risks and concerns over CAD). Liquidity has remained tight post advance tax outflows on limited Government spending In FY2014, the gross borrowing has been frontloaded with 60% supply in H1 Markets maintain caution though OMOs to support After slipping to 2-½ year lows at sub 7.80% levels in mid February, the benchmark bond yields have spiked more than 15 bps to end the fiscal at around 7.96% levels. The OIS curve has bull steepened with the 5Y/1Y spread narrowing to ~25 bps currently as against 41 bps in end February. Factors resulting in such moves: Announcement of gross borrowing numbers The Union Budget FY2014 pegged the gross borrowing at INR 6.23 tn including a bond buyback program of INR 500 bn. The Finance Ministry though later clarified that the gross borrowing will be INR 5.79 tn and the bond buyback will be conducted outside the borrowing calendar. Further, there is a possibility of conducting the bond buyback with the RBI thereby reducing the gross borrowing by an equivalent amount though details will be finalised by mid-april. The immediate impact was the steepening of the Gsec yield curve with the Government planning to swap bonds maturing in next few years with fresh longterm bonds. Liquidity remains tight on advance tax outflows The LAF deficit has persisted above the INR 1 trillion mark since mid-march, on account of advance tax outflows and as the Government balances with the RBI continue to remain elevated. FY2014 outlook for yields Supply pressures to be frontloaded As per the H1 FY2014 borrowing calendar, the Government will borrow INR 3.49 trillion, starting from first week of April, with the auction size of INR bn. The borrowing program will also include INR bn worth inflation indexed bonds this fiscal. It should be noted that the gross borrowing has been frontloaded in H1, with 60% of total supply (INR 5.79 trillion) to hit the market in the first half of the year. Yield curve has steepened post Budget OIS curve has bull steepened last few months (%) 8.3 Yield curve 28-Mar Feb-13 (%) 7.70 Spread 5Y-1Y (RHS) 1Y OIS 5 Y OIS d 720d 1440d 2160d 2880d 3600d 4320d 5040d 6840d 10800d Dec-12 Jan-13 Feb-13 Mar-13 Source: Bloomberg, ICICI Bank Research Source: Bloomberg, ICICI Bank Research 8

9 Inflation expected to decline in the near term, though fuel and MSP price hikes pose upside risk Widening CPI-WPI wedge has complicated monetary management and limited policy room FY2014 would also require aggressive OMO support With widening CAD and upside risks to inflation, we expect only one more 25 bps repo cut in H1 Current 8.15% 2022 benchmark to face illiquidity premium in the coming months The traders await the details of the inflation indexed bond s due in next 15 days and the bond swap program and its implications for gross borrowing likely to be released by mid-april. Inflation: near term outlook favourable though upside risks in the medium term The WPI inflation print for March to be released next month is expected at ~6.2% YoY, on the back of a favourable base effect and sharp decline in core inflation. However, food inflation remains elevated and faces further upside risks from MSP hikes. Moreover, administered price hikes would put upward pressure on fuel inflation. Another worry is the high level of CPI inflation that has been rising since October In fact, the rising WPI-CPI wedge is exacerbating challenges for monetary management. WPI inflation is likely to witness a sharp uptrend in H2 FY2014, led by fuel inflation and amidst an unfavourable base effect, thereby sharply constraining monetary policy space. RBI s OMO support to continue - Given our analysis of the demand-supply dynamics in the Gsec market, we believe that as part of the liquidity fine-tuning operations, the RBI is likely to conduct open market operations to the tune of INR 1500 bn in the next fiscal versus INR 1546 bn in FY2013. Cautious RBI likely to provide only one more repo rate cut in H1 FY2014 Given the guidance provided by the RBI in its latest policy meeting and the expectations of rise in inflation trajectory during the course of the year, we expect only one more 25 bps repo rate cut in H1 FY2014. It should be noted that the current benchmark 8.15% 2022 is likely to witness some illiquidity premium in the near term, with the total outstanding issuance of INR 700 bn. The historical experience shows that the prevailing benchmark is replaced by a new benchmark if the total issuance exceeds INR bn. Other factors that would be watched for by the market would be the changes to the HTM limit of 25% coupled with developments on political front in the run up to general elections. 10Y yield expected to Overall, we expect the benchmark bond yields to trade in a range of 7.60% - trade in 7.60% % 8.10% in FY2014, with the timing of rate cut and OMOs to determine the range in FY2014 trajectory for yields. Moreover, with the majority of issuance concentrated in the 10Y 14Y segment and on the back of the proposed bond swap program, the yield curve is expected to steepen. High Govt balance with RBI weighed on liquidity OMOs to balance Gsec market in FY2014 (` bn) Oct Oct-12 LAF 09-Nov Nov Dec Dec-12 GoI surplus with RBI 04-Jan Jan Feb Feb Mar Mar-13 Demand and Supply for G-secs (` bn) Supply FY2013 FY2014 Dated securities Tbills Net SDL issuance Total Demand FY2013 FY2014 SLR demand by banks Demand from PFs Demand from insurance companies Demand from FIIs Total Gap* *This is likely to be met through demand from RBI Source: Bloomberg, ICICI Bank Research Source: Bloomberg, ICICI Bank Research 9

10 Inflation Kanika Pasricha Fuel price hikes pose risk to inflation while core to moderate February inflation print spiked to 6.84% YoY after hitting a near 3-year low in prior month While administered price hikes are fuelling inflation, declining trend in core has capped the upside Inflation likely to drop to In FY2014, inflation expected to stay below 7% in H1 FY2014 while unfavourable 6.2% in March-2013, base effect will drive the inflation levels sharply higher in second half of the year. though it faces upside risk from fuel and MSP hikes Widening CPI-WPI wedge is a rising concern for RBI WPI likely to average 7% in FY2014 from 7.3% in FY2013, with March-2014 projection at 7.6% YoY The wholesale price inflation increased to 6.84% YoY in February-2013 after hitting a near 3-year low in the previous month. The rise in headline inflation has primarily been on the back of fuel amidst hike in administered prices for LPG and diesel, that together contributed ~115 bps to the February inflation print as against the total contribution of fuel inflation at 157 bps. Primary inflation slipped to 9.70% YoY versus prior reading of 10.3% YoY amidst a favourable base effect. The sequential momentum remained elevated at 0.58% MoM as compared to 0.69% MoM in January However, in an encouraging development, core inflation slipped to 3.8% YoY, lowest level since March-2010, thereby creating space for a 25 bps repo rate cut in the March monetary policy meeting. The WPI inflation print for March to be released next month is expected at ~6.2% YoY, on the back of a favourable base effect and decline in core inflation. Upside risk to inflation is from hikes in administered prices (diesel, LPG, coal and electricity tariffs) along with MSP hikes in a year with 10 state elections. Meanwhile core inflation is expected to stay muted amidst a modest improvement being witnessed in GDP growth. In fact, it is only the demand-led component of WPI inflation that has driven the decline in inflation trajectory since October Meanwhile, the wedge between the CPI and WPI inflation has been widening since Q3 FY2013 and has been a cause for concern for the RBI. Food inflation has been the major driver of the wedge, with the weight of food at 49% in CPI versus 22% in WPI. Meanwhile, there has been divergence in core CPI and WPI, though the two series cannot be compared. (For details, Please our report titled Analysing the drivers of the WPI-CPI wedge, February 6, 2013 ) Overall, we expect WPI inflation to average 7% YoY in FY2014 versus 7.3% YoY in FY2013, with inflation projected to rise from 6.2% YoY in March 2013 to 7.6% YoY in March Administered price hikes driving up fuel inflation Core inflation has eased to near 3-year lows Fuel inflation Non-administered Administered (RHS) (% YoY) (% YoY) Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 Manufacturing ex-food (%) YoY MoM (RHS) (%) Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12 Feb-13 Source: Office of the Economic Advisor, ICICI Bank Research Source: Office of Economic Adviser, ICICI Bank Research 10

11 Feature: Enhancing India s export competitiveness- need of the hour Manufactured products have always formed a major part of merchandise exports However, over the last decade, the share of manufactured products in India s total exports has declined from 72% in FY2004 to 60% in FY2012 India s relative comparative advantage in manufacturing lags far behind that of other Asian peers High raw material costs including labour costs is a key reason for India s low competitiveness India is lagging behind in its manufacturing prowess Relative Comparitive Advantage in Manufactured goods India China HK Singapore Thailand Korea Surbhi Ogra Looking at India s widening trade deficit, it has become extremely important to analyse the underlying reasons for India s unimpressive export performance. Since a significant part of India s exports are manufactured, it will be important to dwell into the key reasons that have led to the erosion of India s manufacturing competitiveness, resulting in our weak export performance. Analysing the reasons behind the declining competitiveness of India s manufacturing sector Manufactured products have always formed a major part of merchandise exports. However, over the last decade, the share of manufactured products in India s total exports has declined from 72% in FY2004 to 60% in FY2012. The chart below shows Relative Comparative Advantage (RCA) of a few Asian economies in the manufactured goods segment. The intertemporal analysis shows that India is clearly lagging behind, while other Asians are seen strengthening their positions. The situation is much worse when one looks at the manufactured goods sub-component comprising of high skill and technology intensity, where India has a RCA of 0.5 while Hong Kong and Singapore boast of a RCA of over 2.0. High raw material costs: This forms a major component of the rise in company costs in recent years. Meanwhile, logistic costs in India are much higher compared to international standards. Further, the depreciation in INR has added to the imported costs. Labour market related issues 1. High labour costs: For much of the previous decade, the rise in rural wages was rather muted, as labour market conditions were quite loose. In recent years the trend in wage growth has picked up on the back of a host of factors like inflation, government schemes such as MGNREGS and significant increase in minimum support prices. Further the success of these schemes has caused a shortage in the availability of industrial workers which has in turn resulted in a rise in industrial wages. This has resulted into a vicious circle as rising wages leads to further rise in the raw material costs. 2. Lack of skilled labour force: This has implications on quality, delivery and costs, which are key for a companies overall competitiveness. 3. Declining labour productivity: Skill shortage is one of the key factors weighing on labour productivity in India. 4. Labour market rigidity: Rigid labour laws are a big deterrent for setting up new enterprises and the entrepreneurs, wary of the fact that they will be unable to offload workers, do not hire them in the first place. Competitiveness in high technology intensive manufacturing is vey low India's comparitive advantage index Labour-intensive & resource-based manufactures Manufactures with low skill & technology intensity Manufactures with medium skill & technology intensity Manufactures with high skill & technology intensity Source: CEIC, Reuters Ecowin, CICI Bank Research Source: CEIC, Reuters Ecowin, ICICI Bank Research 11

12 Lack of sufficient infrastructure is another hurdle towards growth Indian manufacturers have to deal with procedural Less focus towards innovation and R&D delays and governance As things stand today, India s share in export of advanced technology product issues, which further adds is extremely small, which underscores the lack of focus on innovation and R&D. to their costs India is one of the smallest spenders on R&D and has the lowest number of researchers among major developing countries. India s relative weakness in R&D is also reflected in the number of patents India has obtained in recent years. Not much emphasis is given to innovation and R&D While high fiscal deficit is not directly linked to the competitiveness of the industry, it acts as a deterrent for domestic and foreign investment East Asian countries adopted several export push policies that can provide important lesson for India Lack of sufficient infrastructure The Prime Minister concedes that infrastructure is the biggest bottleneck to faster economic growth. Poor quality and irregular supply of infrastructure and intermediate services such as power, roads, ports, etc are one of the key problems being faced by Indian industries. Procedural delays and governance issues A delay at each of these levels causes the cost to escalate and erodes the competitive edge that our industries have. Fast tracking key infra projects is the need of the hour. In this respect the Cabinet recently cleared the proposal to set up Cabinet Committee on Investment, headed by Prime Minister, to fast-track mega projects of over INR 10 bn. High fiscal deficit: While this factor is not directly linked to the competitiveness of the industry, high fiscal deficit causes is a deterrent for domestic and foreign investment. Curbing the fiscal deficit will help revive the economy's growth momentum by making avenue for private investments, which, in turn, would address the deficit further. Another factor that is specific to the export competitiveness is the relatively low inflows of FDI into export oriented industries, as the majority of FDI continues to be directed towards domestic market production. FDI for exports has significant advantages in terms of their marketing tie-ups, buy back arrangements, product knowledge etc, which forms a strong base for future growth. Thus focus needs to be on developing the special economic zones as they have the potential to change the scenario for manufactured exports from India. Once India starts to capture a larger share of the export market, it will be able to enjoy better economies of scale which in turn will make our economy more competitive in the global space. This will kick-start a positive cycle that will ensure rising returns for the nation in the coming decades. It will also help in reducing our dependence on imports by encouraging import substitution and thus help our economy transcend from being a net importer to being current account surplus. Analysing the experience of East Asian countries The export led growth experiences of some of the East Asian economies is likely to provide important lessons for India. Fiscal incentives like tax Export-push policies: holiday s and subsidized These policies primarily focused on according preferential treatment to credit were given to boost exporting firms. the export industry 1. Fiscal incentives: These incentives ranged from tax-holidays to exporters, income tax rebates to subsidized credit. 2. SEZs and EPZs: Many countries established Special Economic Zones (SEZs) and Export Processing Zones (EPZs) to boost exports. Firms operating in these zones benefitted from an export -oriented environment, with tax allowances, lower tariffs, better infrastructure, more flexible labor markets, and less demanding bureaucracy. 12

13 Some countries used currency devaluation, but most focused on other aspects like institutional innovation, labor force complementarities In almost all countries under study, the government made a concerted effort to maintain macroeconomic stability during the period of implementation of export-promoting policies There is limited responsiveness of exports to currency movements in the case of India, with global growth appearing as a much prominent driver of exports As things stand today in the global context, India might find it difficult to achieve its exports target of USD 500 bn in FY2014 Import substitution policies: Almost all the East Asian countries adopted some form of import substitution policy in order to help its infant industries get a foot-hold in the domestic and eventually global markets. These policies often included import controls and import tariffs. Protection was combined with either compulsion or strong incentives to export. Currency devaluation This channel involves devaluing the currency in order to make the respective country s export basket more attractive. Almost all the East Asian countries have at some point resorted to currency devaluation to promote their exports. However, it s been an important policy ingredient for China. Institutional innovations: Several new institutions were set up to help in the outward orientation of the economy. These institutions performed a range of functions from gathering market information for exporting firms, establishing an overseas trade network, marketing the exports through trade fairs etc. Labor force complementarities Many countries inherited a very skilled and educated labor force and organized labor market institutions that made it easier for them to implement their export oriented policies. Other supporting factors In almost all countries under study, the government made a concerted effort to maintain macroeconomic stability during the period of implementation of export-promoting policies. This meant that the budget deficits were within limits together with low levels of foreign debt. Further, most of the governments also invested heavily in infrastructure. Analysing the responsiveness of India s exports towards Rupee depreciation History is full of examples where countries have registered strong exports growth even in the face of currency appreciation. For instance, Korea s export growth averaged 20% per year between 2003 and even as the won appreciated about 23% in real effective terms. A statistical analysis further confirms the limited responsiveness of exports to currency movements in the case of India, with global growth appearing as a much prominent driver of exports. An export growth estimation model was constructed using world GDP growth and USDINR as independent variables. The results show that a 1 Rupee change leads to a 0.2% YoY change in exports while a 1% YoY change in world GDP leads to a 4.8% YoY change in exports. Thus in the face of weak global fundamentals, a depreciated currency alone will be unable to drive our exports growth, thereby underscoring the need for improving our competitiveness. Conclusion The Government will have to focus on improving our As things stand today in the global context, India might find it difficult to competitiveness if we are achieve its exports target of USD 500 bn in FY2014. The Government will have to increase our share in to focus on improving our competitiveness if we are to increase our share in world trade world trade. And as we have experienced in the recent past, a weak currency alone will not be a sufficient condition to improve our competitiveness. Infrastructural development, skilling of the labour force, redressal of governance issues are some of the structural changes the Government needs to adopt to scale up our manufacturing sector. The annual supplement to the Foreign Trade Policy that is due to be announced in April is likely to focus on boosting exports and also revive SEZs from a more long-term perspective. This is a move in the right direction as is the Government s commitment to promote investments, which will have a two pronged benefit of boosting India s exports and encouraging import substitution, which together will help reign in India s trade deficit. 13

14 Key macroeconomic Indicators Unit Period Latest Previous FY12 FY11 Real GDP % YoY Q3 FY Agriculture % YoY Q3 FY Industry % YoY Q3 FY Services % YoY Q3 FY IIP % YoY Jan PMI Index Feb WPI inflation % YoY Feb CPI inflation % YoY Feb External Sector Indicators Unit Period Latest Previous FY12 FY11 Exports % YoY Feb Imports % YoY Feb Trade balance USD bn Feb Current Account USD bn Q3 FY Capital Account USD bn Q3 FY BOP USD bn Q3 FY FX reserves USD bn 15-Mar Leading indicators Unit Period Latest Previous FYTD Corresponding period last year Auto Sales % YoY Feb Passenger Cars % YoY Feb Commercial Vehicles % YoY Feb Cellular Subscribers % YoY Jan Railway freight % YoY Jan Cement % YoY Mar Reserve Money Credit outstanding Aggregate Deposits Money Supply SLR investment Monetary Indicators Corresponding Unit Period Latest Previous FYTD avg period last year INR bn Mar-13 % YoY INR bn Mar-13 % YoY INR bn Mar-13 % YoY INR bn Mar-13 % YoY INR bn Mar-13 % NDTL

15 Fiscal Indicators Unit Period Latest Previous FY12 FY11 Fiscal Deficit as a% of budgeted % February FY Total Expenditure as % of budgeted % February FY Total Receipts as a % of budgeted % February FY RBI Action Cumulative change in FYTD (bps) Cumulative change in FY12 Policy Rates Unit Period Latest Previous Repo rate % 29-Mar Reverse Repo % 29-Mar CRR % 29-Mar Auctions Unit Latest Previous FYTD FY12 Dated security auction INR bn 29-Mar , OMO Purchase INR bn 29-Mar SMO Purchase INR bn 29-Mar MSS buyback INR bn 29-Mar Market Indicators % change since Unit Period Latest Last month avg last month FYTD BSE Sensex Index 28-Mar Exchange Rate (USD/INR) - 28-Mar day T-Bill % 28-Mar yr GOI bill % 28-Mar OIS (5-year) % 28-Mar MIFOR (5-year) % 28-Mar MIBOR (NSE) % 28-Mar Global snapshot % change since Unit Period Latest Last month avg last month CYTD Currencies Euro - 29-Mar British Pound - 29-Mar Japanese Yen - 29-Mar Swiss Franc - 29-Mar DOW - 29-Mar-13 Equities FTSE - 29-Mar Nikkei - 29-Mar Others Global PMI - Feb USD Libor 3mth % 28-Mar Ted Spread bps 28-Mar

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