India Fixed Income: Markets likely to remain cautious in the near term

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1 3M 6M 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 1Y 11Y 12Y 13Y 14Y 15Y 19Y 24Y 3Y In Focus: India Fixed Income For private circulation only India Fixed Income: Markets likely to remain cautious in the near term Yield curve has steepened sharply (%) Yield curve 15-Jan-15 3-Sep-15 Current Fiscal arithmetic for remains comfortable though FY217 Budget is in focus as fiscal dynamics appear challenging on implementation of the 7 th Pay Commission (7PC). While we maintain our post-budget rate cut call, bar for the same has been raised higher in the light of 7PC. Fundamental support to gilts is muted and sentiment is likely to remain cautious ahead of the Budget Source: Reuters, ICICI Bank Research Supply pressures likely to remain elevated in the next fiscal Net borrowings^ Gross borrowings* Nominal GDP Fiscal deficit# Fiscal deficit % of GDP) FY217 borrowing s projections (as (est) FY217 (F) ^using dated securities (& gold bonds) and projecting 83% of fiscal deficit to be financed through market borrowings, *including redemption (after adjusting for the impact of debt switch/buyback of ~INR 3 bn), #9% nominal GDP growth projected for FY217 Source: Budget documents, ICICI Bank Research January 18, 216 Kanika Pasricha kanika.pasricha@icicibank.com Niharika Tripathi niharika.tripathi@icicibank.com Sumeet Agrawal sumeet.agrawal@icicibank.com Please see important disclaimer at the end of this report Dampened risk sentiment supported global bond market rally Since the start of new year, markets have been rattled with falling crude oil prices, volatility in Chinese stock markets, structural slowdown in China and geopolitical tensions. Consequently, a rally in DM bond markets was seen with UK and US bond yield falling by more than 2 bps in last 2 weeks. Fiscal and inflation uncertainty have raised the bar higher for further rate cuts December-215 CPI edged up to 5.6% YoY versus prior of 5.4% YoY on account of an unfavourable base effect. Further, the elevated pulses and vegetables CPI is a cause for concern though Government measures are likely to lead to some correction in the coming months. Going forward, we expect the RBI s Jan % YoY CPI projection to be comfortably achieved. In FY217, while 7PC is likely to adversely affect housing CPI, the underlying trend for CPI ex housing is expected to be closer to RBI s 5% target on weak commodity prices and demand conditions. However, the implication of 7PC on fiscal roadmap may act as a deterrent towards monetary easing. On balance, while we maintain our post-budget rate cut call, bar for the same has been raised higher in the light of 7PC. Liquidity to deteriorate in Q4; room open for OMO purchases The liquidity situation is expected to witness seasonal deterioration in Q4 on account of buildup in Government balances and increase in currency in circulation. Meanwhile, we expect liquidity situation to receive support from 3 factors: (1) Debt buyback of ~INR 3 bn, (2) OMO purchases worth ~INR 2-25 bn and (3) FX intervention of ~INR 45-5 bn. On balance, systemic liquidity deficit is projected at ~INR 13 bn INR 14 bn by end Q4. Yield likely to continue to steepen Recent months have witnessed a relatively higher pressure on longer end of the yield curve vis-à-vis shorter end on account of Higher demand for low duration Gsec: The RBI s demand for bonds in the form of open market operations has been concentrated in shorter dated securities. Expected rise in supply pressures: In the next fiscal, assuming that the government adheres to the roadmap and budgets the fiscal deficit at 3.5% (of GDP), net borrowings are likely to decline. However, gross borrowings are expected to increase above INR 6 tn levels (after accounting for debt buy back worth INR 3 bn). Further, the duration of supply issuance is likely to continue to increase in order to adjust for heavy redemption pressures in coming years. Reduced probability of further policy easing: As witnessed in the historical past, yield curve steepens sharply as investors perceive a near end to the monetary accommodation cycle. Fundamental support to gilts is muted and sentiment is likely to remain cautious ahead of the Budget. Markets could come under further pressure on an increase in global market volatility. Meanwhile, OMO purchases are expected to provide some support. On balance, we expect the new 1Y bond yield to trade in a range of % in the near term.

2 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 India Fixed Income DM bond yields have dropped amid weakness in global risk sentiment Government bond yields (%) Value at 216-start Value 1- week ago Latest value 1/Jan/16 11/Jan/16 18/Jan/16 US Treasuries UST 1yr UST 2yr Europe bond yields (1-year) Germany France UK Japan (1-year) JGB 1yr Global bond yields to remain supported amid falling crude prices 1-year bond yields US Germany UK WTI Crude (RHS) (%) (USD/bbl) Source: Bloomberg, ICICI Bank Research Dec 215 CPI to come in largely flat at 5.5% YoY Inflation ( new base =1) (% YoY) Weight (%) Nov-15 Dec-15 Headline Food Cereals Vegetables Protein Pulses Fuel and light Core Pan, tobacco & intoxicants Housing Clothing Services Transport ex-transport Dampened risk sentiment supported global bond market rally Since the start of the new year, markets have been rattled with falling crude oil prices, volatility in Chinese stock markets, structural slowdown in China and geopolitical tensions dampening global risk sentiment. Consequently, a rally in DM bond markets was seen with UK and US bond yield falling more than 2 bps in last 2 weeks. A high correlation between crude oil prices and government bond yields is seen. Crude prices are likely to trade with a downward bias in the near term amid concerns over China (second largest oil consumer), increase in oil exports (on lifting of sanctions) and OPEC s current stance (to not cut output). With crude prices likely to remain subdued, global bonds will remain supported. CPI edged up to 5.6% YoY in December-215 CPI inflation picked up to 5.6% YoY in December from 5.4% YoY in the previous month. The sequential momentum of headline CPI index edged down to (-).4% MoM from.4% MoM previously. Meanwhile, the annual inflation print edged up on an unfavourable base effect. Food inflation came in at multi-month highs of 6.3% YoY vs. prior of 6.1% YoY. Cereals inflation continued to remain muted. Going ahead, this number is likely to see correction as prices cool and the unfavourable base effect wears off. Protein inflation fell to 1.5% YoY from record high levels of 11.6% YoY in November. Inflation in milk and eggs sub-components witnessed a decline, with the latter slipping into negative territory. Pulses inflation remained above 4% YoY, though we expect the Government measures to bear fruit in Q4. Vegetables CPI spiked to double digit levels. This move was in contrast to the sharp cooling in on-the-ground prices. We expect the official index to correct in the coming months. Core inflation showed a marginal uptick to 4.7% YoY. However, the subdued domestic demand coupled with weak international crude prices are likely to support muted core inflation, which we expect to stay below 5% YoY in the coming months. Bar remains high for further monetary accommodation Given that the Dec-215 CPI data was broadly in line with our expectations, we are keeping our March-216 CPI projection unchanged at 5.4% YoY. In the next fiscal, the 7 th Pay Commission (7PC) is likely to adversely affect housing inflation. We project March-217 CPI at 5.6% YoY. This accounts for ~4-5 bps impact of 7 th PC on headline CPI. Excluding housing, CPI is projected to decline from 5.5% YoY in March-216 to 5.1% YoY by the end of next fiscal, which is closer to the RBI s CPI target of 5% YoY. This implies that the underlying trend for CPI ex housing is likely to be closer to the Central Bank s target levels, on the back of subdued global commodity prices and domestic demand conditions. However, we believe that while the RBI may choose to ignore the inflation impact of 7PC, its possible implication for fiscal roadmap may act as a deterrent for further policy easing. On balance, while we maintain our post-budget rate cut call, bar for the same has been raised higher in the light of 7PC. 2

3 India Fixed Income Fiscal dynamics (April-Nov 216) Fiscal component o ver FY215 (% Yo Y) (% YoY) Receipts Gross taxes States' share Net to Centre Non taxes Non-debt capital Disinvestment Expenditure April-Nov Revenue Capital Fiscal deficit Fiscal deficit (% of GDP) 3.9 Source: CGA, ICICI Bank Research Strong tax collections led by indirect taxes while direct tax growth lags Tax comp o nent (INR b n) (% Yo Y) (INR b n) (% Yo Y) Gro ss Tax Revenue of which Direct Tax of which Corporate Tax Income Tax Ind irect Tax of which BE Ap ril-no v Excise duty Custom duty Service tax Source: CGA, ICICI Bank Research Subsidy saving has been muted especially for fuel (in ` bn) FY215 (est) Subsidy bill April-Nov FY215 Fertiliser Food Petroleum Total Source: CGA, ICICI Bank Research Fiscal dynamics look positive although concerns persist For the period April-November, the Government registered fiscal deficit of 87% of the budgeted aim vis-à-vis the 98.9% seen over the same period in the last fiscal. The firm growth in indirect taxes along with spending restraint lent support to the fiscal. Gross tax collections remained robust: Gross taxes grew at 21% YoY during April-November, higher than the budgeted 16% YoY. Indirect tax collection remained robust on the back of elevated growth in excise duties. Spending restraint being implemented; focus on capex a key positive: Expenditure growth remained below budgeted target of 8% YoY. Meanwhile, the quality of spending has improved with focus on capital spending, which is likely to stimulate growth trajectory. However, following factors pose concerns over fiscal health: Direct tax collections clocked 9% YoY during April-Nov, sharply lower versus the budgeted 14% YoY levels. Income tax growth remains the major laggard. Disinvestment is sharply below the targeted INR 695 bn. In April-, stake sales totalled only INR 129 bn. The spectrum reserve with the Government for auction in this fiscal appears to be limited. Meanwhile, clarity on auction of 21 MHz (freed by defence) and 7 MHz is awaited. One Rank One Pay (OROP) and Bank recapitalization are likely to weigh on the fiscal dynamics. It is also important to note that the fiscal arithmetic is based on an 11.5% YoY nominal GDP growth in. However, given subdued inflation and low growth in GDP deflator, nominal GDP growth is projected at 8-9% YoY. This is likely to lead to fiscal slippage of another INR 2-3 bn. Subsequently, additional measures will be warranted to accommodate this slippage. On balance, the Government is required to rationalise spending and/or take steps to increase revenues through sources like PSU dividends, in order to meet the 3.9% of GDP fiscal deficit target for. Spending cuts likely to continue in Source: ICICI Bank Research Our assessment o f fiscal arithmetic (` bn) Rev enues Overachievement ab o ve b ud g eted Indirect taxes 35 Non-tax revenues 25 Exp enses Hits Saving ab o ve b ud g eted Fuel subsidy Misses Fiscal sub -comp o nent (Rev enues) Slip p ag e o ver b ud g eted Direct taxes 25 Disinvestment 5 Fiscal sub -comp o nent (Exp enses) Excess o ver b ud g eted One rank one pay defence pension scheme 8 Bank recapitalisation 18 Net imp act o n fiscal arithmetic Net slip p ag e 41 Total slip p ag e (accounting fo r imp act o f fall in no minal GDP g ro wth) 61 3

4 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 India Fixed Income Seasonal factors were the prime drivers of liquidity deterioration in Q Govt balance with the RBI Drivers of systemic liquidity in Q3 776 Liquidity positive Currency in circulation 36 Banks' reserve balances (required) Source: ICICI Bank Research Liquidity negative -15 OMO sale (if any) -182 Balance (possibly FX intervention) Government balances to trend higher in Q4 2, 1,5 1, 5-5 Government balance with the RBI Seasonal increase in currency in circulation in Q4 to weigh on liquidity Increment in currency circulation FY214 FY215 Q1 Q2 Q3 Q4 We are more worried regarding the fiscal dynamics for FY217, in the light of implementation of 7PC. In FY217, the Government aims to reduce deficit by.4% of GDP to 3.5% of GDP. However, the Pay Commission will increase the expenditure burden by.5% of GDP, which is likely to make it difficult for the Government to adhere to the consolidation roadmap. Liquidity to deteriorate in Q4; room open for OMO purchases Systemic liquidity deteriorated significantly in Q3. The sharp increase in currency in circulation on account of festive demand and rise in Government balances post advance tax payments weighed on systemic liquidity. Meanwhile, primary liquidity injection by RBI provided support. For Q4, the liquidity situation is likely to continue to witness seasonal deterioration on account of rise in currency circulation along with buildup in Government balances. Meanwhile, we expect liquidity situation to receive support from 3 factors: (1) Debt buyback of ~INR 3 bn, (2) OMO purchases worth ~INR 2-25 bn and (3) FX intervention of ~INR 45-5 bn. On balance, we expect the systemic liquidity balance to move from deficit of INR 1264 bn levels as of end-dec 215 to a deficit of INR 125 bn-inr 135 bn by end-jan 216 and INR 11 bn-inr 12 bn by end-feb 216. Thereafter, the deficit is likely to worsen to INR 135 bn- INR 145 bn by quarter end post advance tax outflows. Liquidity drivers projected in Q4 Opening balance : INR 1264 bn deficit Increment in systemic liquidity balance Driver Jan-16 Feb-16 Mar-16 Increment Overall change in systemic liquidity Drivers Govt balance with the RBI Curre ncy in circulation Banks' reserve balances (required) OMO purchase s 1 1 Balance (possibly FX intervention) Closing balance Closing liquidity de ficit Source: RBI, ICICI Bank Research Primary liquidity injection via FX route and OMO purchases would be required in Q4 Our liquidity drivers analysis indicates that the BoP (i.e. spot FX intervention) was ~USD 3 bn in Q3 (vs. Q1 and Q2 numbers of USD 1 bn and USD -.9 bn respectively) Given our annual BoP projection of ~USD 24 bn and a cumulative number of ~USD 12 bn during Q1-Q3, we expect the Q4 BoP at ~USD 12 bn. Assuming an 8-9% nominal GDP growth, RBI is expected to increase its balance sheet by INR 16 bn - INR 18 bn in. The contribution of FX assets is expected to be ~INR 16 bn, thereby leading to the required increase in domestic (assets) by ~INR 1 bn. Given that the RBI has conducted (net) OMO sales of ~INR 13 bn since the start of this fiscal, the OMO purchases expected in Q4 is ~INR 2-25 bn. 4

5 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 3M 6M 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 1Y 11Y 12Y 13Y 14Y 15Y 19Y 24Y 3Y India Fixed Income Yield curve has steepened sharply (%) Yield curve 15-Jan-15 3-Sep-15 Current Source: Reuters, ICICI Bank Research Supply pressures likely to remain elevated in the next fiscal Net borrowings^ Gross borrowings* Nominal GDP Fiscal deficit# Fiscal deficit % of GDP) FY217 borrowing s projections (INR b n) (as (est) FY217 (F) ^using dated securities (& gold bonds) and projecting 83% of fiscal deficit to be financed through market borrowings, *including redemption (after adjusting for the impact of debt switch/buyback of ~INR 3 bn), #9% nominal GDP growth projected for FY217 Source: Budget documents, ICICI Bank Research Yield curve steepens as investors perceive an end of the rate cut cycle (bps) 1Y-2Y Gsec Repo rate (RHS) (%) Yield likely to continue to steepen Recent months have witnessed a relatively higher pressure on longer end of the yield curve vis-à-vis shorter end on account of following factors: (1) Higher demand for low duration Gsec: The RBI s demand for bonds in the form of OMO purchases has been concentrated in shorter dated securities. Further, the banks preference for Gsec with lower duration is rising, as they implement Liquidity Coverage requirements as per Basel III norms. Moreover, the expected rise in foreign demand for Gsec, with authorities providing for a calibrated hike in debt limits is also concentrated at the shorter end of the curve. (2) Expected rise in supply pressures: In the next fiscal, assuming that the Government adheres to the roadmap and budgets the fiscal deficit at 3.5% (of GDP), net borrowings are likely to decline. However, gross borrowings are expected to increase above INR 6 tn levels, on account of heavy debt redemption pressures. RBI s medium-term debt strategy report states that weighted average maturity of debt issuances needs to rise to limit rollover risk in coming years. Increased duration of Gsec issuances in order to account of heavy debt redemption profile in the coming years Source: RBI, ICICI Bank Research Weighted average maturity (in years) Year Issuances during the year Outstanding as on end- March FY FY FY FY FY (3) Reduced probability of further policy easing: With the inflation and fiscal concerns surrounding the 7th Pay Commission which would be implemented by Jan-216, the bar for further policy accommodation has been raised higher. As witnessed in the historical past, yield curve steepens sharply as investors perceive a near end to the monetary accommodation cycle. The above factors led to an upward pressure on the yield curve in 215. In fact, the 7.72% 225 bond yield, after hitting lows of ~7.5% in early October-215, retraced back to 7.79% levels currently. The Government issued a new benchmark bond earlier this month with a coupon rate of 7.59%. Fundamental support to gilts is muted and sentiment is likely to remain cautious ahead of the Budget. Markets could come under further pressure on an increase in global market volatility. Meanwhile, OMO purchases are expected to provide some support. On balance, we expect the new 1Y bond yield to trade in a range of % in the near term. Further, the pressure on the longer end of the curve is likely to persist in the coming months. Source: Bloomberg, ICICI Bank Research 5

6 India Fixed Income ICICI Bank: ICICI Bank Towers, Bandra Kurla Complex, Mumbai Phone: (+91-22) Treasury Research Group Economics Research Sunandan Chaudhuri Senior Economist (+91-22) sunandan.chaudhuri@icicibank.com Kamalika Das Economist (+91-22) (ext 628) kamalika.das@icicibank.com Kanika Pasricha Economist (+91-22) kanika.pasricha@icicibank.com Samir Tripathi Economist (+91-22) samir.tripathi@icicibank.com Niharika Tripathi Economist (+91-22) (ext 6943) niharika.tripathi@icicibank.com Sagrika Gogia Economist (+91-22) (ext 218) sagrika.gogia@icicibank.com 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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