In the spotlight Government steps in to protect financial system after NBFC loan defaults

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1 India Insights Monthly update on Indian markets October 2018 Summary In a rare move, the Indian government assumed control of one of India s largest infrastructure development and finance companies after the company defaulted on loan repayments In October the RBI changed its monetary policy stance to calibrated tightening from neutral while leaving rates unchanged Year-to-date, domestic investors have added a total of USD 12.2 billion into Indian equities, while foreign investors have sold USD 2.0 billion in the same period In the spotlight Government steps in to protect financial system after NBFC loan defaults In a rare move, the Indian government assumed control of one of India s largest infrastructure development and finance companies after the company defaulted on loan repayments. The government stepped in amidst worries that the fallout from these defaults could spread to other non-banking financial companies (NBFCs) as well as the wider economy. The company had previously been identified as systemically important by the Reserve Bank of India (RBI) The company was responsible for arranging the financing for some of India s most significant infrastructure projects in the past three decades. It is believed to have accrued large debts (to the tune of $12.5 billion) after it diversified its business to include project development. This left the company in a vulnerable position when interest rates picked up in 2018 and it began to miss loan repayments The defaults led to a series of credit rating downgrades on the company and its subsidiaries and sparked fears of contagion within the NBFC sector. It also triggered concerns that the company s inability to finance and support the projects it has undertaken could adversely affect the infrastructure sector as a whole This commentary provides a high level overview of the recent economic environment, and is for information purposes only. It is a marketing communication and does not constitute investment advice or a recommendation to any reader of this content to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management accepts no liability for any failure to meet such forecast, projection or target.

2 Government steps in to protect financial system after NBFC loan defaults (contd.) This was an unusual move and largely unexpected as the Indian government has rarely stepped in to take control of a private company In September, Indian rating agency ICRA had downgraded the company s credit rating to default, after it failed to meet repayment obligations on both short-term and long-term borrowings Before the government assumed control, shareholders of the company had signed off on a non-convertible debt sale, a higher borrowing limit and a rights offering in a bid to resolve its debt repayment issues Following the takeover, the government said it would seek to end the string of defaults by the infrastructure finance company and ordered an inquiry by the Serious Fraud Investigation Office. It also appointed a new six-member board for the company, including some of India s top bankers, and is n process of selling its assets This was an unusual move and largely unexpected as the Indian government has rarely stepped in to take control of a private company. The last successful attempt was in 2009 when the government took over a large software services company which had falsified its accounts Intervention to avoid contagion NBFCs with retail focused franchises, differentiated and proven business models across cycles, and efficient asset liability management can navigate through this volatile phase Shares of Indian non-bank financiers plunged in the days following the takeover announcement as non-bank lenders across the board had been hit by the rise in funding costs After the government assumed control of the company in question, the RBI warned of stricter regulations for the sector to ward off default risks rising from the asset liability mismatch. The RBI is likely to tighten regulations around NBFCs capital adequacy norms, related party transactions and asset liability mismatches NBFC regulations in India have been undergoing changes since the 2008 financial crisis, with the RBI prescribing tighter prudential norms and raising minimum tier I capital requirement to 10% (from 7% in a phased manner) The prospect of stricter rules comes at a time when funding in general is becoming difficult and this may force smaller NBFCs to shut Non-bank financiers have raised concerns about the timing of these upcoming regulatory changes as the announcement coincided with the beginning of the festival season, in India when borrowing activity typically tends to pick up In a bid to increase liquidity for cash-strapped NBFCs, the RBI relaxed regulations, giving banks room to lend more to NBFCs and housing finance companies The central Bank enhanced the single-borrower exposure limit for NBFCs from 10% of a bank s capital funds to 15%. However, this enhanced limit for lending is not available to NBFCs lending to infrastructure. It also gave banks an incentive to use part of their government securities pool to meet liquidity coverage ratio (LCR) norms if they provide additional credit to finance companies While banks are primarily the source of finance in India, NBFCs (and housing finance companies) are becoming more important. It is estimated that NBFC balance sheets currently account for less than one-fifth of the banking sector This default has led to increased concerns in financial markets on the liquidity situation of NBFCs. However, we believe NBFCs with retail focused franchises, differentiated and proven business models across cycles, and efficient asset liability management can navigate through this volatile phase Source: : HSBC Global Asset management, October

3 03/14 07/14 11/14 03/15 07/15 11/15 03/16 07/16 11/16 03/17 07/17 11/17 03/18 07/18 Equity market Increase in oil prices, INR depreciation, and concerns surrounding liquidity in the non-bank financial companies (NBFC) space impacted market sentiment domestically Indian equities continued to retreat month-to-date (as of 25 Oct), with the MSCI India Index (INR) and NIFTY Index falling by 8.8% and 7.3% respectively. Global markets saw heightened volatility in October, with the VIX hitting a level of 25 on 11 October This follows a weak month of September, with the MSCI India Index (INR) falling 7.1%, breaking its 5-month streak of outperformance over MSCI Emerging Markets. Year-to-date, Indian equities had been relatively resilient to global risks up until August, and the drop in September and October has wiped out the year-to-date gains. Increase in oil prices, INR depreciation, and concerns surrounding liquidity in non-bank financial companies (NBFC) impacted market sentiment domestically Market valuations have come down on the back of the recent correction, with forward P/E now trading at 15.9x earnings growth expectations in India still remain the highest in Asia ex Japan, with 2018 estimates registering a 21% increase versus 13.1% for the region In the coming weeks, news flow around the upcoming state and general elections will impact investor sentiment and market momentum. In early October, the Election Commission announced the polling dates for five state elections - Madhya Pradesh, Rajasthan, Telangana, Chhattisgarh and Mizoram. These elections will begin on 12 November and conclude on 7 December. The results of these polls will be scrutinised as they are the last round of state elections to be held before the general elections in May The ruling party in India - Bharatiya Janata Party (BJP) will go head to head with its main rival, the Congress, in three of the five states Other factors for Indian equity investors to watch out for include corporate earnings, RBI policy actions, global crude price dynamics, rising trends of protectionism in the developed economies and interest rate actions in the US Indian equities saw net outflows of about USD200 million in September. Foreign investors were net sellers in September, while domestic investors continued to add to the market. Year-to-date, domestic investors have added a total of USD 12.2 billion into India equities, while foreign investors have sold USD 2.0 billion in the same period Capital inflows into Indian equities Rolling 12 months net inflow into equity mutual funds (USD billion) Foreign institutional investors Domestic institutional investors Source: Motilal Oswal, SEBI, NSE as of September 2018 Investment involves risks. Past performance is not indicative of future performance. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC accepts no liability for any failure to meet such forecasts, projections or targets 3

4 Sector Views Sector Weighting Sector focus Financials Consumer Discretionary Materials Real Estate Utilities Industrials Telecom Information Technology Health Care Consumer Staples Energy Overweight Overweight Overweight Underweight Underweight Underweight Source: HSBC Global Asset Management as of end-september 2018 The Indian currency s sharp correction against the US dollar this year has helped export-oriented companies, particularly in the software services sector as these companies earn a large portion of their revenues in foreign currencies while a proportionally higher percentage of their expenses are accrued in the local currency The share of services exports, which mainly comprises of software, has increased to 7.3% of India s gross domestic product (GDP) in the June quarter, holding strong when compared with previous quarters. The boost to services exports from a weaker currency is in contrast to overall shipments, which haven t benefited as much from the sliding rupee as they are affected by various supply chain disruptions such as the GST rollout The US is the top destination for India s export of software/ services, accounting for more than 50% of India s total exports in the previous financial year The industry body, National Association of Software and Services Companies (NASSCOM) has projected a growth rate of 7-9% for the Indian software industry in financial year ending in March 2019 The Indian rupee (INR) has been Asia s worst-performing major currency so far this year amidst higher USD funding costs, concerns over trade wars, weaker EM economic momentum, and contagion from select EM countries with weak or deteriorating fundamentals. Most significantly, risk aversion towards economies, such as India, that run current account deficits has worsened, with higher oil prices seen boosting their import bills Two of India s largest software services companies announced their September quarter earnings recently, reporting strong growth in their bottom lines. In addition to the currency weakness, Indian software companies earnings were also boosted by the pick up in the banking and financial services vertical, led by the US market, despite lingering issues such as visa curbs, slowdown in client spend and shift towards automation Chart in focus Contributors to rise in India s trade deficit 1Q FY2017 to 1Q FY2019, in USD billion Oil / Oil products 10.6 Manufactured good ex gold / other precious metals 8.0 Gold / other precious metals 6.7 Others 1.4 Total increase of USD 26.7 billion Source: Ministry of Commerce & Industry, DGCI&S, CMIE, Nomura Research, as of October

5 09/15 10/15 11/15 12/15 01/16 02/16 03/16 04/16 05/16 06/16 07/16 08/16 09/16 10/16 11/16 12/16 01/17 02/17 03/17 04/17 05/17 06/17 07/17 08/17 09/17 10/17 11/17 12/17 01/18 02/18 03/18 04/18 05/18 06/18 07/18 08/18 09/18 10/18 Fixed income The RBI held repo rates unchanged at 6.5% and changed its monetary policy stance to calibrated tightening from neutral Contrary to market expectations, the RBI did not hike rates in its 5 October policy meeting, leaving the repo rate unchanged at 6.5%. The RBI changed its monetary policy stance to calibrated tightening from neutral. The decision to hold rates comes on the back of inflation forecasts for FY2019 being revised down, but with risks to the upside. The RBI action reiterated that inflation, will remain the key anchor for monetary policy and has established that inflation target and currency management will be separately managed The government announced a cut of INR 700 billion in the originally budgeted gross market borrowings for FY2019 to INR 5.35 trillion, due to higher than expected small savings collections and lower buybacks than previously announced. These savings were enhanced by INR 200 billion than were expected in March 2018 RBI in October announced and subsequently conducted OMO purchases for a total amount of INR 360 billion, given expected liquidity deficit during the festive season. This along with reduction in crude prices and stable INR kept bonds well supported. 10-year government bond yields tightened by 16bps month-to-date to 7.87% (as of 25 Oct) India s headline CPI inflation increased marginally to 3.8% year-on-year in September from 3.7% in August on the back of low food price inflation. Core inflation also moderated, although it still remains relatively high From a strategy standpoint, we are underweight duration at the margin, but may look to extend should we see a more positive risk environment. Following the recent relaxation in minimum tenor for corporate bonds for foreign investors, we have increased our holdings of corporate bond papers after having sold corporate bonds in the 10Y segment and government bonds in the 15Y segment without sacrificing yield. We expect to hold this position, since we have no fundamental concerns about the high quality credits we have been buying Yields look attractive vis-à-vis policy rates and inflation (%) Currency RBI s policy on currency management will be limited to the extent of managing volatility and not to target any level The INR depreciated in the first half of the month to above 74 versus the dollar but recovered post the sharp fall in crude prices from the peak levels seen earlier in the month Trade deficit saw a reduction to USD 14 billion in September compared to USD 17.4 billion driven by lower year-on-year growth in imports as compared to the preceding month RBI emphasized on 5 October that rate action would be focused on inflation targeting, and that currency management will be limited to the extent of managing volatility and not to target any level. Source: Bloomberg, HSBC Global Asset Management, Bloomberg data as of 25 October

6 Data watch Indicator Industrial Production (IP) (% YoY) Latest data Consensus data Previous data Analysis 4.3 (Aug) (Jul) The lower yoy IP growth was largely owing to the base effect while the sequential momentum picked up led by capital goods and consumer nondurable goods. Overall, the IP data coupled with an increase in the manufacturing PMI in September should help ease some concerns about the strength of the industrial sector recovery. Local passenger vehicle (PV) sales (units) 292,658 (Sep) (-5.6% YoY) NA 287,186 (Aug) (-2.5% YoY) PV sales were weighed on by rising fuel cost, higher insurance premiums and recent price hikes by auto companies. The government s move to cut fuel prices may bring some respite on this front, while there is some hope for the festival demand, but high inventory levels are a concern. Exports (USD) (% YoY) Imports (USD) (% YoY) Trade Balance (USD) -2.1 (Sep) NA 19.2 (Aug) Lower oil import growth despite higher oil prices as well as lower gold imports during the festival season came as a surprise. The slowdown in oil imports could reflect possible inventory drawdown and normalisation 10.5 (Sep) NA 25.4 (Aug) -14.0bn (Sep) -17.3bn -17.4bn (Aug) given Indian refineries ramped up imports in the past few months before US sanctions became effective; as well as demand adjustment to higher oil prices (but the recent fuel price cuts will reduce demand elasticity to prices). Non-oil export growth stayed tepid, despite this year s INR REER depreciation and partly reflecting a high base. Going forward, the trade balance will likely be driven by oil prices, gold demand, the adjustment to a weaker INR, slower domestic demand growth (curbing non-oil, non-gold imports), the effect of the government s import curbs (but the impact of tariff hikes will likely be limited), remonetisation and improvements in GST refunds (helping an export recovery) and softer global growth. Inflation (% YoY) - CPI - WPI 3.77 (Sep) 5.13 (Sep) (Aug) 4.53 (Aug) The subdued trends in headline CPI is noteworthy considering the higher oil/fuel prices and a sharp increase in the minimum support price (MSP) of winter crops. Food price inflation has been exceptionally benign. Core CPI inflation was relatively sticky but also moderated with normalising housing inflation as base effects (from government employee housing rental allowance, HRA, hikes) reverse. The near-term inflation outlook could be influenced by MSP procurement, festival demand, the cut in fuel prices/taxes (offsetting oil price rises), the FX pass-through of a weaker INR, state HRA, fiscal trajectory, and softer domestic demand growth limiting the impact on core inflation from rising input price pressure. Repo rate (%) Reverse repo rate (%) Marginal standing facility (MSF) rate (%) (5 Oct) (1 Aug) The recent softening in inflation, the meaningful cuts to the RBI s CPI inflation forecasts for this and next year, and the transmission lags of the past rate hikes were the key motivations behind no change in policy rates, amid concerns over a liquidity crunch after one of the country s largest, quasi-public non-bank finance companies defaulted on a series of short-term obligations. The policy decision also sends a clear signal that the central bank would not use interest rate defence as a tool to manage currency weakness, but would respond if inflationary pressure builds up from financial market developments (e.g. INR depreciation). However, the change in the policy stance to calibrated tightening from neutral reinforces vigilance/caution about the inflation outlook. GDP at market prices (% YoY) Gross valueadded (GVA) at basic prices (% YoY) 8.2 (Apr- Jun) 8.0 (Apr- Jun) (Jan- Mar) 7.6 (Jan- Mar) Strong June-quarter GDP growth was on the back of a low base effect (due to the GST and lingering demonetisation impacts last year) and led by a pickup in domestic private demand and a smaller drag from net exports thanks to higher exports. We think the 8%+ growth is unlikely to be sustained and we expect growth to moderate in the near term as the base effect fades amid tighter financial conditions, slower global growth, adverse terms of trade from oil prices and fiscal constraints. Current Account Balance (CAB) (quarterly, balance in USD and % of GDP) -USD15.8b -2.4 (Apr- Jun) NA -USD13.0b -1.9 (Jan- Mar) The wider CAD was led by a larger goods trade deficit while the services trade surplus narrowed slightly. There was a sharp rise in remittances, buoyed by a weaker INR, and a moderation in investment income outflows. A wider CAD plus portfolio outflows and a contraction in short-term trade credit turned the overall balance of payments into the first deficit in six quarters. The CAD is likely to widen beyond 2.5% of GDP in FY19 (vs. -1.9% in FY18), though a weaker INR could help the adjustment with policy measures to address the current account gap and its funding. Indicates improved data on month-on-month/quarter-on-quarter/year-on-year basis Indicates worsened data on month-on-month/quarter-on-quarter/year-on-year basis Indicates no change in data on month-on-month/quarter-on-quarter/year-on-year basis Source: Bloomberg, HSBC Global Asset Management, as of October

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