MUMBAI MONITOR. Quarterly review: decisive election outcome strengthening momentum

For Professional, Institutional and Accredited Investors only. Q3 2014 MUMBAI MONITOR Quarterly Review and Outlook 1-2 India budget: Going for growth 3 Sector review: Cement industry 4-5 Indian fixed income market: Focus on government borrowing and flows 6-7 Quarterly review: decisive election outcome strengthening momentum The positive momentum continued for Indian equities in the second quarter of 2014. The MSCI India 10/40 index gained 13.30% in USD terms over the quarter, driven first by expectations surrounding the general election in May and then by its decisive outcome. After nearly three decades of coalition governments being slow to make policy decisions, the historic victory achieved by the Bharatiya Janata Party (BJP)-led National Democratic Alliance (NDA) should give Narendra Modi s new government a strong mandate to put in place its economic programme and try to boost the Indian economy. While exit polls had already started to give early indications of a BJP victory, the final results surpassed most expectations, with the BJP alone garnering an absolute majority in the Lower House. The market focus is now on reforms. Initial measures and speeches by Narendra Modi s government indicate that it is determined to push through the priorities highlighted during the election campaign. One of the first was the increase in rail fares, which is seen as a key step towards improving the finances of Indian railways. Interestingly, the hike was higher for passenger fares (14.2%) than for freight (6.5%), while historically, governments have tended to increase freight fares more rapidly, thus putting most of the burden on industry. This rebalancing, which could be unpopular, highlights the government s resolve to improve competitiveness of the industry. There were positive indicators signalling a potential re-acceleration of growth. The final figure for GDP growth in the last quarter of the Indian fiscal year (Q1 of calendar year 2014) stood at 4.6% YoY, essentially unchanged from the previous quarter. However, the Index of Industrial Production (IIP) figures gradually improved along the quarter, up by 3.4% YoY in April 2014, compared with drops of 0.5% in March and 1.9% in February. Inflation remained sticky, with the Consumer Price Index (CPI) which is the inflation measure targeted by the Indian central bank first edging up before cooling towards the end of the quarter. CPI inflation surprised positively at 7.3% YoY in June, down from 8.3% in May. The Reserve Bank of India (RBI) left all its key policy rates unchanged during the quarter, sticking to its objective of targeting inflation of 8% by January 2015 and 6% by January 2016. Bloomberg is the source for all data in this article, as of end of June 2014. mumbai monitor

Quarterly outlook: Sustained pace of reforms needed to meet high expectations The new government is already showing its determination to push through measures to re-accelerate growth. In particular, the initial focus has been on removing layers of decision-making by abolishing all the groups of ministers and dissolving cabinet committees to open the door to faster action. In the same spirit, the energy ministry now encompasses both power and coal, which should facilitate coordinated efforts. The corporate affairs ministry has allowed infrastructure finance companies to issue secured debentures with maturities up to 30 years, which should boost infrastructure funding. While these are encouraging signs, more decisive actions are expected. The Union budget, announced in early July (see article opposite), gave investors an opportunity to assess how the government will address its priorities and in particular how it will try to strike a balance between promoting growth and controlling the fiscal deficit. While the budget speech lacked specifics on topics such as the overhaul of the subsidy system, it successfully showed the government s resolve to strike a balance between promoting growth by boosting foreign investment and infrastructure spending, while maintaining the fiscal deficit in check. Beyond the economic agenda outlined in the budget, decisive measures over the next few months will be essential to lift earnings growth expectations and further support the equity market, especially given the risks of potentially weak monsoons and high crude oil prices driven by tensions in Iraq. Monsoon rainfalls were 43% below average in June, which could lead to food price inflation in the coming months. While it is only the beginning of the raining season, July s rainfalls will be critical for sowing. We believe that if the new government addresses the key issues of inflation and employment, it could speed up growth in the medium to long term. Job creation in a country with favourable demographics such as India should boost consumption and be followed by higher investment, ultimately leading to a virtuous growth cycle. Therefore, while there could be volatility in the short term as the pace of recovery is likely to be slower than some expect, we are positive on the outlook for Indian equities in the next two to three years. Are you convinced that the new government s initiatives will lift earnings growth while controlling the fiscal deficit? Share your thoughts now. Bloomberg is the source for all data in this article, as of end of June 2014.

3 - Mumbai Monitor - BNP Paribas Investment Partners - Q3 2014 India budget: going for growth India s finance minister, Arun Jaitley, presented India s much-awaited 2014-2015 (FY15) budget on 10 June. While his speech lacked specifics on topics such as the overhaul of the subsidy system, we think it successfully showed the government s resolve to strike a balance between promoting growth and maintaining the fiscal deficit in check. Beyond the economic agenda outlined in the budget, decisive measures over the next few months will be essential to lift earnings growth expectations and further support the equity market. What was at stake? After the convincing victory of the BJP in May s general election, all eyes were on the new government s first budget. Beyond the overall objective of reviving growth by boosting foreign investment and infrastructure spending, the main expectations were: 1) Fiscal transparency in terms of achievable numbers on subsidies, revenues and expenditure 2) Revival of privatisations as conventional sources of revenue may not suffice to achieve fiscal deficit targets 3) A limit on overall subsidy levels to reduce spending 4) Simplification of the taxation system, while providing a roadmap for the introduction of the long-awaited goods and services tax (GST). Except on fiscal transparency, the budget delivered on most of these expectations, especially on subsidies. Optimistic fiscal assumptions The fiscal deficit budgeted for FY15 was left unchanged compared to the interim budget at 4.1% of GDP versus 4.5% in FY14, a positive surprise since the market had expected an increase to 4.3%-4.5%. The government is targeting an 18% YoY rise in tax revenues in FY15 versus 13% in FY14, which may be difficult to achieve, so divestments could play a key role in keeping the fiscal deficit under control. Meanwhile, the allocation to subsidies was left unchanged at 2% of GDP, which may be too optimistic and result in slippage in offbudget expenditure, or otherwise require subsidy cuts to meet the government s ambitious fiscal deficit reduction target. Boosting infrastructure To boost growth and job creation, the government announced INR 500 billion (around USD 8.3 billion) in projects to expand and improve roads, ports and power infrastructure, as well as tax exemptions to promote investment in small and medium-sized factories. Moreover, close to USD 1.2 billion has been budgeted to develop a hundred small cities. While public spending will be a key driver of the boost in infrastructure spending, the finance minister has stressed the essential role that the private sector needs to play, in particular through the setup of infrastructure investment trusts. Also, banks will be allowed to raise long-term funds (through bond issues) for infrastructure lending, which should help increase the allocation of capital to the infrastructure sector. The economic agenda outlined in the budget announcement is critical in helping to maintain positive investor sentiment, especially given the risks of potentially weak monsoons and relatively high crude oil prices, driven up by tensions in Iraq. While equity valuations now appear fair, decisive economic measures over the next few months will be essential to lift earnings growth expectations and further support the equity market. In your opinion, which measures are most crucial in supporting the equity market? Email us your thoughts? Towards a lower fiscal deficit Beyond these optimistic assumptions for FY15, the good news came in the shape of the government s commitment to mediumterm fiscal consolidation, targeting a fiscal deficit of 3.6% of GDP in FY16 and 3% in FY17. This fiscal discipline should be made possible by a rationalisation of the subsidy system and higher tax revenue. On subsidies, the government intends to move to more targeted food and fertiliser subsidies, and to formulate a new rural policy. On the revenue side, it aims to implement the goods and services tax, without however giving a specific timeframe. A revival of GDP growth should help to increase fiscal revenues. Attracting foreign investors The main measure to attract foreign direct investment (FDI) was the increased cap on defence and insurance sector investment from 26% to 49%. Also, Mr. Jaitley tried to address concerns over retrospective taxation by saying that all new cases arising from the retrospective tax amendments of 2012 would be scrutinised by a high-level committee before any action is taken.

4 - Mumbai Monitor - BNP Paribas Investment Partners - Q3 2014 SECTOR REVIEW: CEMENT INDUSTRY Industry dynamics Cement is the most important building material in any modern economy. It would be difficult to imagine how the worldwide pace of urban and infrastructure development could be maintained without cement. As with so many other commodities, the global cement industry is dominated by China. Chart 1 shows that China leads every other nation, with an estimated production of 2.3 billion metric tonnes (MT) in 2013. India is the second largest market with an estimated production of 250 million MT. Other leading producers include the USA, Iran and Brazil. Chart 1: Major cement-producing countries (2013) Country Production (mn MT) China 2 300 India 250 USA 78 Iran 75 Brazil 70 Turkey 70 Vietnam 65 Source: US Geological Survey, January 2014 However, unlike many other commodities, the cement industry is regional and involves very few trade flows as cement s high volume and low value makes it very costly to transport over long distances. Cement demand in India Demand for cement in India is split across housing (67%), infrastructure (13%) and the construction and industrial sector (20%). Within the housing sector, cement demand is largely skewed in favour of rural India, so the rising trend in rural income levels is a key driver of demand there, while interest rate movements can impact housing demand in urban areas. The government s investment plans are also a key determinant of cement demand growth in the infrastructure sector. Over the past 12 years, cement demand has grown at an annual average of 1.1-1.2x real GDP growth in India. In the future, we believe cement demand in the housing sector will be driven by: 1) favourable demographics; 2) increasing urbanisation; and 3) rising affordability. A gradual recovery of the investment cycle in India (USD 1 trillion projected by the government s Planning Commission for the 12th Five-Year Plan 2012-17) should also support long-term cement demand growth. Chart 2: Per capita cement consumption Country Production (mn MT) China 1 580 Turkey 800 Vietnam 720 World 520 Brazil 350 USA 250 India 195 Source: US Geological Survey, January 2014 Production process Cement is produced in two steps. First, clinker is produced from raw materials (limestone and coal). In the second step, cement is produced from clinker. In the first step, the raw materials (known as raw meal) are crushed and homogenised into a mixture which is fed into a rotary kiln. The raw meal is heated to 2 000 C in the kiln and clinker is formed. The kiln is slightly inclined to allow the clinker to slowly reach the other end, where it is quickly cooled to 100-200 C. The second phase of the process is handled in a cement grinding mill. Gypsum and other cementitious material (such as blast furnace slag, coal fly ash etc.) are added to the clinker to form cement. As can be gauged, the production process is fuel-intensive, so fuel is the highest cost component. Current state of the market in India India s cement demand grew by a modest 1% YoY to 240 million MT in FY14. A slowdown in urban housing, governmentled infrastructure spending and industrial capex resulted in demand growth falling from 7%-8% YoY in the previous two years. The only segment in which demand has been maintained has been rural housing, thanks to the rise in rural income levels, which have grown at double-digit rates in recent years. As demand growth became weaker, pricing also suffered due to over-capacity following a spate of capacity additions since FY10 that outpaced demand growth as seen in the chart 4. The average retail price per 50 kg bag of cement in India fell by 1% YoY to INR 311 1. 1 Source: UBS Securities report dated June 2014 Over the long term, we think there is significant upside potential for demand growth in India, as the country s annual per capita cement consumption is at 195 kg one of the lowest among developing markets. In Brazil it is 350 kg, in China, 1 580 kg, and the global average is 520 kg.

5 - Mumbai Monitor - BNP Paribas Investment Partners - Q3 2014 Chart 3: Capacity additions (mmt) 45 40 35 30 25 20 15 10 5 0 17 7 8 7 6 8 8 34 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14EFY15EFY16EFY17E Change in year end capacity (MMT) Source: UBS Securities report, June 2014 Chart 4: Effective capacity growth versus demand growth (%) 25% 20% 15% 10% 5% 0% 10% 4% 5% 12% 8% 8% 20% 42 29 38 15% 13% 10% 11% 9% 8% 6% 6% 5% 5% 4% 4% 5% 3% 2% FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 YoY total effective capacity (%) YoY demand growth (%) Source: UBS Securities report, June 2014 The region that has suffered the most is the south, which had the highest surplus capacity (mainly in the state of Andhra Pradesh). While capacity utilisation nationally stood at about 68%, in the southern region (which accounts for some 37% of national capacity) it was only about 55% 2. With demand and pricing remaining subdued, cost inflation has remained high. Power and freight expenses were driven by higher diesel prices while raw material costs rose on account of higher fly ash and gypsum prices. The operating margins of most cement companies in India have thus been squeezed down. 26 12 21 15 10 Outlook After a challenging past few years, we expect the industry s future prospects to improve. Falling returns on equity and capital employed will see new capacity additions taper off in the next three years (See chart 3). In any case, it is becoming more and more difficult to set up a greenfield cement plant in India. The number of new limestone extraction leases granted is dwindling and land acquisition has become a costly affair. Coal availability is also not improving as supply continues to lag demand growth. The replacement cost for setting up a 1 million MT per annum plant has doubled in the past seven years. On the demand side, we believe infrastructure spending will be an important growth driver. With a new pro-growth national government in place, we foresee a pickup in infrastructurerelated activities in sectors like roads and railways. In the recently-presented annual Budget for FY15, the government has proposed to build 8 000 kilometres of road in the current fiscal year. In the rail sector, work on the Dedicated Freight Corridor Project will ramp up in the next two years. Apart from the project itself, we believe this will result in a large number of warehouses being built along the route of the freight corridor. Lower capacity growth and stronger demand growth will help improve the industry s capacity utilisation. We expect national capacity utilisation to improve from 68% in FY14 to 75% by FY17 (Source: UBS Securities dated June 2014). Regionally, we expect the western and northern regions to see the highest levels of capacity utilisation as the industry there is fairly consolidated with two dominant major players Holcim (ACC and Ambuja Cement) and Ultratech. 2 Source: UBS Securities dated June 2014 Are you positive on the potential growth of the cement industry? Send us your thoughts.

6 - Mumbai Monitor - BNP Paribas Investment Partners - Q3 2014 Indian fixed income market: focus on government borrowing and flows Update on government borrowing after the India budget The long-term gross market borrowing plan of the government for Fiscal Year (FY) 2015 is in line with the envisaged plan in the interim budget at INR 6 trillion or 6.4% up on FY 2014. However, since this amount is similar to the earlier estimate in the interim budget, there is no pressure expected on the liquidity in the system. Gross borrowings in the form of external assistance are estimated to grow by 19.6% to INR 282 billion from INR 236 billion in FY14. Net borrowing from the internal debt market is likely to increase slightly to INR 4.612 trillion in FY15 from INR 4.539 trillion last year. Net borrowing under external assistance will grow by 5.4% to INR 57 billion in FY15. The implicit interest rate for FY15 appears to have fallen to 6.9% from 7.13% in FY14, which suggests that the government anticipates a decline in interest rates. Moreover, it appears as though interest rates will continue to be inflation-driven and hence are out of the budgetary context. Indian government debt is set to rise by 11.9% in FY15 to INR 49.6 trillion. Internal debt accounts for 96% of overall government debt, and it is estimated that this will grow by 12.3% to INR 47.716 trillion. External government debt will rise by 3.1% to INR 1.884 trillion. It is estimated that the government s other liabilities will rise by 11% to INR 62.226 trillion in FY15 from INR 55.871 trillion last year. FII inflows in fixed income market - year to date (INR bn) Net debt purchases Dated securities T-bills Corp bonds CPs 2013-101 Year to date 916 442 20 239-9.19 Jan-14 129 49 91 0.36-11 Feb-14 185 29 82 39 36 Mar-14 99 42-35 110-18 Apr-14-108 11-32 -59-27 May-14 201 146-64 108 11 Jun-14 186 166-22 41 0.11 Jul-14 224 Source: HSBC, 30 July 2014 We believe that, although the stance of the Reserve Bank of India has become neutral, monetary policy will not be loosened for some time yet. Do you agree that monetary policy is unlikely to loosen for some time? Email your views now. Foreign flows into government securities have reached ownership limit The extension of the 5% withholding tax on all corporate debt issued by Indian companies abroad would bring about muchneeded uniformity in the tax treatment of investors. This move could help attract foreign investors to Indian corporate bonds, thereby deepening the bond market. It would also aid companies in tapping the bond markets to raise funds. The government reiterated the importance of deepening the bond market and the currency derivative markets in the country and regulators have been urged to lower restrictions to help achieve this. Foreign Institutional Investors (FIIs), which have been providing a lot of support to the market by buying into government securities, reached the limit of USD 20 billion (under open category INR 995 billion). FIIs have bought INR 916 billion of Indian debt this calendar year of which INR 442 billion has been in government securities. Since the general election result, USD 5 billion has been bought in government securities.

7 - Mumbai Monitor - BNP Paribas Investment Partners - Q3 2014

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