Market Strategy Monthly

Treasury Research Group For private circulation only

August 29, 2013

Executive Summary
Global outlook: Global economy under transition
The global economy is in a transition phase, as the US economy prepares to shift from an extremely low interest rate regime. The surge in volatility suggest that the Fed QE tapering is coming sooner (i.e. September) rather than later (i.e. December). Sharp surge in US interest rate will have negative implication for US growth while at the same time ramification for EM economies. EM economies are presently exposed to sudden sharp capital outflows as external sector vulnerability has increased over the last few years. EM central banks now faced with a trade-off between growth objectives and stability in bond and currency markets. We believe that the Fed policy makers will adjust the QE tapering program such that the rate normalization cycle is gradual.

State of the Indian economy: Economy in a crucible of uncertainty and volatility

The Indian economy has gone through a watershed period during the past two months, which will structurally alter the way policymakers grapple with macroeconomic decision making. The RBI undertook interest rate defense for a sharply depreciating currency but we should keep in mind the core structural reasons, which has caused this crisis and which require credible and sustainable commitment to long term on ground reforms and not just short term palliatives.

Currency: Rupee remains under tremendous pressure

The depreciation pressure on Indian Rupee persisted through the month of August. The normalization of the US yield curve has led to the significant capital outflows from EM economies including India. To prevent the depreciation pressure in the Indian Rupee, RBI tightened liquidity conditions by raising the short term interest rate. The previous episodes of monetary tightening suggest mixed impact on INR. Indias rising external sector vulnerability too is weighing on Rupee. Creating an enabling environment key to stability in the Indian Rupee.

Rates: Markets under severe stress as RBI strives to save the Rupee
The bond markets have witnessed heavy volatility primarily on RBI's measures as part of the interest rate defense policy strategy to save the Rupee. The yields are likely to remain elevated tracking the Rupee with its fate linked to Fed policy stance and hence the September 17-18 FOMC meeting will remain in focus. Moreover, the extent of inversion of the yield curve will increase with expectations of continued liquidity tightening with the RBI likely to continue with the measures to address FX volatility.

Inflation: Upside risks to inflation from weak Rupee and rising food prices
Inflationary concerns have re-emerged as clearly signaled by the upward surprise in the July WPI inflation print. Going forward, the sharp Rupee depreciation, rising global crude prices and up tick in metal prices, together make a case for upside risks to inflation. Overall, we expect WPI inflation to average 5.7% in FY2014, with an average of ~5.2% in H1-2014 and a sharp rise to average 6.1% YoY in the second-half of the fiscal.

Feature: Analyzing risks to crude oil supply on account of Syria

Although Syria itself is not a major producer of crude oil, however any potential conflict in the country could easily spill over to two major OPEC oil producers - Iraq and Iran. Besides, possible involvement of Iran in any potential conflict could lead to disruptions in oil tanker flow through the Strait of Hormuz (which accounts for 20% of worlds oil trade). In a pessimistic scenario, oil production from Gulf countries (Saudi Arabia, Kuwait, Qatar and UAE) is also likely to be affected, especially if the Strait of Hormuz is disturbed. The future trajectory of oil prices would depend on unfolding events in Syria in particular and the Middle East region in general.

Market Strategy

Global Overview
Samir Tripathi

Global economy in transition

The global economy is in a transition phase, as the US economy prepares to shift from an extremely low interest rate regime which will have a major implication for global growth prospects as well as financial markets. In light of gradual improvement in economic activity in the US, the consensus view seems to be evolving that the ultra easy policy is not sustainable and there are unintended consequences in terms of distorted asset price signals and high inflation down the line. In this regard, it should be noted that the key genesis for the US house price bubble during last decade and the subsequent credit crisis of 2008-09 was led by the prolonged period of easy monetary stance adopted since 2000-01. With gradual recovery in US, the focus has shifted to when and how the Fed would begin the policy normalization process. The surge in volatility in the financial market tends to suggest that the tapering of quantitative easing (QE) is coming sooner (i.e. September) rather than later (i.e. December). The expectation that Fed will taper its asset purchase program, has led to a sharp reversal in US interest rates. As the Fed rhetoric on unwinding its monetary easing stance gained traction in early May, the US Treasury bond market witnessed significant sell off, with 10 year bond yield moving from 1.62% to 2.82% presently. Given the sharp spike in US interest rate since May, a major part of the Fed QE tapering is already there in the price. Also the fact that further rise in US interest rate will have negative implication for growth, the Fed policy makers will take note of the rising macro risk of any such eventuality, especially for an economy growing at a moderate pace. In this regard, it should be noted that US real GDP grew at a stronger-than-expected 1.7% QoQ (ann.) rate in Q2 against consensus expectation of 1.0% QoQ (ann.) rise. Component wise, private consumption and investment sector contributed 2.6 percentage points to growth while external sector/government spending were the key drag on growth, subtracting around 0.88 percentage points from overall growth. The US economy grew by 1.4% at an annualized rate in H12013. In the last FOMC meeting, the Fed expected US GDP growth to be 2.3%-2.6% in 2013. To attain that kind of growth for full year, US economy will have to grow by 3.2%-3.8% in H2'2013. At this point this seems highly unlikely. Further rising yields in the US has also led to a sharp increase in mortgage rates, which may set back the nascent housing market recovery that we have seen so far. On the other hand, the implication of normalization of interest rate cycle in US will have significant ramifications for the EM economies, especially given the fact that these economies were the key beneficiaries of the capital inflows during the monetary easing cycle of 2008-2013.

The global economy is in a transition phase, as the US economy prepares to shift from an extremely low interest rate regime

The surge in volatility suggest that the Fed QE tapering is coming sooner (i.e. September) rather than later (i.e. December).

Sharp surge in US interest rate will have negative implication for US growth

Normalization of yield curve will have ramification for EM economies

Market Strategy

EM economies are presently exposed to sudden sharp capital outflows

With US interest rates rising, interest rates in EM countries have also gone up significantly. The strong capital inflows" to EM economies in the past few years, expose these to large sudden reversals if markets expect an exit from unconventional policies. Normalisation of yield curves in core economies on the backdrop of narrowing growth differentials in the EM-DM space and talks of moderation of stimulus in US have put pressure on EM assets. Further evidence suggests that cross asset correlations have significantly risen during the last five years and therefore there is scope of significant spillover impact on EM equities, currencies, and bond markets. Particularly, the external sector vulnerability has increased in many emerging market economies, especially the ones running current account deficit, resulting in sharp depreciation in EM currencies. Brazilian Real, Indian Rupee, South African Rand and Turkish lira are the key currencies that have depreciated by 15-18% since May 1st 2013. This is further reflected in significant capital outflows from the EM economies in the last few months. For instance, India has witnessed capital outflows to the tune of USD 11.6 bn since May 2013, out of which USD 9.0 bn is from the debt segment and the remaining from the equity markets. Similar trend is witnessed across other EM Asian economies. To accentuate the problem further, the exchange rates volatility has led to pressures on EM debtors and will have negative implications for EM corporates with unhedged FX exposures. Along with this, rising global interest rate scenario will have adverse implications for debt servicing requirements of EM countries. The rise in core economies yield curve have also led to the change in stance of Central Banks in the EM region where they are now faced with a trade-off between growth objectives and stability in bond and currency markets. To conclude, the global economic is in a transitionary phase and the reversal of easy monetary policy stance by the Fed will have implications for both the US as well as global economies especially the EM economies. Rising rates in US has the potential to slowdown growth in general and housing sector in particular. The spillover impact will also be felt in the EM economies, through capital outflows and rising rates, at a time when growth is already adjusting at a lower level. Amidst this backdrop, we believe that the Fed policy makers will adjust the QE tapering program such that the rate normalization cycle is gradual and not disruptive as has been the case during the last few months.

The external sector vulnerability has increased in many EM economies, especially the ones running current account deficit

The exchange rates volatility will have negative implications for EM corporates with unhedged FX exposures. EM central banks now faced with a trade-off between growth objectives and stability in bond and currency markets

We believe that the Fed policy makers will adjust the QE tapering program such that the rate normalization cycle is gradual

Market Strategy

State of the Indian Economy

Kamalika Das

Indian economy in a crucible of uncertainty and volatility

This month witnessed the precipitous fall in the Rupee where it is now within striking distance of the 70 to a Dollar mark and has seen a near monotonic depreciation trajectory for the past few weeks.
The Indian economy has gone through a watershed in the past two months, which is likely to structurally alter the way policymakers view the macroeconomic landscape. This month witnessed the precipitous fall in the Rupee where it is now within striking distance of the 70 to a Dollar mark and has seen a near monotonic depreciation trajectory for the past few weeks. This has predictably shaken the foundations of all theories which are used to come to grips with the scenario. In a snapshot, the most important consequence that we saw in the backdrop of a falling Rupee was that the RBI adopted some form of interest rate defense of the currency. Prima facie, there are broadly a few things that policy makers can resort to in times of a sharp fall in the currency. They are viz. direct intervention through the forex reserves channel, institute growth oriented structural reforms or raise interest rates so that speculating against the home currency becomes costlier. The RBI chose the latter option as it was likely to be the most effective given that structural measures take a few quarters to pan out and our forex reserves do not permit a sustained onslaught on market forces. As a result, we saw the short term bank funding costs raised (read MSF hiked to 10.25%) and the LAF channel curtailed. The RBI has also announced other forms of liquidity withdrawal such as auction of cash management bills every week. However, what came to pass was not a convincing amount of currency stability as the Rupee continued to depreciate and other markets such as equities and bonds reacted very violently in the negative territory. Taking into cognizance these developments, especially on the bond markets, the RBI capitulated a bit recently and made provisions that banks could make accounting changes in lieu of their fixed income portfolio and that the RBI would consider tapering its tightening action as and when required. Since then there has been some degree of calm in the markets and most likely positioning will be ranged in the run up to the crucial Federal reserve meeting due later this month, which is likely to decide the fate of QE tapering. Be that as it may, it stands to reason that although short term measures are important to check the first wave of volatility and to shore up sentiment and in the process arrest capital outflows but we must not lose sight of the core issues that caused the deceleration in the first place. Our external sector has increasingly become more vulnerable over the years and as a case in point, our current account balance has gone up from being roughly balanced during 2004-05 to USD 88 bn last year. This sharp deterioration accompanied with an equally sharp increase in short term debt obligations over the same period of time is a significant cause for concern and needs to be addressed. IIP stagnates for Q1 FY2014
Mining (% YoY) 17 12 7 2 -3 Manufacturing Electricity IIP

The RBI chose to adopt the interest rate defense to stem the sharp fall in the currency

Although short term measures are important to check the first wave of volatility and to shore up sentiment and in the process arrest capital outflows but we must not lose sight of the core issues that caused the deceleration in the first place

GDP growth has declined sharply in FY2013

(% YoY) 12 10 8 6 4 2 0 Q2 FY2006 Q4 FY2006 Q2 FY2007 Q4 FY2007 Q2 FY2008 Q4 FY2008 Q2 FY2009 Q4 FY2009 Q2 FY2010 Q4 FY2010 Q2 FY2011 Q4 FY2011 Q2 FY2012 Q4 FY2012 Q2 FY2013 Q4 FY2013 GDP at factor cost

-8 Aug-12 Dec-12 Jun-12 Jun-13 Oct-12 Apr-13 Feb-13

Source: CEIC, ICICI Bank Research

Source: CEIC, ICICI Bank Research

Market Strategy

The Q1 GDP data for FY2014 is due to be released end August and is unlikely to show any substantial improvement in economic activity as compared to Q4 FY2013, which ended at 4.8% YoY

The Finance Minister in his recent communication has reiterated that the Government is well aware of the problems on the external front and that the current account deficit has to be controlled as soon as possible. To this end, he has committed to a target of CAD at USD 70 bn and has also announced measures on the export front and hiked import duties on mainly precious metals etc. While, this is an important step to begin with but care must also be taken that more deep rooted concerns such as raw material availability, provision of core infrastructure, boosting productivity and enhancing skill component etc are very important for the economy to take the next leap forward to break out of the current vicious cycle and achieve the 8-9% growth rates seen until recently. In this context, we note that the Q1 GDP data for FY2014 is due to be released end August and is unlikely to show any substantial improvement in economic activity as compared to Q4 FY2013, which ended at 4.8% YoY. As far as high frequency data is concerned, the scenario is fairly dismal as industrial production as measured by IIP has averaged -1% YoY for April-June and the services PMI component has gone into contraction territory in July for the first time since 2011. The only comfort seems to be on the agriculture front, where crop sowing data shows that the Kharif crop is well on track and given fairly normal Monsoons we should see some fillip on the farm output side. Apart from this, Government spending in this quarter has also been fairly robust and the Government balance with the RBI steadily decreased over Q1. This may provide some respite to the community, social and personal expenditure front. However, the two more important constituents of services, viz. trade, hotels and financial services are likely to show weak growth. As a consequence, Q1 GDP is also likely to be sub 5% and close to what we ended FY2013 with. With the sharp depreciation in the Rupee, inflationary pressures are likely to keep mounting in the economy and are a source of a parallel macroeconomic concern. In other important developments, the Lok Sabha passed the Food Security Bill, which is set to cover a population of around 82 crores and will entail procurement of around 62 mn tons of grain. The fiscal impact in the current year is however minimal and the full effect will only kick in next year onwards. Given the current rate of sharp increase in oil prices globally, our fiscal arithmetic will be adversely impacted through a rise in oil under recoveries as well. In light of this, there are talks by the Oil Ministry of a INR 5/litre one off hike in diesel prices soon. Although, the fiscal looks to be under stress from food and oil subsidies but the Finance Minister has reiterated firmly that the budgeted estimate will not be breached. Short term rates to remain high for the moment
(%) 12.0 11.0 10.0 9.0 8.0 7.0 Jan-13 Jun-13 May-13 Aug-13 Feb-13 Mar-13 Apr-13 Jul-13 3m T bill

With the sharp depreciation in the Rupee, inflationary pressures are likely to keep mounting in the economy and are a source of a parallel macroeconomic concern

Fiscal arithmetic to be adversely affected by food and oil subsidies but FinMin reiterates that target will not be breached

Inflation showing a sharp uptick

(% YoY) 8.5 8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 Jan -12 Ju l-12 M ay-12 M ar-12 WPI

S ep -12

Jan -13

N ov-12

M ay-13

M ar-13

Ju l-13

Source: CEIC, ICICI Bank Research

Source: Bloomberg, ICICI Bank Research

Market Strategy

Forex Strategy
Samir Tripathi

Rupee remains under tremendous pressure

The depreciation pressure on Indian Rupee persisted through the month of August and the currency has been one of the worst performers in the EM currency basket. Though a part of the sell off in the currency markets reflect the weak domestic fundamentals in some of these EM economies, the timing of the selloff (i.e. May2013- present) suggest that expectation of the normalization of yield curve in the US is the key trigger for the capital outflows from the EM economies.

The depreciation pressure on Indian Rupee persisted through the month of August

What is driving EM currency markets?

The normalization of the US yield curve has led to the significant capital outflows from EM economies.
The normalization of the yield curve i.e. the unwinding of the monetary policy stance in the US has led to the selloff in the US bond market, with the 10 year treasury yield rising from a low of ~1.65% in April end to ~2.72% presently. The reversal in the US treasury market has acted as the trigger for the rotation out of bond funds both in US and EM economies. This is reflected in significant capital outflows from the EM economies in the last few months. For instance, India has witnessed capital outflows to the tune of USD 11.6 bn since May 2013, out of which USD 9.0 bn is from the debt segment and the remaining from the equity markets. Similar trend is witnessed across other EM Asian economies. As a result, since early May the correlation between 10 year US Treasury yield and the EM currency basket has increased sharply.

To prevent the depreciation pressure in the Indian Rupee, RBI tightened liquidity conditions by raising the short term interest rate

Previous episodes of interest rate defense has mixed success in combating INR depreciation
To address the capital outflows and thereby prevent the depreciation pressure in the Indian Rupee, RBI has announced a series of measure to tighten liquidity conditions by raising the short term interest rate. In this regard, we looked at the three previous episodes (i.e. East Asian crisis (1997-98), Tech Bubble (2000-01) and Global financial crisis (2007-08)) where in the RBI has raised interest rate. Out of the three episodes, during the East Asian crisis and Tech bubble episode, RBI measures were aimed toward addressing the Rupee volatility, during the Credit crisis of 2008-09, RBI aimed to check inflation by tightening monetary policy. thereby weighing on Emerging Market currencies
Correlation with US Treasury 10 year yield 1.0 Jan-April 2013 May 2013 -present

Reversal in US Treasury market has acted as the trigger for rotation out of bond funds
(%) 3.1 2.7 2.3 1.9 1.5 M ay-13 Aug-13 Jan-13 Jun-13 M ar-13 Apr-13 Feb-13 Jul-13 US 10 year bond yield

0.6

0.2

-0.2

-0.6 USDZAR USDMYR USDBRL USDTRY USDINR USDIDR

Source: Thomson Reuters, ICICI Bank Research Source: Bloomberg, ICICI Bank Research

Market Strategy

The key takeaways from the previous episodes of monetary tightening measures:-

The previous episodes of monetary tightening suggest mixed impact on INR

The duration of monetary tightening measures announced during the previous three episodes lasted between 2-6 months The impact of monetary tightening on USDINR is mixed. During the Tech bubble episode, INR appreciated in the aftermath of the policy reversal, in the other two episodes, INR continued to depreciate in the ~10-16% range, even after the reversal of the policy measures. Monetary tightening measures partly led to growth slowdown during the Tech bubble episode (2001) and the more recent credit crisis of 2008-09. During these periods, monetary tightening lasted for ~6 months.

The previous episodes depreciation pressure was led by external factors. Indias rising external sector vulnerability too is weighing on Rupee

Indias growth during 2001 and 2008-09 was also impacted by overall slowdown in global economy.

Takeaways for the present

As a caveat, the past three episodes of heightened uncertainty discussed above, were primarily on account of external factors. In the present episode, although Fed QE tapering triggered the depreciation in INR, worsening domestic fundamentals and rising external sector vulnerability too is weighing on Rupee sentiment. The external vulnerability has worsened in the last few years, in light of the rising current account deficit. In terms of financing the current account deficit, though the stable sources of capital (i.e. FDI and ECB) has played a crucial role in financing a part of the deficit, in the recent years i.e. 2010 onwards, reliance on portfolio related flows have a key role in financing the CAD. This has increased Rupees vulnerability in the recent years.

Creating an enabling environment key to stability in the Indian Rupee

Creating an enabling environment for stability in FX market

Any policy announcement towards providing stability in FX market will require a.) Encouraging stable capital flows in the near term and b.) Initiating urgent structural reforms. Though the outlook for the capital flows will to an extent depend on external development i.e. Fed policy meeting scheduled for September 18th, the creation of enabling environment will go a long way in attracting the stable source of flows i.e. FDI in the medium to long term.

USD/INR performance in previous episodes of monetary tightening measures

External vulnerability has worsened in the last few years, in light of the rising current account deficit
(USD bn)

Financing the CAD (CAD+FDI+ECB)

10 5

East Asian financial crisis Tech bubble Global Financial crises

USDINR performance during the period 2 Qrt prior During the period 8.6 -0.4 2.7 4.7 -2.2 9.8

2 Qrtpost 9.9 0.8 16.4

0 -5 -10 -15 -20 Growing external sector vulnerability

Source: Reuters, ICICI Bank Research

M a r-00

M a r-01

M a r-02

M a r-03

M a r-04

M a r-05

M a r-06

M a r-07

M a r-08

M a r-09

M a r-10

M a r-11

M a r-12

Source: Bloomberg, ICICI Bank Research

M a r-13

Market Strategy

Fixed Income Strategy

Kanika Pasricha

Markets under severe stress as RBI strives to support the Rupee

Bond markets are witnessing heavy volatility as the RBI has adopted an interest rate defense for the Rupee
The bond markets have witnessed heavy volatility over the last two months as part of the global EM debt sell off amidst concerns regarding tapering of its quantitative easing (QE) program by the US Fed later this year and more importantly, on RBIs measures as part of the interest defense policy strategy to save the depreciating Rupee. Since early May, the Rupee has depreciated more than 20%, while the 10-year bond yield has risen more than 150 bps to trade above a new threshold of 9%. The slew of measures announced by the policymakers to stabilize the Rupee and address the hardening of yields at the longer-end of the yield curve have shown limited effect amidst weak investor sentiment. RBI has adopted an interest rate defense for the Rupee and kept gilts under pressure The Indian currency has been the worst affected on account of concerns over tapering of QE program by the US Fed, given our elevated current account deficit and weak domestic fundamentals amidst slowing growth and rising inflationary concerns. Against this backdrop, the RBI decided to adopt an interest rate defense for the Rupee by increasing the cost of Rupee liquidity and support debt flows amidst rise in yields especially for the shorter tenure. Since 15th July, the RBI has adopted a slew of liquidity tightening measures as highlighted in the section above. The liquidity tightening measures were introduced in various tranches amidst persistence of depreciation pressure on the Rupee and in order to ensure that the call rate trades consistently at the higher end of the policy corridor at 10.25%. The measures have led to a rise in systemic liquidity deficit to `1100 bn currently as against ` 630 bn as of end-June. Our projections show that the liquidity deficit is likely to increase beyond `1.5 trillion in September amidst advance tax outflows, if the RBI continues with the liquidity tightening measures to support the Rupee.

Rupee under pressure on domestic fiscal, growth & inflation issues coupled with Fed QE tapering concerns RBI has tightened liquidity and increased cost of liquidity to harden yields and support debt flows

Yield curve has inverted sharply since July 15th

The consequent tightening of the liquidity situation has led to an inversion of the yield curve, with the 3-month and 10-year yields rising by ~3% and ~1.5% since 15th July. The heavy supply pressures in August (`790 bn) have put an additional upward pressure on the yields. This led the authorities to announce some measures to address the market conditions. Yield curve has inverted sharply Gsec demand-supply dynamics reflect need for OMO buybacks
(%) 11.5 11.0 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 2Y 3Y 4Y 5Y 6Y 6Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 19Y 24Y 30Y 3M 6M Yield curve 23-Jul 15-Jul 27-Aug

Source: Bloomberg, ICICI Bank Research

Demand and Supply for G-secs (` bn) Supply FY2013 FY2014 Dated securities 4675 4840 Tbills 280 198 Net SDL issuance 1453 1453 Total 6408 6491 Demand FY2013 FY2014 SLR demand by banks 2360 2630 Demand from PFs & insuance companies 1803 1830 Demand from Mutual funds 350 200 Demand from FIIs 210 0 Demand from RBI 1685 1831^ Total 6408 6491 Excess demand/(supply) ^Depending upon RBI policy objectives at various points of time #assuming 29% of NDTL and 14% deposit growth Source: RBI, ICICI Bank Research

Market Strategy

To limit the hardening of yields at the longer end of the curve, the RBI has announced various measures to address market conditions

The RBI has decided to conduct OMOs to ease the pressure at the longer-end of the yield curve. The RBI has been a key buyer of duration in the last few fiscal years, with the OMO purchases worth more than `1600 bn in FY2013. Our Gsec supply-demand projections also reflect the need for ~`2000 bn worth demand from the RBI to match the heavy supply requirements. Moreover, the pace of liquidity tightening through cash management bill sales is likely to be calibrated and scaled down as and when stability is restored in the Rupee market. Further, the banks have been allowed to limit the accounting losses on Gsec investments by transferring a part of trading portfolio into HTM up to 24.5% of NDTL. Various implications of liquidity tightening measures The interest rate defense for the Rupee has helped reduce the pace of FII outflows from the debt markets to USD 1.2 bn in August versus USD 7.6 bn cumulative in June and July. Nevertheless, the extent of FII debt utilization has slipped from 55% of the limits in early May to 37% currently. Rise in cost of borrowing has led various banks to raise base rates over the last fortnight. This has increased downside risks to our FY2014 growth projection as it would delay the recovery in investment cycle. Gsec trading volumes have declined sharply with the average gross volumes declining to ` 160 bn in August-2013 versus ` 550 bn in April. Market liquidity has reduced sharply in various market segments like CPs and CDs, with the issuances in CP and CD market slipping to ` 66.0 bn and ` 32.4 bn respectively in the second fortnight of July versus ` 277.2 bn and ` 105.9 bn in the last fortnight of April. Mutual funds as market participants have shifted their funds deployment towards CBLO markets from CD market. The latest data for the month of July-2013 shows that the funds have reduced their investments in CDs by ` 350 bn, while their CBLO market exposure has been increased by ` 380 bn. Despite the rise in downside risks to growth, the credit growth has surged to 16% levels as per the latest data. This is possibly attributable to the substitution of CP issuances with the relatively cheap bank credit by the corporates. A similar trend is being witnessed in case of NBFCs. Moreover, mutual funds witnessing heavy redemption pressures are taking the OD facility against FD from the banks, to meet the demand for funds.

The steps taken to protect the Rupee have led various banks to raise base rates and have affected liquidity in various market segments like CPs, CDs

However, credit growth has spiked given the relatively cheap funding available through banks

Yields to remain elevated amidst a pressured Rupee Bond markets remain under intense pressure tracking the Rupee with its fate linked to Fed policy stance. In this context, the September 17-18 FOMC meeting is in focus. Moreover, the extent of inversion of the yield curve will increase with expectations of continued liquidity tightening with the RBI likely to continue with the measures to address FX volatility. Credit growth above 16% on market disruptions FII debt utilisation has dropped to sub 40%
credit-deposit ratio (RHS) (% YoY) 21 19 17 15 13 11 Aug-11 Aug-12 May-12 May-13 Aug-13 Nov-11 Nov-12 Feb-12 Feb-13 Aggregate deposits Credit (%) 80 78 76 74 72 70
1 Government Debt

Yields to remain elevated amidst persistence of depreciation pressure on the Rupee

S.No

as on

FII debt Utilisation Status 27-Aug

10-May

Type of Instrument

Debt Debt Upper Cap Upper Cap utilization utilization (USD bn) (%) (USD bn) (%)

(i) (ii) ^^
1(a) 2 2(a) Treasury Bills
Corporate Debt

30.0 25.0 5.0

5.5 51 3.5

Commercial Papers
Grand Total

81.0

43.8 52.5 6.4 60.7 33.0 69.5 37.1

25.0 25.0 0.0

5.5

51.0 3.5 76.0

76.4 76.4 0.0 93.8 43.6 81.5 54.7

Source: Bloomberg, ICICI Bank Research

^^Investments by long-term investors such as SWFs, multilateral agencies, pension & insurance funds and foreign central banks Source: NSDL ICICI Bank Research

Market Strategy

Inflation
Kanika Pasricha

Upside risks to inflation from weak Rupee and rising food prices
WPI inflation provided a sharp upward surprise in the July print
Inflationary concerns have re-emerged as clearly signaled by the sharp upward surprise in the July WPI inflation print that came in at 5.79% YoY versus consensus estimate of 5% YoY and a full percentage point higher compared to 4.7% average inflation in Q1 FY2014. Looking at the details of the July inflation print, the food inflation spiked to 11.9% YoY versus 9.7% YoY in the previous month. This is primarily attributable to a 46.6% YoY rise in vegetables prices amidst a 144.9% YoY increase in inflation in onions. Further, fuel inflation increased to 11.31% YoY versus prior reading of 7.12% YoY. The sequential momentum of the fuel index jumped to 3% MoM as against 1.1% MoM, with a contribution of 8.2% MoM from the nonadministered component while the administered prices increased by 1.36% MoM. Moreover, the non-food manufactured products inflation rose to 2.33% YoY after slipping to a 3 year low of 2.1% YoY in June. The sharp Rupee depreciation has pressured the manufacturers to raise prices in spite of weak pricing power, with the sequential momentum of core inflation increasing to 0.53% MoM, highest since April-2012. Going forward, the sharp Rupee depreciation, rising global crude prices and up tick in metal prices, all together make a case for upside risks to inflation in the near term. The core inflation component is 55% of the WPI basket and 50% of this basket is composed of metals and chemicals, with their domestic prices are determined by the import parity prices (in INR terms). Hence, Rupee depreciation is likely to have a significant impact on core inflation. The authorities are also considering a one-time hike in diesel prices by ` 5/L given that the rising global crude prices amidst geopolitical tensions in the Middle East has led to a rise in diesel under-recovery to `10/L from `3/L in lateApril. The 20% depreciation in the Rupee coupled with rise in crude and metal prices is likely to feed into core and non-administered fuel inflation. Overall, we expect WPI inflation to average 5.6-5.8% in FY2014, with an average of ~5.2% in H1-2014 and a sharp rise to average 6.1% YoY in the second-half of the fiscal. We also expect the core inflation to surge past 3% levels in H2 FY2014, with rising upside risks to this component. INR depreciation poses upside risks for core inflation
CRB index (% YoY) 30.0 15.0 0.0 -15.0 -30.0 Aug-12 Sep-12 Jun-13 Jan-13 May-13 Aug-13 Dec-12 Oct-12 Nov-12 Mar-13 Apr-13 Feb-13 Jul-13 CRB (INR adjusted) WPI-core (RHS) 8.0 6.0 4.0 2.0 0.0

There was a broad based spike in sub-components

Core inflation increased as manufacturers decided to pass on the rising costs due to Rupee depreciation Going forward, Rupee depreciation, rising global crude prices and up tick in metal prices, pose upside risks to inflation

We expect WPI to average 5.7% in FY2014, with core inflation likely to surge past 3% mark in H2 FY2014

Non-administered price increases amidst elevated global crude prices driving fuel inflation
Fuel inflation (% YoY) 40 30 20 10 0 -10 Jan-11 Jan-12 Jan-13 Jul-10 Jul-11 Jul-12 Oct-10 Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Jul-13 Non-administered Administered (RHS) (% YoY) 18 16 14 12 10 8 6 4 2 0

Source: Bloomberg, ICICI Bank Research

Source: Bloomberg, ICICI Bank Research

10

Market Strategy

Feature: Analyzing risks to oil supply on account of escalating tensions in Syria

Tadit Kundu Crude oil prices hovering around the highest levels in six months

Brent crude oil price breached the USD 117/bbl level on Wednesday for the first time in six months Recent statements by US officials have raised speculation of possible military action

The Brent oil price on Wednesday breached the USD 117/bbl level for the first time in six months, as speculation rose that the US might conduct military strikes against the Syrian Government (over the episode of an alleged chemical weapons attack in Syria). The Brent price is currently hovering around USD 116/bbl, while WTI is hovering around USD 111/bbl. Recent statements by US and UK Government officials have raised speculation of possible military action. Meanwhile, US reportedly moved four warships in the Mediterranean Sea, close to the Syrian coast. The analysis below tries to put in context the risks to oil supply emanating from any potential conflict around Syria.

A confluence of geopolitical issues Syria, Libya and Egypt have raised risks to oil supply from the Middle East and North Africa region

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Market Strategy

A. Why is Syria important for oil supply? Syria per se is not a major oil producer Syria currently produces around 28,000 barrels of oil per day (bpd), which is only 0.03% of global oil output. Even at its peak, before the outbreak of the Civil War, Syrian oil output was around 360,000 bpd (0.4% of global oil output).

Syria per se is not a major oil producer

Syria is not even a major oil transportation route: Unlike Egypt, which controls the important Suez canal, Syria cannot claim to control any important oil supply route. The Kirkuk-Baniyas oil pipeline, which used to transport oil from Iraq to Syrian coast, has remained out of operation since 2003. In short, Syria, per se, is not important for the global oil market.

However, Syria risks engulfing the entire region

However, Syria risks engulfing the entire region Owing to history and demographics, any potential Syrian conflict is very likely to affect the neighbouring countries of Iraq and Lebanon, besides Iran. Of them, Iraq and Iran are major oil producers and OPEC members. A.1. Possible effect on oil supply from Iraq Iraq has shown rise in political violence in recent days, tied to happenings in Syria. According to the UN, the Iraq conflict death toll in July 2013 topped the 1000-level, the highest since April 2008. Consequently, there remain concerns that oil facilities in Iraq might be disrupted if the Syrian conflict escalates and Iraq becomes a proxy battleground. Meanwhile, a conflict in Syria can also threaten the crucial 335,000 bpd KirkukCeyhan pipeline, which transports oil from Iraq to Ceyhan oil terminal in Turkey and runs close to the Turkey-Syria border.

Iraq has shown rise in political violence in recent days, tied to happenings in Syria

Syrias crude oil output, even at its pre-War levels, amounted to only 0.4% of global output
('000 bpd) 400 350 300 250 200 150 100 50 0 Jan-11 Jan-12 Jan-13 Jul-10 Jul-11 Jul-12 Oct-10 Oct-11 Apr-11 Apr-12 Oct-12 Apr-13 Jul-13 Syria crude oil output

Conflict poses risks to 335,000 bpd Iraq-Turkey oil pipeline that runs along Turkey-Syria border

Source: Bloomberg, CICI Bank Research

Source: News reports, ICICI Bank Research

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Market Strategy

Iran has diplomatically supported the Assad Government in Syria There remain concerns that the Syrian conflict might engulf Iran, thereby prompting disruptions to oil tanker flow through the Strait of Hormuz

A.2. Possible effects on Iran Iran has diplomatically supported the Assad Government in Syria. Various reports have alleged that the Iranian Government is also materially supporting the Assad Government. Involvement of Iran in the conflict could further reduce its oil exports, already strained under US-EU sanctions. A.3. Possible effects on the Strait of Hormuz The Strait of Hormuz is a narrow waterway between Oman and Iran. It is an important oil transit route, transporting around 17 mbpd of oil from the Middle East region. Iran had previously threatened to close the Strait in case of hostilities. There remain concerns that the Syrian conflict might engulf Iran, thereby prompting disruptions to oil tanker flow. B. Other geopolitical issues in the Middle east region B.1. Libya: strikes disrupt oil export terminals Persistent political unrest and strikes by workers/security guards has led to intermittent shutdown of the countrys export terminals. Therefore, Libyas oil output fell to 0.8 mbpd in July from 1.4 mbpd in March. B.2. Egypt: Continued unrest could endanger Suez oil flow Egypt remains in a state of flux since a Government change in early July. There remains possibility that tanker movement across the Suez canal might be disrupted. However, the probability of such an event is as yet minimal. Moreover, Suez canal shutdown would only impose manageable hurdles to global crude oil movement. C. Overall picture: A confluence of factors has significantly increased geopolitical risks

Continued political unrest in Egypt and Libya have added to concerns over stability of oil supply from the region

In a pessimistic scenario, oil production from Gulf countries (Saudi Arabia, Kuwait, Qatar and UAE) is also likely to be affected, especially if the Strait of Hormuz is disturbed

Thus, we already see conflict in Syria, Libya and Egypt along with concerns of conflict quickly engulfing Iraq and Iran In a pessimistic scenario, oil production from Gulf countries (Saudi Arabia, Kuwait, Qatar and UAE) is also likely to be affected, especially if the Strait of Hormuz is disturbed US military presence in both the Mediterranean Sea and the Persian Gulf adds to tensions Consequently, oil prices are likely to climb even higher in the next few days and could touch USD 120/bbl. The future trajectory of oil prices would depend on unfolding events in Syria in particular and the Middle East region in general consequently crude oil prices have spiked in recent days
(USD/bbl) 120 116 112 Brent WTI

In a pessimistic scenario, the Syrian conflict poses risks to oil supply from the Middle East
World July crude oil production (% of world total) Saudi Arabia Iran Other ME* nations Iraq Outside ME*

Ou tsid e M id d le E a st (74% )

108
M id d le E a st* (26% )

104 100 3-Jul 10-Jul 17-Jul 24-Jul 31-Jul 7-Aug 14-Aug 21-Aug 28-Aug

ME*: Middle East (Egypt & Libya included for calculation purposes) Source: Bloomberg, ICICI Bank Research

Source: Bloomberg, ICICI Bank Research

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Market Strategy

Real GDP Agriculture Industry Services IIP PMI WPI inflation CPI inflation

Unit % YoY % YoY % YoY % YoY % YoY Index % YoY % YoY

Key macroeconomic Indicators Period Latest Previous Q4 FY13 4.8 4.7 Q4 FY13 1.4 1.8 Q4 FY13 2.7 2.5 Q4 FY13 6.6 6.7 Jun-13 -2.2 -2.8 Jul-13 50.1 50.3 Jul-13 5.8 4.9 Jul-13 9.6 9.9

FY13 5.0 2.0 2.1 7.1 1.2 53.7 7.4 10.2

FY12 6.3 3.7 3.5 8.2 3.1 54.5 9.0 8.4

Exports Imports Trade balance Current Account Capital Account BOP FX reserves

Unit % YoY % YoY USD bn USD bn USD bn USD bn USD bn

External Sector Indicators Period Latest Jul-13 11.6 Jul-13 -6.2 Jul-13 -12.3 Q4 FY13 -18.2 Q4 FY13 20.5 Q4 FY13 2.7 16-Aug-13 278.8

Previous -4.6 -0.4 -12.2 -31.8 31.5 -0.2 278.6

FY13 -2.7 0.8 -194.7 -88.2 89.3 3.8 0.3

FY12 24.7 32.8 -183.4 -78.3 67.9 -12.8 0.0

Leading indicators Unit % YoY % YoY % YoY % YoY % YoY Period Jul-13 Jul-13 Jul-13 May-13 Jul-13 Latest -1.3 -2.5 -16.9 -6.4 6.3 Previous -4.3 -12.1 -23.1 -5.9 7.9 FYTD 0.9 -4.9 -22.3 25.3 18.7 Corresponding period last year 12.3 5.1 2.6 45.0 14.7

Auto Sales Passenger Cars Commercial Vehicles Cellular Subscribers Railway freight

Monetary Indicators Unit INR bn % YoY INR bn % YoY INR bn % YoY INR bn % YoY INR bn % NDTL Period 16-Aug-13 9-Aug-13 9-Aug-13 9-Aug-13 9-Aug-13 Latest 15725 7.1 55091 16.6 71037 14.1 87697 12.2 21871 28.3 Previous 15637 7.1 54053 13.5 70869 13.7 87390 12.5 22167 28.8 FYTD avg 14429 23 46050 17 60786 15 76134 15 21701 28.8 Corresponding period last year 11717 103 39380 19 52995 15 66467 16 19356 29.0

Reserve Money Credit outstanding Aggregate Deposits Money Supply SLR investment

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Market Strategy

Fiscal Deficit as a% of budgeted Total Expenditure as % of budgeted Total Receipts as a % of budgeted

Unit % % %

Period

Fiscal Indicators Latest 48.4 23.0 10.6

Previous 33.3 13.1 3.3

FY13 94.0 98.5 101.1

FY12 98.9 98.9 98.9

June FY2013 June FY2013 June FY2013

RBI Action Cumulative change in FYTD (bps) -25 -25 0 FYTD 2,840 227 0 0 Cumulative change in FY13 -100 -100 -75 FY13 5460 1550 0 0

Policy Rates Repo rate Reverse Repo CRR Auctions Dated security auction OMO Purchase SMO Purchase MSS buyback

Unit % % % Unit INR bn INR bn INR bn INR bn

Period 28-Aug-13 28-Aug-13 28-Aug-13 28-Aug-13 28-Aug-13 28-Aug-13 28-Aug-13

Latest 7.25 6.25 4.00 Latest 150 62.3 0 0

Previous 7.50 6.50 4.25 Previous 150 96.6 0 0

Market Indicators Unit Index % % % % % Period 28-Aug-13 28-Aug-13 27-Aug-13 27-Aug-13 28-Aug-13 28-Aug-13 28-Aug-13 Latest 17852.10 68.16 9.98 8.88 9.07 7.60 10.31 Last month avg 18899.77 61.90 9.92 8.77 8.57 7.44 9.63 % change since last month -9.86 15.31 5.51 4.72 9.02 4.11 42.21 FYTD 0.90 53.36 91.94 13.55 31.85 19.69 177.90

BSE Sensex Exchange Rate (USD/INR) 364-day T-Bill 10-yr GOI bill OIS (5-year) MIFOR (5-year) MIBOR (NSE)

Global snapshot Last month avg 1.3322 1.55 97.81 0.93 15307 6544 13804 50.6 0.26 23.7 % change since last month 0.69 0.88 -0.77 -1.01 -5.0 -2.1 -5.6 0.2 -1.9 24.2 CYTD -6.7 -3.9 4.7 -11.2 41.7 18.5 26.5 0.2 2.0 23.2

Unit Euro British Pound Japanese Yen Swiss Franc DOW FTSE Nikkei Global PMI USD Libor 3mth Ted Spread % bps

Period 28-Aug-13 28-Aug-13 28-Aug-13 28-Aug-13 28-Aug-13 28-Aug-13 28-Aug-13 Jul-13 27-Aug-13 27-Aug-13

Currencies

Latest

Equities

1.3370 1.5517 97.45 0.919 14776 6415 13338 50.8 0.26 19.9

Others

15

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Economics Research Sunandan Chaudhuri Kamalika Das Kanika Pasricha Samir Tripathi Tadit Kundu Rupali Sarkar Pooja Sriram Nikhil Gupta Shanjukta Nath Senior Economist Economist Economist Economist Economist Economist Economist Economist Economist (+91-22) 2653-7525 (+91-22) 2653-1414 (ext 6280) (+91-22) 2653-1414 (ext 2260) (+91-22) 2653-7233 (+91-22) 2653-1414 (ext 2087) (+91-22) 2653-1414 (ext 2023) (+91-22) 2653-1414 (ext 2023) (+91-22) 2653-1414 (ext 2180) (+91-22) 2653-1414 (ext 2085) sunandan.chaudhuri@icicibank.com kamalika.das@icicibank.com kanika.pasricha@icicibank.com samir.tripathi@icicibank.com tadit.kundu@icicibank.com rupali.sarkar@icicibank.com pooja.sriram@icicibank.com nikhil.gupta@icicibank.com shanjukta.nath@icicibank.com

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