india outlook - nomura

8/3/2019 India Outlook - Nomura

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Rolling back the clouds

Macro risks near term butlargely discounted, see muchimproved second half

We expect growth in India to stay slow, inflation to slowly ease, therupee to be weak near term and rate cuts to happen with a lag.

In this environment, we prefer banks and exporters such as IT and

pharma to capital goods and autos. We are also underweight theconsumer sector. We would play the investment cycle throughcement rather than infrastructure.

Our top picks are SBI and Axis Bank on a more benign rate

environment, and exporters like Infosys and Lupin on the weak

rupee. We like Power Grids regulated return profile.Key analysis in this anchor report includes:

Outlook for economic growth and the investment cycle Why we expect the rate-cutting cycle to be back-ended in 2012 if

further rupee pressure disrupts the fall in inflation momentum

A look at the near-term currency headwinds due to concerns aboutcapital flows and Europe

How valuations stack up historically. We see 15-20% market upsidethrough the year

EQUITY RESEARCH

A

NCHOR

REPORT

January 13, 2012

Research analystsIndia Strategy

Prabhat Awasthi - NFASL

[email protected]+91 22 4037 4180

Nipun Prem - NSFSPL


Sanjay Kadam - NFASL


And the India Research Team

See Appendix A-1 for analystcertification, importantdisclosures and the status ofnon-US analysts.

India outlook 2012


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India outlook 2012EQUITY STRATEGY

EQUITY RESEARCH

ANCHOR REPORT: Rolling back the clouds

Macro risks near term butlargely discounted, see muchimproved second half

January 13, 2012

Macro risks near term, but largely discounted; we see a much

improved 2H

Taking stock of Indias macroeconomic variables today makes fordepressing reading. Policy inaction, rising rates and an adverse global

environment have taken a toll on growth. A fragile external account hascaused the rupee much distress, particularly against a backdrop of

volatile global risk sentiment. Politics and policy continue to disappointand populism has elevated the fiscal deficit.

We start 2012 against this backdrop. The bad news is that not muchis likely to change in the 1H of this year. The sharp depreciation of

the rupee on global cues has hijacked inflation. India has to fund its highcurrent account deficit; there are also large debt repayments to contend

with. This is likely to create growth and currency headwinds as capitalinflows are constrained by the ongoing European crisis.

The good news is that these headwinds are temporary and arelikely to dissipate in 2H12. Capital constraints should ease as slower

growth and a weaker rupee rein-in the current account and debtrepayments run their course. Cooler growth and range-bound global

commodity prices are likely to accelerate the downtrend of inflation. The

rupee could well appreciate on these cues. Growth may well remainsubpar as the impact of rate cuts lifts the economy with a lag. However,

we believe India will continue to enjoy high growth differentials.

With the market earnings multiple at a 23% discount to its 5-yearaverage, market valuations are fairly pricing in the negativescenario, in our view. Growth plays and domestic cyclicals have been

punished, while strong cash flows and consumer-facing companies havebeen rewarded. There could be some risk to earnings, but no more than

5%, we think.

We acknowledge that the positive dynamics could well take about

six months to kick in. However, we could well move towards a more

benign rate environment in this period. The backdrop for equities in the

1H12 is likely to be slowing growth, gradually falling inflation, weakrupee and a peaking rates cycle. We prefer banks and exporters (IT

and pharma). We are underweight capital goods, infra &construction, autos and global cyclicals.

Fig. 1: Stocks for Action

Source: Nomura research ricin asof 6 Jan

Anchor themes

The backdrop for equities in1H12 would be slowing growth,gradually falling inflation, a

weak rupee and an improvingrate environment. Our key stockpicks are the rate cyclicals,SBIN and AXSB, and exporters,INFO and LPC. We also likePWGR as a defensiveregulated utility.

Research analysts

India Strategy

Prabhat Awasthi - NFASL

[email protected]

+91 22 4037 4180

Nipun Prem - NSFSPL


Sanjay Kadam - NFASL


And the India Research Team

Stock Rating Price TP Upside/Downside (%)

State bank of India (SBIN IN) Buy 1,672.8 2,400 43

Axis Bank (AXSB IN) Buy 853.5 1,400 64

Infosys Technologies (INFO IN) Buy 2,832.2 3,300 17

Lupin (LPC IN) Buy 442.9 576 30

Power Grid (PWGR IN) Buy 99.8 120 20

See Appendix A-1 for analystcertification, importantdisclosures and the status ofnon-US analysts.


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Nomura | India outlook 2012 January 13, 2012

2

Contents

4 Executive summary

6 Sector strategy

7 Growth has been a casualty; we expect a couple of quarters of tepidgrowth before recovery

12 Digging deeper into investments

17 The rupee: capital flows and eurozone concerns

23 Inflation: Less of a risk this year provided the rupee does not weakenfurther

28 Rates cuts to likely be back-loaded if further rupee pressure disruptsfall in inflation momentum

29 Valuations not demanding and are pricing in a significant cut toearnings, but waiting for triggers

31 Earnings expect some downside to FY13F earnings

34 Policy and political economy a clouded picture

36 Key themes

38 Long-only basket

39 APPENDIX

45 Economics

45 Policy holds the key

47 Sector outlooks

49 Autos & auto parts

51 Banks

53 Cement

55 Coal

57 Consumer

59 Infrastructure

61 IT services

Also see our Anchor Report: Asia

Pacific outlook 2012 So the world

doesn't end after all(5 December, 2011)
http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=478110&cid=XpzDLUBExW4=


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3

64 Metals & mining

66 Oil & gas/chemicals

68 Pharmaceuticals

70 Power & utilities

72 Property

74 Telecoms

77 Company profiles

79 Axis Bank

83 Infosys

86 Lupin

90 Power Grid Corp of India

93 State Bank of India

99 Appendix A-1


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Executive summaryIndia today finds itself smack in the middle of a whirlpool of pessimism. Taking stock of

Indias macroeconomic variables makes for depressing reading. Policy inaction, rising

rates and a difficult global environment have taken a toll on growth. Meanwhile, a fragile

external account has caused the rupee much distress in the backdrop of volatile global

risk sentiment. Politics and policy continue to disappoint and populism has elevated

fiscal deficit concerns.

Its against this backdrop that we enter into 2012. The bad news is that not much is likelyto change in the first half of this year. The good news is that these headwinds are

temporary and would dissipate in the second half of the year.

The incremental deterioration in Indias macro fundamentals was triggered by the

sudden global risk flare-up late last year following the sovereign downgrade of the US

and rising deleveraging fears for eurozone banks. The resulting sharp depreciation of the

rupee has hijacked inflation and arrested its otherwise declining momentum. This has

pushed back the rate-cutting cycle, which we think would be back-loaded in 2012. The

RBI would find it difficult to justify a rate cut unless inflation is reined in to more

comfortable levels, probably closer to 7%.

However, inflation should be less of a concern for markets this year, in our view. As the

economy slows down, pressure on labour markets should recede and wage increases

should slow. A strong US dollar and a slow-moving global economy are likely to keep

global commodity prices in check. This should aid the decline of inflation further.

Gradually declining inflation and continuing growth concerns would likely keep bond

yields in benign territory in the first-half of the year.

India has to fund its high current account deficit, which has been made worse by a switch

in allocation of household savings into valuables. Unlike the last crisis in 2008, there are

also large debt repayments to contend with on account of private borrowings raised in

2006-07. This is likely to create growth and currency headwinds as capital inflows are

constrained by the ongoing European crisis. After its sharp underperformance, we

reckon the rupee is probably undervalued at current levels. This should gradually

improve India's current account with a lag while concerns on debt repayments diminish

through the year. We see this happening in 2H12.

Growth would continue to face headwinds. The lagged effects of past tightening and tight

liquidity are likely to continue to play out in 1H12. Private consumption is starting to slow,

government spending power is muted and investment cycle is adjusting to slower growth

amidst uncertainties on external demand. Market sentiment is likely to take its cue from

weakness in industrial production growth in 1HCY11F. However, India should continue to

enjoy its high growth differentials vs. developed economies in a weak global growth

scenario expected this year.

However, market valuations are no longer expensive at current levels and are pricing in

a significant cut in earnings and further downside to economic growth. The market

earnings multiple would start to look more attractive as inflation eases and bond yields

fall.

We expect FY13F Sensex earnings growth of c.10-12%. We believe the trajectory for

earnings through the year would likely slow. Earnings could see some more risk as the

economy feels the lagged impact of the rate tightening cycle. Margin pressures could

persist in first-half from lagged effects of rate tightening and high commodity prices.

However, a weak outlook for global commodity prices would subsequently be a tailwind

for corporate margins provided the rupee does not depreciate further from here. As well,

base effect tailwinds will come into play in the second half of the year.

So how do we play this? The backdrop for equities in the first-half of the year would be

slowing growth, gradually falling inflation, weak rupee and peaking rates cycle. We prefer

banks and exporters (IT and pharma). Given concerns on the capex cycle, are

underweight domestic cyclicals capital goods and infra & construction. We would play

Indias investment cycle through the cement sector rather than capital goods. Slowing

growth would lead to weak government finances which would mean that its ability to


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spend incrementally would be compromised. In our opinion, the consumer cannot expect

too many freebies from the government from here on in.

We see little hope for big-bang reforms during the tenure of the present government.

However, the outcome of the upcoming state elections in the first-half could shape policy

expectations and could very well lead to a positive surprise.

We expect the market to rise 15-20% from here and take cues from the likely

improvement in the macroeconomic environment in the second half of the year. Further

deterioration in Europe poses a key risk. Exaggerated declines in the market could

provide a good buying opportunity.

Fig. 2: Key themes

Source: Nomura Research

Key theme Comments

Growth We expect continuing headwinds to growth. Tight systemic liquidity and adverse base effects are likely to lead to weak industrial growth

numbers in 1H12. Private consumption is starting to slow, government spending power is muted and investment cycle is adjusting to slower

growth and uncertainties on external demand. Market sentiment is likely to take its cue from weakness in IIP growth in 1HCY11F. However,

India should continue to enjoy its high growth differentials vs. developed economies in a weak global growth scenario expected this year.

Inflation While inflation momentum has come off its highs, the rupee's depreciation would mean that the fall of inflation momentum would be slower.

As the economy slows down pressure on labour markets should recede and wage increases should slow. We expect more tapering off in

2HCY12F on base effects. Inflation should become less of risk to markets this year. As well, a strong US dollar and a slow-moving global

economy are likely to keep global commodity prices in check this year. A prospective improvement in the current account would be a tailwind

for the rupee.

Earnings We expect FY13F Sensex earnings growth of c.10-12%. We believe the trajectory for earnings in 2012 would likely be slow. Earnings could

see some more risk as the economy feels the lagged impact of the rate tightening cycle. We see margin pressures in 1H12 from lagged

effects of rate tightening and high commodity prices. Weak outlook for global commodity prices in 2012 would subsequently be a tailwind for

corporate margins, provided the rupee does not depreciate further from here. In addition, base effect tailwinds are likely to come into play in

2H12.

Investment cycle/capex We expect some disappointment in the short- to medium term. We see several obstacles to the capex cycle, despite strength in demand.

With a few large sectors driving organised manufacturing capex, the investment outlook for these key capex-driving sectors remains muted

next year. Meanwhile, the unorganised manufacturing sectors suffers the most in an environment of very tight liquidity and high rates. We

believe that new order inflows would remain poor as the economy adjusts to a lower growth path and government spending power remains

limited due to poor finances.

Policy We expect monetary policy to start easing, albeit slowly. The downward trajectory of inflation momentum has been pushed back by rupee

depreciation. The external environment remains a key determinant of the RBI's ability to respond to slower growth. We expect rate cuts to be

back-loaded this year. Key risks are further rupee weakness arising from eurozone deleveraging concerns; a cost-push shock (higher oil

prices on geopolitical risks); and fiscal profligacy. We do not expect positive developments on reforms to be a catalyst for the market nextyear. However, the outcome in the upcoming state elections could prove important in shaping policy.

Liquidity We expect liquidity to remain tight in the near term, particulary due to external account pressures. Funding costs for corporates are likely to

remain high in the next six months before starting to come off. Bank NIMs may continue to do fine due to lack of overseas funding and

sigificant forex debt repayments which would likely be funded by India banks.

Rates Rate cuts are likely to be back-loaded this year: While inflation should be on the decline, its fall has been tempered by the weakness in rupee.

Hence, it would take much longer for the RBI to be comfortable enough with inflation numbers before going in for a rate cut even as growth

slows down further. We reckon that a fall in inflation below 7% or so could trigger policy actionunlikely to be reached in 1H12, we

reckonunless the RBI deems growth headwinds to have intensified enough to warrant a cut with inflation at 6-7%. Significant rate cuts are

also unlikely in 1H12 because external sector pressures and concerns on capital flows would be elevated. A cut would reduce Indias rate

differentials at a time when the RBI is taking several measures to attract capital inflows.

Rupee The rupee is l ikely to remain under some pressure over six months on account of large debt repayments on capital account and lack of

external funding on account of the European situation. The rupee is probably undervalued at current levels and this should gradually improveIndia's current account while concerns on debt repayments diminish through the year. Falling inflation should also help support India's high

rate differentials. This should lead to a rally in the currency later in the year. Key risks to this view are from oil prices and disorderly defaults in

the European economy.

Valuation Valuations are no longer expensive and are pricing in a significant cut in earnings, further downside to economic growth and an elevated rate

cycle. The market earnings multiple would start to look more attractive as inflation eases and bond yields fall. We see limited downside to the

markets. However, there is also limited visibility the in near-term; the 2H of the year looks better. We do note that the market would continue

to lack short-term triggers.


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6

Sector strategy

Fig. 3: Sector strategy

Note: Relative weightings for sector allocation given here are different from absolute sector ratings given in the sector sections of this report

(*) Relative to BSE100 index

Source: Nomura research

Sector Headwinds Tailwinds

Relative weighting

for asset

allocation (*) Strategy comments

Autos Expect lower volume growth due to slowdown in

economic growth and lower customer demand. We

expect the growth to decline substantailly for two

wheelers and commercial vehicles, while cars mayrecover after a flat year. Margins will come under

pressure due to fight for market share in low growth

environment.

Fall in raw material costs could lead to margin

support. Decline in interest rates will be a minor

positive as well.

UNDERWEIGHT Slow growth, rising

competition

Banks 1) Ri sing incrementa l delinquenc ies and credi t

costs; 2) lower-than-anticipated loan growth for

FY13F; 3) domestic & global macro uncertainty;

4) delayed onset of interest rate cuts

1) accelerated interest rate cuts 2) lower than

forecasted delinquencies 3) decreasing global risk

aversion

OVERWEIGHT NIMs pro tected , ra te cycle

peaked, valuations cheap,

possible benefits from

refinaning of foreign debt

payments

Cement Low activity in the infra and real estate space

continuing to impact demand for cement. High level

of capacities leading to low level of capacity

utilization and need to maintain production

discipline

Cement producers are able to maintain pricing at

levels where they are seeing reasonable

profitability and mid-cycle returns. Easing political

situation in key southern states could improve

demand growth

OVERWEIGHT Strong cash f lows, pric ing

discipline

Consumer One of the big headwinds for the consumer sector

is likely to be the depreciating rupee. This will take

a toll on profitability of companies like Asian Paints

(APNT IN), Hindustan Unilever (HUVR IN), Nestle(NEST IN) and GCPL (GCPL IN). Another big

headwind is likely to be slow down in discretionary

spends and is likely to impact companies like Titan

(TTAN IN).

Most companies are now focusing on expanding

rural footprint through enhanced distribution which

could boost growth. Slowing food inflation will also

be beneficial for consumer companies.

UNDERWEIGHT Consumer slowdown,

expensive valuations

Electrical

Equipment

Margin pressure from rising foreign and domestic

competition and higher raw material and wage

costs; shortages of labour; weak recovery in

industrial capex

Power-related capex upside; T&D equipment

makers to likely witness pickup in orders

UNDERWEIGHT Slowing investment cycle,

fuel shortages

Infra &

Construction

Weakness in investment cycle; land acquisition,

environmental and policy issues; labour shortages

Roads and power sector order flow; Interest rate

cuts

UNDERWEIGHT Slowing investment cycle,

government finances weak

IT Services Moderation in demand led by client decision making

inertia and macro economic uncertainty.

Rupee depreciation benefits to margin and EPS

(Tier-1 IT have EPS sensitivity of 1.4-2.3% for

every 1% INR depreciation). Long term trends of

consolidation, offshore penetration, productisation

and pervasiveness of technology favourable for tier

1 IT which will aid them to gain market shareagainst MNCs.

OVERWEIGHT Exporter , US strength

Metals &

Mining

Global macro concerns: European debt worries,

China slowdown - these fears have kept restocking

slow despite low inventory levels and hence metal

prices have not recovered which is usual during

fourth quarter.

Domestic demand beginning to improve, weak

INR, volume-led earnings growth led by completion

of expansion plan - Indian demand seems to be

improving and net imports have begun to rise

which is good news for expansions expected in the

near term.

UNDERWEIGHT Global growth concerns

Oil & Gas High oil pr ice; Continued policy paralysis and

continued impasse on key contentious issues

Oil price downside; New LNG capacity coming on-

stream; positive govt actions to bring reforms

UNDERWEIGHT Global growth concerns,

policy issues

Pharma Imposition of new pricing control regime in India as

proposed in the draft policy. The move shall be

negative particularly for MNCs.

Depreciation of INR against the export currencies

particularly against the USD is a net positive for

the sector. Also the sector shall present

unprecedented product opportunities in the US

market, which can present upsides to current

forecasts.

OVERWEIGHT Exporter , patent expiries in

the US

Power Power: [1] Intensifying fuel risk (sourcing & pricing)leading to project delays / low PLF, [2] SEB

financials remain precarious, payment timelines

lengthening. Coal: Delays in project clearances,

ambiguity over price revision

[1] Recent policy diktats on retail tariff revision toimprove SEB financials (albeit in the medium

term), in turn provide pricing flexibilty of domestic

coal, [2] 2012 policy offings to boost l onger-term

fuel security: coal block auctions, policy on sale of

captive coal

OVERW EIGHT Regulated return

Real Estate Unaffordable pricing leading to lower volumes. Low

volumes and execution issues are leading to cash

flow problems for developers who are leveraged

Likely reduction in mortgage rates and

improvement in the approvals situation could lead

to improving volumes while any price correction

could boost volumes further

OVERW EI GHT Ra te cyclical, likely

household switch back into

real estate

Telcos Regulations; volatile competition; questions over

data economics (substitution impact)

Revenue and margin Impact of recent voice price

hikes; data upside

OVERW EI GHT Strong cas h f lo ws,

reasonable valuations


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Growth has been a casualty; we expect a couple of quartersof tepid growth before recovery

Growth pessimism: India today finds itself smack in the middle of a whirlpool of

pessimism. And this overwhelmingly negative sentiment is not without reason growth

has come off, inflation and interest rates remain high amidst tight liquidity, corporate

earnings have taken a knock, fiscal concerns are high, government decision making has

been stymied and the legislature remains hamstrung; the reforms process has largely

disappointed and the rupee has lost significant ground.

Slowdown in growth momentum has occurred due to a combination of endogenous and

exogenous factors: (1) aggressive tightening by the RBI (intentional and endogenous)

and tight systemic liquidity in the face of high inflation; (2) weak global growth and poor

global risk appetite (exogenous) and (3) supply-side disruptions in key factors of

production problems related to land acquisition, environmental clearances, coal-

supply linkages and mining bans arising out of delays in government decision-making

and policy (endogenous).

Indias growth differentials are stabilising at just below pre-crisis levels: Before we

discuss further, it is vital that the ongoing slowdown in India is juxtaposed with that in

other global economies. The two exhibits below show for the pre-and post crisis periods

the evolution of absolute GDP growth for major economies and Indias relative growthdifferentials. Two key conclusions stand out: (1) at an aggregate level, the growth

experience of these economies has broadly been similar to Indias growth rates

dropped post crisis, recovered after a few quarters (strong base effects) and have been

gently falling over the past year-and-a-half.

Fig. 4: Despite the pessimism surrounding Indias growth, the economy still enjoyshigh absolute growth rates in a weak global growth environment

Source: Bloomberg, Nomura research

(2) Indias growth differentials rose in the period following the crisis until mid-2009 asIndias economic performance was supported by strong momentum in domestic

consumption; differentials declined subsequently until mid-2010 (stronger base effects

boosted growth rates of regions that were hit harder during the crisis) and have since

stabilised at just slightly below pre-crisis levels.

(20)

(15)

(10)

(5)

0

5

10

15

20

Jun-04

Sep-04

Dec-04

Mar-05

Jun-05

Sep-05

Dec-05

Mar-06

Jun-06

Sep-06

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Mar-07

Jun-07

Sep-07

Dec-07

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Mar-09

Jun-09

Sep-09

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Mar-10

Jun-10

Sep-10

Dec-10

Mar-11

Jun-11

Sep-11

GDP growth rates

India China BrazilRussia US JapanGermany UK EU

(%)

Growth pessimism is at a peak

Growth has taken a hit on tight

monetary conditions, weak

global macro, ineffectual policy

and supply-side disruptions

However, Indias growthdifferentials remain high and are

stabilising just short of pre-crisis

levels


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Fig. 5: Indias growth differentials have since stabilized at just slightly below pre-crisislevels


The growth slowdown has caused market multiples to contract: While growth (and

its expectations) have fallen globally, the significant underperformance of Indian equities

over the past year reflects investor concerns on endogenous reasons for Indias growthslowdown excessive tightening of policy rates in the face of high inflation (although,

Indias WPI basket is largely driven by global commodity prices), supply-side disruptions

in key factors of production, and overall negative sentiment resulting from high-profile

cases of graft that have afflicted the government and the policy paralysis that ensued. As

the Exhibit below shows, the loss of confidence in Indias growth story has been reflected

in the contraction of the markets earnings multiple.

Fig. 6: The decline in growth has been reflected in the de-rating of the market multiple


As the exhibit below shows, the combination of growth concerns, elevated inflation,

subpar political governance, and a much-depreciated rupee have driven the significant

underperformance of Indian equities compared to regional peers last year.

-10

-5

0

5

10

15

20

25

Jun-04

Sep-04

Dec-04

Mar-05

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Sep-11

Average China BrazilRussia US JapanGermany UK EU

(%)

(80)

(60)

(40)

(20)

-

20

40

6080

100

(10)

(5)

0

5

10

15

20

Jan-00

May-00

Sep-00

Jan-01

May-01

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Jan-02

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Sep-02

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Jan-04

May-04

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Jan-08

May-08

Sep-08

Jan-09

May-09

Sep-09

Jan-10

May-10

Sep-10

Jan-11

May-11

Sep-11

(y-y %) (y-y %)IIP (LHS)

Sensex 12-m fwd P/E change (RHS)

The market has de-rated on

growth concerns

Indias market

underperformance relative to

major peers was stark in 2011


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Fig. 7: Slowing growth, high inflation and a much weaker rupee have causedsignificant underperformance of Indian equities compared to regional peers

Source: Bloomberg, Nomura researchNote: All equity market indices are USD-denominated

Understanding the slowdown - business cycle decomposition: One way to assess

the nature of the ongoing slowdown is to tease out the cyclical components of time

series of GDP by expenditure, to understand how consumption and investments have

fared, and by output, to understand how sectors have fared.

The aim of the exercise is two-fold: 1) to identify sectors that are leading the slowdown,

and 2) to determine the extent to which Indias long-term trend growth rate has declined

post-crisis. Aggregate economic time series are viewed as fluctuating around a longer-

term trend and deviations from trend are caused by seasonal and cyclical factors. The

cyclical fluctuations are caused by business cycle conditions, in turn determined by key

macroeconomic variables such as interest rates, inflation and exchange rate.

We worked with 50 quarters of GDP data, both from output and expenditure sides. For

each output series, we first deseasonalised the raw data and then used an HP-filter to

obtain the underlying trend and cycle components of the underlying seasonally adjusted

series. The Hodrick-Prescott filter is an empirical technique commonly used inmacroeconomics to decompose economic time series into trend and cyclical

components.

Trend growth rate of GDP has come off the pre-crisis highs: Trend growth rates

peaked around 2007 and have been on the decline since for most sectors, except for

agriculture (Exhibit below). This is not surprising for two reasons: (1) outright

contractions in economic activity and weak growth have plagued most countries post

crisis, and (2) Indias is a supply-constrained economy and the declining trend growth

rates are reflective these constraints.

Within sectors, the relative resilience of services stands out in contrast to the decline in

industry. The slowdown in industry has largely been driven by manufacturing and

construction; the decline in trend growth rates of electricity and mining output have been

relatively less pronounced. Agriculture has seen its trend growth rise since 2002. This

has been driven by: a fall in the volatility of farm output; rising area under irrigation; rise

in ancillary activities and income on the back of spill-over effects of higher overall

economic activity, wealth effects of rising land prices and higher farm support prices.

50

60

70

80

90

100

110

120

130

Dec-10

Jan-11

Jan-11

Feb-11

Mar-11

Mar-11

Mar-11

Apr-11

Apr-11

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May-11

Jun-11

Jun-11

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Dec-11

Dec-11

US EUR HK JAPAN

CHINA TAIWAN KOREA INDIA

SING INDO

(Base 31 Dec'10=100)

We employ business cycle

decomposition techniques to

understand the extent of the fallin trend growth rate of output

Regarding trend growth rates,

the relative resilience of services

stands in contrast to the declinefor industry


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The investment cycle has been a casualty of elevated cost of capital: Much as

elevated interest rates have taken their toll on overall GDP growth, the investment cycle

too has become a casualty of higher cost of capital and tight liquidity this past year (the

government has done its fair bit too, but more on that later). The exhibit below shows

that interest rates today strongly influence investment growth six months from now. The

relationship looks much like the one between non-agri GDP growth and interest rates

given that investments are about 34% of GDP.

Fig. 12: Growth in investments is strongly influenced by interest rates, with a lag of

about six months, similar to the lag observed between GDP growth and interest rates

Source: Business Beacon, Bloomberg, Nomura research

Digging deeper into investments

The outlook on the investment cycle depends on how its different subcomponents are

expected to behave this year. National income data are not very useful here, in our view,

because segment-wise details are only available with a lag. The latest figures for capital

formation by the corporate sector, government and households are available for up to

FY10. So the best we can do is to consider alternative data to piece together a coherentpicture of what has happened in each of these segments.

Divergent signals: This deep dive is also necessary to reconcile diverging signals in the

economy. The current slowdown has been characterised by slowing GDP growth and

expanding current account deficit. Another interesting dichotomy has been between

industrial growth and commercial vehicle sales. Despite poor growth numbers and very

high interest rates, commercial vehicle sales are growing steadily and have shown some

recent signs of strengthening.

We believe that the answer lies in how interest rates are affecting the economy. We think

that the corporate capex cycle has not yet slowed down meaningfully (even though new

project plans are getting shelved/delayed). Instead, the impact on rates has largely been

on household savings behaviour. This would explain a worsening of the current account

deficit in face of slowing growth.

High inflation and interest rates have caused a shift from housing construction to

gold: High inflation has in our view caused the erosion of domestic purchasing power of the

rupee and prompted a switch to alternative avenues like gold. High interest rates and

elevated property prices have reduced the affordability of housing. Importantly, expectations

have been increasing of an imminent fall in property prices amidst weakening domestic

sentiment arising from a growth slowdown. This has resulted in weak cement demand and

strong demand for gold imports, thereby depressing housing construction activitymore than

half of cement demand comes from private housing in the unorganised sector; slowdown in

government-led infrastructure would also be an important reason for slowdown in cement

demandand worsening Indias current account deficit. This hypothesis finds resonance in

cement despatch and gold imports data over the past two years which have been

characterised by high inflation and interest rates.

9

10

11

12

13

14

15

16(10)

(5)

-

5

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25

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Jun-11

Dec-11

(yy %) (%)Fixed investment ,2-qtr lag (LHS)

Prime lend ing rate, inverted scale (RHS)

High interest rates and low

affordability of housing has

caused a decline in housing

construction and lowered

cement demand. The switch ofhousehold savings to gold has

widened the current account

deficit.

The current slowdown has

coincided with a widening of

current account deficit and

strong commercial vehicle sales

The investment cycle has been

a casualty of high rates and

slowdown in government-led

investment


14/106


13

Fig. 13: High interest rates and inflation have caused a switch in household portfoliosaway from housing into gold. The encircled portion in the chart illustrates this.

Source: Business Beacon, Nomura research

Bank credit data provides further evidence of the slowdown in housing construction

which explains the fall in cement demand. This can be seen in the Exhibit below - the

share of housing in total non-food credit outstanding is at its lowest post crisis. Inaddition, credit data also show that FY12 has seen the lowest growth in housing credit

YTD, which is again consistent with slow cement demand growth.

Fig. 14: The share of housing in non-food credit outstandinghas declined in line with the slowdown in housing

construction activity and decline in cement demand

Source: RBI, Nomura research

Fig. 15: This is also visible in the slower expansion of creditto the housing sector, which has declined in FY12

Source: RBI, Nomura research

The corollary of this hypothesis is that as inflation shows signs of easing from here on,

and interest rates start coming off, households would reallocate their portfolios towardshousing away from gold. The fall in gold imports has already started happening, aided by

the sharp depreciation of the rupee; an acceleration of this trend would be a significant

positive for the current account deficit.

Momentum of execution in government-led projects has come off: Hamstrung

government decision-making has taken a toll on infrastructure projects owned and

sponsored by the government. We believe the outlook on this front is likely to remain

weak in the near term, given the fragile state of government finances. We discuss

government policy later in a separate section.

Corporate capex has not yet fallen meaningfully: We have reasons to believe that

corporate capex activity has not declined meaningfully yet and the slowdown would be a

gradual process. Evidence for our view comes from the following data:

0

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14

(4,000)

(2,000)

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Jun-11

(USDmn) (%)Gol d & silver imports (y-y chg ), 2qma (LHS)

Cement d espatches (y-y %), 2qma (RHS)

8.5

9.0

9.5

10.0

10.5

11.0

11.5

Nov

Jan-

Mar

Nov

Sep

Dec

Feb

Jul-10

Sep

Nov

Jan-

Mar

Aug

Oct-11

(%) Housing credit outstanding as % of total non-food credit

0

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8

0

50

100

150

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FY08 FY09 FY10 FY11 FY12

(INRbn) (%)Credi t expansion (Apr-Oct) (LHS)

% in crease (Apr-Oct) (RHS)

Credit expansion to the housing

sector in FY12 fell to its lowest

in five years


15/106


14

Commercial vehicle sales are still strong: The strength in commercial vehicle sales

belies a significant weakening of corporate capex. Sales came off sharply in the period

immediately during the crisis period in late 2008. However, CV sales on an annual

basis have been inching upwards and came in at above 42% y-y in November. There

are no base effects at play either.

Fig. 16: The strength in commercial vehicle sales belies a significant weakening ofcorporate capex. Annual growth rate of CV sales has been rising and came in above42% y-y in November

Source: SIAM, Nomura research

Capital goods imports have been surprisingly resilient: Another reason to suspect that

capex activity has not yet weakened meaningfully is that capital goods imports still look

elevated. On a monthly basis, imports peaked in May-11 and have started to come off a bit.

We expect imports to fall further from these levels to reflect the ongoing slowdown in growth

and weakening order inflows. This would be positive for the current account deficit.

Fig. 17: Capital goods imports still look elevated and should fall from current levels toreflect the slowdown in growth


Sales growth of capital goods companies have held up well: The Exhibits below

shows sales growth of three categories of companies in the BSE500 index: a) Capital

goods (a proxy for the corporate capex cycle); b) real estate (proxy for housing); and c)

construction ex L&T (proxy for government-related capex spends).

As the exhibits below show, capital goods companies sales growth has remained

surprisingly resilient while both real estate and construction companies have seen a

significant fall off in their growth trajectories. This supports the supposition that the

(100)

(50)

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250

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(y-y %) CV (s.a.)

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Jan-11

Apr-11

Jul-11

(USDmn)

The strength in CV sales belies

a significant weakening of

corporate capex

Capital goods imports are still

elevated and should fall from

here

Sales growth of cap goods

companies is still resilient.Meanwhile, it has come off for

real estate and construction (ex-

L&T) companies


16/106


15

slowdown in investment cycle is largely a function of slowdown in government spends

and household switching from physical assets to valuables for investments.

Fig. 18: Sales growth for capital goods companies are stillresilient

Source: Ace Equity, Nomura research

Fig. 19: Meanwhile, growth trajectories for construction (ex-L&T) and real estate companies have come off significantly


Future imperfect? Past momentum is no guarantee for the future: Forecasting the

trend of investments is made difficult by several important considerations:

Policy changes can reaccelerate the capex cycle: One big issue dogging new

investments is government policy. Environmental issues, land acquisition-related

uncertainties and general political and bureaucratic decision-making slowdown is

leading to slowdown in large ticket investments. While the current political environment

still remains poor, any changes on the positive side can lead to a pick up. Nevertheless,

looking at the current environment, we believe it is safe to say that 2012 would be a

very slow year for new projects.

A reversal in monetary policy should reaccelerate household investments in real

estate: As the monetary policy eases, we expect households to start allocating capital

away from valuables into physical and financial assets. However, significant easing is

required before this switch starts to happen. Given that RBI would have a lagged

response to fall in inflation, this phenomenon would take at least 9-12 months to fully

materialise.

Government finances would remain poor: Given the fiscal deficit overshoot, the

ability of the government to divert more resources into capital formation remains

extremely limited. Government was a big driver of capex cycle in the last five to six

years both at the state (roads, irrigation etc) and central level.

Corporate sector has money but needs better policy: On an overall basis, two basic

preconditions for a strong capex cycle: (1) unfulfilled demand (as evidenced by trade

deficit and shortages), and (2) financial ability to invest (as evidenced by aggregate

balance sheet strength of corporates) are not the constraining factor on capex. Thepolicy environmentmonetary, fiscal and pace of decision makingare the main

constraints. These may continue to remain unfavourable for some more time.

Global uncertainty adds to capex cycle slowdown: The chart below shows the

latest breakdown of capex of BSE500 companies by sectors. Telecom, oil & gas,

metals & mining and power are the four largest contributing sectors in overall capex. All

of these face some headwinds in terms of policy or the global environment. This means

that new projects in these sectors would remain quite slow. We note that the current

momentum in the capex cycle is driven by projects planned earlier and as the new

pipeline weakens, the capex cycle would continue to weaken prospectively.

0

5

10

15

20

25

30

Mar-08

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Dec-08

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Sep-11

(y-y %)

0

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(100)

(50)

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Mar-08

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Sep-11

(y-y %) Real Estate (RHS)

Con struction ex L&T (LHS)

New capex activity would be

slow on policy issues, slow

government decision-making,

poor public finances adverse

political environment

Corporate balance sheetsappear strong and demand is

not an issue

New activity in big capex-driving

sectors face global uncertainties

and policy headwinds


17/106


16

Fig. 20: Capex in oil & gas, telecom, power and metals & mining sectors constitutedclose to three-fourths of total capex by BSE500 group of companies in FY11


Fig. 21: Reasons for slowdown in incremental capex activity in the four big capex

sectors


Bottom-line on capex only expect a lagged recovery: From the perspective of the

next twelve months, we believe that the following factors would weigh heavily on the

capex cycle:

Rates: Interest rates have risen significantly and we believe an easing of the cycle issometime away. Decisions on investments in new projects would clearly remain slow till

the time rates reduce to lower levels from here. This would mean that 2012 would be

weak for new orders.

Policy: Uncertainty on account of pending policy decisionsland acquisition bill, FDI in

retail, fuel-related policy etcwould continue to cast a shadow on investment

decisions. Additionally, the uncertain political environment also means that the

bureaucratic machinery would remain slow, slowing down fresh approvals.

Global environment: Till the time the European crisis does not abate, capital

availability would remain an overhang on the capex cycle.

The capex slowdown would manifest as: 1) slow new order momentum and 2) gradually

reducing sales growth of capital goods companies. As can be seen below, new order

inflows for a group of five companies that we cover (LT IN, IVRC IN, NJCC IN, HCC IN

and PUNJ IN) were down y-y in 2QFY12. This situation is likely to continue for some

more time.

Autos , 3.86%

Oil & gas ,22.71%

Infra & cap goods, 5.36%

Cement, 2.48%

Consumer,2.63%

Pharma, 2.23%

IT, 3.10%Power, 15.13%

Metals & mining ,15.86%

Telecom ,17.85%

Transport ,3.91%

Misc, 4.88%

Sector Reasons for slowdown in new capex activity

Oil and gas Slow decision making. Adverse policy environment

Metals Environment clearances, ban on mining and global slowdown would mean new

project activity would be slow

Telecom Significant policy uncertainty. Saturation of voice market

Power Fuel unavailability

Expect only a lagged recovery in

capex


18/106


17

Fig. 22: New order inflows for infra & construction companies under our coveragewere down y-y in the Sep-qtr. The slowdown in new orders is expected to continue


The rupee: capital flows and eurozone concerns

The unexpected weakening of the rupee has presented fresh challenges for the

economy in form of 1) higher deficit on account of oil subsidies; 2) inflation stickiness; 3)

strain on servicing foreign loans; and 4) dilution of investor returns in dollar terms. We

believe that Indias rupee weakness, which in the first phase has been attributed to its

large current account deficit and European crisis, would persist for some time. Even

though we believe that the current account would improve from here, it would be the

capital account which would pose significant challenges to the rupee. These challenges

are likely to continue for the most part of 2012, following which rupee should start to rally,

in our view.

The unexpected appreciation of the dollar following the US sovereign downgrade

jolted the rupee initially: The rupees decline in began in August last year and

coincided with the unexpected flight-to-safety-induced appreciation of the USD followingthe S&Ps sovereign downgrade of the US. We suspect the first leg of rupees fall was

prompted by a rush to cover unhedged short USD positions and was not driven by FII

selling FIIs had bought net USD305mn in equities and sold net USD15mn in bonds in

September and October, even as the rupee had moved from INR46.1 to INR48.7

through these two months . The rupees decline was not in isolation and was joined by

other high-beta Asian currenciesIndonesian rupiah (IDR) and Korean won (KRW)as

can be seen in the Exhibit below.

80

100

120

140160

180

200

220

1QFY09

2QFY09

3QFY09

4QFY09

1QFY10

2QFY10

3QFY10

4QFY10

1QFY11

2QFY11

3QFY11

4QFY11

1QFY12

2QFY12

Order inflows for infra & construction companies(Base 1QFY09 = 100)

The capital account would be a

cause for concern this year

while the current account

concerns would likely improve

The unexpected appreciation of

the USD following the US

sovereign downgrade in Augustjolted high-beta Asian

currencies; the INR

underperformed significantly


19/106


18

Fig. 23: The global risk event triggered by the US sovereign downgrade brought high-beta Asian currencies under pressure; however, the rupees underperformance has

been stark


Twin deficits, high inflation and lack of RBI support: However, once the flood gates

had opened and the rupee breached established trading ranges, the rupee found itselfunder severe and unrelenting pressure as market expectations of continued rupee

weakness were getting increasingly broad-based. The rupee underperformed the KRW

and IDR in the following period and two factors accelerated its underperformance: (1)

Indias economic fundamentals were distinctly poorer, underpinned by its twin current

account and fiscal deficits (Exhibit below) and high inflation that had led to severe

erosion of the rupees domestic purchasing power, and (2) the RBI did not publicly state

its intention to support the rupee; how successful the RBI would have been in defending

the rupee, had it chosen to do so, is another matter.

Fig. 24: The rupees weakness was underpinned by Indias

high current account deficit

Source: Nomura Global economics

Fig. 25: and a high fiscal deficit

Source: Nomura Global economics

The rupees sharp decline and expectations of further weakness, amidst heightened risk

aversion on account of the eurozone debt crisis, induced aggressive forward covers by

hedgers, accompanied by fair bit of speculation, we reckon. The sharp appreciation of

the USD in off-shore forwards across maturities has reflected the rise in forward

premiums in the on-shore forward market and depreciation of the rupee in the spot

market.

Uncertainty regarding the rupee is near an all-time high: We are all too aware of the

hazards of making point forecasts of exchange rates and make no attempt to do so here,

95

100

105

110

115

120

125

Aug-11

Sep-11

Oct-11

Nov-11

Jan-12

INRUSD IDRUSD KRWUSD

(Base 100=1 Aug'11)

(4)

(3)

(2)

(1)

0

1

2

3

CY2011E CY2012E CY2013E

India Korea Indonesia

(%)

(6)

(5)

(4)

(3)

(2)

(1)

0

1

CY2011E CY2012E CY2013E

India Korea Indonesia(%)

The INR underperformed its

peers given its high currentaccount deficit and inflationproblem

Currency options markets are

suggesting a high sense ofuncertainty about where therupee will find support


20/106


19

especially during these times of high global uncertainty. The implied volatility of the

rupee, based on at-the-money USDINR currency options, is closet to all-time highs and

makes it difficult to say with any degree of certainty about where the rupee would find

support in the near term (Exhibit below). A quick back-of-the-envelope calculation based

on the current implied volatility of at-the-money currency options suggests that there is a

90% chance that the rupee could be trading between 42 and 63 by the end of the year

a very wide range, indeed.

Fig. 26: The average implied volatility of the rupee based on currency option contractsis close to its highs, reflecting the overall sense of uncertainty regarding the rupees

trajectory


In our view, the rupees near-term fate is contingent on how severe deleveraging

concerns on eurozone banks become: The outlook for the rupee in the near term

would be conditioned by how the European debt crisis evolves. It is fair to say that the

rupee would struggle to stabilize to pre-August levels so long as the eurozone is under

strain, global risk aversion is high and concerns on capital flows to India persist. It can be

seen from the relationship between CDS spreads for European banks and INR/USD ratethat the rupees depreciation since August has much to do with the risk flare-up in

eurozone banks.

Europe is largely an exogenous parameter, but one that will have a significant bearing on

the rupee in the coming months. Our working assumption for the near term is one in

which European banks would most likely remain under deleveraging pressure and shore

up their capital positions in the face of funding pressures from debts maturing this year

and more stringent Basel III norms coming into effect next year. As the global reserve

currency, the excess demand for dollars that would arise should deleveraging concerns

in the eurozone exacerbate in the coming months is the key risk to the rupees

performance, we think. The RBI, in its December Financial Stability Report estimated the

consolidated claims of European banks on India at 8.6% of Indias nominal GDP.

4

6

8

10

12

14

16

Aug-11

Sep-11

Oct-11

Nov-11

Dec-11

USDINR 1m Imp Vo l USDINR 3m Imp Vo l

USDINR 6m Imp Vol USDINR 1yr Imp Vo l

(%)

Deleveraging concerns in

Europe are an overhang on the

rupee in the short-term


21/106


20

Fig. 27: The rupees sharp decline since August has been driven by deleveraging risksfacing eurozone banks


Refinancing and redemption pressures: While developments in Europe would set

the risk appetite for global capital, the rupee, in addition, would have two key

overhangs to contend with as we make our way into 2012.

A big chunk of the large external commercial borrowings (ECBs) by Indias corporate

sector during 2006-07 is coming up for redemption this year. The figure below plots

gross inflows of ECBs against gross outflows lagged by 5 years (this conforms to the 3-

7 year maturity of an average ECB loan). We estimate that about USD30bn worth of

ECB loans would have to be dealt with by corporates they would have to either be

repaid or rolled over. If the risk backdrop is mild then most of these loans would have a

good chance of being repaid or refinanced, albeit at higher interest rates. Anecdotal

evidence suggests that about 30% of ECB payments are hedged; this figure would

likely have increased in light of the recent sharp depreciation of the rupee. If this were

the case, then downward pressure on the rupee would likely be contained to the extent

corporates have already immunised themselves by taking adequate forward covers. To

the extent that this is not the case, the excess demand for dollars would imply further

rupee weakness. In either case, this uncertainty in itself would likely keep the rupees

outlook volatile.

40

42

44

46

48

50

52

54

56

0

100

200

300

400

500

600

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(bps) Euro ban ks 5y r CDS (LHS) INRUSD ( RHS)

Close to USD40bn of ECBs and

FCCBs need to be refinanced or

redeemed in 2012


22/106


21

Fig. 28: Large external commercial borrowings taken on by the Indian corporate sectorfive years ago are going to come up for redemption this year


Another source of concern for the rupee and sentiment, although not as large in terms

of absolute numbers as ECBs, is redemptions of FCCBs (foreign currency convertible

bonds). With current stock prices much below conversion prices, near-certainredemptions of FCCBs are another overhang on the rupee. The exhibit below breaks

down the amounts outstanding by year 2012, with about USD7bn (mostly in the first

nine months of the year) would be when most of these bonds would have to be

redeemed.

Fig. 29: Upcoming FCCB redemptions peak in 2012 and then taper off after that


Fundamentally speaking, inflation differentials are on the way down: Even as risk

aversion and concerns on capital flows are l ikely prevent a quick reversal of the rupee in

the near term, the rupees outlook over the year is supported by improving fundamentals

rate differentials are likely to stay high, and the sharp depreciation of the rupee so far

would likely begin to show up as a contraction of the current account deficit.

A country with an inflation problem is most likely to see its currency depreciate. High

relative inflation reduces real rate differentials, while the erosion of domestic purchasing

power of its currency spills causes an erosion of its purchasing power externally. The

Exhibits below show that this has largely been the case for the INR/USD exchange rate.

Seen in this context, the rupees decline is not altogether surprising.

0

1,000

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Jun-11

ECB gross inflows

ECB gross outflows (lagged 5 years)

(USDmn)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

CY2012 CY2013 CY2014 CY2015

(USDmn)

Falling inflation differentials and

contraction in current accountdeficit should emerge as

fundamental tailwinds for the

rupee later this year


23/106


24/106


25/106


24

Fig. 35: Headline inflation and its subcomponents have stabilised at unacceptably highlevels post crisis


Downward sticky inflation is anathema to any central bank because it sets the stage for

inflation expectations to be high too given that expectations of future inflation are formed

adaptively individuals base their investment, savings and consumption decisions basedon past inflation. The RBIs natural response has been to progressively raise policy rates

and, in conjunction with its aggressive anti-inflationary stance, keep systemic liquidity at

tight levels (see figure below).

Fig. 36: Rising inflation has resulted in significant tightening of policy rates and tight

systemic liquidity

Source: Bloomberg, Business Beacon, Nomura research

High interest rates and an anti-inflationary policy stance, amidst weakeningeconomic activity, have kept liquidity tight and led to fall in growth rate of the

monetary base: Progressively higher interest rates since mid-2010 have caused the

opportunity cost of money to rise. This has resulted in a switch from currency holdings

and demand deposits to higher-yielding term deposits, causing the rates of growth of M1

and M3 to sharply diverge (see figures below). The extent of the fall in the transactionary

demand for money suggests a much reduced amount of economic activity. The growth

rate of the monetary base has come off significantly on the back of the fall in currency-in-

circulation and because the RBI did not inject meaningful primary liquidity into the

economy by way of open market operationsOMOs (open market operations) have

picked up since end of Nov-11in keeping with its anti-inflation stance.

(15)

(10)

(5)

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WPI Prim articles

Mfg prods Fuel & power

(%)

(1,500)

(1,000)

(500)

0

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(2)

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Feb-09

Jun-09

Oct-09

Feb-10

Jun-10

Oct-10

Feb-11

Jun-11

Oct-11

(%) (INRbn)Net LAF balance (RHS)

Repo rate (LHS)

WPI (y-y) (LHS)

Weakening economic activityand high inflation have reduced

transactionary demand for

money and caused a shift tohigher-yielding term deposits

and gold


26/106


25

Fig. 37: High inflation has been met by rising interest rates.The higher opportunity cost of money has caused a sharp

divergence between M1 and M3 rates of growth


Fig. 38: which has been driven by a switch from currencyin circulation and demand deposits to higher yielding time

deposits


High gold imports have worsened Indias external position and put pressure on

the rupee: In addition to prompting a reallocation of household savings towards higher-

yielding term deposits, the erosion of the rupees domestic purchasing power has also

caused a shift towards physical forms of savings, i.e. gold. The resulting fall in the supply

of loanable funds in the economy has put incremental pressure on interest rates. This

switch to gold has come at the expense of housing construction activity and has caused

a notable divergence between cement demand, which has been weak, and gold imports,

which touched record levels earlier this year.

The figure below shows the relationship between Indias gold & silver imports and WPI

inflation. Indias WPI basket is commodity-heavy and changes in global commodity

prices could drive the mutual relationship between gold prices (and hence nominal

imports) and inflation. To account for this, we plot real gold imports (by deflating nominal

gold imports by gold prices) against inflation, and find that the relationship holds up well

on average. This increase in gold imports has put considerable pressure on the rupee

through the trade route. This has happened in the backdrop of a fragile global risk

environment and elevated concerns on capital flows. Also, the fall in real rate differentials

because of rising inflation differentials has further weakened the rupees case. However,

after adjusting for valuables in both merchandise imports and exports data, we find that

trade and current account deficits would have appeared much more manageable.

Fig. 39: Gold provides a hedge against high inflation

Source: Bloomberg, Business Beacon, Nomura research

Fig. 40: Strong gold imports have worsened Indias externalposition. Trade and current account deficits appear less

alarming after adjusting for valuables


0

5

10

15

20

25

30

Oct-00

Mar-01

Sep-01

Mar-02

Sep-02

Feb-03

Aug-03

Feb-04

Jul-04

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jun-07

Dec-07

Jun-08

Dec-08

Jun-09

Dec-09

Jun-10

Dec-10

Jun-11

Dec-11

(y-y %) M1 M3

(20)

(10)

0

10

20

30

40

50

Jan-04

May-04

Oct-04

Mar-05

Aug-05

Jan-06

Jun-06

Nov-06

Apr-07

Sep-07

Feb-08

Jul-08

Dec-08

May-09

Oct-09

Mar-10

Aug-10

Jan-11

Jul-11

Dec-11

(y-y %) Currency

Demand deposits

Time deposits

(1)

1

3

5

7

9

11

13

20

40

60

80

100

120

140

Jun-05

Oct-05

Feb-06

Jun-06

Oct-06

Feb-07

Jun-07

Oct-07

Feb-08

Jun-08

Oct-08

Feb-09

Jun-09

Oct-09

Feb-10

Jun-10

Oct-10

Feb-11

Jun-11

Oct-11

(Base 100=Apr'05) (%)

Real go ld imports index, 3mma (LHS)

WPI, 3mma (RHS)

(20)

(15)

(10)

(5)

0

5

Mar-07

Jun-07

Sep-07

Dec-07

Mar-08

Jun-08

Sep-08

Dec-08

Mar-09

Jun-09

Sep-09

Dec-09

Mar-10

Jun-10

Sep-10

Dec-10

Mar-11

Jun-11

Trade balanceCABTrade balance ex-valuablesCAB ex-valuables

(As % of GDP)

The strong pick-up in gold

imports has put pressure on the

external position and the rupee


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29/106


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29

Valuations not demanding and are pricing in a significantcut to earnings, but waiting for triggers

What has gone wrong with the Indian market in the last few months?: When we

became more constructive on the market in June-end last year, our view was driven by

slowing inflation momentum and a consequent lagged drop in interest rates, which would

have led to firming up of markets. Subsequently, the European situation flared up starting

August, which in more ways than one has delayed market recovery. First, the weakening of

external demand has delayed the recovery of the current account. Second, the rupee has

underperformed significantly in the last five months as capital flows have turned weaker.Third, this has pushed back the anticipated fall in inflation. Fourth, the fall in the rupee has

exacerbated the fiscal situation and has led to higher oil and fertiliser subsidies.

As we take a fresh view on the market this year, we think that a likely continuation of the

European situation means that the Indian economy would have to contend with adjusting its

growth downwards in order to deal with the weaker global situation. This is especially true in

view of Indias capital account which is going to remain under pressure for another twelve

months. We think a significant recovery is Indias external situation is a near certainty over

this period as a slowing economy would lead to a current account recovery and debt

repayments would whittle down to more manageable levels. In our view, the markets are not

discounting this recovery market multiples are now discounting the rate cycle to remain

elevated for a significantly longer period. However, between then and now, the path of the

market is less clear.

The market is trading at a reasonable discount to its long-rangeaverage: At current

levels, the market is trading at 12.0x 12-month consensus-based forward earnings, which

translates to a 23% discount to its five-year average. At these levels valuations appear to be

discounting a significant cut to earnings and further downside to economic growth.

Fig. 47: The market is trading at a reasonable discount to its 5-yr average


and could get cheaper with respect to bonds if inflation comes off: Additionally, with

respect to bonds, we think equity valuations are beginning to look a lot more attractive, as can

be seen in the Exhibit below, which plots the Sensex earnings yield vs. the 10- year

government bond yield.

Bond yields have come off from their highs of Nov-11 on the back of growth concerns and

expectations of the next move by the RBI to be a cut in rates; OMO support by the RBI also

aided the decline in bond yields. Although inflation has in a way been hijacked by the sharp

depreciation of the rupee, food inflation has started to decline, leading to tempering of inflation

expectations. Manufactured products inflation should begin to react to the ongoing slowdown

in growth and a tepid outlook for global commodity prices in the face of slow global growth

expected in 2012 and a likely stronger dollar amidst elevated risk aversion emanating from

ongoing eurozone debt problems. Any major downside surprise in inflation could easily push

equities into relatively cheap territory quite quickly, in our view.

4

9

14

19

24

29

34

Apr-97

Oct-98

Mar-00

Sep-01

Feb-03

Jul-04

Dec-05

Jun-07

Nov-08

May-10

Oct-11

Sensex 12-m fwd P/E

5-year average = 15.5x

Market multiples are pricing in a

significant cut to earnings,further downside to economic

growth and an elevated rate

cycle

Valuations would start looking

more attractive as inflation

eases and bond yields fall

Our change in view on the

market in end-June was

hijacked by the global risk flare

up and the ensuing rupee

weakness


31/106


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31

Clouded first half, better second half: Of the four macro variables mentioned above,

there is little visibility of improvement in the immediate future. Market multiples have

already adjusted downwards to account for lower growth and high interest rates. To that

extent, we believe that the downside to the markets is limited as interest rates should

start to come down, albeit with a delay. The path to recovery would be rather clouded as

the news flow would improve only with a lag.

Earnings expect some downside to FY13F earnings

Earnings have been cut by 10-12% over the past 12 months: In Dec-10, we had

argued that prospects for corporate profitability in 2011 would be shaped by a tough

macroeconomic environment and saw downside risk to consensus earnings growth

expectations of 20% for FY12F. The Exhibit below shows the evolution of FY12F and

FY13F consensus earnings for the Sensex over the past 12 months. Given the

reasonably strong economic environment through FY10, consensus earnings

expectations were stable until the early part of 2011. Since then we have seen consistent

consensus earnings downgrades. Earnings have been cut by 10% for FY12F and by

12% for FY13F, much in line with our expectations and consistent with the deterioration

in the macroeconomic environment in the latter part of 2011.

Fig. 50: Consensus earnings have fallen significantly over the past year


with a tough macro backdrop for earnings: At the beginning of 2011, the prospect

for earnings for the year appeared subpar to us signs of increasing tightening of

liquidity, sticky inflation, an inflation-focussed RBI (policy rates were hiked by 225 bps in

2011) and rising cost pressures from global commodities portended a tough

macroeconomic backdrop for corporates in the year ahead. It was after the sovereign

risk flare-up in the later part of 2011 that prompted serious downgrades of earnings by

consensus, aided by policy-led slowdown in the investment cycle. The sharply

depreciating rupee in the last quarter and the all-around growth-pessimism prompted yetanother round of downgrades after Oct-11. Readings on industrial production, which had

been hovering around an average of 7.5% in the 1HCY11, took a decided turn for the

worst in the second half of the year and added further pressure on FY12F and FY13F

earnings estimates.

Expect FY13F Sensex earningsgrowth of around 10-12%: We think the trajectory for

earnings in 2012 would likely slow. Earnings could see some more risk as the economy

feels the lagged impact of the rate tightening cycle; the Exhibit below shows the leverage

of corporate earnings to growth. We reckon another couple of quarters of growth

slowdown as the effect of tight credit plays out with a lag. This would likely translate into

weakening earnings growth in the first half of the year. We also note that there are

headwinds to earnings growth from adverse base effects in the first half of FY13F as

earnings slowdown worsened in the second half of FY12.

86

90

94

98

102

Dec-10

Feb-11

Mar-11

May-11

Jun-11

Aug-11

Sep-11

Nov-11

Dec-11

SENSEX Earning s Index FY12

SENSEX Earning s Index FY13

(Base 100 = Dec'10)

Consensus earnings have beencut 10-12% over the past year

The macro environment turned

decidedly tough for earnings in

2H11

See downside risk to earnings

growth in 1H of this year. As

well, there are adverse base

effects to contend with.Pressures should subside in

later part of the year

There is limited visibility the in

near-term. The second-half of

the year looks better


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33

Fig. 52: Margin pressures on account of higher commodity prices might persist foranother 3-6 months. The benevolent effect of weakening global commodity prices was

offset by the sharp depreciation of the rupee

Source: Ace Equity, Bloomberg, Nomura research

Note: BSE100 ex-oil & gas and banks

Revenue growth has benefited amidst high inflation and strong pricing power ofcorporates: Revenue growth has surprised positively this past year. Corporate top-lines

have been resilient even as profits have been weak. One explanation for this could that

firms have enjoyed strong pricing power on an overall basis and have been able to pass

along rising input costs. This is not entirely surprising given that Indias is a supply-

constrained economy and is probably characterised by excess demand at a given price

level. Another reason for the strength in net sales growth is that manufactured product

prices still remain high because the global commodity complex and aggregate demand

have not collapsed like they did during the crisis period.

Fig. 53: Revenue growth bears a close relationship with inflation on average,suggesting that corporates have reasonably strong pricing power

Source: Ace Equity, Bloomberg, Nomura research

Note: BSE100 ex-oil & gas and banks

Overall, we expect 10-12% earnings growth in FY13F: Based on assumptions on

domestic and global growth, inflation and global commodity prices, we estimate FY13F

Sensex earnings growth of 10-12%.

(40)

(30)

(20)

(10)

0

10

20

30

40

50

(10)

0

10

20

30

40

50

60

Mar-02

Sep-02

Mar-03

Sep-03

Mar-04

Sep-04

Mar-05

Sep-05

Mar-06

Sep-06

Mar-07

Sep-07

Mar-08

Sep-08

Mar-09

Sep-09

Mar-10

Sep-10

Mar-11

Sep-11

(y-y %) (y-y %)COGS1qtr l ag (LHS) CRB (RHS)

(2)

0

2

4

6

8

10

12

14

(10)

0

10

20

30

40

50

60

Mar-0

2

Sep-0

2

Mar-0

3

Sep-0

3

Mar-0

4

Sep-0

4

Mar-0

5

Sep-0

5

Mar-0

6

Sep-0

6

Mar-0

7

Sep-0

7

Mar-0

8

Sep-0

8

Mar-0

9

Sep-0

9

Mar-1

0

Sep-1

0

Mar-1

1

Sep-1

1

(y-y %) (y-y %)Net sales (LHS) WPI (RHS)

Expect FY13F Sensex earningsgrowth of 10-12%


35/106


34

Policyand political economy a clouded picture

A tough year for the government: 2011 was a tough year for the economy from the

policy environment point of view. The aftermath of the 2G scandal put the incumbent

government in a relatively weaker position. Parliament sessions have been largely

dysfunctional; attempts at pushing through reforms, such as pension bill and FDI in retail

have been blocked by allies of the ruling coalition. The anti-graft movement has slowed

down decision-making across government levels. We do not have high hopes from the

government on an overall basis for the rest of its term.

UPA, in general, is not a reformist government: We do note that the reform processunder the present government has always been weak lack of reforms has been an old

issue, not a new one (please see Appendix).

Why has the perception on policy making plunged to new depths then? First, it is due to

the policy paralysis and weakness set into motion as corruption scandals unfolded over

the course of the past year. Second, in part it is due to the governments inability to

control its finances, which is keeping interest rates at high levels. Third, the RBIs

tightening, which has slowed down the economy, is also getting blamed on governments

policy actions as the necessity of raising rates is considered, to some extent, as cleanup

action post fiscal mess of government finances.

We think there are two fundamental issues that are impacting the policy environment in

India:

Fragmentation of mandate: Post the 1991 Mandal Commission (reservations), caste

dynamics became a very important driver of Indian politics. This essentially led to

fragmentation of politics at state levels. The result of this has been constant

marginalization of national parties at the expense of local parties. Additionally, since the

agenda at state levels tends to be more populistas recently seen in TMCs opposition

to the governments moves to hike fuel prices, raise retail FDI and pass pension

reformthe national agenda tends to get diluted.

Fig. 54: Fragmentation of Indian politics


Governance and politics: The second issue with the present government is the split

nature of power sharing at the center. UPA-I saw creation of the National Advisory

Council (NAC) which advises the prime minister on policy. NAC is headed by the

President of the Congress party, Ms. Sonia Gandhi, and its other members usually

consist of several social activists. NAC is largely responsible for populist schemes such

as National Rural Employment Guarantee Act (NREGA) and is now pushing for the

Food Security Bill. NACs suggestions have led to a significant increase in social

spending, which has led to a structural increase in the fiscal deficit.

Another issue is about authority of the prime minister. In all governments formed earlier,

prime ministers are typically politicians who are also de facto leader of political parties.

Thus there has been a separation of governance from politics which by nature of

Year

Dominant

party

No. of

seats

2nd biggest

party

No of

seats

Top party/total

seats

Top 2

parties/total

seats Remarks1971 INC 352 CPM 25 68% 73%

1977 BLD 295 INC 154 54% 83% Bhartiya Lok Dal - transitory party which won power as a

result of emeregency related pushback (Janta Dal)1980 INC 353 JNP (S) 41 65% 73% Janata Dal declined and Congress came back to power

1984 INC 404 BJP 2 79% 79%

india outlook - nomura

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