IMOS 080207.pmd - IBEF

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Indian Markets Outlook and Strategy

February 7, 2008

Rajeev Malik

(65) 6882-2375 [email protected] JPMorgan Chase Bank, N.A.

Siddharth Mathur

(65) 6882-2214

[email protected] JPMorgan Chase Bank, N.A.

Vikas Agarwal* (91-22) 6639-2961

[email protected] JPMorgan Chase Bank, N.A.

Bharat Iyer

(91-22) 6639-3005

[email protected] J.P. Morgan India Pvt. Ltd.

www.morganmarkets.com

Contents

Special Focus 2

Macroeconomic Outlook 5

Equity Market Outlook 6

Rates Markets Outlook 8

The certifying analyst is indicated by an *. See pages 13-14 for analyst certification and important disclosures, including investment banking relationships.

• Special Focus: India’s fiscal deficit has improved considerably over the past few years. However, reported deficits overstate the extent of improvement as off-budget liabilities are estimated at 2.0-2.5% of GDP. Indeed, issuance of special bonds to oil, food and fertilizer companies is rising, distorting the government’s regular borrowing program. Upcoming spending ahead of elections risks further increase in special bond issuance

• Macroeconomic outlook: Merchandise trade deficit in December narrowed against expectations, owing to relatively weaker growth in both exports and imports. Separately, the government revised up the GDP growth estimate for 2006-07 to 9.6%oya from an earlier estimate of 9.4%. JPMorgan expects the economy to grow 8.6%oya in the current fiscal year and moderate to 7.5% in 2008-09. The IP data scheduled to be released next week will likely grow 7.7%oya in December, recovering from a one-off weakness in November owing to the impact of Diwali holidays.

• Equities: 3Q FY08 (Oct to Dec) earnings growth for the Sensex and MSCI Index companies show a meaningful deceleration. While revenue growth for the Sensex companies has been decelerating over the past three quarters, earnings growth during 3Q dipped sharply to 16%, after sustaining a growth of over 25% over CY07. Profit margin, on an oya basis, contracted for most of the sectors except Consumer Discretionary and Staples. Interestingly, the CNX mid cap universe continued to record robust growth rates.

• Currency: USD/INR trended higher owing to outflows from foreign portfolio investors and a flip in carry. Near-term, this can continue as overnight fx forward is still in discount and the global backdrop fragile.

We stay positioned for further near-term upside in spot USD/INR

• Fixed income: Rate markets sold-off following the RBI’s quarterly policy review as the central bank sounded hawkish. Sentiment has improved since and rates have partially retreated from the highs. We believe the outcome of easy liquidity is unlikely to change for at least the next several weeks. We recommend staying received 1y OIS. In bonds, the demand-supply balance is improving further: stay long duration.

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• Fiscal deficit has improved over the past few years

• Reported deficits overstate the extent of improvement - off-budget liabilities are estimated at 2.0-2.5% of GDP

• Issuance of special bonds to oil, food and fertilizer companies is rising - distorting the regular borrowing program

• Upcoming spending ahead of elections risks further increase in special bond issuance

Fixing the fiscal black mark

A striking feature among India's economic trends in recent years has been the significant improvement in fiscal trends.

Large fiscal deficits have long been a black spot but began to shrink from the early part of the current decade. Indeed, the consolidated (centre plus states) fiscal deficit is likely to narrow to around 5.5% of GDP in 2007-08 (fiscal year runs from April 1 to March 31) after having been close to 10% of GDP.

Strong economic growth that boosted tax collection, fiscal reforms, especially the implementation of a state value added tax and recommendations of the Twelfth Finance

Commission, a structural decline in interest rates, and some restraint on government spending despite coalition politics (note that pending could have been much higher given the political compulsions) have all contributed to the improving fiscal dynamics. Indeed, the Fiscal Responsibility and the Budget Management (FRBM) Act, which was made

operational by the current government in 2004-05, envisages the fiscal deficit to narrow to 3% of GDP by 2008-09. It also mandates the government to eliminate the revenue (operating) deficit by the same fiscal year. The budget for 2007-08 forecast the fiscal and revenue deficits (as % of GDP) at 3.3% and 1.5%, respectively. While the headline fiscal deficit is on track to drop to 3% of GDP by 2008-09 as scheduled (barring, of course, a hit to finances by the implementation of the recommendations of the sixth Pay Commission), the revenue deficit target will likely be missed.

Indeed, it would be almost impossible for the government to shrink the revenue deficit by 1.5% of GDP in a single year.

But special issuance masks the true fiscal picture However,

Special Focus

India: Rising special bond issuance highlights weakening fiscal discipline

official fiscal data overstate the magnitude of improvement in fiscal finances, a key point that has been often stated by the Prime Minister's Economic Advisory Council (EAC). This is because of significant off-budget liabilities, such as "bonds"

issued to oil companies to compensate for the losses arising from selling local fuels at subsidized prices, securities issued to the Food Corporation of India (FCI), and accumulated fertilizer subsidies. These, along with the losses of state electricity boards push up government liabilities by an outsized 2-2.5% of GDP. While the government has been issuing oil bonds since 1997-98, it has been increasing the reliance on these special bonds by resorting to FCI bonds in 2006-07, and to fertilizer companies in 2007-08. Strictly speaking, these special bonds are not fiscal neutral, as they increase government liabilities and the interest expenditure on these bonds increases the revenue deficit, and hence puts upward pressure on the headline fiscal deficit.

Because the government prepares a statement of cash

Indian Markets Outlook and Strategy

Rajeev Malik (65) 6882-2375 [email protected]

Vikas Agarwal(91-22) 6639-2961 [email protected]

Consolidated fiscal deficits have improved over time % of GDP

Federal expenditure and receipts % of GDP

Siddharth Mathur (65) 6882-2214 [email protected]

2 4 6 8 10

90 92 94 96 98 00 02 04 06

Consolidated Federal

States

6 8 10 12 14 16 18 20

90 92 94 96 98 00 02 04 06

Total ex penditure

Rev enue and capital* receipts

* excluding borrowings and other liabilities

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receipts and expenditure for its annual budget, akin to a cash-flow statement, non-cash transactions - such as the issuance of special bonds - are not included within the budget accounts. Thus, the headline fiscal deficit masks the true extent of the improvement in the government's fiscal finances.

The pickup in special bond issuance should concern investors. Indeed, such issuance provides the government a convenient way to skirt the strict requirements of the FRBM Act. While the Act focuses on the fiscal and revenue deficits, it does not limit government debt issuance. As a result, the government is able to continue with its populist subsidies in defiance of the legislated fiscal stance. Of course, the fiscal cost will have to be borne when these special bonds mature, the first of which will be in March 2009. The government will provide for that INR133 billion redemption in its 2008-09 budget, which is due end-February.

Worryingly, special issuance is picking up The most special bonds have been issued to oil marketing companies. Although global oil prices have risen

substantially over the past few years, only a fraction of that rise has been passed through to domestic fuel prices. This has eroded the profitability of the local oil companies. To compensate for selling fuel below market prices, the

government conceived of a mechanism whereby this implicit subsidy was split three ways between the oil marketing companies, the upstream oil companies and the government itself. Under this mechanism the government bears around 40% of the subsidy and the rest is evenly split between upstream and downstream companies. With the extent of under-recoveries estimated in excess of INR800 billion for the current financial year (year that started April 1, 2007), the government will thus need to issue close to INR320 billion of oil bonds in the current year. This follows oil bond issuance of INR500 billion over the past two years.

The Food Corporation of India (FCI) and fertilizer companies have also received bonds as compensation for selling their produce at unremunerative prices. In addition, the

government is likely to issue special bonds in order to participate in the State Bank of India's (SBI) rights issue.

Taken together, more than INR1 trillion of special bonds will

be issued by the end of the current financial year. This additional issuance clearly impedes the cheap financing of the regular government deficit.

Investor demand is slowly improving

Recipients are not always able to sell these bonds at their par value either, with investors demanding a discount depending on market conditions. Although the bonds carry identical sovereign risk to regular government issuance, these special securities are not eligible investment for banks statutory liquidity ratio (SLR). This reduces their

attractiveness to banks and results in their trading cheap to Special bonds curently outsanding

INR billion

Coupon Amount Maturity

Oil bonds

7.33% 20 8-Mar-09

7.07% 20 23-Mar-09

5.00% 3 23-Mar-09

6.96% 90 30-Mar-09

7.47% 20 8-Mar-12

7.44% 20 23-Mar-12

7.00% 58 9-Sep-12

7.61% 18 7-Mar-15

7.59% 18 23-Mar-15

8.13% 50 16-Oct-21

7.75% 50 28-Nov -21

8.01% 42 15-Dec-23

8.20% 50 12-Feb-24

7.95% 113 18-Jan-25

8.40% 50 29-Mar-26

Food bonds

8.15% 50 16-Oct-22

8.03% 50 15-Dec-24

8.23% 62 12-Feb-27

Fertilizer bonds

8.30% 39 7-Dec-23

Others

UTI 47 -

IFCI 4 -

Total 872

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regular government securities of similar maturity. However, insurance companies and pension funds have recently been allowed to invest in special securities, which should help narrow this discount. Additionally, demand from the trading community will improve as the interest-rate cycle turns favorable.

However, the threat of continued supply remains a burden and hampers the secondary market performance of special bonds. Spreads recently widened to a record 70bp over regular government security of corresponding maturity.

Although we believe that the regular issuance of special bonds is an unhealthy practice, at such spreads these bonds offer an attractive investment proposition

Threat of increased reliance going forward Recommendations of the sixth pay commission are a legitimate risk to the recent fiscal consolidation. In addition, there is a possibility that some of the increased spending -- a fallout of the likely generous expenditure increases to be awarded by the commission -- is carved out of the budget by issuing special bonds. This can potentially be an attractive

Issuance of special bonds is picking up

INR billion percent

*2007-08 is estimated

mechanism to continue reporting an improved fiscal outcome. This risk is exacerbated by the likelihood of stepped up spending ahead of the general elections scheduled for 2009. In our view, rating agencies will not take a benign view of such developments. Further ratings upgrades are highly unlikely till "true" instead of the

"reported" deficits are lowered.

0 200 400 600 800 1000 1200 1400 1600

2005-06 2006-07 2007-08*

10%

15%

20%

25%

30%

35%

40%

45%

Gov t's net 50%

issuance (INR

Off-budget bonds (INR bn)

As % of gov t borrow ing

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• Merchandise trade deficit contracts against expectations

• Official GDP estimate for last fiscal year revised up to 9.6%oya from an earlier estimate of 9.4%

• December IP data likely to recover from previous month, but overall trend toward moderation

India’s merchandise trade deficit shrinks

India's merchandise trade deficit shrank to a three-month low of US$5.4 billion in December, after averaging US$6.4 billion per month in the first eight months of the current fiscal year that began April 1. Exports and imports in Decem- ber increased less than our expectation: exports grew 16%oya, while imports gained 18.1%.

Export growth in December appears to have fallen back to a more sustainable pace following outsized readings in Octo- ber and November that resulted in average over-year-ago (oya) growth of around 31% in those two months. Total import growth also moderated in December, despite higher oya global prices for crude oil.

While product-wise details will be announced with a lag, the available data for April-August shows that several industries (e.g. textiles, garments, handicrafts, leather products, etc) have been hit by INR's appreciation. Also, the headline export growth appears to be inflated by strong gains in gems & jewellery, and petroleum products. These trends probably continued through December.

Export growth is likely to moderate further owing to a combination of the hit from INR appreciation and softening external demand. However, still-strong domestic demand and high oil prices will continue to boost import growth. Overall, the current account deficit will likely widen to US$22.2 billion (1.9% of GDP) this year, though financing the deficit should not be challenging. Given the political heat gener- ated by the hit to some labor-intensive industries from INR's outsized appreciation last year, the government and the central bank will likely fight INR appreciation in the near-term.

Official GDP estimate revised up

The government revised up the estimate of GDP growth in 2006-07 (the fiscal year that ended March 2007) to 9.6%oya from 9.4% announced previously. India's GDP growth has averaged 6.9% annually so far in the current decade, and

Macroeconomic Outlook

Gunjan Gulati (91-22) 6639-3125 [email protected]

Merchandise trade balance US$ billion, 3mma

Exports and industrial production

% oya, 3mma

8.7% p.a. in the three years to 2006-07. These outcomes are much better than the average annual growth rate of 5.8% in the nineties. However, growth is poised to moderate in the current fiscal year that ends March 31, owing to a combination of higher interest rates and currency appreciation.

JPMorgan expects the economy to grow 8.6%oya in the current fiscal year, and 7.5% in 2008-09.

December IP likely to rebound

Industrial production for December, due next week, will likely show a recovery from the weakness posted in Novem- ber. IP likely increased 2.0%m/m, sa, to be up 7.7%oya. No- vember IP grew 5.3%oya, owing mainly to the impact of Diwali holidays. These holidays fell in November this past year but in October of 2006. Even though the overall trend in IP growth is toward moderation, the December data are likely to show a recovery from the previous month. The cumulative impact of monetary tightening and softer external demand will soften industrial activity in the coming months, but higher capex and infrastructure spending will likely be key offsetting forces. We expect monthly IP to increase in the range of 7.0-8.5%oya in the remaining months of the current fiscal year.

The government this week revised up the estimate ofGDP growth in 2006-07 (the fiscal year that ended

-7.0 -6.0 -5.0 -4.0 -3.0 -2.0 -1.0 0.0

2000 2001 2002 2003 2004 2005 2006 2007

0 10 20 30 40 50

4 6 8 10 12 14

2003 2004 2005 2006 2007

Ex ports

IP

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Bharat Iyer (91-22) 6639-3005 [email protected]

Equity Market Outlook

• Latest quarterly earnings report for Sensex companies shows a meaningful moderation

• Earnings growth deceleration is more noticeable for Energy, Materials , Utilities & Telecom sectors

•

Profit margin deteriorated for most sectors , except Consumer Discretionary & Staples

• Revenue and earnings growth trend are relatively robust for the CNX Midcap universe

•

Increasing weights of interest rate cyclicals &

Healthcare sectors and reducing Industrials in the model portfolio

Q3 earnings - Meaningful moderation

Q3 earnings for the Sensex constituents (adjusted for extra- ordinary gains) moderated to 16% YoY (vs trend growth of about 25% in the previous three quarters). Earnings growth for the first nine months of FY08E now stands at 21% YoY.

In terms of breadth, the split was fairly even between companies that met, exceeded and disappointed vis a vis expectations. Sectoral trends were mixed. Private sector banks, Auto and Cement companies surprised positively, while Industrials, PSU banks and Metals reported disappointing set of numbers.

Revenue growth is expected to continue to moderate into FY08 due to a statistical base effect and the lagged impact of the monetary tightening measures implemented by the central bank. Growth rates in absolute terms should remain healthy due to strong economic momentum (JPMorgan forecasts GDP growth of 8.6% for FY08E and 7.5% for FY09E) and sustained buoyancy in the investment cycle.

Volatility in global commodity prices, particularly for energy, could have a bearing on the trend herein.

Net income and margin performance

While revenue growth has been moderating for a while, earnings growth has seen a sharp deceleration to 16% (after sustaining growth rates of nearly 25% over the last three quarters).

Source: JPMorgan

Revenue growth -Stabilizing

Aggregate revenues for Q3 for Sensex companies increased 16% YoY. This is in line with the trend reported over the first two quarters of FY08, but a significant moderation from the 29% seen in FY07. The moderation has been across sectors, but is more noticeable in the case of Energy, IT, Health Care and Materials sectors.

In terms of momentum relative to YTD performance, financials are driving performance. Energy, Telecoms, Utilities and Materials are witnessing sharp deceleration, while Consumer Staples and Discretionary appear to be bottoming out.

Exceed Met Disappoint

ACC Bharti Airtel Bharat Heav y Els.

Ambuja Cement Cipla Hindalco Industries

Grasim Industries DLF NTPC

HDFC HDFC Bank Oil & Natural Gas

ITC ICICI Bank Tata Steel

Larsen & Toubro

Infosy s

Technologies Wipro M&M Maruti Suzuki

Ranbax y Labs. RIL

SBI Saty am Comp

Bajaj Auto TCS

Table 1: Sensex companies: Q3 performance vs. expectations

Source: Bloomberg

Note: "Met" category is 0-3% band.

Figure 2: Sensex companies* - Profit growth 10%

15%

20%

25%

30%

35%

Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Figure 1: Sensex companies - quarterly revenue growth trend (%YoY)

Source: Bloomberg, JPMorgan Calculations 0%

10%

20%

30%

40%

Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07

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Bharat Iyer (91-22) 6639-3005 [email protected]

Source: JPMorgan calculations, Bloomberg

In terms of sectoral contribution, Telecom, Financials, and IT companies drove earnings, while Health Care, Utilities &

Materials lagged.

While the moderation in revenues has been going on for a while, the deceleration in earnings over 3Q was largely driven by margin pressure for most sectors.

Mid cap stocks

Quarterly performance of CNX midcap 100 stocks was noticeably better than the large cap universe. Aggregate sales have grown by 20% YoY, and net profit by 33%.

Performance was, however, driven largely by Energy and Financials sectors (account for 53% of total earnings growth).

Energy and Utilities sector witnessed margin improvement, while Consumers and IT services sector saw margin

compression.

Outlook for FY08

The street currently estimates earnings growth of 23% for FY08E. With YTD earnings growth up only 21%, street estimates for FY08E appear a bit challenging at this stage. It must be pointed out though that the base effect over 3Q was particularly challenging, given earnings growth of nearly 35% for the corresponding period last year. We currently estimate 4Q earnings growth of 18-20%.

Market Strategy

We expect Indian equities to remain range bound as earnings and valuations support could likely be negated by investor sentiments in the global financial market. Indian equities will likely remain extremely dependent on global cues.

We prefer Financials and Consumers sectors as further monetary easing among the developed economies has likely increased the possibility of an early rate cut in India.

Separately, expectations from the federal budget to be announced toward the end of February are likely to support consumption, agriculture, education and infrastructure related companies.

We have replaced Dr Reddy's by Ranbaxy and added Hero Honda to our model portfolio.

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QoQ YoY QoQ YoY

Consumer Discretionary 1.2 0.4 0.2 0.4

Consumer Staples 1.3 -3 1.9 0.6

Energy -2.7 -1 -2 -1.1

Financials

Health Care -9.3 -9.6 -1.6 -6.2

Industrials -0.3 -0.5 1.7 -0.2

Information Technology 4.7 -0.7 0.2 -0.4

Materials 1 0.6 0.1 -0.8

Telecom 1.9 0.2 -0.9 1.5

Utilities 0.4 -3.6 -2.5 -4.6

Aggregate -0.3 0 -0.5 1.4

Median 0.1 0 0.1 0.4

MSCI India Sensex

Table 2: Margin trend - sectoral performance

Source: MSCI, Bloomberg

FY 07 FY 08 (E) FY 09 (E)

Consumer Discretionary 20 16 17

Consumer Staples 19 16 18

Energy 26 16 17

Financials 19 19 26

Health Care 35 26 17

Industrials 48 25 29

Information Technology 37 22 20

Materials 44 31 5

Telecommunication

Serv ices 213 76 31

Utilities 17 16 13

Sensex 32 23 19

Table 3: Sectoral earnings growth expectations

Source: JPMorgan calculations, Datastream, IBES

20 25 30 35 40 45

Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Figure 3: CNX Midcap companies - Profit growth

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Rates Markets Outlook

• USD/INR spikes owing to outflows from foreign portfolio investors and a flip in carry

•

We stay positioned for further near-term upside in spot USD/INR

•

Rate markets sold off following the RBI’s policy review as the central bank appeared hawkish

•

Sentiment has improved since and rates have partially retraced the move

•

Liquidity conditions to stay easy for the next several weeks: receive 1y OIS

• Demand-supply dynamics improve for bonds: stay long 28-year bond

It has been a rather volatile past two weeks. Spot USD/INR after trading a narrow range, spiked sharply higher this week owing partly to the outsized refunds from an equity offering and partly to fears of an imminent shortage of dollars within the banking system. Rate markets did not respond favorably to the RBI's policy review due to the hawkish rhetoric on inflation. Interest rates have since retreated on the realization that the policy review did little to alter status quo.

We believe there is further near-term upside to USD/INR barring timely action from the central bank. We retain our tactical long in spot USD/INR. In interest rate markets, we remain long duration across several curves.

Fed delivers a 50bp cut

The FOMC reduced the Fed funds target rate by 50bp on January 30, in line with market expectations. This, however, failed to excite financial markets, in contrast to the response

after the September 2007 meeting. Concerns of further write- downs at many financial institutions only strengthened.

Bond insurers were in the limelight as rating agencies downgraded some leading names. Weak economic reports further intensified fears of an impending recession. Although equity markets did rebound from the lows, activity stayed choppy and sentiment mixed.

FIIs pull out funds from India

Foreign portfolio investors continued to off-load local equities. Indeed, net sales in January were an outsized US$4.3 billion, the largest in the history of the series.

Admittedly, some recovery has been witnessed early February. Still, this has been more than offset by the refunds from an equity offering that received outsized bids.

Interestingly, recent initial public offerings (IPOs) have seen a tepid response with few even failing to be fully subscribed, despite a reduction in the offer price. The uncertain global backdrop further enhances the possibility of muted interest in the near-term.

Dollar shortage a reality

The overnight fx forward is in discount owing to a shortage of dollars with banks. The proximate reason is that the RBI likely absorbed the dollars when inflows took place last month and is not supplying it back at the time of outflows.

This has resulted in a short-term mismatch of dollars available with banks. Moreover, prudential regulations govern banks dollar borrowings abroad. This channel might already have been exhausted to the maximum extent possible. Sale of dollars by the central bank or the RBI entering into sell-buy swaps with banks are the only possible immediate solutions. In our view, the former is unlikely - INR needs to weaken considerably more to elicit a JPMorgan’s foreign exchange forecasts

exchange rates vs. USD Implied fx rates plunge at the front end of the curve

percent

-5 0 5 10 15

Feb-05 Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08 Ov ernight

implied fx

1m implied fx Actual

6-Feb-07 Mar-08 Jun-08 Sep-08 Dec-08

€ 1.46 1.54 1.55 1.55 1.54

£ 1.96 2.03 2.04 2.05 2.05

¥ 106.4 98 101 101 103

CNY 7.18 6.80 6.70 6.50 6.30

KRW 944.7 930 950 970 990

INR 39.5 38.5 38.0 37.5 37.0

Forecast (end of period)

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response from the RBI - while the latter might be constrained by exposure limits of various inter-bank participants.

Most banks are liquidating their paid fx forward positions, leading to a collapse in forward points. With this, carry has flipped sides. It is now attractive to be long USD and is likely reflected in inter-bank positioning.

Still, unlikely to be protracted

The ongoing shortage of dollars is likely to only be a short- term phenomenon. Two essential pre-requisites for a protracted shortage of dollars are: (1) net outflows on a BoP basis and (2) absence of central bank dollar sales or worse, continued dollar purchases. Although the above

combination is happening currently, the situation will not sustain. The last quarter of a financial year experiences a rather strong current account outcome owing to urgency in crediting export proceeds and buoyant remittances from overseas Indians. This will likely ensure the balance of payments stays in surplus. In addition, other capital account flows - particularly private equity investment - will stay strong. The RBI is unlikely to intervene regularly unless spot USD/INR threatens to break on the downside, something that is highly unlikely when net outflows are taking place from India.

Further near-term upside to USD/INR

Most exporters have been on the sidelines despite the spike in USD/INR as fx outrights are largely unchanged - the spike in spot has been offset by the sharp decline in forward points. In our view, this situation is unlikely to change immediately. Carry sensitive participants have switched sides and are already positioned long USD or adding such

positions. In addition, the global backdrop remains highly fragile and unsupportive of an outsized rebound in foreign equity flows. We stay positioned for near-term INR weakness.

Medium-term backdrop continues to be attractive Despite near-term uncertainties, INR remains attractive over the medium-term. Foreign direct investment is expected to stay elevated, particularly private equity investment. In fact, anecdotal evidence suggests the likelihood of further acceleration this year. The outlook for portfolio investment though unpredictable in the very near-term, is fairly attractive over a six to nine month view. Indeed, equity market valuations appear reasonable following the recent correction. In addition, export growth is robust outside the sectors that have been hit hard by last year's INR

appreciation. Thus, although the current account deficit might widen, the deterioration will most likely be modest.

Over time, exporters will recommence hedging, especially once stability returns to fx forwards. We thus remain optimistic over a longer time horizon and forecast USD/INR at 37 by year-end.

FIIs sell a record US$4.3 billion in January

US$ billion, 30-day cumulative USD/INR

Large divergence between true and visual liquidity INR billion

Visual liquidity is net drain of funds at the RBI’s LAF while true liquidity is a JPM estimate

JPMorgan’s policy rate forecast percent, p.a.

-2 -1012345 6

Oct-06 Feb-07 Jun-07 Oct-07 Feb-08

39 41 43 45 47 FII inflow s, US$ billion

USD/INR

-600 -400 -200 0 200 400 600 800

Aug-07 Sep-07 Oct-07 Nov -07 Dec-07 Jan-08 True liquidity

Visual liquidity

Forecast (end of period) Country Current 08Q1 08Q2 08Q3 08Q4 United States 3.00 2.75 2.75 2.75 2.75 Euro area 4.00 4.00 4.00 4.00 4.00 United Kingdom 5.50 5.25 4.75 4.75 4.75

Japan 0.50 0.50 0.50 0.50 0.75

Hong Kong 4.50 4.25 4.25 4.25 4.25

Korea 5.00 5.00 5.00 5.00 5.00

India 7.75 7.75 7.75 7.50 7.50

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Market strategies

•

Tactically long USD/INR:

We entered long spot USD/INR at 39.42 and stay positioned for a move to 39.8. Positive carry, wobbly equity markets, an uncertain global backdrop and muted exporter response are all supportive of a move higher in USD/INR. The risk, of course, arises from central bank action to sell USD/INR. Continue to target a move to 39.8 while risking 39.4

•

Close short KRW/INR:

We tactically close this position owing to the possibility of a near-term spike in INR. We will look to re-enter the trade once INR stabilizes. Exit for a negligible gain.

RBI disappoints bond market participants

The RBI left interest rates unchanged at its quarterly policy review, a disappointment to many who were expecting a 25bp cut in the repo rate or at least a material softening in the policy stance. Crucially, investors were perhaps spooked by the frequent reference to inflationary risks. The continued emphasis on liquidity management was interpreted as a desire to keep liquidity conditions tight. In response, bond yields rose and OIS rates spiked sharply higher, particularly at the front end of the curve. However, a partial retracement has taken place owing to the gradual realization that the central bank will do little to change status quo.

Continued priority to liquidity management in policy hierarchy

The RBI re-emphasized liquidity management by

highlighting "..liquidity management will continue to assume priority in the conduct of monetary policy". Although early last year this phrase was synonymous with a tighter liquidity

Sterilization continues to lag intervention INR billion, weeks starting Nov 9, 2007

backdrop, it is far more nuanced in the current context. In view of the heightened global uncertainties and continued volatility, the RBI is unlikely to actively drain funds from the money market. At the same time, the central bank will still be uncomfortable with outsized surplus liquidity as it runs the risk of spilling over into speculative activity which then could potentially fuel inflation. Indeed, this has been the observed stance since the previous CRR hike, implemented early November 2007. To be sure, sterilization issuance will be conducted, as necessary; just that, sterilization will lag intervention, as has been the case of late. Therefore, the money market will continue to experience surplus liquidity conditions, for at least the next several weeks.

March: 2008 will not repeat 2007

The seasonal tightness in the second half of March 2008 might be far less severe than what was observed last year.

First, the stock of surplus liquidity will most likely be around INR100 billion just prior to the quarterly tax payout as Liquidity to stay easy till mid-March

Amount drained at RBI’s LAF auction, INR billion JPMorgan’s long-term interest rate forecasts percent, p.a.

-100 -50 0 50 100 150 200 250 300

1 2 3 4 5 6 7 8 9 10 11 12

Sterilization (INR billion) Interv ention (INR billion)

Negative sterilization in a week refers to no roll-over of maturing MSS securities

-500 -300 -100 100 300 500 700 900

Feb-07 May -07 Aug-07 Nov -07 Feb-08

Actual

6-Feb-08 Mar-08 Jun-08 Sep-08 Dec-08

United States 3.55 3.75 3.85 4.00 3.95

Euro area 3.86 4.02 4.00 3.99 3.98

United Kingdom 4.41 4.75 4.85 5.15 5.35

Japan 1.41 1.30 1.45 1.60 1.85

India 7.48 7.30 7.15 7.00 6.80

Forecast (end of period)

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holdings of the banking system have increased

considerably: INR1.4 trillion currently compared with INR600 billion then. Finally, the RBI will be uncomfortable with undue volatility in overnight rates, a fact that found implicit mention in the policy statement. Thus, overnight rates at the stratospheric levels of last year are highly unlikely. In fact, even low double digit overnight fixings are unlikely, in our view.

Demand-supply balance is favorable

Bank deposits increased by INR425 billion during the fortnight ended Jan 18, 2008, following an INR460 billion increase in the previous fortnight. Bank credit also expanded at a brisk pace of INR200 billion, with a clear pick up in the pace of sequential accretion in the past three fortnights.

Accordingly, the oya growth jumped to 23%, though still within the 24-25% comfort zone of the RBI. Still, the incremental credit-deposit ratio remains depressed at 56%

compared with 90% in the corresponding period of the previous year. Thus, deployment of bank deposits into government securities will continue, in our view. In addition, banks' liabilities continue to expand at a fast pace. This might necessitate bond buying by balance sheets to build surplus bond holdings, prior to the expected seasonal swing in liquidity mid-March. After last year's experience, not many banks will be willing to risk being short of funds and securities.

In addition, insurance companies and pension funds will have large investible surpluses, part of which will be deployed in the bond market. Mutual funds, after a weak January, are once again experiencing a rise in inflows, further boosting the demand backdrop. Moreover, issuance has slowed to a trickle - there is just one INR90 billion auction due tomorrow, after which there is no issuance for the next two months, as part of the government's regular borrowing program. Sterilization issuance is a risk, but is unlikely to be outsized, as fx market intervention has slowed considerably in the past week.

Stay bullish on interest rate markets

The combination of continued easy liquidity conditions and attractive demand-supply backdrop is supportive of further bond price gains. We stay bullish and recommend owing positions at several points in various curves. Maintain end-

Market strategies

• Re-enter received 1y OIS:

We were stopped out of our received 1y OIS

recommendation at 6.7% (entered 6.57%) as the initial market reaction following the RBI's policy announcement was for a marked rise in swap rates. We re-entered the trade at 6.79% on the belief that liquidity conditions will stay easy in the foreseeable future. We stay received, targeting a move to 6.5% while tightening stop to 6.75%.

Last 6.69%

• Stay long 28-year bond:

We remain invested in the 8.33% 2036 bond as the long- end of the curve will be the key beneficiary of a

progressively less hawkish RBI and a favorable demand- supply backdrop. In addition, the recent sell-off has likely reduced speculative positioning. Target a move to 7.5%

while widening stop to 7.9%; entered 8.33%, last 7.82%.

• Hold 5-year AAA corporate bond:

Allocation toward corporate bonds will increase in a meaningful fashion, once investors anticipate a change in the interest rate cycle. Indeed, the current spread of 160bp to government bonds is rather elevated and will compress considerably; note that it had compressed to a low of 30bp in the previous bull market. However, we do admit that it might take a while for this trade to perform as issuance has gathered pace. We still stay invested as downside appears limited. Target a move to 8.3% while risking a spike to 9.3%; entered 9%, last 9.05%.

• Hold 1-year certificate of deposit:

Comfortable money market liquidity, expected drop in issuance and a likely rise in demand will herald gains.

Target a move to 8.0% over a 3m horizon while risking a spike to 9.3%; entered 8.85%, current 9.0%.

• 5y OIS is too rich vs. bonds:

The spread remained elevated even as the bond market outlook continued to be favorable. However, longer dated OIS might underperform as some paring down of positions is possible. We stay invested targeting a reduction in the spread to 30bp while risking a widening to 110bp. entered 79bp, current 82bp.

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