IMOS 081010.pmd - IBEF

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Indian Markets Outlook and Strategy

January 10, 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 11-12 for analyst certification and important disclosures, including investment banking relationships.

JPMorgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Customers of JPMorgan in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where

• Special Focus: Monetary policy will turn less hawkish in 2008 with the possibility of a reduction in the repo rate later in the year. This coupled with an improved demand-supply backdrop will support bond price gains. We recommend acquiring duration in the government and the AAA corporate curve. Tight liquidity will no longer be a key policy priority, in our view. Over time, this will result in bull steepening of rate curves. Separately, INR will retain a path of modest appreciation.

We recommend USD-put spreads to execute this view. In addition, investors can contemplate a short KRW/INR trade to position for INR outperformance in a regional context.

• Macroeconomic outlook: The current account deficit unexpectedly widened in 3Q07; however, a stronger capital account surplus helped offset the impact. Driven by net portfolio investments and banking capital, the surplus on capital account more than doubled in 3Q07 to that in the previous quarter. Further, the merchandise trade deficit for November remained elevated despite a relatively healthy export performance.

• Equities: We expect the equity market to drift higher as valuations are likely to derive support from both the numerator and the denominator, i.e. earnings and the likelihood of a lower discount factor. Key index heavyweights are likely to meet quarterly earnings expectations, in our view. Also, valuations of export related sectors have already corrected and we do not expect substantial downside from current levels. Separately, budget expectations are likely to support consumption, agriculture, education and infrastructure related companies.

• Currency: INR strengthened marginally owing to a pick-up in foreign equity inflows and renewed hedging by exporters. However, gains were limited by the RBI’s fx operations. We forecast only gradual INR strength this year after outsized gains in 2007 though revise lower end-year forecast to 37 from 38 previous.

• Fixed income: All interest rate curves rallied over the past few weeks on unusually strong volumes. We expect gains to continue as the fundamental backdrop is improving while even certain technical factors have turned supportive. We hold positions at several points across curves. Our highest conviction position, at this juncture, still remains the 29-year government bond.

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• Monetary policy to turn less hawkish through 2008: buy duration

• Tight liquidity will no longer be a key policy priority:

front end of rate curves to benefit, albeit only gradually

• INR to retain a path of modest appreciation: enter USD- put spread

• Bond-OIS spreads have widened considerably: will compress over time

In our previous special focus (issue dated Dec 13, 2007), we had dealt with the key issues for investors in 2008. In this publication, we intend to take a step further and identify the crucial themes and supplement them with executable trade ideas.

Monetary policy to turn dovish, demand-supply dynamics to improve: buy duration

After three years of strong expansion, the pace of growth is expected to moderate, in part owing to the steep monetary tightening of last year and partly due to the marked slowdown in external demand. Moreover, the pace of credit expansion is likely to ease further. Undoubtedly, signs of the same have been visible since the middle of 2007. Importantly, the balance of credit off-take will improve i.e. incremental growth will largely come from corporates as opposed to retail. In addition, headline WPI inflation will continue to print below the central bank's forecast. That said, we do acknowledge some upside risks from elevated prices of energy and other commodities. On balance, moderating growth along with a still low inflation print will allow the central bank to turn less hawkish as the year progresses.

Evolving expectations for the developed economies, particularly greater rate cuts by central banks, might further aid this process. Indeed, on the JPMorgan forecast, the RBI will reduce the repo rate by 25bp to 7.5% in the July policy review, though will leave the operational policy rate, the reverse repo rate, unchanged for the year.

The above fundamental backdrop when combined with vastly improved demand-supply dynamics, will pave the way for meaningful bond price gains this year. In our view, demand will comfortably outstrip supply despite an expected worsening in the government's fiscal situation as banks,

Special Focus

India: A few trade ideas for 2008

insurance companies and mutual funds will all need to scale up bond market purchases. We recommend executing a bond bullish view by concentrating investments at the long end of the bond curve. Although the entire curve will rally, gains will be greatest for longer tenors as spreads are still elevated in that segment, despite the recent compression.

Longer tenor corporate bonds also appear attractive as spreads are still large relative to history. In the previous bull market, 5-year AAA corporate bond spreads had

compressed to as low as 30bp. It is currently 145bp and thus the potential for compression remains substantial. We recommend buying 5y AAA.

Money market liquidity to remain comfortable:

receive OIS, enter curve steepeners or buy front- end bonds

The RBI has been tightening monetary policy since Sep- 2004, when it first hiked the cash reserve ratio by 50bp. Over the next two and a half years, the central bank raised the reverse repo rate (the rate at which RBI drains funds) by 150bp and the repo rate (the rate at which RBI absorbs 10-year bond yield: the previous bull market had seen a large rally %

Indian Markets Outlook and Strategy

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

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

4.5 5.5 6.5 7.5 8.5 9.5 10.5

Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

Credit growth to moderate further % oya

20 22 24 26 28 30 32 34 36

Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08

RBI's target is 24-25%

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funds) by 175bp. Starting Dec-2006, a crucial shift took place: the RBI migrated to quantitative from interest rate tightening. In the following twelve months, the central bank raised the cash reserve ratio (CRR) five times to 7.5%.

However, it is important to distinguish measures taken prior to April 2007 from the ones post April. The first three hikes - Dec-Mar - were with the intent of draining surplus liquidity to ensure banks were short on funds and thus, increase the effectiveness of monetary policy. The next two - July and October - in our view, were part of the equitable burden sharing of sterilization costs. Indeed, monetary policy has achieved its objective of moderating loan growth and preventing the economy from overheating. The RBI will thus, be more comfortable in allowing liquidity conditions to remain easy. Also, it is important to remember that banks will be reluctant to reduce lending rates till there is uncertainty on the liquidity outlook. Therefore, a marked reduction in the RBI's sterilization operations is only likely this year. Still, the RBI might occasionally drain funds to prevent the liquidity surplus from ballooning - which then runs the risk of spilling over into some already frothy asset markets. That said, it might take a while for investors to accept that liquidity will indeed remain easy, especially after the volatility in 1Q last year. Thus, it maybe some time before market momentum improves and these trades perform.

There are various trades investors can contemplate to position for a more benign liquidity environment. Our preferred trades are:

Receive front end of the OIS curve: On our estimates, the fair value of 1-year OIS is roughly 6.4% assuming sustained easy liquidity conditions, no reductions in the policy rate and only infrequent (seasonality related) periods of tight

liquidity. Sentiment swings, however, can cause the traded product to be extremely volatile. Investors should

incorporate this while factoring take profit and stop loss levels.

Alternatively, for those wishing to limit directional exposure, curve steepeners are a remunerative option. The shape of the curve currently appears too flat relative to the expected trajectory of overnight rates. Investor preference for implementing a view of softer interest rates through longer tenor swaps is a legitimate near-term risk. Among the various tenors, we find 1s5s to be the most attractive, though fully admit this is a more volatile option. A less profitable though more stable alternative is to pay the 2s4s spread.

Buy front end government bonds: The largest

underperformer of last year might be the clear outperformer this year. The front end of the bond curve was weighed down by unprecedented issuance of sterilization bills and bonds in 2007. As explained earlier, we expect 2008 to be markedly different with considerably lower issuance for sterilization. In addition, easy liquidity will increase the carry attraction of this tenor. Admittedly, investors' desire to acquire duration could result in a preference for the longer end of the curve.

Buy 1-year certificate of deposit: Moderating credit growth and comfortable liquidity will enhance the attraction of relatively high-yielding assets such as certificate of deposits (CDs). The spread to the government curve is still elevated and will compress as investors are convinced that liquidity is The OIS curve is still fairly flat

1s5s OIS spread versus overnight rates, basis points on x-axis and percent on y-axis

0 2 4 6 8 10

-50 -30 -10 10 30 50 70 90

latest

40% of 2007 bond issuance was at the front end of the curve as opposed to almost nothing in 2006

INR billion

0 200 400 600 800 1000 1200

<5y r 5-7y r 8-10y r 11-20y r >20y

2006 2007

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enduring.

FX policy to remain unchanged: modest appreciation of the INR to continue

Following the outsized move in 2007 - INR strengthened by close to 11% on a real trade weighted basis - another year of large nominal strength appears unlikely. Capital flows to India will remain strong -- as long as the US economy does not enter a recession -- albeit at a mildly lower pace than 2007. Moreover, exporters will continue to increase hedge ratios as the view of inevitable medium-term INR strength remains firmly entrenched. The expected widening in the current account deficit will offset some of this, but the BoP surplus will remain robust, leading to strengthening pressure on INR. Still, it might be politically infeasible to digest another year of hefty appreciation owing to the perceived economic and potentially adverse political costs of such a move. Thus, we expect the RBI to stay on the bid in spot USD/INR, as required, to moderate the pace of INR gains.

An obvious trade that springs to mind on a view of steady but gradual appreciation is a leveraged USD put spread. We like the following structure: buy 39 strike USD-put INR-call at cost of 0.26% and sell 2.5x 38 strike USD-put INR-call at 0.12% for a net zero cost. Those who have a more bullish INR view can contemplate buying at-the-money USD-put coupled with selling out-of the money USD-call INR-put to lower the initial cost.

To position for INR outperformance relative to some Asian peers, we like a short KRW/INR trade. Korean growth is

geared to the global IT cycle, which might witness a slowdown due to the ongoing growth moderation in the US.

In fact, the Korean current account is expected to turn to deficit from a small surplus previous. Moreover, foreigners continue to offload Korean equities. In contrast, the Indian economy appears relatively insulated from a larger-than- anticipated demand slowdown in the developed world. Also, foreigners continue to pile into Indian equities despite the Indian market having one of the most expensive valuations in the emerging world; perhaps, foreigners are willing to pay for the robust corporate earnings growth, which up until now, has consistently surprised on the upside. Finally, the carry profile of this trade is also favorable.

Curve misalignment

Despite the fact that OIS is a non-funded and a more liquid curve which has certain inherent advantages over

government bonds, the current spread at the 5-year point appears excessive. To be sure, this trade was fairly popular for long periods of time in 2007. Barring certain brief occasions, it was almost always was a recipe for losing money. In our view, the excessive issuance pressure hindered performance of this trade last year. The situation is likely to be different this year as sterilization related issuance will moderate significantly. Thus, we expect this trade to perform well. Admittedly, there is a near-term risk of an even further widening owing to investor flows. Thus, it is recommended only for passive investor who can hold it through some negative mark-to-market swings.

INR strength was concentrated in the Apr-May and Sep period last year

USD/INR

39 40 41 42 43 44 45

1-Jan 1-Mar 1-May 1-Jul 1-Sep 1-Nov

Outsized mov e in USD/INR

The nex t w av e of selling mid-September

Only gradual INR strength

Bond-swap spreads have widened considerably 5-year bond minus 5-year OIS, basis points

-120 -100 -80 -60 -40 -20 0 20 40 60 80 100

Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08

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

• Current account deficit worsened in 3Q07, but was easily financed by a stronger capital account surplus

• Surplus on capital account surged in 3Q07 driven by net portfolio investment and banking capital

• Buoyant imports continued to bloat the merchandise trade deficit in November

Current account deficit above expectations

India posted a deficit of US$5.5 billion in its current account (CA) for 3Q07, an outcome worsened by a wider merchandise trade deficit (US$21.7 billion) along with a slight moderation in the surplus on invisible trade (US$16.2 billion).

The CA deficit in 3Q07 followed one of US$4.7 billion in 2Q07. Faster growth in imports than in exports increased the merchandise trade deficit in the quarter. As in the previous quarters, net private transfers and net exports of software services were the key contributors to the “invisibles” surplus in 3Q07. The contribution of private transfers jumped to US$10.1 billion from US$8.3 billion in 2Q07. However, software service earnings moderated to US$7.2 billion, from US$7.9 billion in 2Q07.

The surplus on capital account more than doubled to US$33.9 billion in 3Q07, from a surplus of US$15.3 billion in the previous quarter. The jump was primarily driven by net portfolio investment (US$10.9 billion), banking capital (US$6.2 billion), and external commercial borrowings (US$3.6 billion). The overall balance of payments (BoP) posted a surplus of US$29.2 billion in 3Q07, way more than the US$11.2 billion surplus in 2Q07. Looking ahead, higher global crude oil prices and the likely impact of significant INR appreciation are expected to widen the CA deficit further to US$22.2 billion (1.9% of GDP) in 2007-08, from US$9.6 billion (1.1% of GDP) in the prior year. However, capital inflows will remain strong, more than offsetting the shortfall in the CA. Thus the overall BoP is likely poised to record another sizable surplus (US$60-65 billion) this fiscal.

Merchandise trade deficit still high

The merchandise trade deficit remained elevated at US$7.4 billion in November 2007, significantly higher than the monthly average of US$6.3 billion in April-October. The trade deficit in April-November thus reached US$52.8 billion. Merchandise export growth surged to 26.8%oya in No- vember, unexpectedly higher than the average gain of 21.1% in the first seven months of the fiscal year. Exports during the first eight months came to around 61.5% of the

Macroeconomic Outlook

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

target (US$160 billion) fixed by the Ministry of Commerce and Industries for the full fiscal year. Commodity break- downs available for April-June 2007 showed decelerating exports across all major categories, excepting gems and jewelry. Petroleum products, engineering goods, and gems and jewelry together contributed 52% of overall export growth in 2Q07; they are likely driving the current strength in exports as well. Import growth further strengthened in November, reflecting growth in the value of both oil and non-oil products. Total imports grew 29.3%oya in November compared with an average of 23.8% in April-October. Oil imports grew only 16.7%oya despite the big rise in global crude oil prices.

Non-oil import growth was also strong at 35.3%oya. Oil and non-oil imports grew an average of 9.9%oya and 34.6%, re- spectively in April-October 2007.

For 2007-08, the higher crude oil import bill, strong non-oil imports, and slower export growth will be key factors widening the trade deficit further. We expect the trade deficit to deteriorate to US$102.2 billion from US$64.9 billion in 2006- 07. The widened merchandise deficit is likely to more than offset the sizeable surplus on invisible trade. The CA deficit is thus expected to widen to US$22.2 billion in 2007-08 (1.9%

of GDP) from US$9.6 billion (1.1% of GDP) in the previous fiscal year. However, financing the wider CA deficit will not be a problem as capital inflows will more than offset the shortfall in CA.

Balance of payments

% of GDP, fiscal year beginning April 1

Merchandise trade balance US$ billion, 3mma

-7 -6 -5 -4 -3 -2 -1 0

2000 2001 2002 2003 2004 2005 2006 2007

-6 -3 0 3 6 9

00 01 02 03 04 05 06 07

Ov erall balance

Capital a/c balance

Current a/c balance

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

Equity Market Outlook

• Liquidity-driven rally continues; Indian equities outperform emerging market peers

• Quarterly earnings to be a mixed bag; Energy , Telecom and Industrials will post strong growth

•

The anticipated 50bp cut by the FOMC at the next meeting likely to support FII flows

•

Budget expectations likely to support Agriculture, Infra and Education related stocks

Indian equities gained over the past month as liquidity drive, both from the domestic and Foreign Institutional Investors (FIIs) continued. Last month was not so good for global growth, as economic data indicate a worse-than-expected growth performance. However, India's economic growth remains relatively strong, despite the moderation in credit growth in industrial activity.

We have been highlighting in our reports that demand for Indian equities from domestic institutions is on a structural uptrend. As per our estimates, domestic mutual finds and insurance companies invested approximately US$15bn in equities in 2007. Additionally, FIIs invested a record-high US$17bn last year. We expect demand for India equities to remain strong in 2008 as well.

Quarterly earnings - Repeat of 2Q performance 3Q-FY 08 reporting season has started and we expect the sectoral trend to be similar to what was exhibited in 2Q.

Telecom, Industrials and Energy companies are expected to report strong set of numbers, while Consumer Discretionary, Non-ferrous materials and Cement companies are likely to disappoint. Key sectoral expectations are mentioned below:

Energy - We expect strong quarterly earnings numbers supported by higher refinery margins globally and volume growth.

Industrials - Growth momentum continued for the sector, and we expect margin performance to be maintained.

Telecom - Subscriber growth momentum remained impressive in 3Q, and financial performance is likely to surprise

positively, especially following a disappointing 2Q.

Financials -Expect Private sector banks to report strong quarterly performance. PSU Bank earnings are likely to lag, given relatively higher loan-loss provisions, margin pressures, and rising non-performing loans

Consumer Staples - The combination of better product mix and strong volume growth is likely to support strong quarterly earnings for key large cap companies.

IT Services - Demand environment for IT services remained decent over 3Q and we estimate a strong 7-10% Q/Q US$- based revenue growth from large Indian IT players. Margins should largely see an upward trajectory due to normalization of salary hikes, though Wipro (acquisitions) and Patni could be exceptions.

Materials - Price hikes and volume growth should help earnings for steel companies. However, non-ferrous companies' margins are expected to disappoint given lower pricing. Separately, cost pressures are likely to cap quarterly earnings for cement companies

Health Care - Appreciating INR and continued margin pressure on generic business are likely to keep profitability of pharma companies unimpressive, in our view.

Consumer Discretionary -Monthly sales numbers for two wheelers and CVs have been disappointing and financial performance is likely to reflect that.

Developed economies and policy support JPMorgan expects a 50bp rate cut at the FOMC meeting scheduled for January 31, 2008. An analysis of historical changes in Fed funds rate indicates that a rate hike typically tends to decelerate flows, while a rate cut leads to an acceleration of inflows into Indian equities over the immediate term. (See Table 2). Admittedly, this analysis has its limitations as there are a number of other factors influencing foreign flows.

Table 1: Earnings estimate changes (%)- 3M Median

MSCI Sector FY 08 FY 09

Energy 10.4 10.4

Health Care 3.5 1.3

Telecommunication Serv ices

2.8 2.6

Materials 2.5 8.2

Consumer Discretionary 2.3 1.7

Utilities 0.6 1.9

Information Technology 0 -0.1

Consumer Staples -0.1 2.9

Financials -0.2 0.5

Industrials -1.5 -1.1

Source: MSCI, IBES

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

Table 3: JPMorgan India Model portfolio

Source: MSCI, Datastream, JPMorgan

Market Strategy

We expect the equity market to drift higher as valuations are likely to derive support from both the numerator and the denominator, i.e. earnings and the likelihood of a lower discount factor. The key index heavyweights are likely to meet earnings expectations, in our view. Also, the valuations of export-related sectors have already corrected, and we do not expect substantial downside from the current levels.

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.

No. of occurrence

Rate Change (bps)

Monthly change in FII flows (%) –

Median

1 -100 802

8 -50 70

9 -25 110

22 25 -4

1 50 -82

Table 2: Fed rate changes in monthly FII flows - (1997 to 2007)

Source: MSCI, IBES

MSCI JPM Dev. PER PER (E) DY (E) ROE (E)

Ticker Price Rating 1M Ytd Weight Weight (%) FY 07 FY 08 FY 08 (%) FY 07(%) Consumer

Discretionary 297 0 -4 2.9 4.2 1.3 19.1 17.1 1.2 23

Tata Motors TAMO.B 774 OW 0 4 1.2 2 0.8 15.5 15.4 4.7 30.9

Bajaj Auto

BJAT.B

O 2,538 OW -6 -3 0.6 2.2 1.6 20.8 20 1.6 25

Consumer 223 17 10 4.5 5.1 0.5 29.7 27.4 1.8 33.8

Itc ITC.BO 231 OW 22 10 2 2.3 0.3 32.1 27.8 1.5 27.7

Hindustan Unilever HLL.BO 235 N 13 10 1.7 1.7 0 28.7 29 3.2 65.7

Dabur India DABU.B 119 N -2 22 0 1.1 1.1 40.8 30 0 56.6

Energy 1,816 8 6 19.7 18.9 -0.8 29 26 2.6 22.7

Reliance Industries RELI.BO 3,051 OW 7 6 15.9 16.9 1 34.8 32.8 0.4 0.3

Oil & Natural Gas ONGC.B 1,322 NR 11 7 2.7 2 -0.7 15.9 13.1 2.8 0.1

Financials 6,465 8 6 29 28.5 -0.5 45 35.6 0.5 11.4

Hdfc Bank HDBK.B 1,716 OW 0 -1 3.3 3.5 0.2 50.1 39.1 0.4 19.5

Housing Development Fin.

HDFC.B

O 3,064 OW 5 7 4.6 9.3 4.7 50.8 41.2 1 31.3

Icici Bank ICBK.BO 1,334 OW 7 8 8.2 9.4 1.2 41.4 34.8 0.8 13.4

Axis Bank AXBK.B 1,069 OW 14 11 1.7 2.1 0.5 45.8 37.6 0.5 21

State Bank Of India SBI.BO 2,465 OW 1 4 1 2.2 1.2 20.4 19.7 0.5 11.8

Dlf DLF.BO 1,151 OW 14 7 1.9 2 0.1 100.9 29.5 0.2 78.7

Health care 524 5 -4 2.6 2.7 0.1 20.6 22.5 0.9 25.2

Dr.Reddy'S REDY.B 703 OW 5 -4 0.7 1.6 0.9 10 19.8 1 29.2

Sun SUN.BO 1,113 OW 0 -9 0.5 1.1 0.6 39.6 24.5 0.7 36

I ndustrials 1,870 2 2 12 15 3 44.9 38.9 0.5 25

Bharat Heavy Els. BHEL.B 2,494 N -9 -3 2.3 4.5 2.2 50.6 37.6 0.5 28.7

Larsen & Toubro LART.B 4,333 OW 2 4 3.8 8.3 4.6 68.8 50.2 0.6 29.7

Punj Lloyd PUJL.B 549 OW 9 166 0 2.2 2.2 232.4 47.3 0 16.4

I nformation

Technology 459 -4 -6 10.2 11.2 1.1 22.5 19 0.8 32.3

Infosys INFY.BO 1,662 N -3 -6 6.1 6.3 0.2 25.1 20.7 0.9 37.1

Tata Consultancy

Svs. TCS.BO 991 OW -7 -9 1 2.8 1.8 25.8 19.1 0.9 54.5

Satyam Computer Services

SATY.B

O 425 OW -4 -5 1.6 2.2 0.6 19.9 16.7 0.8 27.9

Materials 1,094 0 -2 7.4 4.9 -2.5 15 13.8 0.8 28

Grasim Industries GRAS.B 3,401 OW -7 -7 1 2.3 1.3 20.3 12.7 0.9 32.5

Steel Authority Of

India SAIL.BO 263 OW -4 195 0 2.6 2.6 17.5 14.5 1.4 42

Telecommunicati

on Services 243 9 6 4.5 5.1 0.6 42.2 31.4 0.2 10.6

Bharti Airtel BRTI.BO 974 OW 2 55 0 5.1 5.1 45.8 28.4 0 43.6

Utilities 1,241 23 13 7.1 4.3 -2.7 35.3 34 0.9 15.2

Tata Power TTPW.B 1,567 OW 18 7 0.9 4.3 3.4 44.5 51.7 0.5 8.9

MSCI India 883 6 3 100 100 0 30.4 26.4 0.8 19.6

Change (%)

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Rates Markets Outlook

• INR strengthened as equity inflows remained strong and exporter hedging gathered pace

•

We forecast modest INR strength this year; revise lower end-2008 forecast to 37 from 38 previous

•

Enter USD-put INR-call spread to position for gradual INR strength

•

Interest rate markets rallied on strong volumes

• Stay bullish; own positions at several points in various curves

USD/INR declined by around 0.3% since we last published IMOS in mid-December. Interest rate markets witnessed a fairly large rally in that period, with yields declining across products. We believe INR will continue to strengthen at a gradual pace with gains moderated by the RBI's fx

operations. On rates, we remain bullish and stay invested at various points in all curves.

Equity markets rebound

Indian equity markets have surpassed previous highs at a time when developed markets continue to struggle. Indeed, the excess return on the SENSEX relative to the S&P 500 is 7%, since beginning 2008. Importantly, this is not just an India specific phenomenon as most emerging markets have delivered a strong performance while developed markets sagged.

Will this be sustained?

The critical question still is whether this performance divergence will be sustained, particularly if the growth

outlook for the developed world deteriorates further.

Already, US recession expectations are increasing. Even on the JPMorgan forecast, recession risks remain

uncomfortably high at 45%. Worryingly, risks have only risen over the past month owing to the greater-than- anticipated moderation in employment generation and manufacturing activity. Incoming news flow will thus, be crucial in shaping investor expectations. To that extent, the upcoming FOMC meeting on January 30 will be a key event.

Currently, futures are fully pricing a 25bp cut and greater than fair odds of a 50bp rate cut. If the Fed fails to deliver, expectations might take a turn for the worse.

Still, near-term flow backdrop appears attractive The equity issuance pipeline for this year is reportedly large at around US$20 billion, more than double the amount raised in 2007. In addition, the 1q issuance pipeline at US$8 billion is fairly large. The largest initial public offering (IPO) in India, Reliance Power, will raise close to US$3 billion next week.

Foreign money inflow will be at least US$1.5 billion and possibly even US$2 billion. If the degree of oversubscription is substantial (say 50 times), then the cumulative inflow just during the application period can potentially be in the region of US$10 billion.

Central bank's fx operations pick-up

Amidst an improved flow backdrop compounded further by a surprising resumption in exporter hedging, the RBI had to step up its fx purchases to moderate INR gains. On our estimates, the RBI's fx operations have already exceeded US$4 billion for just the past week. As near-term flow expectations remain strong, intervention might need to remain elevated if INR gains are to be arrested. We believe

JPMorgan’s foreign exchange forecasts exchange rates vs. USD

Indian equities have outperformed developed markets SENSEX and S&P500, indexed to 100 at 2006 begin

90 110 130 150 170 190 210 230

Jan-06 May -06 Sep-06 Jan-07 May -07 Sep-07 Jan-08 SENSEX

S&P 500

Actual

9-Jan-07 Mar-08 Jun-08 Sep-08 Dec-08

€ 1.47 1.54 1.55 1.55 1.54

£ 1.97 2.03 2.04 2.05 2.05

¥ 109.0 98 101 101 103

CNY 7.26 6.80 6.70 6.50 6.30

KRW 938 930 950 970 990

INR 39.3 38.5 38.0 37.5 37.0

Forecast (end of period)

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this will be the case. In fact, in a recent speech, Governor Reddy made the following remark: "Prudence demands that, in terms of initial reaction, all large capital inflows are treated as temporary, and if these flows result in excess volatility in the forex markets, some intervention becomes necessary".

This is not to suggest INR will not strengthen, just that the pace of appreciation will be managed, perhaps to within modest limits.

INR to continue strengthening

Looking beyond the near-term, we believe INR's prospects remain bright. Capital inflows will continue at an elevated albeit somewhat lower level. A wider current account deficit will reduce the BoP surplus relative to last year's record; still, as the overall surplus will remain robust, appreciation pressure on INR will continue. In our view, the pace of INR gains will be lower than last year owing largely to political considerations. It might be difficult for policymakers to tolerate another outsized move owing to the potential adverse implications of such a move for politically sensitive sectors. Accordingly, we forecast gradual strength in 2008.

We revise slightly lower the USD/INR forecast trajectory and now expect a decline to 37 by end-2008.

Market strategies

•

Position for gradual INR strength:

We buy 3m 39 strike USD-put INR-call at a cost of 0.26%

and sell 2.5x 38 strike USD-put INR-call at 0.12% for a net zero cost. This trade will be in the money as long as USD/

INR remains in the 38-39 range.

Rate markets record meaningful gains

The much awaited rally in bonds commenced with a bang late December. Still, most of the gains were recorded in 2008, making it a rather happy new year for bond market traders. In our view, interest rates will continue to decline this year. We thus remain invested in several curves.

Less hawkish central bank to support further gains Moderating credit growth, well-behaved headline WPI inflation and deteriorating global growth expectations are all supportive of a less hawkish stance from the RBI. Indeed, recent RBI's actions suggest little urgency to drain surplus funds with banks. In fact, the central bank has infused more funds by not rolling-over maturing securities than what it drained from the 50bp CRR hike late last year.

To be sure, the expected acceleration in flows owing to a large equity issuance next week might necessitate greater intervention and thus, some increase in sterilization. Still, the pace of sterilization will be considerably lower this year, in our view, owing to a diminishing need to maintain a tight monetary policy.

Fuel price hike to have only minimal market impact

Recent developments suggest a hike in local fuel prices is only a matter of time. In our view, investors are already anticipating such a move. Unless the announced increase exceeds 10%, the market impact will likely be muted. On the contrary, it might just prompt further buying as the announcement will remove uncertainty and reduce the possibility of another near-term revision.

Demand-supply backdrop turns favorable There is little issuance left in this fiscal year (that ends March 31, 2008). Of this, INR100 billion is due to be auctioned tomorrow, leaving just INR90 billion for the next two and a half months. Admittedly, further grant of bonds to oil marketing companies and to the Fertilizer Corporation of India might increase the total issuance profile. However, as those bonds are not eligible for SLR investment of banks, the impact may not be as significant.

Moreover, it is the demand side of the equation that appears far more attractive. Nationalized banks’ investment in bonds has picked up considerably. Indeed, the 10-day cumulative investment has crossed INR90 billion, the largest ever in the past two and a half years. Similarly, mutual funds, which have been dormant in the bond market in the current rate RBI’s fx operations were extremely large in 2007

US$ billion

- 20 40 60 80

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2005

2006 2007

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cycle, have increased bond holdings lately. This perhaps owes to a shift from liquid to the higher duration income and gilt funds. In addition, pension funds and insurance companies usually have large surpluses at this time of the year, a part of which will be utilized through stepped up bond purchases. Finally, the RBI will need to buy bonds to replenish maturing securities. In the month of December, RBI's net purchases were around INR50 billion, only half of what matured early January.

Remain bullish on bonds

From a tactical perspective, the surge in volumes is an extremely bullish development as it reflects renewed investors interest. Over a longer horizon, a less hawkish RBI and greater rate cuts in the developed world will remain the key pillars of support for the bond market. We forecast the 10-year bond yield at 6.8% by end-2008. We also turn bullish on corporate bonds as the potential for spread compression is still sizable.

Market strategies

• Hold 29-year government bond:

We hold the 29-year bond as there appears to be rising interest in increasing duration in bond portfolios.

Speculative positioning is not yet crowded which along with a favorable demand-supply balance and comfortable money market liquidity will herald further gains, in our view. Revise target to 7.7% while tightening stop to 8.05%; entered 8.33%, current 7.94%

• Hold 2-year government bond:

We stay invested in the 2-year bond, anticipating further gains as liquidity conditions stay easy and issuance remains muted as the RBI only passively drains surplus liquidity. Target a move to 7.25% while tightening stop to 7.6%; entered 7.76%, current 7.46%.

• Close 1s5s OIS curve steepeners:

We exited the trade as market momentum turned unfavorable owing to sizable receiving interest at the longer end of the curve. Closed for a profit of 6bp, after carry and slide adjustment.

Headline WPI inflation likely to remain below the RBI’s 5% forecast percent

• Enter received 1y OIS:

We execute our view of comfortable money market liquidity by entering received 1y OIS. If, as we expect, the RBI's sterilization operations are modest, the front end of the curve will gain the most. Target a quick move to 6.6%

with a stop of 6.95%; entered 6.82%.

• Enter 5-year government bonds hedged through a paid position in 5-year OIS:

The spread between bonds and OIS at the 5-year tenor has widened to an all-time high. Moreover, bond market fundamentals have improved considerably: speculative positioning, though not light, can neither be categorized as heavy; carry is extremely attractive and the demand- supply balance has not been this favorable in a while.

Admittedly, there is a near-term risk if investors view OIS as a better instrument to execute a view of softer interest rates. Still, this trade appears extremely attractive from a strategic perspective. We entered with the spread at 79bp, targeting a move to 30bp over a 3m horizon.

• Enter 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%.

• Enter 5-year AAA corporate bond:

The current spread of 145bp to government bonds is still elevated, relative to history As investors are convinced that the interest rate cycle has indeed turned, this spread will compress considerably. Target a move to 8.3% while risking a spike to 9.3%; entered 9%.

2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08

final WPI

inflation prov isional likely inflation

trajectory , not a forecast

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