>INDIA STRATEGY & ECONOMICS (MORGAN STANLEY)

Investor Feedback: A Wall of Worries to Climb

• Our recent trip to Europe indicates that investors are a bit tentative about India. They worry, among other things, about the rate at which the market has risen since election day, the high correlation with global markets, as well as local issues such as the 10-year bond yield, the rains, the Central Bank’s likely exit policy, the government’s reform agenda or lack thereof, and valuations.

• We think most of these concerns are already in play and in the price. Some of them are events we are unlikely to witness (for example, the rains affecting industrial growth or the 10-year bond yield rising further). Our prognosis is that Indian equities could stay volatile in the near term, since the next six months’ projected growth is already in the price. Indian equities continue to be vulnerable to a sell-off in global equities or a sudden spike up in crude oil prices. However, at the same time, we believe that investors should use such volatility to buy Indian shares, since the growth outlook for the next 12-18 months remains firm and is still not priced into equities. Our favored sectors are Consumer Discretionary, Energy, Financials, and Industrials. The next few pages detail the concerns that were raised on our trip and our responses.

■ Concern # 1: Is the 10-year Bond Yield Going to Rise Further?
We believe the 10-year bond yields have peaked and the government has taken action by moving to lower tenure bonds to take the pressure off the 10-year bonds. The only technical issue that remains is the exhaustion of HTM limit with banks. There is a major hump in the government borrowing calendar in September. Once that is over, we think the 10-year is likely to stabilize from October (unless there is a very strong recovery in credit growth and/or oil goes to USD95-100/bbl). The incremental credit-deposit ratio is at its 2003 low. Credit growth is at 14.1% as of August 28, and this has created abundant liquidity in the system. Sterilized liquidity (excess liquidity) stock, including reverse repo less repo balances, MSS bonds, and the government's balances with the Reserve Bank of India (RBI), rose to US$35.4 billion as of July 17, from US$20.6 billion at end-March. Thus, we believe that liquidity will not be a problem to fund the deficit.

■ Concern # 2: Will RBI’s Exit Strategy Derail Growth or the Markets?
Investors worry that rising inflation and excess liquidity will lead to Central Bank tightening. We maintain our view that the RBI will initiate its first policy rate hike in early 2010, as we believe
it will likely wait for a sustained economic recovery and is unlikely to change its path due to food inflation pressure along with the drought. However, if the robust trend of 7%-plus industrial growth is maintained, the RBI could move on CRR in 2009. The market’s response historically to the first rate hike has been mixed. To us, the ensuing flattening of the yield curve would actually be positive for the markets (as it would confirm growth), especially for Financials.

■ Concern # 3: Will Poor Rains Reduce Growth?
We maintain our view that poor agricultural output due to below-normal rainfall will have limited impact on industry and services growth, for four reasons: 1) The share of farm income in total rural income is now below 50%; 2) the acceleration of the government's rural spending is acting as an offsetting factor (government spending in the form of social welfare schemes will be about USD20 billion compared with USD7 billion in F2007); 3) an increase in minimum support prices for farm produce purchased by the government from farmers is partially offsetting income loss due to lower output volume, and 4) the government's effort on mitigation measures. While we expect non-agriculture GDP growth to decline by 0.5ppt because of poor agricultural growth, we see an offsetting surprise in the current trend for industrial production and the services sector.

■ Concern # 4: Will the Government Deliver?
We expect the government to deliver steady reforms. The key agenda includes tax reform (both direct and indirect), increased infrastructure investments (watch the data on road contracts in the coming months as indicator for execution), and fiscal consolidation (the 13th Finance Commission report is likely to be published later this year). If the new direct tax code is an indication, the next few reform steps from the government could become important equity market drivers.

■ Concern # 5: Isn’t the Market Pricing In All the Good News?
For long-term investors, the equity risk premium implied by the market (represented by the BSE Sensex) using our residual income model is currently around 6%. We think this is a fair level of risk premium for investors looking to make a long-term commitment to Indian equities. The short-term call is less clear, with the outlook mired by the excessive volatility the market is going through as it grapples with the pace of growth recovery versus the prospects of Central Bank tightening both at home and abroad. Other factors such as equity supply, monsoons, and crude oil will also influence share prices. Indeed, the market is pricing in almost all the growth recovery that we are forecasting in the coming six months. However, markets are yet to price in the earnings and industrial growth for F2011, which bear upside, according to our view. To that extent, investors with a 12-18 month view are likely to realize positive returns from equities.

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