FIRST GLOBAL

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Macroeconomic research
Why Bond Yields are likely Headed Up
Including
The not-so-known factor in determining Interest Rates
It is our case that the trend of yields firming up that has
been seen in the last few days will continue for the next
few months at least… and simply put, that’s bad news for
Indian banking stocks…PSU Banks, anyway

October 11, 2006

Research Contact: Associate Director, Research: Hitesh Kuvelkar Email: hiteshk@fglobal.com

Sales Offices: US Sales: Tel. No: 1-212-2276611 Email: us@fglobal.com

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Research Note issued by First Global Securities Ltd., India
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IMPORTANT DISCLOSURES CAN BE FOUND AT THE END OF THIS REPORT.
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The Short Story

Before plunging into macroeconomic factors, correlation, regression co-efficients et al, for
forecasting interest rates & yields, let’s first point out why this is not another not-immediately-usable
macroeconomic report. In short, you should care about the direction of yields.

First, for the banking sector, this is the most important determinant, not just of profits & margins
(particularly via the investment portfolio), but also of stock prices. In fact, the stock market has
figured out pretty much a one-to-one
correlation between yields and banking
First, for the banking sector, this is the most stock prices. As illustration, the banking
important determinant, not just of profits & margins sector has been a laggard in the market
(particularly via the investment portfolio), but also of since the middle of 2005…but the
stock prices. In fact, the stock market has figured out
moment the 10-year G-sec yield topped
pretty much a one-to-one correlation between yields
and banking stock prices. As illustration, the
out on 17th July 2006, the Banking
banking sector has been a laggard in the market indices & stocks started moving up in
since the middle of 2005…but the moment the 10- exact tandem. The correlation was eerie.
year G-sec yield topped out on 17th July 2006, the It is our case that the trend of yields
Banking indices & stocks started moving up in exact firming up that has been seen in the last
tandem. The correlation was eerie. It is our case that few days will continue for the next few
the trend of yields firming up that has been seen in months at least …and simply put, that’s
the last few days will continue for the next few bad news for the banking stocks,
months at least …and simply put, that’s bad news for especially the PSU banks.
the banking stocks, especially the PSU banks.

Movement of 10 Yr G Sec Yield and BANK NIFTY

8.5
5250
8.3

8.0 4750

7.8
4250
7.5

7.3 3750

7.0
3250
6.8

6.5 2750
Apr-06
Apr-06
Mar-06
Mar-06
Feb-06
Feb-06

May-06
May-06

Aug-06
Aug-06
Jan-06
Jan-06
Jan-06

Sep-06
Sep-06
Oct-06
Jun-06
Jun-06
Jul-06
Jul-06
Jul-06

Yie ld on 10 Yr Gse c bond (%) (LHS) Bank Nifty Inde x (RHS)

Source: FG Research, Bloomberg

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One more point: over the last few days, the heads of various banks have been all over the press
extolling the virtues of easy money and why the good times of Q2 will continue into the rest of the
years. Would’ve been very heartening, except that merely a few months, even weeks ago, the same
persons and banks foresaw interest rates continuing to harden.

To give only one example, the Chairman of one of our largest banks gave these statements just a few
weeks apart

“Interest rates were unlikely to see any further rise in the next three to six months”. “Keeping in
mind the international interest rate scenario, we may see some softening in the near future.”

(“Lower interest rates on the horizon” Financial Express 27th September 2006)

“Interest rates are unlikely to soften in the short to medium term”.

(“XYZ Bank board to meet on Aug 12 in Bhopal” The Hindu 9th August 2006)

Both statements were made by the same senior banker a few weeks apart. The only reason we
haven’t named the bank, is because similar statements can be dug out for most large banks’ CEOs.
As we’ve said in another recent report, the truth is that
most managements tend to extrapolate the immediate
As we’ve said in another recent past and often don’t have a very good crystal ball for the
report, the truth is that most variables in their industries. We hope we can give a
managements tend to extrapolate better perspective and forecast.
the immediate past and often
don’t have a very good crystal ball
for the variables in their
industries.

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The Way ahead

During the last few weeks, there has been frenzy in the bond market due to oil prices (the most
important determinant of interest rates) retracing to normal levels after touching a high of USD 78.5
per barrel in September 2006. While inflationary concerns arising out of rising oil prices do impact
the interest rate movement in India and any fall in oil prices will lower inflationary concerns, we
think that there are other equally important
determinants of the interest rate trend, such as the
Our models show a rising trend in pace and level of credit growth, the competing
yields. The biggest reason is for the demand of funds between public and private sector
first time this decade, we will see over and government borrowing programs. Once these are
several quarters - from the second factored in, our models show a rising trend in yields.
half of FY07 onto FY08- a high The biggest reason is for the first time this decade, we
demand for funds from both the will see over several quarters - from the second half
government, as well as private of FY07 onto FY08- a high demand for funds from
borrowers. This is what will keep both the government, as well as private borrowers.
yields high. This is what will keep yields high.

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The known factors

Credit growth and yield
The Scheduled Commercial Banks (SCBs) in India have delivered a stellar performance over the last
few years, as far as credit disbursal is concerned.
During the last twenty-four months (from October
During the last twenty-four months 2004-September 2006), credit grew at an average of
(from October 2004-September 31.5% M-o-M, as compared to a much modest M-o-M
2006), credit grew at an average of growth of 18.5% from October 1999-September 2004).
31.5% M-o-M, as compared to a The correlation between yields and credit growth is also
much modest M-o-M growth of improving…just as we’d predicted last year. Of course,
18.5% from October 1999- the data points are few for the last correlation.
September 2004). The correlation
between yields and credit growth is
also improving…just as we’d
predicted last year.

Positive relationship between yields and credit growth improves…finally

Correlation between change in 10 yr G sec yield and change in Corporate
Credit by SCBs (M-o-M change)
From Dec 1998 to Sep 2005 21%
From Dec 1998 to Sep 2006 23%
From Sep 2005 to Sep 2006 30%

The key issue here is what does such rapid growth in credit mean for the interest rates? Although the
correlation between credit disbursed and yields on 10 yr G Sec does not produce a significant
relationship, the relationship has improved on the back of the two important factors, viz., demand
side factor - strong corporate demand during the last few months and tight liquidity - and supply
side factor – SCBs are facing a resource crunch, which ultimately impacts the pricing of loan and
the interest rate movement. And this is exactly what we had mentioned a year ago in our report on
interest rates:

Quote:
A statistical regression exercise does not show a clear relationship of interest rates with money
supply & government borrowings. To our mind a major reason for this is that a consistent data
series for these variables was available only from FY99. However, the next few years thereafter
were characterized by excess liquidity where the upward pressure on interest rates due to either
tighter money supply or the ‘crowding out’ of private borrowings due to excess government
borrowings could not become visible as both these would’ve required a supply constraint to
operate in face of adequate demand. Whereas, in this period it was, by and large, demand which
was the constraint. Essentially, in the first few years of this decade, liquidity was in excess relative

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to the corporate demand for funds. Hence, crowding out was not visible. … However, this trend
has changed as the demand for funds from the corporate world & households has picked up.

…In our view, the lack of apparent correlation of yields with Money Supply & Government
Borrowings has been due to the excess liquidity and/or lack of corporate demand in the period
(FY99) for which consistent data is available. This relationship is clearly undergoing a change in
the last 12-18 months, as demand for funds has picked up.

Unquote:
(From First Global’s “Where are interest rates headed...and why it should concern you (India
Macro Research)” dated September 26, 2005)

Outstanding credit by SCBs and growth on M-o-M basis

18,000 40
16,000 35
14,000 30
12,000
25
10,000
20
8,000
15
6,000
4,000 10

2,000 5

0 0
12/31/98 3/31/00 6/29/01 9/30/02 12/31/03 3/31/05 6/30/06
Corporate Credit (Rs bn) (LHS) M-oM Growth(%) (RHS)

Source: FG Research, Bloomberg

Money supply and yield

While money supply, as widely denoted by M3, grew at a modest rate of 15.2% M-o-M (from
October 1999-September 2004), the growth of M3 has further improved to 16% over the last 24
months M-o-M (from October 2004-September 2006) and even higher to 18% M-o-M during the last
twelve months (from October 2005-September 2006). With a credit growth of more than 30% M-o-
M, this was bound to happen. And the next thing as an outcome of the same “credit growth-money
supply cycle”, which we see to happen, is rise in inflation that again may propel interest rates to rise.
However, statistically speaking, the correlation between M3 and the change in the 10-year G Sec
yield has worsened during the last few years.

Correlation between change in 10 yr G sec yield and change in money supply

(M3) (M-o-M change)

From Dec 1998 to Sep 2005 15%

From Dec 1998 to Sep 2006 13%

From Sep 2005 to Sep 2006 0%

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Money Supply (M3) and M3 growth in the system

35,000 25

30,000
20
25,000

20,000 15

15,000 10

10,000
5
5,000

0 0
12/31/98 3/31/00 6/29/01 9/30/02 12/31/03 3/31/05 6/30/06

Money Supply (M3) (Rs bn)(LHS) M-o-M grwoth (%) (RHS)

Source: FG Research, Bloomberg

Government borrowing and Yield

For the fiscal year 2006-07, the Government of India’s gross market-borrowing programme
stands at Rs.1520 bn and net market borrowing stands at Rs.1020 bn, which forms 67.10% of its
budgeted borrowing. So far, the government has borrowed Rs.890 bn through twenty bond issues
in H1 FY07. Hence, the remaining Rs.630 bn is the government’s planned borrowing for H2
FY07. With most of the SCBs now on the brink of their minimum SLR holding level, the
government’s planned borrowing program for the H2FY07 is expected to easily sail through as
banks will need those bonds to satisfy their SLR requirements...assuming the borrowings don’t
exceed targets And this probably drove the decline in the 10-year G Sec yield over the last few
months, along with the oil factor, which has allayed inflationary concerns in the near-term. But hang
on…let us now check what could happen if
SCBs are faced with both corporate credit
What could happen if SCBs are faced with demand continuing into FY08 as well and the
both corporate credit demand continuing into government simultaneously planning to borrow
FY08 as well and the government close to Rs.1500 bn once again in FY08 (with
simultaneously planning to borrow close to
the government borrowing 61% of its budgeted
Rs.1500 bn once again in FY08…
borrowing for FY07 in H1FY07 alone and
… this will become a case of the “crowding considering that oil bonds are yet to be issued,
out” effect, where the government as well as we think that the government borrowing
the private sector will both compete for the program for FY08 will not be lower than that in
same resources of SCBs and will, therefore, FY07). And this will become a case of the
result in the building of a platform for a rise
“crowding out” effect, where the government as
in the interest rates.
well as the private sector will both compete for
the same resources of SCBs and will, therefore,
result in the building of a platform for a rise in the interest rates.

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If we expect deposits in the Indian banking system to grow at 14% a year for FY07 and FY08, then
banks will need to buy bonds worth Rs.1500 bn in those two years in order to maintain their SLR
levels. And with H1FY07 already behind us, we think that banks can still accommodate bonds well
above approximately Rs.1100 bn over the next 18 months. The point here is who will dictate the
terms of pricing of bond issues once the banks have adequate SLR with them? Will it be the seller of
the bonds (the government) or the buyer of the bonds (banks, PDs, Foreign Institutions)? We believe
that the government may initially dictate the terms, as
banks (the major buyer of such issues) will need those
The government may initially dictate bonds to satisfy their SLR requirements. Even so, the
the terms, as banks (the major buyer of ‘crowding out’ effect will persist as private demand
such issues) will need those bonds to
also soars pushing up bond yields in the secondary
satisfy their SLR requirements. Even so,
the ‘ crowding out’ effect will persist as market. Plus, unlike the low interest rate regime,
private demand also soars pushing up banks will try to avoid carrying any excess SLR
bond yields in the secondary market. portfolio, as the loan demand appears to remain
Plus, unlike the low interest rate regime, robust. When seen in the context of the strong credit
banks will try to avoid carrying any growth prevailing in the system (loans and advances
excess SLR portfolio, as the loan grew by 30% on a M-o-M basis in more than 24
demand appears to remain robust. months), banks would be better off by lending to
corporate and retail credit demand, as compared to
lending to the government by subscribing to its bond
offerings.

Hence, based on our belief that banks may not invest even a extra paise on G Sec Bonds than what is
required to maintain the minimum SLR level, the
government may face pressure on the demand side
Banks may not invest even a extra paise on
with respect to its borrowing program. Hence, we G Sec Bonds than what is required to
think that the government may have to offer higher maintain the minimum SLR level, the
interest rates on G Sec bonds, which will further government may face pressure on the
push up the yields. demand side with respect to its borrowing
program. Hence, we think that the
Although government borrowing has not shown a government may have to offer higher
significant statistical relationship with yield over interest rates on G Sec bonds, which will
the period October-1998-September 2006 (the further push up the yields.
reasons have been explained in the quote given
earlier from our Sept 2005 report), the negative
correlation of government borrowing with credit growth (at a negative 5.7%) lends further credence
to our belief that there will be a rise in the interest rates, as both the government as well as the private
sector will compete for the resources lying with SCBs.

Correlation matrix for Yield on 10 Yr G Sec, Credit growth,

Govt Borrowing and Money Supply
Yield on Credit Govt Money Supply
10Y G Sec Growth Borr (M3)
Yield on 10Y G Sec 1
Credit Growth 0.230 1
Govt Borr 0.035 -0.057 1
Money Supply (M3) 0.127 0.347 0.195 1

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Term structure of interest rates

With the RBI beginning to raise its reverse repo rate since the last quarter of CY04, the yield curve
has continued to rise to its current level. The yield on 10-year G Sec, which hit rock bottom during
the first quarter of CY04, has begun to move upwards since then. And it is not just the 10-year G
Sec, but the yield curve (plot of yields of G Sec of different maturities) that is itself moving up
(please refer to the graph below).

Upward sloping yield curve of G Secs as at the end of different end period
8.00
7.50
7.00
6.50
6.00
5.50
5.00
4.50
4.00
3M 6M 1Y 2Y 3Y 4Y 5Y 7Y 8Y 9Y 10Y
As on 30th September 2006 As on 31st March 2006
As on 31st March 2005 As on 31st March 2004

Source: FG Research, Bloomberg

Yield on G Secs of various maturities from the start of CY07

7.25% 8.50%

7.00%
8.25%
6.75%
8.00%
6.50%

6.25% 7.75%

6.00%
7.50%
5.75%
7.25%
5.50%

5.25% 7.00%
4/1/06 5/1/06 6/1/06 7/1/06 8/1/06 9/1/06 10/1/06

3M (LHS) 6M (LHS) 1 Yr (LHS) 10 Yr (RHS)

Source: FG Research, Bloomberg

The recent decline in the 10-year G sec
yield from its year high of 8.38% has come
as a small relief of sorts to the bond
market, as the yield on smaller maturity G
secs (T-Bills) is still trading at close to the
highs achieved in July 2006. And the firm
yield on shorter-term maturity makes us
confident that the yield on longer maturity
will once again move towards the year
high levels during the months to come.
The recent decline in the 10-year G sec yield from its year high of
8.38% has come as a small relief of sorts to the bond market, as the
yield on smaller maturity G secs (T-Bills) is still trading at close to
the highs achieved in July 2006. And the firm yield on shorter-term
maturity makes us confident that the yield on longer maturity will
once again move towards the year high levels during the months to
come. A correlation analysis between the yield on G secs of
different maturity shows a strong relationship (please refer to the
matrix on next page).

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Correlation between yield on G Secs of different maturities

3M 6M 1Y 2Y 3Y 4Y 5Y 7Y 8Y 9Y 10Y
3M 1.00
6M 1.00 1.00
1Y 0.99 1.00 1.00
2Y 0.99 0.99 1.00 1.00
3Y 0.98 0.99 1.00 1.00 1.00
4Y 0.98 0.98 0.99 1.00 1.00 1.00
5Y 0.98 0.98 0.99 1.00 1.00 1.00 1.00
7Y 0.98 0.98 0.99 1.00 1.00 1.00 1.00 1.00
8Y 0.98 0.98 0.99 0.99 0.99 0.99 1.00 1.00 1.00
9Y 0.98 0.98 0.99 0.99 0.99 0.99 0.99 1.00 1.00 1.00
10Y 0.98 0.98 0.99 0.99 0.99 0.99 0.99 1.00 1.00 1.00 1.00

RBI’s stance on interest rates

After a low interest rate regime that prevailed until late CY04, the RBI switched to raising interest
rates (via its signal reverse repo rate). The move was in sync with the global trend of interest rates
being raised by most of the central banks across the globe, led by the US. And while the US has
halted its rate hike spree, we still feel that the RBI will continue to raise interest rates for at least a
couple of quarters, based on the rising concern over excessive credit growth, money supply and the
expected fear of inflation. We expect the RBI to increase the reverse report rate by another quarter
percentage point in its “Mid Term Review of the Annual Policy Statement on October 31, 2006”.

Reverse Repo Rate in India

6.00
5.75
5.50
5.25
5.00
4.75

4.50
4.25
4.00
Aug-04

Aug-05
Feb-05

Feb-06
Jun-05

Jun-06
Dec-04

Dec-05
Apr-05

Apr-06
Oct-04

Oct-05

Source: FG Research, Bloomberg

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And the not-so-known factor

Current account balance and its impact on interest rates
Historical data suggests that as the current account shows a deficit, the yield on G Sec bonds go up.
The graphs below show that the correlation is very strong. The underlying logic that pushes up the
yield with the current account balance turning negative is
that the current account deficit (that is equivalent to the net
Historical data suggests that as inflow of capital from abroad) leads to an appreciation in
the current account shows a domestic currency, followed by expanding imports and a
deficit, the yield on G Sec deteriorating current account balance. And in order to
bonds go up. The graphs below continue to attract capital inflow so as to bridge any current
show that the correlation is account deficit, the interest rates rise further. And the latest
very strong. current account balance figures make a solid case for a rise
the in G sec yield in the near future.
However, there are also some fundamental reasons that make a case for such CAD to continue for
some more time in the future, which will keep the interest rates on the higher side. In fact, as India’s
growth trajectory takes off, the CAD is likely to remain high for some time to come – just as it
should for any country at this stage of growth – just as it should for a country at our stage of
development. In fact, the only reason for a lowering of the deficit will be lower oil prices, but this
is unlikely to be enough for driving the CAD. The capital goods imports, for instance, have grown
at a CAGR of 32% over FY03-05.

Current Account Balance vis-à-vis yield on 10-yr G Sec bonds historically

15000 12.0%

10000
10.0%
5000

0 8.0%

-5000
6.0%
-10000

-15000 4.0%
FY00 FY01 FY02 FY03 FY04 FY05R FY06P
Average yield on 10 Year Gsec Bond (RHS)
Current Account Balance (USD mn) (LHS)

Current Account Balance vis-à-vis yield on 10-yr G Sec bonds over last
nine quarters
6,000 8.0%
4,000 7.5%
2,000
7.0%
0
6.5%
-2,000
6.0%
-4,000
-6,000 5.5%
-8,000 5.0%
Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107
Average yield on 10 Year Gsec Bond (RHS)
Current Account Balance (USD mn) (LHS)

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IMPORTANT DISCLOSURES
Price Target
Price targets (if any) are derived from a subjective and/or quantitative analysis of financial and non
financial data of the concerned company using a combination of P/E, P/Book, Dividend Yield,
earnings growth, Dividend Discount Model and its stock price history.

The risks that may impede achievement of the price target/investment thesis are -
1) Any slowdown in credit growth may lead to interest rate softening as against our opinion of
rise in interest rates.

2) Any reduction in planned borrowing of Government in FY07 as well as FY08 as against our
rough estimates may leave SCBs with sufficient funds to lend given no slowdown in credit
growth and hence interest rate may soften in that scenario.

3) The Current Account balance, which at present is showing deficit balance, may turn in to
positive with fall in oil prices and rise in invisibles and hence may end up pushing interest
rates even higher.

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Rating system of First Global

Our rating system consists of three categories of ratings: Positive, Neutral and Negative. Within each
of these categories, the rating may be absolute or relative. When assigning an absolute rating, the
price target, if any, and the time period for the achievement of this price target, are given in the
report. Similarly when assigning a relative rating, it will be with respect to certain market/sector
index and for a certain period of time, both of which are specified in the report.
Rating in this report is relative to: CNX Nifty 50 Index
Positive Ratings

(i) Buy (B) – This rating means that we expect the stock price to move up and achieve our specified
price target, if any, over the specified time period.
(ii) Buy at Declines (BD) – This rating means that we expect the stock to provide a better (lower)
entry price and then move up and achieve our specified price target, if any, over the specified time
period.
(ii) Outperform (OP) – This is a relative rating, which means that we expect the stock price to
outperform the specified market/sector index over the specified time period.

Neutral Ratings

(i) Hold (H) – This rating means that we expect no substantial move in the stock price over the
specified time period.
(ii) Marketperform (MP) – This is a relative rating, which means that we expect the stock price to
perform in line with the performance of the specified market/sector index over the specified time
period.

Negative Ratings

(i) Sell (S) – This rating means that we expect the stock price to go down and achieve our specified
price target, if any, over the specified time period.
(ii) Sell into Strength (SS) – This rating means that we expect the stock to provide a better (higher)
exit price in the short term, by going up. Thereafter, we expect it to move down and achieve our
specified price target, if any, over the specified time period.
(iii) Underperform (UP) – This is a relative rating, which means that we expect the stock price to
underperform the specified market/sector index over the specified time period.
(iv) Avoid (A) – This rating means that the valuation concerns and/or the risks and uncertainties
related to the stock are such that we do not recommend considering the stock for investment
purposes.

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