Strategy
Research Analyst Report
Strategy
October 1, 2015
+ / - (%)
1m 3m 12m
-0.3 -5.0 -0.2
-0.6 -0.2 13.7
-0.5 -5.9 -1.8
0.6 1.1 19.9
September 30, 2015
Nifty
7,949
NSE MidCap 12,985
Sensex
26,155
BSE MidCap 10,799
AAA, 1y – WPI, Manufactured (%)
10.7
6.0
1.3
-3.4
Feb01
Oct04
Jun08
Feb12
Sep15
Projected real interest rates (%)
12
AAA 1y - WPI, Manufactured
Products
Jan16
Oct15
Aug15
Jun15
Jan15
4
Sep15
Deposit Rate CPI-IW, Food
8
0
Cons. Durables and Cap. Goods (%)
23
Cons. Durables
Capital Goods
10
-3
-16
Apr09
Jul10
Oct11
Jan13
Apr14
Jul15
Correlation with GOI 5y bond yields
Libor 3m
Libor 6m
Libor 1y
US 1y
US 3y
US 5y
US 10y
0.00
0.31
0.62
0.93
Anand Shanbhag
Email: anand.shanbhag@tatacapital.com
Tel: +91 22 6606 9402
1 October 2015
Why real lending rates may stay high after the cut
In Sep15 the spread between nominal lending rates and inflation reached its
highest level in 15 years. Over the next two quarters it may fall by a little over
100-bp, and yet stay close to its high. An encouraging sign is the recovery in
industrial growth in the face of rising real rates. The resilience is particularly
noticeable in the segments of Consumer Durables and Capital Goods. The
challenge in 2016 may be posed by the expected rise in rates in the advance
economies. The correlation of Indian rates with the Libor and US treasuries is
likely to be held high by a decline in India’s fiscal deficit ratio.
Real lending rates are near their highest point in 15 years: The rise in
real lending rates has been under way for at least 18 quarters. The very high
real rates are only partly explained by the slow decline in nominal lending rates.
The Repo rate itself, adjusted for inflation, is at its highest level in 15 years.
Another reason is that inflation during the months of Jun15, Jul15 and Aug15
was at its lowest in five years, despite the deficient monsoon rains. The real
deposit rate too had risen sharply but was pulled down after Jul15 by cuts in the
nominal deposit rates.
And, may stay high even after the cut in the Repo: A gentle rise in both
WPI and CPI inflation would shrink real rates over the next four months. But,
even if the 50-bp cut in Repo rate were to be fully passed on, real lending rates
in early 2016 are likely to stay close to their recent highs. A possible reason for
banks’ reluctance to pass on the cuts to borrowers may be the anticipated
burden of provisions on NPLs to low-rated customers.
Industrial growth is recovering despite high real rates: Growth in the
Consumer Durables and Capital Goods segments of the IIP has recovered over
the past year despite the trend of high and rising real lending rates. In the
previous economic cycle, the trend growth of Consumer Durables had an inverse
relationship with real lending rates. In 2015 growth has persisted and become
stronger despite the rise in rates.
Strong link with global rates could pull up nominal rates in 2016: A
wide range of rates in India have been strongly correlated with global
benchmarks such as US treasury yields and Libor. The correlation has stayed
high in past years when India’s fiscal deficit has been shrinking, as in FY16. So,
the likely rise in interest rates in the US during 2016 may tend to exert an
upward pull on Indian rates. This would oppose the downward bias on rates
arising from a decline in inflation.
Risk factors: Widening spread between deposit and lending rates could be a
sign of a large, impending burden on banks’ profitability. A potential rise in
nominal lending rates in 2016 could stall the mild industrial recovery.
1
Strategy
Real lending rates are near their highest point in 15 years
The real lending rate has been estimated by subtracting the inflation in Manufactured Products,
excluding Food products, from the Base Rate of banks or, a proxy such as yields on corporate
bonds. After rising for over four years, real lending rates are at their highest in 15 years. The slow
decline in nominal lending rates is only part of the reason for the high real rates. The Repo rate
itself, adjusted for inflation, is at its highest level in 15 years. Another reason is that inflation
during the months of Jun15, Jul15 and Aug15 was at its lowest in five years, despite the reported
deficiency in the monsoon rains. The real deposit rate too had risen sharply but was pulled down
after Jul15 by cuts in the nominal deposit rates.
Exhibit 1: AAA 1-year – WPI, Manufactured (%)
13.4
Trailing rates
Spot rates
Exhibit 2: BBB 1-year – WPI, Manufactured
14.7
Trailing rates
Spot rates
7.8
9.8
2.2
4.9
-3.4
Feb01
Oct04
Jun08
Feb12
Sep15
Source: Bloomberg, http://www.mospi.nic.in, Tata Capital Securities
0
Feb01
Oct04
Jun08
Feb12
Sep15
Source: Bloomberg, http://www.mospi.nic.in, Tata Capital Securities
Real interest rates are near their highest point in 15 years
The real lending rate is
estimated by subtracting
WPI inflation from AAA bond
yields. Real deposit rates
have been estimated by
subtracting CPI inflation
(Food) from nominal time
deposit rates.
A ‘real’ interest rate is measured by subtracting the most appropriate inflation
number from the nominal interest rate. In Exhibits 1 and 2 the real lending rate
has been estimated by subtracting inflation measured by Wholesale Price Index
for manufactured products from corporate bonds yields. The trailing real rates
use the interest rate 12 months prior to the date for inflation. The real deposit
rate has been estimated by subtracting food inflation within the Consumer Price
Index (Industrial Workers) from the time deposit rate (1 to 3 years). Exhibit 4
indicates that the real deposit rate is now below its 15-year high.
Exhibit 3: Repo rate – WPI, Manufactured (%)
10.8
Trailing rates
Exhibit 4: Deposit Rate – CPI-IW, Food (%)
8.9
Spot rates
5.9
1.1
1
-6.7
-3.9
Feb01
Oct04
Jun08
Feb12
Source: RBI, http://www.mospi.nic.in, Tata Capital Securities
1 October 2015
Sep15
-14.5
Feb01
Trailing rates
Spot rates
Oct04
Jun08
Feb12
Sep15
Source: RBI, http://www.mospi.nic.in, Tata Capital Securities
2
Strategy
Exhibit 5: Change in rates: Dec14 - end-Sep15(%)
Exhibit 6: Change in rates: Dec14 - 25th Sep15(%)
Base Rate,
-0.28
Base Rate,
-0.28
AAA 1-y,
-0.28
AAA 1-y,
-0.34
Repo, -0.75
Repo, -1.25
GOI 1y,
-0.81
GOI 1y,
-0.96
-1.35
Time
Deposits,
-0.88
-0.90
-0.45
0.00
Source: Bloomberg, RBI, Tata Capital Securities
-1.35
Time
Deposits,
-0.88
-0.90
-0.45
0.00
Source: Bloomberg, RBI, Tata Capital Securities
Three forces that are lifting real lending rates

Base Rates of banks rose
less than deposit rates in
the preceding phase of
rising rates during 2013-14.
Nominal lending rates have fallen lesser than nominal deposit rates
During the past nine months, the fall in benchmark lending rates has been less
than half that in time deposit rates. This is similar to the period from Dec12 to
Jun13 when time deposit rates were cut by 50-bp, about twice the extent of the
fall in lending rates represented by AAA bond yields and by the Base Rate. The
current spell of larger cuts to deposit rates partly offsets the changes between
Jun13 and Mar14 when deposit rates rose more (38-bp) compared with the rise
in the Base Rate (15-bp).

Repo rate too is at a 15-year high, relative to WPI inflation
Exhibit 3 reveals that the gap between the Repo and WPI inflation in
Manufactured Products is at its highest in 15 years. This is true even if the gap is
measured using trailing rates viz. the gap between the Repo in Aug14 and the
inflation in Aug15.

Food inflation in the WPI
has fallen to a five-year low
and is less than half that in
2014. Food inflation in the
CPI too has fallen sharply.
Low Food inflation in the
monsoon months is
supplementing the effect of
very low Fuel inflation.
1 October 2015
Exceptionally low inflation during the monsoon months of 2015
Exhibit 7: Annualised inflation in June, July and August (m-o-m, %)
2011
2012
2013
2014
2015
WPI
WPI - Food
WPI - Fuel
6.7
13.6
15.1
8.6
15.2
8.0
19.1
41.7
36.6
8.9
27.3
1.8
-2.6
12.9
-21.9
CPI, New
CPI, New - Food
CPI, New - Fuel
18.4
17.5
28.3
16.9
24.0
12.7
17.8
25.0
8.5
15.5
25.0
5.0
10.7
18.3
4.4
Source: http://www.mospi.nic.in, Tata Capital Securities
3
Strategy
Why real lending rates may stay high even after the cut in the Repo
A complete pass-through of the 50-bp cut in the Repo rate would only have a mild effect on real
interest rates. They are likely to stay close to their recent highs and well above the levels in early
2015. Inflation measured by both the WPI and the CPI is likely to rise till Jan16. Yet, it may stay
lower than its level in Jan15. So, even if the Base Rate and AAA bond yield were to fall by 50-bp,
the real lending rates are likely to stay high. A possible reason for banks’ reluctance to pass on
the cuts to borrowers may be the anticipated provisions on NPLs to low-rated customers.
Exhibit 8: WPI inflation (y-o-y, %)
Exhibit 9: Inflation in WPI segments (y-o-y, %)
10.0
20
4.9
7
-0.2
-6
Food
Manufactured Products
Fuel
-5.3
Jan11
Mar12
May13
Jul14
Source: http://www.mospi.nic.in, Tata Capital Securities
Sep15
-19
Jan11
Mar12
May13
Jul14
Sep15
Source: http://www.mospi.nic.in, Tata Capital Securities
WPI inflation may stay low until early 2016, at least
Exhibit 9 assumes that Fuel
prices would stop falling and
rise at 1% y-o-y. Prices of
Manufactured products’ are
assumed to stop falling by
end of Dec15. Food prices
are assumed to change
month-on-month at the
average for the past three
years.
Exhibit 9 depicts the forecast year-on-year change in the Food (24.3% weight
including food products), Fuel (15.8% weight) and Manufactured products
(55.0% weight excluding food products). In each of the months after Aug15 the
m-o-m change in Food is assumed to be the mean of the m-o-m for the
corresponding month in the three previous years. If the seasonality that was
seen in past years were to persist then Food inflation is likely to stay within 1%
y-o-y. The m-o-m change in Manufactured products prices is assumed to reach
0% at end of Dec15; the average for the past 12 months was -1.8%. In case of
Fuel, the month-on-month change in prices is assumed to be 1% annualized i.e.
fuel prices are assumed to stabilize near the levels at end of Aug15.
Exhibit 10: Food Inflation in CPI-Industrial Workers and CPI-New (%)
Food inflation in the CPI-IW
could rise in the last quarter
of 2015 but, is likely to stay
low compared with the past
four years. Our forecast
assumes that the m-o-m
change in food prices stays
at the average for the past
three years.
16.5
11.0
CPI-IW, Food
CPI-New, Food
5.5
0.0
Jan11
Mar12
May13
Jul14
Sep15
Source: http://www.mospi.nic.in, Tata Capital Securities
1 October 2015
4
Strategy
Deposit rates may continue to fall more than lending rates
Between Dec14 and 25th Sep15 yields on AAA rated bonds with a duration of 1year fell by 28-bp but, yields on BBB rated bonds rose by 125-bp. This suggests
that pricing of the bonds with the lowest investment grade was factoring in a
larger amount of credit risk.
Exhibit 11: Change in Deposit rates, Base Rate and Bond Yields (%)
Between end of Dec14 and
25th September 2015, the
banks cut their Base Rate by
a third of the cut in the
Time Deposit rates.
BBB 1-y, 1.25
Base Rate, -0.28
AAA 1-y, -0.28
Yields on AAA bonds fell by
the same extent as the Base
Rate but, yields on BBB
bonds rose by 125-bp.
Time Deposits,
-0.88
-0.9
-0.1
0.7
1.5
Source: RBI, Bloomberg, Tata Capital Securities
Do banks need to hold their
interest spread high in order
to offset a rise in loan
provisions?
It is likely that banks may decide to widen the apparent spread between their
deposit rates and lending rates in order to compensate for an increase in their
credit costs. If BBB bond yields are assumed to be a proxy for the effective
lending rate to borrowers with a low credit quality then banks’ could be applying
a higher interest rate to this segment even as their incremental cost of funds has
been in decline.
Real rates may stay high even if the Repo cut is fully passed on
A full pass-through of the 50-bp cut in the Repo implies that the Base Rate,
deposit rates and yields on corporate bonds would fall by 50-bp from their levels
on 25th September 2015. Exhibit__ examines the scenario where such a passthrough does happen and, projects the real interest rates after applying the
forecast inflation rates.
Exhibit 12: Projected real interest rates (%)
8
4
BR - WPI Mfd.
AAA - WPI Mfd.
Repo - WPI
Mfd.
Deposit Rate CPI-IW, Food
Aug15
Sep15
Oct15
Jan16
12
Jan15
Jun15
The CPI-IW, Food could rise
by c50-bp to 5.0% at end of
Jan16f. That, coupled with a
50-bp cut in nominal deposit
rates would cut the real
deposit rate by c100-bp to
c2.1%. This rate would be
higher than that in Jan15
and Jun15.
0
Source: http://www.mospi.nic.in, Bloomberg, RBI, Tata Capital Securities
While the real rates would fall from the very high levels observed in Aug15 and
Sep15, they would stay high compared with historical levels. The forecast real
rates at end of Jan16 are likely to be well above their respective levels in Jan15.
1 October 2015
5
Strategy
Industrial growth is recovering despite high real rates
Growth in the Consumer Durables and Capital Goods segments of the IIP has recovered over the
past year despite the trend of high and rising real lending rates. In the previous economic cycle,
the trend growth of Consumer Durables had an inverse relationship with real lending rates. In
2015 growth has persisted and become stronger despite the rise in rates.
Exhibit 13: Trend growth of the IIP (%)
8.0
Exhibit 14: Cons. Durables grth. and real rate (%)
23
12
Cons. Durables
BR - WPI, Mfd.
0.0
-8.0
IIP
10
8
-3
4
IIP x-Con. Durables
-16.0
Jan12
Cons. Durables
Mar13
May14
Jul15
Source: http://www.mospi.nic.in, Tata Capital Securities
-16
Apr09
Jul10
Oct11
Jan13
Apr14
0
Jul15
Source: http://www.mospi.nic.in, RBI, Tata Capital Securities
Industrial growth was held down by weak Consumer Durables
Growth in most segments of
the IIP began to recover in
Feb13. The overall growth
was depressed by weakness
in Consumer Durables.
The ongoing recovery in
Consumer Durables has not
been hampered by rising
real interest rates.
TTM growth in Capital
Goods has been rising for
10
quarters.
It
was
estimated at c5% in Jul15.
Exhibit 13 indicates that the trailing-twelve-months (TTM) growth of the Index of
Industrial Production (IIP) had begun to rise in early 2013 in all its segments
with the exception of Consumer Durables. The segments other than Consumer
Durables account for 91.5% of the IIP. However, the weakness in the latter was
severe enough to hold down the aggregate growth of the IIP. The turning point
in the IIP came in Oct14 when Consumer Durables’ TTM began to rise, albeit
from a very low level. This recovery in Consumer Durables has lasted till date.
Exhibit 14 reveals an inverse relationship between growth of Consumer Durables
and real lending rates. Growth began to decline in late 2010 about two quarters
after the rise of real lending rates. The recovery in growth in late 2009 had
coincided with a decline in real rates.
Exhibit 15: Trend growth in Capital Goods segment of the IIP (%)
23
10
-3
-16
Apr09
Jul10
Oct11
Jan13
Apr14
Jul15
Source: http://www.mospi.nic.in, Tata Capital Securities
1 October 2015
6
Strategy
Strong link with global rates could pull up nominal rates in 2016
During 2015, interest rates in India have had correlations of up to 86% with global benchmarks
such as US treasury yields and Libor. Over the past 15 fiscal years the correlation has been high
during periods when India’s fiscal deficit ratio has been low. The fall in the fiscal deficit ratio
during FY15 and its likely contraction during the FY16 and beyond suggest that this correlation
may stay high. So, the likely rise in interest rates in the US during 2016 may tend to exert an
upward pull on Indian rates. This may offset the downward bias on rates arising from a decline in
inflation.
Exhibit 16: Correlation with BBB 3-yr. yields
Exhibit 17: Correlation with GOI 5-yr. bond yields
Libor 3m
Libor 3m
Libor 6m
Libor 6m
Libor 1y
Libor 1y
US 1y
US 1y
US 3y
US 3y
US 5y
US 5y
US 10y
US 10y
0.00
0.31
0.62
0.93
Source: Bloomberg, Tata Capital Securities
0.00
0.31
0.62
0.93
Source: Bloomberg, Tata Capital Securities
Correlation of up to 86% during 2015
The yield on Indian government bonds continues to have a relatively high
correlation with global benchmark interest rates. Correlation between the yield
on the GOI 5-year bond and US treasury yields has been as high as 93%. Yield
on the BBB 3-year bond too has a high correlation with Libor and US treasuries.
This correlation has been measured using the rates at the end of the past nine
months.
Long-term correlation too has been high in most years
Exhibit 18: Correlation – GOI 10-y yield and US 10-y Treasury (%)
11 of the past 15 fiscal
years saw positive
correlation between the
yields on the 10-year
government bonds in India
and the US.
The correlation has
weakened in years when
India’s fiscal deficit had
soared high.
1.00
0.60
0.20
-0.20
-0.60
Mar01
Mar03
Mar05
Mar07
Mar09
Mar11
Mar13
Mar15
Source: Bloomberg, Tata Capital Securities
1 October 2015
7
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Disclosure of Interest Statement in Strategy as on October 1, 2015.
1. Name of the analyst:
Anand Shanbhag
2. Qualifications of the analyst:
B.E., PGDM
3. Research Analyst or his/her relatives has actual/beneficial ownership of 1% or more securities of the subject company at the end of the month
immediately preceding the date of publication of Research Report:
No
4. Tata Securities Limited’s actual/beneficial ownership of 1% or more securities of the subject company at the end of the month immediately preceding
the date of publication of Research Report:
No
5. Broking relationship with company covered:
No
6. Investment Banking relationship with company covered:
No
7. Research Analyst has served as an officer, director or employee of Subject Company:
No
8. Research Analyst or his/her relative’s financial interest in the subject company:
No
9. Tata Securities Limited’s financial interest in the subject company:
No
1 October 2015
8
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1 October 2015
9