02 August 2011 Economics Research

http://www.credit-suisse.com/researchandanalytics

India: How big an interest rate risk to growth?

Emerging Markets Economics Asia
Research Analysts Devika Mehndiratta +65 6212 3483 devika.mehndiratta@credit-suisse.com

With the RBI ratcheting up the pace of rate hikes recently, we address two key questions in this report: 1. Are rates tight or loose? Many are beginning to worry that the 475bps effective hike in nominal policy rates might lead to a big hit on growth. In contrast, some look at a still negative real policy rate and conclude that interest rates are still too stimulative. How does one reconcile the two arguments? 2. Assuming the hikes in interest rates are indeed contractionary, how adverse an impact will these have on GDP growth? What are the chances that GDP growth slips to below 7%? Even though interest rates in real terms dont look high, we continue to expect GDP growth to slow to 7.5% in both 2011 and 2012, with risks to the downside. This is because (1) we find that changes in nominal interest rates do seem to matter, and (2) interest rates have increased at a much faster pace this time than in the previous cycle (of 2006). On the brighter side even with the extra 50bps in policy rate hikes that we now expect, we believe full-year growth should not slip too much below 7%. Thats because household consumption - 57% of GDP looks relatively less rate sensitive: a) Indias household consumption is not that leveraged, and b) negative wealth effects for households should also be small. Investment spending is likely to be hit by higher rates. However debt-sustainability in the corporate sector, as far as we can make out from debt-equity ratios, should not become a serious issue.

Exhibit 1: Real benchmark lending rate (PLR) for banks* - positive; but not above the historical trend levelyet
10 8 6 4 2 0 -2
Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12

'Real' bank PLR

Current

* Benchmark Prime Lending Rate (PLR) for State Bank of India. Forecast assumes another 50bps hike in the PLR and a moderation in our inflation measure (see page 4) to 7% by March 2012 from 9% now. Source: Credit Suisse, CEIC

ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER IMPORTANT DISCLOSURES, PLEASE REFER TO https://firesearchdisclosure.credit-suisse.com.

02 August 2011

I: Interest rates too high or too low?

Many clients are seemingly beginning to worry about what could be a meaningful hit on growth from the 475bps1 of effective hikes in the policy rate. In contrast, others appear to be looking at the popular rules-of-thumb used to judge the tightness of interest rates, and are wondering if interest rates might still be too low and not the other way round.

From a growth perspective, are current interest rates restrictive or stimulative?

The popularly used rules-of-thumb:
1) Nominal interest rates are much lower than nominal GDP growth are interest rates too stimulative? Interest rates, whether you look at the policy repo rate at 8.0%, the 10-year government bond yield at 8.45%, mortgage rates at about 10.50% or banks benchmark lending rate at 14.25%2 - all are below nominal GDP growth, which stood at 18% in 1Q 2011. But interestingly, nominal interest rates in India have never really exceeded nominal GDP growth at least since 2003! So, if we were to follow the line of reasoning that interest rates below (above) nominal GDP growth are stimulative (contractionary), then wed have to conclude that interest rates in India have been stimulative for at least the last six years. There are several data issues of relevance here which should we be using? Some look at policy rates, others might look at bond yields and so on. Ideally one would like to consider an economy-wide average cost of funds but in the absence of such a series, we look at the floating rate charged by the countrys largest mortgage lender HDFC Ltd (Exhibit 2), as well as banks benchmark prime lending rate (PLR) in Exhibit 3.

Exhibit 2: Interest rates (mortgage) and GDP growth

%, % yoy

Exhibit 3: Interest rates (PLR) and GDP growth

%, % yoy

21 19 17 15 13 11 9 7 5
2005 2006

Mortgage rate* Nominal GDP growth

21 19 17 15 13 11 9 7 5
1996 1998

Nominal banks' benchmark lending rate (PLR)* Nominal GDP growth

2007

2008

2009

2010

2011*

2000

2002

2004

2006

2008

2010

*Floating rate charged by HDFC Ltd., the countrys largest mortgage provider; end-year rates; latest for 2011 Source: Credit Suisse, CEIC

* SBIs benchmark prime lending rate (PLR); end year rates; latest for 2011. Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service, CEIC

While the policy repo rates have been hiked by about 375bps, the effective hike is larger since the interbank call rate moved from the bottom of the policy rate corridor to the top end i.e, another additional 100bps 2 There is no published series for corporate lending rates. What we use here is the benchmark Prime Lending Rate (PLR). This is slowly getting replaced by a new benchmark called the 'base rate' but we use the PLR instead since, unlike for the 'base rate', we have historical data for the PLR. It is worth bearing in mind that the PLR indicates the upper range of lending rates. Much of actual lending takes place at rates below the PLR.

India: How big an interest rate risk to growth?

02 August 2011

In contrast, nominal lending rates were mostly restrictive (rates were higher than nominal GDP growth) prior to 2003. We have mortgage rates data going back only until 2005, therefore, to go back further in time, we look at the State Bank of Indias (largest bank in India) benchmark Prime Lending Rate (PLR)1. This interest rate versus nominal GDP growth quick-check seems to suggest that bank lending rates have been notably more stimulative in India post 2003. This phenomenon (of having years with interest rates below nominal GDP growth) is not peculiar to India. The spread, however, certainly seems larger there. We look at peers, such as Indonesia and Korea, and find that interest rates have often been below nominal GDP growth (in approximately six of the last ten years). But the extent by which lending rates are lower than nominal GDP growth is larger in India (average 3pp) than in the other two (0.9pp in Korea and 1.9 in Indonesia), Exhibit 4. 2) Lets turn to the second commonlyused quick-check for judging the appropriateness of the level of interest rates real interest rates.

Exhibit 4: Nominal GDP growth minus nominal lending rates

%

4.0

Average 2000-2010 Latest*

3.0

2.0

1.0

0.0 India Indonesia Korea

growth SBI PLR for India, Real rates are not really negative as * 1) 1Q GDPfor largeminus latest lending rate. 2)lending rate as per the lending rate corporations for Korea and IMF for Indonesia Source: Credit Suisse, CEIC some argue. In our discussions with clients, some are quite alarmed when they look at the difference between Indias policy rate (the repo rate is currently at 8%) and the inflation rate (latest WPI inflation reading is 9.4% yoy). Their conclusion is that real interest rates are still in negative territory by a large magnitude (-140bp) and that monetary policy is thus extremely stimulative. But we think it is important to (1) also look at other interest rates in the economy because clearly one would get different results depending on which interest rate one uses. Households would be influenced more by mortgage and deposit rates, corporates by both bond yields and commercial bank lending rates, etc. Here, while corporate bond yields are about zero in real terms (the five-year AAA corporate bond yield is currently at 9.42%), mortgage rates (at 10.50%) and rates charged by banks for projects such as roads, etc. (anecdotally at around 11% or more) are positive. (2) Instead of looking at the real interest rate level at just one point in time, its more useful to see where it is today compared with its trend/average level over a longer period of time.

Estimating real rates is of course no easy task but particularly so in India due to the lack of a reliable measure of not just inflation expectations, but inflation itself. First of all, there is the question of which interest rate to use. Then on inflation, some use actual inflation and some inflation expectations. In India, as most of us know, the widely used measure of inflation (Wholesale Price, or the WPI) is fraught with issues but in the absence of a good CPI measure, policymakers and markets all focus on this. For estimating real rates in this report, we attempt to use inflationary expectations. Here, the central bank has started providing results from a quarterly households expectation survey but it does not go back prior to 2006. Hence instead of using RBIs index for households inflationary expectations, we use the average of WPI and CPI as an indicator of households year-ahead inflationary expectations for the entire period since we find this to be a reasonable proxy for the latter. We also checked if the RBIs household inflationary expectations series might be correlated with say a longer-term moving average of inflation (WPI or CPI), but that wasnt the case (more on this in Appendix 1).

India: How big an interest rate risk to growth?

02 August 2011

Exhibit 5: Real benchmark lending rate (PLR) for banks* - positive; but not above the historical trend levelyet
%

10 8 6 4 2 0 -2
Mar-00 Mar-01 Mar-02

'Real' bank PLR

Current

Mar-03

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10

Mar-11

* Benchmark Prime Lending Rate (PLR) for State Bank of India. Forecast assumes another 50bps hike in the lending rate and our inflation expectation measure (see appendix1 ) moderating to 7% by March 2012 from 9% now. Source: Credit Suisse, CEIC

Exhibit 6: Real deposit rates and corporate bond yields bit below historical trend levels
%

6 4 2 0 -2 -4 -6
May-03

Real bank deposit rates* Real corporate bond yield

May-05

May-07

May-09

Jan-02

Sep-02

Jan-04

Sep-04

Jan-06

Sep-06

Jan-08

Sep-08

Jan-10

* 1 year deposit rate and 5-year bond yield. Nominal rate minus average of WPI and CPI inflation. Source: Credit Suisse, CEIC

Most real interest rates are in positive territory (not negative as many assume). It is worth noting though, that these have only just returned to historical trend levels and not higher. We look at real benchmark bank lending rates, bank deposit rates and corporate bond yields (Exhibits 5 and 6). By themselves, these suggest that interest rates are not as restrictive as some of us might believe. Indeed, in Exhibit 5 above, we see that bank lending rates in real terms have moved up, but are back to only historical trend levels (the dashed line). Real bank lending rates are likely to move higher and back to the previous peak only in 2012 (Exhibit 5). This is assuming that the nominal benchmark prime lending rate moves up another 50bps from current levels, and assuming that our measure of inflationary expectations moderates in line with the moderation that we expect in both WPI and CPI inflation post December this year.

Jun-11

Oct-10

Mar-12

India: How big an interest rate risk to growth?

02 August 2011

To summarise we have looked at two rules-of-thumb often used by observers for judging the tightness of interest rates - 1) nominal interest rates versus nominal GDP growth and 2) real interest rates. The first of these quick-checks suggests that despite the effectively 475bps increase in policy rates in this cycle, most interest rates appear still very stimulative since these are much lower than the nominal rate at which the economy is growing. And not just that, it also suggests that this has been the case since 2003! The second rule-of-thumb suggests a more mixed picture real bank lending rates are positive and back to average trend levels whereas real corporate bond yields and bank deposit rates are close to zero and below historical trend levels. All in all, if we were to draw a conclusion based on these two quick checks, we would say that neither of these two suggests that the current level of interest rates is particularly restrictive from a growth perspective. An obvious question pops up: Since neither of these rules-of-thumb seems to suggest that interest rates are restrictive, why are we expecting the rate hikes so far to lead to a slowdown in growth at all? The reasons are as follows: 1. We find that changes in nominal lending rates also matter. In fact, according to our regression exercise for GDP3 growth, we found nominal rates to have a greater impact on growth than real rates (India: Livin on a prayer, 19 Nov 2010), with every 1pp increase in the nominal bank PLR reducing our measure of private sector GDP growth by 0.4pp within a year, and a further 1pp in the second year. Other variables that were statistically significant as explanatory variables were: world trade, the real effective exchange rate (REER) and oil prices.

Exhibit 7: Nominal rate and pvt. sector GDP growth

% yoy %, inverted scale

Exhibit 8: Real rates and pvt. sector GDP growth

% yoy %, inverted scale

14 12 10 8 6 4 2
1993 1997 2001 2005 2009

10 12 14 16
Private sector GDP growth Bank lending rate, forward by 1-yr, RHS, inverted scale

14 12 10 8 6

Private sector GDP growth 'Real' Bank lending rate, forward by 1-yr, RHS, inverted scale

18 20

8 4 2
1993 1997 2001 2005 2009

2012F 2012F

10
2012F

* SBIs benchmark Prime Lending Rate (PLR). Financial year averages. Source: Credit Suisse, CEIC

* SBIs benchmark Prime Lending Rate (PLR). Financial year averages. Source: Credit Suisse, CEIC

In nominal terms, bank lending rates4 appear to be at their highest level since 1998 and are up about 250bps from the recent low in 3Q 2010 (Exhibit 9). Its worth bearing in mind that were focusing more on the trend of this benchmark prime lending rate (PLR) over time and were not reading too much into its standalone value at any particular point of time (latest reading is 14%) because a big chunk of bank lending happens at rates lower than the published PLR.

3 4

Private sector GDP measured as GDP ex agriculture and ex government and social services. See footnote 2 on page 2.

India: How big an interest rate risk to growth?

02 August 2011

Exhibit 9: In nominal terms, lending rates are at all-time highs since 2002
%

15 14 13 12 11 10 9 8 7 6 5
Aug-02 Jan-02

Banks' 1 yr deposit rate Banks' benchmark lending rate (PLR)*

14.3

8.4

May-08

Mar-05

Feb-07

Oct-05

Apr-03

Dec-03

Sep-07

Aug-09

Apr-10

Dec-10

Jun-06

Jan-09

Jul-04

* PLR Is the State Bank of Indias benchmark Prime Lending Rate. This benchmark is now slowly being replaced with a new benchmark called the base rate. A decent chunk of lending takes place at rates lower than this PLR. Source: Credit Suisse, CEIC

How come bank lending rates are at all-time highs when the policy repo rate is 100bps below the previous peak? This mainly reflects the fact that while policy rates were slashed in 2009 right back to the lows of 2004, bank deposit rates (and hence lending rates) proved to be sticky downwards and remained a good 150bps above the 2004 lows. This is possibly because banks wanted to avoid lowering deposit rates too much more in 2010, as that could have meant exceptionally large negative real deposit rates (Exhibit 6) and partly this could be due to banks choosing to operate with larger spreads now (between lending and deposit rates). Why is it that nominal rates appear to have more of an impact on growth than real rates? Theres probably some money illusion at work where at least some economic agents (corporates or households) are more influenced by nominal variables and dont necessarily think in real terms as much as is theoretically assumed. Indeed one very rarely hears even the central bank of the country (RBI) talk about real interest rates in its formal discussions on the economy. Another plausible reason could be that actual real interest rates might be behaving differently from our own approximation. This is in turn could be because actual inflation expectations might be behaving differently than that depicted by our proxy for inflation expectations (which in turn weve constructed in a way so as to capture the trend in RBIs survey measure of household expectations). 2. The pace at which interest rates have been hiked this time is a lot quicker than the previous tightening cycle of 2006. Its not just the level of the interest rate that matters but also how quickly rates are cut/raised. An increase in rates delivered over a shorter period of time would presumably be more of a shock to households and corporates since theres less time to adjust. Here its worth noting that as far as bank lending rates are concerned, the pace of increase in rates has been much swifter this time than in the 2006 tightening cycle (Exhibit 10).

Jul-11

India: How big an interest rate risk to growth?

02 August 2011

Exhibit 10: Bank lending rates have risen at almost double the pace this time compared with the previous tightening cycle
Time period Start Current cycle Previous cycle Sep-10 Jan-06 Now/End July-11 Aug-08 Bank PLR* Start 11.75 10.25 Now/End 14.25 13.75 pp hike 2.50 3.50 Over no. of months 11 30

* SBIs benchmark Prime Lending Rate (PLR) Source: Credit Suisse, CEIC

3. Talking about the change in nominal interest rates, its worth noting that while most discussions centre around the level of real rates, the change in these goes unnoticed. So while Exhibit 5 highlighted that the current level of the real benchmark prime lending rate is only at the historical trend level and not above, it is worth noting that it has moved up a good 580bps since the low in March 2010. Stepping away from interest rates for a minute In this report, were focusing on the impact on growth from higher interest rates. Needless to say, however, how tight or loose overall monetary conditions are will depend not just on interest rates but on other factors such as the real effective exchange rate (REER). The REER as measured by the RBI indicates that the rupee was up an average 13% yoy in 2010 (April 2010 to March 2011). Given the lags with which a real appreciation usually impacts growth, some headwinds from this are likely to be at play this year. To summarise the popular rules of thumb: nominal rates compared with nominal GDP growth and real interest rates suggest that interest rates in India are probably still stimulative and its only in early 2012 (assuming inflation falls 200bps by then and RBI hikes another 50bps), that interest rates in real terms are likely to move back to the previous peak. We still maintain, however, that rate hikes are likely to be a key factor slowing growth in 2011 because a) Our regression analysis for GDP growth suggests that changes in nominal rates have mattered more than real rates and b) interest rates have gone up at a much faster pace this time (2010 to date) compared with the previous cycle that was 2005-2009 (Exhibit 10).

II: What chance sub-7% growth?

In our judgement, the rate tightening so far is likely to slow growth to 7.5% in both 2011 and 2012 from 8.6% in 2010, even though rates might not look that restrictive as per the popular rules-of-thumb. Moreover, we believe that risks to our growth forecasts are to the downside. But how much to the downside? What are the chances that these rate hikes slam growth even harder to well below 7%? Heres the relatively happy news. We think the chances are low. Admittedly, this is not an easy question to answer particularly because data availability for investment and consumption is far from ideal in India, which in turn makes it difficult to assess interest rate sensitivity. Many Indian observers tend to casually box together both private consumption and investment as being equally sensitive to interest rates. We analyse some important aspects of Indias corporate and household sector, which leave us with optimism that the country will outbid a hard landing despite what we consider a fastpaced and meaningful hike in policy rates. Household consumption (57% of GDP) is unlikely to be particularly hard hit. Thats because: I. Household consumption is not that leveraged retail bank loans are only about 8% of GDP II. Negative wealth-effects of interest rates should be low given that households put only about 6% on average of their incremental savings in equities

India: How big an interest rate risk to growth?

02 August 2011

III. Most studies find the impact of real interest rates on the private savings rate to be ambiguous5 Fixed investments (30% of GDP) are likely to bear much of the brunt from higher interest rates, in our view. It would be incorrect to assume that availability of lower cost foreign borrowings may notably help lessen the adverse impact from higher domestic rates. On the brighter side, as far as debt-equity ratios tell us anything, debt-sustainability looks unlikely to become a serious issue Lets look at these points a bit more in detail.

Consumption
For all the talk of a boom in retail/household sector bank lending, it is worth noting that bank loans to households as a percentage of GDP have actually fallen marginally over the last five years. Bank lending to the household sector remains relatively small in India compared to the region (Exhibit 11), suggesting that private consumption (57% of GDP) continues to be relatively less leveraged in India. There are, of course, pockets of household spending that are credit dependent - automobiles and housing being the key ones6. In addition to bank loans and informal moneylenders, one would imagine that Micro-finance Institutions (MFIs) are another key source of finance for rural households but interestingly outstanding loans of MFIs as a % of GDP are quite small, at under 0.5% of GDP.

Exhibit 11: Bank loans to the household/retail sector India the outlier
% of GDP

30 25 20 15 10 5 0
2002 2003

Indon China India Thailand

2004

2005

2006

2007

2008

2009

2010

Source: Credit Suisse, CEIC

Any indirect wealth-effects of interest rates on consumer demand (through equity/bond investments) are likely to be small. To the extent that households invest in equities, higher interest rates could depress the value of these investments and hence households net worth, creating a negative wealth effect. According to RBI data, however, households put only about 6% of their incremental savings in equity (peak 12.5% in 2007); in contrast, almost half is put in to bank deposits7.
i). Savings behaviour in India - Co-integration and causality evidence, The Singapore Economic Review, February 2010. ii). Determinants and long-term projections of saving rates in developing Asia, ADB working papers, October 2010. 6 Bank loans do not take in to account unorganised lending in the rural sector by moneylenders but since we are ultimately interested in analysing the impact of higher rates on household demand, it should be okay to exclude this from our analysis given that interest rates charged by unorganised rural money lenders are unlikely to be heavily influenced by RBI action on policy rates. 7 Average for the period 2005 to 2008; 2008 is the latest year for which data are available.
5

India: How big an interest rate risk to growth?

02 August 2011

Investments
Its the corporate sector alone that has pushed up the overall bank loans to GDP ratio in recent years (Exhibit 12). And here too, 40% of the increase was led by infrastructure.

Exhibit 12: The increase in the loan/GDP ratio in the last five years has been triggered by the corporate sector alone
% GDP

50 40 30 20 10

Total loans* % GDP Corporate loans ex infra % GDP Hhld loans % GDP Corporate loans % GDP

47 38 38 31

28
25

10

0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
* These are what RBI terms as non-food credit. Source: Credit Suisse, CEIC

Two questions with regard to the corporate sector arise: 1) How vulnerable is investment spending to the hike in interest rates? Much of this should be determined by how dependent corporate India is on domestic debt versus other instruments of financing. Has this sharp rise in bank lending to corporates led to debt-sustainability issues?

2)

1) How dependent is investment spending on debt (and hence on interest rates)? In most years, internal resources have accounted for a sizeable chunk of financing according to data for over 3000 public limited companies collated by the RBI. In the 2000s (2000 to 20098), on average, internal sources such as reserves and depreciation provisions accounted for a larger chunk of financing (40% of total) than debt 20% of total financing needs (Exhibit 13). It can be argued that this is more or less in line with the pattern in other peer countries.

Exhibit 13: Financing sources

% of total

60 50 40 30 20 10

Financing through debt, % of total Financing through internal accruals, % of total

0 More importantly, are corporates increasingly relying more on external debt over the last few years? If yes, higher domestic interest rates need not Source: Credit Suisse, RBI bite as much as we consider. We think this is important because if indeed there is evidence that corporates successfully manage
2000 2001 2002 2003 2004 2005 2006 2007 2008
8

2009-10 (Year ending March 2010) is the latest year for which data are available.

2009

India: How big an interest rate risk to growth?

02 August 2011

to diversify away from higher cost domestic debt to lower cost external debt, then higher domestic interest rates need not have that significant an impact on their investment decisions. Anecdotally, this indeed seems to be the case for some large corporates. But our estimates below suggest that this does not hold true for the corporate sector as a whole. Looking at the flow of credit to the corporate sector, we find that even in 2007, when domestic interest rates were close to the peak and foreign capital inflows were strong, domestic credit (bank loans and bonds) continued to dominate as it accounted for close to 70% of the corporate sectors total credit intake (Exhibit 14).

Exhibit 14: Corporate sector borrowings domestic borrowing still dominates

INR trn Borrowings by the corporate sector* Domestic Bank loans Corporate bonds External External Commercial Borrowings (ECBs), net Short-term credit, net Foreign currency denominated bonds Total 2006 3.2 3.2 0.1 1.1 0.7 0.3 0.1 4.3 2010 5.8 5.3 0.5 1.1 0.5 0.5 0.1 7.0 Avg 2006 to 2010 4.2 3.9 0.3 1.0 0.5 0.3 0.1 5.2 74 73 2 26 17 7 2 100 84 76 8 16 8 7 2 100 2006 % total 2010 Avg 2006 to 2010 81 75 6 19 11 6 3 100

* 1. We have compiled this by identifying key sources of debt. 2. Bank borrowings are estimated as change in outstanding non-food bank loans ex retail loans. Borrowings through ECBs and short-term credit are estimates in net terms i.e, gross inflows minus repayments Source: Credit Suisse, CEIC , RBI, the BLOOMBERG PROFESSIONAL service

2) At least as far as debt-equity ratios suggest, corporate sector debt-sustainability looks okay. Needless to say, higher interest costs are likely to squeeze profitability, which is also under pressure from other input costs. But are there signs of debt having risen to unsustainable levels? We look at debt/equity ratios for a sample of 255 listed companies having available balance sheet data for the year-ending March 2011. We find that while corporates have taken on debt quite aggressively over the last decade, the equity base too has kept pace so that gross debt/equity ratios have actually come off over the long term from about 0.64 in 2002 to 0.52 now (Exhibit 15). Given that there was no sustainability crisis in 2008 (when debt-equity ratios were somewhat higher than at present, interest rates had reached a peak and the economy was subject to the Lehman shock), we would imagine that from a sustainability point of view, things should be okay in 2011/2012. This is at an aggregate level specific sectors such as real estate look more vulnerable, however.

Exhibit 15: Debt/equity ratio* Median for a sample of 240 listed companies

0.7 0.6 0.5 0.4 0.3 0.2 2002 2003 2004 2005 2006 2007 2008 2009 2010
Debt/equity ratio Net debt/equity ratio

* Net debt = gross debt cash holdings. Years are financial years ending in March, e.g., 2010 is year-ending March 2011. Source: Credit Suisse, CMIE

India: How big an interest rate risk to growth?

10

02 August 2011

Appendix 1
BOX: RBIs survey measure of household inflation expectations - determinants The RBI now publishes a quarterly survey of households inflation expectations. Unfortunately however, the series only starts in 2006 and for our analysis of the trend in real interest rates, we really need to go back further. As a result, we checked if the RBI series for households inflation expectations displays some connection with actual current inflation readings of the CPI or the more popularly used WPI (Wholesale Price Index). If it does, we can use that as an alternative. For instance, since expectations are often considered to be adaptive, do we find evidence that households inflation expectations closely track, for example, the six-month or one-year moving average of the WPI or CPI (Exhibit 19)? We find a simple average of WPI and CPI inflation readings provides the best proxy for households inflationary expectations as surveyed by the RBI, (Exhibit 18) except for the last year, where RBIs survey expectations have remained sticky more in line with WPI inflation rather than CPI inflation.

Exhibit 16: RBIs hhld expectations and WPI

% yoy

Exhibit 17: RBIs hhld expectations and CPI

% yoy

16 12 8 4 0
Jun-06

Hhld inflation expect'n, yr ahead WPI

16 12 8 4 0

Hhld inflation expect'n, yr ahead CPI*

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-06

Dec-07

Dec-08

Dec-09

Source: Credit Suisse, CEIC, RBI

* CPI for industrial workers Source: Credit Suisse, CEIC, RBI

Exhibit 18: RBIs hhld expectations and avg WPI & CPI
% yoy

Exhibit 19: RBIs hhld expectations and 1-yr moving avg of WPI+CPI
Hhld inflation expect'n, yr ahead 1 yr moving avg of avg WPI+CPI

16 12 8 4 0

Hhld inflation expect'n, yr ahead Avg of WPI and CPI

16 12 8 4 0
Jun-06

Dec-06

Jun-07

Dec-07

Jun-08

Dec-08

Jun-09

Dec-09

Jun-10

Dec-10

Dec-10

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Source: Credit Suisse, CEIC, RBI

Source: Credit Suisse, CEIC, RBI

Jun-11

Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

Jun-11

India: How big an interest rate risk to growth?

11

EMERGING MARKETS ECONOMICS AND FIXED INCOME STRATEGY

Kasper Bartholdy Head of Strategy and Economics +44 20 7883 4907 kasper.bartholdy@credit-suisse.com Eric Miller, Managing Director Global Head of Fixed Income and Economic Research +1 212 538 6480 eric.miller.3@credit-suisse.com

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Alonso Cervera Head of Non-Brazil Latin America Economics +52 55 5283 3845 alonso.cervera@credit-suisse.com Mexico, Chile Nilson Teixeira Head of Brazil Economics +55 11 3841 6288 nilson.teixeira@credit-suisse.com Carola Sandy +1 212 325 2471 carola.sandy@credit-suisse.com Argentina, Peru, Colombia Casey Reckman +1 212 325 5570 casey.reckman@credit-suisse.com Venezuela, Panama, El Salvador Lorraine White +1 212 538 4311 lorraine.white@credit-suisse.com Research Analyst

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Alexey Pogorelov +7 495 967 8772 alexey.pogorelov@credit-suisse.com Russia, Ukraine, Kazakhstan

NON-JAPAN ASIA ECONOMICS

Dong Tao Head of Non-Japan Asia Economics +852 2101 7469 dong.tao@credit-suisse.com China, Korea Robert Prior-Wandesforde +65 6212 3707 robert.priorwandesforde@creditsuisse.com India, Indonesia Christiaan Tuntono +852 2101 7409 christiaan.tuntono@credit-suisse.com Hong Kong, Taiwan Devika Mehndiratta +65 6212 3483 devika.mehndiratta@credit-suisse.com India, Philippines Santitarn Sathirathai +65 6212 5675 santitarn.sathirathai@credit-suisse.com Thailand, Vietnam Kun Lung Wu +65 6212 3418 kunlung.wu@credit-suisse.com Malaysia, Singapore

STRATEGY
Igor Arsenin Head of Latin America Strategy +1 212 325 6437 igor.arsenin@credit-suisse.com Daniel Chodos +1 212 325 7708 daniel.chodos@credit-suisse.com Latam Local Markets Strategy Ray Farris Head of FX Strategy +65 6212 3412 ray.farris@credit-suisse.com Paul Fage Head of EMEA Strategy +44 20 7883 7994 paul.fage@credit-suisse.com Helen Parsons, CFA +1 212 538 8889 helen.parsons@credit-suisse.com Strategy Daniel Katzive +1 212 538 2163 daniel.katzive@credit-suisse.com FX Strategy Ashish Agrawal Asia Strategy +65 6212 3405 ashish.agrawal@credit-suisse.com Saad Siddiqui +44 20 7888 9464 saad.siddiqui@credit-suisse.com Strategy

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Investment principal on bonds can be eroded depending on sale price or market price. In addition, there are bonds on which investment principal can be eroded due to changes in redemption amounts. Care is required when investing in such instruments.

When you purchase non-listed Japanese fixed income securities (Japanese government bonds, Japanese municipal bonds, Japanese government guaranteed bonds, Japanese corporate bonds) from CS as a seller, you will be requested to pay purchase price only.