MUMBAI ASSESSES THE MARKETS, EXPECTS MORE RBI MOVES

UNCLAS SECTION 01 OF 03 NEW DELHI 002962

SENSITIVE
SIPDIS

STATE FOR SCA/INS AND EEB
USDOC FOR ITA/MAC/OSA/LDROKER/ASTERN/KRUDD
DEPT PASS TO USTR MDELANEY/CLILIENFELD/AADLER
DEPT PASS TO TREASURY FOR OFFICE OF SOUTH ASIA MNUGENT
TREASURY PASS TO FRB SAN FRANCISCO/TERESA CURRAN

E.O. 12958: N/A
TAGS: EAGR ECON EFIN EINV ETRD IN
SUBJECT: MUMBAI ASSESSES THE MARKETS, EXPECTS MORE RBI MOVES


1. (SBU) Summary. In meetings in Mumbai on November 14-15, Mumbai
financial and market analysts shared their views on liquidity
conditions and their expectations for further monetary actions with
Econoffs from New Delhi and Mumbai. They also conveyed a "wait and
see" approach to re-entering India's debt and capital markets,
pointing to political uncertainties stemming from ongoing state
elections and imminent national elections, as well as global
financial and economic uncertainties. End summary.

STILL A LACK OF LIQUIDITY?
--------------


2. (SBU) Most market participants agree that the Reserve Bank of
India (RBI) has moved relatively quickly to shore up liquidity in
the system since mid-September, when some interbank lending rates
shot up to more than 20%. However, Ridham Desai, Managing Director,
Morgan Stanley, asserted that there was still a liquidity, as
opposed to a confidence, problem. He linked it to declining net
capital inflows, which are putting downward pressure on the rupee.
Because of the speed of the weakening rupee, the RBI has been
intervening in the forex markets to prop up the rupee by the sale of
dollars. Those sales take rupees out of the system, thus
counteracting the central bank's efforts to enhance liquidity.


3. (SBU) Desai described a drastic reduction in trade credit in
October, as well as potential drops in worker remittances and
Non-Resident India (NRI) fixed deposits as other possible weaknesses
in India's balance of payments in the months ahead. He estimated
that, at $14 billion so far this year, non-foreign institutional
investor (FII) outflows, especially trade credit, have been higher
than FII outflows of roughly $11 billion, which have been the main
focus for explaining the weakening rupee. (Comment: Since FII
outflows have been rather steady through 2008 and did not noticeably
spike in September-October, when the rupee dropped the most,
non-FII, especially trade finance-related outflows are likely an
important part of the picture. End comment.) These reduced inflows
would continue to put pressure on the rupee, Desai expected, and
thus prolong RBI currency intervention at the cost of enhanced
liquidity.


4. (SBU) While not disputing Desai's assertion that India's markets
lack liquidity, JP Morgan's Ritu Kocchar and Ashvin Parekh of Ernst
and Young pointed to a few changes that have eased domestic pressure
on liquidity and, to some degree, on the rupee. They noted that
money market redemptions - which surged in September and October as
Indian global companies tapped their cash reserves to help finance
their domestic working capital as well as their overseas
subsidiaries denied dollar financing -- have eased considerably, in
light of several recent RBI facilities and possible improvements in
short-term financing abroad. Others also pointed to the
government's issuance of new oil bonds to the state-owned oil
marketing companies (OMCs).


5. (SBU) The RBI is currently accepting the oil bonds directly from
the OMCs in exchange for hard currency to the OMCs to finance their
imports. OMCs had been borrowing large amounts in the domestic
markets to cover the losses they were incurring because of
government controls on domestic energy prices. The OMCs' borrowing
(and dollar) needs have dropped drastically with the oil bonds and
RBI exchange facility. (Comment: Soon the need for oil bonds and
exchange facilities will also drop drastically as the OMCs' oil
price contracts roll over to represent current spot prices at less
than half of July's peak. End comment.)


6. (SBU) In contrast, Vivek Kudva, President, Franklin Templeton
Asset Management India, stated that banks were unwilling to lend,
independent of liquidity, because the banks fear a recessionary
impact on corporate business. Commercial banks are also imposing
high costs on letters of credit and trade finance right now as well,
he said. Kocchar agreed that bank sentiment was low and thought
that a reduction in interest rates would boost banks' confidence in
corporate borrowers' ability to service their loans.

WHAT CAN THE RBI STILL DO?
--------------


7. (SBU) Even in the wake of the RBI's significant efforts to
enhance liquidity since September, including a 150 basis point

NEW DELHI 00002962 002 OF 003


reduction in the benchmark lending rate and a 300 basis point
reduction in the cash reserve ratio (CRR),interlocutors thought
there was still more that could be done. Kocchar singled out the
CRR as the most effective tool available to the RBI, since it
immediately affects liquidity in the system. She easily expected
the CRR, now at 5.5%, could go below 3%. Kocchar cited the RBI as
having said there is no floor to the CRR. While she has heard
predictions of a rate reduction in January and April (in the run-up
to national elections),Kocchar also thinks the RBI could reduce the
CRR by 50 basis points as early as this month, while state elections
are underway. Morgan Stanley's Desai thought the CRR could be
lowered to zero, which he calculated would release more than $40
billion in liquidity.


8. (SBU) Kocchar also anticipated more interest rate reductions
through the repo rate, the rate at which the central bank lends to
other banks. She anticipated that could help improve sentiment in
the financial system. Sentiment still needs a boost, she claimed,
because lending has not really revived, even as the RBI has enacted
near weekly liquidity enhancements totaling more than $25 billion.
Kocchar pointed to the government's borrowing program (which crowds
out liquidity to the private sector) as well as continued market
uncertainties as leading to lending volatility, exacerbated by
banks' wish to reduce assets to increase safety and security.

EXPECTATIONS OF INCREASED PRESSURE ON CORPORATE LOANS
-------------- --------------


9. (SBU) In addition to improving sentiment, Kocchar thought that
lower rates would ease pressure on retail loans, as consumers' cost
of financing would go down. In contrast, Kocchar expected lending
to small and medium enterprises (SMEs) to be hardhit, as corporate
loans to this segment will be stressed by the SMEs' decreased
ability to service their loans amidst a business cycle downturn.
Others also pointed to a weakness in corporate loans. Morgan
Stanley's Desai remarked that a number of Indian companies,
including a few large ones, will have to restructure their loan
portfolios. While Indian companies are relatively underleveraged
financially, Desai argued that many of them had significantly
increased their operating costs in recent years, by expanding
production and payrolls. As India's economy slows as a fallout of
the global financial crisis and downturn in global demand, the
decline in revenues will make it harder to support operating costs.
He expects this period to last about a year and a half, before the
Indian economy picks up. (Comment: Unlike American firms, Indian
firms will be reluctant to lay off workers as a cost-cutting
strategy, and will instead turn to banks for restructuring their
loans, and to the government for assistance on duties, tariffs, or
price support measures. End comment.)


10. (SBU) Ernst and Young's Ashvin Parekh estimated that banking
non-performing loans (NPLs) had risen from a recent low of $9
billion to around $20 billion, although still a small percentage of
total banking assets at roughly 3.5 percent. He also expected that
some major corporates as well as SMEs might need to restructure
loans, since both primary and secondary equity markets had dried up
in recent months, foreclosing that route for big companies. Parekh
attributed it to instances of overexpansion, like Desai.

CURRENT POLITICAL ECONOMY PROMOTES WAIT AND SEE
-------------- -


11. (SBU) DK Joshi, Principal Economist, CRISIL, stated that he was
waiting for the 2008 annual reports of US companies in order to gain
a "true picture" of the US economy and hence its impact on India's
economy. Ashvin Parekh of Ernst and Young characterized Indian
markets as being in a holding pattern, pointing to industrial
production, corporate results, and inflation data in January as
major signposts for business decisions in 2009. Kochhar also
expected a "wait and see" in the markets, although she attributed
this to the state and upcoming national elections. She said that
companies are hesitating to undertake expansion because there is no
policy clarity right now.


12. (SBU) Morgan Stanley's Desai also stated that the business
community was unsure about how elections would shape the business
environment. He said this was not because of hesitancy if either
the BJP or Congress end up at the helm, but because of concern that

NEW DELHI 00002962 003 OF 003


the Left parties would come back in a coalition government, which he
calculated as a 50% chance of happening. Desai anticipates four
"equally probable" electoral outcomes: the UPA wins with the Left,
the BJP-led NDA coalition comes to power, the UPA comes in with
Mayawati and the BSP, or a "Third Front" is formed of the Left
parties with Mayawati. Overall, though, Desai said he tells
potential investors that foreign direct investment is still a good
option and even more affordable now as Indian companies realize
their valuations must come down. Ajay Shah, Senior Fellow at the
National Institute of Public Finance and Policy echoed the effect of
the Indian election cycle on investment and business decisions. He
suggested that if the elections came out with a bad outcome (which
he defined as a weak coalition/non standard coalition/hung
parliament),which he put at a 30% probability, then it could have a
detrimental impact on the economic policy framework and financial
markets. He was of the opinion that investments would be postponed
until election results were out and there was a clear cut policy
framework in place.

COMMENT
--------------


13. (SBU) Mumbai interlocutors expect businesses and banks to wait
a few months for clearer signs of the extent of the impact of the
global economic slowdown on India (more septel). This inclination
seems bolstered by a sense of political uncertainty cast by ongoing
state elections, which could signal whether national elections will
be held early and how different parties will fare. This feeling of
political uncertainty is likely to last until after national
elections, to be held by no later than May 2009. In the meantime,
since local economists are not clear how much the current signs of
slowdown stem from a decline in demand and how much from lack of
financing, a lending paralysis could exacerbate an otherwise modest
situation. However, there are signs of improving liquidity in the
system, as the RBI has undertaken more than a dozen policy measures
since mid-September. Even more importantly, the central bank still
holds more policy tools in the CRR and repo rate to get banks
lending again. We expect the RBI to deploy them in the weeks ahead.


WHITE