PNB Gilts Ltd

MACROECONOMIC REVIEW

Gross Domestic Product (GDP)

During 2012-13, growth in GDP (April-December, 2012) declined to 5.0 per cent from 6.6per cent a year ago. This was mainly due to the protracted weakness in industrial activityaggravated by domestic supply bottlenecks and slowdown in the services sector reflectingweak external demand. The Central Statistics Office (CSO)'s advance estimate places theGDP growth for 2012-13 at 5.0 per cent as against 6.2 per cent in FY 2011-12. The slowdownin growth was witnessed across the board, with all the sectors being affectedsignificantly. While, Industry and

Agriculture continued to decline, the Services sector which is supposedly the mostresilient was also seen succumbing to the poor macro economic conditions prevalent duringthe year. Industry is expected to grow at 3.1 per cent, while agriculture output isexpected to grow at 1.9 per cent following lower than normal rainfall in the initialphases of the monsoon season.

The expenditure side analysis suggests sharp slowdown in both private consumption (4.1per cent in FY 2012-13 as against 8.0 per cent in FY 2011-12) and investment, especiallyprivate investment. While high inflation and high interest rates contributed towards thefall in consumption, private investment languished on account of tight monetary policyregime, lower demand for Indian merchandise and stalling of fresh projects due to policyrestriction. Net exports also suffered due to weak global demand. Inelastic demand for oilimports and resilient demand for gold imports kept the overall imports high, exacerbatingthe trade deficit situation. The fall in private consumption, investments and net exportscould not be complemented with increased government expenditure due to high fiscaldeficit. The government curtailed expenditure to meet the fiscal deficit target for thefinancial year in order to prevent further imbalances due to capital outflows and ratingdowngrades.

International Trade and Debt

India's international trade situation was precariously placed during FY 2012-13, withexports registering negative growth rates throughout the year except in April, 2012. Aftergetting bolstered by a slew of measures announced in FY 2011-12, exports fell dramaticallyin FY 2012-13 as global economic conditions deteriorated. Cumulatively, export growth indollar terms was negative at 4.9 per cent (April to January, 2013) as against 21.3 percent growth in FY 2011-12. Imports also decelerated during the year, albeit not as sharplyas exports. At USD 406.9 billion imports in FY 2012-13 (April-January) registered a growthof 0.01 per cent as against 32.3 per cent in full FY 2011-12. Oil imports grew by 12.8 percent in period April to December of FY 2012-13, while non-oil imports decelerated by 5.1per cent, with gold and silver imports declining by 14.7 per cent during the year. Thetrade deficit of USD

167.2 billion for FY 2012-13 (April-January) was 7.9 per cent higher than the USD 154.9billion in FY 2011-12 (April- January). The Current Account Deficit (CAD) was alsoimpacted adversely due to decline in net exports. With sharp rise in trade deficit, theCAD widened to USD 39.0 billion in H1 of FY 2012-13 as against USD 36.4 billion incorresponding period of last year. As a proportion of GDP, CAD stands at 4.6 per centduring H1 of FY 2012-13 vis--vis 4.0 per cent in H1 of the preceding year.

India's external debt increased by USD 20.0 billion (5.8 per cent) to USD 365.3 billionat end September 2012 over end March 2012 level. The increase has been primarily onaccount of higher NRI deposits, short-term debt, and External Commercial Borrowings, whichtogether contributed 94.7 per cent of the total increase in the country's external debt.The maturity composition of the external debt remained skewed towards long term loansaccounting for around 77 per cent of total outstanding external debt.

Inflation

Inflationary pressures remained strong during the first half of the year mainly led bypersistently high food inflation. However, the headline inflation was markedly lower, withWPI inflation averaging at 7.3 per cent as against 8.9 per cent in FY 2011-12. Fuelinflation averaged in double digits during 2012-13, largely reflecting upward revisions inadministered prices and the pass-through of high international crude prices to freelypriced items. Non-food manufactured products inflation ruled above the comfort level inthe first half of 2012-13 but declined in the second half to come down to 3.5 per cent byMarch, reflecting easing of input price pressures and erosion of pricing power. Pricepressures moderated from December onwards with wholsale inflation decreasing below 7 percent mark.

However, retail inflation as meaured by CPI, having greater weighatge of food items,continued to remain at elevated levels due to higher food prices. Nevertheless, the WPIinflation, benefitting from sharp decline in prices of non-food manufactured products, hasmoderated significantly falling in line with RBI's projected trajectory. By March, 2013,WPI inflation at 6.0 per cent turned out to be lower than the Reserve Bank's indicativeprojection of 6.8 per cent, mainly due to a sharp deceleration in non-food manufacturedproducts inflation in the second half of the year.

Commodity Prices

Global commodity prices displayed stability during the year, with only grains and oilprices exhibiting upward trend due to supply shortages. Energy and non-energy pricescontracted during the year partly due to base effect and partly because of actual declinein prices of commodities such as base metals and beverages. Oil prices remained underpressure due to continued economic headwinds arising from deteriorating Euro crisis anduncertainties pertaining to the US fiscal policies. Average WTI oil price was down at USD91.95 per barrel in FY 2012-13 as against USD 97.19 per barrel in FY 2011-12.

Fiscal Deficit

The fiscal health of the government was largely stable during the year, with governmentbeing able to meet the fiscal deficit target for the year. The fiscal deficit target wasmainly met by cutting down plan expenditure by almost 18 per cent over the budgetedestimate. The non-plan expenditure on the other hand over shot the budgeted estimate by3.27 per cent on account of higher outflow towards fuel, food and fertilizer subsidy. Thedisinvestment and spectrum sale targets of Rs. 30000 crore and Rs. 40000 crorerespectively were not met as the government could realize only Rs. 24000 crore and Rs.14407 crore from disinvestment and spectrum sale respectively. On the revenue side, thetax revenues fell short of budgeted estimate by 3.67 per cent on account of slowingcorporate activity. Market borrowings through issuance of G-sec were contained well withinthe budgeted estimate. As against budgeted gross market borrowing of Rs. 570000 crore, thegovernment borrowed Rs. 558000 crore during the year. However, short term borrowings weremuch higher at Rs. 45746 crore as against budgeted estimate of Rs. 9000 crore. The revisedestimates (RE) of Central Government finances for 2012-13 show that the Gross FiscalDeficit-GDP ratio at 5.2 per cent was around the budgeted level and within the target setout in the revised roadmap.

Government Borrowings

During FY 2012-13, the government adhered to its market borrowing program in the G-seccategory as squeeze in expenditure limited the government's requirement for additionalfunds. The gross borrowing during the year was lower by Rs. 12000 crore to Rs. 558000crore as against budgeted estimate of Rs. 570000 crore. However, short term borrowingswere sharply higher at Rs. 45746 crore as against budgeted estimate of Rs. 9000 crore. Inaddition to this, state governments also raised funds to the tune of Rs. 170967 crorethrough market borrowings as against Rs. 159900 crore during the previous year.

Monetary Policy

The combination of growth slowdown, persistence of inflation above the comfort leveland a historically high CAD posed a special challenge for monetary policy during 2012-13.The Reserve Bank addressed this with calibrated reductions in the policy rate andliquidity easing measures. Despite a large injection of liquidity through Cash ReserveRatio (CRR) cuts and Open Market Operations (OMOs), liquidity conditions tightenedespecially since November, 2012, mainly due to large and persistent build-ups ingovernment cash balances.

Taking cognizance of falling growth, the Reserve Bank lowered policy interest rate andthe Statutory Liquidity Ratio (SLR) by 100 bps each and the CRR by 75 bps in 2012-13 ontop of a 125 bps cut in the CRR in Q4 of 2011-12. It also undertook liquidity injectionsthrough outright purchases of G-secs as a part of OMOs totaling about Rs. 150000 croreduring the year. After front-loading a 50 bps policy rate cut in April, 2012, the Reserve

Bank had to hold rate in the absence of the expected momentum on fiscal consolidationand elevated inflation concerns. However, since September, 2012, a renewed commitment tocontain the fiscal deficit provided space to the Reserve Bank for further policy easing.In response, the policy rates were lowered further by 50 bps in Q4 of 2012-13. Rising CADrisks, however, prompted the Reserve Bank to exercise caution while easing.

Money Market

Liquidity remained under pressure throughout the year because of persistently highgovernment cash balances with the Reserve Bank and elevated incremental credit to depositratio for much of the year. The net average liquidity injection under the daily liquidityadjustment facility (LAF), at Rs. 73000 crore during the first half of the year, increasedsignificantly to Rs. 101200 crore during the second half. In order to alleviate liquiditypressures, the Reserve Bank lowered the CRR of Scheduled Commercial Banks (SCBs)cumulatively by 75 bps on three occasions and the SLR by 100 bps during the year.Additionally, the Reserve Bank injected liquidity to the tune of Rs. 154600 crore throughOMO purchase auctions. The net injection of liquidity under the LAF, which peaked at Rs.180800 crore on March 28, 2013 reflecting the year-end demand, reversed sharply to Rs.84200 crore by end-April, 2013.

Treasury Bill Market

During FY 2012-13, government borrowed heavily via T-bills in order to offset shortagein revenues. The borrowings through T-bills were much higher than envisaged in the annualbudget. Borrowing through T-bills stood same as in preceding financial year at Rs. 610000crore. However, despite the glut in supply and tight liquidity conditions, yields ontreasury bills in primary market eased significantly as rate cut expectations continued tohold throughout the year. Weighted average implicit yield at cut-off price on 91 DTB, 182DTB and 364 DTB stood at 8.20 per cent, 8.17 per cent and 8.05 per cent as against 8.41per cent, 8.46 per cent and 8.38 per cent in the previous year respectively.

Primary Market

FY 2012-13 was characterized with government's unwavering resolve to maintain fiscalprudence. By keeping the fiscal deficit under control, government managed to keepborrowings well under the budgeted estimate for the year. The gross borrowings throughdated issuances for the FY 2012-13 stood at Rs. 558000 crore, while net borrowings stoodat

Rs. 467384 crore. The weighted average maturity of the dated securities issuedincreased over the year, while the primary yields declined in view of the favorable marketconditions and lower interest rate regime for long dated securities. The weighted averagematurity of issuances stood at 13.50 years vis-a-vis 12.66 years in the previous year. Theweighted average yield of dated securities issued during FY 2012-13 eased to 8.36 per centcompared to 8.52 per cent during FY 2011-12.

Secondary Market

During 2012-13, reflecting expectations of a reduction in policy rate, optimism aboutimprovement in the fiscal situation, reduction in the primary issuances and expectationsof further measures from the government to rein in the fiscal deficit, G-sec yields eased.The continuation of OMO purchase auctions also added to the positive sentiment.

The yield curve flattened owing to sharp rise in short term rates and fall in long termyields. While short term rates remained under continuous upward pressure due to tightliquidity conditions and status quo on interest rates, long term yields softened due tolower supply especially in the second half of the year. Yield on 10-yr benchmark paperclosed the year at 7.95 per cent after touching a high and low of 8.76 per cent and 7.80per cent respectively as against 8.57 per cent as on March 31, 2012.

Forex Market

During FY 2012-13, rupee depreciated by over 7 per cent over previous year's closing asrecord high current account deficit levels, deteriorating domestic growth and fragileglobal economic scenario weighed on the domestic currency. Rupee eroded sharply in valueagainst the USD in the first quarter of the year, weakening to all time lows as globalrisk aversion stemming from continued uncertainty surrounding the

European crisis resulted in waned demand for risky assets. Fear of rating downgradefurther weighed on sentiment pushing rupee below 57 per USD mark. However, rupee trimmedthe fall by the end of the second quarter, climbing back to 52 per USD levels as improveddata flow from US perked up the risk appetite globally. During the residual part of theyear, rupee stabilized and traded in a narrow range of 53 to 55 per USD. With US fiscalcliff issue being tackled by the US government, the demand for risk assets received aboost. Rupee closed the FY 2012-13 at 54.34 per USD as against 50.95 per USD as on March31, 2013.

Primary Market

In primary market, the Company continued to comply with all the regulatory requirementsof bidding under Minimum Underwriting Commitments (MUC) and Additional CompetitiveUnderwriting (ACU) for Primary Dealers. During the year, Company earned an underwritingcommission of Rs. 1.76 crore as against previous year's commission of Rs. 1.77 crore. InTreasury bill auctions, in the first half, GoI raised

Rs. 340000 crore as against Rs. 329000 crore in the corresponding period of lastfiscal. In the second half, GoI raised another Rs. 270000 crore through T-bills as againstRs. 281000 crore raised in corresponding period last fiscal. The Company submitted bidsaggregating Rs. 57890 crore against the commitment of Rs. 42700 crore (being 7 per cent ofnotified amount). Out of this, bids amounting to Rs. 19117 crore were accepted. Fulfillingits primary market commitment, Company achieved success ratio of 42.28 per cent and 47.91per cent in H1 and H2 respectively of FY 2012-13.

Secondary Market

During FY 2012-13, total secondary market outright turnover stood at Rs.1,98,139 croreas against Rs. 208982 crore in FY 2011-12. The Central G-sec segment recorded the maximumturnover of Rs. 162267 crore followed by T-bill segment which registered churning of Rs.17578 crore. Company's total turnover ratio (secondary market) stands at 157 times fortreasury bills and 275 times for government dated securities as on March 31, 2013 againstthe minimum RBI stipulation of 10 times and 5 times respectively.

Portfolio Size and Composition

Portfolio size and composition is a function of arbitrage opportunities andtradability. In milieu of improved market conditions and softening of yields, Companyincreased holding of Central G-sec as compared to the previous year. Daily average holdingof Central G-sec during FY 2012-13 stood at Rs. 624 crore as against Rs. 462 crore in FY2011-12. The Central G-sec holding was strategically increased to more than Rs. 1000 crorein anticipation of fall in yields in the fourth quarter. Yields fell from 8.20 per centlevels in November, 2012 to 7.85 per cent in January, 2012 and Company took advantage ofthe sharp fall in yields and reduced the Central G-sec holdings booking profits. Companyalso maintained high holding of Treasury Bills in view of positive arbitrage and minimalrisk. Daily average holding in T-bills during the year stood at Rs. 1576 crore as againstRs. 870 crore during the preceding year. The peak holding in T-bills stood at Rs. 2385crore.

Liability Mix

During the year, Company judiciously utilized different sources of borrowings namelyCall Money, Centralized Borrowing and Lending Obligation, Repo, LAF etc. for active fundmanagement. In view of extreme shortage of funds in the banking system, Company heavilyutilized finance support made available by RBI to keep the borrowing cost under check. Theaverage borrowings from all sources amounted to Rs. 2330 crore as against Rs. 1531 crorein FY 2011-12. The average leverage size during the year was higher at 3.87 times asagainst

2.69 times in FY 2011-12, while the maximum leverage for the year stood at 5.56 timesof the Net Owned Funds. The average cost of funds during the fiscal at 8.00 per cent (8.14per cent in FY 2011-12) was about 11 bps lower than the average NSE overnight MIBOR of8.11 per cent during the year.

Trading Stance and Risk Management

During FY 2012-13, trading performance improved significantly and Company postedtrading income of Rs. 40.05 crore as against trading loss of Rs. 14.50 crore in FY2011-12. The exceptional performance in this segment was a result of a judicious mix ofnimble trading technique and astute prognosis of market conditions. Besides, conducivemarket conditions also contributed towards the improved bottom-line performance. Companymaintained a balanced composition of securities with an aim to maximize arbitrage incomeand also with a view to have better trading opportunities. Risk management is a criticalelement of Company's trading business. The Company's Mid-office is primarily responsiblefor formulating and implementing the risk management policies. Value-at-risk, PVBP limits,sensitivity analysis and cut-loss policies form the core of market risk management system.Counterparty exposure limits and instrument-wise exposure limits were the primary toolsused for managing the credit risk in the business. Similarly, well-established anddocumented systems and procedures provide adequate defense against the operational risk.

Financial Performance

During the year, Company's Profit before Tax (PBT) rose to Rs. 88.76 crore as on March31, 2013 as against Rs. 29.64 crore as on March 31, 2012. The profitability was boosted byenhanced trading performance by the Company. During the year, Company registered tradingincome of Rs. 40.05 crore as against trading loss of Rs. 14.50 crore in FY 2011-12. Thenet worth of the Company has risen by 7.9 per cent to Rs. 620.08 crore as on March 31,2013. Company was adequately capitalized with capital adequacy ratio at 42.34 per cent ason March 31, 2013 as against RBI's minimum stipulation of 15 per cent.

Human Resource Development

Human resource development is given high weightage and Company employs the best HRpractices to ensure a healthy and motivating work environment for its employees. Employeeskills are constantly upgraded and honed by providing training suiting to individualrequirements. Besides, in-house lectures and workshops are also conducted on a regularbasis to stimulate healthy exchange of ideas.

Opportunities and Threats

Looking ahead, economic activity during FY 2013-14 is expected to show only a modestimprovement over last year, with a pick-up likely only in the second half of the year.Accordingly, the Reserve Bank's baseline projection of GDP growth for 2013-14 is 5.7 percent. Inflation has been projected at 5 per cent by March, 2014. Based on this, benigninterest rate is expected to prevail. However, there are certain risks. First, the biggestrisk to the economy stems from the Current Account Deficit (CAD) which, last year, washistorically the highest and well above the sustainable level of 2.5 per cent of GDP asestimated by the Reserve Bank. A large CAD, appreciably above the sustainable level yearafter year, will put pressure on servicing of external liabilities. Second, even as thelarge CAD is a risk by itself, its financing exposes the economy to the risk of suddenstop and reversal of capital flows, if global liquidity rapidly tighten. The third riskfactor is that a sustained revival of growth is not possible without a revival ofinvestment. But investment sentiment remains inhibited owing to subdued businessconfidence and dented business profitability. And finally, the effectiveness of monetarypolicy in bringing down inflation pressures and anchoring inflation expectations could beundermined by supply constraints in the economy, particularly in the food andinfrastructure sectors. Without policy efforts to unlock the tightening supply constraintsand bring enduring improvements in productivity and competitiveness, growth could weakeneven further and inflationary strains could re-emerge. However, as witnessed in FY2012-13, RBI may yet again deploy OMO buyback purchases to create demand for mammoth G-secsupply and also infuse liquidity in the system as the CRR space for infusing liquidity isnow quite limited. With regard to fiscal deficit projection for the next year, we believethat government would be able to stick to its fiscal deficit plan. A high CAD and regularsupply of government bonds in form of auctions will weigh negatively on the markets whileregular OMOs and benign inflation alongwith subdued growth would be positive factors forthe market in the FY 2013-14. Amidst these counterbalancing forces, the markets may remainmore volatile than FY 2012-13, though in a narrower range. The Company proposes to be morenimble footed in trading and also look for more stable avenues of revenue to maintainconsistency in the returns to the stakeholders. The Company shall also endeavour to focuson non traditional sources of income like fee based services and equity markets.