Economy Outlook NOT SO 20 20 Jan-20-EDEL

Economic Outlook 2020
January 6, 2020
NOT SO 20/20
Easing liquidity
Exports recovery
Kapil Gupta Prateek Parekh, CFA Padmavati Udecha

+91 22 4063 5406 +91 22 6623 3469 +91 22 6620 3103 Edelweiss Securities Limited
kapil.gupta@edelweissfin.com prateek.parekh@edelweissfin.com padmavati.udecha@edelweissfin.com
Economic Outlook 2020
Executive Summary
From ‘moment of excitement’ (2000-10) – as John Keynes would have put it - to lingering
‘uncertainty’ (2011-19), EM have seen a remarkable reversal of fortunes. The exponential
exports boom has given way to diminishing returns of debt-build up. But what’s next for
EMs? After US leverage (1990-2008), and China leverage (2009-2018), we think it could be
the rise of German/Europe leverage which could put EM back on growth path. Meantime,
India’s last decade has been one of prolonged economic drift at a time of best demography
(2010-20), strong reform push and soft crude oil prices. And for host of reasons, India’s
traditionally resilient and labour-intensive bottom of the pyramid (farm sector, MSMEs and
real estate) has wilted - causing chronic demand shortfall. In fact, India’s CAD could
potentially move towards balance (barring oil risks) amid overvalued INR, weak exports –
clearly a dynamic of internal devaluation.
Still, three factors should secure a modest economic bounce in 2020 – easing
liquidity/lower rates, exports recovery and normalization of food prices. GDP growth will
likely accelerate ~70-80bps to ~5.8%. Yet, a virtuous cycle will require more, including
addressing institutional rigidities in the 2014 macro-policy framework – which is too rule-
based and over-emphasizes macro-stability (vs. growth). Desired policy response is also
held back due to notions that do not stand scrutiny - financial savings are not a constrain on
fiscal deficit and sovereign rating actions (up/down) barely impact the economy/markets.
Similarly, small savings rate is not a hindrance to rate transmission as is widely believed. It
is about time that policy framework is put to review. The risk to the near-term outlook
arise from escalating geopolitical tensions and spike in crude oil prices.
EM growth: First exports, then debt – What next?

For EMs, the invincibility of 2001-2010 has given way to vulnerability in 2011-2019. Underlying
this is the shift in EM growth model – from exports-led to domestic demand-led. As trade
surpluses eroded, capital flows became the anchor for BoP stability. Thus, Fed’s repeated
attempts at tightening (2013, 2015, 2018) were met with EM turmoil. But now with Fed
expanding balance sheet again, fiscal relaxation in some countries, the global economy is due
for modest uptick. Yet, a sustained upswing would require much more. We argue that just as
2000-2010 was about US leverage (anchoring EM surpluses); 2010-2019 was about China/EM
leverage (anchoring German surpluses); the next decade may see Europe/German leverage
upcycle. German exports may be hitting a wall of China deleveraging, just as China exports hit a
wall of US deleveraging 10 years ago. With ECB’s president urging a fiscal response and ECB
reaching monetary limits, German fiscal expansion/leverage could stop being a strange idea.
Indian Economy: A lost decade amidst best demography

The liquidity crisis of last one year has heightened the sense of gloom. But if one raises the
vantage point, India has been in an economic drift through much of 2011-19. Credit/ capex
cycle peaked out in 2011 and exports soon after. Consumption held up aided by leverage until
the liquidity crisis of 2018. This prolonged economic weakness has worked to stall the migration
engine – economy has barely added construction/manufacturing jobs in last 5 years (NSS data).
The lost opportunity is more striking as 2010-20 was the best in terms of demographic dividend.
Today, there is belief that slowdown is structural. But isn’t it ironical that the reforms
undertaken so far – Inflation-targeting, GST, IBC, RERA, fuel subsidy reforms, Uday power sector
reforms, ease of doing business, JAM trinity – were aimed at enhancing structural growth?
1 Edelweiss Securities Limited

Not so 20/20
Bottom of the Pyramid – Missed opportunity?

In this prolonged economic drift, we argue that India’s traditionally resilient bottom of the
pyramid - farm sector, MSMEs and real estate especially in small towns– has wilted. These are
highly labour-intensive (comprising 80% of the work force) and thus carry socio-economic
implications. Downtrend in global food prices (debt-deflation in farm sector), war on cash
economy (DeMon/GST hampered real estate, MSMEs), restrictive macro-policies (constrained
aggregate demand) and stagnant exports (hurt farm/MSME) – all worked to stall the migration
engine and undermine the purchasing power at the bottom of the pyramid. Are conditions
improving? To some extent yes. Exports are stabilising (to help MSMEs); liquidity conditions are
gradually normalizing/rates moving lower (important for real estate) and food inflation too is
normalizing from decadal lows (positive for farm cash flows). Yet, government spending at
bottom of the pyramid i.e. in social/rural sector (weak in last 4 years) needs to be scaled up. INR
overvaluation too needs correction to lift MSME and farm sector prospects.
Current account balance – Surplus in times of deficiency

India’s Current Account Deficit (CAD) is narrowing and could move towards balance in next 1-2
quarters – a favourable swing of 2% of GDP in about a year. This is outdone by only two other
episodes FY01-04 and FY14, when CAD narrowed by 4% of GDP. Very often, improving CAD
reflects a favourable macro-dynamic but not always. In the first episode (early 2000s),
undervalued INR, rebounding global economy led the improvement despite sharp recovery in
domestic demand. In second episode (FY14), it was largely a factor of undervalued INR and gold
import restrictions. Both were favourable dynamic. However, in the current episode, CAD is
narrowing despite overvalued INR, and stagnant exports, suggesting sharp compression in
domestic demand. Clearly, the economy is getting pushed into internal devaluation without a
BoP crisis. Thus, domestic macro-policies need to be more stimulative.
Policy response – Institutional rigidities?

RBI’s easing cycle starting January 2015 has been the most reluctant on record. It lowered repo
rate by just 300bps in 5 years and kept liquidity persistently tight clogging the monetary
transmission. RBI’s inflation projections consistently overshot actual outcomes by a whopping
~150bps (on average since FY15), thus pushing real rates high even as global rates were falling.
This pushed INR into overvalued zone –a further drag on demand. Besides, correlation of RBI ‘s
inflation expectations survey with actual inflation and wages is much more tenuous than was
claimed in Urjit Patel Committee Report and so is the relation between real interest rates and
deposit growth. Similarly, fiscal policy has been even more inert – a historical anomaly. FRBM
targets have preempted any countercyclical response. Besides, contrary to popular belief,
financial savings are not a constraint on fiscal expansion and sovereign rating actions (up/down)
barely impact the economy/markets. Basically, the policy frameworks adopted amid crisis of
2012-2013 carried too much recency bias. It suited well to tackle financial stability risks but
highly ill-suited to address growth concerns. It’s high time that these are put to review.
Conclusion: Modest recovery; virtuous cycle still away

We expect modest bounce in activity in 2020 helped by easing liquidity/lower rates, improving
exports and normalizing food prices. Thus, FY21 GDP growth is likely to scale up to 5.8%, up
from 5% in FY20. Inflation should average around 4.5% not much different from FY20 and
should not hinder RBI from taking repo rate towards 4.5% in the current easing cycle.
Meanwhile, CAD should remain benign at ~1% of GDP and BoP in ample surplus. That said, kick
starting capex, migration engine would require greater aggression and coordination between
fiscal-monetary response, weaker exchange rate and a stronger global economy. In near-term,
the risks arise from escalating geopolitical tensions and spike in crude oil prices.

Economic outlook 2020
Contents
Executive Summary ...........................................................................................................1
Focus charts ......................................................................................................................4
EM growth: First exports, then debt – What next? ..........................................................6
Indian economy: A lost decade amidst best demography ..............................................12
Bottom of the Pyramid – Missed opportunity? ..............................................................16
Current account balance: Surplus in times of deficiency ................................................28
Fiscal constraints: Self-Imposed Than Macro-Economic? ...............................................31
Monetary policy: Institutional rigidities? ........................................................................36
Conclusion: Modest recovery; virtuous cycle still away .................................................44

Not so 20/20
Focus charts
I. Global Economy – Improving money should help, but sustained upswing hinges on German leverage
20 2
General government balance
16 0
Germany has
(% of GDP)
12 (2) maximum fiscal space
(% YoY)
8 (4)
4 (6)
0 (8)
Nov 01 Nov 04 Nov 07 Nov 10 Nov 13 Nov 16 Nov 19 2012 2013 2014 2015 2016 2017 2018 2019
Global M1 growth (%, YoY) Germany USA China
II. Indian economy - lost a decade during best phase of demography

35 2.8
2.6
Phase of
30 best
2.4 demography
25
(%, YoY)
1.9
(%)
20 2.0
1.8
15
1.6 1.4
1.4
10
1.2
5 2000s 2010s 2020s 2030s 2040s
FY00 FY04 FY08 FY12 FY16 FY20YTD Contribution of demography to average annual
Aggregate credit growth per capita income
III. Bottom of the pyramid – Farm sector, Real estate and MSME have been hurt, weighing on rural wages
20
Slowing War on
global cash 16
Sharp collapse
trade Real economy
Estate
12
(%, YoY)
Farm Bottom of the Macro-

pyramid 4
debt- economic
(Labour intensive
deflation policies
segments) 0
. Farm FY08 FY10 FY12 FY14 FY16 FY18 FY20
MSME sector YTD
Rural wage growth Food Inflation - RHS

IV. MSMEs have been badly hurt by the war on cash economy; ramp up in government spending could help
130 30
(Rebased to 100 in March 2013)
125 25
120 20
Big gap
(%, YoY)
115 post GST
15
110
10
105
5
100
Mar 13 Nov 14 Jul 16 Mar 18 Oct 19 0
FY97 FY00 FY03 FY06 FY09 FY12 FY15 FY18
IIP labour intensive (proxy for MSME)
Non- Labour intensive sectors Total spending on rural and social
V. Fiscal constraints – Low household savings or ratings downgrades have historically not led to higher borrowing costs
22 13 Rates fell despite high ...and in recent 115
Sovereign Upgrade
20 govt. borrowing... years as well
Sovereign Downgrade Deep 100
18 downturn 11
(4QMA, % YoY)
16 post upgrade
to investment 85
14 grade
(%)
(%)
9
12 70
10 7
Sharp revival 55
8 post downgrade
to Junk
6 5 40
Sep 97 Mar 03 Sep 08 Mar 14 Sep 19 Nov 98 Nov 05 Nov 12 Nov 19
India 10Y bond yield
Nominal GDP (4QMA, %, YoY) Govt. borrowing as % of HH financial savings (%, RHS)
VI. Monetary policy – Transmission not constrained by small savings; RBI’s high inflation forecasts have led to lower rate cuts
9 180
Small savings did 135
not impede
transmission... 80
8
(20)
(bps)
(%)
7 -53 -43
(120)
-143
6 (220) -187
(320) -273
5
FY15 FY16 FY17 FY18 FY19 FY20
Mar 01 Mar 07 Mar 13 Mar 19
SBI 1 year deposit rate 1Y small savings rate H2 Actual inflation vs. MPC's forecast
Source: Bloomberg, CMIE, Budget documents, Bank of Internationl Settlements, IMF Economic Outlook Database – October 2019, Edelweiss
research; Note: Global M1 growth is the average of M1 growth of USA, Europe and China

Not so 20/20
EM growth: First exports, then debt - What next?

For EM, the invincibility of 2001-10 has given way to vulnerability in 2011-19. Cycles have
shortened, external surpluses have eroded and equity returns have been
underwhelming. At the fundamental level, this reflects shift in EM growth model— from
external-oriented (exports) to domestic demand-led (rising debt) over the past decade.
This meant that capital flows became the anchor for BoP stability rather than current
EM have seen remarkable reversal account surpluses. That’s why Fed’s repeated attempts at tightening (2013, 2015, 2018)
of fortunes—from invincible in were met with EM turmoil. But now with Fed rate hikes behind, EM stability is more
2000s to vulnerable in 2010s secure. Fed’s u-turn is accompanied by broad-based monetary easing elsewhere and
modest fiscal relaxation in Europe, Japan and parts of EM. Global money supply is
bottoming out and, to that extent, a shallow recovery is on the cards.
Yet, a sustained upswing will require much more. World economy needs an engine of
leverage. Just as during 2000-10 US leverage anchored EM surpluses and during 2010-19
China/EM leverage anchored German surpluses; the next decade may see
Europe/German leverage upcycle. After all, the German exports model may be hitting a
wall of China deleveraging, just as China’s export model hit a wall of US deleveraging 10
years ago. With the ECB’s president urging a fiscal response and ECB reaching monetary
limits, German fiscal expansion/leverage may not be a strange idea anymore.
Economic performance of EM has been quite underwhelming over the last decade when
compared to the pre-GFC period. Since GFC, EM cycles have become much shorter and volatile,
which is also reflected in the asset markets’ performance. Economic growth rates (IIP, exports),
accretion in forex reserves, forex and equity performance pale in comparison with the scale up
in these economies and markets in the decade preceding the GFC. This is not how it was
envisaged at the beginning of the last decade.
Chart 1: Economic performance of EM has been underwhelming post GFC, a lost decade of sorts
9 10
Sharp growth
8 8 ...led by industrial
deceleration...
activity
7
6
(%, YoY)
(%, YoY)
6
4
5
2
4
0
3
2003 2007 2011 2015 2019 YTD
2003 2007 2011 2015 2019E
EM IIP
EM real GDP growth
Source: Bloomberg, IMF World Economic Outlook Database – Oct 2019, Edelweiss research

Chart 2: EM ROEs have slowed sharply during the decade Chart 3: EM equities have been flattish since 2011
18 1,350
16
1,100
14
(USD)
(%)
850
12
600
10
8 350
2001 2004 2007 2010 2013 2016 2019 Dec 03 Dec 07 Dec 11 Dec 15 Dec 19
MSCI EM ROE MSCI EM
Source: Bloomberg, Edelweiss research
From invincible to vulnerable: What has gone wrong?

EM growth models have One of the key reasons for such a weak and volatile performance of EM post GFC is that the EM
undergone a vital shift post GFC... growth model has undergone an important shift. EM, at the aggregate level, have seen
dramatic erosion in current account surpluses in the post GFC world, led by China. For example,
during 2002-08, EM current account surpluses ramped up from 1% of GDP to 5%, but have now
shrunk back to just zero—a massive swing. In other words, net exports model of EMs came
under increasing strain once the US consumer leverage engine stalled in 2008. And, in the face
of slowing exports, EM had no choice but to ramp up debt to support nominal GDP growth.
Shrinking trade surpluses post GFC meant that capital account flows assumed far more
...with capital account shaping the
importance in shaping EM Balance of Payments (BoP) dynamics than current account flows
BoP dynamics as trade surpluses
(unlike pre-GFC). Balance of Payments is extremely important for EM as this shapes their
vanished
liquidity and thus industrial activity.
Chart 4: EM current account surpluses have eroded, making capital flows essential for BoP stability
5 3 Fed tightening
EM current account has has weighed on
4 shrunk post GFC 2 EM flows
3
(% of GDP)
(% of GDP)
1
2
0
1
0 (1)
(1) (2)
2000 2003 2006 2009 2012 2015 2018 2000 2003 2006 2009 2012 2015 2018
EM current account balance (% of GDP) EM financial account
Source: IMF World Economic Outlook Database – October 2019, Edelweiss research

Not so 20/20
Because of shrinking EM trade surpluses, EM growth dynamics have become far more sensitive
Fed repeated attempt at tightening to external shocks, especially the US Fed’s tightening. EM policy choices also get highly
during 2013-2018 have been met constrained in such a BoP set up. For example, in the past five years, Fed’s repeated attempts
with EM turmoil... at tightening—Bernanke’s QE tapering in 2013, Janet Yellen’s rate tightening (2015) and Jay
Powell’s twin tightening (2018)—have been met with turmoil in EM. Thus, 2013 onwards, EM
reserves growth has effectively come to a halt. And, within EM, China has seen the biggest
swing in surpluses. In fact, today, China is increasingly looking like a regular EM whose external
surpluses have vanished, debt is very high and exchange rate is still managed.
Fed tightening done: A breather for EM

...however, Fed tightening cycle is From the vulnerability standpoint, what has changed in 2019 is that the Fed has progressively
behind now, which is positive for moved from double-tightening in 2018 to single-tightening in early 2019 and now to re-
EM expansion of the balance sheet. This has helped stabilise EMs BoP situation (compared to 2018)
and many central banks across the globe have followed suit. In addition, fiscal authorities too
have started to respond (though early days still), especially in Europe and Japan, and also in
parts of EM. As a result of these policy actions, global money supply (global M1) has bottomed
out after two years of deceleration (refer to, Fed’s ‘not QE’ to stall dollar rally? ).
Chart 5: Global M1 money supply growth improving

20
16
12
(% YoY)
0
Nov 01 Nov 04 Nov 07 Nov 10 Nov 13 Nov 16 Nov 19
Global M1 growth (%, YoY)
Economic activity PPIs Asset prices
55 15 15 7 15 0.55
54 13 0.50
12 4 12
53 PMI in 11 0.45
(% YoY)
(%, YoY)
(%, YoY)
(% YoY)
expansion
9 1
(x)
52 9
(x)
9 0.40
51 7 0.35
6 (2) 6
50 5 0.30
49 3 3 (5) 3 0.25
May 13 Sep 15 Jan 18 May 20 Nov 02 Nov 08 Nov 14 Nov 20 Nov 02 Nov 08 Nov 14 Nov 20
Global Mfg PMI Global M1 (adv. by 12 months) Global M1 (adv. by 12 months)
Global M1 (adv. by 6 months, RHS) Global PPI (RHS) India midcap vs. Sensex - RHS
Source: BIS, Bloomberg, Edelweiss research; Note: Global M1 is average M1 money supply growth of US, Europe and China

Hence, we believe, global growth is beginning to stabilise after several quarters of sharp
deceleration. Global manufacturing PMI, which has been lingering in contraction zone for six
months, has moved into expansionary zone. Similarly, global commodity prices, which have
been falling for a while, have made a modest rebound and accordingly we foresee producer
price indices (PPIs) also to stabilise soon. Going ahead, even global IIP and global trade should
stabilise. This compares favourably with the situation just a few months ago when global
recession risks were escalating and the debt-deflation dynamic was becoming entrenched.
What will it take for a sustained upswing?

EM net exports model of 2000s
As argued earlier, EM growth is stabilising. The Fed’s tightening cycle of 2013-18 is now behind
hinged on US household leverage...
and it is embarking on re-expansion of its balance sheet. Thus, EMs external vulnerability has
diminished. But, this may not automatically translate into a sustained upswing. Here, a larger
question is at play—what will propel the growth dynamics in the global economy over the next
five-seven years and how EM are placed in that dynamic. This understanding requires a look at
the growth drivers at the global level over the past two decades:
EMs outward looking growth model (1998-2008): During the first period (1998-2008), the US
...however, post 2010, EM exports
consumer leverage cycle anchored export-led growth in EM. The external surpluses of EM
model hit the wall US household
expanded rapidly and EM central banks channeled these surpluses back into the US. This
deleveraging
created a double-pyramid of money supply—expanding money supply in EM while
simultaneously keeping monetary conditions in the US easy, which in turn sustained US
consumers’ borrowing binge, and thus EM exports boom. All this enabled EM to run robust
nominal GDP growth rates without having to take too much debt in their economies. Through
much of this period, EMs debt to GDP largely remained flat. However, the GFC put a break on
this growth model as US consumers started to deleverage.
EMs inward looking growth model (2009-18): Once the US consumers’ debt binge ended, the
net exports model of EM was not reliable anymore. As Europe too was going through its own
challenges of austerity/internal devaluation (and thus pushing their economies into surpluses),
EM had to rely on domestic demand and, therefore, debt to support aggregate demand. Thus,
post 2011, EM, especially China, saw significant rise in the debt-to-GDP ratio.
Chart 6: Pre-GFC, US leverage anchored EM exports Chart 7: Post GFC, exports collpased, but debt climbed
5 5 135
2000s 2010s 115 2000s 2010s
4 EMs outward EMs inward 4 No rise in EM EMs debt
120
looking model looking model debt rises
3 105 3
(% of GDP)
(% of GDP)
105
(%)
(%)
2 2
95
90
1 1
85 75
0 0
(1) 75 (1) 60
Dec 99 Dec 03 Dec 07 Dec 11 Dec 15 Dec 19 Dec 99 Dec 03 Dec 07 Dec 11 Dec 15 Dec 19
EM Net exports US HH Debt to Income (RHS) EM Net exports EM private sector debt (RHS)
Source: BIS, Bloomberg, Edelweiss research

Not so 20/20
What could next decade potentially look like?

If one follows the progression of external surpluses and debt dynamics of US, Europe and EM
(especially China) over the past 20-25 years, what stands out is that first US leverage anchored
expanding EM surpluses. Thereafter, EM (led by China) leveraged, which anchored Germany’s
(and Europe more broadly) large external surpluses. Going ahead, since EM, especially China,
debt engine is peaking out for now; Germany’s surpluses are under threat.
Chart 8: With EM hitting debt limits, it’s time for Euro area to lever up
2000s: 2010s:
125 4.5
EMs ran net exports model Euro area ran net exports
as US HH leveraged model as EMs leveraged
3.5
115 EM private sector
Debt(RHS)
2.5
(% of GDP)
105
US HH Debt to
(%)
income 1.5
95
EM current Euro area 0.5
account balance current account
(RHS) balance (RHS)
85
-0.5
75 -1.5
Sep 99 Sep 03 Sep 07 Sep 11 Sep 15 Sep 19
Source: IMF World Economic Outlook database – October 2019, Bloomberg, Edelweiss research
In some sense, we believe Germany is at a similar macroeconomic juncture as China was post
EMs debt binge anchored Euro the GFC. Just like China had to embark on a debt boom as US debt engine peaked out in 2008,
area’s trade supluses in last 10 it’s likely that German/Europe debt may have to ramp up in coming years as the China debt
years... engine has peaked out.
What follows, therefore, is that over coming years, we are likely to see Germany’s, or more
broadly Europe’s, external surpluses eroding and debt rising, much as has happened in case of
...however, EMs, especially China, China and EM in the past 10 years. Therefore, it is highly likely that in order to revive the
seem to be hitting debt limits European/German economy, policymakers may resort to expansion in fiscal deficit. And, very
importantly, Germany has the most fiscal space. Its fiscal balance has remained in surplus
through much of the past decade. In fact, intellectual climate in Europe seems to be already
moving in that direction—Christina Lagarde, new ECB head, stated recently that Europe needs
a fiscal response. Further, the ECB is running out of further ammunition to support European
growth. In addition, negative sovereign bond yields are already hurting pension and insurance
funds in Europe. And, at one level, negative sovereign bond yields just reflect excess demand
for safe assets and, therefore, one way to normalise the markets is to increase supply of
government paper.

Chart 9: Germany continues to run fiscal surplus

2
It’s probably time for Euro area, General government balance
primarily led by Germany, to lever
up... 0
Germany has
(% of GDP)
(2)
maximum fiscal
space
(4)
...and Germany has large fiscal (6)

space
(8)
2012 2013 2014 2015 2016 2017 2018 2019
Germany USA China
Source: IMF World Economic Outlook database – October 2019, Edelweiss research
All this point to the fact that authorities in the region may have to resort to fiscal policies at
some stage. Indeed, as per IMF, fiscal impulse in Europe will be positive first time in seven
years. This may help stabilise activity in the near term, but this response has to scale up to
generate a sustained upswing in the European, and more broadly, global economy.
Chart 10: Euro area’s fiscal impulse is finally turning positive
0.5
There are early signs of fiscal Turns positive for
0.3
austerity easing in Europe. The first time in a
quantum of fiscal stimulus will 0.1 decade
(% of GDP)
shape global economic recovery

-0.1
-0.3
-0.5
-0.7
2013 2014 2015 2016 2017 2018 2019
Euro area fiscal impulse
Source: IMF fiscal monitor – October 2019, Edelweiss research

Note: Fiscal impulse is calculated as the change in fiscal deficit
Overall, with the Fed’s tightening cycle behind, EMs stability is secured in 2020. However, a
sustainable growth revival will entail fiscal stimulus, especially in Europe. Intellectual climate
around the same is certainly changing and the magnitude of stimulus will determine EMs
growth prospects in the near to medium term.

Not so 20/20
India: A Lost Decade Amidst Best Demography

The liquidity crisis and consumption slowdown of past one year has heightened the
sense of gloom. But, if one raises the vantage point, it’s apparent that the economy has
been in a prolonged drift through much of 2011-19—a telling reversal of fortunes
compared to the economic boom of the preceding decade (2001-11). Credit and capex
cycles peaked out in 2011 and exports soon after. Consumption held up aided by
leverage until the liquidity crisis of 2018. This sub-optimal growth dynamics have
persisted for far too long and have stalled the migration engine—the economy has barely
added construction/manufacturing jobs in the past five years (NSS data). No surprises,
therefore, that rural wages have stagnated. And, all this at a time when India went
through the best decade (2010-20) of its demographic dividend. Today, there is rising
clamour that the slowdown is becoming structural. Isn’t it ironical then that the reforms
undertaken so far—inflation-targeting, GST, IBC, RERA, fuel subsidy reforms, Uday power
sector reforms, ease of doing business, JAM trinity—were meant precisely to address
the structural bottlenecks?
2010-19: India’s lost decade

While the current weakness in high frequency macro indicators have caught the headlines,
Growth rates of most macro
we need to take cognizance of the fact that it is not just a recent phenomenon limited to a
indicators have weakened
few months/quarters. In sharp contrast to the previous decade (2000-2010), which saw a
significantly in 2010s versus 2000s
booming economy (led by global and domestic factors), the current decade has been much
sombre—annualised growth rates of all macro indicators are sharply lower. 2010-19 turned
out to be India’s lost decade.
Macro indicators highlight prolonged and broad-based slowdown

Several macro indicators clearly highlight that the economic drift has gone on for far too
long. Aggregate credit growth, corporate RoEs and aggregate tax revenues are at multi-
decade lows. Further, exports and rural wage growth have been adversely hit this decade.
These indicators are a reflection of the demand weakness in the economy, while
unfortunately all the growth stimulating measures announced by the government are on the
supply-side.
Chart 11: Aggregate credit growth at multi-decade lows… Chart 12: …so is corporate RoE
35 24
29 21
23 18
(%, YoY)
(%)
17 15
11 12
5 9
FY00 FY04 FY08 FY12 FY16 FY20YTD FY00 FY04 FY08 FY12 FY16 FY20 YTD
Aggregate credit growth Corporate ROE
Source:CMIE, Bloomberg, Edelweiss research; Note: Aggregate credit is the sum of non-food bank credit and corporate bonds

Chart 13: Aggregate tax revenue too at multi-decade lows Chart 14: Rural wage growth also remains extremely subdued
30 21
25 18
15
20
(%, YoY)
12
(%, YoY)
15
9
10
6
5
3
- -
FY00 FY04 FY08 FY12 FY16 H1FY20 FY00 FY04 FY08 FY12 FY16 FY20YTD
Aggregate tax revenue growth Rural wage growth
Chart 15: Exports have been largely flat is last 10 years Chart 16: Exports outperformance of 2000s did not sustain
350 20
300 India's exports
15 outperform world
250 trade
FY01-11:
FY11-20:
Exports CAGR 10
(USD bn)
(%, YoY)
200 Exports CAGR India's exports

19% perform in line with
3%
150 5 world trade
100
0
50
(5)
-
FY02 FY04 FY06 FY08 FY10 FY12 FY14 FY16 FY18 FY20
YTD
India's exports (USD Bn) YTD India export growth minus world trade export growth
Chart 17: Capex cycle peaked out in 2012 Chart 18: This cycle has seen sharp rise in GNPAs
38 15
35 12
(% of GDP)
32 9
(%)
29 6
26 3
23 0
FY00 FY04 FY08 FY12 FY16 H1FY20 FY00 FY04 FY08 FY12 FY16 H1FY20
Capex (as % of GDP) GNPA (%)
Source:CMIE, CPB Netherlands World Trade Monitor, Government budget documents, Edelweiss research

Not so 20/20
Migration engine has slowed

A comparison of jobs addition to the non-farm sector during FY12-18 versus FY05-12 (NSS
Weak capex activity has weighed
survey periods) presents a stark contrast. As per NSS data, only 2.5mn new jobs were added
on migration in recent years...
per year during FY12-18 versus 7.4mn/ year during FY05-12 in the nonfarm sector of the
economy. The sharp slowdown in jobs addition coincides with peaking of the capex cycle in
FY12. Manufacturing and construction jobs have taken the maximum brunt. To be sure,
weakness in job creation could be somewhat overstated due to the fact that FY18 (survey
year) happened to witness the combined impact of demonetisation/GST on the economy.
Still, the slowdown in jobs addition in the past seven-eight years is telling.
Chart 19: Weakness in non-farm sector stalls migration engine

9
7.4 Annual Change in employment (mn)
7
Sharp dip
5 4.6
...as per NSS, India added 2.5mn
(Mn)
non-farm jobs per year over FY12-

3 2.5
18, a marked slowdown from 1.8
7.4mn jobs added per year over 1.5 1.2 1.4
FY05-12 1 -0.5
(1)
Non-farm Manufacturing & Trade & Others
construction transport services
FY05-12 FY12-18
Source:NSSO Periodic Labour Force Survey reports, Edelweiss research
India’s lost decade amidst large opportunity

The lost decade, as described above, looks even more striking if seen in the context of three
important tailwinds:
This slowdown in job creation has
occurred amidst best demographic 1. Best demographic dividend: India is one of the few large countries in the world which is
dividend, high macroeconomic enjoying favourable demographic conditions. And, as per Economic Survey 2016-17, the
stability and big reforms push best decade of demographic dividend within the generally favourable demographic trend
happened to be 2010-20—the decade that registered weak economic and jobs
performance.
2. Macroeconomic stability: Macroeconomic vulnerability has been quite low in the last
five years. Crude oil prices collapsed sharply and so did inflation. Similarly, even current
account deficit remained benign. But despite macroeconomic stability, the economic
sluggishness has persisted.
3. Big reform push: The last five years also marked a big shift in the political landscape with
a stable government at the Centre. And, the government pushed through several supply-
side reforms—inflation-targeting, DBT, GST, IBC, RERA, fuel subsidy reforms, Uday power
sector reforms, ease of doing business, PSU bank recapitalisation and several others.
Despite these reforms, the sense of economic drift continued.

Chart 20: Phase of best demography is now history

2.8
2.6
Phase of best
demography
2.4 during lost decade
1.9
(%)
2.0
1.8
1.6
1.4
1.4
1.2
2000s 2010s 2020s 2030s 2040s
Contribution of demography to average annual per capita income
Source:India’s Economic Survey – 2016-17, Edelweiss research
Chart 21: Crude oil prices have been stable for 5 years... Chart 22: …India’s macro-vulnerability has also reduced
150
25
120
22
90
(USD/bbl)
19
60 16
30 13
0 10
Dec 01 Dec 04 Dec 07 Dec 10 Dec 13 Dec 16 Dec 19 FY 01 FY 04 FY 07 FY 10 FY 13 FY 16 FY 19
India's vulenerability index
Crude oil
Source:India’s Economic Survey – 2016-17, Edelweiss research
Note: India’s macrovulnerability index is the averageof inflation, CAD (% of GDP) and aggregate fiscal deficit (% of GDP)
Overall, India has witnessed a lost decade of sorts with capex and credit cycles peaking out
in 2012. In line, the jobs engine too has slowed. What’s striking is that this prolonged
downturn has happened at a time when India has gone through a decade of best
demographic dividend, benign global commodity prices and a very stable government that
pushed several structural reforms.

Not so 20/20
Bottom of the Pyramid – Missed opportunity?

India’s capex/credit cycles peaked in FY12 and the going has been tough since then. It’s
not just the length of the slowdown that’s worrying, but that India’s tradionally resilient
bottom of the pyramid—farm sector, MSMEs and real estate—has wilted. These are low
productivity, but highly labour-intensive (80% of working population), segments and thus
carry socio-economic implications. Downtrend in global food prices (debt-deflation in
farm sector), war on cash economy (demonetisation/GST hampered real estate, MSMEs),
restrictive macro-policies (constrained aggregate demand) and stagnant exports (hurt
farm/MSME) worked to stall the migration engine and undermine purchasing power at
the bottom of the pyramid. Though NBFCs retail-lending boom helped ease the pain, the
liquidity crisis of 2018 proved to be the proverbial last straw that broke the camel’s back.
Are conditions improving? To some extent yes. Exports are stabilising (important for
MSMEs) and thanks to the RBI, liquidity conditions are gradually normalising and
transmission is picking pace. Domestic food inflation too is normalising from decadal
lows, helping lift farm cash flows. Yet, stabilisation is not the same as onset of a virtuous
macro-dynamic. While sustained monetary aggression (on rates/liquidity) is of utmost
necessity, relying on it alone will be inadequate. Government spending at the bottom of
the pyramid—in social/rural sector (weak in past four years)—needs to be scaled up. INR
overvaluation too needs correction to lift MSME and farm sector’s prospects.
India’s bottom of the pyramid, One of the biggest victims of India’s lost decade has been the bottom of the pyramid. By this,
accounting for 80% of work force, we mean labour-intensive segments of the economy—farm sector, real estate and MSME.
seems to have wilted in the last While their overall value add in the economy may be low, they account for a lion’s share of
few years... labour force (80% plus). Traditionally, this segment has remained relatively resilient. However,
this time around other factors such as weak exports, war on the cash economy, low agri food
prices and adverse macro-economic policies have severely impacted this segment. We discuss
the prospects of each of these segments in the section below.
Chart 23: Bottom of the pyramid accounts for more than 80% of workforce
India's FY18 Employment breakup
Others
17%
...war on cash economy, agri-

Agriculture
disinflation and 2018 liquidity crisis 44%
have weighed on these segments
MSME
39%
Source:FY18 NSSO Employment report, Edelweiss research

Fig. 1: What has hurt the bottom of the pyramid?
War on cash
Slowing global economy
trade Real
Estate
Bottom of the
pyramid
(Labour intensive
Farm debt- segments) Macro-
deflation . economic
Farm
MSME policies
sector
NBFC crisis: The straw that broke the camel’s back
a) Farm: Emerging from debt-deflation dynamic

One of the key constituents of India’s bottom of the pyramid is the rural/farm sector. It is a very
low value-add sector (low productivity), but is highly labour-intensive. Over the past four-five
years, this sector has taken a serious hit, much in contrast with 2005-13 when rural fortunes
were at their best. What went wrong? We have long argued that the farm sector has been
trapped in the debt-deflation dynamic for a while now and this, along with other adverse
In past five years, low farm prices factors such as overvalued INR, slower government spending and war on cash economy
have led to weak agriculture (demonetisation), further aggravated the problems. Given that these problems have lingered
incomes... for long, it has undermined the purchasing power in the rural/farm economy. (For more details,
refer our note – Rural Cycles: Looking beyond monsoon)
Chart 24: Food inflation and rural wage growth have taken a big hit post 2014
20
Sharp collapse
16
...and, also hampered farm sectors’
debt servicing ability 12
(%, YoY)
0
FY08 FY10 FY12 FY14 FY16 FY18 FY20 YTD
Rural wage growth Food Inflation
Source:CMIE, Edelweiss research

Not so 20/20
Farm sector debt-deflation dynamic is shaped heavily by global food price cycle
India’s food price cycle is heavily influenced by the global food prices. And, since 2014, global
food prices moved sharply lower and over the past two-three years have been clocking a
flattish trend at subdued levels. In line, India’s food inflation collapsed during 2014-15—a
period of two consecutive droughts. As a result, nominal agri GDP tapered sharply, thus
exaggerating the farm sector’s debt burden. These, along with slower pace of migration, are
the key factors behind reversal of fortunes in the rural/farm economy.
Chart 25: Amidst sluggish prices, agri debt burden climbed… …we seem to be in similar phase
23 40 Favorable agri Adverse agri
Phase of favorable agri Phase of poor agri
debt dynamic debtdynamic
dynamic... debt dynamic...
20 39
38
17
(%)
(%)
37
14
36
11
35
8 34
FY94 FY96 FY98 FY00 FY02 FY04 Sep-11 Sep-13 Sep-15 Sep-17 Sep-19
Agri credit to agriculture GDP
Nominal agri credit as % of agri GDP (4QMA)
18 ...led by improved Weak farm prices

...owing to high farm ...as farm prices
prices remain weak prices hurt debt dynamic
15
12
9
(%)
(3)
FY95 FY00 FY05 FY10 FY15 H1FY20
WPI agri prices
Source: CMIE, Edelweiss research
INR overvaluation exaggerated debt-deflation dynamic

India is a net exporter in agriculture goods and since the value-add is low, it competes in
international markets primarily on prices. In fact, India is a price-taker in several agriculture
Overvalued INR further added to
commodities. Therefore, agri-trade is highly sensitive to exchange rate movements.
farm distress
Arguably, INR movements matter more to the farm sector than manufacturing or other
commodity sectors because the agri sector does not even have any natural hedge from an
appreciating INR, neither a high import content (land, labour are key costs of production) nor
foreign debt.

Table 1: Impact of INR appreciation on various tradeables

Impact of INR
Agriculture commodities Metals/Oil commodity Manufacturing
appreciation on
High as there is no differentiating factor in High as there is no differentiating Moderate as product quality is also
Exports/imports
end product factor in end product important
Low as non-tradeables namely land and High as tradeables account for large Moderate to high as input factors
Input costs
labor account for higher part of input costs part of input costs also are tradeables
Moderate as forex debt may or may

Balance sheet Nil as forex debt component is low High, given high share of forex debt
not be present
Net impact on
Very high High Moderate
profitability
Source:Edelweiss research
In the past, phases of sizeable INR depreciation have always led to improvement in the agri-
trade balance and vice versa. Since 2014, the INR started to move into overvalued territory
and since then it has remained so. This too weighed on farm incomes and compounded the
debt-deflation dynamic.
Chart 26: Swings in India’s agri-trade balance are highly influenced by currency behaviour
9
FY14-FY17:
FY04-FY11: Collapse in int'l
7 Positive terms of trade prices and
owing to higher int'l overvalued INR
prices become
headwinds
(% of GDP)
5
FY11-FY14:
INR
3 depreciation
helping agri
competitiveness
1
FY99 FY02 FY05 FY08 FY11 FY14 FY17 H1FY20
India's net agri balance as % of agri GDP
But, is the stress associated with debt-deflation easing?

To some extent, yes. After all agri-inflation is starting to normalise after remaining extremely
subdued over the past few years. In FY20, for example, food CPI/agri-WPI is likely to average
5% after lingering at less than 2% in the past two-three years. To that extent, nominal agri-GDP
is picking up from subdued levels in recent years. Thus, the nominal cash flow situation is
improving. However, this improvement does not necessarily mean a full-fledged turnaround in
the rural/farm economy is round the corner. This is because a large part of food inflation rise in
recent months is led by perishables (vegetables, etc), and hence would prove temporary. That
said, other commodities such as cereals, milk are also rising, but the rise should largely be seen

Not so 20/20
as normalisation from extremely low levels. We will certainly become more constructive on
nominal farm incomes if we see upswing in the global food price cycle.
Chart 27: Global food price outcomes shape India’s food inflation
Historically, global food price 60 25
downcyles have lasted 6-7 years
(1981-97, 1998-2004).... 44 19
28 13
(%, YoY)
(%, YoY) 12 7
(4) 1
(20) (5)
May 00 May 04 May 08 May 12 May 16 May 20
FAO (advanced by six months)
India WPI of international food components (RHS)
Source: Bloomberg, CMIE, Edelweiss research; Note: FAO index has been constructed using
weights of the Indian basket. Domestic index comprises commodities that are traded
internationally (cereals, meat, sugar, oilseeds, dairy)
Therefore, the key question is, are we at the cusp of global agri-price upcycle? Historically,
downcycles in global food prices lasted six-seven years—1981-87, 1998-2004. The current
downcycle is also nearing six years, having started in 2014. But this does not necessarily mean
...but today, the stocks-to-use
that upcycle is in offing. Surely, a few crop prices have risen (wheat), but the rise is not broad-
levels are still elevated in major
based. More importantly, the stocks-to-use ratios of several agri-commodities are still elevated.
crops
For example, global stocks of wheat and soybean are close to their peaks. In other crops, such
as corn, though inventory levels have corrected, they are still high by historical standards.
Chart 28: Global food stocks are still high in most key crops
40 30 35
28 30
35
26
25
(%)
(%)
(%)
30 24
22 20
25
20 15
20 18
1999 2004 2009 2014 2019 10
1999 2004 2009 2014 2019
1999 2004 2009 2014 2019
Global wheat stocks to use ratio (%) Global soybean stocks to use (%)
Global corn stocks to use(%)
Source: USDA, Bloomberg, Edelweiss research

Outlook: Challenges subsiding, but not out of the woods yet

Overall, we believe, domestic food inflation is normalising from very low levels, implying that
farmers’ nominal cash flows would also normalize vs. past couple of years. However, sustained
The worst is likely behind for the
food price upcycle may still be sometime away and accelerating migration would require big
farm sector, but onset of
capex revival. Thus, government spending in rural/social sector becomes the key monitorable.
favourable dynamics may still be
But given large tax shortfall, it is quite probable that the government may slowdown spending.
some time away...
Already there are indications that the government may end up saving from the allocations for
PM Kisan (rural income transfers) as it seems to be facing implementation challenges.
Chart 29: Government spending needs to ramp up significantly

30
25
...ramp-up in government spending 20

could go a long way in reviving
(%, YoY)
rural economy’s fortunes 15
10
0
Total spending on rural and social
Source: CMIE, State budget documents, Edelweiss research
b) MSME: A casuality in the war on cash economy

The importance of MSMEs in the Indian economy cannot be overstated. Akin to the farm
sector, MSMEs too are labour intensive. However, over the past decade, they have been at
the receiving end for several reasons:
War on cash economy

MSMEs have taken severe beating The twin shocks of demonetisation and GST in quick succession worked to undermine the
post DeMon and GST... cash economy. And MSMEs, largely informal and well entrenched in the cash economy, took
a signficant hit. This is apparent in macro data as well.
For example, post demonetisation/GST, various goods segments such as paints, jewellery,
tiles, etc., saw a sharp divergence in growth rates between listed organised players and the
unlisted segment (largely MSMEs). In the long run, this is good for the economy as it leads to
better productivity, larger economies of scale and higher government tax revenues.
However, in the short run, it has adverse effect on employment as organised players are
much more efficient and can gain market share without absorbing additional labour. In fact,
the divergence between organised (capital intensive) and unorganised (labour intensive) is
apparent in overall industrial production data as well. It shows that labour-intensive
segments have been struggling ever since implementation of GST.

Not so 20/20
Chart 30: Post GST, labour-intensive IIP has collapsed

130
(Rebased to 100 in March 2013)

125
120
Big gap post
GST
115
110
105
100
Mar 13 Nov 14 Jul 16 Mar 18 Oct 19
IIP labour intensive (proxy for MSME) Non- Labour intensive sectors
.
Chart 31: Shift from unorganised to organised hitting MSMEs—Visible across segments like paints, Jewellery, etc.
20 880
Big
15 divergence
680 post demon
(rebased to 100)
10
(%, YoY)
5 480
0
280
(5)
(10) 80
Sep 12 Sep 13 Sep 14 Sep 15 Sep 16 Sep 17 Sep 18 Sep 19 FY08 FY11 FY14 FY17 H1FY20
Paints IIP Asian Paints volume growth Titan jewellery sales India gold imports
Source: CMIE, Edelweiss research; Note:Leather, readymade garments, textiles,handicrafts, sports goods, footwear, paper/wood
products and gems and jewellery are classified as labour-intensive exports while chemicals, engineering goods, electronic goods andother
manufactured goods (excluding commodities) are classified as capital intensive exports herewith
Slowdown in global trade/exports

MSMEs play a vital role in exports, directly and indirectly, as a part of the production chain.
However, global trade growth peaked out in 2013-14 and India’s exports too started to slow
down (India’s exports closely follow global trade cycle historically). For example, India’s
Slowdown in global trade and manufactured exports stood at USD305bn in FY12, and eight years later, in FY20, they are
overvalued INR have also weighed likely be USD325bn, mere 1% CAGR.
on MSMEs prospects
Apart from weak global trade, an overvalued INR also played an adverse role. On account of
low value add, MSMEs compete primarily on prices in international markets and, therefore,
the exchange rate is of signficant import. This slowdown or stagnancy in overall
manufactured exports harmed MSMEs directly and indirectly.

Chart 32: Overall exports have been stagnant since 2012

350
300
250 FY12-20:
FY02-12:
Exports CAGR: 1%
(USD bn)
200 Exports CAGR: 20%
150
FY96-02:
100 Exports CAGR: 5%
50
-
FY95 FY00 FY05 FY10 FY15 FY20 YTD
India's exports (USD Bn)
Source: CMIE, Edelweiss researc
NBFC liquidity crisis: The straw that broke the camel’s back
While dent in the cash economy (demonetisation and GST) and lingering slowdown in global
Easy liquidity conditions helped trade severly impacted businesses of MSMEs, what kept them going was the easy flow of
MSMEs sail through difficult times, liquidity and lower borrowing cost (due to NBFC lending boom post demonetisation) which
but 2018 liquidity crisis halted that enabled them to leverage in a weak cash-flow scenario.
As per CIBIL, MSMEs outstanding debt to MSME Gross Value Add has increased from 32% in
2013 to 48% in 2018, a meaningful increase. In fact, some of this rise in MSME debt may just be
a shift of borrowing from informal to formal sources, the latter being much cheaper. Whatever
the case, easier liquidity conditions over the past three-four years helped them sail through
difficult times. However, post the NBFC liquidity crisis, the MSME segment has witnessed sharp
slowdown in flow of funds and rise in borrowing costs. Even lending standards for MSMEs have
tightened significantly as per various corporates and bank commentaries. This combination of
weak incomes and sharp credit slowdown has severely hurt MSME incomes.
Chart 33: Easy liquidity post DeMon helped MSMEs endure several challenges; however, that changed in 2018-19
28
50 26 26 26
48 25 Sharp slowdown
25 24 post NBFC crisis
46 23
44
22
20
(%, YoY)
42
39 19
(%)
17
38 37
16
13
34 32 33 13
30 10
2013 2014 2015 2016 2017 2018 Jun 17 Dec 17 Jun 18 Dec 18 Jun 19
MSME outstanding balance as % MSME GVA MSME loans outstanding
Source: CIBIL, CMIE, Edelweiss research

Not so 20/20
Outlook: Improving liquidity and exports to help

The liquidity situation has improved recently. The RBI’s durable liquidity growth is at decadal
high and this is likely to gradually ease the credit freeze for MSMEs. With ample liquidity
Easing liquidity and improving available in the system, it is only a matter of time that risk aversion among lenders begins to
exports outlook should provide a ease. In fact, early signs of this are already visible with AAA corporate bond spreads starting
breather for MSMEs but full to ease. Also, the adverse shock from demonetistaion and GST is largely behind and hence
recovery may have to wait we believe the healing process has commenced. Global trade is also stabilising after slowing
since early 2018. However, progress is likely to be slow. Aggregate domestic demand is weak,
interest rates need to move lower still and INR overvaluation needs to correct.
Chart 34: High quality bond spreads are compressing now

460 140
420 120
380
100
(bps)
(bps)
340
80
300
60
260
220 40
Dec 09 Dec 11 Dec 13 Dec 15 Dec 17 Dec 19
5 year BBB bond spreads 5 year AAA bond spreads - RHS
Source: Bloomberg, Edelweiss research
Note:These are updated as on December 31, 2019
Though the strong headwinds of the past two years are waning, improvement in MSMEs is
likley to be slow. Either global economic recovery needs to be stronger than currently
envisaged or domestic policymakers need to be more aggressive in cutting rates, boosting
government spending and also correcting INR overvaluation.
c) Real estate: Poor macroeconomic policies taking a toll

Apart from the farm sector and MSMEs, real estate is the next big labour-intensive sector
which too has been facing challenges for long. In fact, within aggregate capex in the country,
the biggest slowdown is in the real estate sector. Why so?

Chart 35: Real estate capex has slowed sharply…
9
Capex slowdown is the most
pronounced in real estate... 8
(% of GDP)
6
3
FY12 FY13 FY14 FY15 FY16 FY17 FY18
Household real estate capex (% of GDP)
Source: National accounts, CMIE, Edelweiss research
Slow macroeconomic response

One of the primary reasons for the prolonged real estate slump is the behind the curve
fiscal/monetary response in this business cycle. Real estate is one of the most interest rate
sensitive sectors of the economy and hence high real rates adversely impact the sector. Even
in recent years while lending rates have eased, they are still high relative to income growth
and rental yields.
Chart 36: Interest rates are still high relative to incomes

...high real interest rates have 15
been a big headwind for real
estate
10
(%)
(5)
Oct 03 Oct 07 Oct 11 Oct 15 Oct 19
Wage bill growth minus home loan rate
Source: CMIE, Bloomberg, Edelweiss research; Note: SBI home loan rate has been considered
herewith. Wage bill growth is the growth in the wage bill of 20,000 companies taken from
MCA corporate database, whose combined wage bill is INR12trn
NBFCs were the key lenders in developer financing

Last year’s NBFC crisis has weighed Sentiments in real estate have got further dampened over the past one year post the NBFC
severely on developer financing crisis. This is predominantly because NBFCs accounted for ~90% of incremental flow of funds
to developers during FY15-18. Post the NBFC crisis last year, most NBFCs have scaled back
lending, especially to real estate developers. While banks have increased their exposure to

Not so 20/20
the sector, it nowhere offsets the sharp scaledown by NBFCs. As a result, activity in this
segment has taken a further knock.
Chart 37: NBFCs accounted for 90% of developer financing growth

20
Break of YoY growth in developer financing
0
16 6 3
12 3
(%, YoY)
17
8
13 14
10
4
0
FY15 FY16 FY17 FY18
NBFCs Banks
Source: RBI, CMIE, Bloomberg, Edelweiss research;
Outlook: Government is taking steps, but scale is small

Going ahead, some of the recent measures announced by the government (setting up of real
Affordable housing is an effective
estate fund, incentives for buying asset pools of NBFCs, etc.) and improving liquidity
scheme but allocations need to
conditions should ease the pain in the sector. However, headwinds still persist. First, the RBI
ramp up
needs to be more aggressive in pursuing rate cuts. Second, the government can ramp up
spending in some of its existing affordable schemes.
Chart 38: Government spending on affordable housing hasn’t ramped up materially and its size is still quite small
0.30 8
0.27 6
(% of GDP)
(% of GDP)
0.24
4
0.21 Affordable housing is
2 low in overall scheme
0.18 of things
0
0.15
FY12 FY14 FY16 FY18 FY20 (BE)
(BE) Central govt. spending on housing
Central govt. spending on housing HH real estate capex
State stamp duty collection*
Source: RBI, CMIE, Bloomberg, Edelweiss research; Note government spending on affordable housing include spending through IEBR as
well; *State stamp duty collections are multiplied by 10 to depict the transaction value as that’s the approximate rate in the country
While, these schemes do provide incentives for households to leverage, their size is
minuscule in comparison to overall real estate spending. In fact, a look at the government’s
affordable housing-related spending, one does not notice any major scale-up in spending in
this segment.

The way ahead: Government spending needs to ramp up

Clearly, from the discussion above, the bottom of the pyramid is reeling under pressure for
some time now. Easing farm debt-deflation, expanding liquidity and stabilisation in exports
should bring a signficant breather to this segment. Yet, unless migration accelerates (which
Fiscal spending will have to do the
requires capex revival) or global food price upswing becomes enduring, a sustainable revival
heavy lifting to fix problems at the
of farm sector may have to wait. In this scenario, what should policymakers do?
bottom of the pyramid...
We believe, fiscal spending support is a must at the bottom of the pyramid. The government
needs to expand its spending in rural and social sectors, the pace of which has slowed in the
past five-seven years. Monetary policy/liquidity support will surely help but alone it may not
be able to turnaround the conditions at the bottom of the pyramid.
Note that states and central governments together spend INR15tn/year on rural (agriculture,
..but has been slow in recent years
rural employment, rural roads, etc) and social (health, education, social security, etc.)
sectors, as per FY18 data. Further, government machinery is well entrenched in these
segments and, therefore, existing schemes can be ramped-up quickly. During all previous
downturns, the government has ramped-up spending in these segments, thus cushioning the
income blow due to downturn. This time, the ramp up is missing and, hence, the sharp crack
in consumption. It’s perhaps time that government focusses on spending in these areas.
Chart 39: Government spending in rural and social sectors needs to ramp up
30
25
20
(%, YoY)
15
10
0
Total spending on rural and social
Source:Central government budget documents ,RBI, CMIE, Edelweiss research; Note: Total
spending includes aggregate spending of state and centre combined. Also, rural and social
sector spending include spending done on agriculture, irrigation, health, education, social
security, sanitation, etc.
Overall, some of the headwinds faced by the bottom of the pyramid in the form of tight
liquidity and farm deflation are fading. However, they are not yet out of the woods and
need aggressive government intervention in the form of direct spending to revive their
fortunes.

Not so 20/20
Current Account: Surplus In Times Of Deficiency

India’s current account deficit (CAD) is narrowing and is likely to move into balance in the
ensuing one-two quarters—a favourable swing of 2% of GDP in about a year. This
quantum of swing is outdone by only two other episodes—FY01-04 and FY14—when
CAD narrowed by 4% of GDP. Often, improving CAD reflects a favourable macro-dynamic,
but not always. It can narrow because currency is competitive and/or external demand is
good (a favourable narrowing), but can also narrow because domestic demand has
faltered (adverse dynamic). We show that in early 2000s, an undervalued INR and a
rebounding global economy led to improvement despite sharp recovery in domestic
demand. In FY14, it was largely undervalued INR and gold import restrictions. However,
in the current episode, CAD is narrowing despite an overvalued INR, and weak exports,
suggesting sharp compression in domestic demand. In EMs, such internal adjustments
are undertaken during severe BoP shocks, but the fact that it is happening amidst large
BoP surpluses in India indicates that domestic macroeconomic policies need to be more
stimulative and there is leeway to do so.
CAD improvements: A historical perspective

India’s CAD has started to improve of late and going by recent trade deficit trend, it appears
that the CAD situation could move into balance. If so, this will mean nearly 2% swing in CAD
as % of GDP in four-five quarters’ time, which is quite sizeable. What’s happening?
Is CAD narrowing always good?
...depends on what’s driving it Historically, there are two other episodes where India’s CAD narrowed sharply. Typically,
CAD movements are a play of domestic demand relative to external demand and
undervaluation/overvaluation of exchange rate. In the chart below we highlight three
espisodes (including current) of large improvement in CAD and analyse what dynamics are at
play.
FY01-FY04 – 4% of GDP improvement

FY14 – 4% of GDP improvement
FY20 – 2% of GDP improvement
Chart 40: CAD has seen three main phases of improvement

3
1
4QMA (% GDP)
(1)
(3)
(5)
Mar 96 Mar 00 Mar 04 Mar 08 Mar 12 Mar 16 Mar 20
Current account balance (% of GDP)

FY01-04: CAD improved 4% of GDP despite strong domestic demand

The most dramatic improvement in India’s CAD was during early 2000—a favourable swing
Over FY01-04, CAD improved 4% of ~4% of GDP, taking CAD into surplus. Surprisingly, this happened despite signficant pick up
despite strong domestic demand, in domestic demand, as seen in credit growth, nominal GDP growth, among others. What led
thanks to weak INR and booming to this improvement, therefore, was a combination of sharply reviving global economy/trade
global growth (led by global synchronous fiscal/monetary stimulus) as well as a competetitve exchange
rate. Thus, it was a favourable dynamic which led to improvement in CAD.
FY14: CAD swings by 4% of GDP owing to undervalued FX and gold import restrictions
The second episode of improvement in CAD was FY14, where CAD as % of GDP moved from
5% to 1% on trend basis—a large swing. Here, modest recovery in global economy helped at
the margin (domestic demand was stable); what really moved the needle was compression
in gold imports (through regulatory means by the government), but equally important it was
the undervaluation of the exchange rate (after QE tapering episode in mid-2013) which
played a signficant role. For example, the farm sector benefitted the most from a weak INR.
Net exports of agri-sector as % of agri-GDP expanded sharply during this period. Thus, this
improvement in CAD was also driven by a favourable dynamic.
FY20: CAD set to swing by ~2% owing to compression in domestic demand

The underlying trade balance is narrowing and out projections point towards the likelihood
of CAD moving into balance in the next one-two quarters. However, this likely improvement
is a reflection of adverse dynamic, unlike the previous two episodes. For example, while
In FY14, CAD improved 4% due to external demand/global exports are stable, the INR has been overvalued for a sustained
undervalued exchange rate and
period now. And, despite that CAD is shrinking, which suggests that broad-based slowdown
curb on gold imports; domestic
in domestic demand is driving this improvement. Thus, this improvement is more a reflection
demand was largely stable
of internal adjustment (slowdown in domestic demand/wages etc) rather than external
adjustment (undervalued INR or recovering global economy).
This is consistent with the fact that despite policy rate cuts in the past six months, the RBI
remains behind the cruve. After all, the gap between nominal GDP growth and 10Y yield is
now at 20–years’ low. Thus, monetary policy is not fully stimulative as yet. Similarly, fiscal
policy is also neutral, at best. This CAD improvement despite INR overvaluation, therefore, is
coming at the cost of domestic demand slowdown.
Chart 41: Global growth is a bigger headwind this time compared to previous cycles
25 Strong global Stable global Slowing global
growth growth growth
15
The current episode of CAD
(4QMA, % YoY)
improvement is occurring despite

5
global slowdown and overvalued
exchange rate...
(5)
(15)
(25)
World Trade value (4QMA, % YoY)
Source: CPB Netherlands World Trade Monitor, Edelweiss research

Not so 20/20
Chart 42: Current CAD improvement despite INR overvaluation…

105
Overvalued
Undervalued Undervalued INR
INR INR
...Hence, unlike past, the current 100
episode of CAD improvement is a
case of internal devaluation
95
90
85
To that extent, CAD surplus isn’t a
BIS (REER) Long term average
virtuous one
Chart 43: …and is primarily led by collapse of domestic demand

20
Rising Stable Collapse in
domestic domestic domestic
17 demand
demand demand
14
11
5
Nominal GDP ex CAD (4QMA, % YoY)
Source: BIS, Bloomberg, CMIE, Edelweiss research

Table 2: Factors that helped improve India’s CAD in previous episodes
FY01-04 FY14 FY20
Global Demand Strong Modest Weak
INR competitiveness Undervalued Undervalued Overvalued
Domestic Demand Strong Modest Weak
Current account adjustment dynamics Very positive Positive Negative

Source: BIS, Bloomberg, CMIE, Edelweiss research
Unlike previous episodes of CAD improvement, this time it’s happening due to domestic
demand slowdown rather than competitive exchange rate or improving global demand.
Hence, to that extent, achieving macro stability is not a virtuous one.

Fiscal Constraint: Self-Imposed Than Macro-Economic

Is there space for fiscal stimulus? That’s the question for 2020. Those who believe not are
essentially concerned about three things. First, rates will rise as government borrowing
as % of financial savings is at 100%. We believe not necessarily. During early 2000, this
ratio persisted at 100% for five years while yields declined sharply. In subsequent four
years, bond yields actually climbed even as this ratio declined precipitously from 100% to
50%. It’s the credit cycle, inflation and monetary policy that anchor yields foremost.
Second, what about inflation? Here again, big movements in CPI are driven by the global
food price cycle, which is still benign. Also, domestic pricing power remains curtailed.
Think of early 2000 when fiscal deficit was 10% of GDP for five years, but inflation
remained unusually benign.
Finally, what if fiscal slippage triggers sovereign ratings downgrade. Historically, the
reaction of currency/bond market to ratings action is neither decisive nor persistent. It is
shaped more by macro dynamics rather than ratings action per se. After all, the
sovereign downgrade to junk in 2002 was followed by the biggest upswing in capital
inflows and growth, while sovereign upgrade to investment grade in 2011 marked peak
of the growth cycle. In all, fiscal expansion cannot be judged good or bad in isolation.
Macroeconomic context matters. Today, it may be prudent to be ‘fiscally imprudent’.
One of the most puzzling aspects of the current downturn has been the limited use of fiscal
and monetary levers to revive growth. Why so?
We believe, the pursuit of tight macroeconomic policies has its genesis in the period of high
macroeconomic vulnerability that persisted over FY11-14. It’s a period when inflation
remained above 10%, CAD was over 5% of GDP and INR depreciated ~35%. Hence, to that
extent, policymakers prioritised macroeconomic stability over growth and perhaps rightly so.
Chart 44: Fiscal policy has not been counter-cyclical in the current cycle
12 19
Fiscal policy has not been counter Fiscal Fiscal Barely any fiscal
cyclical in current economic 11 expanded expanded expansion 17
downswing by 400 by 500bps
10 bps 15
(% of GDP)
(%, YoY)
9 13
8 11
7 9
6 7
FY96 FY00 FY04 FY08 FY12 FY16 FY20E
Aggregate fiscal (including FCI) ex asset sale (% of GDP)
Nominal GDP growth (%, YoY, RHS)
Source: CMIE, Government budget documents, FCI Annual report, Edelweiss research

Not so 20/20
However, post FY14, with inflation falling and benign CAD, the tight macroeconomic regime
seems, to an extent, self-imposed. We still seem to be fighting a battle long won. In all
previous episodes of India’s downturn, fiscal has expanded 400-500bps, but this time around
policymakers have refrained from fiscal expansion. What’s puzzling is that despite the sharp
economic slowdown in FY20 and weakness in government tax revnue, most commentators
and policymakers are still recommending to stick to fiscal deficit targets. Is there room for
fical expansion?
a) Fiscal stimulus: Are low household financial savings a hindrance?

The most common argument against fiscal expansion today is who will fund the government.
Government needs to leverage as After all, aggregate government borrowings (state + Centre + FCI) amount to ~8% of GDP,
private sector does not have the almost equal to household financial savings. In this scenario, if the government starts to borrow
balance sheet strength… more, the argument goes, there will be limited resources left for corporates and, hence, it could
lead to higher interest rates.
History does not support this thesis. The fact is that fiscal stimulus has not led to crowding out.
For example, during FY99-04, aggregate government borrowing stood at 100% of household
financial savings and yet interest rates fell 500-600bps. In fact, when government borrowing
as % of household financial savings reduced, interest rates rose, mapping the overall growth
and the RBI’s monetary stance.
Even in the past four years, while government borrowing as % of household financial savings
has been 100%, interest rates have dipped, mapping RBI’s monetary cycle and inflation
…this will not result in higher outcomes. Thus, we do not believe that fiscal stimulus will lead to higher interest rates at this
interest rates at this juncture (as stage of the business cycle, especially if the RBI remains accommodative.
RBI remains accommodative)
Chart 45: Fiscal expansion need not cause crowding out; context matters
13 Rates fell despite high 115
...also in ...and in recent
govt. borrowing... 2009 years as well
100
11
85
(%)
(%)
9
70
7
55
5 40
Nov 98 Nov 01 Nov 04 Nov 07 Nov 10 Nov 13 Nov 16 Nov 19
India 10Y bond yield Govt. borrowing as % of HH financial savings (%, RHS)
Source: CMIE, Government budget documents, Edelweiss research; Note government

borrowing is the sum of state, centre fiscal deficit and FCI borrowing
b) Does fiscal expansion always lead to high inflation?

Another popular concern is that fiscal expansion could lead to higher inflation as government
spending is inefficient and it eventually increases macro-vulnerabilities. The most common
example quoted is that of the FY09 stimulus, which led to higher inflation. However, in our view,
India’s inflation is more a function of global food prices rather than macroeconomic policies.

In fact, that’s the main reason that despite more than 10% aggregate fiscal deficit in the early
part of the decade, strong economic recovery and sharp cut in interest rates, India’s CPI
In early 2000, inflation remained
inflation remained benign at 4% for nearly six years. Given that the global food price upcycle
benign despite higher fiscal deficit,
seems to be some time away (going by agri-inventory data), we believe inflation concerns are
largely owing to benign global food
misplaced. And, in any case, given the weak demand and pricing power, core inflation risk is
prices
quite low. Hence, if fiscal is expanded, it’s unlikely to start an inflationary cycle.
Chart 46: High fiscal deficit does not necessarily cause inflation
14 12
11
High fiscal
10
deficit yet low
(% of GDP)
inflation
(%)
8
5
2 6
FY00 FY02 FY04 FY06 FY08 FY10 FY12 FY14 FY16 FY18
CPI Inflation Aggregate fiscal (including FCI) ex asset sale (% of GDP) - RHS
Source:CMIE, Government Budget documents, FCI annual reports, Edelweiss research
c) Fiscal expansion could lead to ratings downgrade: Does it matter?

What about the risk of ratings downgrade and associated flight of capital in case there is
Track record of Rating agencies fiscal expansion? This concern has further increased in recent months with Moody’s changing
leaves much to be desired India’s ratings outlook to negative and even S&P making noises about potential risks of a
ratings downgrade. So, what has been the impact of rating agencies on growth, interest rates
and currency?
First, with regards to growth, history is unambiguously clear—ratings actions have barely
impacted the economic cycle. India was downgraded to junk by S&P 500 in October 2002, at
the bottom of the biggest growth boom that India has seen. Moody’s upgraded India to
investment grade in December 2011—at the peak of the growth cycle. Thus, getting it
horribly wrong on both sides.
Second, rating agencies’ actions have hardly had any influence on interest rates and
…and their influence on interest
currency. In each of the downgrades (including junk), interest rates actually fell in the
rates and currency is rather limited
subsequent 12 months. Further, on the currency and capital flows front as well there is no
pattern.
This seems only natural, because markets are far more efficient and timely in assessing the
evolving economic conditions and, therefore, adjust real time. Hence, policymakers need not
feel overly constrained by the implications of their policy choices on ratings actions..

Not so 20/20
Chart 47: Sovereign ratings actions and growth outcomes

22
Sovereign Upgrade
20
Sovereign Downgrade
18
Deep downturn post
16
(4QMA, % YoY)
upgrade to investment
grade
14
12
Sharp revival post
10 downgrade to Junk
6
Sep 97 Sep 99 Sep 01 Sep 03 Sep 05 Sep 07 Sep 09 Sep 11 Sep 13 Sep 15 Sep 17 Sep 19
Nominal GDP (4QMA, %, YoY)
Chart 48: Rating changes and currency movement Chart 49: Rating changes and bond yields
100 Rating
12 Rating
Rating Rating downgrades upgrades
50
8 downgrades upgrades Junk
0
4
(%)
(%)
(50)
0
(4) (100)
Downgraded (150)
(8)
to "Junk"
(12) (200)
Sept' 02
July' 01
Dec' 11
Oct' 98
Oct' 10
Jan' 07
Nov' 17
Sept' 02
Dec' 11
July' 01
Oct' 98
Oct' 10
Jan' 07
Nov' 17
12M change in USD/INR after rating change (%) 12M change in 10Y G-sec after rating change (bps)
Source: Bloomberg, CMIE, Edelweiss research
d) Should fiscal policy focus on supply or demand?

Finally, within the fiscal framework, what should be the key priority—to put more money in
the hands of consumers and boost demand in the near term or reduce taxes and incentivise
investments over the long term?
Here, macro-context matters a lot. Today, the economy is severelly demand constrained,
with capacity utilisation running below 75% and power & industry output contracting. In this
scenario, supply-boosting measures such as corporate tax cuts could be ineffective and may
end up being saved.

In fact, given the deep distress at the bottom of the pyramid, government spending/transfers
to these segments could have a much higher multiplier. This is evident from various RBI
Fiscal policy should focus on direct studies as well, which indicate that direct government spending, especially by states, has a
spending rather than rely on far higher fiscal multiplier compared to that of tax cuts. Within tax cuts as well, the least
supply-side measures through tax multiplier is corporate tax cut. While this will definitely entail long-term benefits, its ability to
cuts turnaround the business cycle is limited.
Fig. 2: Government’s fiscal multiplier pyramid
Source: Bloomberg, Edelweiss
States account for two-third of overall development spending, but markets mainly focus on
the central government’s budget. Also, with regards to spending, it’s the social and rural,
State governments spend heavily
which account for 75% of development spending. Here states have a high allocation and,
at the bottom of the pyramid and,
hence, it’s important that their tax revenues remain protected. Also, for states, some
hence, some relaxation in their
relaxation of the 3% FRBM target is warranted.
fiscal targets is warranted
Table 3: State governments are much larger players in development spending

(FY18, INR trn)
Particulars
Total Central govt. State govt.
Total spending 50 25 26
Development spending 29 10 19
Social/Rural 15 3 11
Infra 5 3 2
Non-development spending 21 14 7
Source: Bloomberg, Edelweiss
We believe, fiscal constraints are self-imposed rather than macroeconomic. Market

concerns with regards to interest rates, inflation and currency seem misplaced under
conditions of weak aggregate demand. In our view, there is room for atleast 1.0-1.5% of
GDP fiscal expansion.

Not so 20/20
Monetary Policy: Institutional rigidities?

Just like fiscal policy, monetary response too has been a laggard this cycle, be it liquidity,
interest rates and don’t forget exchange rate. Amongst these, the RBI is finally expanding
durable liquidity at 20% plus (after being tight for 80% of the previous decade). This
should boost transmission. Contrary to popular belief, the small savings rate is not a
hindrance to transmission—in 2000, when the small savings pool amounted to a
whopping ~25% (7% currently) of deposit base, deposit rates slipped below small savings
rate and still deposit growth accelerated. As regards rate easing and currency, the RBI’s
policy leaves much to be desired. With a 300bps cut in repo rate (since January 2015) in
five years, it is the slowest on record. Why so?
To a reasonable extent, the genesis could be traced to certain shortcomings inherent in

the inflation targeting framework (2014). At that time, macro-backdrop of high
inflation/large CAD and falling INR proved overwhelming. In our view, the framework
overemphasized macro-stability (at the cost of growth) and allowed for little flexibility.
And, in the absence of credible high frequency data on unemployment, growth concerns
were further short-changed. That’s not all. RBI’s inflation forecasts (basis for policy
making) consistently overshot actual outcomes by a huge margin, thus delivering tighter
policy than warranted. Importantly, the correlation of RBI‘s inflation expectations survey
with actual inflation and wages is much more tenuous than was claimed by the Urjit
Patel Committee Report and so is the relation between real rates and deposit growth.
Finally, 4% inflation target is perhaps too low—11/13 studies mentioned in the Urjit Patel
Committee Report cite 5% or more as appropriate level. Thus, it may be time for
reassessment of the framework to allow a better suited and timely response to evolving
macroeconomic conditions.
Apart from fiscal policy, monetary policy too has been behind the curve in the current cycle.
Monetary policy has essentially three aspects—liquidity, level of repo rate and exchange rate.
Liquidity, not small savings, constrain transmission

After keeping the system in tight On the liquidity front, the system has been subject to tight liquidity for most of the previous
liquidity for over a decade, RBI is decade. RBI’s durable liquidity (prime source of liquidity) has grown slower than nominal GDP
growing durable liquidity at 20- for most of the previous decade, weighing adversely on growth. Such an approach on liquidity
25%... is understandable when inflation and CAD were high (until 2014). However, despite the big
improvement in macro-stability and shifting its stance to easing in early 2015, the central bank
continued to keep systemic liquidity in deficit.
However, in the past one year, Mint Street has done a commendable job of reversing liquidity
conditions. Durable liquidity, which was running below nominal GDP growth, has moved higher
and is now at 20-25%. Such strong liquidity infusion has helped stabilise the financial system,
which had been destabilised post IL&FS default in late 2018.
...this should improve transmission
and lower credit spreads Further, this, along with RBI’s recent operation twists (buying long-dated securities and selling
shorter-dated ones), should ensure increased transmission and lower risk aversion in ensuing
months. In fact, early signs of the same are already visible with increased transmission in recent
months and some compression of credit spreads as well.

Chart 50: RBI is doing a commendable job on liquidity

30
25
RBI liquidity growth at
20 decadal highs
(%, YoY)
15
10
0
Nov 04 Nov 07 Nov 10 Nov 13 Nov 16 Nov 19
RBI Durable liquidity
Chart 51: This should lower lending rates… Chart 52: …and bond spreads
7.0 460 140
8.5
420 120
6.5
8.2
380
100
(%, YoY)
(%, YoY)
(bps)
6.0 340
7.9
80
300
7.6 5.5
60
260
7.3 2205.0 40
Jan 18 Jul 18 Jan 19 Jul 19 Jan 20 Dec 09 Dec 11 Dec 13 Dec 15 Dec 17 Dec 19
5 year BBB bond spreads
Lending rate Repo rate (RHS) 5 year AAA bond spreads - RHS
Source: CMIE, Edelweiss research; Note: RBI’s durable liquidity is the sum of FX assets and G-sec purchases by RBI. For DeMon period (Nov
2016– Nov 2018), we have used 2Y CAGR; Note: SBI 1 year MCLR has been taken as lending rate
Is small savings rate a constraint?

One of the primary reaons cited for poor transmission is the small savings rate, which, the
In early 2000, despite small argument goes, is a floor for deposit rates. However, historically, there are episodes when
savings being ~25% of deposit this floor has been breached. In 2004, SBI’s 1Y deposit rate had hit a low of 5%, nearly
base (7% currently), deposit rates 250bps lower than the prevailing small savings rate. This despite the fact that small savings
slipped meaningfully below small accounted for 25% of bank deposits (on outstanding basis) versus mere 7% currently. At that
savings rate... juncture, despite deposit rates hitting a low of 5%, deposit growth rate actually accelerated.
This was because, as we have argued earlier, it’s credit which creates deposits and not the
other way around (refer to our note - Invest to save). In 2004, given the strong credit growth
(partly fueled by sharp cut in lending rates), deposit growth also remained strong. Also,
...and still deposit growth liquidity is fungible. Any investment in small savings will lead to spending by the government,
accelerated which in turn will eventually flow to the banking system. Thus, concerns on high small savings

Not so 20/20
rate impeding transmission are overstated. It’s the liquidity and banking sector’s capital
adequacy which drive transmission.
Chart 53: Small savings rates were much below deposit rates in early 2000 despite accounting for 25% of total deposits
9 Small savings did 30 ...despite high share
not impede in total deposits
transmission... 25
8
20
(%)
(%)
7
15
6 10
5
5
SBI 1 year deposit rate 1Y small savings rate Outstanding Small savings as % of total deposits
Chart 54: Low deposit rates did not hurt deposit growth
14 Deposit growth 30
accelerates despite
12 low rates 24
10 18
(%, YoY)
(%)
8 12
6 6
4 0
Dec 99 Dec 04 Dec 09 Dec 14 Dec 19
SBI 1 year term deposit rate Deposit growth rate (%, YoY) - RHS
Rates are still high relative to growth

While the RBI is certainly doing a commendable job on the liquidity front, its action is still
Current easing cycle is slowest and slow on the policy rates front. The current easing cycle has been the slowest and shallowest
shallowest in past decades... on record, with rates going up twice in 2018. Also, in 2019, while the RBI has cut rates, its
actions are still slower compared to the slowdown in growth. After all, nominal GDP growth
is now below the 10Y bond yield, clearly reflecting weak debt servicing ability.
Historically, whenever this has happened, Mint Street has been aggressive in cutting interest
...nominal growth is growing below rates. This time around, however, its policy response has been weak. In fact, recently RBI’s
10Y bond yield governor said that we can’t incessantly cut rates. The question then is, if the RBI cannot
aggressively cut rates when growth is weak, inflation benign, current account nearing
surplus, when can it?

Chart 55: Current easing cycle has been the shallowest Chart 56: In 2019, rate cuts have lagged growth slowdown
9 12
500bps 600bps 300bps easing
easing in 3 easing in
8 in 5 years 9
years 1 year
7
6
(%)
(%)
6
3
5
0
4
3 (3)
Dec 00 Sep 05 Jun 10 Mar 15 Dec 19 Sep 01 Sep 04 Sep 07 Sep 10 Sep 13 Sep 16 Sep 19
India 3M t-bill India Nominal GDP growth minus 10Y bond yield
High real interest rates kept INR overvalued

Apart from hurting debt servicing ability of domestic participants, persistently high real rates
have also manifested in persistently overvalued exchange rate. Since 2014, India’s real rates
have been persistently kept higher, when they were much lower in rest of the world. As a
result, India’s exchange rate has become overvalued. This has weighed heavily on India’s
export competitiveness, which have taken a beating post 2013. And, the impact is maximum
on lower value-add segments, which are extremely sensitive to INR’s movements. Hence, if
real rates are brought down further, it will help correct the INR’s overvaluation.
Chart 57: RBI’s delayed rate cuts have led to INR overvaluation
4
3 India real rate (based on CPI)
2
(%, YoY)
Sharp INR rally

1 post 2014
0
(1)
(2)
125Sep 04 Sep 07 Sep 10 Sep 13 Sep 16 Sep 19
INR REER
120
115
(x)
110
105
100
95
20Sep 04 Sep 07 Sep 10 Sep 13 Sep 16 Sep 19
15 India export growth minus world
trade export growth
(%, YoY)
10
5
0
(5)
Sep 04 Sep 07 Sep 10 Sep 13 Sep 16 Sep 19
Source: Bloomberg, CMIE, CPB World Trade Monitor, Edelweiss research

Not so 20/20
And, the best time to correct the INR’s overvaluation is during USD weakness. The central
bank needs to ensure that the INR does not appreciate relative to other EMs. It must
Some of the tenets of monetary intervene in forex markets and absorb foreign inflows. This will help add permanent liquidity
policy framework need as well as correct the overvalued INR and this will imporve India’s export competitiveness.
reassesment...
What’s behind RBI’s reluctant response? A look at monetary framework
Why RBI’s easing has been so reluctant in the current easing cycle (starting January 2015)
versus previous cycles? Now that five years have elapsed, it is pertinent to note the
challenges and difficulties associated with implemtation of the flexible inflation targeting
framework as adopted in 2014. The framework has been premised on the Urjit Patel
Committee Report on inflation targeting. Below we discuss a few tenets of the report and
...RBI’s framework accords high challenges associated with them:
importance to household inflation
expectations a) RBI’s inflation expectations survey, inflation outcomes and wages
The Urjit Patel Committee Report had recommended that headline inflation, rather than core
inflation, should be the nominal anchor. This despite headline inflation having 60% fuel and
food, which are much less amenable to RBI’s policy actions. Its predominant argument was
that inflation expectations are shaped by food inflation shocks, which in turn weigh on wage
expectations. To quote,
“Specifically, a 100bps shock to food inflation immediately affects one-year forward

expectations by as much as 50bps and persists for 8 quarter.. …shocks to WPI inflation have
In past five years, despite the sharp
no statistically significant impact on inflation expectations, indicating that targeting the WPI
collapse in inflation and rural
would do little to anchor inflation expectations.”
wages, household inflation
expectations remain sticky –Urjit Patel committee report on inflation targeting, January 2014
However, in the past six years since the report was published, food inflation has softened from
14% to 2%, rural wage growth has softened from 15% to 3%, but household inflation
expectations have barely moved lower from 12% to 9%. If inflation expectations are so sticky,
as the survey suggests, despite collapse in food inflation and rural wages, is the RBI focusing too
much on the wrong indicator?
Chart 58: Little correlation between inflation expectations, inflation and wages
15 20
12 17
14
9
(%)
(%)
11
6
8
3
5
0 2
Nov 11 Nov 13 Nov 15 Nov 17 Nov 19 Nov 11 Nov 13 Nov 15 Nov 17 Nov 19
Inflation expectations (1Y ahead) Food inflation Inflation expectations (1Y ahead) Rural wage growth
Source: RBI, CMIE, Edelweiss research

b) Inflation forecasting errors quite large
Inflation forecasts form an important element of inflation-targeting framework and, therefore,

accuracy with which the index is forecastable becomes an important consideration.
We argue that given unusually large weight of food (especially vegetables) in the CPI,
forecasting is challenging. It is borne out by facts. For example, the RBI itself has consistently
RBI’s inflation forecast have
missed its Q4/H2 inflation forecast that it set at the start of the year by a very large margin—
overshot actual outcome 150bps averaging 150bps each year during FY15-FY19. Thus, policy response was delayed. Rates were
on average in past five years...
kept persistently higher than warranted by the growth-inflation dynamic.
Chart 59: MPC inflation forecast and reality

180
135
80
(20)
(bps)
-53 -43
(120)
-143
...leading to unusually tight macro- (220) -187
economic policy
(320) -273
H2 Actual inflation vs. MPC's forecast
Source: CMIE, MPC policy documents, Edelweiss research
c) Is RBI’s obsession with maintaining high real rates justified?
Another important tenet of the Urjit Patel Committee’s Report was positive real rates to sustain
deposit growth. To quote,
“High inflation in itself impedes transmission of monetary policy. This impact is exacerbated if
interest rates on financial products do not adjust to inflation and yield negative returns. In
India, gold and real estate compete with deposits, thereby constraining the degree of
flexibility available to banks, particularly in lowering the deposit rates (given the fear of loss
Deposit growth has actually slowed
of deposits) in an easing phase of monetary policy.” - Urjit Patel Committee report, 2014
even as RBI maintained high real
interest rates
However, the irony is that ever since real rates have moved into positive territory, deposit
growth has actually slowed sharply. The main reason for this is that high real rates weigh
adversely on credit growth, which in turn hurts deposit growth. Hence, here again, RBI’s policy
prescription and analysis lay over emphasis on the period of high inflation, with little
cognizance to period prior to it and little debate on counterfactual possibilities.

Not so 20/20
Chart 60: Deposit growth has slowed despite high real rates
8 25
Is 4% target for headline CPI too
low? 6
20
4
(%, YoY)
(%)
2 15
0
10
(2)
(4) 5
Nov 03 Nov 05 Nov 07 Nov 09 Nov 11 Nov 13 Nov 15 Nov 17 Nov 19
Real interest rates Deposit growth (%, YoY, RHS)
d) Level of target: Is 4% too low for India?
Finally, while the framework/mandate does provide flexibility of having inflation target of 4%
+/- 2%, the RBI has been fixated about maintaining inflation at 4%. So, is 4% appropriate?
The Urjit Patel Committee’s Report has cited 13 studies on the level of inflation target
appropriate for India. Here, it’s striking that 11 out of 13 have prescribed inflation target of 5%
or above, with one having 4.8% and only one study dated 1985 has prescribed 4%. So, why did
the central bank choose 4% as the mid-point target?
Table 4: Inflation target recommendations

Mid point of threshold
Study Year of study
inflation target (%)
Chakravarty Committee Report 1985 4.0
11/13 studies conducted on Rangarajan 1998 6.0
appropriate inflation target Kannan and Joshi 1998 6.5
recommend 5% or more
Vasudevan, Bhoi and Dhal 1998 6.0
Samantaraya and Prasad 2001 6.5
Report on Currency and Finance 2001 5.0
Bhanumurthy and Alex 2010 5.3
Singh, Prakash 2010 6.0
RBI Annual Report 2010-11 2011 5.0
Pattanaik and Nadhanael 2013 6.0
IMF 2012 5.5
Mohanty et al 2011 4.8
Subbarao 2013 5.0
Source: Urjit Patel committee on monetary policy framework, Edelweiss research

India had undergone a big depreciation in exchange rate in three years prior to adoption of
inflation targeting. Its inflation was running in double digits and had high CAD of 5%. Hence, its
policy framework was heavily skewed towards attaining macro-stability.
RBI’s policy framework was drafted

India’s best period of macro-stability was from FY02 to FY06, where inflation was benign, CAD
in 2013-14 and had heavy recency
in surplus to mild deficit and economic growth was booming. Here, the real policy rate was
bias towards macro-stability at the
1.5% and inflation averaged 4.0%. Hence, it chose inflation target of 4% and the RBI tried to
expense of growth
maintain real rate of 1.5-2.0%.
However, in economics, the line between causality and coincidence often gets blurred. One of
the main reasons for such benign macro-stability and high growth during FY02-06 was the
Goldilocks external tailwinds—strong global growth and benign global food prices. This boosted
export growth (which grew more than 20%), led to strong capital flows across EMs (which
aided domestic infrastructure growth) and low global food prices kept inflation in check despite
the sharp surge in oil prices. Also, a booming economy helped fill government coffers and thus
significantly reducing India’s fiscal deficit despite India embarking on big social sector spending.
Thus, the combination of healthy macro environment along with high growth achieved in FY02-
06 can be more attributable to global scenario rather than purely domestic policy choices.
Now that 5 years have elapsed, it’s

Thus, overall the inflation targeting framework, by design and implementation, is overly
perhaps time to reassess some of
skewed in favour of macro-stability (at times at the expense of growth). But, balance is a
the tenets of inflation targeting
must. A prolonged period of economic slowdown could lead to its own set of socioeconomic
framework
problems. The problem is further exaggerated by lack of credible high frequency data on
unemployment, thus heavily skewing the debate towards inflation. It targets headline
inflation with 60% food and fuel which is neither forecastable nor tenable to monetary policy
leading to potential of large policy errors. Hence, it’s perhaps time to reassess India’s
monetary policy framework and bring in flexibility in the true sense.

Not so 20/20
Conclusion: Modest recovery; virtuous cycle still away

The economy is poised for a modest bounce in 2020 as liquidity squeeze is unwinding and
lending rates & bond spreads are moving lower. India’s bottom of the pyramid (farm sector,
MSME and real estate) should perk up a bit amidst normalising food prices and easier financial
conditions relative to FY20. In addition, global economy too is emerging from the woods amidst
global monetary easing and fiscal support in select pockets. This should help, not just exports,
but also capital flows to India. We expect FY21 GDP growth to scale up to 5.8%, up from 5.0%
projected in FY20. However, the virtuous dynamic of capex/income growth may still be distant.
Interest rates: We expect the RBI to resume easing, taking the terminal repo rate towards 4.5%
(from 5.15%) in the current easing cycle. Liquidity support to continue. Sustained rise in crude
oil prices poses a risk.
Inflation: CPI is normalising after remaining extremely subdued in recent years. Next few
readings could be high. Core too could pick up led by higher telecom prices, railway fares etc.
But the dynamic of rise is not concerning. Globally, food prices have moved up, but in select
commodities and the stocks-to-use ratio still remains elevated. We expect FY21 CPI inflation to
average 4.8%, 50bps higher than FY20 projections.
Fiscal deficit: Fiscal slippage for FY20 is likely to be ~50-70bps versus the 3.3% budgeted target
given poor tax collections. We do not anticipate consolidation in FY21.
CAD: External balance is narrowing owing to domestic demand weakness and could potentially
move into balance by Q4FY20. For year as a whole (FY20), we expect CAD to be ~1% of GDP in
FY20 and should hold around similar levels in FY21 led by exports recovery along with some
bounce in domestic economy.
Risks: One of the important risks to the outlook could arise from durability of food inflation
spike. If the uptrend in food inflation proves more enduring, it will stall further monetary easing
and the RBI could become even cautious on liquidity. Rural economy, however, will benefit
from stronger uptrend in food inflation.
Second, if fiscal impulse in FY21 turns negative, it will hamper recovery.
Third, if geopolitical tensions escalate, then rise in crude oil prices could weigh on India’s BoP as
it’s a supply side shock. Historically, rising crude oil prices have had little impact on India’s BoP
as it was accompanied with improving global growth which lifts India’s exports and also capital
flows. However, given that its likely to be a supply shock, there could be more negative
implications of the same.

Table 5: Key macro economic forecasts

FY17 FY18 FY19 FY20E FY21E
Macro-stability
CPI Inflation (Avg) 4.5 3.6 3.4 4.3 4.8
Current account balance (% of GDP) (0.7) (1.8) (2.1) (1.0) (1.0)
USD/INR (Avg) 67.1 64.5 70.0 71.5 71.0
Policy choices
Repo rate (exit rate) 6.25 6.00 6.25 5.15 4.50
Central govt. fiscal deficit (% of GDP) 3.5 3.5 3.4 3.8 3.8
Growth
Real GDP (%, YoY) 8.2 7.2 6.8 5.0 5.8
Nominal GDP (%, YoY) 11.6 11.3 11.2 8.0 10.5
Source: Edelweiss research

Not so 20/20
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Digitally signed by ADITYA NARAIN
DN: c=IN, o=EDELWEISS SECURITIES LIMITED,
Aditya Narain ou=SERVICE,
2.5.4.20=3dc92af943d52d778c99d69c48a8e0c89
e548e5001b4f8141cf423fd58c07b02,
Head of Research
NARAIN
postalCode=400011, st=MAHARASHTRA,
serialNumber=e0576796072ad1a3266c27990f20
bf0213f69235fc3f1bcd0fa1c30092792c20,
aditya.narain@edelweissfin.com cn=ADITYA NARAIN
Date: 2020.01.06 13:45:43 +05'30'
Date Title
Recent Research
28-Dec-18 Economy Release Jan-19
Calendar
17-Dec-18 External Trade Trade deficit slows sequentially, but

stays elevated
12-Dec-18 Inflation Sharp fall in headline CPI
12-Dec-18 IIP Gets a low base boost

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Not so 20/20
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Economy Outlook NOT SO 20 20 Jan-20-EDEL

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Economic Outlook 2020

Kapil Gupta Prateek Parekh, CFA Padmavati Udecha

EM growth: First exports, then debt – What next?

Indian Economy: A lost decade amidst best demography

1 Edelweiss Securities Limited

Bottom of the Pyramid – Missed opportunity?

Current account balance – Surplus in times of deficiency

Policy response – Institutional rigidities?

Conclusion: Modest recovery; virtuous cycle still away

2 Edelweiss Securities Limited

Executive Summary ...........................................................................................................1

Focus charts ......................................................................................................................4

EM growth: First exports, then debt – What next? ..........................................................6

Indian economy: A lost decade amidst best demography ..............................................12

Bottom of the Pyramid – Missed opportunity? ..............................................................16

Current account balance: Surplus in times of deficiency ................................................28

Fiscal constraints: Self-Imposed Than Macro-Economic? ...............................................31

Monetary policy: Institutional rigidities? ........................................................................36

Conclusion: Modest recovery; virtuous cycle still away .................................................44

3 Edelweiss Securities Limited

II. Indian economy - lost a decade during best phase of demography

Farm Bottom of the Macro-

4 Edelweiss Securities Limited

5 Edelweiss Securities Limited

EM growth: First exports, then debt - What next?

6 Edelweiss Securities Limited

From invincible to vulnerable: What has gone wrong?

7 Edelweiss Securities Limited

Fed tightening done: A breather for EM

Chart 5: Global M1 money supply growth improving

Economic activity PPIs Asset prices

8 Edelweiss Securities Limited

What will it take for a sustained upswing?

9 Edelweiss Securities Limited

What could next decade potentially look like?

10 Edelweiss Securities Limited

Chart 9: Germany continues to run fiscal surplus

...and Germany has large fiscal (6)

Chart 10: Euro area’s fiscal impulse is finally turning positive

shape global economic recovery

Source: IMF fiscal monitor – October 2019, Edelweiss research

11 Edelweiss Securities Limited

India: A Lost Decade Amidst Best Demography

2010-19: India’s lost decade

Macro indicators highlight prolonged and broad-based slowdown

12 Edelweiss Securities Limited

200 Exports CAGR India's exports

13 Edelweiss Securities Limited

Migration engine has slowed

Chart 19: Weakness in non-farm sector stalls migration engine

non-farm jobs per year over FY12-

India’s lost decade amidst large opportunity

14 Edelweiss Securities Limited

Chart 20: Phase of best demography is now history

Source:India’s Economic Survey – 2016-17, Edelweiss research

15 Edelweiss Securities Limited

Bottom of the Pyramid – Missed opportunity?

...war on cash economy, agri-

Source:FY18 NSSO Employment report, Edelweiss research

16 Edelweiss Securities Limited

Fig. 1: What has hurt the bottom of the pyramid?

NBFC crisis: The straw that broke the camel’s back

a) Farm: Emerging from debt-deflation dynamic

17 Edelweiss Securities Limited