Thematic | June 2016
Economy
CONSUMPTION
INVESTMENT
India 2020: Consumption driven
to investment led-Why and How?
Nikhil Gupta
(Nikhil.Gupta@MotilalOswal.com); +91 22 3982 5405

Thematic | Economy
Contents
Executive summary ............................................................................................................. 3
Info-graphic: Indian economy from investors’ perspective ................................................. 5
Info-graphic: Indian economy from economist’s perspective .............................................. 6
How long can consumption drive economic growth? .......................................................... 7
Is political agenda supporting our thesis? ......................................................................... 10
Key economic projections for FY17-18 .............................................................................. 12
Info-graphic: Indian economy from investors’ perspective ............................................... 13
I. Indian economy from investors’ perspective ................................................................. 14
II. Indian economy from economist’s perspective ............................................................. 20
Info-graphic: Indian economy from economist’s perspective ............................................ 22
II.1. Know your economy .................................................................................................. 23
II.2. Unique trends that make India the fastest growing economy .................................... 28
II.3. Remember the “Theory of Everything” ...................................................................... 38
II.4. Expectations for next two years ................................................................................. 45
III. Will India be ready to grow at 10% by 2020? ............................................................... 54
Conclusion ........................................................................................................................ 64
Appendix I: Data details .................................................................................................... 66
Appendix II: Understanding the “Theory of Everything” ................................................... 67
Appendix III: Rational investor ratings index (RIRI) ........................................................... 68
Appendix IV: Detailed economic projections .................................................................... 69
Motilal Oswal research is available on www.motilaloswal.com/Institutional-Equities, Bloomberg, Thomson Reuters, Factset and S&P Capital.
Investors are advised to refer through important disclosures made at the last page of the Research Report.
June 2016
2

Thematic | Economy
Economy
India 2020: Consumption
driven to investment led -
Why & How?
Economy
Executive summary
This report aims to explain the framework with which we analyze the Indian economy. The
intent is to share the lenses we use to look at an(y) economy. We have not seen other
reports using this framework to explain the Indian economy.
Why should one read this report?
Is this a report written by an Economist? “We know India’s real GDP growth and
have heard the market forecasts…”, “India’s current account deficit is in control and
inflation is likely to remain stable…”. Why should we read this report? If one
believes that Economics is all about GDP growth, inflation, etc, one must read this
report, because we show that (a) Economics is much more, and (b) Economics could
be way more fun than it usually appears to be. Three things that differentiate this
report are:
1.
Covering an economy in one identity:
“What if a large part of an economy could
be explained by a single identity?”
This is exactly what we have done here.
Notwithstanding its vastness, we believe an economy could be explained by one
single identity. We call this
“The Theory of Everything”.
This single identity
covers a large part of the economy by taking care of five facets – fiscal deficit,
current account deficit, consumption, savings and investments. This identity also
helps to understand the behavior of three participants in an economy –
households, private corporate sector, and (consolidated) public sector.
2.
Purely data-driven analysis, no airy talk:
“In God we trust, all other must bring
data.”
- W Edwards Deming. We are not God, and that’s why you will see only
data-driven analysis here. If a finding cannot be backed by data, it comes with a
fair degree of uncertainty (especially in macroeconomics), which is why we have
resisted such analysis. Every conclusion in this report is supported by data from
reliable sources. There is a reason why we have more than 90 exhibits in a 70-
page report. This, we believe, is our strength. We don’t make conclusions out of
thin air.
3.
Independent analysis helps us challenge, if needed, market consensus:
“If
everyone is thinking alike, then somebody isn't thinking.”
– George S Pattron Jr.
Since
our analysis is entirely data-driven, we are able to stick out our neck and
make conclusions, as you will see below, which may be in contrast to common
beliefs.
Overall, while GDP growth and inflation are important, it is equally important to
understand them in an appropriate manner. This is exactly what we intended to do.
This report is divided into three parts. Part I analyzes the comparative performance
of the Indian economy, which is what matters for investors. Part II covers the
domestic fundamentals of the economy. We propound the KURE framework and
explain the economy in a single equation. In Part III, we discuss the possible
scenarios for India by 2020. We believe that the economy must address few
challenges, if it wants to graduate to a sustainable high growth path.
June 2016
3
Mr Nikhil Gupta
Please click here for Video Link
ECONOMY

Thematic | Economy
Key conclusions
Not only do we establish
the sanctity of the new GDP
series, but also conclude
that the current slowdown
is not as severe as the
previous slowdown in the
2000s
1.
Consumption demand is not really weak…:
Irrespective of the tag of
“the
fastest growing economy in the world”,
one keeps hearing about weak
consumption demand, as is reflected by the subdued topline of India Inc. By
incorporating the mid-level of the corporate pyramid with the (highly covered)
top level, not only do we establish the sanctity of the new GDP series, but also
conclude that the current slowdown is not as severe as the previous slowdown
in the 2000s, primarily because of resilient consumption demand. In other
words, we firmly establish that the current economy is driven by consumption,
rather than investments.
2.
…as reflected by falling savings, high inflation and wide external deficit:
Notably, India’s consumption has been relatively resilient amid weak disposable
income growth. As a consequence, household savings in India have fallen to the
lowest level in two decades. In fact, a comparison of the current slowdown with
that of the early 2000s shows that the combination of high consumption and
weak investment has inevitably led to higher inflation in India. By creating a
measure of price gap (actual inflation – desired inflation), we find that India’s
inflation is ~55% higher today. This makes us conclude that like the wholesale
price index (WPI), retail inflation (based on consumer price index (CPI)) must
undershoot the medium-term target for at least a few quarters. Moreover, we
find that although current account deficit (CAD) has narrowed recently, it has
not improved to a desired level.
3.
Lower savings act as a structural constraint to higher investment rate…:
As a
result of falling savings and narrower CAD, investment rate has also fallen. Using
“The Theory of Everything”,
we show that an increase in national savings is a
necessary condition for investment rate to pick up again. This is primarily
because the contribution of foreign capital to domestic investments, going
forward, will be limited due to incomplete adjustments in CAD. Further, we
argue that the revival in investment rate has to be led by the private corporate
sector, as higher household (or public) investments imply lower efficiency of
capital, which must be avoided.
4.
…which may make higher sustainable growth challenging:
Overall, we believe
that the current economic model could remain in place for the next few years,
which will help India touch 8% real GDP growth. However, consumption-driven
growth will increasingly become destabilizing (as inflation will continue to rise).
India must replace consumption with investments as the key driver of growth
(exactly opposite of what is recommended for China). The transformation, we
believe, would involve some sacrifice in terms of GDP growth, which implies
India could take a little longer (probably after 2020) to graduate to the next level
of economic growth (9-10%). We would not be surprised to see the Indian
economy growing at 7-8% for a few years, as investments take over
consumption as the key driver of GDP growth. After the transformation,
however, India could grow at 10% on sustainable basis.
India’s consumption
has been relatively
resilient amid weak
disposable income
growth
An increase in national
savings is a necessary
condition for investment
rate to pick up again
Consumption-driven
growth will
increasingly become
destabilizing (as
inflation will continue
to rise)
June 2016
4

Thematic | Economy
Info graphic:
perspective
Indian
economy
from
investors’
June 2016
5

Thematic | Economy
Info graphic:
perspective
Indian
economy
from
Economist’s
June 2016
6

Thematic | Economy
How long can consumption drive economic growth?
Notwithstanding the recent
debate on actual GDP growth
(whether 6% or 7%), there is no
argument over the fact that
consumption is the key driver of
economic growth in India,
while investments lag
In the words of the Reserve Bank of India (RBI), the Indian economy is a beacon of
stability. Indeed, it is. Irrespective of one’s (dis)comfort with the new GDP series, the
Indian economy has turned corners in the past few years. Although the world
economic growth has eased further from 3.5% in 2012 to 3.1% in 2015, India’s GDP
growth has improved.
Growth being driven by consumption…:
The tag of
“fastest growing economy in the
world”,
however, needs some introspection. Notwithstanding the recent debate on
actual GDP growth (whether 6% or 7%), there is no argument over the fact that
consumption is the key driver of economic growth, while investments lag
(Exhibit 1).
Exhibit 1: Average growth in key real GDP components (% pa)
13.3
2001-04
2013-16
8.4
5.6
3.2
2.8
6.0
4.1
Investments
Exports
(1.0)
Imports
Consumtpion
* Consumption includes both private and government consumption
Source: Central Statistics office (CSO), MoSL
In fact, growth in consumption has been resilient enough to make the recent
economic performance look better than the economic performance in the previous
slowdown in the early 2000s
(Exhibit 2).
The average growth in the past four years
has been 6%, closer to 7.2% growth during the boom period in mid-2000s and much
better than 4.5% growth in the previous slowdown in early 2000s. What kind of
introspection, then, are we talking about? (Please see Appendix I at the end of
report for details on data used in this report.)
Exhibit 2: India’s real GDP growth has not slowed as much due to consumption (Index)
6%
7.2%
4.5%
Recent period
since FY13
Boom period
in mid-2000s
Slowdown in
early 2000s
Source: Organisation for Economic co-operation and development (OECD), MoSL
June 2016
7

Thematic | Economy
Our analysis of India’s growth
drivers makes us skeptical of the
sustainability of the current
economic model, in which
consumption is doing all the
heavy lifting, while investments
are resting on their laurels
…financed by household savings:
Notwithstanding high economic growth, policy
makers must not lose sight of the drivers of economic growth. Our analysis of India’s
growth drivers makes us skeptical of the sustainability of the current economic
model, in which consumption is doing all the heavy lifting, while investments are
resting on their laurels. There are three key reasons, which make us believe so:
1. Consumption is financed by savings, rather than higher disposable income. It
implies consumption is replacing potential investments
(Exhibit 3).
2. Notwithstanding the recent sharp deceleration in CPI-based retail inflation, the
current inflation is still higher than the medium-term target of 4%. In fact,
India’s inflation differential with major trading partners has risen further in the
past one year, hurting India’s competitiveness
(Exhibit 4).
3. Related with the first reason, the share of consumption in India’s current
account deficit (CAD) has widened, while investment-led deficit has narrowed
substantially. Ideally, India’s current account should have been in surplus.
without Exhibit 4: Despite recent fall in India’s inflation, widening
differential v/s trading partners has hurt competitiveness
140
120
100
80
(2010=100)
Inflation differential with trading partners
High inflation
differential =
Low competitiveness
Exhibit 3: Consumption growth has happened
proportionate growth in disposable income
Early 2000s
160
140
120
100
80
0
1
2
3
Number of years
4
Boom period
Real personal disposable income
Recent
5
China
India
Indonesia
Philippines
Real disposable income is nominal income deflated by PCE deflator
Data from FY15 onwards are our estimates/projections
Calculated using nominal and real effective exchange rate data
Source: CSO, Bank for International Settlements (BIS), MoSL
Resilient consumption may continue driving growth for the next two years…:
Regardless of our skepticism, we would not be surprised if the current economic
model continues for the next few years. Accordingly, savings will fall further, CAD
will widen and inflation will start reversing its current south-ward trajectory.
Not only might the
economy then find it
difficult to grow at 10% by
2020, but it might also find
it challenging to maintain
8% growth
…unlikely to lead to sustainable growth:
With these forces tightening their grip on
the economy, policy makers will have to shift their focus back on containing these
beasts. Not only might the economy then find it difficult to grow at 10% by 2020,
but it might also find it challenging to maintain 8% growth. The four key changes
necessary for the economy to move to a sustainable growth path, and then
graduate to higher growth are:
1. Inflation must fall towards 2% at least for a few quarters
2. National savings, driven by households, must witness an increase
3. Domestic investments, driven by private corporate sector, must replace
consumption-driven growth
4. Global environment has to be supportive
June 2016
8

Thematic | Economy
Today’s Indian
economy must be
compared with the
previous slowdown in
the early 2000s rather
than the boom period
of 2005-08
What leads us to these conclusions:
At a time when 4% inflation looks difficult, a
recommendation of bringing inflation down to 2% may appear misplaced to our
readers. The key difference between our research and the market participants could
be the benchmark with which we compare the current economic environment. We
believe that today’s Indian economy must be compared with the previous slowdown
in the early 2000s rather than the boom period of 2005-08. This comparison not
only tells us that the current environment is more buoyant than in the early 2000s,
but also that (1) retail inflation is much higher, (2) national savings must rise for
revival of the investment cycle, and (3) higher investments must be driven by the
corporate sector rather than households.
A prolonged rural slowdown may be required…:
To bring down inflation, rural
wages may be a catalyst
(Exhibit 5).
We would not be surprised if the current
episode of weak rural wages is prolonged. There are two key reasons for this: (a) the
rural sector has high marginal propensity to consume, and (b) productivity of the
rural sector is low, not justifying higher wage growth. Hence, the rural economy is
unlikely to be as buoyant as it was between FY09 and FY13.
Exhibit 6: …strongly correlated with inflation
15
12
9
6
Avg growth was +8.5%
between FY11 and FY13
3
0
(5)
*Data for January-February 2016
0
5
10
15
20
Nominal rural wage growth (%, YoY)
25
y = 0.4891x + 2.2216
R² = 0.7949
We would not be
surprised if the current
episode of weak rural
wages is prolonged
Exhibit 5: Rural wages have collapsed recently (% YoY)…
21
14
7
0
(7)
(14)
Real rural wages
Avg growth was +0.1%
between FY00 and FY10
CPI index for rural laborers (RL)
Source: Labour Bureau, Reserve Bank of India (RBI), MoSL
…leading to lower consumption unless savings are rebuilt:
If so, a fall in
consumption growth, we believe, may be inevitable to bring down inflation. Further,
consumption growth will have to moderate to a level where savings start to re-build.
This may be unavoidable because we do not expect incomes to grow fast enough to
support higher consumption and higher savings (like in FY04-FY08 period). As
savings re-build, it will allow the investment rate to increase. Given limited gains due
to capital efficiency, an increase in investment rate is necessary for India to increase
its economic growth from 7-8% towards 10%.
Consumption must be replaced by investments:
In short, lower consumption is
necessary to help bring down inflation, re-build saving and keep CAD contained. The
longer the current economic model continues, the more destabilizing it will become.
The shift from consumption to investments, thus, will become inevitable for the
economy. There could be some disturbances during the transition; however, this is
an unavoidable to create a sustainable model of development.
9
The shift from
consumption to
investments, thus, will
become inevitable for
the economy
June 2016

Thematic | Economy
Is political agenda supporting our thesis?
The government sector plays a critical role in determining the buoyancy of the rural
economy, and thus, India’s inflation. Therefore, one must keep an eye on the
government’s preferences.
Firstly, we must note that the current government, in its first stint, has shown its
ability and experience in allowing the economy to adjust during the early 2000s. We
believe that the domestic adjustments during that period – namely, lower inflation,
current account surplus, high deposit rates, etc – created strong potential for the
economy to grow sustainably at a faster rate. To grow at 10% in the 2020s, we
believe the economy must create the same potential. This is unlikely without the
government’s support.
Therefore, it is important to note how the central government has done in the past
couple of years. To bring inflation down further, a key requirement is continued
slowdown in rural wages, unless their productivity increases. The government’s core
revenue expenditure (excluding interest) plays an important role in determining
rural buoyancy. Core revenue expenditure growth was 4% in FY16, marking the
lowest growth in 34 years. This, we believe, helped to keep rural wage growth
contained
(Exhibit 7).
Since the correlation works with a lag of 18-24 months, we
expect rural wages to remain subdued in the foreseeable future
(Exhibit 8).
Core revenue expenditure
growth was less than 4% in FY16,
marking the lowest growth in 34
years. This, we believe, helped to
keep rural wage growth
contained
Exhibit 7: Core revenue expenditure* (RE) growth lowest in Exhibit 8: …which is highly correlated (with lag) with real
more than three decades in FY16…
rural wages
50
40
30
20
10
0
0
(10)
(% YoY)
Revenue spending ex interest
60
45
30
15
RE ex interest (-24m)
(% YoY,
12mma
Real rural wages (RHS)
(% YoY)
22
14
6
(2)
*Excluding interest payments
RE growth is with a lag of 24 months
Source: Union Budget documents, CMIE, Labour Bureau, MoSL
Unlike the CG’s high
influence in driving
consumption growth, we
believe its influence in total
investments is limited
While the government has curtailed its consumption spending, it has pushed ahead
its capital expenditure. In FY16, the central government’s capex grew more than
25%, marking its highest growth in six years. Nevertheless, unlike the CG’s high
influence in driving consumption growth, we believe its influence in total
investments is limited because (a) the share of the government (central + states) in
the economy’s total investments is ~13%, and (b) like household investments, public
investments are not as efficient as corporate investments. Notably, the share of the
government has risen from 9.5% in FY12 to ~13% in FY15; however, higher public
investments limit the gains in capital efficiency.
10
June 2016

Thematic | Economy
Exhibit 9: Key investors in the economy
FY12
11.1
9.5
43.4
Households
Private corporate
Government*
Other public sector
36.1
43.3
* General government (Central + States)
Source: Central Statistics Office (CSO), CMIE, MoSL
12.8
9.9
33.9
Households
Private corporate
Government*
Other public sector
FY15
June 2016
11

Thematic | Economy
Key economic projections for FY17-18
Exhibit 10: Economic forecasts of key macro-economic parameters
Economic variable
Real sector
Real GDP
Consumption*
Fixed investments
Real GVA
Industry#
Services
Nominal GDP
IIP
Real PDI
Total savings
Total investments
Prices & rates
CPI
WPI
GDP deflator
10-yr yield (year-end)
INR/USD (average)
M3
Bank credit
Bank deposits
Balance of payments
CAD
Capital & financial account
Foreign exchange reserves
(+(withdrawal)/-(accretion))
Central government finances
Total receipts
Total spending
Revenue spending
Capital spending
Fiscal balance
% YoY
% YoY
% YoY
% YoY
% of GDP
16.7
8.1
8.5
5.2
(4.9)
14.8
10.6
10.3
12.5
(4.5)
9.1
6.7
6.9
4.8
(4.1)
8.4
7.3
5.5
20.9
(3.9)
15.5
10.8
11.8
3.9
(3.5)
14.1
12.4
12.8
10.0
(3.4)
% of GDP
% of GDP
USD bn
(4.8)
5.0
(3.8)
(1.7)
2.5
(15.5)
(1.3)
4.4
(61.4)
(0.8)
2.3
(32.1)
(1.4)
2.4
(21.4)
(2.0)
3.0
(24.5)
% YoY
% YoY
% YoY
%
Unit
% YoY
% YoY
% YoY
10.1
7.4
7.9
7.96
54.5
13.6
14.1
14.2
9.3
6.0
6.2
8.80
60.5
13.4
13.9
14.1
5.9
2.0
3.3
7.74
61.2
10.8
10.4
12.6
4.9
(2.5)
1.0
7.47
65.5
10.4
9.9
8.1
4.7
1.9
3.1
~7.00
68.0
11.3
11.1
8.8
5.0
2.9
3.6
69.8
12.3
12.0
11.7
% YoY
% YoY
% YoY
% YoY
% YoY
% YoY
% YoY
% YoY
% YoY
% of GDP
% of GDP
5.6
4.5
4.9
5.4
3.6
8.1
13.9
1.1
3.6
33.8
38.6
6.6
5.8
3.4
6.3
5.0
7.8
13.3
(0.1)
4.9
33.0
34.7
7.2
7.2
4.9
7.1
5.9
10.3
10.8
2.8
2.9
33.0
34.2
7.6
6.6
5.3
7.2
7.4
8.9
8.7
2.4
4.1
31.8
32.5
7.8
8.1
6.6
7.7
6.2
9.0
11.1
5.2
6.3
29.9
31.3
8.1
9.0
7.1
7.9
6.9
9.7
11.9
5.8
7.0
28.6
30.7
Units
FY13
FY14
FY15
FY16
FY17F
FY18F
* Private + Government consumption
# Includes construction
Please see Appendix IV for detailed projections
Source: CSO, RBI, CMIE, MoSL
June 2016
12

Thematic | Economy
Info graphic: Indian economy from investors’
perspective
June 2016
13

Thematic | Economy
I. Indian economy from investors’ perspective
Unlike Economists, for whom absolute performance may be as important, comparative
performance holds the key for investors. The key parameters that confirm India’s
outperformance are:
th
Economic resilience has helped India to rise from the world’s 12 largest economy in
th
2008 to 7 this year, increasing India’s dominance in the world economy.
At a time when most major economies in the world are witnessing declining working
population, threatening to push them into stagnation, India’s demographic structure is
an enviable asset.
In the past four years, India’s vulnerability matrix has improved markedly and reward
matrix has also recovered. Hence, risk-reward matrix makes India the most attractive
investment destination.
Most importantly, the Indian economy has improved without increasing its leverage.
The debt-to-GDP ratio has been stagnant since 2012 and the debt intensity of India’s
GDP growth is one of the lowest among major emerging economies.
While most emerging
economies have lost share
in the past few years, the
dominance of China and
India (Indonesia too to a
lesser extent) has
increased in the world
economy
The Indian economy has come a long way from its weak fundamentals in 2012.
While some of the long-term structural factors remain benign, the extent of
improvement in other fundamentals vis-à-vis other major emerging market
economies has been excellent in the past 3-4 years. We believe this is what matters
most for global investors, who look at relative performance rather than absolute
performance. In this part, we look at the comparative performance of the Indian
economy vis-à-vis its counterparts in the developing world and some developed
economies too.
I.1. Economic resilience has increased India’s dominance in world economy:
Notwithstanding the Great Financial Crisis (GFC), which has rattled the developed
world for 7-8 years, growth of the Indian economy has been impressive.
Exhibit 11
shows the share of major developed economies (and India) in the world economy.
Barring the US, major developed economies have lost share in the world economy.
Exhibit 12
compares the share of major emerging and developing economies in the
past five years. While most emerging economies have lost share in the past few
years, the dominance of China and India (Indonesia too to a lesser extent) has
increased in the world economy.
Exhibit 11: Share of major advanced economies and India in Exhibit 12: Share of major developing economies in the world
the world economy (%)
economy (%)
Germany
8
India
Italy
USA (RHS)
32
4
3
24
3
2
1
16
2011
2012
2013
2014
2015
2016E
Gross domestic product (GDP) at current prices in US Dollar terms
0
2011
2012
2013
2014
2015
2016E
Brazil
India
Russia
China (RHS)
20
15
10
5
0
5
0
Source: International Monetary fund (IMF), MoSL
E=IMF’s estimates
14
June 2016

Thematic | Economy
Owing to the relative resilience of the Indian economy in the past few years, its
ranking in the world economy has improved dramatically. As
Exhibits 13-14
show,
India has moved up from the 12
th
largest economy in the world in 2008 to the 7
th
largest this year (as per IMF’s forecasts).
Exhibit 13: India’s ranking has improved from 12 in 2008…
2016E
China,
15.4
Japan,
Germany,
6.0
4.7
UK, 3.7
USA,
25.1
France, 3.3
India, 3.1
Italy, 2.5
Brazil, 2.1
Canada, 2.0
Spain, 1.7
Russia, 1.5
2016 data is IMF’s forecasts
th
Exhibit 14: …to 7 in 2016 in the world economy (%)
th
7
12
Others,
29.0
2008
2016E
Source: IMF, MoSL
India’s working population
continues to grow at 1.7%
per annum against the
global average of 1.1%.
I.2. India’s demographic structure an enviable asset:
At a time when the developed
world is feared to be suffering from secular stagnation
1
, partly because of declining
(or decelerating growth in) working population (aged 15-64 years), a vast youth
population (aged below 14 years) is an enviable asset for any economy.
Exhibit 15
shows that the growth in working population is decelerating at the global level;
however, India’s working population continues to grow at 1.7% per annum against
the global average of 1.1%. Notably, Eurozone (EZ), like Japan, is already witnessing
a shrinking working population, while China is facing stagnant working population.
Exhibit 16
shows the share of youth population in major economies, reflecting the
potential growth in working population after a decade or so. The lower the share of
youth population, the higher is the risk of contraction in working population over
the next decade. The share of youth population is the highest in India at 29.2% of
total population and the lowest in Japan at less than 13% in 2014.
Exhibit 15: Working population (aged 15-64 years,% YoY)
2.5
2.0
1.5
1.0
0.5
0.0
2010
2011
2012
2013
2014
China
India
USA
World
Exhibit 16: Share of youth population (aged 0-14 years)
29.2
19.1
12.9
26.2
17.7
17.2
15.2
China
EZ
India
UK
USA
Japan
World
Source: World Bank, MoSL
Data for 2014
1
The concept was introduced by Lawrence H. Summers in late 2013, who is the Charles W. Eliot University Professor and President Emeritus
at Harvard University. Read an ebook on secular stagnation
here
15
June 2016

Thematic | Economy
India’s working population
continues to grow at 1.7%
per annum against the
global average of 1.1%.
Exhibit 17
below, which shows the median age of the population, reinforces India’s
favorable demographic structure vis-à-vis other large economies. The median age of
population in India is 27 years, lower than the world median of 30 years. Notably,
the median age in Japan is 47 years, which makes it the world’s oldest nation.
Further, the old-age (aged 65+ years) dependency ratio in India is 9% against the
world’s (and Asia’s) average of 13% (11%) in 2015
(Exhibit 18).
India’s demographic
structure gives it an enviable advantage, which, if utilized carefully, has the potential
to take India to the next level in economic development.
Exhibit 18: Old-age dependency ratio in 2015
46 46 47
(%)
31 32
28 28
35
43
Exhibit 17: Median age of population in 2015
(Years)
30 30 31
41 43
38 39 40 41
37
27
19
9
11 11 13 13
22 24
Source: United Nations Population Division (UNPD), MoSL
Old age dependency ratio is defined as the share of old-age (65+
years) as working population (15-64 years)
I.3. India’s vulnerability matrix has improved markedly…:
Whether capital flows are
driven by
investment model
(arguing change in macro environment precedes and
causes investment flows) or
liquidity model
(capital flows precede and cause
growth) is an ongoing debate
2
and beyond the scope of this report. There are
enough experiences to validate both theories; however, as investors usually carry
out fundamental research before making investment decisions, the
investment
model
dominates, at least conceptually. If macroeconomic risks increase in an
economy, capital inflows would reduce (or capital outflows would increase). It is,
thus, important to keep the domestic house in order (which is determined by the
state of other economies as well).
The government of India (GoI) introduced a macroeconomic vulnerability index
3
(MVI) in its 2014-15 Economic Survey, comprising of inflation, fiscal deficit and
current account deficit. We replace fiscal deficit with the primary balance (fiscal
deficit excluding interest payments) of the government and use the same structure
to re-calculate MVI for several economies. The lower the MVI index is, the safer the
economy is. A reduction (increase) in MVI over time reflects improvement
(deterioration).
Exhibit 19
on the next page compares the change in MVI for several
emerging economies, for the entire group of emerging & developing Asia and all
economies rated “BBB-” (India’s rating) by Standard & Poor’s. India is the second
most improved economy in the past four years – between 2012 and 2016. On the
other hand, the MVI index has increased since 2012 in its closest competitors –
China and Indonesia (the deterioration in Brazil and Russia is obvious because of
recession in these economies).
India is the second
most improved
economy in the past
four years – between
2012 and 2016
2
3
Pettis Michael,
“The Volatility Machine: Emerging economies and the threat of Financial collapse”,
Oxford University Press (2001)
The concept is borrowed from The Government of India (GoI) introduced in Economic Survey 2014-15. See Appendix III for details.
16
June 2016

Thematic | Economy
Exhibit 19: Change in MVI for various economies (2012-2016)
3.9
1.1
(0.9)
(8.6)
(11.4)
(0.8)
(0.7)
(0.6)
(0.3)
1.3
5.6
6.0
6.7
* Emerging & developing Asia, as defined by IMF
Average of all economies rated “BBB-“ by Standard & Poor’s
Source: Economic Survey 2014-15, IMF, MoSL
While India’s RIRI has
improved in the past five
years, China, Philippines
and Thailand have higher
RIRI
...and reward matrix has also recovered:
Gauging risk, however, is only one side of
the balance sheet assessment for investors. The rewards are equally important,
which could be measured by real economic growth. Consequently, we re-calculate
another index, known as Rational Investors Ratings Index
4
(RIRI), introduced in the
same Economic Survey of 2014-15. Higher RIRI implies higher reward and lower
vulnerability, which suggests better rating by investors.
Exhibit 20
below compares
the actual value of RIRI for the same set of economies in the past five years. While
India’s RIRI has improved in the past five years, China, Philippines and Thailand have
higher RIRI. Nevertheless, as financial markets react to incremental flow of
information, what may matter more for investors is change in RIRI rather than the
actual value of RIRI.
Exhibit 20: RIRI values for various economies
Brazil
Russia
5
3
0
-3
-5
2012
2013
2014
2015
2016E
* Emerging & developing Asia, as defined by IMF
Average of all economies rated “BBB-“ by Standard & Poor’s
Source: Economic Survey 2014-15, IMF, MoSL
China
Thailand
India
Turkey
Indonesia
E&D Asia*
Philippines
BBB-
While several economies
have improved on
vulnerability index since
2012, India and Turkey are
the only two economies
that have performed well
on the entire risk-reward
matrix
4
Risk-reward matrix makes India the most attractive investment destination:
Exhibit 21
on the next page shows the change in RIRI for the same set of economies
considered in this study. While several economies have improved on vulnerability
index since 2012
(Exhibit 19),
India and Turkey are the only two economies that
have performed well on the entire risk-reward matrix, measured by RIRI. This, we
believe, makes India a definite investment destination for global investors.
The concept is borrowed from The Government of India (GoI) introduced in Economic Survey 2014-15. See Appendix III for details.
17
June 2016

Thematic | Economy
Exhibit 21: RIRI values for various economies
2.3
1.1
(1.2)
(4.3)
(3.9)
(1.1)
(0.9)
(0.8)
(0.8)
(0.8)
(0.4)
(0.2)
(0.2)
* Emerging & developing Asia, as defined by IMF
Average of all economies rated “BBB-“ by Standard & Poor’s
Source: Economic Survey 2014-15, IMF, MoSL
I.4. Is Indian economy highly leveraged?
The Indian economy is usually associated
with high government debt, which is seen as a key concern. There is no doubt that
government debt in India is one of the highest among emerging markets; however,
the recent global financial crisis has taught us that what matters is total debt of the
non-financial sector (private + government), rather than just sovereign debt.
Therefore, we look at total debt of the economy (excluding financial sector).
In the emerging world,
government debt as a
percentage of GDP is one of
the highest in India.
Private debt in India is
among the lowest in the
sample considered for this
study
Exhibit 22
compares the total government debt of various emerging economies. In
the emerging world, government debt as a percentage of GDP is one of the highest
in India. However, as
exhibit 23
shows, private debt in India is among the lowest in
the sample considered for this study. Government debt is monitored closely by
investors, but this does not make it more important than private debt. Several
economies have witnessed slowdown (recession also) because of high private debt
(Spain and Ireland are classic examples). Private debt is just as important as
government debt; to get a holistic view of an economy, one should look at the total
non-financial debt of the economy.
Exhibit 23: Comparison of private non-financial debt in 2015*
66
(% of GDP)
193
120
38
38
56
58
69
70
73
73
133
Exhibit 22: Comparison of government debt in 2015*
(% of GDP)
38
41
49
53
63
16
4
25
30
31
33
16
*For the first three quarters of 2015
Source: BIS, IMF, MoSL
June 2016
18

Thematic | Economy
India’s total debt-to-GDP
ratio has been largely
unchanged in the past three
years, while it has increased
substantially in almost all
other major emerging
markets
Exhibit 24
shows the total non-financial debt of the sample. India lies in the middle,
implying neither too high nor too low debt. Again, investors are more interested in
the trend (or flow) of total debt rather than the outstanding stock.
“How is the debt-
to-GDP moving?”
is more pertinent for investors. The answer lies in
exhibit 25,
which shows that India’s total debt-to-GDP ratio has been largely unchanged in the
past three years, while it has increased substantially in almost all other major
emerging markets. This is what gives more confidence in the Indian economy.
Exhibit 25: Trend in debt-GDP ratio since 2012
234
139 150
187
(percent
points, pps)
17
18
18
19
23
44
Exhibit 24: Total non-financial debt in 2015*
(% of GDP)
119 119
55
62
63
71
85
104
1
7
9
11
12
13
* For the first three quarters of 2015
Source: BIS, IMF, MoSL
India features among
the economies with low
debt intensity – it needs
1.3 units of investment
to produce one unit of
GDP
Finally, an important metric related to an economy’s debt is “debt intensity
5
of GDP
growth”. This measures
“how many units of debt are needed to produce an
additional unit of GDP in the economy?”.
The lower it is, the better.
Exhibit 26
shows
the debt intensity for each of the 12 economies studied in this analysis. The exhibit
shows the average of the three-year period ending 2015 to smoothen any one-time
shocks. India features among the economies with low debt intensity – it needs 1.3
units of investment to produce one unit of GDP. This is in comparison to almost 4
units of debt needed by China, and an average of 2 units needed by the sample of
12 economies.
Exhibit 26: Debt intensity of economic growth (Unit)
3.9
2.3
2.4
2.9
4.3
0.6
0.9
1.2
1.3
1.5
1.7
1.7
Recent data as of 2015
Source: BIS, IMF, MoSL
5
Debt intensity of GDP growth = average change in debt in ‘t-1’ and ‘t’ period/change in GDP in ‘t’ period
19
June 2016

Thematic | Economy
II. Indian economy from economist’s perspective
To make projections, it is important to understand what happened in the recent
past and how the economy is doing currently. We have explained our
understanding of the Indian economy in this part of the report. We have analysed
this part using the KURE theme. We define KURE as:
K
Know Your Economy
The first challenge presented to us is the divergence between new GDP data
and India Inc topline.
GDP data or India Inc topline – what to believe? Is consumption demand low
or high in India? How painful/serious has been India’s current slowdown?
These are the questions we have answered in Section I.
U
UNIQUE TRENDS THAT MAKE INDIA WORLD’S FASTEST GROWING ECONOMY
We further discuss what has helped India become the
“fastest growing
economy in the world”.
The tag, we believe, has led to few changes in the economy, which, if not
addressed carefully and in time, have the potential to make the economy
unsustainable.
REMEMBER THE ‘THEORY OF EVERYTHING’
R
We follow Section II with an identity, which, according to us, covers a large
part of the economy.
We call it the
“Theory of Everything”
because the equation covers
consumption, savings, investments, fiscal deficit and current account
balance.
In other words, the identity has the potential to explain a large part of an
economy.
EXPECTATIONS FOR NEXT TWO YEARS
E
Finally, we conclude Part II by giving our detailed expectations on the Indian
economy for the next two years - FY17 and FY18.
We argue that India could touch 8% real GDP growth by FY18. We also give
our forecasts of the Indian Rupee (INR) against the US Dollar (USD) based on
real effective exchange rate (REER) model and our outlook for the bonds
market in FY17.
June 2016
20

Thematic | Economy
KURE Theme
Source: MOSL
June 2016
21

Thematic | Economy
Info graphic:
perspective
Indian
economy
from
Economist’s
June 2016
22

Thematic | Economy
K
II.1. K
now your economy
II.1. K
now your economy
We try to bridge the gap between resilient GDP growth and weak India Inc
topline by incorporating the medium and bottom levels of the corporate
pyramid.
We reckon that the listed corporate space may be losing market share to the
non-listed space, which continues to witness high sales growth and great
profit margins.
In the recent past, resilient consumption demand has helped to mitigate the
adverse pressure on real GDP growth, which is better than it was in the
previous slowdown in early 2000s.
There is a growing debate
between the Central
Statistics Office (CSO),
which releases India’s
national accounts data
including GDP, and India Inc
about the state of India’s
consumption
II.1.1 What to believe? GDP data or India Inc topline
There is a growing debate between the Central Statistics Office (CSO), which
releases India’s national accounts data including GDP, and India Inc about the state
of India’s consumption. Net sales of India Inc have plunged from a healthy growth of
9.5% in FY13 to a contraction of 3.5% in the first three quarters of FY16
(Exhibit 27).
Such abysmal topline numbers have led India Inc to believe that consumption
demand has declined dramatically in the country.
According to CSO, India’s nominal consumption (both private and government)
growth has eased only gradually from 14.5 % in FY13 to 11.2% in FY16. Further, real
consumption growth, as per CSO data, is estimated to grow 6.6% in FY16, much
better than 4.5% in FY13 and 5.8% in FY14.
Exhibit 27: Growing divergence between GDP data and India Inc sales
30
20
10
0
-10
(% YoY)
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
FY13 FY13 FY13 FY13 FY14 FY14 FY14 FY14 FY15 FY15 FY15 FY15 FY16 FY16 FY16 FY16
Consumption includes private and government
Source: RBI, CSO, MoSL
India Inc sales
GDP: Nom consumption
GDP: Real consumption
This is what makes the task of policymakers difficult. What to believe? This question
has troubled us for almost a year from the time CSO published new GDP estimates.
The question is of paramount importance to understand whether the economy
needs policy support to boost consumption or not.
We believe both sides of
the argument are correct.
National consumption has
been resilient; however,
India Inc is not enjoying it
6
We believe both sides of the argument are correct. National consumption has been
resilient; however, India Inc is not enjoying it. The unlisted or unincorporated
corporate sector is flourishing and gaining market share
6
.
Please refer to Appendix I for details on corporate data used in this analysis
23
June 2016

Thematic | Economy
Exhibit 28
shows that the share of RBI sample (2,700-odd companies) in national
consumption (from CSO data) has fallen from 44% in FY13 to 36.6% in FY15.
The share of companies
covered by MCA, but not by
RBI in its quarterly data, has
risen from ~11% in FY13 to
over 14% in FY15
Another interesting thing to note is that the share of companies covered by Ministry
of Corporate Affairs (MCA) (~250,000 companies), but not by RBI in its quarterly
data, has risen from ~11% in FY13 to over 14% in FY15. It implies that the share of
the uncovered corporate sector, which could be called the unorganized (or informal
or unregistered) sector, has also risen from ~45% in FY13 to 49% in FY15. (Please
note the change in GDP base did not change this analysis.)
Exhibit 28: Share of different sample of companies in national Exhibit 29: Sales growth of different sample of companies in
consumption
the past two years
(%)
RBI sample
Ex-RBI MCA sample
Others*
(% YoY)
RBI sample
42.5
45.2
10.8
44.0
FY13
47.0
13.5
39.5
FY14
49.0
14.4
36.6
FY15
2.0
FY14
18.4
3.6
FY15
18.7
16.5
Ex-RBI MCA sample
Others*
RBI sample corresponds to companies covered by RBI quarterly data for 2,700 odd companies
Ex-RBI MCA sample corresponds to expanded data covering 2,50,000 companies, which excludes RBI sample
* Others are companies not covered by MCA also (estimated as residual)
Source: RBI, CSO, MoSL
Exhibit 29
shows that while the sales of RBI sample companies grew at low single
digits (for changing set of companies) in FY14 and FY15, growth for the rest of the
corporate sector was in high teens. Deceleration in case of ‘others’, companies not
covered by MCA and which account for 49% of total consumption, was marginal –
from 18.4% YoY in FY14 to 16.5% in FY15.
Expanded coverage of the corporate sector explains higher GDP growth:
One of
the key revisions in the GDP data released by CSO last year was the use of new data
source – MCA database – for estimating the corporate sector’s contribution to the
economy. Earlier, the corporate sector’s contribution was estimated using the RBI
study on company finances, which was based on some 2,700-odd listed companies
and Index of Industrial Production (IIP). The MCA database covers almost 500,000
companies. Not surprisingly, data for the manufacturing sector has witnessed a
marked upward movement post revision.
The most-tracked listed
companies in the country,
captured by the RBI sample,
may not be the real
representative of the
economy
This may represent a classic sample problem. The most-tracked listed companies in
the country, captured by the RBI sample, may not be the real representative of the
economy. To understand the stark difference, we have prepared
Exhibit 30
for
different sample of companies released by RBI. Since RBI releases data only for the
past three years in a single press release, and MCA data was included in the recent
data released by RBI for 2014-15, we have MCA data only for three years – FY13,
FY14 and FY15. This data covers ~17,000 public limited companies against 2,700
companies covered in the RBI’s quarterly release. The exhibit is an eye-opener.
24
June 2016

Thematic | Economy
On the expanded coverage,
the PAT margin was more
than double at 10.8% in
FY13 and broadly
unchanged in FY15
If we just look at the ~2,700 companies’ data available on quarterly basis and
include large companies, profit margin seems to have stabilized at low levels.
However, with the CSO coverage quadrupling on inclusion of MCA database, the
condition of the corporate sector shows dramatic improvement. The PAT margin of
the limited coverage was ~6% in FY13 (~2,700 companies), which eased to ~5.5% in
FY14 and 5.8% in FY15. On the expanded coverage, the PAT margin was more than
double at 13.9% in FY13 and unchanged in FY15.
Exhibit 31
shows the PAT margin for the limited coverage, which gets most of the
attention, and compares it with that for the expanded coverage. The difference is
stark. The PAT margin for the companies not included in the limited coverage was as
high as 24% in FY15, more than 4x the PAT margin for the limited coverage.
Exhibit 31: Comparison
corporate samples (%)
30.2
24.3
24.0
The PAT margin for the
companies not included in
the limited coverage was as
high as 24% in FY15
Exhibit 30: Net profit margin of different corporate samples
released by RBI (%)
15
RBI quarterly data
Net profit margin
Expanded coverage
of
PAT
margin
for
different
RBI sample
Ex-RBI MCA sample
10
5
6.0
5.5
5.8
0
FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15
FY13
FY14
FY15
RBI sample corresponds to 2,700-odd companies (and include only public companies)
Expanded coverage is MCA sample implying coverage of ~17,000 public companies
Source: RBI, MoSL
Though the large
corporates, which are not
doing as well, receive most
of the investor attention,
policymaking decisions
should be constructed on
holistic analysis
Overall, the expanded coverage, which is now incorporated in CSO’s GDP data,
shows that consumption has not slowed as much as is reflected by the weak
position of the large corporates. Though the large corporates, which are not doing
as well, receive most of the investor attention, policymaking decisions should be
constructed on holistic analysis, which confirms resilient consumption in the
economy, holding up real GDP growth at high levels.
June 2016
25

Thematic | Economy
II.1.2. How painful/serious has India’s current slowdown been?
In order to understand that, let us compare the economic performance in the recent
period (FY12-17E) with that in the previous slowdown. Though liberalization began
in 1991, the economy actually opened up in 1995. An analysis of the Indian economy
in the past two decades shows that the only episode of significant slowdown was in
early 2000, which coincided with the Dot-com bubble in the US. Accordingly, we
have compared India’s recent performance with that in the early 2000s (FY99-04)
and the boom period (FY03-08).
The current
slowdown is not
as severe as the
previous one
Exhibit 32
compares India’s real GDP growth in the past five years with that of the
early 2000s and the boom episode. India’s real GDP growth has averaged 6.8% per
annum since FY12 as against 4.2% in the previous slowdown (early 2000s) and 8.8%
during the boom period. The current slowdown is not as severe as the previous one.
(Even if one believes that real GDP growth was 5.5% in FY15 and 6.0% in FY16, the
average growth would be ~5.5%, better than in early 2000s.)
Exhibit 33
shows the key reason for the better-than-early-2000s real GDP growth.
India’s consumption has grown ~6.5% in five years to FY17 (our projection for FY17),
close to the 7% growth witnessed in the boom period of FY04-08. Consumption
growth, however, averaged 4.5% in the early 2000s. The exhibit is in line with our
conclusion from the first part of the current section, where we argued that
consumption demand has not slowed dramatically in the current slowdown.
Exhibit 33: ….primarily because of strong consumption in
the recent slowdown
160
140
120
100
80
0
2
4
6
8
10
12
14
16
18
20
22
Number of quarters
Consumption includes both private and government consumption
Source: OECD, RBI, MoSL
(Index)
Early 2000s
Boom period
Recent
India’s consumption has
grown ~6.5% in five years to
FY17, close to the 7%
growth witnessed in the
boom period of FY04-08
Exhibit 32: India’s real GDP growth has not slowed
dramatically…
180
160
140
120
100
80
0
2
4
6
8
10
12
14
16
18
20
22
Number of quarters
Data from 4QFY16 onwards are our projections
(Index)
Early 2000s
Boom period
Recent
The share of consumption
in GDP is at the highest
level in the past 12 years.
Reinforcing our conclusion in
Exhibit 33,
we also find that consumption demand
(including private and government consumption) in India crossed 70% of GDP in
FY16, up from 67% in FY12, marking the highest level since FY05
(Exhibit 34
on the
next page). In other words, the share of consumption in GDP is at the highest level
in the past 12 years. In fact, we believe it will increase further towards 72% in FY17,
due to the continuation of consumption-driven growth in the economy.
Exhibit 35
on the next page compares the share of consumption across various Asian
economies in 2014 (the recent period for which data is available). It is apparent that
India has one of the highest shares of consumption, as against the lowest of 48% in
Singapore and the average of 65% in the sample taken.
It is apparent that India has
one of the highest shares of
consumption
June 2016
26

Thematic | Economy
Exhibit 34: India’s consumption is at the highest level in
more than a decade
80
76
72
68
64
60
FY00
FY03
FY06
FY09
FY12
FY15
FY18F
Consumption includes both private and government consumption
Data from FY16 onwards are our projections
70.1
67.2
70.1
Exhibit 35: Share of consumption in India vis-à-vis other
Asian peers
(%)
66
48
50
66
66
69
70
83
Consumption includes both private and government consumption
Source: World Bank
Box 1. What does potential output tell us about the recent slowdown?
In a recent working paper , Reserve Bank of India (RBI) attempted to estimate India’s potential GDP and output gap.
Although the focus of the RBI’s paper was different and not related to our study, a look at the historical trend of the output
gap (actual output – potential output) presented in the RBI’s paper gives an interesting and relevant finding. The exhibit is
shown below.
7
It is important to note that the negative output gap in the current slowdown is one of the lowest witnessed by the Indian
economy in several slowdowns since 1980s. The negative output gap did not even touch 2%; in all the past three
slowdowns since 1980, the negative output gas was close to 4%.
This implies that the fall in actual output below potential output is less severe than in the previous slowdown. This is exactly
what we have concluded in our analysis.
Composite output gap estimate
Source: RBI
7
Bhoi, Barendra Kumar and Behera, Harendra Kumar,
“India’s Potential Output Revisited”,
April 2016, RBI Working paper series 05/2016
June 2016
27

Thematic | Economy
II.2.
Unique trends that make India the fastest
U
II.2.
Unique trends that make India the fastest growing economy
Three key facts making India the fastest growing economy in the world:
Consumption has replaced investments as the key driver of growth. The former is
financed by savings, not disposable income.
Notwithstanding the fall in domestic inflation, the “price gap” remains as high as 54%.
Further, India’s inflation differential vis-à-vis major trading partners has increased
recently, hurting India’s competitiveness. We argue that inflation must be allowed to
undershoot the 4% target for at least a few quarters.
In comparison to the previous slowdown in the early 2000s, the recent adjustments in
India’s current account deficit are highly incomplete. The economy probably needs a
surplus on its external account to create the potential for high & sustainable growth.
Real personal disposable
income (PDI) growth in
the recent period has
lagged the growth
witnessed in early 2000s,
let alone the boom period
of FY04-08
Since 2008, real output growth has become rare. The developed world as a whole
has grown only 1%, while the developing and emerging economies have grown at an
average of 5.2%. India is the fastest growing economy in the world, estimated to
have grown 7.6% in the recently concluded year and expected to grow ~8% this
year. Our analysis shows that three unique but related factors have allowed the
Indian economy to become the fastest growing major economy in the world. As
discussed in the previous section, high consumption growth has helped India to
maintain its GDP growth. However, high consumption, at a time when investments
have slowed drastically, has come at the cost of higher inflation, lower savings and
higher current account deficit (CAD). We have discussed these three factors in this
section.
II.2.1. Higher consumption financed by savings, not higher
income
As discussed in the previous section, India’s consumption growth has been resilient
enough to make it the world’s fastest growing economy. Our first impression was
that resilient household income (households account for 85% of total consumption
in the economy) has led to the resilience in consumption demand. However, as
shown in
Exhibit 36
on the next page, real personal disposable income (PDI) growth
in the recent period has lagged the growth witnessed in early 2000s, let alone the
boom period of FY04-08. Real PDI grew at a cumulative rate of 29% in the five years
to FY04, 43% in the five years to FY08, and is expected to grow 23% in the five years
to FY17.
June 2016
28

Thematic | Economy
Exhibit 36: Real personal disposable income growth has been Exhibit 37: …implying consumption growth financed by
lackluster…
household savings
Early 2000s
160
140
120
100
80
Boom period
Recent
240
200
160
120
80
Early 2000s
Household savings
Boom period
Recent
Real personal disposable income
0
1
2
3
4
5
0
1
2
3
4
5
Number of years
Real disposable income is nominal income deflated by PCE deflator
Data from FY15 onwards are our projections
Number of years
Household savings in absolute terms (INR) converted into index
Source: CSO, RBI, MoSL
Indian household savings
have grown only 25% (in
absolute INR terms) against
~87% growth in the early
2000s and ~98% growth in
the mid-2000 period
If income growth is weaker than it was in the early 2000s, how have the households
maintained their consumption growth closer to the levels in FY04-08? The answer
lies in household savings
(Exhibit 37).
Since FY12, Indian household savings have
grown only 25% (in absolute INR terms) against ~87% growth in the early 2000s and
~98% growth in the mid-2000 period. As a percentage of GDP, household savings
have collapsed from 23.6% in FY12 to 19% in FY15 and are projected to dip further
towards 17% in FY17. This, as shown in
Exhibit 38,
is the lowest in the past two
decades.
Exhibit 38: Household savings have collapsed in the past few years
30
25
20
15
10
FY1996
(% of GDP)
Household savings
16.9%
FY1999
FY2002
FY2005
FY2008
FY2011
FY2014
FY2017F
FY16 is our estimate and FY17 is our forecast
Source: RBI, CSO, MoSL
Households have financed
their consumption out of
savings rather than higher
incomes. This strategy is
unsustainable in the longer
period
Households, thus, have financed their consumption out of savings rather than
higher incomes. This strategy is unsustainable in the longer period. Falling
household savings, which accounted for more than two-thirds of total savings in the
economy, act as a serious constraint on the ability of the non-financial corporate
sector to increase investments towards pre-crisis level. This is because savings are
the key source of investments. Without domestic savings, an economy has to
depend on foreign borrowings or current account deficit (CAD) for investments. As
we discuss later, there is not sufficient room for CAD to help investment rate
increase significantly.
June 2016
29

Thematic | Economy
While Indian households
reduced their savings and
increased their
investments, their US
counterparts did the
reverse by building savings
and cutting investments
It is also important to understand the behavior of Indian households vis-à-vis their
counterparts in other economies. We take the US as a representative of the
recession-hit economies.
Exhibits 39
and 40 compare household savings and
investments in India and in the US. Over FY09-13, while Indian households reduced
their savings and increased their investments, their US counterparts did the reverse
by building savings and cutting investments. The latter was a typical behavior of
households in all economies hit by recession/slowdown. Indian households
exhibited the opposite trend.
Exhibit 39: Household savings have collapsed in India…
27
24
21
18
15
FY06
FY08
FY10
FY12
FY14
FY16E
(% of GDP)
India
Household savings
(% of GDP)
8
7
6
5
4
We have calculated FY numbers for the US using quarterly data
FY16 data for the US is for Apr-Dec 2015
8
Exhibit 40: ….while investments were strong till recently
18
(% of GDP)
15
12
India
9
6
FY06
FY08
FY10
FY12
FY14
FY16E
USA (RHS)
4
2
Data for FY16 for India is MoSL’s estimate
Source: US Bureau of Economic Analysis (BEA), RBI, MoSL
Households' investments
(% of GDP)
8
7
5
USA (RHS)
The diverse behavior of
Indian households implies
two things – either they
believe that the slowdown
in disposable income is
fleeting, or that the fall in
savings is more structural in
nature
The diverse behavior of Indian households implies two things – either they believe
that the slowdown in disposable income is fleeting or that the fall in savings is more
structural in nature. Given India’s culture, demographic structure and the absence
of social security net, the latter seems unlikely. If the former is true, then
households’ perception of temporary slowdown could be challenged anytime, as
real disposable income growth has remained subdued for five consecutive years.
8
Indian household savings = net financial savings + physical savings
30
June 2016

Thematic | Economy
II.2.2. Has inflation eased sufficiently?
India’s retail inflation has fallen from double-digit levels in six consecutive years
between FY09 (starting April 2008) and FY14 (ending March 2014) to ~5% in FY16.
We expect retail inflation to average 4.7% in the current year (FY17) and undershoot
the 5% target for January 2017. Considering this, one could assume that inflation
has fallen sufficiently. In this section, we look at inflation from various perspectives
and conclude that retail inflation at 5% is higher than it should have been. We
believe inflation must be allowed to undershoot the medium-term target of 4% for
at least a few quarters
9
.
“Price gap” is as high as 54%:
Inflation is the rate of change in prices. Hence, the
base matters. If inflation has averaged 10% in the past few years, 5% in the next
year would imply much higher price level than in a scenario where inflation had
averaged 5% in the past few years as well. To help grasp the difference between the
rate of change in prices (inflation) and the price level (index), we introduce the
concept of “price gap”. Just like “output gap” is the difference between actual
output and potential output, we define “price gap” as the difference between actual
price (or index) level and the optimal (or target) level. The logic is simple. If the
authorities try to target zero output gap, the “price gap” should also be minimal -
the actual price level should be closer to the optimal price index. If the actual index
is higher than the optimal index, the economy will have a
positive price gap.
This
happens when
consumption
demand is very high and producers have bargaining
power. A
negative price gap
occurs when actual prices are lower than optimal,
which happens when
consumption
demand is low and producers/sellers lose their
bargaining power.
If the authorities try to
target zero output gap, the
“price gap” should also be
minimal
Price gap = Actual price index - Optimal price (or target) index
From late 1990s to 2006,
the actual index closely
tracked the optimal index.
In 2007, the “price gap”
turned positive and has
been rising consistently
since then
We derive the optimal price index through the desired (or targeted) inflation, which
we take as 4%.
Exhibit 41
compares the optimal index with the actual index level.
From late 1990s to 2006, the actual index closely tracked the optimal index. In 2007,
the “price gap” turned positive and has been rising consistently since then
(Exhibit
42).
The “price gap” scaled a peak of ~59% in April 2015. As per the recent reading in
April 2016, it was 54%.
Exhibit 42: “Price gap” estimate for Indian economy
75
50
54%
25
0
(25)
(%)
Price gap
18M MA
Exhibit 41: Comparison of optimal and actual price level
370
290
210
130
50
Optimal price level
(FY99=100)
Actual price level
CPI for industrial workers (IW) is used to measure retail prices
Optimal index is calculated assuming 4% inflation over the period
9
(Actual index - optimal price level)/Optimal level
Source: CSO, MoSL
Please note the entire analysis on inflation is conducted using Consumer Price Index for Industrial Workers (CPI-IW) for which a long
historical time series is available
June 2016
31

Thematic | Economy
Box 2. How has WPI-based price gap behaved?
After reading the section on retail price gap, we realized that the readers could be interested in looking at the wholesale
price gap, especially after the recent decline in wholesale price index (WPI).
We derive the WPI optimal price index through the desired (or targeted) inflation of 4%. WPI based price gap rose to its
highest level of 34% in late 2013, when CPI based price gap was 45%
(Exhibit 42
above).
As WPI-based inflation started easing from 2014 onwards and moved into negative territory in late 2014, the WPI price gap
has fallen substantially to 20% by April 2016. In fact, as per our projection of WPI for the next two years, we believe the gap
will narrow further toward 15% by the beginning of 2018.
Accordingly, as we have prescribed above, CPI also needs to undershoot the medium term target of 4% for at least few
quarters in order to bring the CPI index closer to the optimal price index.
Comparison of optimal WPI and actual WPI (FY99=100)
300
250
200
150
100
50
Optimal WPI
Actual WPI
WPI “Price gap” estimate for Indiasince late 1990s
48
36
24
12
0
(12)
(%)
WPI-based price gap
18M MA
Optimal WPI index is calculated with 4% inflation over the period
(Actual index - optimal price level)/Optimal level
Source: Office of Economic advisor (OEA), MoSL
Comparison of inflation in the previous slowdown:
Another way to analyze if retail
inflation has eased towards the desired level is to compare the current trajectory
with those in the previous slowdowns. Taking forward our analysis from the first
section of Part II, we have looked at the trajectories in three periods of five years
each – early 2000s (FY99=100), boom period (FY03=100) and recent period
(FY12=100).
Exhibit 43
on the next page compares the inflation trajectories during
these three episodes.
Compared to the previous
slowdown in the early
2000s, retail inflation is 20%
higher
The average retail inflation (based on CPI-IW) during FY00-04 was 3.9%, while it
averaged 5% during FY04-08. In comparison, retail inflation (based on CPI-IW)
averaged 8% over FY13-16. Compared to the previous slowdown in the early 2000s,
retail inflation is 20% higher (~17% higher than in the boom period).
For comparison purpose, we have also added the CPI-India series with our
projections for FY17. Notably CPI-India tracks CPI-IW very closely with the new
series only 2.5% lower than the old series of CPI-IW.
June 2016
32

Thematic | Economy
Exhibit 43: CPI trajectory during various episodes
150
135
120
105
90
1
6
11
16
21
26
31
36
41
46
Number of months
51
56
61
66
71
Early 2000s
Boom period
Recent
CPI-India
20%
FY17 numbers for CPI-India are our projections
Source: RBI, CSO, MoSL
All other things equal,
higher inflation reduces the
competitiveness of an
economy
Has India’s ‘inflation differential’ fallen?:
A key reason to track an economy’s
inflation trajectory is the impact of inflation on the economy’s competitiveness. All
other things equal, higher inflation reduces the competitiveness of an economy (one
could argue the role of tradable and non-tradable in this discussion; however, it is
beyond the scope of this study). Similarly, if the fall in inflation in ‘Economy A’ is
lower than the fall in inflation in its trading partners, even lower inflation will not
increase the competitiveness of Economy A, as the inflation differential (of Economy
A vis-à-vis its trading partners) remains high(er). Therefore, one must look at the
inflation differential of an economy vis-à-vis its trading partners.
Using the effective exchange rate data from Bank for International Settlements
(BIS), we calculate inflation differential
10
by dividing nominal effective exchange rate
(NEER) and real effective exchange rate (REER).
Exhibit 44
on the next page
compares India’s inflation differential with other Asian peers. Notwithstanding
easing domestic inflation, not only is India’s inflation differential with its major
trading partners the highest among Asian economies, but has risen in the past one
year. In other words, though India’s inflation has eased domestically, inflation in
India’s trading partners has fallen more. Due to high and rising inflation differential,
India, despite falling inflation, has not gained on competitiveness.
Exhibit 45
compares India’s inflation differential with the movement in nominal
effective exchange rate (NEER). Though India’s NEER has weakened ~24% since
2010, higher inflation differential has offset the impact of weaker nominal currency.
The INR has, thus, strengthened in real terms and this is hurting India’s
competitiveness.
Notwithstanding easing
domestic inflation, not only
is India’s inflation
differential with its major
trading partners the highest
among Asian economies,
but has risen in the past
one year
Though India’s NEER has
weakened ~24% since 2010,
higher inflation differential
has offset the impact of
weaker nominal currency
10
We must admit it is difficult to measure inflation differential accurately because of the tradable and non-tradable argument. Our measure
of inflation differential is also not perfect. Apart from tradable and non-tradable baskets, different weights for different items in different
countries also represent another limitation.
June 2016
33

Thematic | Economy
Exhibit 44: Comparison of India’s inflation differential with Exhibit 45: Rising inflation differential has offset the impact
other Asian peers (2010=100)
of weak nominal exchange rate
140
120
100
80
(2010=100)
Inflation differential with trading partners
High inflation
differential =
Low competitiveness
150
130
110
90
70
China
India
Indonesia
Philippines
Source: BIS, RBI, MoSL
(2010=100)
24%
NEER
Inflation differential
34%
Inflation differential = Broad REER/ Broad NEER index
Box 3. A look at inflation targeting regimes in other major economies
The exhibit below compares the recent inflation in some inflation targeting and some non-inflation targeting economies. Of
the nine economies considered (besides India), five are inflation targeting and the rest do not target inflation explicitly.
Five of these nine economies have inflation within the target range. Interestingly, two of the four non-compliant economies
– Brazil and Russia are reeling under stagflation, while South Africa is flirting with recessionary pressures. Barring these
three economies, India’s inflation is the highest at above 5%.
Comparison of recent inflation in inflation targeting developing economies
Country
Target measure
Inflation targeting
Brazil
Headline CPI
Yes
China
Headline CPI
No
India
Headline CPI
Indonesia
Headline CPI
Yes
Malaysia
Headline CPI
No
Philippines
Headline CPI
Yes
Russia
Headline CPI
No
Singapore
Headline CPI
No
South Africa
Headline CPI
Yes
Thailand
Core CPI
Yes
2016* inflation
9.9
2.2
5.3
4.2
3.1
1.1
8.1
(0.7)
6.4
(0.4)
* Jan-April 2016
Source: Report of the expert Committee to Revise and strengthen the monetary policy framework, various official sources, RBI, MoSL
Desired inflation
4.5% +- 2 pp
3.5%
4.0% +- 2 pp
4.5% +-1 pp
2%-3%
4.0% +-1 pp
5%-6%
3%-4%
3% - 6%
0.5% -3.0%
June 2016
34

Thematic | Economy
II.2.3. What does current account balance (CAB) tell us?
Linked with the first two variables is the current account balance (CAB). Though CAB
has improved substantially in the past few years, the question is if the adjustment is
complete. We believe CAB has not yet improved to a level that is in line with the
economic activity. The adjustment is incomplete.
Exhibit 46
shows the movement in India’s CAB during the three episodes – early
2000s (FY99-04), boom period (FY03-08) and recent period (FY12-FY17). Two key
highlights from the exhibit are:
1. The recent period began with highly unfavorable circumstances.
2. The current period is reminiscent of the boom period rather than the early
2000s period.
Towards the end of the slowdown in early 2000s, India’s current account had a
surplus of 2.1% of GDP in FY04 against a deficit of 1% of GDP in FY99 (the beginning
of the slowdown). As the economy entered into the boom period, current account
balance worsened from +2.1% of GDP in FY04 to -1.3% of GDP in FY08. In the recent
period, though the CAD (current account deficit) has narrowed substantially from an
all-time peak of 4.8% of GDP in FY13 to an estimated 0.8% of GDP in FY16. The
current CAD level is closer to what it was at the beginning of the early 2000s period
or late boom period
(Exhibit 47).
This makes us uncomfortable.
Exhibit 47: India’s CAB in the past two decades
Recent
4
2
0
(2)
(% of GDP)
0
2
4
6
8
10
12
14
16
18
20
22
(4)
(6)
Ealy 2000s
(% of GDP)
Current account balance
Boom period
Recent period
The current CAD level is
closer to what it was at the
beginning of the early
2000s period or late boom
period. This makes us
uncomfortable.
Exhibit 46: Trends in current account balance (CAB)
6
3
0
(3)
(6)
(9)
Early 2000s
Boom period
Number of quarters
Source: RBI, CSO, MoSL
FY97 FY99 FY01 FY03 FY05 FY07 FY09 FY11 FY13 FY15 FY17F
Source: RBI, CSO, CMIE, MoSL
The balance on
consumption basket has
fallen from a decent surplus
1. The balance on consumption basket has fallen from a decent surplus of 1.5% of
GDP in FY14 to only 0.5% in FY16. Notably, the average surplus on consumption
of 1.5% of GDP in FY14 to
only 0.5% in FY16
basket in the past two decades was 1% of GDP.
June 2016
35
As discussed earlier, the recent economic recovery is driven by consumption
demand rather than investment demand. To cement our analysis further, we have
re-classified India’s merchandise trade into three baskets – oil, consumption and
investments, and accordingly, calculate trade balance on each of these baskets. We
show the break-up of India’s merchandise trade balance using these classifications
during two periods – early 2000s
(Exhibit 48
on the next page) and the recent period
(Exhibit 49)
to help understand the contribution of each item to total trade deficit.
Key highlights are:

Thematic | Economy
The non-oil trade deficit
was 3.2% of GDP in FY16,
close to what it was in FY06-
FY07 and more than double
of 1.5% of GDP in FY15
2. The deficit on investment basket, however, has been broadly unchanged in the
past three years at closer to 3% of GDP. In the early 2000s slowdown, the deficit
on investment basket was closer to nil and increased towards 3% of GDP by
FY07. The long-term average deficit has been 2.2% of GDP.
3. Finally, the non-oil trade deficit (excluding rest items) was 3.2% of GDP in FY16,
close to what it was in FY06-FY07 and more than double of 1.5% of GDP in FY15.
The average deficit on non-oil basket has been less than 2% of GDP.
Exhibit 49: Components of goods’ trade in recent period
Consumption
(% of GDP)
1.4
(0.4)
1.7
(0.3)
(3.1)
0.1
(4.3)
1.5
(2.9)
(5.8)
(6.1)
Investment
0.7
(3.2)
(4.4)
Oil*
CAB
0.5
(3.3)
(2.9)
11
Exhibit 48: Components of goods’ trade in early 2000s
Consumption
(% of GDP)
1.1
(0.9)
(3.2)
(3.0)
0.2
1.8
Investment
Oil*
CAB
11
(2.6)
FY 00
FY 01
FY 02
FY 03
FY 13
FY 14
FY 15
FY 16
* Including non-consumption, non-investment (rest) items also
Source: RBI, CSO, CMIE, MoSL
From mid-2000s onwards,
the economy moved into
deficit mode on non-oil
non-valuables as well.
India’s trade deficit on non-
oil non-valuables was 2.3%
in FY16, slightly lower than
the average deficit of 2.7%
of GDP in the past decade
Alternatively, we further classify merchandise trade balance based on oil, valuables
(gold, silver, pearls, precious stones, etc) and non-oil non-valuables. Traditionally,
India’s trade deficit was primarily constituted by oil only. As the economy opened
up, India’s attraction for valuables started impacting its external account, as
valuables account moved from an average surplus of 0.4% of GDP till mid-1990s to
an average deficit of 0.5% of GDP in mid-2000s
(exhibit 50).
Finally, from mid-2000s
onwards, the economy moved into deficit mode on non-oil non-valuables as well.
India’s trade deficit on non-oil non-valuables was 2.3% in FY16, only slightly lower
than the average deficit of 2.7% of GDP in the past decade.
Exhibit 50: Components of CAB since 1990s (% of GDP)
5
0
(5)
(10)
(15)
FY 94
FY 96
FY 98
FY 00
FY 02
FY 04
FY 06
FY 08
FY 10
FY 12
FY 14
FY 16
Valuables includes gold, silver, pearls, precious stones etc
Source: RBI, CMIE, MoSL
Oil
Valuables
Non-oil non valuable
Trade balance
11
Consumption includes agriculture items, leather products, readymade garments, gems & jewelry and paper/wood items
Investments include all other items excluding consumption basket, petroleum and ‘other commodities’.
36
June 2016

Thematic | Economy
About one-third of the gains
on account of lower oil
prices were offset by lower
surplus on consumption
deficit in the past two years,
which reflects high
consumption demand
Overall though the current account deficit (CAD) has improved substantially from an
all-time peak of 4.8% of GDP in FY13 to less than 1% of GDP in FY16, it is closer to
the CAD at the beginning of the previous slowdown (FY00) or towards the end of the
previous boom period (FY08). Notwithstanding the crash in non-fuel commodity
prices, almost two-third of the gains on oil and valuables trade in the past three
years has been offset by higher deficit on non-oil non-valuables. Further, while the
deficit on investment basket was largely unchanged in the past three years, about
one-third of the gains on account of lower oil prices were offset by lower surplus on
consumption deficit in the past two years, which reflects high consumption demand,
as discussed above.
June 2016
37

Thematic | Economy
R II.3. Remember the “Theory of
of Everything”
II.3. R
emember the “Theory
Everything” growing
In this section, we look at the factors that allowed the Indian economy to move from a
low-growth period in the early 2000s to high-growth in the mid-2000s.
We find that investments were the key driver of GDP growth during the mid-2000s,
which made the high-growth period sustainable.
To repeat that performance, we believe India must re-build its collapsing household
savings, which is the key source of financing for domestic investments.
Moreover, the revival in investments has to be led by the private corporate sector, as
higher public or household investments hurt capital efficiency.
Thus far, we have dissected India’s current macro-economic environment. We make
two key conclusions. One, the current slowdown is not as severe as the topline
corporate statistics suggest. Consumption growth has been resilient and this has
helped limit the deceleration in economic activity. Two, the tag of ‘fastest growing
economy in the world’ has led to a few noteworthy features in the economy – lower
savings, higher-than-desired retail inflation and sub-optimal adjustment in current
account deficit (CAD). After understanding the current situation, the obvious
question is, what to expect next? Before we get on to our expectations and
projections, it would be a good idea to understand the transition of the Indian
economy from the low-growth early 2000s to the boom period of FY04-08.
The key reason of
sustainable
high growth
during mid-2000s was that
the key driver of economic
activity was investment
rather than consumption
The most notable feature of the boom period was
sustainable
high growth. By
sustainable,
we mean non-inflationary acceleration in real GDP growth. Although
real GDP grew at an average of 8.8% between FY04 and FY08, more than double of
that between FY01 and FY03, retail inflation averaged 4% between FY04 and FY06,
similar to the inflation rate during the slowdown (FY00-03). The key reason of
sustainable
high growth during mid-2000s was that the key driver of economic
activity was investment rather than consumption.
Exhibit 51
shows the major contributors to real GDP growth in the three episodes
we have studied in our analysis. Although the contribution of consumption (private
+ government) to real GDP growth increased from 3.4 percentage points (pp) in
early 2000s to 5.1 pp during the boom period, the contribution of investments
almost quadrupled from 1.4 pp to 5.7 pp. In other words, the average growth in
investments during the boom period was ~19% per annum, as against a meager
growth of 6% in the early 2000s
(Exhibit 52).
As the economic boom was primarily
driven by corporate investments and better capital efficiency (measured by
incremental capital-output ratio (ICOR)), the higher growth period was non-
inflationary or sustainable.
The average growth in
investments during the
boom period was ~19% per
annum, as against a meager
growth of less than 6% in
the early 2000s
June 2016
38

Thematic | Economy
Exhibit 51: Contributors to real GDP growth (pp)
Consumption
15
10
5
0
(5)
2000-03
2004-08
2013-16
1.5
3.4
Discrepancy
Investments
GDP growth
Net exports
Exhibit 52: Average growth in GDP components (% CAGR)
2000-03
18.7
15.4
17.8
2004-08
20.1
2013-16
5.7
5.1
1.2
4.0
6.1
6.6
3.2
2.8
4.5
7.2
6.0
(1.0)
Investments
Exports
Imports
Consumtpion
Source: RBI, CSO, MoSL
Not surprisingly then, the ratio of investment to GDP (also known as investment
rate) increased dramatically from 24.8% of GDP in FY03 to 38.1% of GDP in FY08
(Exhibit 53).
The ratio of final consumption, on the other hand, fell from 75.8% of
GDP to 67.2% in FY08
(Exhibit 54).
Exhibit 53: Investment rate increased rapidly during the Exhibit 54: …while consumption rate fell to an all-time low
boom period…
level of that period
48
36
24
12
0
(% of GDP)
Total investment
Up from 24.8% in FY03
to 38.1% in FY08
110
95
80
65
50
All-time lowest level
of 67.2% in FY08
(% of GDP)
Final consumption
Source: RBI, CSO, MoSL
The investment rate has
fallen from its all-time peak
of 39.6% of GDP in FY12 to
32.5% in FY16 - the lowest
since FY04, while the
consumption rate has
increased to above 70%,
marking the highest level in
12 years
Things, however, have reversed in the past few years. The investment rate has fallen
from its all-time peak of 39.6% of GDP in FY12 to 32.5% in FY16 - the lowest since
FY04, while the consumption rate has increased to above 70%, marking the highest
level in 12 years. We firmly believe that if the Indian economy has to re-witness the
boom period of 2004-08, investment is the only route. In other words, the share of
investment has to pick up again at the cost of consumption.
This brings us to the question of
“What is required for investment rate to rise in the
coming years?”
The answer lies in an identity, which we call
“The Theory of
Everything”.
Investment = Savings + Foreign borrowings
The identity, quoted above, tells us that domestic investments in an economy can
either be financed by domestic savings or through foreign borrowings. The latter is
only those foreign borrowings (or foreign capital inflows), which finance current
account deficit (CAD). If foreign capital does not finance CAD, it will add up to
June 2016
39

Thematic | Economy
foreign exchange reserves, which do not add anything to investments (or
consumption) of an economy. Consequently, the identity could be re-written as:
Investment = Savings + Current account deficit
Therefore, to increase investments, either domestic savings have to go up, or CAD
has to widen. Let’s look at what happened during the first decade of the 21
st
century.
India’s CAD moved from a deficit of 1% of GDP in FY2000 to a surplus of above 1% of
GDP in FY03. Notably, however, domestic savings were largely intact at ~25% of GDP
during the slowdown of early 2000s. As can be concluded from the above identity,
the narrowing of CAD, along with stable domestic savings led to a contraction in
investment rate from 26.5% of GDP in FY00 to 24.7% of GDP in FY03.
Nevertheless, things began to change dramatically since FY04. Although CAB
continued to improve towards the post-independence highest level of +2.3% of
GDP, total savings in the economy rose from 26% to 29% of GDP, helping to push
the investment rate higher to 27% in FY04. Further, as the economy strengthened,
current account moved from a surplus of 2.3% of GDP in FY04 to a deficit of 1.3% in
FY08 and total savings increased from 29% of GDP in FY04 to ~37% of GDP in FY08.
Domestic investments rose from 27% to 38% during the boom period
(Exhibit 55).
Exhibit 55: Financing of domestic investments in India
45
(% of GDP)
National savings
CAD
1.3
Domestic investments
2.8
2.7
4.3
4.8
30
0.9
15
23.2
1.0
25.5
0.5
23.7
24.8
(0.7)
25.9
(1.2)
29.0
0.4
32.4
1.2
1.0
2.3
1.7
1.3
0.8
33.4
34.6
36.8
32.0
33.7
33.7
34.6
33.8
33.0
33.0
31.8
0
(2.3)
-15
FY99
FY00
FY01
FY02
FY03
FY04
FY05
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
FY15 FY16E
E = estimates
Source: RBI, CSO, MoSL
Between FY08 and FY13,
incremental domestic
investments were entirely
driven by foreign
borrowings, as the fall in
domestic savings was
completely offset by
widening CAD
Exhibit 56
on the next page compares the identity at key turnaround points in the
economy. As investments increased from ~27% of GDP in FY04 to ~38% of GDP in
FY08, national savings contributed the lion’s share of ~70% (moved from~29% of
GDP to ~37% of GDP). Foreign capital (or CAD) accounted for less than one-third of
the total increase in domestic investments during the boom period. Nevertheless,
between FY08 and FY13, incremental domestic investments were entirely driven by
foreign borrowings, as the fall in domestic savings (of 3pp) was completely offset by
widening CAD (3.5pp). This is what made the economic growth over FY09-13 highly
unsustainable. As
Exhibit 57
shows, with CAD returning to more normal levels,
domestic investments have also fallen in the recent period. In FY16, we believe the
40
June 2016

Thematic | Economy
investment rate has fallen further (to sub-33%), as the savings rate is estimated to
have fallen below 32% and CAD also narrowed further to sub-1% of GDP.
Exhibit 56: Contribution of savings and foreign borrowings to Exhibit 57: Contribution of savings and foreign borrowings to
domestic investments at key turnaround points
domestic investments in the recent period
National savings
60
40
20
0
(20)
FY04
FY08
FY13
FY16E
29.0
(2.3)
(% of GDP)
1.3
36.8
4.8
33.8
0.8
31.8
CAD
Domestic investments
48
36
24
12
0
FY12
FY13
FY14
FY15
FY16E
Source: RBI, CSO, MoSL
34.6
33.8
33.0
33.0
31.8
National savings
(% of GDP)
4.3
4.8
1.7
1.3
0.8
CAD
Domestic investments
Extending the above identity, another key feature to note is the contribution of
various institutions to economic growth. An economy has three different players –
households, private corporate sector and consolidated public sector (including
central and state governments and public enterprises). Each of these institutions
saves and invests in the economy. If an institution saves more than its investment, it
becomes a ‘net lender’ to the economy. On the contrary, higher investments than
savings imply that the institution is a ‘net borrower’. In an ideal and normal period,
households are ‘net lenders’ (save more), private corporate sector is the key ‘net
borrower’ (key investor) and the public sector is the minor ‘net borrower’. The sum
of the balances (savings - investments) of these three institutions defines the
current account balance (CAB) or the balance with the rest of the world.
During the most recent
period (FY13-16E), the fall
in national savings is
entirely driven by
households, which is
partially offset by higher
corporate savings
As the economy improved,
the corporate sector led the
investment recovery
Exhibit 58
on the next page shows the break-up of savings and investments by each
of the three institutions in the Indian economy in the past two decades. There are
two key highlights pertaining to three key periods:
1.
Key trends on sectoral savings:
The first leg of higher savings in early 2000s
(FY01-04) was driven by households and the public sector. However, the second
leg of higher savings during the mid-2000s (FY04-08) was contributed by the
private corporate sector and the public sector. During the most recent period
(FY13-16E), the fall in national savings is entirely driven by households, which is
partially offset by higher corporate savings.
2.
Key trends on sectoral investments:
During the early 2000s, the share of
households in total investments increased, while the share of private corporate
sector fell towards 20% of total investments in FY03. As the economy improved,
the corporate sector led the investment recovery. The share of the corporate
sector increased to 45% of total investments, while the share of households fell
from 50% of total investments to 30%. In the recent period (FY12-16E), the
share of households has fallen once again from ~45% of total investments to
sub-35%, made up by the private corporate (60%) and the public sectors (40%).
June 2016
41

Thematic | Economy
Exhibit 58: Details of sectoral savings and investments in India
% of GDP
Savings
Total (1)
Households
Corporate
Public
sector
1.9
-0.2
-0.5
-1.3
-1.6
-0.3
1.3
2.3
2.4
3.6
5.0
1.0
0.2
2.6
1.5
1.4
1.3
1.2
1.2
Total (2)
Investment
Households*
Corporate
8.4
6.7
7.0
4.9
5.1
5.7
6.5
10.3
13.6
14.5
17.3
11.3
12.1
12.8
13.2
13.6
13.1
14.1
13.7
E&O (3)
Public
sector
7.4
1.1
7.3
0.7
7.6
-0.2
7.1
0.1
7.2
-1.3
6.4
-0.2
6.6
0.7
7.4
0.4
7.9
0.4
8.3
-0.2
8.9
0.1
9.4
-1.2
9.2
0.2
8.4
0.0
7.5
-0.6
7.2
0.4
7.1
0.0
7.4
0.1
7.6
0.1
* Includes valuables
CAD#
1.3
0.9
1.0
0.5
-0.7
-1.2
-2.3
0.4
1.2
1.0
1.3
2.3
2.8
2.7
4.3
4.8
1.7
1.3
0.8
FY98
24.2
18.1
4.2
24.5
8.7
FY99
23.2
19.5
3.8
23.5
9.5
FY00
25.5
21.7
4.3
26.8
12.2
FY01
23.7
21.3
3.7
24.1
12.1
FY02
24.8
23.1
3.3
25.6
13.2
FY03
25.9
22.2
3.9
25.0
12.8
FY04
29.0
23.1
4.6
26.1
13.0
FY05
32.4
23.6
6.6
32.5
14.7
FY06
33.4
23.5
7.5
34.3
12.8
FY07
34.6
23.2
7.9
35.9
13.0
FY08
36.8
22.4
9.4
38.0
11.9
FY09
32.0
23.6
7.4
35.5
14.8
FY10
33.7
25.2
8.4
36.3
15.0
FY11
33.7
23.1
8.0
36.5
15.3
FY12
34.6
23.6
9.5
39.6
18.8
FY13
33.8
22.4
10.0
38.3
17.5
FY14
33.0
20.9
10.8
34.7
14.4
FY15
33.0
19.1
12.7
34.2
12.7
FY16E
31.8
17.8
12.8
32.5
11.2
E = estimates
# Current account balance = Total investments + errors & omissions (E&O) - total savings
Data on 2004-05 base is up to FY11; FY12-FY15 is on 2011-12 base;
FY16 figures are our estimates
Source: CSO, RBI, MoSL
The deterioration in CAD
between FY08 and FY13
was primarily because of
the household sector,
rather than the
consolidated public sector,
as is widely believed
From savings and investments, we derive sectoral balances (savings – investments)
of each institution and look at the contribution of each institution to the economy’s
current account balance (CAB).
Exhibit 59
on the next page shows the sectoral
balances at key turnaround points in time, while the long-term series is shown in
Exhibit 60.
As the CAB improved from -1% of GDP in FY00 to +2.3% of GDP in FY04,
the key drivers were the public sector and households. The deterioration of CAB to -
1.3% of GDP in FY08 was entirely because of the corporate sector. Another key
finding is that the deterioration in CAD between FY08 and FY13 was primarily
because of the household sector, rather than the consolidated public sector, as is
widely believed
12
. In the recent period, however, the improvement in CAB was
majorly driven by the corporate sector, which continued to increase its savings (see
Exhibit 58
above) and failed to match its investments with higher savings. The public
sector also continued to borrow on net basis at a higher rate, eating up a significant
portion of the low resources provided by households.
“…Juxtaposing savings with investment, it becomes clear that it was the large saving-investment gap of the consolidated public sector,
complemented by a less pronounced gap in the private corporate sector, which could not be fully defrayed by the savings of households, that
constituted the aggregate saving-investment gap…”
says the Economic Survey 2014-15 which was released on 27 February 2015.
June 2016
42
12

Thematic | Economy
Exhibit 59: Sectoral balance at key turnaround points
FY00
9.4
10.6
10.2
5.0
(0.9)
(3.6)
(8.1)
6.5
Exhibit 60: Long-term series of sectoral balances
Households
E&O
20
10
0
(% of GDP)
Corporate
CAB
Public
FY04
FY08
FY13
FY16E
(% of GDP)
(2.6)
(2.0)
(5.3)
(3.9)
(5.8)
(6.3)
-10
-20
(7.9)
Households
Corporate
Public
Source: RBI, CSO, MoSL
FY98 FY00 FY02 FY04 FY06 FY08 FY10 FY12 FY14 FY16E
Source: RBI, CSO, MoSL
Why does sectoral analysis matter?
As stated earlier, in an ideal and normal world, households should be the ‘net
lender’ to the economy, the private corporate sector should be the key ‘net
borrower’, while the public sector should be a minor ‘net borrower’. This is because
the private corporate sector is the most efficient investor in the economy, which
invests primarily in ‘equipment & software’, while household investments are
primarily into real estate. The former helps to increase productivity in the economy.
The corporate sector
invests almost three-fourth
of its total investments in
machinery & equipment,
while households invest
almost entirely in
construction
Exhibit 61
shows that the corporate sector invests almost three-fourth of its total
investments in machinery & equipment, while households invest almost entirely in
construction (or dwellings). Exhibit
62
shows that while over half the total real
estate investment in the country is by households, more than 70% of the investment
in ‘machinery & equipment’ is by the private corporate sector. Notably, the public
sector also invests more than three-fifth in the construction activities, which si also a
low-efficiency activity.
Exhibit 62: Investments in different assets by institutions
Households
(% of total)
6.2
Private corporate
Public sector
Exhibit 61: Investments by institutions in different assets
(% of total)
Construction
Machinery & equipment*
7.2
38.0
74.0
92.8
62.0
26.0
Public sector
Private corporate
Households
56.4
71.4
17.8
25.8
Construction
22.4
Machinery & equipment*
Source: RBI, CSO, MoSL
* Includes investment in cultivated biological resources and
intellectual property
June 2016
43

Thematic | Economy
Exhibits 63 and 64
summarize the impact of sectoral investments on the real
economy. The exhibits clearly show that real GDP growth is highly positively
correlated with corporate investments, while higher household investments (or
physical investments) coincide with a weak economy.
Exhibit 63: Real GDP growth is positively correlated with Exhibit 64: …and
corporate investments…
investments
Corporate investment
60
45
30
15
0
FY92 FY95 FY98 FY01 FY04 FY07 FY10 FY13 FY16E
3yma = 3-year moving average
(YoY, 3yma)
(% of total GFCF)
Real GDP (RHS)
10
8
5
3
0
60
45
30
15
0
FY92 FY95 FY98 FY01 FY04 FY07 FY10 FY13 FY16E
Source: RBI, CSO, MoSL
(YoY, 3yma)
negatively correlated
with
household
Household investment
(% of total GFCF)
Real GDP (RHS)
10
8
5
3
0
The analysis of the transition of the Indian economy from the low-growth period in
the early 2000s to the high-growth period in the mid-2000s gives us three lessons:
1. High growth is sustainable (non-inflationary) if driven by investment boom.
2. Recovery or turnaround in domestic investments must be financed by national
savings rather than by foreign borrowings (or CAD).
3. The more the share of the private corporate sector in total investments, the
better it is for the economy. On the contrary, higher share of real estate
investments (or household investments) coincides with a weak economy.
June 2016
44

Thematic | Economy
II.4. Expectations for next two years
E II.4. Expectations for next two years
Key expectations are:
A surplus monsoon could push agricultural output growth towards 6%, which may
help GDP to grow 7.8% in FY17. Non-farm GDP growth, however, could fall from 8.3%
to 8% this year.
Although we expect retail inflation to average 4.7% in FY17, it is likely to reverse the
trajectory and average 5% in FY18, primarily because of continuation of consumption-
driven recovery.
Accordingly, while we don’t expect RBI to cut policy rates substantially from the
current levels, bond yields could drop towards 7% by March 2017 due to RBI’s open
market operations worth INR1,600b.
Finally, the Indian Rupee (INR) is likely to weaken further and average 68 against the
US Dollar (USD) in FY17. However, we expect the INR to remain strong in REER terms.
As per our understanding of the Indian economy, the basis of which we have
detailed in the previous sections of Part II, this final section is devoted to the most
likely future trajectory. We have divided this section into three segments. In the first
segment, we look at the economic projections for the next two years – FY17 and
FY18. The detailed economic projections are provided in Appendix IV. In the second
segment, we give our views on the bond market and follow it up with our forecasts
for INR in the final section of this part.
II.4.1 Where do we see Indian economy moving in the next two
years?
Our expectation of better
agriculture output is based
on the IMD’s (Indian
Meteorological
Department) monsoon
projections. The higher
growth hinges on hope to
that extent
Since the 1980s, agriculture
output growth has averaged
8.4% in the years associated
with a surplus South-West
(SW) monsoon
Real GDP growth of 8% achievable in the next two years:
To begin with, we believe
that real GVA (gross value added) growth could jump from 7.2% in FY16 to 7.7% in
FY17. The biggest delta in economic growth would come from the agriculture
economy, excluding which we expect real GVA to grow 8% in FY17, lower than 8.3%
in FY16. Our expectation of better agriculture output is based on the IMD’s (Indian
Meteorological Department
13
) monsoon projections. The higher growth hinges on
hope to that extent. Whether the actual monsoon will be as good as the IMD
expects is for us to see; however, historical data suggests
(Exhibits 65-66)
that
agricultural output has been better than the long-term average in the years of
surplus monsoon (irrespective of the extent of the surplus). Since the 1980s,
agriculture output growth has averaged 8.4% in the years associated with a surplus
South-West (SW) monsoon. We assume real agriculture output growth of 6% in
FY17, as against a meager growth of 1.2% in FY16 and a decline of 0.2% in FY15.
13
http://www.imd.gov.in/pages/press_release.php
45
June 2016

Thematic | Economy
Exhibit 65: Agriculture output is positively impacted by good
South-West (SW) monsoon
10
0
(10)
(20)
(30)
(% deviation
from LPA)
FY2002
FY2005
FY2008
FY2011
(% YoY)
FY2014
(10)
FY2017F
SW monsoon
Agriculture output (RHS) 10
5
0
(5)
Exhibit 66: Surplus SW monsoon has ALWAYS resulted in
better agriculture output growth
20
15
10
5
0
(5)
Long-term average
growth of 3.4%
(% YoY)
Agriculture output
(10)
FY1981 FY1987 FY1993 FY1999 FY2005 FY2011 FY2017F
Dotted years imply surplus monsoon
Source: RBI, CSO
We believe consumption
demand would remain the
key driver of real GDP
growth. Accordingly, we
expect the share of
(nominal) consumption to
move up to 71.4% of
(nominal) GDP in FY17 and
further to ~73% in FY18
Deriving GDP (gross domestic product) numbers from GVA requires us to add in our
assumption for net indirect taxes (NIT). We believe real GDP could grow 7.8% in
FY17 and 8.1% in FY18, assuming real NIT grows 8.6% in FY17 and 9.6% in FY18. Like
in the past few years, we believe consumption demand would remain the key driver
of real GDP growth. Accordingly, we expect the share of (nominal) consumption to
move up to 71% of (nominal) GDP in FY17 and further to ~72% in FY18 (Please see
Exhibit 34
on page 23). Total investments, on the other hand, will remain a
secondary contributor to higher real GDP growth
(Exhibit 67).
Exhibit 68: Consumption to outpace investment growth
Discrepancies
165
150
135
5.3
5.9
120
105
Forecast
Real consumption
(FY12 = 100)
Real investments ex valuables
Exhibit 67: Key contributors to real GDP growth
Consumption
9
6
3
0
(3)
FY13
FY14
FY15
FY16E
FY17F
FY18F
Source: RBI, CSO
1.7
3.0
3.8
-0.4
4.8
(pp)
2.2
2.3
1.4
4.4
2.5
Investments
Net exports
90
Q4 FY12 Q4 FY13 Q4 FY14 Q4 FY15 Q4 FY16 Q4 FY17 Q4 FY18
Source: RBI, CSO
Net financial savings are
unlikely to rise meaningfully
and are likely to remain
broadly unchanged at 7.8%
in FY18
The widening gap between consumption and investment growth, as shown in
Exhibit 68
above, is likely to make it challenging to maintain high sustainable (or
non-inflationary) growth. If consumption continues to drive real GDP growth, it
would be primarily financed by savings, as growth in real disposable income is
unlikely to accelerate substantially in the next couple of years. Household savings
will continue to inch down from ~18% of GDP in FY16E to ~16% by FY18
(Exhibit 69).
Within household savings, net financial savings are unlikely to rise meaningfully and
are likely to remain broadly unchanged at 7.8% in FY18. If so, gross savings of the
economy will continue to shrink. As discussed in Section III, lower savings will make
pick-up in investments unlikely, as the widening CAD (as per our projections) will fail
June 2016
46

Thematic | Economy
to offset the fall in national savings
(Exhibit 70).
Accordingly, gross capital formation
(or total investment) is likely to fall from 32.5% of GDP in FY16 to 30.7% in FY18.
Exhibit 69: National savings likely to fall further…
(% of GDP)
Households
Private corporate
Public sector
Exhibit 70: …which implies a fall in investment rate
(% of GDP)
48
National Savings
CAD
Investments
9.5
10.0
10.8
12.7
12.8
36
11.8
11.3
24
12
0
4.3
4.8
1.7
33.0
1.3
33.0
0.7
31.8
1.4
29.9
2.0
28.6
23.6
22.4
20.9
19.1
34.6
17.8
33.8
16.9
16.1
FY12
FY13
FY14
FY15
FY16E
FY17F
FY18F
FY12
FY13
FY14
FY15
FY16E
FY17F
FY18F
E = MoSL's estimate
F = MoSL’s forcasts
Source: RBI, CSO
With our growth
projections and drivers, we
expect inflation to move
higher and average 5% in
FY18, with a reading of
above 5% in January 2018
However, inflation unlikely to fall to 4% by January 2018:
With higher consumption
and lagging investment, economic growth will soon become unsustainable. This
combination will prevent retail inflation from falling towards 4%, as is targeted by
the Reserve Bank of India (RBI) by January 2018. We believe retail inflation will ease
further from 4.9% in FY16 to 4.7% this year (meeting its 5% target by January 2017);
however, with our growth projections and drivers, we expect inflation to move
higher and average 5% in FY18, with a reading of above 5% in January 2018.
Accordingly, we expect the policy repo rate to fall to 6.25% by the end of 2016 and
stay unchanged for the entire 2017. With an average retail inflation of 5%, it will
imply a real policy rate of 1.25% in FY18.
June 2016
47

Thematic | Economy
II.4.2 Bond market: Expect 10-year yield to fall towards 7% by
March 2017
Based on our real GDP growth and core WPI forecasts (Please
see Appendix IV),
we
believe high-powered money supply (M0) will have to increase 12.7% in FY17. It
means that the RBI will have to inject INR2,650b (USD39b) in the form of foreign
exchange reserves (FXR) and open market operations (OMOs). Our base case
balance of payments (BoP) projection is a surplus of USD21.4b in FY17 (see
Exhibit
71
below), which implies that OMOs of USD17.6b (or INR1,200b) will be needed to
meet M0 requirements. Including additional OMOs of INR500b on account of RBI’s
intent to provide durable liquidity in the system, the RBI may have to conduct total
OMOs worth INR1,700b (USD25b) in FY17, implying an average monthly OMO of
INR142b (or USD2.1b). Considering the demand for central government (CG) papers
by various participants (banks’ demand will be impacted based on FCNR
redemptions), there will be an excess demand of INR770b for CG securities, which,
we believe, could pull down yields towards 7% by March 2017.
Our base case balance of
payments (BoP) projection
is a surplus of USD21.4b in
FY17 (see
Exhibit 71
below),
which implies that OMOs of
USD17.6b (or INR1,200b)
will be needed to meet M0
requirements
We believe real GDP could
grow 7.8% in FY17 and
estimate core WPI inflation
at 0.6% for FY17, which
implies 12.7% growth in the
reserve money
Base case: Excess demand of INR720b to pull yields towards 7%...
Exhibit 71
shows the entire working of the excess CG-sec demand the markets could
witness in FY17. We believe real GDP could grow 7.8% in FY17 and estimate core
WPI inflation at 0.6% for FY17, which implies 12.7% growth in the reserve money (or
high-powered money, M0). In absolute terms, this implies an injection of INR2,650b
(USD39b) in M0 by the RBI. Broadly, M0 is injected via two ways – using foreign
exchange reserves (FXR) and RBI’s open market operations (OMOs). If FXR are more
than required, RBI conducts OMO sale, implying selling of government securities to
such excess liquidity. On the contrary, if FXR are less than needed, RBI buys
government securities and injects money via OMO purchases. As per our base case,
which includes current account deficit (CAD) of 1.4% of GDP in FY17 and an outflow
of USD12b on account of FCNRB redemption, we expect a surplus of $21.4b on the
balance of payments. It implies that the RBI will have to buy government securities
worth USD17.6b (or INR1,195b) in FY17 to meet M0 demand.
Exhibit 71: Calculation of potential OMOs in FY17
Unit
Reserve money requirement* (1)
FCNR(B) redemption
BOP surplus/Forex reserves (2)
OMOs requirement (3) = (1)-(2)
Durable liquidity (4)
Total OMOs (5) = (3)+(4)
Central G-sec supply
CG-sec gap# (6)
Excess CG-sec demand (7) = (5)-(6)
% YoY
INR b
USD b
USD b
INR b
INR b
INR b
INR b
INR b
INR b
INR b
Base case
No FCNR
redemption
12.7
2,650
0.0
33.4
2,271
379
500
879
4,252
357
522
Higher FCNR
redemption
The RBI will have to buy
government securities
worth USD17.6b (or
INR1,195b) in FY17 to meet
M0 demand
-12.0
21.4
1,455
1,195
1,695
928
767
-20.0
13.4
911
1,739
2,239
1,717
522
Average USDINR rate of 68.0 assumed for FY17
* M0 growth = constant + α(real GDP growth) + β(non-food manufacturing WPI inflation) + ε,
# Please see Exhibit 72 on the next page
Source: RBI, Union Budget documents, MoSL
June 2016
48

Thematic | Economy
Additionally, to meet its intent of providing durable liquidity to the system, we
assume additional OMOs worth INR500b, implying total OMOs worth INR1,695b in
FY17. If so, we believe that there could be an excess demand for central government
securities, which will pull down yields towards 7% by March 2017.
The higher the redemption,
the lower will be deposit
growth, hurting banks’
ability to buy G-secs
Impact of FCNRB redemption on banks, and thus, G-secs
It is also important to note that FCNR(B) redemption would also have a direct impact
on banks’ deposits – banks are the largest holders/buyers of government securities.
The higher the redemption, the lower will be deposit growth, hurting banks’ ability
to buy G-secs.
Exhibit 72
below shows the potential buying of G-secs by commercial
banks under various scenarios – based on FCNRB redemptions. Under our base case
scenario of USD12b redemption, we assume that commercial banks (CBs) would
offset 70% of the redemption (12*68*0.7 = 571) by subscribing less to G-secs.
Accordingly, CBs will buy only INR1,147b (or 27%) of CG-secs supplied in FY17 as
against an estimated 43% in FY16. If so, there will be a gap of INR928b, which will
have to be bought by the RBI. Nevertheless, with OMOs worth INR1,695b, it implies
an excess demand for G-secs, which, we believe, will pull down yields towards 7%.
Exhibit 72: Key buyers of central government papers
Base
case
Total supply (1)
Total demand (2)
Net commercial banks’ demand = (a) - (b)
Commercial banks’ demand (a)
Impact of FCNRB redemption# (b)
FIIs
Insurance companies
Others* excluding RBI
G-sec gap = (1) – (2)
928
3,324
1,147
1,718
571
No FCNR
redemption
4,252
3,895
1,718
1,718
0
451
935
791
357
1,717
Higher FCNR
redemption
2,535
358
1,718
1,360
Average USDINR rate of 68.0 assumed for FY17,
Base case = $12b outflow; Higher FCNR(B) redemption = $20b,
# Assuming 70% of the reduction in deposits (USD12 bn) due to FCNR(B) redemption is financed by
subscribing to lower G-secs in Base case, 100% (of USD20 bn) in Bear case,
* Include provident funds, mutual funds, corporate etc,
Source: RBI, MoSL
Worst case may not really be worse for CG-secs
Lower FXR will require the
RBI to conduct more OMOs,
which, as per our estimate,
could be closer to
INR2,240b (or USD32.9b)
What if FCNRB redemption is much higher? Further, what if banks offset the entire
(100%) fall in deposits by CG-secs? Interestingly, it will not hurt bond markets
significantly, as we expect lower BoP surplus to be entirely offset by higher RBI
OMOs. A higher redemption (of say USD20b) on account of FCNRB this year, will
bring down BoP surplus to USD13.4b. It will also reduce the ability of banks to buy
CG-secs. However, lower FXR will require the RBI to conduct more OMOs, which, as
per our estimate, could be closer to INR2,240b (or USD32.9b) (see last column in
Exhibit 71
below). If so, even the higher G-sec gap of INR1,717b
(Exhibit 72)
will be
easily covered by higher OMOs. Therefore, even higher FCNRB redemption – the so-
called worst case scenario – may not really be worse for G-secs, which will continue
to witness excess demand, and thus, lower yield. The fall in yield, however, could be
closer to 7.1-7.2%, rather than 7%.
49
June 2016

Thematic | Economy
What if RBI grows reserve money (M0) by 10% instead of 12.7%?
One could argue that the real risk for G-secs in FY17 (which we otherwise believe
would be a good year for bond markets) is the possibility of RBI belief that lower
growth is required in M0. Let’s assume that RBI feels comfortable to increase
reserve money by 10% against our expectation of 12.7%. It means an increment of
INR2,100b in reserve money in FY17. As per our base case then, RBI will have to
conduct OMOs worth INR1,145b including OMOs for durable liquidity. Notably,
although there will be an excess demand for G-secs, it will be much lower at
INR217b, which may reduce the extent of fall in the benchmark sovereign yields.
Overall, we believe that FY17 will be a good year for bond markets, as the yields
could fall toward 7% due to excess demand for central government papers.
Overall, we believe that
FY17 will be a good year for
bond markets, as the yields
could fall toward 7% due to
excess demand for central
government papers
June 2016
50

Thematic | Economy
II.4.3 Exchange rate: Expect average of INR68/USD in FY17
We use a 6-currency (or narrow) REER (real effective exchange rate) model to
forecast INR/USD. Our INR/USD forecasts take into account movements in the
currencies of India’s other major trading partners such as the Euro (EUR) and the
Chinese Renminibi (CNY). We expect the INR to weaken 3.8% against the USD and
average at INR68/USD in FY17. It is most likely to weaken another 2.7% and average
at INR69.8/USD in FY18. (Please note that our forecasts are based on forecasts of
inflation for trading partners and the movements in EUR/USD and USD/CNY, which
we have taken from Bloomberg).
While the INR has
weakened ~37% in nominal
terms against the USD, a
large part of the weakness
has been offset by the rising
inflation differential,
leading to a minor ~7%
weakness in real terms
How much has INR weakened against USD in the past four years?
INR is down from 47.9 against USD in FY12 to 65.5 in FY16. ~37% weaker? No, INR
has weakened less than 7% since FY12. The difference between 37% and 7% is the
inflation differential between the US and Indian economies. While the INR has
weakened ~37% in nominal terms against the USD, a large part of the weakness has
been offset by the rising inflation differential, leading to a minor ~7% weakness in
real terms. The former (nominal exchange rate (NER)) is what we usually discuss in
daily work-life; however, what actually matters for the economy and investors is the
latter (real exchange rate (RER)).
Exhibit 73
below shows the movement of the INR
against the USD in nominal and real terms. Notably, INR/USD has been broadly
unchanged in real terms since 2012, as the sharp weakness in nominal terms was
largely offset by higher and rising inflation differential
(Exhibit 74).
Exhibit 74: …explained by the inflation differential
120
110
100
90
80
Mar-11
(2013-14=100)
Price differential
Exhibit 73: Differential between nominal and real USD/INR…
140
125
110
95
(2013-14=100)
80
Mar-11
Mar-12
Nominal USD/INR
Real USD/INR
Strong INR
Higher India's
inflation vis-a-vis US'
Weak INR
Mar-13
Mar-14
Mar-15
Mar-16
Mar-12
Mar-13
Mar-14
Mar-15
Mar-16
Source: RBI, Bloomberg
Source: RBI, Bloomberg
Though the INR has
strengthened ~10% against
the EUR in nominal terms in
the past four years, it has
strengthened ~18% in real
terms because of higher
inflation differential
What about EUR and CNY?
The US is India’s third largest trading partner. Eurozone is the largest trading
partner, followed by China. Therefore, it is important to understand the movements
in the Euro (EUR) and the Renminbi (CNY) against the INR; these are actually derived
from the movements of the EUR and CNY against the USD. Though the INR has
strengthened ~10% against the EUR in nominal terms in the past four years, it has
strengthened ~18% in real terms because of higher inflation differential
(Exhibit 75).
Moreover, like against the USD, while the INR has weakened ~37% against the CNY
in nominal terms, it has weakened ~11% in real terms
(Exhibit 76).
June 2016
51

Thematic | Economy
Exhibit 75: Differential between nominal and real EUR/INR…
138
126
114
102
(2013-14=100)
90
Mar-12
Mar-13
Mar-14
Weak INR
Mar-15
Mar-16
Nominal EUR/INR
Strong INR
Real EUR/INR
Exhibit 76: …and CNY/INR
130
120
110
100
(2013-14=100)
90
Mar-12
Mar-13
Mar-14
Weak INR
Mar-15
Mar-16
Nominal RMB/INR
Real RMB/INR
Strong INR
Source: RBI, Bloomberg
Source: RBI, Bloomberg
Expect INR to weaken against USD but strengthen in REER terms
Overall, apart from nominal exchange rate, domestic inflation also affects foreign
trade. Just like the exchange rate, understood as domestic currency relative to
foreign currency, the inflation differential between the domestic economy and the
trading partner is also important.
It is not possible to forecast
INR/USD without
accounting for other
important currencies such
as the EUR and CNY.
Therefore, we use a real
effective exchange rate
(REER) model to forecast
INR/USD
It is not possible to forecast INR/USD without accounting for other important
currencies such as the EUR and CNY. Therefore, we use a real effective exchange
rate (REER) model
14
to forecast INR/USD. We implicitly take into account the
movements of other important currencies against the USD. Since the narrow REER
consists of six currencies (including the USD), we use Bloomberg consensus
estimates for the remaining five currencies (USDEUR, CNYUSD, JPYUSD, HKDUSD
and GBPUSD). Further, we use Bloomberg estimates for inflation forecasts of trading
partners and merge them with our forecasts for India’s inflation to project INR/USD.
Given below
(Exhibit 77)
are our forecasts for bilateral exchange rates in nominal
terms and India’s narrow REER for FY17 and FY18.
Exhibit 77: Currency forecasts for the next two years
INR/USD
FY14
FY15
FY16
FY17F
60.5
61.1
65.5
68.0
INR/EUR
81.2
77.5
72.3
74.4
INR/CNY
9.9
9.9
10.3
10.3
REER*
99.9
106.0
109.4
109.8
FY18F
69.8
74.0
10.6
111.2
F = Forecasts
* Narrow index (against six currencies). This index is our calculation, which is insignificantly different
from official REER index.
Source: RBI, Bloomberg, MoSL
14
We have used forecasts for other currencies from Bloomberg as of May 31, 2016. The key assumption of our model is that INR/USD will
remain unchanged (at 100.0) in real terms in FY17 and FY18. We calculate the nominal INR/USD, using inflation forecasts for India (MoSL)
and the US (from Bloomberg) to calculate bilateral real exchange rate.
June 2016
52

Thematic | Economy
How do changes in foreign currency impact INR/USD?
Higher-than-expected
depreciation in any other
trading partner currency vis-
à-vis the USD will open the
room for further weakness in
INR against USD
Assuming the sanctity of Bloomberg forecasts, we do not expect the INR to weaken
towards 70 against the USD in FY17. Nevertheless, higher-than-expected
depreciation in any other trading partner currency vis-à-vis the USD will open the
room for further weakness in INR against USD.
Exhibit 78
below shows the impact of
a 10% shock (unexpected) in the five major currencies. Other factors remaining
unchanged, our analysis reveals that a 10% weakness in the EUR (average 0.99
against USD versus Bloomberg forecast of 1.10) in FY17 will allow the INR to weaken
an additional 3.5% against the USD to keep the REER level same as in our base-case
scenario. In other words, INR/USD could average 70.4 in FY17, as against 68.0, if the
EUR falls to parity against the USD.
Similarly, if the CNY weakens 10% more than current expectations, the INR will have
to weaken an additional 2.5% against the USD and average at 69.8 in FY17 to keep
the REER index unchanged at 109.8.
Exhibit 78: Impact of non-USD currency shock (10%) on INR/USD
INR/
USD
Base case
EUR
RMB
JPY
HKD
GBP
68.0
INR/
EUR
74.4
-7.3% (67.0)
INR/
CNY
10.3
-9.5%(9.3)
INR/
JPY
0.6
INR/
HKD
8.8
INR/
GBP
98.6
REER
109.8
113.7
112.7
110.5
110.5
110.5
70.4
69.8
68.4
68.4
68.4
3.5%
2.6%
0.6%
0.6%
0.6%
Adjusted
REER*
Adjusted Additional
INR/
weakness in
USD#
INR/USD
-1.9%(0.5)
-5.7%(8.0)
-10.1%(88.7)
The higher (lower) the
inflation in trading partner
(given India’s inflation), the
lower (higher) the nominal
depreciation needed to
maintain REER
Apart from nominal exchange rates, inflation will also tend to change REER. As a rule
of thumb, the higher (lower) the inflation in trading partner (given India’s inflation),
the lower (higher) the nominal depreciation needed to maintain REER. As a
corollary, the lower (higher) the domestic inflation (given foreign inflation), the
lower (higher) the nominal depreciation required to keep REER unchanged.
June 2016
53

Thematic | Economy
III. Will India be ready to grow at 10% by 2020?
Current growth model unsustainable; 10% looks challenging
We take a step forward and investigate what the Indian economy could look like in 2020.
In particular, we discuss if the economic growth could touch 10% by 2020.
We argue that it will be challenging for India to graduate from the current growth rate
of 8% per year to 10% on sustainable basis by 2020, unless there is a shift from
consumption-driven to investment-led growth.
This is primarily because we believe that the current level of retail inflation is high,
which will rise further under the existing economic model. We believe inflation must
fall towards 2-3% for at least a few quarters.
The initial phase of lower consumption growth could be painful; however, as inflation
undershoots the medium-term target of 4% and households start re-building their
savings, it will create conducive environment for investments to drive economic
recovery.
Besides, higher savings and lower inflation, global economy, and capital efficiency will
also play a key role in helping India to touch 10% growth in the 2020s.
Consumption-driven growth
will increasingly become
more destabilizing, as
inflation will face upward
pressure. Hence, India must
replace consumption with
investments as the key
growth driver
We believe that the current economic model, in which consumption continues to
outpace investments and drive real GDP growth, could remain in place for at least
the next two years (till FY18). This will help India touch 8% real GDP growth.
However, consumption-driven growth will increasingly become more destabilizing,
as inflation will face upward pressure. Hence, India must replace consumption with
investments as the key growth driver (opposite of what is recommended for China).
The issue does not seem alarming currently, especially due to the recent weakness
in inflation; however, the longer the current model continues, the more
unsustainable the economy will become. For sustainable growth, investments must
be the key driver. How does India shift from consumption to investments?
There are two ways in which India could bring investments to the forefront: First, by
increasing the investment rate (as % of GDP), and second, by increasing the
efficiency of investments (or capital). The latter is measured as incremental capital
output ratio (ICOR). Over 2004-08, the Indian economy witnessed a rise in
investment rate along with higher capital efficiency (or lower ICOR). A look at the
four Asian Tigers – Hong Kong, South Korea, Singapore and Taiwan – however,
shows that the former (higher investment rate) is an easy, convenient and more
widely established source of higher growth. The latter (higher capital efficiency) has
its limits.
There are two ways in
which India could bring
investments to the
forefront: First, by
increasing the investment
rate (as % of GDP), and
second, by increasing the
efficiency of investments
June 2016
54

Thematic | Economy
III.1. What does history tell us?
A comparison of Hong Kong
and Taiwan shows that
notwithstanding similar
investment rate, the
average growth rate in the
former was ~85% of that in
latter, primarily because of
better capital efficiency in
Taiwan
Exhibit 79
below shows the key economic parameters for the four Asian Tigers
between the 1960s and the 1980s, the high growth (8%+) period for these
economies. Two of the four economies – Hong Kong and Singapore – grew rapidly
without impressive capital efficiency (low ICOR). On the other hand, Korea had an
average growth of above 9% for three decades, with an investment rate of below
30% and an average ICOR of only 2.2x. A comparison of Hong Kong and Taiwan
shows that notwithstanding similar investment rate, the average growth rate in the
former was only 85% of that in latter, primarily because of better capital efficiency
in Taiwan.
Exhibit 80
compares ICORs of the Asian Tigers, reflecting different capital
efficiency in these economies during the high-growth period.
Exhibit 80: Capital efficiency in Asian Tigers
Korea
25
20
15
10
5
0
(x)
Singapore
Hong Kong
Taiwan
Exhibit 79: Summary of key parameters during 1960s-80s
Investment rate
1960s-80s
Hong Kong
Korea
Singapore
Taiwan
GDP
growth
8.2
9.2
8.7
9.7
ICOR*
7.4
2.2
5.7
3.5
Average
27.3
20.0
44.0
28.7
Min-Max
21.1-37.4
8.1-30.0
30.7-53.1
15.4-39.0
*Calculated as average investment rate in ‘t’ and ‘t-1’ period divided by
GDP growth in ‘t’ period
3-year moving average
Source: World Bank, Official sources, MoSL
Excessive reliance on either
method – higher
investment rate or better
ICOR – may make an
economy unsustainable
The history, thus, shows some economies witnessed higher growth due to better
capital efficiency and some due to higher investment rate. Excessive reliance on
either method – higher investment rate or better ICOR – may make an economy
unsustainable. The former may limit private consumption or lead to wider CAD,
while the latter may lead to underutilization of savings. A combination of the two
methods is the best way to approach sustainably higher growth. During 2004-08,
high growth in the Indian economy was driven by a rise in investment rate and
improved capital efficiency (ICOR). India must attain a similar model this time.
June 2016
55

Thematic | Economy
Barring the recent drop in
household savings, the
sector contributed almost
70% to the national savings
III.2. What is needed to increase investment rate in India?
For higher investments, national savings must rise. To start with, it is important to
look at the composition of total national savings. Barring the recent drop in
household savings, the sector contributed almost 70% to the national savings.
Therefore, it is imperative to understand the behavior of households. As shown in
Exhibit 81
below, household savings in India are divided into three parts – gross
financial savings (GFS), financial liabilities and physical savings (investments). Since a
large portion of financial liabilities is used to build physical savings, the former are
deducted from GFS to arrive at net financial savings (NFS). NFS, along with physical
savings, comprise total household savings.
Exhibit 81: Major contributors to India’s national savings
Household
% of GDP
Total
(1)=(4)+(5)
Gross financial
savings (2)
Financial
liability (3)
Net financial
savings
(4)=(3)-(2)
Physical
savings (5)
5.8
8.7
9.5
11.5
11.4
12.6
12.3
12.1
13.4
11.7
11.9
10.8
13.5
13.2
13.2
15.9
14.7
13.0
11.0
9.9
Private
corporate
sector (6)
4.4
4.2
3.8
4.3
3.7
3.3
3.9
4.6
6.6
7.5
7.9
9.4
7.4
8.4
8.0
9.5
10.0
10.8
12.7
12.8
Public
sector (7)
Total national
savings
(8)=(1)+(6)+(7)
FY97
15.8
11.2
1.2
10.0
FY98
18.1
10.9
1.6
9.3
FY99
19.5
11.5
1.5
10.0
FY00
21.7
11.7
1.8
10.2
FY01
21.3
11.4
1.5
9.9
FY02
23.1
12.1
2.2
10.5
FY03
22.2
12.7
2.4
10.0
FY04
23.1
13.7
2.5
11.0
FY05
23.6
13.8
3.7
10.1
FY06
23.5
15.8
5.0
11.9
FY07
23.2
17.8
6.6
11.3
FY08
22.4
15.5
3.8
11.6
FY09
23.6
12.9
2.9
10.1
FY10
25.2
15.3
3.1
12.0
FY11
23.1
13.9
3.6
9.9
FY12
23.6
10.7
3.3
7.4
FY13
22.4
10.7
3.3
7.4
FY14
20.9
10.4
2.7
7.7
FY15
19.1
10.0
2.3
7.7
FY16E
17.8
9.7
2.0
7.7
Data based on 2004-05 until FY11; 2011-12 base from FY12 onwards
2.2
22.4
1.9
24.2
-0.2
23.2
-0.5
25.5
-1.3
23.7
-1.6
24.8
-0.3
25.9
1.3
29.0
2.3
32.4
2.4
33.4
3.6
34.6
5.0
36.8
1.0
32.0
0.2
33.7
2.6
33.7
1.5
34.6
1.4
33.8
1.3
33.0
1.2
33.0
1.2
31.8
Source: RBI, CSO, MoSL
As per the recent available data, household savings declined to ~19% of GDP in FY15
(and below ~18% as per our estimate in FY16) from an all-time high of 25% in FY10.
While NFS has been unchanged at ~7.5% of GDP in the past five years, it has fallen
substantially from an average of ~11% in the first decade of the 21
st
century. The
latter matters because NFS is the key source of financing for non-household
domestic investments. Since NFS, however, is derived by deducting financial
liabilities from GFS, we delve deeper into household GFS and its constituents.
Overall, Indian households
prefer short-term safe
assets such as bank
deposits and resist risky
assets
A look at the composition of household GFS
(Exhibit 82)
shows that deposits (bank
and non-bank) account for more than half of total financial savings, another one-
third goes into long-term safe assets (insurance, pension and government paper),
currency accounts for another 10%, while risky assets (shares and debentures)
account for less than 5%. Overall, Indian households prefer short-term safe assets
such as bank deposits and resist risky assets. Bank deposits play a vital role in
household financial savings, and thus, India’s national savings.
56
June 2016

Thematic | Economy
Exhibit 82: Households’ gross financial savings (GFS) and components
% of GFS
Currency
Deposits
43.1
43.7
43.5
42.5
42.1
41.8
41.8
41.6
41.3
41.9
44.3
45.2
46.9
46.2
46.9
47.9
48.8
50.3
50.2
Life insurance
9.1
9.4
9.6
10.0
10.5
11.0
11.6
11.8
12.3
12.6
13.0
14.2
15.0
16.6
16.9
17.3
17.3
17.2
17.4
PF & pensions
17.8
17.9
18.5
19.1
19.3
18.8
18.2
17.5
16.8
15.9
14.9
14.1
13.6
13.6
13.5
13.2
13.0
12.8
13.1
Shares &
debentures
6.6
6.0
5.5
5.7
5.6
5.3
4.9
4.6
4.2
4.4
4.8
5.5
4.8
4.8
4.2
3.9
4.0
3.8
3.9
Claims on
government
Others*
FY97
11.7
FY98
11.2
FY99
11.1
FY00
10.8
FY01
10.2
FY02
10.2
FY03
10.0
FY04
10.1
FY05
9.9
FY06
9.7
FY07
9.6
FY08
9.