APRIL 2015

ECONOMIC AND INVESTMENT COMMENTARY

Fundamentals:
India - Great Expectations

Global investors are constructive on India. Improved macro balances

support this view. But structural reforms will take time.
In what is proving
to be a challenging
year for many
emerging markets,
India stands out
as an economy
with both strong and improving
growth prospects. India is in fact set
to become the fastest growing major
economy in 2015. In this edition of
Fundamentals, LGIM Emerging Market
Strategist, Brian Coulton, examines
the medium-term outlook.

INSIDE:
Market overview:
Equities surges
and bond
bubbles
Snapshot:
UK housing - One
Direction?
UK forecast:
Inflated opinions

Few countries have seen as rapid a

turnaround in global investor sentiment as
India over the last two years. In mid-2013
the Indian rupee was one of the weakest
performing emerging market currencies
as a large current account deficit, declining
foreign currency reserves, high inflation
and sluggish growth placed India firmly

in the Fragile Five group of countries. By

contrast the rupee has been one of only a few
global currencies to have remained broadly
steady against an otherwise surging US
dollar since last October.
Lucky Generals
There is no doubt that some of this shift in
fortunes is down to luck. In particular, India
has benefitted greatly from the massive
decline in global oil prices. Indias net oil
imports were USD102bn or 5.4% of GDP in
2013-14. Lower oil prices have seen Indias
gross monthly oil import bill fall to USD7bn
in early 2015 from USD14bn in September
2014 and the overall trade deficit has
improved by a similar amount (figure 1).
In addition to improved external balances,
lower global oil prices have helped bring
down inflation and reduce the scale of fiscal
subsidies required to keep retail energy

Rolling 4 quarter, % GDP

Figure 1. The trade deficit has improved

India: Current Account Balance

0.0

02

ECONOMIC AND INVESTMENT COMMENTARY

-2.0
-4.0
-6.0
-8.0
-10.0
-12.0
Q1 2012

Q1 2013
Current Account

Q1 2014
Trade Balance

Sources: RBI, Datastream, LGIM

But it would be churlish to put the

majority of Indias turnaround
mainly down to good fortune.
Firstly, macroeconomic policy
settings have improved in the last
couple of years, helping to reduce
previous imbalances. Secondly,
the new political landscape
ushered in after the May 2014
election raises the chances of
growth-enhancing structural
reforms being implemented.
Unintended Consequences
While it is easy to criticise policy
with the benefit of hindsight,
it looks as if macro policy was
eased too much in the wake of the
global financial crisis. On the fiscal
front, the federal government
primary balance swung from a
surplus of 1% of GDP in 20067 to a deficit of 3.2% of GDP in
2009-10. IMF estimates of the
cyclically adjusted primary deficit
(at the wider general government
level) show a huge 5% of GDP
deterioration between 2007 and
2009 (figure 2). This deterioration
was much larger than the average
across the G20 countries and
occurred despite economic

growth in India rebounding

very rapidly after just one weak
quarter in Q1 2009.
The fiscal easing had important
consequences for the balance of
savings and investment (figure
3). Private sector savings and
investment ratios did not move
dramatically in India after the
global financial crisis. This was
in contrast to many advanced
economies where household and
corporate deleveraging pressures
saw private savings rise and
investment fall after 2008. The
upshot was that the fall in public
sector savings contributed to a
widening in Indias current account
deficit, increasing the economys
reliance on foreign financing.
The rise in current government
spending also increased
inflationary pressure. One
component of the rise in
spending was an increase
in the coverage of the rural

In principle, the inflationary

consequences of these
redistributive policies could
have been contained by a strong
monetary policy framework.
But the reality was far from
this. Policy interest rates were
persistently negative in real
terms between 2009 and
2011, inflation and inflation
expectations were in the double
digit range and the monetary
framework was eclectic. The RBI
followed a multiple indicator
based approach with little clarity
about which inflation measure
wholesale or consumer

Figure 2. The primary deficit fell sharply

India: Fiscal Defcit and Current Spending

% GDP

prices (diesel, kerosene and LPG)

at centrally administered levels.
Serendipity has also struck in
the form of recent large upward
revisions to real GDP growth, as
Indias statisticians have revamped
the national accounts data.

employment guarantee scheme

(known as MGNREGA). This
scheme aims to ensure 100
days of paid work per year for
one adult in each volunteering
rural household. According to
RBI research, MGNREGA wage
rates were above market wages
in most of the key rural labour
markets. The indexation of
scheme wages to prices may also
have exacerbated the second
round inflationary impact of
global food price shocks. Rural
wage inflation increased sharply
after this scheme was rolled
out nationally in 2008 (figure 4).
Further inflationary fiscal support
to the rural sector was provided
in the form of large increases in
Minimum Support Prices (MSPs)
for farm produce over 2008-12.

15

14
13

12

% GDP

APRIL 2015

11
10

-2
2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15

Federal Primary Deficit

IMF cyclically adjusted primary deficit (general government,calendar years)
Federal Current Spending (RHS)

Source: MOF, IMF, LGIM

03

ECONOMIC AND INVESTMENT COMMENTARY

Figure 3. Savings and investment balance deteriorated in 2009

4

beginning of next year. Declines

in food and energy inflation have
played a big part in lower headline
CPI but core measures have also
been falling. Household inflation
expectations fell to their lowest
level for five years in Q4 2014.

India: Gross Savings and Investment

2
% GDP

0
-2
-4
-6
-8
-10
2003-04

2005-06

2007-08

2009-10

2011-12

2013-14

Savings Minus Investment, National (= Current Account Balance exc. Errors and
Omissions)
Saving Minus Investment, Public Sector

Source: MOF, LGIM

prices was the most important.

Uncertainties about the monetary
framework contributed to
pressure on the rupee in 2013.

spending on rural employment

guarantees has declined as a
share of GDP. Rural wage and
price inflation have fallen sharply.

Redressing the Balance

Most important of all, there

has been a major reform of the
monetary policy framework
with the introduction of a
formal inflation-targeting
regime based on the consumer
price index (figure 5). The RBI
started to re-orientate its policy
communication in early 2014 after
an internal committee proposed
shifting to a 4% target with
bands of +/- 2%. With actual CPI
inflation around 10% at that time,
the committee proposed a glide
path for approaching the target
of 8% by January 2015 and 6% by
January 2016. The government
recently formalised the framework
in line with the proposals.

Fiscal pressure on rural inflation

has also been scaled back.
The increase in MSP prices for
agricultural products has been
much lower in the last two
years. And as figure 4 illustrates,

The new arrangements got off

to a good start CPI inflation
fell to 5.1% in January 2015 and
looks set to be below 6% by the

The Modi government has made

some important progress to date.
Legislation has been introduced

Figure 4. Rural fiscal spending increased rapidly

0.7

India: Public spending on Rural Employment Guarantee Scheme and

Rural Wages

0.6

25
20

0.5
% GDP

Macro policy has, however,

taken a decisive turn for the
better over the last two years.
Firstly, the federal fiscal deficit
was brought down to 4.1% of
GDP in 2014-15, in line with the
target despite a 3% shortfall in
nominal GDP growth. The deficit
has been in line with budget
targets for three consecutive
years now and has fallen from
5.7% in 2011-12. Secondly,
current budgetary spending
has been reduced to below 12%
of GDP, the lowest since before
the global financial crisis. The
decline in fuel prices has helped
a lot, but the government also
took the opportunity to remove
diesel subsidies completely
last October. While the 2015-16
Budget announced a slower pace
of consolidation than entrenched
in previous medium-term plans,
it embedded a further decline in
current spending and an increase
in capital spending, a less
inflationary mix.

The long road to

structural reform
Prospects for structural reform
have improved since Prime
Minister Modis sweeping victory
in the May 2014 general election.
The new government has a strong
pro-growth and development
bias and has demonstrated a lot
of determination to push ahead
with change. However, political
realities mean the process of
implementation is likely to be
protracted. The key supply side
challenges lie in infrastructure
constraints particularly the
power sector, labour market
restrictions, inefficiencies in food
distribution and wider barriers to
internal trade. Labour laws, which
strongly discourage individual
firms from employing a large
workforce, are a barrier to India
developing the sort of low valueadded manufacturing export
industry that has been a key
driver of growth and urbanisation
in East Asia.

0.4

15

0.3

10

0.2

% YOY

APRIL 2015

0.1
0

0
2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15
Public spending on rural employment guarantee scheme (MGNREGA) as % GDP
Rural wage inflation (RHS)

Source: RBI, Ministry of Rural Development, LGIM

APRIL 2015

Figure 5. Clearer inflation targeting, based on CPI bands

India: Inflation Target

20
15
%

04

ECONOMIC AND INVESTMENT COMMENTARY

10
5
0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
CPI
Lower Tolerance

Target
Policy Interest Rate

Upper Tolerance

Source: RBI, DAtastream, LGIM

to allow for more inward foreign

direct investment in railways,
defence, real estate and insurance.
State-owned Coal India recently
sold a 10% equity stake and
mining laws have been amended
to allow for more transparent
auctions of mining rights and to
allow the mining of coal by the
private sector for commercial sale.
In addition, the 2015-16 Budget
prioritised infrastructure spending,
particularly on roads and railways.
Ongoing fiscal constraints mean
the share of public government
investment in GDP will remain
low, but efforts are underway to
encourage state firms and the
private sector to double-up on the
federal governments efforts on
infrastructure. At the micro level
there appears to be a strong effort
to encourage a more businessfriendly approach in the public
sector to help reduce many of
the inefficiencies that currently
constrain investment a measure
recently passed to reduce the
power and discretion of labour
inspectors was a good case in
point.
However, the political context
dictates that progress in many
of the key reform areas will
need to be built slowly and
carefully. In particular, many
of the laws and regulations
which have constrained the

supply side are wholly or jointly

under the purview of state level
governments. This is true, for
example, of labour legislation,
food distribution arrangements
and consumption taxes. While
Modi has a large majority in
the Lower House he lacks a
majority in the Upper House
where MPs are chosen by state
legislatures. Modis BJP party
directly controls only eight out
of 29 state legislatures and while
his popularity remains high,
the timetable of state elections
prevents a rapid turnaround.
Moreover the perception that
rural producers a key electoral
constituency could be losers
from structural reforms could
complicate Modis effort to win
hearts and minds on the benefits
of reform.
There are, however, grounds for
optimism. The government has
demonstrated an awareness of
the importance of the states to
the wider reform process and
shown a determined pragmatism.
In the area of labour reform it has
encouraged states to enact their
own changes and taken measures
to facilitate this. Several states,
led by Rajasthan, are moving
forward in raising the threshold
of employees above which firms
have to consult the authorities on
firing decisions.

More significantly, the latest

budget announced a move
towards increased fiscal
federalism, with states given a
much larger degree of control over
total government revenues than
before. These moves are part of
an effort to secure agreement on
the Goods and Services Tax (GST)
which will require a constitutional
amendment and hence consent by
the Upper House and a majority of
state legislatures. The GST would
help to broaden and simplify
Indias indirect tax base and would
pave the way for a single domestic
consumer market. Academic
research suggests the GST would
increase Indias growth by up to
1.5% per annum. Passage of the
GST by the national parliament
later this year which looks
increasingly likely would be a
major achievement.
Great expectations
India has no doubt benefitted
from factors beyond its control.
But the improvement in macro
balances also reflects better
economic policies. Fiscal policy
has been tightened, inflationary
fiscal support measures in the
rural sector have been scaled
back and the monetary policy
framework has been enhanced
dramatically. These changes
should help India achieve
growth rates of 7% to 8% over
the medium term. Structural
reform will inevitably be a slow
and complicated process, but
there is a good chance of material
changes being implemented.

APRIL 2015

05

ECONOMIC AND INVESTMENT COMMENTARY

Market overview:
Equity surges and bond bubbles
Last month, we mentioned
the return of volatility, which
has continued into March.
Equity strength shows no
signs of abating as Chinese
equities reached a 17-year
high, Japanese markets hit a
15-year peak, the German Dax
rose above the 12000 points
mark and the US was also
up, despite some intermittent
volatility. Meanwhile,
corporate bond spreads have
continued to compress while
government bond yields in
Europe are also lower. Indeed
the ongoing firmness in bond
markets has reignited concern
from some investors about
bond bubbles.

UK

Consumer spending growth

The combination of lower inflation,
oil prices and mortgage rates with
higher wages and employment
levels is resulting in a stellar
environment for UK consumer
spending. Survey data and GDP
growth have stabilised recently
in the UK, with growth expected
to move sideways throughout
the rest of the year. Osbornes
latest budget announcement
passed with little controversy as
the political race begins to heat
up ahead of the general election
in May. In the interim, domestic
equity indices have continued to
climb and government bond yields
have again moved lower as the
annual inflation rate fell to zero in
February.
US

Weaker data
With the notable exception of the
labour market, economic data from
the US are generally running below
expectations with the economic
surprise index now at its lowest
level since 2009. The market is

focused on whether the Federal

Reserve raises rates in June or
later in the year. There seems to
be rhetoric that supports both
sides, with some FOMC members
calling for earlier rate hikes in
order to avoid dangerous bubbles
whilst others are more sanguine,
referencing weaker wage growth
as justification for lower rates for
longer. The higher levels in US
equity markets may represent
the reassurance investors find in
current datas ability to quell the
Feds rate increase at a gentler,
moderate pace.

EUROPE

Austere politics
Political instability in Europe
continues to be the most
prominent risk for investors as
support for anti-austerity parties
in the periphery and core countries
will keep political pressure high.
Indeed, the latest Spanish local
election results showed a swing
towards anti-austerity parties.
However, as Draghi defends the
merits of quantitative easing in
Europe, factors such as better
credit demand and availability,

Figure 1. Global equity markets

130
120
110
100
90
80
Jan 2014

Mar 2014

May 2014

Jul 2014

Sep 2014

Nov 2014

S&P 500

Nikkei 225

FTSE All-Share

MSCI Emerging markets

Jan 2015

Mar 2015

Eurostoxx 50

Source: Bloomberg L.P. chart shows price index

performance in local currency terms

APRIL 2015

06

ECONOMIC AND INVESTMENT COMMENTARY

the boost from lower oil prices to

consumption and the increase to
export competitiveness provided
by the weaker euro could improve
European growth. Government
bond yields have fallen once
again across the curve, as equities
continue to trade at, or around,
near-term highs.

Figure 2. 10-year government bond yields

7
6
5

4
3
2
1
0
Jan 2014

Mar 2014

May 2014

Germany

US

Jul 2014
UK

JAPAN

Italy

Nov 2014

Jan 2015
Spain

Mar 2015
Portugal

Source: Bloomberg L.P.

Equity strength
The most recent purchasing
managers report release from
Japan was subdued but there are
some positives signs too. Exports
have increased in both yen and
volume terms and wage inflation
has increased with unions
expected to push for even larger
increases this year. Against this
backdrop, Japanese equities have
continued to post new highs and
government bond yields have
continued to fall.

Sep 2014

ASIA PACIFIC/EMEA

FIXED INCOME

Oily repercussions

Lower yields

Emerging markets have fared

badly from the oil price decline.
Russia and Brazil look vulnerable
in particular. Russias rapid
currency depreciation and
stronger balance sheet may
prevent a full-blown crisis, even
in the face of sanctions, but
Brazil has no policy space left
and its economy is expected
to contract this year. On the
other hand, policy easing in
China is set to cushion the
slowdown in investment as it
rebalances towards a consumer
led economy. Indeed, China cut
rates again this month, its second
cut in just three months. India is
set to be a global growth leader
this year as its reform progress
gathers pace.

Government bond yields across

the developed world were
lower month-on-month (in the
opposite direction to prices),
with the moves particularly
pronounced at the long end of
the curve. This may be down to
the ongoing rate brinkmanship
as the Federal Reserve remains
the focus for bond markets. Once
again, corporate bond markets
have made further gains with
many companies particularly
from the US taking advantage
of the particularly low yields in
European markets to issue new
debt. In the secondary market,
bonds such as Nestle have
dipped into negative territory, an
inconceivable situation just a few
years ago.

APRIL 2015

07

ECONOMIC AND INVESTMENT COMMENTARY

Snapshot:
UK housing One Direction?
The UK housing market appears to have reached an inflexion point. After shooting higher in 2013, mortgage
approvals reversed course in 2014, wiping out most of the previous years gains. Various culprits were
blamed: the mortgage market review was formally introduced in the spring of 2014, making it more arduous
to get a loan. The Bank of England added to this over the summer by introducing a cap on the share of high
loan-to-income ratio mortgages. Two MPC members also began to vote for higher interest rates.
Offsetting this was a stronger domestic economy, with unemployment falling rapidly. The governments
Help to Buy scheme saw a return of low-deposit mortgages. And deflation fears in the euro area led to
gilt yields and UK mortgage rates hitting record lows. The government also cut stamp duty for 98% of
homebuyers in December.
The rot seems to have stopped. Data from both banks and estate agents suggest housing activity has
bottomed in recent months (figure 1). We expect this tentative recovery in demand to continue but the
pace remains uncertain. On the positive side, with inflation significantly below target, the Bank of England
is unlikely to hike interest rates this year, and the ECBs QE programme should also keep gilt yields low. But
Mays general election brings political risk: fears of a hung parliament, mansion tax and EU referendum will
cast a shadow over the market.
Figure 1. New estate agent buyer enquiries vs mortgage approvals
70

75,000

50

65,000

30

55,000

10

45,000

-10

35,000

-30

25,000
09

10

11

12

13

14

15

RICS survey - net % balance of agents reporting rising new buyer enquiries (LHS)
Number of mortgage approvals - official BoE data (RHS)
Number of mortgage approvals - preliminary British Bankers' Association data (RHS)

Source: Reuters ecowin

Despite falling demand, house prices continued to grind higher last year. Homebuilders were quick to
cut housing starts in line with sales. With supply also constrained by falling unemployment and recordlow interest rates, estate agents continued to report demand outstripping supply last year. The ratio of
the number of sales relative to the number of properties on their books remained above average in 2014,
consistent with solid real house price gains (figure 2).
Looking forward to 2015, we suspect strong fundamentals will ultimately outweigh political risks and both
housing turnover and house prices will edge up together in one direction.
Figure 2. UK house prices vs RICS sales-to-stock ratio
50

0.8

40

0.7
0.6

30

0.5

20

0.4

10

0.3

0.2

-10

0.1
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
UK Nationwide house prices, 6-month annualized growth rate (LHS)

RICS sales:stocks ratio (RHS)

Source: Reuters ecowin

APRIL 2015

08

ECONOMIC AND INVESTMENT COMMENTARY

UK forecast:
Inflated opinions
UK economy

Price inflation
(CPI)

GDP
(growth)

10-year
gilt yields

Base rates

$/

Market participants forecasts

2014
%

2015
%

2014
%

2015
%

2014
%

2015*
%

2014
%

2015*
%

2014

2015**

2014

2015**

High

1.60

2.40

3.10

3.00

2.90

3.10

1.00

1.25

1.64

1.77

0.80

0.89

Low

-0.20

0.80

2.30

1.50

1.60

1.80

0.50

0.75

1.35

1.37

0.62

0.63

Median

0.50

1.70

2.60

2.40

2.20

2.36

0.63

1.00

1.50

1.52

0.70

0.72

Last month median

0.50

1.70

2.60

2.40

2.15

2.38

0.75

1.00

1.51

1.53

0.73

0.73

Legal & General Investment Management

0.40

1.50

2.50

2.30

2.40

3.00**

0.50

1.00

n/a

n/a

n/a

n/a

Source: Bloomberg L.P. and LGIM estimates

*Consensus forecasts are for end of Q2 2016
**End 2016 forecast

GDP growth expected to move sideways is not an inspiring headline. But after several quarters of modest
acceleration, albeit not always smooth, we think weve reached a plateau in UK GDP. As a result, for the first time
in two years, we are no longer expecting the UK economy to defy expectations.
The main reason is oil. As we highlighted in Beyond Goldilocks February edition of Fundamentals, lower
oil prices will result in lower investment. For an economy with a significant oil and gas industry, that fall in
investment will have a negative impact on GDP. As well as a weaker investment outlook, sterling strength and
weak growth from OPEC and Russia mean that the prospects for exports are also underwhelming.
One area where we are more positive is consumption. Cheaper energy, coming at a time when more people are
working and wages are increasing, means we all spend more. Wage growth is now starting to come through at
the highest levels seen in two years and we expect this to continue to grind higher in 2015 as unfilled vacancies
fall and recruitment difficulties continue. However, we would expect wage growth to be slower in 2016 as after a
year of near zero inflation, wage demands are more likely to be muted.
Theres a lot of excitement with inflation reaching such low levels, and frequent comments that we could be
heading into a Japanese-style deflationary environment. We dont see that happening. If we look at headline
inflation, the fall in oil is probably the single biggest factor falling some $50 per barrel over the past year,
pushing consumer energy prices down by around 16% from Feb 2014. To repeat that same effect over the next
year, oil prices would have to fall towards zero!
However, this technical effect on headline inflation is not the only one to look for. Wage growth may be
increasing, but productivity is not. Productivity is a term that gets used a lot when looking at any economy. In the
case of the UK, productivity is usually preceded by weak. This perhaps gets taken for granted, but its worth
noting that productivity growth is currently near zero. Even with our expectation that this recovers somewhat,
we expect wage growth to outstrip this by around 2% which feeds directly into unit labour costs and ultimately
to core inflation. So while headline figures may bump along at or near deflation levels, wed expect this to be
relatively short-lived.
The forecasts above are taken from Bloomberg L.P. and represent the views of between 2040 different market participants
(depending on the economic variable). The high and low figures shown above represent the highest/lowest single forecast from
the sample. The median number takes the middle estimate from the entire sample.
For further information on Fundamentals, or for additional copies, please contact jennifer.daly@lgim.com
For all IFA enquiries or for additional copies, please call 0845 273 0008 or email cst@landg.com
For an electronic version of this newsletter and previous versions please go to our website
http://www.lgim.com/fundamentals
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