Stimulus to drive rebound in growth - Capital Economics
India Economics

Stimulus to drive rebound in growth

India Economic Outlook
Written by Shilan Shah
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India’s economy slowed sharply in the first half of the year but, with policy support being stepped up, growth should gradually recover. And despite the recent soft patch for the economy, we remain optimistic about India’s longer-term prospects.

  • Overview – India’s economy slowed sharply in the first half of the year but, with policy support being stepped up, growth should gradually recover. And despite the recent soft patch for the economy, we remain optimistic about India’s longer-term prospects.
  • Domestic Demand – A pullback in credit from NBFCs caused growth to drop sharply in the first half of the year. But policy stimulus has helped to lower funding costs, which should lead to a gradual recovery in investment and household spending over the coming quarters.
  • External Demand & Risks – The current account deficit narrowed a touch in the four quarters to Q2, and we think that the overall external position will remain secure over the coming quarters.
  • Inflation – Headline consumer price inflation has remained comfortably below the RBI’s target of 4.0% so far this year, but a continued acceleration in food inflation and pick-up in underlying price pressures are likely to push the headline rate above target in 2020.
  • Monetary & Fiscal Policy – The finance ministry is aiming to reduce the central budget deficit from 3.4% of GDP in FY18/19 to 3.3% of GDP in FY19/20. But this already looks doubtful. After five months, the deficit was already at almost 80% of the amount budgeted for the whole year, and several expansionary measures have recently been unveiled. Meanwhile, the RBI has slashed interest rates by a cumulative 135bp this year, and further loosening is still likely.
  • Long-term Outlook – We expect India to sustain growth of 5-7% per year over the next two decades, making it the fastest-growing major economy in the world. As a result, its economy should more than triple in size and its share of world GDP should double.

Key Forecasts

Key India Forecasts

Quarterly

Annual

% y/y

(unless otherwise stated)

2019

2020

Q2

Q3e

Q4f

Q1f

Q2f

Q3f

2018

2019

2020

2021

 

Output & Activity

GDP

5.0

6.0

6.2

6.4

6.4

6.5

7.4

5.8

6.5

7.0

Household Consumption

3.1

6.0

6.0

6.5

6.5

6.7

8.5

5.6

6.5

6.5

Government Consumption

8.8

8.0

8.0

8.0

6.0

6.0

11.3

9.5

6.5

6.0

Investment

4.0

6.0

6.0

7.0

7.0

7.0

12.2

5.0

7.0

8.0

Exports

5.7

7.0

7.0

7.0

7.0

7.0

10.6

7.5

7.0

8.3

Imports

4.2

6.0

6.5

7.0

7.0

7.0

16.2

7.5

7.0

7.5

External Sector (% of GDP)

Current Account (4Q Sum)

-2.0

-1.7

-1.5

-1.8

-1.8

-1.9

-2.4

-1.5

-2.0

-2.5

Prices

Consumer Prices

3.1

3.3

3.4

3.5

3.7

4.3

4.0

3.0

4.0

4.3

Wholesale Prices

2.7

1.0

0.8

1.5

2.5

3.5

4.3

1.8

3.0

4.0

Fiscal (% of GDP)

Central Government Balance1

-3.4

-3.6

-3.4

-3.2

General Government Balance1

-6.3

-6.6

-6.0

-6.0

Monetary (end period, %)

Repo Rate

5.75

5.40

4.90

4.90

4.90

4.90

6.50

4.90

5.25

6.00

Reverse Repo Rate

5.50

5.15

4.65

4.65

4.65

4.65

6.25

4.65

5.00

5.75

Cash Reserve Ratio

4.00

4.00

4.00

4.00

4.00

4.00

4.00

4.00

4.00

4.00

Markets (end period)

Sensex Equity Index

39,395

38,489

37,500

38,000

39,000

40,000

36,068

37,500

42,000

44,500

5-yr Government Bond (%)

6.77

6.36

6.50

6.50

6.50

7.00

7.20

6.50

7.00

7.50

10-yr Government Bond (%)

6.90

6.69

7.00

7.20

7.25

7.30

7.40

7.00

7.50

8.00

INR/USD

68.9

70.7

73.0

73.0

73.5

74.0

69.7

73.0

75.0

76.0

Gold ($/oz)

1,412

1,495

1,500

1,400

1,385

1,375

1,283

1,500

1,350

1,250

Brent Crude ($/pb)

67

62

60

60

62

64

54

60

65

68

Sources: Refinitiv, Bloomberg, Capital Economics; 1 Fiscal years (2018 = FY17/18)


Overview

Stimulus to drive rebound in growth

  • India’s economy slowed sharply in the first half of the year but, with policy support being stepped up, growth should gradually recover. And despite the recent soft patch for the economy, we remain optimistic about India’s longer-term prospects.
  • India’s much-maligned GDP data show that growth slipped to a six-year low in Q2. (See Chart 1.) Much of the slowdown appears to be related to a pullback in credit from the non-bank financial (NBFC) sector ever since a large-scale default last year. This has caused investment and consumption growth to slump.
  • But policy support has been stepped up. The Reserve Bank of India (RBI) has trimmed interest rates by 135bp so far this year while also unveiling other liquidity-inducing measures. This has helped to bring down funding costs for NBFCs. (See Chart 2.)
  • Meanwhile, fiscal policy has also been loosened, with the finance ministry recently announcing tax breaks for large firms. This should help to support growth over the coming quarters, albeit at the cost of the government running a wider budget deficit than it originally projected. (See Chart 3.)
  • In all, the acute weakness of the first half of the year is unlikely to persist, although the rebound is more likely to be gradual than spectacular. We are forecasting growth of 5.8% this year and 6.5% in 2020, from 7.4% in 2018.
  • The external position looks secure. In the near term, relatively lacklustre domestic demand will keep a lid on imports. Barring a surge in oil prices, this should keep the current account deficit contained. (See Chart 4.) And India’s low level of foreign-currency debt means that the further falls in the rupee we are expecting won’t have severe economic consequences.
  • Headline inflation also remains in check and below the RBI’s 4.0% target. But if we are right that growth will recover, that will put upward pressure on underlying inflation, causing the headline rate to edge above target over the coming months. (See Chart 5.)
  • The current easing cycle still has a little further to run but, beyond the very near term, we think the MPC will opt for modest rate hikes before the end of 2020. (See Chart 6.)
  • We’ve made relatively sanguine assumptions. However, a key risk is the government’s continued attempts to undermine the independence of the RBI – most recently by strong-arming the central bank into transferring a windfall dividend to the finance ministry. A loss of central bank credibility could cause an unmooring of inflation expectations over the coming years.
  • This is a blot on an otherwise fairly upbeat long-run outlook. Structural reforms have been stepped up over recent months, with the government consolidating some state banks and reducing restrictions on foreign direct investment.
  • And aided by the strongest electoral mandate since the early 1980s (see Chart 7) as well as a relatively stable consensus over the importance of reform, the Modi government is likely to continue gradually implementing growth-enhancing measures over the course of its second term. Overall, we think the economy will be a star performer in the emerging world over the next decade. (See Chart 8.)

Overview Charts

Chart 1: GDP (% y/y)

Chart 2: NBFC AAA-Rated Corporate Bond Yield (%)

Chart 3: Central Gov’t Fiscal Deficit (% of GDP)

Chart 4: Current Account Balance (4Q Sum, % of GDP)

Chart 5: Consumer Prices (% y/y)

Chart 6: RBI Policy Rates (%)

Chart 7: Lok Sabha Election Results
(% of Seats Won by Leading Party)

Chart 8: CE GDP Forecasts
(2018 – 2027)

Sources: Refinitiv, CEIC, Bloomberg, Capital Economics


Domestic Demand

Activity to recover from H1 weakness

  • India’s national accounts data are much-maligned but, the latest numbers showing a further slump in growth in Q2 do at least tally with other indicators. For example, the OECD’s leading indicator for India, which aims to capture swings in the business cycle, points to a loss of momentum since the start of the year. (See Chart 9.)
  • According to the GDP data, private consumption was the biggest drag on growth in Q2, while investment growth also remained sluggish. (See Chart 10.) Much of the slowdown appears to be related to problems in the non-bank financial (NBFC) sector, which has faced a sharp rise in funding costs ever since the large-scale default by the IL&FS Group last year. But more recently, the RBI’s rate cuts and other liquidity-inducing measures have helped to bring down NBFC funding costs. (See Chart 11.)
  • That should help to support economic activity. Timely data on production of capital goods suggest that, while a spectacular rebound is unlikely, the slump in investment growth has at least bottomed out. (See Chart 12.)
  • Household consumption growth should also gradually pick up. In particular, the drop in issuance of car loans from NBFCs should start to reverse as funding costs drop, which will provide some much-needed support for the beleaguered autos sector.
  • More broadly, consumption of smaller ticket items should hold up well over the coming months. Growth in production of non-durable goods has remained robust despite the broader slowdown in industrial production. Meanwhile, growth in personal loans (excluding for vehicles) continues to rise at a decent pace. (See Chart 13.)
  • Consumers will also benefit from the (partial) guaranteed income scheme introduced by the government prior to the general election, as well as the current level of oil prices, which we expect to remain relatively low by recent standards over the coming years. (See Chart 14.)
  • Structural factors, including India’s youthful demographics and a low level of household debt (see Chart 15), provide further reasons to remain upbeat on the long-run prospects for private consumption.
  • Government consumption growth dropped in Q2 as spending was reined in after the general election. But while a renewed surge is unlikely, it is unlikely to become as much of a drag as we had previously thought. The finance ministry has recently unveiled several expansionary measures including cuts to corporation tax, with an estimated cost of US$20bn (0.7% of GDP). (See the Monetary & Fiscal section below for more on the implications for the fiscal deficit.)
  • Bringing all of this together, we think the economy will grow by 5.8% this year, and rebound to 6.5% next year as policy stimulus takes effect. Our forecasts are below those of most forecasters, including the IMF. (See Chart 16.) But India should nonetheless remain one of the world’s fastest growing economies over the coming years.

Domestic Demand Charts

Chart 9: OECD Composite Leading Indicator

Chart 10: GDP by Expenditure (% y/y)

Chart 11: NBFC AAA-Rated Corporate Bond Yield (%)

Chart 12: Investment & Capital Goods Production

Chart 13: Total Credit (% y/y, 3ma)

Chart 14: Brent Crude ($pb)

Chart 15: Household Debt (% of GDP)

Chart 16: GDP (% y/y)

Sources: CEIC, Bloomberg, Capital Economics


External Demand & Risks

External position not under threat

  • The current account deficit narrowed a touch in the four quarters to Q2, and we think the overall external position will remain secure over the coming quarters.
  • Admittedly, merchandise export growth has been weak (see Chart 17), and the downbeat outlook for global demand suggests that a sharp turnaround is unlikely any time soon.
  • But import growth is also likely to remain subdued as the costs of key commodity imports remain low. Global oil prices are still low by recent standards. We think that they will edge up only slightly over the next year as a sluggish global economy keeps a lid on prices. This will have a material impact on the import bill, given that oil accounts for around 25% of goods shipments into India.
  • The recent surge in gold prices is also not as big a concern as it has been in the past, as a shift in consumers’ preferences for the precious metal is likely to keep import volumes in check. We think that gold imports will stay at around 1% of GDP in annual terms, in contrast with past highs of more than 3%.
  • Trade relations between the US and China remain a big concern for much of Asia. Our baseline assumption is that the trade war will escalate in the run up to next year’s US presidential elections. But this matters little for India due to its limited supply-chain exposure to China (see Chart 18), an inadvertent positive stemming from its failure to develop a world-class manufacturing sector.
  • India doesn’t look particularly exposed to a more protectionist US either. Total merchandise exports from India to the US are equivalent to less than 2% of Indian GDP. (See Chart 19.)
  • Finally, India is the largest recipient of overseas remittances in the world (see Chart 20), and we think that inflows will remain fairly strong over the coming years – in part a reflection of the fact that newer technologies are helping to reduce the cost of sending money home.
  • Bringing all of this together, we expect the current account deficit to remain contained at around 1.5-2.5% of GDP over the next few quarters. (See Chart 21.)
  • What also matters is how the current account deficit will be financed. The latest data show that net foreign direct investment inflows – which tend to be the most stable and long-term source of funding – held steady throughout the first half of 2019, and were significantly higher than volatile portfolio inflows. (See Chart 22.)
  • We are optimistic that FDI inflows will rise over the coming quarters. After all, policymakers have recently announced measures to ease restrictions on FDI in several sectors, echoing the Modi government’s welcoming approach to foreign investment in the initial years of its first term. We think that further FDI reform is likely.
  • On the rupee, we expect weakness against the dollar over the next couple of years as slower global growth causes investors to retreat from riskier assets. We expect it to depreciate to 73/$ by end-2019 and 75/$ by end-2020, from around 71/$ currently. (See Chart 23.)
  • There should be limited economic fallout from this. After all, the fall in trade-weighted terms will be mild, and India has a very low burden of FX debt (see Chart 24), meaning that renewed currency weakness won’t exacerbate strains in the banking sector.

External Demand & Risks Charts

Chart 17: Goods Exports ($USbn)

Chart 18: Origin of Value Added in China’s Exports to US (% of country’s GDP, 2018)

Chart 19: Goods Exports to US (% of GDP, 2018)

Chart 20: Remittances Inflows ($USbn)

Chart 21: Current Account Balance (4Q Sum, % of GDP)

Chart 22: Net Capital Inflows (4Q Sum, % of GDP)

Chart 23: Rupee vs $US

Chart 24: FX Debt (% of GDP, 2018)

Sources: Bloomberg, CEIC, Capital Economics, World Bank


Inflation

Inflation to rise above RBI target before long

  • Headline consumer price inflation has remained comfortably below the RBI’s target of 4.0% so far this year, but we think that it will rise above target in 2020 as food inflation accelerates and underlying price pressures start to pick up.
  • Predicting movements in headline CPI inflation is difficult given the volatile nature of food and fuel prices, and their large weighting in the consumer price basket. (See Chart 25.) However, high-frequency price data can provide some indication over the near term.
  • Food inflation looks set to rise further over the coming months. Vegetable prices have jumped since March and, even if they now stabilise in seasonally-adjusted terms, vegetable price inflation will still accelerate over the next six months or so. (See Chart 26.)
  • Meanwhile, we are forecasting the price of Brent crude oil to rise slightly in 2020, which would be consistent with a rebound in transport inflation beyond the next couple of months. (See Chart 27).
  • In contrast with the recent acceleration in the headline rate, core inflation has dropped sharply since the start of the year. (See Chart 28.) But we think that core inflation will rise again soon.
  • Admittedly, the decline in the price of gold in rupee terms that we expect should weigh on “personal care” inflation (a key component of core CPI) in the year ahead. (See Chart 29.)
  • However, domestic demand is likely to pick up over the coming quarters. After all, fiscal policy has been loosened significantly and interest rates have been slashed by a cumulative 135bp so far this year. Further monetary easing also looks likely.
  • As a result, underlying price pressures should rise and push headline CPI inflation above the RBI’s target by the middle of next year. (See Chart 30.) We think the MPC will respond by modestly hiking interest rates before the end of 2020. That would be in line with the fact that policy rates in India very rarely stay on hold for prolonged periods.
  • The longer-term concern is that the independence of the RBI is being eroded. This has intensified following the central bank’s recent decision to transfer a record dividend to the government this year.
  • Our forecasts are relatively sanguine. We expect inflation to average 3.0% in 2019 and 4.0% in 2020. But if the RBI caves in to government pressure and delays tightening policy in an environment of higher inflation, it risks losing credibility. That could cause a partial reversal in the success that it has had in reining in price pressures since 2013. Inflation expectations have a decent relationship with actual inflation. (See Chart 31.)
  • Wholesale price inflation has recently fallen to its lowest rate in two years. (See Chart 32.) Fuel inflation is likely to keep a lid on the headline rate throughout the rest of the year as global oil prices remain low. Nevertheless, we think that underlying price pressures will soon build. In turn, WPI inflation should bottom out over the coming months.

Inflation Charts

Chart 25: Consumer Price Basket (%)

Chart 26: Weekly Vegetable Prices and
Vegetables CPI (% y/y)

Chart 27: Brent Oil Price and
Transport & Communications CPI (% y/y)

Chart 28: Consumer Prices (% y/y)

Chart 29: Gold Prices and Personal Care CPI (% y/y)

Chart 30: Consumer Prices (% y/y)

Chart 31: Actual and Expected Inflation (%)

Chart 32: Wholesale Prices (% y/y)

Sources: Refinitiv, CEIC, Dept of Consumer Affairs, RBI, CE


Monetary & Fiscal Policy

Finance Ministry on course to miss fiscal deficit target

  • The finance ministry is aiming to reduce the central budget deficit from 3.4% of GDP in FY18/19 to 3.3% of GDP in FY19/20. But this already looks doubtful. After five months, the deficit was at almost 80% of the amount budgeted for the whole year. (See Chart 33.)
  • Admittedly, the finance ministry will receive a bumper dividend payment worth 0.9% of GDP from the RBI this year. (See Chart 34.) Only about half of this was initially budgeted.
  • However, Finance Minister Nirmala Sitharaman has unveiled several expansionary measures over recent weeks. Among the most notable, the rate of corporation tax for domestic companies has been trimmed from 30% to 25%. New companies set up after 1st October will be subject to a corporation tax of just 15%. The finance ministry puts the cost of these measures at US$20bn (0.7% of GDP).
  • Compounding the matter, the finance ministry is still relying on bullish projections for revenue collections from the GST, which habitually fall short of target. (See Chart 35.)
  • And Ms Sitharaman has set the asset sales target for this year at a record INR1.0trn (0.4% of GDP). (See Chart 36.) Despite some recent success, this target is often missed, and achieving this year’s goal is reliant on the smooth sale of Air India – the national carrier. This seems highly unlikely given that an initial deadline for companies to register an interest in buying Air India last year passed with no companies submitting proposals.
  • In all, we think the finance ministry will have no choice but to relax its deficit target – as has been the case in three of the past four fiscal years. A looser fiscal stance should provide some support to growth over the coming quarters, but it also means that debt levels won’t fall as fast as anticipated. We estimate that public debt will fall to 66% of GDP by 2023, compared to the IMF’s current forecast of a fall to 63% of GDP. (See Chart 37.)
  • On monetary policy, the Reserve Bank under the stewardship of Shaktikanta Das has trimmed interest rates by a cumulative 135bp so far this year. Further easing looks likely. After all, the resignation of deputy governor Viral Acharya has reduced the influence of hawks from the MPC, and in its most recent policy meeting the committee maintained its official stance at “accommodative”.
  • We are forecasting one more 25bp cut in this cycle. That would bring the repo rate down to 4.90%, the lowest since early 2010. (See Chart 38.) With efforts to improve the monetary transmission also being stepped up, the recent slowdown in lending growth (see Chart 39) should start to reverse.
  • Beyond the next few months, the gradual recovery in growth that we are expecting will put upward pressure on core inflation. We expect the RBI to respond with modest rate hikes towards the end of next year. This is in contrast to the consensus and markets, which expect no change in rates in 2020. And yet, the risks to our interest rate forecasts are on the upside. In particular, a perceived loss of independence at the RBI could cause an unmooring of inflation expectations, which may require more aggressive rate hikes.
  • If our more hawkish forecasts for monetary policy prove correct, it is likely that government bond yields will pick up over the coming quarters. We think the 10-yr yield could jump to 7.5% by the end of 2020, from around 6.7% currently. (See Chart 40.)

Monetary & Fiscal Policy Charts

Chart 33: Central Gov’t Fiscal Deficit

Chart 34: RBI Transfers to Finance Ministry

Chart 35: Central Gov’t Revenues From GST (INRbn)

Chart 36: Central Gov’t Asset Sales (INRbn)

Chart 37: Gross Government Debt (% of GDP)

Chart 38: RBI Policy Rates (%)

Chart 39: Bank Lending to Private Sector

Chart 40: 10-Yr Government Bond Yield (%)

Sources: Controller General Accounts, RBI, Refinitiv, Capital Economics


Long-term Outlook

India to remain a global outperformer

  • We expect India to sustain growth of 5-7% per year over the next two decades, making it the fastest-growing major economy in the world. As a result, its economy should triple in size and its share of world GDP should almost double. (See Chart 41.)
  • Employment is likely to increase rapidly for two reasons. First, the expansion in the working-age population is set to continue. India will replace China as home to the world’s largest labour force by 2025. (See Chart 42.)
  • Second, female employment is likely to increase from its current very low levels. (See Chart 43.) India’s low female participation rate is often attributed to entrenched cultural norms. But we think it reflects a historic failure to implement labour market reforms and develop the strong manufacturing base that has been the gateway for women in poor countries to enter formal employment.
  • Labour market reform will probably continue to be sluggish in the near term, but we are more optimistic about long-run prospects. Some of India’s more progressive states – such as Rajasthan – have been rolling out reforms to ease the process of hiring and firing workers and reduce trade union power. Such reforms should eventually spread to other states and influence policymaking by the central government.
  • Similarly, other productivity-boosting reforms should continue. Prime Minister Modi’s BJP secured the largest single-party majority in the Lok Sabha since the early 1980s in this year’s election, which should lay the platform for continued gradual reform. Further ahead, growing pressure from businesses and investors should ensure that politicians continue to make progress on reform regardless of who is in power.
  • Our optimism about long-run productivity prospects is underpinned by structural factors. India’s low per capita income means it has the potential to deepen its capital stock, shift the labour force from low to high productivity sectors, and replicate the best practices of richer economies. India should also benefit from high savings and investment rates.
  • The combined central and state budget deficits will remain fairly high, but public debt is still likely to come down gradually as a share of GDP due to the economy’s rapid growth rate.
  • The broad trend is that inflation typically falls as emerging economies converge with advanced economies. Under the stewardship of Shaktikanta Das, the RBI appears less focussed on reining in inflation. But a complete reversal of the inflation-taming success of recent years is unlikely. And we suspect that the RBI will further reduce its inflation target over time, as central banks in many wealthier EMs have done.
  • India is likely to run a small but permanent current account deficit over the long term. After all, domestic investment is likely to remain higher than domestic savings given the government’s tendency to run a budget deficit.
  • The real exchange rate is likely to continue appreciating over the coming years due to strong productivity gains. And given structurally lower rates of inflation now, the pace of depreciation in the nominal rupee exchange against the US dollar will be slower than it has been over the past couple of decades. (See Chart 44.)

Long-term Outlook Charts

Chart 41: Share of World GDP (%, PPP Exch. Rates)

Chart 42: Working Age Population (Millions)

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Chart 43: Female Labour Force Participation (%, 2018)

Chart 44: Rupee vs. US$

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Sources: UN, CEIC, Thomson Reuters, Bloomberg, Capital Economics

Key Forecasts (%y/y, Averages, unless otherwise stated)

2000-2007

2008-2012

2013-2017

2018-2022

2023-2027

2028-2037

Real GDP

7.1

6.4

6.7

6.7

6.2

5.5

Real consumption

5.5

7.7

6.9

7.5

6.0

5.0

Productivity

5.1

6.6

5.3

5.2

4.6

4.0

Employment

2.0

0.3

1.6

1.5

1.5

1.5

Inflation (%, year average)

4.9

9.7

6.1

4.2

4.0

2.8

Policy interest rate

(Repo rate, %, end of period)

7.8

8.0

6.0

6.5

7.0

7.0

Local currency 10-year gov’t bond yield

(%, end of period)

7.8

8.2

7.5

7.3

7.8

7.8

Government balance (% of GDP)

-8.6

-8.6

-7.0

-6.9

-6.0

-6.0

Government debt (% of GDP)

79.3

70.7

69.0

68.0

66.7

68.0

Current account (% of GDP)

-0.1

-5.1

-1.4

-2.0

-1.7

-1.7

Exchange rate (INR per USD, end of period)

41.4

53.4

65.1

77.0

80.0

85.0

Equity market (Sensex, end of period)

20,287

19,426

34,056

46,000

59,305

140,240

Nominal GDP ($bn)

1,238

1,805

2,136

3,510

5,493

10,351

Population (mn)

1,116

1,230

1,309

1,383

1,451

1,538


Shilan Shah, Senior India Economist, +65 6595 1511, shilan.shah@capitaleconomics.com
Darren Aw, Asia Economist, +65 6595 5193, darren.aw@capitaleconomics.com
Mark Williams, Chief Asia Economist, +44 20 7811 3903, mark.williams@capitaleconomics.com

Written by
Darren Aw Emerging Asia Economist
darren.aw@capitaleconomics.com +65 6595 5193
Mark Williams Chief Asia Economist
mark.williams@capitaleconomics.com +44 (0)20 7811 3903