1. We thank staff for their assessment of the recent performance of the Indian economy and their suggestions to sustain the growth momentum while addressing the challenges arising out of increasing integration of the Indian economy with the global economy. The staff report captures the views of our authorities on a number of important issues that came up for discussion in the course of Article IV consultations. There, however, appears to be some difference of perception, particularly on management of the capital account and exchange rate. We briefly highlight the macroeconomic outlook for 2007-08 in the context of various risks and focus on some medium-term challenges.
Recent Performance and Outlook for 2007-08
2. In the current decade there has been a noticeable acceleration in economic growth. During the five years of the Tenth Plan period (2002-07) real GDP growth averaged 7.6 percent per annum. In the last two years (2005-07), real GDP growth accelerated even further averaging 9.2 percent. In the first half of 2007-08, real GDP has increased by 9.1 percent over the corresponding period of the previous year. Growth has been more broad-based with a near double digit growth in industrial production and a pick up in agricultural growth. It is expected that the current momentum would be sustained through the year as a whole.
3. Growth acceleration is well supported by increase in investment demand. At 1999-2000 market prices, the share of investment in GDP is estimated to have increased from 30.7 percent in 2005-06 to 32.2 percent in 2006-07 and further to 34.6 percent in the first half of 2007-08. As the current account deficit remains modest, the bulk of the investment demand is financed by increase in domestic saving. The steady increase in investment gives the cause for optimism that the economy may be moving into a high growth trajectory.
4. Inflation remains contained. During 2006-07 a major concern was possible overheating and risks of a build up of inflationary pressures. India, being a net importer of crude oil and a major consumer of foodgrains, remains vulnerable to both domestic and international supply shocks. Despite the sharp increase in international oil prices and high food prices, the headline inflation, as measured by year-on-year variation in the wholesale price index (WPI), has come down to 3.5 percent by December 2007 as compared with 5.9 percent in the corresponding period of the previous year. Even the consumer price index for industrial workers (CPI-IW), which has a larger share of food items, has come down from 6.3 percent in November 2006 to 5.5 percent by November 2007. The moderation in the inflation outlook reflects liquidity management, and the effect of fiscal measures such as import duty reductions, and administrative measures including import of essential commodities. The policy endeavour is to contain headline inflation close to 5 percent in 2007-08, which is likely to be achieved if there are no major supply and liquidity shocks.
5. Fiscal performance is expected to show further improvement. In 2006-07 both the gross fiscal deficit and revenue deficit of the Central Government turned out to be lower than budgeted. During 2007-08 so far revenue receipts have maintained their trend. Despite some front loading of expenditure, in absolute terms, fiscal deficit decreased by 11 percent and revenue deficit decreased by 17.2 percent during April-November 2007 compared with the corresponding period of the previous year. It is expected that the end-year fiscal and revenue deficit targets would be met and would be consistent with the Fiscal Responsibility and Budget Management (FRBM) road map. Most state governments have adopted rule based fiscal regime by enacting fiscal responsibility legislations. The combined gross fiscal deficit of state governments is budgeted to moderate from 2.8 percent of GDP in 2006-07 to 2.3 percent in 2007-08. More importantly, the state governments are expected to generate a revenue surplus during 2007-08. While the outlook for the combined fiscal position of the Centre and States for 2007-08 seems positive, our authorities are aware that the risk of overrun of expenditures remains.
6. The balance of payments remain manageable though trade deficit continues to expand. In 2006-07 merchandise exports, in US dollar terms, increased by 22.6 percent while imports expanded by 24.5 percent resulting in a trade deficit of over US $ 59 billion. This was largely offset by services exports and private remittances. Consequently, the current account deficit was moderate at US $ 9.8 billion, 1.1 percent of GDP. During the first eight months of 2007-08, both export and import growth rates have moderated over the corresponding period of the previous year. Consequently, the trade deficit continues to expand. Despite widening of the trade deficit, the current account deficit remained contained at US $10.7 billion during the first half of 2007-08, almost at the same level of the corresponding period of the previous year. For the year as a whole, the current account deficit is expected to remain moderate. However, deceleration of export growth rate and widening of trade deficit have raised concerns about the competitiveness of exports arising out of the appreciation of the Indian Rupee.
7. There has been a surge in capital inflows. Capital inflows nearly doubled from US $ 25 billion in 2005-06 to US $ 46 billion in 2006-07. In fact net capital inflows have crossed the US $ 50 billion mark during the first half of 2007-08 and staff projections show that such inflows would reach US $ 110 billion during 2007-08. Thus it is important to recognize that net capital inflows have more than quadrupled in a span of two years. Undoubtedly the fundamentals of the Indian economy have strengthened but at this stage it is not clear as to how much of capital inflows reflect the spillover of extraordinary liquidity injection in advanced markets. Given the uncertainties associated with the current context of global financial markets, our authorities prefer to exercise prudence before concluding that there is a substantial structural shift in the trend of capital inflows. Large capital inflows, however, have provided the opportunity to enhance the transparency of the source of portfolio inflows into the economy. Moreover, the pace of liberalisation of capital outflow has also been hastened. Actual capital flows (gross) due to external commercial borrowings (ECB) were much higher at US $ 13.7 billion during the first half of 2007-08 as compared with US $ 7.5 billion in the corresponding period of the previous year, despite the change in ECB norms. Thus, the ECB measures need to be viewed in the context of modulating debt-creating flows, depending on the domestic investment requirement, rather than an exercise to stopping such flows. Moreover, active management of capital inflows has not restrained investment activity. The overall investment rate remains high which is largely financed by domestic saving, with only about a quarter of net capital inflows during the last three years being absorbed.
8. Capital inflows have complicated monetary and exchange rate management. At the current juncture, the major policy challenge is the management of capital flows and the attendant implication for liquidity and overall stability. Sharp increase in capital inflows has had three primary effects. Firstly, the exchange rate has appreciated. For example, the rupee has already appreciated by around 10 percent against the US dollar between March 2007 and January 2008. The exchange rate policy has been guided by broad principles of careful monitoring and management of exchange rates with flexibility without any predetermined target. Secondly, capital inflows in excess of the immediate absorptive capacity of the economy have translated into an increase in reserves. During 2007-08 so far, foreign exchange reserves increased by US $ 76.1 billion, to reach US $ 275.3 billion by end-December 2007. It is important to recognize that India runs trade and current account deficits in its balance of payments. The reserve accumulation has taken place despite significant deficits. Given the current uncertainties in global financial markets and the spillover of liquidity into emerging markets, it is a matter of judgment as to how much of the capital inflows are of enduring nature. In absence of a reasonable answer to the determination of nature of liquidity, it is also a matter of judgment how greater an exchange rate flexibility will actually aid the process of easing the tensions of impossible trinity without damaging the competitive efficiency of the economy. Finally, reserve accumulation has had a liquidity impact. The expansionary monetary impact has, however, been largely sterilized by the Reserve Bank of India (RBI) through deployment of multiple instruments - issuance of bonds under the Market Stabilisation Scheme (MSS), increase in cash reserve ratio (CRR) and daily open market operations (OMO). Despite the sterilization operations, growth of money supply remains relatively high. However, credit growth has decelerated and currently remains within the projected trajectory of the RBI. With the moderation of credit growth, it is expected that aggregate demand would remain contained during 2007-08.
9. Costs of sterilization need to be weighed against the imperatives of stability. The determination of costs and benefits of sterilization is a complex issue. In the Indian context, the financial costs of sterilization through issuance of MSS have been transparently set out in the Government Budget. CRR and OMO being monetary instruments would in any case be used to maintain appropriate liquidity to retain monetary control. While different objectives of policy would have associated tradeoffs, on balance, reasonable stability has been maintained in the domestic real and financial sectors, thus contributing to global growth and stability. In the present context, given the multiple objectives, monetary policy retains the flexibility to respond to events on a continuous basis. This has been made clear in the periodic detailed quarterly reviews and is well understood by market participants.
10. Financial market conditions are generally stable. The overnight interest rate showed some volatility in the early part of 2007-08 reflecting excess liquidity conditions and global developments. With appropriate policy measures, it has reverted to the interest rate corridor set by the Liquidity Adjustment Facility (LAF) since August 2007. The yields on long-term government bonds have edged down reflecting stable inflationary expectations. While the sub-prime crisis in the US so far has had no major impact in the Indian financial markets, the RBI has sensitized the market participants with an emphasis on vigilance and preparedness in the context of global uncertainties. The buoyant conditions in the Indian capital markets witnessed over the last few years continue to be supported with large investment by Foreign Institutional Investors (FIIs).
Medium-term Challenges and Outlook
11. Reforms remain imperative. While the recent performance of the Indian economy has been impressive, our authorities are deeply conscious of the developmental challenges. There is a clear recognition in the Approach to Eleventh Plan (2007-12) that without significant new policy initiatives the current growth momentum cannot be sustained. There is, therefore, a need to persevere with reforms to attain faster and more inclusive growth.
12. The growth acceleration has had a favourable impact on the living standard of people. The percentage of persons below poverty line has declined from 36 percent of the population in 1993-94 to 28 percent in 2004-05. About 47 million additional work opportunities were created during 1999-2000 to 2004-05. Notwithstanding these positive developments, far too many people still lack access to basic services such as health, education, clean drinking water and sanitation facilities. Accordingly, the Eleventh Plan (2007-12) sets out the vision to restructure policies to make economic growth more broad-based and inclusive while maintaining the pace of growth. The average GDP growth is projected at 9 percent with acceleration through the plan period to end with a rate of around 10 percent. This would imply that with population growing at 1.5 percent per year, real per capita income could double in 10 years.
13. There is considerable emphasis on reinvigorating the agricultural sector which provides employment to nearly 60 percent of the labour force. Agricultural growth has been sluggish reflecting declining investment and absence of major technological breakthrough. The Eleventh Plan envisages a doubling of agricultural growth rate to 4 percent per annum through a step up in investment, expansion in irrigated areas, diversion into high value products, easy access to credit, improvement in incentive structure and functioning of markets. The Government is committed to an expenditure of Rs. 250 billion through public investment in agricultural sector in the next four years. The Government has targeted a disbursal of institutional agricultural credit of Rs. 2,250 billion during 2007-08. The reform of the cooperative sector which is under way would further increase the flow of credit to the agricultural sector on a sustainable basis. The challenges of providing rural infrastructure are being addressed through a flagship government programme (Bharat Nirman).
Industry and Infrastructure
14. The recent buoyancy in industrial performance reflects the competitiveness and productivity of industry in an increasingly open economy amidst significant reduction in tariffs. There is need for continued high growth of industry to absorb the disguised labour force dependent on the agricultural sector. The demographic dividend could be realized only if the labour force is provided with gainful employment. The Government recognizes the shortage of skilled manpower and inadequate infrastructure as the most critical barriers to the growth of the manufacturing sector. Accordingly, the Eleventh Plan envisages raising public spending in education to 6 percent of GDP and ensuring elementary education to all children by 2010. There is emphasis on significantly expanding vocational education and skill developments both through public investment and public private partnership (ppp).
15. Given the large infrastructure requirement of the country, development of infrastructure has been accorded high priority. Planning Commission have estimated the investment required for infrastructure at Rs.20 trillion or US $ 500 billon. Preliminary exercises suggest that investment in infrastructure would need to increase from the current level of 5 percent of GDP to 9 percent. These investments are to be achieved through a combination of public investment, ppp and exclusive private investment.
Achieving Fiscal Sustainability
16. The Government is committed to achieving the FRBM targets on schedule. With a buoyancy in tax revenues, the Government has comfortably met the half yearly target of total non-debt receipts for 2007-08. With the fiscal deficit target of 3.3 percent in 2007-08 in sight, the FRBM target of 3 percent by 2008-09 appears feasible. Despite pressure on resources, the Government has remained committed to the path of fiscal prudence and discipline.
17. The Government recognizes the need to contain subsidies in order to achieve the revenue deficit target. Apart from explicit subsidies, the issuance of bonds to oil companies, Food Corporation of India and fertilizer units have fiscal implications though these are considered cash neutral as there is no immediate cash outgo. The main objective of reform of the subsidy regime is to make them explicit, transparent and work for the poor. Policy options in the subsidy regime are aimed at improving the delivery with better targeting.
18. The approach to direct tax reforms has been towards creating an increasingly efficient, liberal and equitable tax system through reasonable tax rates, fewer exemptions and wider tax base. In the case of indirect taxes, the policy has been to over time reduce customs duty rates to ASEAN levels with significant reductions from year to year. The strategy with regard to excise duty has been to continue the policy of expanding the tax base rather than raise rates with an eventual move towards a single CENVAT rate. The tax base has been broadened by bringing several new services into the tax net. As regards state governments, the introduction of VAT has been a success. The reforms have resulted in steady increase in tax to GDP ratio. The next major step in the reform of indirect taxation is to move towards a national level Goods and Services Tax (GST) integrating the national Excise Duties and Service Tax with state VAT by 2010.
19. The tax administration has been strengthened through creation of new large taxpayers units, expansion of mandatory electronic filing of returns, extension of e-payment facility and making the permanent account number (PAN) as the sole identification number for all participants in the securities market. These measures have resulted in a large increase in income-tax assessees.
20. As regards the expenditure policy, emphasis has shifted from outlays to outcomes so as to ensure that the budgetary provisions are not only spent within the year but the intended outcomes are actually achieved. There is a proposal to consolidate outcome budgets of various ministries of the Government for transparency and better accountability. Further, a set of austerity measures such as ban on creation of new posts has been implemented. While the focus is on moderation of non-developmental expenditure, in view of the growing need for expenditure on social sector and physical infrastructure, the approach to fiscal consolidation continues to be revenue driven.
Ensuring Financial Stability
21. As regards financial sector policy, the emphasis has been to develop a sound, efficient and diversified financial system to facilitate a smooth transmission of monetary policy with financial inclusion. The RBI has consistently emphasized the importance of developing financial markets as well as operational flexibility of market participants in various segments secured by effective regulation and oversight. Keeping in view the increasing complexities and innovations in the organizational structures and processes in the Indian banking system, the cross-border mergers and acquisitions by the Indian banks and corporates and financial globalization, the RBI has taken several initiatives to provide greater sophistication and refinement to its supervisory and regulatory processes. Some of those initiatives are strengthening of the monitoring mechanism for the financial conglomerates in coordination with the other peer regulators, reviewing the supervisory policy for the banks which are the holding companies for the subsidiary entities in the Financial Conglomerates, issues of discussion paper on an appropriate conglomerate structure in the Indian financial system etc. There are also moves to put in place appropriate institutional arrangements for cross-border supervision and supervisory cooperation.
22. The emphasis in financial market has been to facilitate the ongoing integration of various segments through expansion of instruments and focus on the underlying legal framework. The recent initiatives include extension of short sales in government securities, introduction of ‘When Issued’ market in central government securities and expansion of hedging facilities in the foreign exchange market. The Reserve Bank of India Act has been amended to strengthen the legal framework for regulation of OTC derivatives including credit derivatives. Simultaneously, the credit delivery mechanism has been augmented with a focus on agriculture, small and medium enterprises and inclusive growth.
23. The banking system remains sound and well capitalized. In March 2007, the capital adequacy ratio stood at 12.3 percent, well above the international norm. Indian banks with international presence and foreign banks operating in India would be switching over to Basel II in March 2008 followed by other banks by March 2009. Even with a migration to Basel II, the present level of capital is considered comfortable as the additional capital requirement is estimated at 1 percent. Despite strong credit growth for three years in succession, the asset quality of banks continues to improve. The ratio of net NP As to net assets ratio stood at 1 percent in March 2007. However, the RBI has exercised great caution and raised risk weights and provisioning requirements for real estate sector. The assets of the banks in India continue to expand with an increase in the share of private sector and foreign banks. Government ownership has not compromised the commercial character of functioning of public sector banks. The return on total assets (RoA) of banks has improved over the years to reach 0.9 percent in March 2007. The efficiency parameters of the Indian banking system are comparable to many advanced countries. As on December 2007, 29 foreign banks were operating in India with 273 branches besides 35 banks with representative offices. The extent of presence of foreign banks exceeds the commitment made under the World Trade Organisation (WTO). Moreover, both the public sector and private sector banks have significant foreign share holdings.