February 6, 2009
1. The set of staff papers gives an assessment of the outlook for the Indian economy and also presents the views of the authorities on a number of important issues, including some on which there are significant differences in perception and policy diagnosis. The authorities consider the staff assessment to be unduly pessimistic on various fronts.
The Real Economy and the Outlook for Growth
2. The Indian economy has moved closer to its potential growth than ever before, clocking 8.8 per cent per annum on average over the last five years. This period is also characterized by a rapid integration into the global economy. The recent growth experience has, however, been driven largely by domestic consumption and investment, even as the share of net exports rose. India cannot be expected to remain immune to the ongoing global crisis and just like other economies, mature and emerging, the outlook is overcast by heightened uncertainty. While the Indian authorities have consistently ruled out any decoupling, it is important to recognize that there are some positive features that distinguish India's experience and should work as built-in stabilizers.
3. Lead indicators suggest that agricultural production during 2008-09 may be close to or better than last year's record production. Industrial production has slackened considerably when compared with the ebullient performance a year ago but is still growing at close to 4 per cent on a year-on-year basis up to November 2008 (the latest period for which data are available). In fact, sustained performance of the agricultural sector, fiscal stimulus, falling global crude oil prices and softening of domestic input prices of energy, cement and steel are likely to have a positive impact on industrial production in the coming months. Activity in the Service sector appears to be moderating, but is likely to regain its momentum as the upturn begins. Sub-sectors like railway freight traffic and communication have already commenced their pick-up.
4. There is some convergence of views between the staff and the authorities in the assessment that the economy is undergoing a cyclical moderation accentuated by the combined impact of the global downturn and the ongoing financial crisis. On the near-term outlook, the difference between the ‘pessimism’ of the staff assessment and the ‘cautious optimism’ of the authorities' view is essentially one of degree and not of direction. At the current juncture, the authorities expect real GDP during 2008-09 to grow at 7.0 per cent, with a downward bias.
5. In the medium-term, there is near-unanimity – that inherent fundamentals are strong and intact, and demographic dividend, institutional infrastructure, strength of domestic demand, growing entrepreneurial spirit, rise in productivity and untapped growth potential would return the Indian economy to its high growth trajectory. Indeed, the authorities believe that once the global economy begins to recover, India's turnaround will be sharper and swifter. What India is facing today is not a loss of growth but merely a moderation of speed.
6. It is important to recognize that the corporate sector is dealing with the crisis from a much stronger position than it was in earlier downturns. Since 2003, the corporate sector has restructured and refocused its strategies, stood up to foreign direct investment and liberalized imports including of technology and developed a competitive edge and a global scan. Empirical studies show that from 2002-03 onwards, an improvement in productivity and efficiency is taking hold. This has also been reflected in the steady and consistent jump in profitability with growth in post-tax profits in the range of 20-40 per cent since the second half of 2002-03 right up to March 2008 and the moderation in profitability growth thereafter needs to be viewed as a cyclical ebb rather than a structural deterioration.
7. While the downside risk to corporate profitability may have increased in the current global slowdown, this could be partly offset by falling input prices and a gradual reduction in borrowing costs. Moreover, as noted earlier, improvements in industrial production could have a conducive effect on corporate performance in the period ahead.
8. There has been a swift change in the monetary policy stance during 2008-09 – from fighting the upsurge in inflation on the back of soaring international commodity prices in the first half of the year to dealing with the combined impact of the global financial crisis and the follow-on global economic downturn. In the second phase, the objectives have been: to ensure orderly functioning of the domestic financial markets in contrast to the freezing up of money and credit markets in the mature economies; to ensure that liquidity did not become a binding constraint on financial institutions; to keep credit flowing to productive sectors of the economy; and to preserve financial stability and ensure that confidence in the financial system is maintained and the institutions themselves are able to intermediate the financing requirements of the growth process.
9. By and large, the authorities have succeeded in these objectives. At a time when international financial markets seized up and capital flows dwindled and even reversed, the Indian banking sector showed resilience in accommodating both substitution effects and the tightening of financing constraints in some sectors such as mutual funds and non-banking finance companies. Thus, bank credit disbursement actually accelerated on a year-on-year basis with the growth (yoy) in non-food bank credit at 23.1 percent as on January 16, 2009 being higher than that of 22.1 percent as on January 18, 2008. This acceleration of bank credit made up for the drying up of other resources – so much so that during 2008-09 so far (till January 2, 2009), the total flow of resources to the commercial sector from banks and other sources was only marginally lower than in the previous year (Rs. 4847 billion this year as against Rs. 4995 billion last year) and the gap was more than bridged by companies' recourse to internal accruals. There has, however, been a noticeable variation in credit expansion across bank groups. Credit expansion by foreign and private sector banks was significantly lower than a year ago and has been more than compensated for by expansion of credit by public sector banks.
10. Measures aimed at expanding rupee liquidity have resulted in liquidity support of the order of 7 per cent of GDP and the authorities stand ready to do more, if warranted, to achieve the objectives indicated earlier. In January 2009, a special purpose vehicle (SPV) was set up for addressing the temporary liquidity constraints of systemically important non-deposit taking non-banking financial companies. The policy rates i.e., the repo and reverse repo rates under the LAF have been cut by 350 basis points and 200 basis points respectively to historically lowest levels accompanied by appropriate forex intervention. It is important to note that the authorities have undertaken these measures without diluting the quality of collateral accepted by the Reserve Bank.
11. Managing forex liquidity included a firm reassurance by the Reserve Bank to meet any demand supply gaps of foreign exchange in the domestic foreign exchange market, introduction of a forex swap facility (of tenor up to three months) by the Reserve Bank for Indian public and private sector banks with overseas branches or subsidiaries (for funding the swap, banks were allowed to borrow under LAF for the corresponding tenor at the prevailing repo rate), upward adjustment of the interest rate ceilings on the deposits of non-resident Indians, substantial relaxation of the regime for external commercial borrowing, allowing non-banking finance companies / housing finance companies access to foreign borrowing and allowing corporates to buy back foreign currency borrowing to take advantage of the discount in the prevailing depressed global markets.
12. These measures restored normalcy in the money and credit markets swiftly. Bank deposit and lending rates, which had firmed up during the current financial year up to October 2008, started easing from November 2008. In this context, the authorities remain mindful of the dangers of getting locked into a liquidity trap and its consequences in some countries. Thus further interest rate reductions may not be in the interest of ensuring the effectiveness of monetary policy or of the long-term aspirations of growth.
Financial Sector Issues
13. The soundness of the financial sector is among the strengths with which India prepares for the difficult and challenging period ahead. Underlying this favourable position is the approach that has been followed over nearly two decades of reforms – instituting global standards alongside country-specific norms. Also the pace of reform has been carefully calibrated to the size of the change and preparedness of domestic institutions, and generally a big-bang approach has been avoided. This approach has stood India in good stead through two decades marked by financial crises in various parts of the world. While the level of innovation in terms of exposure to structured products and complex derivatives may be low, the overall soundness of the system has been preserved.
14. This approach has forewarned and equipped the financial system and the regulatory authorities for dealing with the inevitable rise in non-performing assets and credit risks in periods of economic downturn. In some sectors, counter-cyclical prudential measures – increase in risk weights and provisioning - taken in the past periods when credit growth was rapid, have been scaled back in view of the current macroeconomic, monetary and credit conditions and consistent with the practice of dynamic provisioning. Where pockets of financial stress have been indicated through early detection tools, the authorities have moved swiftly and decisively to ease liquidity/funding stress and to initiate corrective processes for duration and asset-liability mismatches, as in the case of non-banking financial companies (NBFCs) and mutual funds (MFs).
15. The authorities have announced plans to recapitalize banks and have expressed a readiness for further measures in case of emergence of any symptom of deterioration in asset quality.
Development of Corporate Bond Market
16. The development of a corporate bond market is conditional upon reforms on the demand and supply sides. On the demand side, reforms in the institutional investor base – pension reforms – are awaiting legislative approval. Introduction of repo in corporate bonds has been recommended by a High Level Expert Committee on Corporate Bonds and Securitization to enhance market liquidity. The Reserve Bank has indicated that the introduction of repos in corporate bonds would require greater public issuances and secondary market trading. Another key ingredient is depth and liquidity and for this purpose, further deepening of the government securities market is vital. It is in the context of these prerequisites that corporate bond markets have not developed in many countries. It may be mentioned that the limit on Foreign Intuitional Investment on corporate debt instruments has been raised recently to US $ 15 billion. The limit has not been fully used by the FIIs.
17. It may be noted that India's modest current account deficit has not been contributing to global imbalances. At the same time, external debt is sustainable and low. India's current account deficit (CAD) did widen in the first half of 2008-09 ($ 22.3 billion), but this was episodic and reflecting high oil and commodity prices, even as private transfers and software export earnings were sustained. As net capital flows declined in the wake of a global risk aversion and perceived flight to safety, the overall balance of payments position turned marginally negative during the first half of 2008-09 but was comfortably financed by drawing from the large stock of international reserves. Import growth moderated during October-November 2008 reflecting the fall in international oil prices. Going forward, it is expected that imports may slow down faster than exports. Portfolio outflows have moderated and intermittent inflows have been observed during December 2008 and January 2009. Accretion to non-residents deposits are bolstering the capital account. Foreign direct investment is higher than the level a year ago and there is no evidence so far of any slackening of pace. The volume of proposals already received suggest, in fact, that a further pick-up cannot be ruled out in 2009 if stability is restored in the global financial system. Net capital flows were positive in 2008 largely financing the current account deficit and are expected to continue to do so in 2009. Thus, the stress on the BoP seems to be temporary and a return to normalcy is already underway. At the current juncture, the level of forex reserves is holding at the level prevailing in October 2008 and there is ample cover for imports / debt-service payment for a full year. Looking ahead, the authorities fully recognize risks to the BoP in 2009-10, emanating from weaker export growth and subdued capital flows. The onset of global recovery and improvement in world trade will ease the pressure on the external sector.
18. The rupee had appreciated against major currencies in 2007-08 due to large capital inflows. It depreciated during September and October, 2008 reflecting extraordinary developments in international financial markets and portfolio outflows by foreign institutional investors (FIIs), and has remained range-bound since November 2008. Movements in the exchange rate have been self-equilibrating and would continue to be so under the current exchange rate regime. The exchange rate remains fairly valued giving a fillip to competitiveness. The authorities are committed to managing volatility without defending any level of the exchange rate, thereby promoting financial stability.
Approach to Capital account liberalization
19. Capital account liberalization is viewed by the authorities as a means of integrating the Indian economy into the world and substantial progress has been made in this regard. Global evidence does not support the case for full liberalization of the capital account. The authorities hold that capital account liberalization is a process, not an event. The policy approach is one of a hierarchy in which foreign investment flows have been virtually freed except in strategic sectors while a more prudent approach has been adopted for debt-creating flows. The benefits from reliance on debt flows are unclear. Past crises have clearly demonstrated the vulnerability associated with volatile, short-term, foreign-currency denominated debt flows. The Indian policy approach is based on this framework, and has helped the country in the pursuit of growth acceleration while maintaining financial and macroeconomic stability. In view of the lessons drawn from various international crises, a need has been felt to retain some instruments for regulating the flow of capital in tune with the absorptive capacity of the economy and the preparedness of financial markets and intermediaries. The relevance of further opening up to foreign inflows needs to be considered with a fuller appreciation of this approach, especially in the current context.
20. We broadly agree with the staff's assessment of a deterioration in the fiscal position that is turning out to be weaker than initially anticipated. The cyclically induced discretionary fiscal measures – first in the context of the surge in inflation driven by international commodity prices in the first half of 2008 and subsequently, the fiscal stimulus that became common across countries as the global slowdown deepened – account for erosion in Central public finances. In the event of the global downturn becoming deeper and more protracted as prognosticated in the January 2009 update of the WEO, the burden on the fisc could increase further and diffuse across general government.
21. There are significant downside risks associated with this scenario. First, as the authorities world over mount fiscal policy action to defend their economies against the headwinds of the global slowdown, the prospects of recovery could recede further in time as the private sector and even the public sector in the emerging world face financial crowding out. Second, the staff does well to cite the limited room for fiscal maneuver, given a general government deficit of close to 10 per cent of GDP and a public debt of nearly 77 per cent of GDP. This is unfortunately a situation which various countries, mature and emerging, may be approaching more rapidly than planned, with due adjustments for country-specifics, as their arsenal of monetary measures gets exhausted and the limits of monetary policy are reached. Inevitably, in such a situation, fiscal policy will have to get overextended and issues of medium-term sustainability of the fiscal stance will dominate the debate on global recovery. It is in this context that the authorities remain firmly committed to deepening and broadening the ambit of fiscal reforms, including efforts that secure lasting improvements in tax buoyancy, expenditure containment and targeting, and rule-based deficit management as embodied in the Fiscal Responsibility and Budget Management Act, 2003. It is important to note that the public debt has virtually no external component.
22. In the final analysis, the staff's assessment of the outlook for the Indian economy appears to be driven by model-based scenarios of possible but unlikely catastrophic risks coming together. The robustness of the methodology is yet to be established. It is important to recognize that the staff appears alarmist, perhaps unjustifiably so. In the backdrop of heightened uncertainty in the global financial markets, when a confidence crisis could spread contagiously, such analysis emanating from the Fund could run the risk of triggering further financial instability. Therefore, a careful review may be required as to what portions of such analyses should be placed in the public domain. We also expect that such an analytical approach with appropriate and robust methodology will be applied evenhandedly across countries and regions.
23. The unprecedented crisis gripping the global economy warrants unconventional policy responses particularly in dealing with the “unknown unknowns” about the shape of things to come in the immediate future, most of which emanate from global uncertainty. This is a period of painful adjustment for all. Authorities across the world have been attempting to minimize its impact on the economy. Our authorities will continue to maintain vigil, monitor domestic and global developments and take swift and effective action to minimize the impact of the crisis and restore the economy to its potential growth path.