India’s Recent Macroeconomic Performance
An Assessment and Way Forward1
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Contributor Notes

Author’s E-Mail Address:mkapur@imf.org,rmohan@imf.org

The macroeconomic policy response in India after the North Atlantic financial crisis (NAFC) was rapid. The overshooting of the stimulus and its gradual withdrawal sowed seeds for inflationary and BoP pressures and growth slowdown, then exacerbated by domestic policy bottlenecks and volatility in international financial markets during mid-2013. Appropriate domestic oil prices and fiscal consolidation will contribute to the recovery of private sector investment. Fiscal consolidation would also facilitate a reduction in inflation, which would moderate gold imports and favorably impact real exchange rate and current account deficit.

Abstract

The macroeconomic policy response in India after the North Atlantic financial crisis (NAFC) was rapid. The overshooting of the stimulus and its gradual withdrawal sowed seeds for inflationary and BoP pressures and growth slowdown, then exacerbated by domestic policy bottlenecks and volatility in international financial markets during mid-2013. Appropriate domestic oil prices and fiscal consolidation will contribute to the recovery of private sector investment. Fiscal consolidation would also facilitate a reduction in inflation, which would moderate gold imports and favorably impact real exchange rate and current account deficit.

I. Introduction

The Indian economy recorded robust annual growth of 9 percent plus during 2004-08 and this high growth phase was also accompanied by consolidation of key macroeconomic indicators. However, this process suffered a setback with the onset of the North Atlantic financial crisis (NAFC) in 2008. Growth rebounded initially in response to large monetary and fiscal stimuli but has slowed down significantly subsequently; moreover, a substantial widening of the current account and fiscal deficits occurred from 2008-09, along with inflation climbing to an elevated level. With the observed decline in domestic saving and investment rates, there are concerns that India’s potential growth rate has now fallen significantly (IMF, 2013; Mishra, 2013). Furthermore, given the large twin deficits, concerns were expressed about the possible emergence of a balance of payments crisis (for example, Acharya, 2013; Mody and Walton, 2013; Tarapore, 2013b). These concerns came to the forefront during June-August 2013 following the mention of tapering by the US Federal Reserve from the accommodative monetary policy and the concomitant volatility in the global and domestic financial markets. These concerns have receded somewhat now along with the significant correction in the current account deficit (CAD) that has taken place since the second quarter of 2013-14. There is also a view that the high growth phase of 2004-09 was a debt-led cyclical boom, supported by unprecedented capital inflows, coinciding with an exceptional growth phase in the world economy (Nagaraj, 2013).

Can India be placed on a sustained high growth path again so that it grows consistently over the next couple of decades and beyond? To what extent have domestic economic policies contributed to the slowdown that might have been expected in any case, as a result of the headwinds emanating from the NAFC?

Against this backdrop, this paper begins with an evaluation of India’s recent growth experience in a cross-country perspective (Section II). This is followed by an assessment of the role of domestic macroeconomic policies in the growth slowdown; this section also examines as to whether oil demand is responsive to price movements and as to how much of the recent growth slowdown can be explained through conventional determinants (Section III). Section IV then assesses the factors that have led to the widening of the CAD and explores: (i) the role of income and price elasticities in external trade; and (ii) the determinants of demand for gold imports in order to understand the widening of the CAD. Section V focuses on some key issues in macroeconomic management going forward and concluding observations are in Section VI.

II. Recent Macroeconomic Trends: India in a Global Perspective

After the NAFC in 2008-09, India’s real GDP growth rebounded sharply during 2009-11, but this rebound was short-lived and growth decelerated significantly in the following three years (Table 1). This deceleration in growth was accompanied by a number of disconcerting macroeconomic developments since 2008-09. First, the noteworthy fiscal consolidation process witnessed during 2003-08 suffered a setback and, despite some renewed correction, the fiscal deficit in 2013-14 was still well-above that of the pre-crisis year. Second, the CAD, which was relatively moderate and averaged less than 1 percent of GDP during 1992-2008, widened significantly to just under 5 percent in 2012-13 (but has since more than halved to 2.3 percent in the first three quarters of 2013-14 in response to policy actions). Third, headline inflation, especially consumer inflation, has remained persistently high in the post-crisis period. Fourth, private corporate investment has declined significantly.

Table 1:

Key Macroeconomic Indicators: 2003-14

(Percent)

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Note:@: 36-currency real effective exchange rate index (2004-5=100).#: Nominal effective policy rate less 12-month moving average of non-manufactured products WPI inflation.&: April-December.Source: Reserve Bank of India; Central Statistical Organization.

Part of the domestic slowdown is obviously the outcome of a sluggish global recovery. Global growth fell from an annual average of 4.8 percent during 2003-07 to an average of 2.9 percent during the subsequent 5-year period (2008-12) and the slowdown is visible across all regions, including in emerging markets (Table 2). Clearly, global demand has fallen as a result of the NAFC and there has been some rebalancing of current account balance/GDP ratios across G20 countries. The advanced economies – the US, the UK, and Germany - have recorded improvement in their current account positions. These were mostly associated with real currency depreciations and weak domestic demand. Interestingly, in the aftermath of the NAFC, it is the advanced economies that generally recorded real depreciation of their currencies, while the EME currencies appreciated – the consequence of accommodative monetary policies in the advanced economies. Many EMEs have correspondingly exhibited high CADs. Thus, the slowdown in global growth and demand has had some adverse impact on demand and growth in India, along with other EMEs, while also contributing to the widening of CAD.

Table 2:

Key Macroeconomic Indicators: Variation between 2008-12 and 2003-07

(Percent)

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Source: World Economic Outlook Database (April 2013), IMF.

The slowdown in India’s growth or widening of its CAD is thus not surprising in a cross-country perspective. However, what is of concern is the extent of slow down and magnitude of key imbalances in India. In 2012, amongst the G-20 economies, India had the third largest CAD after Turkey and South Africa; and, India’s fiscal deficit was the second largest after Japan. Compared to India, fiscal deficits in Turkey and South Africa have been more modest, while Japan has a surplus on its current account. Thus, the concern in the Indian context is the high level of twin deficits, which as the crisis literature shows can be a source of future vulnerability. Advanced economies with debt/GDP ratios above 80 percent of GDP and persistent CADs are vulnerable to rapid fiscal deterioration: government borrowing costs increase much more quickly at higher debt levels, especially for countries also running CADs (Greenlaw et al., 2013). Debt thresholds are, however, typically lower for emerging economies (Reinhart and Rogoff, 2009). External vulnerabilities (large current account deficits) and domestic credit booms explain the ongoing NAFC, like the previous crises in emerging markets (Lane and Milesi-Ferretti, 2010). Vulnerabilities of EMEs arising from large CADs were again in evidence during the June-August 2013 episode.

There is also a view that global growth in the pre-NAFC period was well-above potential and the post-NAFC slowdown is a return to the underlying potential growth path, which itself is now seen as below the pre-crisis potential growth rates. Potential growth of developing countries was 6.3 percent during 2005-07, whereas the actual growth during this period averaged two percentage points higher at 8.3 percent; the output gap which was close to zero in 2005 reached 3.5 percent in 2007 (World Bank, 2013). Going forward, the World Bank estimates that potential growth for developing countries will be lower at 5.5 percent for 2012-2015. Thus, the ongoing slowdown in the Indian economy can also be viewed as a part of the worldwide phenomenon of slower potential growth in the post-crisis period.

While the growth slowdown, the widening of the CAD and the widening of the fiscal deficit in India are directionally in line with global trends, the domestic inflation outturn depicts a different picture. Inflation moderated or was largely unchanged in many economies on the back of weak demand in the post-2008 period. In India, however, it has been substantially higher in the post-2008 period (Table 2). Thus, the Indian slowdown and high CAD are not an aberration from these global trends, but what is striking is the extent of the slowdown and the deterioration. This suggests that domestic factors have added to headwinds from the global economy.

We now turn to the role of domestic macroeconomic factors and policies. At the same time, it is worth noting that the domestic financial sector exhibited striking resilience to the NAFC, reflecting India’s prudent approach to domestic and external financial liberalization (Mohan 2011).

III. Domestic Macroeconomic Policies and Growth Slowdown

Part of the growth slowdown in the Indian context during 2011-14 vis-à-vis the immediate post-crisis years (2008-09 and 2009-10) could be attributed to the withdrawal of the large monetary and fiscal stimulus that was administered immediately after the crisis (Rajan, 2013). Following the collapse of Lehman Brothers in October 2008 and the intensification of the NAFC, there were large capital outflows from India reflecting sales by foreign institutional investors in the domestic stock market. There was, however, no direct impact of the Lehman collapse on the Indian banking system due to its limited exposure to toxic assets, in turn reflecting the prudent regulatory framework in India with regard to banks. Indian financial markets also worked normally in the aftermath of the Lehman collapse, albeit with elevated volatility (Mohan, 2011c). Notwithstanding these relatively positive domestic developments, there was a sharp slowdown in the domestic economy in the second half of 2008-09; there was a perception that the global developments would have a serious sustained adverse impact on the real economy, given the relatively high degree of openness of the Indian economy by that time. Here, it is relevant to note that the Reserve Bank of India was in a tightening mode as late as July/August 2008 in response to the then prevailing domestic macroeconomic conditions. Nonetheless, given the sharp downturn in the global economy and the perceptions of these developments having a serious knock-on effect on the domestic economy, India, like many other EMEs, took both monetary and fiscal measures. In response to these stimulus measures, the Indian economy was among the first to recover from the NAFC, with growth during 2009-11 being almost the same as during the pre-NAFC high growth phase (2003-08), but this turned out to be temporary for a variety of reasons discussed later.

On the monetary side, the effective policy rate was cut sharply from 9.00 percent in September 2008 to 3.25 percent by April 2009; the cash reserve ratio was reduced from 9.0 percent to 5.0 percent over the same period. In addition, a number of other monetary and liquidity measures were instituted, which collectively had the potential to release liquidity of more than 10 percent of GDP (Mohan, 2011c). On the fiscal side, the Government, inter alia, cut the CENVAT (the main Central indirect tax in the form of a VAT) rate from 14 percent to 8 percent between December 2008 and February 2009 and also increased plan expenditure. These measures were in addition to the stimulus already in the pipeline from the implementation of the Pay Commission award and the agriculture debt waiver. Reflecting these actions as well as others, the Central government’s headline gross fiscal deficit (GFD) increased from 2.5 percent of GDP in 2007-08 to 6.0 percent in 2008-09. Including bonds issued in lieu of cash subsidies with regard to oil, fertilizer and food sectors, the GFD/GDP ratio recorded an even sharper increase from 3.1 percent to an all-time high of 8.2 percent, which provides a better indicator of the boost to domestic demand from the fisc. Thus, both monetary policy and fiscal policy provided strong support – excessive with hindsight - to the domestic economy in 2008-09.

Monetary Policy

In contrast to the prevailing pessimistic outlook in the global economy, real GDP growth in India in 2009-10 and 2010-11 turned out to be much stronger (Table 3). Stronger growth started getting mirrored in high inflation, initially in food inflation (by end-2009) and in underlying inflation by April 2010. Elevated international commodity prices and domestic structural imbalances in the availability of select domestic food items (pulses and other protein items) added to the inflationary pressures. Monetary accommodation was, however, continued till early 2010. The subsequent withdrawal was done in a phased and gradual manner during 2010-11 and 2011-12 reflecting a number of factors: the high degree of uncertainty about the global as well as domestic outlook; the perception that the initial phase of high inflation was due to food prices; and the real-time data on domestic economic activity under-estimating the strength of domestic demand at that time (Subbarao, 2011). This gradual pace was in contrast to the earlier noted rapid monetary and liquidity stimulus between September 2008 and April 2009. The quantum and the pace of the monetary stimulus in that period was greater than in most major emerging markets (Table 4), despite the fact that no Indian financial institution had been substantially affected by the NAFC.

Table 3:

Real GDP Growth: Forecast and Actual

(Percent)

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@: Forecast made in the last quarter of the preceding fiscal year (taken from the April/May issue of MMD) (for example, forecast made in the quarter ended March 2008 for the fiscal year 2008-09 and so on).Source: Macroeconomic and Monetary Developments (various issues), RBI; Economic Review (various issues), PMEAC; Central Statistical Organization.
Table 4:

Policy Rates in Select Emerging Markets

(Percent)

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Source: Haver Analytics.

While inflationary pressures since 2010 are the outcome of factors noted above, did these also reflect the lagged impact of the high growth in monetary and credit aggregates in the pre-NAFC period? In the face of large and increasing capital flows – from 2.7 percent of GDP in 2003-04 to 8.6 percent in 2007-08 – the Reserve Bank had deployed a range of instruments to manage these capital flows, including sterilized interventions. Nonetheless, growth in broad money averaged more than 21 percent per annum during 2005-08, with growth in non-food credit averaging 28 percent and real GDP growth averaging 9.5 percent during this 3-year period. Actual growth in monetary and credit aggregates was also above the indicative projections set out by the Reserve Bank at the beginning of each of these financial years. All these indicators would suggest signs of overheating in the pre-NAFC period; indeed, inflation indicators did start increasing in 2007-08, but were compounded by the increasing oil prices at that time. Thus, the stimulus measures adopted after the NAFC added to the incipient inflationary pressures already emerging in the economy.

It is also contended by some that higher food inflation during this period is entirely the outcome of the minimum support prices (MSP) policy (Bhalla, 2013b). Although a large increase in the MSP for the various crops has taken place during recent years, especially since 2008-09, the causation is arguable. For example, there was a large increase in the actual prices (as measured by the wholesale price index (WPI)) of pulses during 2005-06 and 2006-07, but only a moderate increase in the MSP of these items. The MSP was then increased in 2007-08 and especially substantially in 2008-09, but even then the cumulative variation in the MSP between March 2005 and March 2010 was trailing the cumulative variation in actual prices for the three major pulses (arhar, moong and urad) and also wheat, although the situation has reversed since then (Table 5). Why did the prices of pulses increase substantially beginning 2005-06? Strong domestic growth from 2003-04 onwards, amidst near plateauing of domestic production of pulses, is one plausible factor. The shift in dietary pattern shifted in favor of protein-rich items on the back of higher incomes is another factor. This trend then seems to have got support from the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) scheme. The increases in the MSP could then be viewed as an attempt by the government to incentivize farmers to increase the domestic production of pulses to meet the rising demand.

Table 5:

Minimum Support Prices and Wholesale Price Index (2003=100)

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Note: MSP = Minimum Support Prices; WPI = Wholesale Price Index.The row ‘Gap’ gives difference (percent) of MSP over WPI.Source: Database on the Indian Economy, Reserve Bank of India.

Here, it is also relevant to note that the Reserve Bank of India had pointed to the possibility of overheating2 as early as 2006, but there was a substantial amount of skepticism of this assessment at that time. No doubt, there is a two-way feedback between actual prices and the MSP, but the above analysis suggests that the higher order of initial increases in the MSP was perhaps also necessitated by higher food demand on the back of high growth and rising incomes. The MSP story focuses on relative inflation. Similarly, the view that the MGNREGA has led to wage pressures stresses the cost-push view of inflation. But, high relative inflation cannot lead to persistent high overall inflation, unless it is generalized and accommodated. For example, non-food non-fuel CPI inflation (rural and urban combined based on the new CPI series) has been around 8 percent since June 2012 (it was higher at around 10 percent during January-May 2012), which is suggestive of generalized pressures. In the face of persistently high food inflation, monetary policy can keep overall inflation within its comfort zone, but this would involve excessive tightening and large output costs for the other sectors of the economy. The MGNREGA may have contributed to the bargaining power of rural workers, but it accounts for only a small fraction of the rural wage increase and the effect is also waning (Rajan, 2014). Thus, productivity gains in food production provide a more durable solution to increase the food production in a non-inflationary manner.

Finally, the higher outlays on the MGNREGA and the higher food subsidy bill are ultimately reflected in the revenue deficits, which then add to domestic demand. If the revenue deficits had been contained through adjustments in other expenditures/higher revenues, then there might have been more merit in the cost-push argument – but only for explaining the short-term increase in inflation, not its persistence.

Real Interest Rates: Borrowers

The extent of monetary accommodation can be better gauged through movements in real interest rates, although these are beset with a number of conceptual issues in regard to the measure of inflation expectations. The relevant measure of inflation and inflation expectations could differ for the various economic agents/groups in the country: while consumer inflation may be more relevant for households, manufactured products WPI inflation could be more appropriate for the industrial sector3 (Mohan, 2002). Accordingly, in this paper, real lending rates are assessed both in terms of headline WPI inflation and non-food manufactured products (NFMP) WPI inflation. Real deposit rates are analyzed in relation to consumer inflation and also in relation to the inflation expectations of households. Apart from the issue of the appropriate inflation rate, a related issue is: are inflation expectations better captured by the year-on-year (y-o-y) inflation rate or some sort of average inflation rate? If inflation expectations are relatively well-anchored, it is likely that the y-o-y inflation matters less and the more appropriate yardstick would be some sort of average inflation rate. Indeed, the empirical exercise carried out later on in the paper favors a real rate using a 12-month moving average of y-o-y inflation. Accordingly, the real policy interest rate is also analyzed presented using this indicator of inflation.

While the nominal policy rate was being increased gradually during 2010 and 2011, the real policy rate was highly negative (with respect to y-o-y headline WPI inflation) and marginally negative (with respect to y-o-y NFMP inflation). Thus, arguably, monetary policy was still in an accommodative mode over this phase, although most commentators characterized it as being too tight. Real policy rates moved from negative territory during 2010 and 2011 to positive territory in 2012, especially when the core inflation indicator is used (Chart 1). The real interest rate trajectory is broadly similar in terms of the 12-month moving average of inflation, and, as can be expected, smoother. According to this measure, and using NFMP inflation, the real policy rate initially fell from an average of 2.2 percent in 2007-08 to 0.9 percent in 2008-09, but then edged up to 2.0 per cent in 2010-11. It fell back to an average of 1.0 percent in 2011-12 (reflecting the more than expected increase in NFMP inflation), but again edged higher to 1.9 percent in 2012-13 (on the back of higher policy rate and some moderation in NFMP inflation). The real policy rate in terms of CPI inflation has been generally negative since mid-2008 (RBI, 2014).

Chart 1:
Chart 1:

Real Policy Rate

Citation: IMF Working Papers 2014, 068; 10.5089/9781484360675.001.A001

Bank lending rates and market rates broadly mirror the policy rates both in terms of nominal and real rates. Real commercial paper rates increased during the course of 2012 and were higher than in the pre-crisis period, especially in terms of core inflation (Chart 2). As regards commercial bank lending rates, the assessment is somewhat complicated by the move of the banking system from the benchmark prime lending rate system to the base rate system in July 2010, but the directional movement is broadly similar to that emanating from trends in the commercial paper rates (Chart 3).

Chart 2:
Chart 2:

Commercial Paper Rate

Citation: IMF Working Papers 2014, 068; 10.5089/9781484360675.001.A001

Chart 3:
Chart 3:

Base Rate

Citation: IMF Working Papers 2014, 068; 10.5089/9781484360675.001.A001

Higher nominal interest rates also had an adverse impact on corporate profitability and hence corporate savings and investment during this period (Chart 4). Corporate savings fell from 9.4 percent of GDP in 2007-08 to 7.1 percent in 2012-13, while corporate investment fell even more from 17.3 percent of GDP to 9.2 percent (Table 6). What explains the larger decline in corporate investment vis-à-vis corporate savings since 2007-08? First, policy bottlenecks -such as obtaining environmental permissions, fuel linkages, or carrying out land acquisition -led to stalling of a number of large projects, which may in turn have discouraged new investment (Government of India, 2013a). Second, the large increase in fiscal deficit and the near trebling of government borrowing requirements appears to have led to some crowding out of the private sector.

Chart 4:
Chart 4:

Corporate Performance

Citation: IMF Working Papers 2014, 068; 10.5089/9781484360675.001.A001

Table 6:

Savings and Investment

(Percent to GDP)

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Source: Central Statistical Organization; Reserve Bank of India.

Third, there is a perception that the decline in domestic corporate investment since the NAFC is due to more outward foreign direct investment (FDI) on the back of domestic rigidities that impede domestic investment. This perception is, however, not borne out by data. Outward FDI by the Indian corporates indeed increased substantially in the pre-NAFC phase from 0.3 percent of GDP in 2003-04 to 1.5 percent in 2007-08, but during this period domestic investment had also increased significantly. Since then, outward FDI has fallen to its 2003-04 levels (it was 0.4 percent of GDP in 2012-13) in tandem with the declining trend in domestic investment (see Table 9). The decline in domestic investment since 2007-08, therefore, cannot be attributed to greater investment abroad.

Table 7:

Industrial Growth

(Percent)

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@: Growth rates are based on ASI data deflated by WPI-Manufactured Products index.#: including construction.Source: Central Statistical Organization.
Table 8:

Fiscal Position of the Centre

(Percent to GDP)

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Note: Data on Central government finances for 2013-14 pertain to revised estimates.Data on combined government finances for 2012-13 and 2013-14 pertain to revised and budget estimates, respectively.Figures in parentheses are GFD including off-budget liabilities.Source: Reserve Bank of India; Union Budget documents; and, Economic Advisory Council to the Prime Minister.
Table 9:

Balance of Payments

Percent to GDP)

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Source: Reserve Bank of India; Ministry of Finance.

Thus, as nominal as well as real lending rates tightened, especially beginning early 2012, the pace of investment activity and economic activity slowed down as expected. While monetary policy supported growth during 2009-11, it contributed to the slowdown in the subsequent phase. Econometric evidence for India and elsewhere suggests that a 100 bps increase in the policy interest rate is associated, on average, with a growth slowdown of 25-50 bps, and the actual impact on growth during each monetary cycle of easing/tightening depends, inter alia, on the extent of transmission to market rates (Kapur and Behera, 2012; RBI, 2013c). The scale of the slowdown in the recent period is much greater than suggested by these estimates and we revisit this issue a little later.

On the extent of the slowdown, some caution is, however, warranted in reaching definitive conclusions, given the large revisions to GDP data in the recent past. There is divergence between industrial growth indicated by the data on the index of industrial production (IIP) and the Annual Survey of Industries, with IIP growth rates being significantly lower than the ASI growth rates in most of the years (PMEAC, 2013). During 2003-12, IIP growth averaged almost 4 percentage points lower than the real growth of gross value added from ASI data, with the difference being pronounced in 2011-12, the latest year for which the ASI data are available (Table 7). Given that the IIP data are available at a high frequency (monthly) and provide a critical input for macroeconomic policy formulation, substantial revisions in IIP data can lead to incorrect policy inferences and actions. Accordingly, it is important to understand and reconcile the differences between the two sets of industrial data. Since it is the ASI data that determine the final GDP estimates, the problems in collecting IIP data should be corrected on a priority basis so that more accurate information is available for short-term policymaking process.

Real Interest Rates: Depositors

Turning to deposit rates, the real rate in terms of consumer inflation has been broadly negative since 2008-09 reflecting the persistently elevated level of consumer inflation on the back of high food inflation. Thus, even as nominal deposit rates increased from the pre-2008 levels, real rates fell from an average of (+) 1.5 percent during 2003-08 to (-) 1.9 percent during 2008-13. Real deposit rates turn out to be more negative, if data on inflation expectations of households are used, which are available from 2006 onwards. According to these data, during 2008-13, the real deposit rate averaged (-) 2.1 percent using households’ “current” inflation expectations and (–) 3.3 percent using households’ “one-year ahead” inflation expectations (Chart 5). Administered interest rates on small savings have also been negative in real terms in the recent years and growth in small savings has been low or negative in this period.

Chart 5:
Chart 5:

Deposit Rate

Citation: IMF Working Papers 2014, 068; 10.5089/9781484360675.001.A001

Negative real deposit rates, along with the growth slowdown, seem to have contributed to the decline in household financial savings accompanied by a switch towards savings in physical assets (gold and property). Financial savings (gross) of households fell from 15.5 percent of GDP in 2007-08 to 10.8 percent in 2012-13, reflecting decline in the major constituents – bank deposits, life insurance funds, and shares and debentures (Table 6). The recent decline has taken gross financial savings to below its 1997-98 levels (10.9 percent of GDP) and just close to its levels in the early 1990s (10.4 percent in 1992-93). Financial savings (net) of households declined by 4.5 percentage points of GDP between 2007-08 and 2012-13, while physical savings went up by an almost similar magnitude. Households’ physical investments in gold increased from an average of 1.1 percent of GDP during 2003-08 to 2.6 percent by 2012-13. The overall household savings at 21.9 percent of GDP in 2012-13 were almost the same as in 2007-08 (Table 6). The stability of the overall household savings rate is remarkable in the face of the significant deceleration in economic activity. Thus, rather than smoothing consumption, households appear to have focused on maintaining their overall savings propensities, perhaps a reflection of the elevated uncertainty in the economic environment. At the same time, the significant deterioration in public finances has not been countered by households through higher savings, which would indicate non-Ricardian behavior and also presents indirect evidence of some role for countercyclical fiscal policy. However, the significant decline in financial savings, if not reversed quickly, has adverse implications for medium-term growth prospects as well as external sustainability.

Does the relationship between real deposit rates and savings hold in other periods? Household savings, for example, increased between 1997-98 (18 percent of GDP) and 2003-04 (23 percent), even as nominal deposit rates recorded a substantial decline (from around 11 percent to around 5-6 percent). But, this period was also marked by a significant fall in inflation. Real deposit interest rates during the early part of this period were almost unchanged and highly positive (4-5 percent till 2001-02, and 2-3 percent during 2002-03 and 2003-04; these were negative in one year only, 1998-99). Thus, the decline in nominal deposit rates tracked the inflation movements – or perhaps trailed the decline in inflation, given the fact that it takes some time for economic agents to revise their inflation expectations. The downward movement in banks’ nominal deposit rates was also facilitated by the downward adjustment in the administered interest rates on small savings during this period. The available evidence, therefore, suggests that real deposit rates do matter for household savings.

Fiscal Policy

As noted earlier, reflecting the fiscal stimulus measures in response to the NAFC as well as the impact of growth slowdown on revenues, the Centre’s headline fiscal deficit/GDP ratio more than doubled to 6.0 percent in 2008-09 (Table 8). The deficit, including the impact of bonds issued in lieu of cash subsidies for oil and others, recorded an even higher order of increase from 3.1 percent of GDP in 2007-08 to 8.2 percent in 2008-09, but then moderated somewhat to 6.6 percent in 2009-10. In nominal terms, the Centre’s fiscal deficit increased from Rs.1,269 billion in 2007-08 to Rs.3,370 billion in 2008-09 (vis-à-vis the budgeted amount of Rs. 1,333 billion) and Rs. 4,185 billion in 2009-10, an increase of 230 percent in just 2 years. Despite this substantial increase in its borrowing requirements, the borrowing costs declined -the weighted average yield on Central government’s dated securities fell from 8.12 percent in 2007-08 to 7.23 percent in 2009-10 – benefiting from the accommodative monetary policy stance during this period and large open market operations of the Reserve Bank.

The fiscal stimulus began to be withdrawn in 2011-12 and 2012-13. The quality of fiscal stimulus provided in the aftermath of the NAFC also seems to have exacerbated the slowdown in 2011-13. Revenue expenditure of the central government increased from 11.9 percent of GDP in 2007-08 to 14.1 percent in 2008-09 (and maintained at this level in 2009-10). This increase was partly on account of subsidies, which increased from 1.4 percent of GDP during 2007-08 to 2.3 percent in 2008-09 and remained around this level till 2012-13. The increase in subsidies was initially due to fertilizers and then due to the incomplete and delayed pass-through of high international crude oil prices to domestic prices (Table 8). Oil subsidies increased from 0.1 percent of GDP during 2003-08 to 1.0 percent in 2012-13. However, these data represent only the actual cash outgo on subsidies and exclude the expenditure covered through the issuance of bonds during 2005-09, especially in 2008-09. Bonds issued in lieu of subsidies to oil companies, fertilizer companies and Food Corporation of India increased from 0.5 percent of GDP in 2005-06 to 1.7 percent in 2008-09.

The demand for oil is generally adjudged to be relatively price inelastic. In the Indian context, the problem has been compounded by the relatively sticky administered prices. However, estimates in this paper show that demand for oil in India does respond to prices in a significant manner (Annex 1 and Annex Table 1). The estimated price elasticity of demand for petrol is (-) 0.66, for diesel is (-) 0.36 and for kerosene oil is (-) 0.54. The price elasticity estimates for India in this paper are comparable to those of other countries: according to the four literature surveys covered in Hamilton (2008), the long-run price elasticity of demand for gasoline is (-) 0.6 to (-) 0.9. Given the estimated elasticities for India, and also the significant amount of under-recoveries, it is evident that if domestic prices had reflected movements in international prices, there would have been some demand response, along with some expenditure switching leading to suppressed demand for other commodities. Furthermore, there would have been a beneficial impact on the fiscal balance, and lower crowding out of the private sector. Moreover, lower oil consumption demand would have led to lower oil imports and hence some containment of the CAD. We can use the estimated price elasticity to illustrate the likely impact on the CAD by focusing on diesel, which accounts for almost 45 percent of domestic petroleum consumption. During 2011-12 and 2012-13, the under-recoveries in case of diesel are estimated to be around Rs.11 per liter4 (around 25 percent of the actual prevailing prices). If the diesel prices had been raised to eliminate the under-recoveries, then the estimated price elasticity of 0.36 suggests that diesel consumption would have been around 9 percent lower. This would have, ceteris paribus, lowered overall imports and the current account deficit by around 0.5 percent of GDP each in 2011-12 and 2012-13, a sizable impact.

In contrast to the upward trend in revenue expenditure, capital outlays of the centre were broadly stagnant over this period at around 1.5 percent of GDP (Table 8). Empirical evidence indicates that fiscal multipliers for government capital outlays exceed government consumption expenditure in India in the long-run as in many other countries (Jain and Kumar, 2013). According to Tapsoba (2013), the fiscal multiplier for government consumption is unity in the first year, but then turns negative and the long-run impact is also negative; in contrast, the first-year as well as the long-run multipliers for government investment are more than unity. These multiplier estimates, in conjunction with the actual stimulus nature, would suggest that higher revenue expenditures provided only short-lived boost to activity, while higher capital outlays would have had a more durable impact on economic activity. Thus, the quality of the fiscal stimulus in the aftermath of the NAFC imparted volatility to the growth path. Had ample fiscal buffers been there prior to the crisis, capital outlays could have been increased significantly, providing a more durable support to the economy.

On the revenue side, gross tax collections have declined, as could be expected given the weakness in growth. Interestingly, the ratio of direct taxes – both income tax and corporate tax – to GDP has been broadly unchanged from 2007-08, but the pre-crisis upward trend has been halted. The decline in tax/GDP ratio is, therefore, on account of indirect taxes, especially excise collections, reflecting initially the drastic reduction in tax rates as part of stimulus measures, and later, the sharp slowdown of the manufacturing sector. While the CENVAT rate was increased to 10 per cent in the Union Budget 2010–11 (February 2011) and further to 12 percent in the Union Budget 2011-12 (March 2012), it was still below the pre-NAFC level of 14 percent.

Given the actual growth outturn, it is apparent that stimulus measures were higher than necessary, and the need for the second and the third packages is debatable, as the Finance Minister Chidambaram himself noted in April 20135. Similarly, as PMEAC (2013) observed, the recovery in growth was grossly underestimated initially, which had an adverse impact on adjustments in the monetary and fiscal stance in 2009-10 and 2010-11 and on inflation: “In retrospect, we could have tightened monetary conditions much earlier, and rolled back the tax incentives at least one full year earlier” (PMEAC, p. 3). Moreover, the quality of the fiscal stimulus, with its focus on revenue expenditure/tax cuts and stagnant capital outlays, added to demand pressures. These demand pressures were mirrored in high inflation; and, negative real deposit rates, on the back of high inflation, contributed to higher gold imports and higher CAD. Similarly, the incomplete pass-through of high international crude prices to domestic petroleum prices dampened the expenditure adjustment effect, which could have reduced oil imports and hence reduce the pressure on the CAD – an issue which we discuss in Section IV.

Saving-Investment Balance: Private Sector Crowding Out?

The worsening of fiscal balances was mirrored in the deterioration in public savings from 5 percent of GDP in 2007-08 to 1.2 percent in 2012-13, largely on account of government administration. Thus, with decline in both public and private corporate savings, the overall savings rate fell from 36.8 percent to 30.1 percent, with the large chunk of decline occurring in 2011-13 (Table 6). On the investment side, public and private corporate investment fell by almost 9 percentage points between 2007-08 and 2012-13, but the strong increase in household investment (mirroring the increase in physical savings in gold and property) buffeted the decline in overall investment rate from 38.1 percent to 34.8 percent. The overall decline in the investment rate during 2008-13 at 3.3 percent of GDP was, thus, less than that of 6.7 percent in domestic savings, in turn mirrored in the significant widening of current account deficit.

Since households are net savers, while the private corporate sector and the public sector are net users of financial savings, a more analytical way of looking at the saving and investment (S-I) trends is to examine the trends in net balances of these three sectors. The household sector’s net financial savings fell from 11.6 percent of GDP in 2007-08 to 7.1 percent in 2012-13; the public sector’s net S-I deficit increased from (-) 3.9 percent to (-) 6.9 percent over this period. Thus, the net financial savings of the household sector that could have become available to the private corporate sector (after taking into account the draft of the resources by the public sector) fell from an average of 6.3 percent of GDP during 2003-08 to just 1.9 percent during 2008-13; these numbers suggest significant crowding out of the private sector in the post-NAFC period, which then had an adverse impact on investment activity. Arguably, the higher fiscal stimulus directly did crowd out the private corporate sector. Furthermore, the stimulus added to inflationary pressures, which then led to negative real interest rates, greater demand for gold and lower household financial savings. If the fiscal stimulus had been moderate, then arguably interest rates for the corporate sector could have declined more than they did and that would have also provided an incentive for more investment.

In this context, a valid counter-argument is that there was no crowding out: the higher public S-I gap since 2008-09 just reflects the fact that the government was responding to the collapse in the corporate sector investment. This counter-narrative would be true if the public S-I gap had increased on account of higher public investment. However, the public investment rate actually declined from its 2007-08 level (Table 6). The increase in the public S-I gap thus is attributable to the decline in public savings and only a part of it is attributable to explicit stimulus measures (the reduction in excise duty). A large part of the decline in public savings owes to the increase in subsidies, especially oil; cash subsidies increased by one percentage point of GDP in 2008-09, but the increase was almost 2 percentage points once bonds issued in lieu of cash subsidies are also included. Higher government subsidies clearly were not a response to lower corporate investment.

But, why has corporate investment not picked up, even though public S-I gap has narrowed since 2010-11? First, the public S-I gap is still higher than the pre-NAFC level. Second, and more importantly, the households’ financial savings rate continues to decline. The policy bottlenecks alluded to earlier and monetary measures have also impacted corporate investment. The high current account deficit increased external vulnerability. Overall, the combined impact of the increase in the public S-I gap (given that it was driven by subsidies and lower revenues), and lower household financial savings reduced the availability of domestic resources to the corporate sector. The impact on corporate investment was also exacerbated by domestic policy bottlenecks, monetary measures and limited space for further external finance.

Another potential argument against the crowding out hypothesis is that there was no increase in domestic interest rates: how can crowding out take place without an increase in interest rates? First, as documented above, monetary policy was in an accommodative mode during the initial period: this was mirrored in a decline in government borrowing costs despite the near-trebling of government borrowings. As RBI (2014, para III.53) notes, there was de facto monetization of the fiscal deficit to the extent of 28 percent of the overall borrowing requirement on average via injections of primary liquidity through OMOs. Second, crowding-out can take place without an increase in domestic interest rates if the economy is open to capital flows, which indeed is the case for India and other EMEs. Net capital flows received by India averaged 4.2 percent of GDP during the 2-year period 2011-13, broadly similar to 4.6 percent averaged during 2003-08, even as domestic growth had slowed down significantly to 5.6 percent from 8.7 percent between these two periods (see Section IV and also Table 9). Low global interest rates made external capital flows highly attractive to those corporate borrowers who could access global markets. Third, the post-NAFC period has been characterized by the unconventional monetary policies in the AEs, which led to record low short- and long-term interest rates globally. The available empirical evidence indicates that accommodative monetary policy in the US forces other central banks to pursue more-than-desired accommodative monetary policies, resulting in low interest rates globally – the “Great Deviation” (Caruana, 2012; Hofmann and Bogdanova, 2012; Taylor, 2013). Thus, the UMPs might have also kept domestic interest rates in India from edging higher. Finally, domestic interest rates started to increase from 2010-11 and this is true for both nominal rates and real rates (adjusted for WPI-manufactured products inflation).

Quantifying the Growth Slowdown

The discussion above suggests that the accommodative monetary and fiscal policies put in place after the NAFC boosted growth during 2009-11, and then the phased reversal of these policies, partial so far in case of fiscal policy, contributed to the