India
Recent Economic Developments

This report describes recent economic developments in India. It highlights that the real GDP growth accelerated from 6¼ percent in 1994/95 to 7 percent in 1995/96, reflecting mainly the growing response in the industrial sector to the earlier reforms. Industrial production rose 12 percent during 1995/96, led by a robust expansion in manufacturing output. The strong performance in the manufacturing sector was more broadly based than in previous years, with particularly rapid growth in capital goods and consumer durables. Growth in both mining output and electricity generation also remained buoyant.

Abstract

This report describes recent economic developments in India. It highlights that the real GDP growth accelerated from 6¼ percent in 1994/95 to 7 percent in 1995/96, reflecting mainly the growing response in the industrial sector to the earlier reforms. Industrial production rose 12 percent during 1995/96, led by a robust expansion in manufacturing output. The strong performance in the manufacturing sector was more broadly based than in previous years, with particularly rapid growth in capital goods and consumer durables. Growth in both mining output and electricity generation also remained buoyant.

I. Introduction

India’s economic expansion gathered momentum during 1995/96, fueled by a vigorous supply response to the reforms, although as capacity constraints tighten, growth looks likely to moderate somewhat in 1996/97.1 Restrictive monetary policy, combined with a delay in administered price adjustments, helped to bring inflation down during 1995/96. However, wholesale price inflation has picked up moderately in recent months following petroleum price increases.

The external situation came under pressure in 1995/96, reflecting both a widening of the current account deficit and a slowdown in private capital inflows. Following several episodes of sharp depreciation of the rupee and a decline in international reserves, the foreign exchange market has stabilized since February 1996 and there has been some buildup in international reserves over the past six months.

The fiscal deficit has declined gradually since 1993/94, but remains large. The central government deficit was brought down to 5.7 percent of GDP in 1995/96 and the 1996/97 budget envisages a further modest reduction to 5 percent of GDP. The overall public sector deficit (including central and state governments, and central public enterprises) remained at over 9 percent of GDP in 1995/96. With the high fiscal deficit, monetary policy has carried the main burden of macroeconomic stabilization. The decline in broad money growth helped to reduce inflation in 1995/96, but the continuation of large fiscal deficits at a time of surging private investment inevitably put upward pressure on interest rates. Concerns over the impact of the tight liquidity conditions on economic activity prompted an easing of monetary policy in early 1996/97.

The process of structural reform was relatively slow in the period prior to the May 1996 Parliamentary elections. Significant headway was made in certain areas of financial sector reform, notably in deregulating interest rates, and further progress was also achieved in lowering tariffs and simplifying the tax system (Box 1). However, delays in establishing an appropriate transparent framework (e.g., with respect to bidding procedures and uncertainties in cost recovery and risk sharing) slowed the expansion of private sector participation in infrastructure sectors and little was achieved in public enterprise and agricultural reform. Recently, the new Government has outlined a number of broad objectives for continuing the structural reform process as a part of its Common Minimum Program (Box 2) and has launched a number of initiatives aimed at encouraging foreign investment, pushing forward tax and tariff reform, and promoting infrastructure.

Recent Structural Reforms

Progress has continued in implementing structural reforms over the past year, particularly in financial markets.

  • Interest rate liberalization. The ceiling on interest rates on bank deposits of over one year maturity was removed in April 1996, while the loan rates of regional rural banks were liberalized in August 1996. Most interest rates are now deregulated except those on deposits of less than one year and on small commercial bank loans.

  • Capital market reforms. A primary dealer system has been established for the government securities market. Screen-based trading systems have been introduced on most stock exchanges. A central share depository system is being set up. These reforms will serve to improve transparency and liquidity in capital markets.

  • Exchange market liberalization. The system of foreign currency exposure limits for commercial banks has been overhauled. Automatic approval is now given for use of foreign currency hedging instruments.

  • Tax reforms. The MODVAT system has been extended to the textiles sector, so that the VAT-like system of tax credits under the excise tax now covers all manufactured products. A few additional services have been included in the indirect tax net. As a base-broadening measure, the budget also introduced a minimum corporation tax to be applied to corporate book profits, while halving the corporate tax surcharge to 7 1/2 percent.

  • Trade reforms. The 1996/97 budget lowered tariffs on a range of raw materials and intermediate goods, reducing the average import-weighted tariff from 25.2 percent to 22.7 percent. A number of additional consumer goods have been transferred to the list of products eligible for import under the special import license (SIL) scheme (a SIL is a tradeable import license allocated to exporters), while other products were transferred from the SIL to the open general license (OGL) list.

  • Foreign investment. The new Government has streamlined the approval process for foreign direct investment, and set up the Foreign Investment Promotion Council (FIPC) to foster such investment. The limit on holdings by individual foreign institutional investors (FIIs) in a company has been raised from 5 percent to 10 percent of the company’s shares, while FIIs have also been allowed to invest in non-listed companies.

  • Infrastructure. Licenses have been allocated for private sector provision of telephone services in eight major delivery areas. Private development is proceeding in a number of infrastructure projects (including power generation, airport, ports, and roads), although progress has generally been slow and little new capacity has yet resulted from these initiatives.

The New Government’s Common Minimum Program

The new United Front coalition government announced its “Common Minimum Program” (CMP) in early June 1996, to provide a general outline of its policy agenda. The CMP emphasizes a shift toward greater decentralization and social justice, as well as continued economic and political reform. A key objective is to raise real GDP growth to 7 percent per year, with the aim of eliminating poverty in India by 2005.

Some of the areas highlighted were:

  • The central government’s fiscal deficit is to be reduced to below 4 percent of GDP through continued tax reform, eliminating unproductive expenditure, and improved targeting of subsidies.

  • The food subsidy system will be revamped to improve targeting for the poor. Underprivileged sections would also benefit from the continuation and extension of reservations in public employment as well as increased investment in education, health care, and drinking water.

  • Agricultural reforms are to focus on increasing rural credit and investment, abolishing regulations and controls to raise incomes, and legislation to guarantee minimum wages, fair conditions, and group insurance.

  • Industrial reforms are to include further easing and greater transparency of regulations on foreign investment. Tax and credit policies are to encourage both domestic and foreign investment in infrastructure.

  • Public enterprise reform will focus on restructuring and rehabilitation. A Divestment Commission will advise the Government on the further withdrawal of the public sector from core and noncore strategic areas.

  • States would be given greater autonomy over development plans and a high level committee will examine the question of greater devolution of financial powers to the states.

II. Economic activity and prices

Real GDP growth accelerated from 6 1/4 percent in 1994/95 to 7 percent in 1995/96, reflecting mainly the growing response in the industrial sector to the earlier reforms (Table 1).2 In contrast to previous episodes of rapid growth, economic performance in 1995/96 was not associated with exceptional agricultural growth related to particularly favorable weather conditions. Output growth is likely to be in the range of 6-6 1/2 percent in 1996/97, with performance in some basic industries beginning to be affected by capacity constraints.

Table 1.

India: Growth Rates of GDP by Sector

(Percent)

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Source: Government of India, Central Statistical Office.

Industrial production rose 12 percent during 1995/96, led by a robust expansion in manufacturing output (Chart 1). The strong performance in the manufacturing sector was more broadly based than in previous years, with particularly rapid growth in capital goods and consumer durables (Appendix Table 4). Growth in both mining output and electricity generation also remained buoyant. In the first three months of 1996/97, industrial production growth slowed to 9 3/4 percent, with particularly weak performance in a few basic sectors: growth of electricity generation has come down sharply, while crude oil and fertilizer production have declined. This weakness in some sectors seems to have been due, at least in part, to emerging capacity constraints reflecting a lack of investment in earlier years.

CHART 1
CHART 1

INDIA ACTIVITY AND PRICES, 1994–1996

Citation: IMF Staff Country Reports 1996, 131; 10.5089/9781451818529.002.A001

Source: Data provided by the Indian authorities; and staff estimates.1/ 3-month moving average.2/ Index for industrial workers.

Agricultural growth moderated in 1995/96 from the high base achieved in the previous year, as foodgrain production--which had reached a record high in 1994/95--declined marginally (Appendix Table 5). With growing internal demand and higher grain exports, public food stocks declined from their record level of 33 million tons in mid-1995 to 22.7 millions tons by April 1996, although still considerably above the Government’s prescribed norm of 15 million tons. Favorable climatic conditions during the first few months of 1996/97 suggest that a further good harvest can be expected this year, the ninth consecutive good monsoon.

Higher public and private savings both contributed to an expansion in gross domestic savings in 1994/95, reversing several years of stagnation (Table 2).3 Gross domestic investment also expanded in 1994/95, associated with the strong recovery in private investment. Investment in machinery, equipment, and construction was particularly buoyant. While firm data are not yet available, investment during 1995/96 appears to have remained strong, as indicated by continued rapid growth in capital goods production as well as buoyant imports of capital goods.4 However, investment in the infrastructure industries appears to have been adversely affected by inadequate internal resource generation and cost recovery (e.g., in the power sector) as well as well as delays in setting up the framework for private sector participation.

Table 2.

India: Saving and Investment

(As percent of GDP at current market prices)

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Source: Central Statistical Organization.

Wholesale price inflation was reduced to 5 percent in 1995/96 from 10 1/2 percent in the previous year (Appendix Table 8). This decline reflected mainly the impact of a tight monetary policy and delays in adjusting administered prices. Most administered prices--which account for almost 16 percent of the wholesale price index (WPI)--had not been adjusted since early 1994.5 Price increases of primary goods (mainly food items) also moderated in 1995/96, owing in part to the sales from foodgrain stocks through the public distribution system, as well as higher imports of essential agricultural goods following the removal of quantitative restrictions on some products (e.g., edible oil) and a reduction in customs duties. Consumer price inflation declined more modestly--from 9.7 percent during 1994/95 to 8.9 percent during 1995/96. The significant differential between wholesale and consumer price inflation was partly due to the lower weight of administered prices in the consumer price index. The CPI has also been less affected by the increasing openness of the Indian economy, which has had little impact on services and many consumer goods--products with a larger weight in the CPI than in the WPI.6

Wholesale price inflation has picked up in 1996/97, reaching 6 1/2 percent by September 1996 (see Chart 1). This rise has reflected the pass-through of a 20 percent increase in administered prices of petroleum products in July (other administered prices have not yet been adjusted) as well as rising cereal prices. Consumer price inflation has continued to decline, falling to 8.3 percent in July 1996, so that the differential between the two indices has narrowed. The authorities have indicated that they aim to hold wholesale price inflation in the range of 6-7 percent in 1996/97 as a whole.

One of India’s key challenges is to provide adequate infrastructure to support continued rapid growth. Insufficient capacity and inefficiencies in critical areas of infrastructure threaten to constrain the expansion of agricultural and industrial production and exports. Faced with growing budgetary constraints, the Government has acted on a number of fronts in recent years to encourage private sector investment in certain infrastructure areas to supplement public investment. However, to date, only limited investments have actually been implemented by the private sector. Obstacles have been; (i) difficulties in ensuring adequate cost recovery, including setting appropriate tariffs; (ii) a lack of a clear framework for allocating risks; and (iii) a relatively thin market for long-term private debt.7

  • To address the growing power deficit, the central government allowed private sector participation in electricity generation in 1991. However, subsequent progress has been slow, in large part because distribution is still dominated by the financially weak state electricity boards (SEBs). To jump start the process, the central government signed agreements-in-principle to provide counter-guarantees for state power purchase agreements with eight large private sector power projects: four of these agreements have now been finalized. Nevertheless, the uncertainties about cost recovery (e.g. in raising electricity tariffs) and complexities in establishing risk-sharing arrangements have contributed to substantial delays in implementing these projects. The Ministry of Power took steps to streamline private power investment, including the introduction of new guidelines for project screening and clearance in early 1996. Several states have begun to implement some SEB reforms, notably in Orissa, where a pilot project has been set up with World Bank assistance, which aims to separate the distribution, generation, and regulatory functions and includes a reform of the electricity tariff structure.

  • In the telecommunications sector, private cellular phone service has commenced in four major metropolitan areas (Delhi, Mumbai, Calcutta, and Madras) and tenders were recently invited for licenses in other areas. Less progress has been made in introducing private sector participation in basic telecommunication services. Only 8 of the 20 basic telecommunication service areas have been awarded so far after two rounds of bidding, owing to problems in the bidding procedures, and no contracts have yet been signed, pending specification of the precise regulations for private sector participation by the recently established regulatory authority.

  • Private participation has made some headway in other areas, including the privatization of several port facilities and final approval for a new international airport in Bangalore. To help upgrade India’s road network, the National Highways Act was amended in 1995 to permit the levy of fees in order to encourage private sector participation in the construction, operation, and maintenance of roads on a build-operate-transfer (BOT) basis. So far, one project has been awarded, and tenders have been invited for five more national highway projects, although it is recognized that the public sector would need to play the dominant role in this area.

Other initiatives to encourage infrastructure investment include steps to ease restrictions on foreign investment in infrastructure (see section V), tax incentives, and plans to set up an Infrastructure Development Finance Company (IDFC) with Rs 10 billion in share capital from the Government and the Reserve Bank. The Government has indicated that the IDFC will provide refinance and financial guarantees, as well as lend directly for infrastructure projects.

III. Fiscal Developments

The pace of fiscal adjustment since 1990/91 has been modest and uneven. A sizeable reduction in the central government deficit was achieved during 1991/92-1992/93 but the gain was partly reversed in 1993/94 (Table 3 and Chart 2). Moderate progress was made in the following two years, bringing the central government deficit down to 5.7 percent of GDP in 1995/96, slightly higher than the target of 5.5 percent of GDP (Table 4). A more substantial reduction in the primary deficit was offset by rising interest payments, as the average interest rate on government debt has risen in response to the shift of government borrowing to market terms since 1991.8 The overall public sector deficit for 1995/96 is estimated at 9.1 percent of GDP, the same as in 1994/95.

Table 3.

India: Public Sector Operations 1/

(In percent of GDP)

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Sources: Data provided by the Indian authorities; and staff estimates.

The consolidated public sector comprises the operations of the central government, the state governments and Union Territories, and the central public enterprises.

The overall balance is less than the sum of its components due to intrasector transfers.

CHART 2
CHART 2

INDIA PUBLIC SECTOR ACCOUNTS, 1990/91 – 1996/97 1/

(in percent of GDP)

Citation: IMF Staff Country Reports 1996, 131; 10.5089/9781451818529.002.A001

Source: Data provided by the Indian authorities.1/ 1996/97 figures are budget estimates
Table 4.

India: Central Government Operations, 1991/92-1996/97

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Sources: Data provided by the Indian authorities; and staff estimates.

Overall balance less divestment receipts.

Overall balance excluding interest payments.

The consolidated public sector comprises the central government, state governments, and central public enterprises.

The 1995/96 budget aimed at a moderate reduction of the central government deficit. Most of the envisaged deficit reduction was to come through reduced expenditure on loans to states and central public enterprises. Continued tax buoyancy--owing to improvements in tax administration and cyclical gains--was expected to offset the revenue impact of reductions in tax rates as part of ongoing tax reforms.9

In the event, revenues increased in line with the budget, although the composition was significantly different. Gains from buoyant personal income and corporate taxes (0.2 percent of GDP), customs duties (0.5 percent of GDP) and telecom license fees (0.2 percent of GDP), largely offset weaker excise duties (0.3 percent of GDP) and a major shortfall in divestment receipts (0.7 percent of GDP). Buoyant tax revenue mainly reflected the strength of the economy and the cumulative effect of measures taken to broaden the tax base and plug leakages in the system, although excise duty collections were affected by higher-than-expected MOD VAT credits for capital goods and problems in tax administration.10 Weak stock market conditions contributed to the failure of the divestment program, which generated only Rs 3.6 billion of the budgeted Rs 70 billion. An unanticipated receipt of Rs 18.5 billion from telecom license fees helped contain the shortfall in nontax revenue to 0.4 percent of GDP (Table 4).

Expenditures were 0.2 percent of GDP higher than budgeted. There was a small overrun in the fertilizer subsidy bill, owing to higher-than-anticipated fertilizer imports toward the end of the year and rising prices in international markets. Loans to states against small savings collections exceeded budget targets by 1/4 percent of GDP, reflecting intensified efforts by states to mobilize such deposits from individuals.11 Several new spending initiatives announced after the budget--most importantly for school mid-day meals and a national social assistance program for the poor--contributed to an increase in plan current spending. However, plan capital outlays fell significantly below budgeted amounts, reflecting a deliberate effort to curtail spending as well as the slow execution of a number of externally financed power projects.

Financing of the central government’s deficit by the Reserve Bank of India (RBI) increased sharply to 1.8 percent of GDP in 1995/96 compared with 0.2 percent in 1994/95. The main reasons for the increased RBI financing of the deficit were: (i) shortfalls in non-RBI market borrowing, reflecting the Government’s reluctance to accept rising interest rates in primary auctions despite tightening liquidity conditions; and (ii) shortfalls in external financing, mainly due to slower-than-expected implementation of externally financed projects. Strong small savings collections provided some offset to these shortfalls.

The deficit of the state governments is estimated to have risen slightly from 2.9 percent of GDP in 1994/95 to 3.1 percent of GDP in 1995/96, reflecting a small decline in grants from the center relative to GDP and the continued expansion in non-developmental expenditure. Rising interest payments--continuing the trend of recent years--and higher outlays on administrative services and pensions were the main contributing factors to the increase in non-developmental expenditure. On the tax reform front, there has been some progress toward a more rational system of indirect taxation, including agreement by state finance ministers to fix floor rates for states’ sales taxes and the partial introduction of the VAT by some state governments.12 After falling sharply to 2.6 percent of GDP in 1994/95, the deficit of central public enterprises came down further to 2.1 percent of GDP, mainly the result of an additional decline in investment spending by these enterprises.

The budget for 1996/97 targets a reduction in the central government deficit to 5 percent of GDP.13 With state government budgets implying a combined deficit of 2.8 percent of GDP but higher public enterprise deficits resulting from an anticipated decline in operating surpluses, the public sector deficit would decline to 8.3 percent of GDP. The bulk of the envisaged fiscal correction at the central level is to come from higher revenue (0.5 percent of GDP). A revived divestment program is expected to raise Rs 50 billion (0.4 percent of GDP), although other non-tax revenues would decline relative to GDP. Tax revenues are to rise by 0.4 percent of GDP, half of which would reflect the estimated impact of new revenue measures and half the cyclical impact of the strong economy. Expenditure is targeted to decline by 0.2 percent of GDP, mainly through slower growth in non-interest current expenditure. The primary deficit of the central government is budgeted to fall to 0.2 percent of GDP, the lowest level in more than ten years.

On the tax reform front, further steps were taken to expand the tax base and reduce tax rates.

  • The surcharge on the corporate income tax was halved to 7.5 percent, and a minimum corporate tax on book profits was introduced in an effort to bring into the tax net zero-tax companies benefitting from extensive deductions and exemptions.14 Sick units and companies engaged in the power and infrastructure sectors will be exempted from the minimum corporate tax. The minimum corporate tax is expected to boost revenue by Rs 20 billion (about 0.2 percent of GDP) in 1996/97.

  • The MODVAT system was extended to the textile sector, implying a full coverage of manufacturing under the system. In an effort to restrict the misuse of MODVAT credits, the issue of MODVAT invoices by dealers was restricted.15

  • Customs duties were reduced on a wide range of capital goods and intermediate inputs.16 Although a 2 percent surcharge on imports was introduced, which effectively raised the peak tariff rate to 52 percent, the effective import-weighted tariff rate (including oil imports) is estimated at 22.7 percent in 1996/97, down from 25.2 percent in 1995/96.

  • Regarding personal income tax, the rate applying to the lower income bracket was reduced from 20 percent to 15 percent and the standard deduction for low-income employees was raised.

  • Additional services were brought into the indirect tax net, including advertising, radio paging, and courier services.

  • Some new tax exemptions were introduced and others were extended. These include new tax holidays for firms developing infrastructure, income tax exemption for funds to finance such development, larger exemptions for saving in the form of life insurance and pensions, and additional mortgage relief for homeowners.

On the expenditure side, key measures in the budget included:

  • Higher allocations for spending on the social sectors, infrastructure, and the fertilizer subsidy.17 Programs for infrastructure financing and the provision of rural credit and basic minimum services to the poor are to be expanded.18

  • The Public Distribution System (PDS) is to be restructured to provide cheaper food grains to the very poor. Although a timetable for the restructuring, and the associated costs, have yet to be worked out, the Government is considering providing food grains at half the market price to all people below the poverty line, which would imply a significant increase in the food subsidy, unless it were combined with a substantial cutback in access by those above the poverty line.19

  • Expenditure on wages and salaries is expected to increase substantially in 1996/97, as a result of pay awards based on upcoming recommendations of the Fifth Pay Commission.20 A budgetary provision of Rs 50 billion (Rs 40 billion in the Union budget, and Rs 10 billion in the Railways budget), or 0.4 percent of GDP, has been made to reflect the impact of the Pay Commission’s recommendations.

  • Central assistance to state plans was increased by Rs 25 billion (0.2 percent of GDP) to support the provision of basic minimum services. States have also been given greater flexibility in the selection and implementation of centrally-sponsored schemes, in line with the Government’s proposals in its Common Minimum Program to delegate greater spending responsibility and flexibility to states.

Finally, the budget speech announced that a number of commissions would be set up to advance the process of fiscal reform. In particular:

  • A Divestment Commission has been established to develop a comprehensive divestment program for the central public enterprises, to determine the extent and modes of divestment, and to monitor the process of divestment. So far, 40 public enterprises have been referred to the Commission.

  • An Expenditure Commission is to examine issues of expenditure control and management, and the level and composition of spending.

  • A Tariff Commission is to be established to examine the level and structure of tariffs, devise a timetable for the removal of quantitative restrictions, and advise on other issues related to WTO jurisdiction, such as trade in financial services.

In addition, the budget speech signaled the Government’s intention to address the remaining recommendations of the Tenth Finance Commission relating to sharing central taxes with the states from a single divisible pool using a uniform rate.21 Implementation of these recommendations would require constitutional amendments.

IV. Monetary developments

With a high fiscal deficit, monetary policy has played the central role in macro-economic stabilization in recent years. In conducting policy, the Reserve Bank has continued to rely on broad money targeting as its basic policy indicator. However, as monetary and exchange market developments have become increasingly interlinked with the opening of the economy, the RBI has paid greater attention to exchange rate and interest rate developments

In response to the surge in foreign private capital inflows during late 1993/94 through late 1994/95, the Reserve Bank of India (RBI) intervened in the foreign exchange market in order to prevent an appreciation of the rupee. Notwithstanding substantial open market operations to partially offset the resulting rise in net foreign assets, broad money accelerated to 18 percent during 1993/94 and 1994/95, which contributed to the pickup in inflation.22

To dampen inflationary pressures, the stance of monetary policy was tightened beginning in late 1994/95. The cash reserve ratio was increased from 14 percent to 15 percent in December 1994 and several measures were taken to discourage inflows of non-resident foreign currency deposits. The RBI sought to maintain this tightened stance during 1995/96, while responding to several shifts in the policy environment. The external situation weakened, which prompted a substantial drainage of liquidity from the system as international reserves declined. RBI credit to government expanded rapidly in the early months of the year, as the authorities intervened in primary auctions to contain increases in interest rates on government securities and the Government made greater resort to ad hoc treasury bills issued directly to the RBI. The RBI also eased refinance limits against government securities in September 1995 and lowered the CRR by 1 percentage point during November/December 1995. The end result was that broad money growth slowed to about 15 percent in 1995/96, in line with the announced target range of 15-16 percent (Table 5 and Chart 3).

Table 5.

India: Monetary Survey, 1992/93-1996/97

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The end-March data for March 1994/95 and 1995/96 contain a surge in deposits associated with the reporting date. The percent changes for broad money in 1994/95 and 1995/96 using mid-March data are 17 7 percent and 14.9 percent, respectively.

Cumulative flow from start of fiscal year.

CHART 3
CHART 3

INDIA MONEY, INFLATION AND INTEREST RATES, 1991/92 – 1996/97

Citation: IMF Staff Country Reports 1996, 131; 10.5089/9781451818529.002.A001

Source: Data provided by the Indian authorities, and International Financial Statistics.

Although growth in bank credit to the commercial sector remained virtually unchanged at 18 percent during 1995/96 (based on mid-March data), a decline in the growth of other sources of private financing exacerbated the tightening of credit conditions (Appendix Table 24). The growth in term lending by the all-India financial institutions fell to 14 percent in 1995/96, down from 24 percent in 1994/95, as these institutions faced higher costs in raising funding. Equity markets also were relatively weak from mid-1994/95 through most of 1995/96, reflecting rising domestic interest rates as well as structural problems in the market.23 As a result, new primary issues declined by almost a third in 1995/96. The weak conditions in the domestic capital market and the fallout from the Mexico crisis also contributed to a decline in new issues of Global Depository Receipts and a slowdown in foreign institutional investment inflows.

The combination of strong demand for investment funds, a temporary slowdown in foreign private capital inflows, and the continued heavy borrowing demands of the public sector led to a sharp increase in both real and nominal interest rates during 1995/96 (Chart 4). Prime lending rates were raised by 1 1/2 to 2 percentage points to 16.5-20 percent by February 1996, while effective lending rates were reportedly 2-3 percentage points above the published prime rates.24 Interest rates on 91-day Treasury bills increased from 9 1/2 percent in late-1994/95 to 13.0 percent in 1995/96. Rates on longer term securities also rose, albeit more moderately, and the yield curve flattened.

CHART 4
CHART 4

INDIA FINANCIAL INDICATORS, 1994–96

Citation: IMF Staff Country Reports 1996, 131; 10.5089/9781451818529.002.A001

Source: Data provided by the Indian authorities.1/ State Bank of India.

The increasing pressures on interest rates highlighted the growing tensions between fiscal and monetary policy. During much of 1995/96, the agreement between the RBI and the Ministry of Finance to limit borrowing through ad hoc treasury bills was not observed.25 Borrowing through ad hoes averaged Rs. 97 billion during 1995/96, and was well above the intra-year limit of Rs 90 billion in 6 of the 12 months. Borrowing through ad hoes was reduced to Rs 59 billion at year-end as the RBI subscribed Rs 55 billion in a special securities issue at a market-related rate.

The Reserve Bank’s monetary and foreign exchange market operations became increasingly integrated in 1995/96. Several periods of heavy foreign exchange sales resulted in a sharp tightening in the domestic money market, with call money rates peaking at 85 percent in November 1995. The RBI used repurchase agreements to partially offset the liquidity impact of the foreign exchange operations. To provide incentives to attract non-resident deposits, the Reserve Bank also eliminated the cash reserve requirements on the non-repatriable foreign currency deposit schemes, halved the requirements on other non-resident deposits, and raised the ceiling on the foreign currency deposit rates from 8 percent to 10 percent.

Concerned with signs that tight liquidity conditions were dampening economic activity, the RBI significantly eased monetary policy in early 1996/97. The CRR was reduced from 14 percent to 13 percent in May 1996 and again to 12 percent in early July. The liquidity impact of the latter reduction was partially offset by eliminating the refinance facility against government securities, although little of the available refinance was being utilized at that time. A further contributor to easing monetary conditions in the early part of the year was a sharp increase in net RBI credit to government through July 1996--including a Rs 200 billion increase in ad hoc treasury bills. However, much of this buildup was subsequently reversed; by September 1996, RBI credit was reduced to Rs 57 billion, with a decline in borrowing through ad hoes to Rs 34 billion.

The easing of the policy stance has been reflected in a pickup in broad money growth to about 16 1/2 percent in September 1996 while short-term interest rates have declined sharply. In particular, interest rates on short-term government securities have come down by about 250 basis points since April 1996 to 10 1/2 percent at end-September, with little RBI intervention in the primary market. By contrast, long-term government bond rates have declined only modestly, despite considerable purchases by the RBI and primary dealers, and the yield curve has steepened substantially.

For 1996/97 as a whole, the Reserve Bank has set a target for broad money growth of 15 1/2-16 percent, aimed at containing inflation to 6-7 percent and sustaining continued buoyant real growth. The RBI indicated in its April 1996 credit policy statement that, as a part of the commitment to the ongoing process of financial liberalization, it would consider further reductions in the CRR, combined with a rationalization of the RBFs refinance facilities, as a medium-term objective. Greater reliance would also be placed on open market operations in conducting monetary policy. The RBI recently recommended in its 1995/96 Annual Report that ad hoes treasury bills be replaced with ways and means advances--which would be used to accommodate temporary mismatches between the inflows and outflows in the Government’s accounts--and that a statutory ceiling be imposed on public debt.

Significant progress has been made in several areas of financial sector reform over the past year.26 A number of steps were taken to deregulate interest rates. The ceiling on deposit rates was removed for deposits with terms of over two years in October 1995 and for terms of 1-2 years in July 1996.27 In addition, the minimum maturity of time deposits was reduced from 45 to 30 days. Since October 1994, banks have been free to set rates on loans greater than Rs 200,000, although lending rates on smaller loans are still regulated.28 In July 1996, the RBI fully liberalized lending rates in the regional rural development banks and freed deposit rates for non-banking financial companies that fully comply with RBI guidelines.

While the stipulated statutory liquidity requirement (SLR) on incremental deposits remained unchanged at 25 percent, the average effective SLR declined further to about 28 percent by end-1995/96 (from 30 percent a year ago), reflecting expansion in the commercial banks’ balance sheets. However, the requirement that 40 percent of total lending be directed to the priority sectors, along with the sub-ceilings on agricultural and small-scale industrial credit, remains unchanged.

Further steps were taken during the past year to reform India’s capital markets.

  • To develop the government securities market, the RBI established guidelines for a primary dealer system in March 1995. So far, six primary dealers have been approved and the new system went into operation in February 1996.29 To catalyze the new system, in July 1996 the RBI offered the primary dealers significant commissions to participate in the auctions, which has resulted in substantial intermediation through primary dealers and contributed to a marked increase in secondary market activity. A delivery-versus-payments system for government securities was also established in July 1995 to improve efficiency and reduce settlement risk. More recently, the RBI announced its intentions to introduce a system of satellite dealers in the government securities market.

  • In the stock market, the Security and Exchange Board of India (SEBI)--the chief regulator of India’s capital markets--strengthened eligibility and disclosure norms to improve the quality of new primary issues and introduced a number of regulations regarding fraudulent and unfair trading practices. Screen-based trading--which has now been introduced in the major stock exchanges and is scheduled to be introduced in the remaining exchanges shortly--will enhance transparency and facilitate market surveillance, A system of share depositories is being set up to provide more efficient and accurate clearing and settlement.

  • To encourage the development of debt markets, beginning in 1995 the RBI permitted private sector institutions to set up money market mutual funds (MMMFs), and in 1996 extended access to these funds to corporations and finance companies.

V. External sector developments

Following two years of surplus, the balance of payments registered a deficit of $1.2 billion in 1995/96, reflecting both current and capital account developments (Table 6). The current account deficit widened, as rapid import growth more than offset a strong export performance. On the capital account side, portfolio equity inflows slowed considerably, while there were sizable other capital outflows. Against this background, the rupee depreciated significantly against the U.S. dollar starting in mid-1995--following two and a half years in which the exchange rate had been virtually unchanged--despite considerable intervention. Foreign exchange reserves fell to $17 billion (equivalent to five months of imports) at end-1995/96 from $20.8 billion at end-1994/95.

Table 6.

India: Balance of Payments, 1991/92-1995/96

(In millions of U.S. dollars)

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Sources: Data provided by the Indian authorities; and staff estimates.

Includes interest on trade finance. Excludes personal imports of gold and silver.

Includes Foreign Currency Convertible Bonds (FCCBs) and other Euro bond issues.

The current account deficit increased to 1.7 percent of GDP in 1995/96 from 1.0 percent in the previous year, as import growth accelerated to nearly 34 percent (in dollar terms), reflecting both rising domestic demand and the impact of the earlier trade reforms.30 Growth in non-oil imports was particularly strong, owing to higher imports of capital goods (e.g., machinery and transport equipment) as well as an expansion in imported inputs for export production (including chemicals, non-ferrous metals, gems, and precious stones).

Exports increased by over 21 percent (in dollar terms) in 1995/96--the third consecutive year of strong growth. As a result, the share of exports in GDP rose to 10 percent in 1995/96, up from 6 percent in 1990/91. While growth of manufactured exports--the main contributing factor to the export recovery during 1993/94-1994/95--moderated somewhat in 1995/96, agricultural exports rose by 44 percent, largely owing to a fourfold increase in rice exports (Appendix Table 26). The latter reflected the liberalization of limits on rice exports in October 1994 and the removal of the export minimum price restrictions in response to large food stocks and another bumper crop.

Turning to the capital account, the slowdown in portfolio equity inflows that started in the fall of 1994 continued for most of 1995/96, amid pre-election uncertainties and the fallout from the financial crisis in Mexico (Chart 5). The drop in issues of Global Depository Receipts (GDRs) was particularly sharp. By contrast, foreign direct investment continued to rise, reaching $2 billion in 1995/96, reflecting a growing pipeline of approved projects. Gross external commercial borrowing (ECB) rose as ECB guidelines were relaxed, but this was largely offset by higher repayments. Net external assistance continued to decline in 1995/96, reflecting rising repayments and slower project disbursements. Other capital flows registered a sizable deficit in 1995/96, possibly responding to the unsettled exchange market conditions.

CHART 5
CHART 5

INDIA SELECTED EXTERNAL INDICATORS, 1994–1996

Citation: IMF Staff Country Reports 1996, 131; 10.5089/9781451818529.002.A001

Source: Data provided by the Indian authorities; and staff estimates.1/ Decrease indicates depreciation.2/ Three month moving average.3/ Portfolio investment by foreign institutional investors (FIIs).

The balance of payments situation strengthened in the first five months of 1996/97, and foreign exchange reserves increased moderately to $18 billion by end-August 1996. Both export and import growth slowed-to 9.7 percent and 4.7 percent, respectively-in the first five months of the year.31 In particular, non-oil imports fell by 3.2 percent, which appears to have reflected some weakening of investment demand as well as delays in imports in anticipation of a lowering of customs duties in the 1996/97 budget announced in July. On the capital account, inflows from foreign institutional investors (FII)--which had begun to recover in late 1995/96--maintained a strong pace through the first four months of 1996/97--although there was some slowdown in August. There were several large new GDR issues in July-September 1996 (totaling about $800 million), and a number of further issues are in the pipeline.

During most of 1993/94-1994/95, the exchange value of the rupee vis-à-vis the U.S. dollar was broadly stable (Chart 6). In response to the large capital inflows during this period, the authorities effectively set a ceiling on the rate by purchasing foreign exchange at Rs 31.37 per U.S. dollar. However, the exchange rate started to come under downward pressure in early 1995/96, reflecting the widening current account deficit and the slowdown in portfolio capital inflows. Pressures were exacerbated as depreciation of the rupee, starting in July 1995, triggered expectations of a further depreciation and prompted speculation in the market via shifts in leads and lags in trade financing. Initially, the RBI refrained from intervening in the market. However, as pressures mounted in September-October 1995, the authorities responded by selling foreign exchange in the market, supported by measures to tighten domestic liquidity and the introduction of a 15 percent interest surcharge on import finance. Following another speculative attack in February 1996--when the rate fell to Rs 38 per U.S. dollar--the authorities took further steps to reduce trade financing leads and lags, including an increase of the interest surcharge on import financing to 25 percent, eliminating post-export refinance in foreign currency terms, and rationalizing the interest rate structure for rupee export credit, which had encouraged delays in repatriating export receipts.32 Since then, the exchange rate had traded in a relatively narrow range. The interest surcharge on import finance was rescinded in July 1996.

Despite the significant depreciation of the rupee against the U.S. dollar, there was only a 3 percent depreciation in the nominal effective rate during 1995/96, as the U.S. dollar strengthened against other major currencies. The partner country inflation differential narrowed, reflecting the deceleration in Indian inflation. In July 1996, the real effective exchange rate was close to its level of March 1993, following the unification of India’s exchange rate system.

CHART 6
CHART 6

INDIA EXCHANGE RATE DEVELOPMENTS, 1991–1996

Citation: IMF Staff Country Reports 1996, 131; 10.5089/9781451818529.002.A001

Source: Data provided by the Indian authorities; IMF, Information Notice System and International Financial Statistics.

Despite the increase in current account deficits since 1993/94, the shift toward non-debt creating capital inflows since 1991 has contributed to an improvement in the profile of external debt. The ratio of total external debt to GDP has gradually declined from 33.9 percent in 1991/92 to 28.4 percent in 1995/96, with the external debt service ratio falling steadily to 26.2 percent in 1995/96 (Appendix Table 30). Since 1996/97 is the last year of peak repayments of exceptional borrowing incurred during the 1990/91 crisis (including India Development Bonds and purchases from the IMF), the debt service ratio is likely to fall further next year.

Substantial progress has been made in lowering import tariffs in recent years. According to World Bank estimates, the average (import-weighted) tariff has been brought down from 64 percent in 1992/93 to 23 percent in 1996/97 (Table 7). Progress has also been made toward removing quantitative restrictions on imports. Under a phased approach, specified commodities on the negative list are first allowed to be imported through special import licenses (SILs) before shifting these commodities to the open general license (OGL) list. SILs are granted to exporters in proportion to their export earnings and are tradeable. As of March 1996, about 60 percent of total imports (measured by tariff lines) was freely imported. In August 1996, a further 62 items (equivalent to 0.6 percent of total tariff lines) were shifted from the restricted list to the SIL list. There were no major changes during 1995/96 and early in 1996/97 to quantitative restrictions on exports, which are primarily on agricultural goods and minerals.

Table 7.

India: Tariff Reform

(End of period; in percent, unless otherwise indicated)

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Sources: Data provided by the Indian authorities; and the World Bank.

India formally accepted the obligations of Article VIII, Sections 2, 3, and 4 of the Fund’s Articles of Agreement in August 1994. Since that time, foreign exchange has been freely provided for payments of most current account transactions, although a number of restrictions remained in place at that time. Progress has been made in eliminating some of these remaining restrictions: (i) restrictions on repatriating current investment income have been eliminated starting with income earned in the 1996/97 tax year, and (ii) the multiple currency practice associated with existing exchange rate guarantees on non-resident deposits is being phased out as deposits under the scheme mature.33

Other restrictions which have remained in place are: (i) restrictions on the transfers of past income on investment by non-resident Indians and overseas commercial bodies; (ii) an Indo-Russian debt agreement under which debt service on the agreement can only be used for the purchase of Indian exports; (iii) bilateral trade and payments agreements with Bulgaria, the former German Democratic Republic, the Czech Republic, Poland, Romania, the Slovak Republic, and the former Yugoslavia; and (iv) a dividend balancing requirement under which transfers abroad of dividends by nonresident investors in consumer goods industries must be balanced by export earnings, for a period of seven years from the date of commencement of commercial production.

The new Government has taken a number of steps to reduce restrictions on capital account transactions. For GDRs, the restriction limiting the frequency of issues to once per year was lifted; the requirement of a three-year track record of good performance was eliminated for those issues intended to fund infrastructure projects; the end-use requirement for project-related expenditure was eased to allow use of 25 percent of proceeds for corporate restructuring; and financial institutions were permitted to raise funds through GDR issues for on-lending purposes. FII investment in unlisted companies has been allowed and the ceiling on investment in a company by individual FIIs was raised from 5 percent to 10 percent of its capital. The ceiling on aggregate FII investment in a company remained unchanged at 24 percent.

The overall ECB ceiling was raised from $6 billion in 1995/96 to $7.9 billion in 1996/97. ECB regulations were also relaxed for infrastructure projects. The ceiling on borrowing was raised to 35 percent of project cost (compared with a norm of 20-30 percent); the end-use requirement and the three-year establishment record requirement were dropped; and the minimum average maturity requirement for loans of more than $15 million was reduced from seven to five years. In addition, the minimum average maturity of ECB by development finance institutions for amounts for non-infrastructure projects exceeding $15 million was reduced to five years and on-lending for rupee expenditure was permitted.

To enhance the efficiency in the foreign exchange market, in January 1996, the RBI permitted commercial banks to decide their own overnight open position limits, subject to RBI approval. Subsequently, in April 1996 banks were allowed to determine their own aggregate gap limit, subject to RBI approval, and to initiate cross currency options in overseas markets.

India: Recent Economic Developments
Author: International Monetary Fund