India: 2005 Article IV Consultation—Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion
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International Monetary Fund
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Publication Date:
21 Feb 2006
eISBN:
9781451818628
Language:
English
Keywords:
ISCR; CR; GDP; import growth; rate; market rate; rate increase; central government; exchange rate; current account; private sector; foreign direct investment; Oil prices; Global
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India’s 2005 Article IV Consultation reports that the government’s medium-term fiscal strategy is broadly appropriate, and faster implementation is crucial for its economy. India’s growth spurt provides a golden opportunity to fast-forward the government’s structural reform agenda. The government is rightly focused on improving the infrastructure, opening and liberalizing further the Indian economy, and alleviating poverty. Steps to improve the business climate and regulatory environment, and reform of restrictive labor laws could have large payoffs in terms of foreign investment and job creation.

Abstract

India’s 2005 Article IV Consultation reports that the government’s medium-term fiscal strategy is broadly appropriate, and faster implementation is crucial for its economy. India’s growth spurt provides a golden opportunity to fast-forward the government’s structural reform agenda. The government is rightly focused on improving the infrastructure, opening and liberalizing further the Indian economy, and alleviating poverty. Steps to improve the business climate and regulatory environment, and reform of restrictive labor laws could have large payoffs in terms of foreign investment and job creation.

I. Introduction

1. India’s economic performance continues to be impressive. For the third year running, growing openness and rising consumer and investor confidence are helping sustain rapid growth, buoying foreign investor interest. Real per capita incomes have risen by over 50 percent over the past decade, igniting consumer expenditure, and firms are investing in new capacity to tap growing internal and external markets. India’s growth spurt has been accompanied by a marked opening to the regional and global economy. Import and export growth (including services) exceeded 33 percent per year in 2003–04, and the share of exports to Asia in India’s total exports rose to about one—third, up from less than one— fourth in 2000.

India’s Consumption Boom

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Sources: World Bank, World Development Indicators; CME; and staff estimates.

2. However, the evolving macroeconomic situation is presenting policy challenges. Rapidly rising domestic demand, a widening trade and current account deficit, and inflationary pressures are key risks to the near-term outlook. The Reserve Bank of India (RBI) has recently raised interest rates, but fiscal policy is adding to demand pressures, reflecting higher outlays on priority infrastructure and social programs and higher transfers to the states.

3. In the medium term, bridging the income and poverty gap will require India to sustain and improve on current growth rates by forcefully addressing its entrenched structural problems. Poverty remains high and concentrated in the rural areas, with 35 percent of the population living on less than a dollar a day in 2000. India’s social indicators continue to lag those of many East Asian countries a quarter of a century ago (India Planning Commission, Mid-Term Appraisal of the Tenth Five Year Plan (2002– 2007)), and achieving the Millennium Development Goals will be difficult (Table 1). Despite facing some of the region’s lowest labor costs, inadequate infrastructure and power, and burdensome red tape have hampered competitiveness. The structural reform agenda is well-known to the authorities. Continued priorities of the Congress-led coalition government include further opening and liberalizing the Indian economy, addressing infrastructure weaknesses, and alleviating rural poverty.

Table 1.

India: Millennium Development Goals, 1990–2003 1/

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Source: World Development Indicators database, April 2005.

In some cases the data are for earlier or later years than those stated.

Halve, between 1990 and 2015, the proportion of people whose income is less than one dollar a day.

Ensure that, by 2015, children everywhere, boys and girls alike, will be able to complete a full course of primary schooling.

Eliminate gender disparity in primary and secondary education preferably by 2005 and to all levels of education no later than 2015.

Reduce by two-thirds, between 1990 and 2015, the under-five mortality rate.

Reduce by three-quarters, between 1990 and 2015, the maternal mortality ratio.

Have halted by 2015, and begun to reverse, the spread of HIV/AIDS. Have halted by 2015, and begun to reverse, the incidence of malaria and

Integrate the principles of sustainable development into country policies and programs and reverse the loss of environmental resources. Halve, by 2015, the proportion of people without sustainable access to safe drinking water. By 2020, to have achieved a significant improvement in the lives of at least 100 million slum

Develop further an open, rule-based, predictable, non-discriminatory trading and financial system. Address the Special Needs of the Least Developed Countries. Address the Special Needs of landlocked countries and small island developing states. Deal comprehensively with the debt problems of developing countries through national and international measures in order to make debt sustainable in the long term. In cooperation with developing countries, develop and implement strategies for decent and productive work for youth. In cooperation with pharmaceutical companies, provide access to affordable, essential drugs in developing countries. In cooperation with the private sector, make available the benefits of new technologies, especially information and communications.

Based on financial year data.

4. Building political consensus for major reforms remains a challenge. After a promising start under the Congress-led government—including the introduction of VAT, the lifting of several FDI restrictions, and continued tariff reductions over the past year—reforms have slowed. Opposition from several political parties that support the governing coalition from outside have halted privatization, slowed liberalization of foreign investment and power sector reform, and stalled labor and agricultural reform. With the opposition winning an absolute majority in recent state assembly elections in Bihar, and elections forthcoming in the Left Front strongholds of Kerala and West Bengal, the near—term prospects for moving ahead with broader reforms are uncertain.

II. Recent Developments and Outlook

5. India’s growth is robust and becoming more broad—based. GDP growth in 2004/05, at nearly 7 percent, was again above trend, as rapid growth in services broadened to encompass industry.1 The contribution to growth of domestic demand has been larger than in most emerging markets in Asia. Strong momentum in manufacturing and services continued in the first half of 2005/06 and GDP growth accelerated to over 8 percent y/y (Table 2). Capacity utilization has risen, and business confidence has soared to a 10-year high (Figure 1). Growth is set to exceed 7½ percent in 2005/06, led by private investment and household demand, and supported by fast credit growth, a normal monsoon, and accommodative monetary and fiscal policies.

A01ufig01

Real GDP and Industrial Production: Deviations from Trend

(In percent)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Source: Staff estimates using the Hodrick-Prescott filter.
A01ufig02

Real GDP Growth for 2004 in Asia

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Figure 1.
Figure 1.

India: Growth

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Sources: Data provided by the Indian authorities; CEIC Data Company Ltd; NCAER; and IMF staff projections.
Table 2.

India: Selected Economic Indicators, 2002/03–2005/06 1/

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

Data are for April-March fiscal years.

Current staff projections.

Latest available figures.

Differs from official data due to revisions in the current account.

Privatization investment proceeds treated as below-the-line financing.

For central government, year-to-date deficit data is reported relative to staff’s estimated annual GDP.

Monthly data are on a customs basis; annual data are on a projected balance of payments basis.

Imports of goods and services projected over the following twelve months.

Data is reported relative to staff’s estimated annual GDP.

Residual maturity basis, except contracted maturity basis for medium and long-term non-resident Indian accounts.

In percent of current account receipts excluding grants.

6. The external current account has shifted into deficit reflecting strong domestic demand and high oil prices. The trade deficit widened to over 5¼ percent of GDP in 2004/05 and the current account reverted into deficit for the first time in three years notwithstanding high growth in exports of goods and services (Figure 2 and Table 3). In the first quarter of 2005/06, goods exports continued to grow robustly—up 22 percent y/y led by engineering and chemicals—but a large increase in both oil and non-oil imports caused the trade deficit to reach 2 percent of projected annual GDP.2 Since then, exports and imports have remained buoyant, growing by 21 percent and 30 percent y/y, respectively, in July-October.

Figure 2.
Figure 2.

India: External Sector

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Sources: Data provided by the Indian authorities; and CEIC Data Company Ltd.
Table 3.

India: Balance of Payments, 2001/02–2005/06 1/

(In billions of U.S. dollars)

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Sources: Data provided by CEIC; and staff estimates and projections.

Data are for April -March fiscal years. Indian authorities’ presentation, including new methodology to estimate direct investment.

Non-customs imports include defense related items.

Net other capital is sum of net banking capital (RBI format) and net other capital (RBI format) less net NRI deposits.

7. Continued strong capital inflows have offset the impact of the widening external deficit on the balance of payments. In 2004/05, almost one-half of inflows were debt-creating as Indian corporates took advantage of favorable global interest rates, an appreciating rupee, and the liberalization of restrictions on external commercial borrowings to borrow abroad. FDI inflows remained weak, but portfolio inflows have gained importance since late 2003. Capital inflows remained strong and reserves rose modestly so far this fiscal year ($1.6 billion) despite the widening current account deficit. Although growing reliance on more volatile debt-creating and portfolio inflows has increased India’s susceptibility to changes in investor sentiment, ample reserve coverage and remaining capital controls mitigate the impact of potential reversals (Box 1 and Table 4).

Table 4.

India: Indicators of External Vulnerability, 2001/02–2005/06 1/

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Sources: Data provided by the Indian authorities; IMF Information Notice System; and staff estimates and projections.

April-March fiscal year.

Latest date available or staff estimate, if noted.

Nominal yield is less than actual WPI inflation.

Data for 2005/06 are on a customs basis, whereas data for previous years are on a BOP basis.

Merchandise trade only; volumes are derived from partner country trade price deflators from the WEO database.

8. The RBI has allowed increased two-way flexibility in the exchange rate. In the eight months to June 2005, the RBI scaled back intervention in foreign exchange markets, and the rupee appreciated by 4 percent against the dollar (6½ percent in real effective terms). Since then—with the exception of a six-week period following China’s July 21 revaluation, when the RBI intervened in response to a pickup in capital inflows—the rupee has depreciated, reflecting pressures from the growing current account deficit and renewed U.S. dollar strength, and the RBI has largely refrained from intervening.

A01ufig03

Bilateral Exchange Rates (National currency per U.S. dollar)

(Percent changes from October 2004 to October 2005)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Sources: IMF, APDCORE Database; and staff estimates.
A01ufig04

Foreign Exchange Reserve Accumulation

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Sources: CEIC Data Company Ltd; and IMF staff estimates.

9. Asset prices have surged. Net foreign institutional investor (FII) inflows (whose holdings account for 13 percent of market capitalization), accelerated from the second quarter of 2005. FII inflows, supported by strong domestic institutional investment, contributed to soaring equity prices. Notwithstanding a correction in October, equity prices are up 43 percent from end-April, leaving the average price-earnings ratio of 18.4 at mid-November high by emerging market standards. Ample liquidity and historically low interest rates have also helped fuel property prices, which have risen in some major cities by over 20 percent annually over the past two years. While there is no evidence of a nationwide housing boom, with much more modest price increases in other major cities, some indicators— including high vacancy rates in new shopping malls— suggest overinvestment in selected sectors. Concerned with speculative pressures, the RBI has raised risk-weights on housing and real estate loans, and imposed controls on real estate investments aimed at curbing speculative FDI inflows (see paragraph 33).

A01ufig05

Stock Market Indices

(October 2004 to October 2005)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Sources: IMF, APDCORE Database, and Bloomberg.
A01ufig09

Property Prices in Asia

(Index 1998=100)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

How Vulnerable is India to a Change in Investor Sentiment?

Capital flows into India have surged in recent years tripling to about $32 billion per annum. These inflows had contributed to the accumulation of international reserves, but with rising world oil prices and the pickup in domestic demand, capital inflows are now financing a growing current account deficit.

Debt-creating flows dominate private capital inflows. Debt-creating-non-portfolio flows primarily reflect banking capital and external commercial borrowings (ECBs), and to a much smaller extent, trade-related credits. India attracts relatively little FDI, and as Indian firms invest abroad, the share of net FDI in total private capital inflows has fallen to about 10 percent. However, portfolio investments are becoming increasingly important and they now account for about one-third of total private capital inflows. These flows mainly enter the equity market—capital controls limit foreign investors access to debt markets—where they account for about 6 percent of market turnover and about 13 percent of market capitialization.1/ As debt-creating and portfolio inflows are more volatile than FDI, growing reliance on such flows to finance the current account deficit leaves India more susceptible to reversals.

A01ufig06

India: Current Account, Private Capital Flows and Reserves

(Four Quarter Cumulative Balance, US$ billions)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

India: Volatility of Capital Flows

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Sources: Reserve Bank of India; Prasad et al (2003); and staff calculations.
A01ufig07

India: Composition of Capital Inflows

(Four quarter cumulative total, US$ billions)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Source: Reserve Bank o f India; and staff calculations.
A01ufig08

India: FII Equity Invesment by Type of Investor

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Source: Securities and Exchange Board of India.

Large international reserves and capital controls provide a buffer against reversals. Reserves exceed the stock of portfolio investments, NRI deposits, and short-term residual maturity external debt by about $50 billion. In addition, capital controls, particularly on volatile inflows like ECBs, remain in place. ECB approvals are capped at $9 billion per annum, and are subject to end-use, term, and prepayment restrictions that help limit vulnerability. Foreign investment in debt is capped at $2.25 billion. Nonetheless, while reserves provide a cushion, especially in the context of a system of capital controls, the growing reliance on capital inflows further underscores the need for sound macroeconomic policies.

1/

Of total trading in other Asian stock markets, foreign shareholders account for 2.7 percent in China, 22½ percent in Korea, 29 percent in Thailand, and 36 percent in Taiwan. In Korea, foreign investors account for 40 percent of domestic market capitalization.

10. Headline inflation has remained moderate, but inflationary pressures are building. In 2004/05, the RBI took several steps to tighten liquidity, including raising reserve requirements and policy interest rates. This, together with the incomplete pass-through of higher oil prices (Box 2), helped to moderate inflation. More recently, however, inflation has risen, reaching 4¾ percent in October (Figure 3) and indicators of broad and reserve money growth have picked up (Table 5). Furthermore, a number of indicators, including capacity utilization, peak electricity shortages, and average turnaround time in ports suggest that supply-side constraints are tightening (Figure 4).

A01ufig10

India: Inflationary Pressures 1/

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

1/Base effects are approximated using a 3-month moving average of annnualized month-on-month seasonally adjusted inflation. In addition, the WPI is restimated as if the authorites fully-passed through to domestic retail prices increases international petroleum product prices, including direct and indirect effects.
Figure 3.
Figure 3.

India: Money and Inflation

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Sources: Data provided by the Indian authorities; CEIC Data Company Ltd; and IMF staff projections.1/Prime lending rate deflated by the WPI.
Figure 4.
Figure 4.

India: Infrastructure Indicators

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Sources: IMD World Competitiveness Yearbook, Indian authorities; World Bank Investment Climate Survey, and staff estimates.
Table 5.

India: Reserve Money and Monetary Survey, 2001/02–2005/06 1/

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Sources: Reserve Bank of India; and staff estimates.

Data are for April - March fiscal years.

Starting in May 2002, figures include ICICI, formerly a large development finance institution, which merged with ICICI Bank Ltd. to form a new commercial bank.

11. Following three years of declining fiscal deficits, a “pause” in deficit reduction was announced for 2005/06. The central government fiscal deficit came in below target in 2004/05 for the second consecutive year, helped by a cyclical rebound in revenue and expenditure compression, but also reflecting greater recourse to off-budget petroleum subsidies (Table 6).3 The current deficit was reduced by 1 percentage point, twice the minimum required under the Fiscal Responsibility and Budget Management Act (FRBMA).4 With higher revenue and expenditure compression also helping states reduce their deficits, staff estimates that the general government actual and structural deficit fell below 7½ percent of GDP, enough to stabilize public debt at around 86 percent of GDP (Table 7).5 In 2005/06, the central government overall and current deficit targets of 4.3 percent of GDP and 2.7 percent of GDP, respectively, fall short of the minimum reductions required by the FRBMA. This reflects increased social and infrastructure outlays and higher transfers to states recommended by the Twelfth Finance Commission (TFC)6 (Box 3 and Figure 5). The budget implies a rise in the general government actual and structural deficit to 7¾ percent of GDP, imparting a pro-cyclical impulse to the economy. The higher deficit has been comfortably financed—largely domestically—so far, with nearly 70 percent of government market borrowings completed by end-October. Reflecting easy liquidity conditions, yields on the 10-year benchmark bond have softened by 13 basis points since end-April.

A01ufig11

India: Fiscal Impulse

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Figure 5.
Figure 5.

India: Fiscal Trends

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Sources: Data provided by the Indian authorities; and staff projections.1/ Excluding privatization receipts.
Table 6.

India: Central Government Operations, 2001/02–2005/06

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

Ratios utilize the CSO’s estimates of nominal GDP.

Ratios utilize implicit GDP in the gross fiscal deficit to GDP ratio given in Union Budget.

Including the surcharge on Union duties transferred to the National Calamity Contingency Fund.

Authorities’ treatment of state debt swap scheme (DSS) in 2002–05 shows the prepayment by States of on-lent funds to the center as net lending.

The Center’s prepayment of its debt to the National Small Savings Fund (NSSF) is treated as a capital expenditure.

Staff’s definition treats divestment receipts as a below the line financing item.

Authorities’ definition treats divestment as a receipt item.

Total revenue and grants less current expenditure.

External debt measured at historical exchange rates.

Prepayment by states of central loans under the DSS.

Table 7.

India: General Government Operations, 2001/02–2005/06 1/

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Sources: Data provided by the Indian authorities; state level data from the RBI State Finance Bulletin. Staff amalagmate and prepare projections.

The consolidated general government comprises the central government (CG) and state governments.

Based on central government provisional unaudited outturn and RBI’s estimate of provisional outturn for state finances.

Based on central government provisional unaudited outturn and staffs’ projection of state finances.

Tax revenue = Tax revenue of central government (CG), including NCCF and states’ share, plus state tax revenue.

Nontax revenue = Nontax revenue of CG, less interest payments by states on CG loans, plus nontax revenue of states.

Expenditure and net lending = Total expenditure and net lending of CG, less net loans and grants to states and union territories, plus total expenditure of states (excluding interest payments on CG loans).

From the RBI Handbook of Statistics , 2004–05, and the RBI Annual Report 2005 ; the authorities treat disinvestment proceeds above-the-line as capital receipts.

Above-the-line items in the CGA, which cancel out in the consolidation (e.g., loans to states).

The Impact of Higher Oil Prices

Despite recent price increases, the pass-through of international prices remains incomplete. After an increase of about 7 percent in September, domestic gasoline and diesel prices remain around 10 percent below import parity levels (nevertheless, at $0.96 and $0.67 per liter respectively, they are relatively high because of taxes). Prices of kerosene and LPG, however, require much larger increases. To limit price increases, the government has also lowered oil taxes and partly replaced ad valorem with specific excises. The average price adjustment required in India to achieve full pass-through is similar to that in other countries in Asia.

India: Pricing of Petroleum Products (Delhi)

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Source: IMF staff estimates.
A01ufig12

Economies with Administered Prices: Petroleum Product Price Increase, December 2003-Latest

(Percent change)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Sources: Country authorities; and IMF staff estimates.

Price controls are imposing quasi-fiscal costs. Costs amounted to ¾ percent of GDP in 2004/05 and ½ percent of annual GDP in the first half of 2005/06. The bulk has been borne by state petroleum companies with explicit budget subsidies only amounting to 0.1 percent of GDP per year. While these subsidies (especially those for kerosene) have shielded some poor households from the impact of higher oil prices, there is substantial leakage of benefits to higher income households (almost 40 percent in the case of kerosene).

Thus far, the impact of high oil prices on growth has been limited. In addition to the incomplete pass-through of international prices, other factors have contributed to this: the rapid growth in exports of refined products; robust growth of other exports, as global demand has remained strong; the strong underlying productivity growth of India’s economy— which allows for a smoother reallocation of resources in the face of a shock; and a supportive monetary policy, made possible by well-anchored inflation expectations.

India: Oil Prices and Imports

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Sources: Reserve Bank of India; Basic Petroleum Statistics , Ministry of Petroleum and Natural Gas; and staff projections.

12. The banking sector continues to strengthen but risks remain. Commercial banks have continued to reduce NPAs, largely reflecting the pickup in credit but also gains in NPL recovery7 and favorable economic conditions, and aggregate capital adequacy remains high (Table 8 and Figure 6). Banks have reduced their exposure to interest rate risk, decreasing their holdings of government paper and shortening maturity. Declining profitability due to rising interest rates has been in part offset by higher credit growth. However, interest rate risk remains a concern with bank holdings of government paper (at 38 percent of assets) still in excess of statutory requirements; rapid credit growth raises concerns about credit quality (Box 4); and cooperative banks (accounting for about 6 percent of banking system assets) remain in poor health.

Figure 6.
Figure 6.

India: Corporate and Financial Sector Soundness

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Sources: Reserve Bank of India; CEIC Data Company Ltd; and IMF Corporate Vulnerability Utility.1/Current assets to current liabilities.2/Operating profits to interest payments.
Table 8.

India: Indicators of Financial System Soundness, 2001/02–2004/05

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Sources: Indian authorities; and staff estimates.

Some loan classification and provisioning standards do not meet international standards.

Gross nonperforming loans less provisions.

Starting in 2001/02, figure includes ICICI, formerly a large development finance institution, which merged with ICICI Bank Ltd. in 2002.

In percent of total assets.

13. Looking ahead, staff expects economic activity to moderate and inflation to rise in the near-term. Real GDP growth is projected at 7½ percent in 2005/06, and is expected to decline slightly to below 7 percent in 2006/07, reflecting further pass-through of higher oil prices and rising global and domestic interest rates (Table 9). Inflation should rise from 5¼ percent in 2005/06 to 6¾ percent in 2006/07, reflecting the expected upward adjustment in fuel prices.8 The possibility of an acceleration in domestic demand supported by credit growth poses a key upside risk to growth and inflation. A more rapid than expected rise in world interest rates, either because of a disorderly global rebalancing or inflationary pressures in the United States, would hit India’s exports, but the impact would likely be more modest than elsewhere in Asia, as India is still relatively closed.

Implications of the Twelfth Finance Commission (TFC) for the States

The recommendations of the TFC, which have been implemented by the government, could provide a significant boost to state fiscal adjustment. States will benefit from a higher revenue share and higher grants, and from debt restructuring and relief. The latter is conditional upon passage and implementation of fiscal responsibility legislation targeting current balance by 2008/09 and a 3 percent of GDP overall deficit by 2009/10. Some grants are tied to higher annual expenditure on social priorities (0.2–0.3 percent of GDP). The net benefit for state finances approaches 0.6 percent of GDP in 2005/06, falling to 0.3 percent of GDP by end-period, as grants do not to grow in line with nominal GDP.

The incentive to take part in the TFC’s debt relief may be too small for some states. The combined incentive for all states is larger than that in previous finance commissions, but it varies state by state. Some states will receive comparatively little debt relief in relation to the primary adjustment they need to achieve. The center will ensure that all states adhere to their fiscal adjustment paths by enforcing a tighter state borrowing regime, involving global ceilings and increased market discipline. The center in particular will only lend to fiscally weak states.

A01ufig13

TFC: Resource Implications for the States

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

India: Sustainability of State Debts Post-TFC 1/

(In percent of GSDP)

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Sources: World Bank; IMF staff estimates.

Assumes all debt relief and fiscal adjustment are realized up-front.

Assumes an overall deficit of 3 percent of GSDP.

When a positive gap exists, the debt level would decline.

Assumes three-quarters of the fiscal adjustment is via revenues.

Stronger adjustment may be required for some states. Under the staff’s baseline scenario, the targeted adjustment does not ensure sustainability for four states, and in five others debt would remain over 250 percent of revenue. In 11 states, interest payments would exceed 18 percent of revenue (the norm suggested by the 11th Finance Commission).1/ Expenditure reforms, including power sector, wage and pension, and subsidy reforms, and revenue measures, including higher user charges and tax base broadening, would be needed to put these states finances on a stronger footing.

1/

For details, see Selected Issues.

Credit Growth

India had the fastest rate of credit growth in Asia in 2004/05. In the year ending in March 2005, bank credit grew by over 30 percent, the ratio of private sector credit to GDP grew to around 40 percent, and the aggregate credit-to-deposit ratio exceeded 60 percent. However, credit remains low compared to GDP (around 40 percent), reflecting a low level of financial intermediation compared to other countries.

Rising incomes and consumption amid falling borrowing costs have fueled credit demand. Retail banking, particularly for housing and credit cards, is a new growth area for banks.

While credit growth is broad based, it rose fastest in public sector banks and priority sectors. Priority sectors (such as agriculture and small industry) accounted for 40 percent of total nonfood credit growth. Housing credit has grown rapidly, accompanied by an exuberant real estate market.

A01ufig14

India: Growth in Total Credit and Deposits, 2000–05

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

A01ufig15

Asian Countries with Highest Real Rates of Credit Growth in 2004

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Rapid credit growth raises concerns given some banks’ weak risk assessment systems. The overall NPA ratio is low, and stress tests show that the banking system is resilient to the deterioration in credit quality that typically accompanies periods of rapid credit growth. However, NPAs are highest in public banks and in some priority sectors, and rapid credit growth is putting pressure on the capital adequacy of some banks. In addition, while credit card debt is still small, the rapid rise in such debt (36 percent in 2004/05), as well as the already sizable share of nonperforming loans (8 percent on average) and reports of unfair market practices, point to the possibility of future problems.1/

1/

Selected Issues examines recent credit growth and related risks in more detail.

Table 9.

India: Macroeconomic Framework, 2001/02–2009/10 1/

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

Data are for April-March fiscal years.

Differs from official data due to revisions in the current account.

Statistical discrepancy adjusted.

Onlending of small savings collections to state governments excluded from central government expenditures and net lending; divestment proceeds treated as below-line financing.

Imports of goods and services projected over the following twelve months.

Residual maturity basis, except contracted maturity basis for medium and long-term non-resident Indian accounts.

14. India’s medium-term prospects are bright provided that key fiscal and structural reforms are implemented. Staff projects growth at 6½ percent annually in the medium-term, but agreed with the authorities that growth could reach their objective of 8 percent in a reform scenario where successful fiscal adjustment creates space for needed infrastructure and social spending and structural reforms accelerate. Long-term growth prospects are aided by favorable demographics, which has the potential to raise savings and employment substantially over the next several decades. However, job creation and commensurate investments in human capital and infrastructure are key to realize this potential, especially as 60 percent of the increase in working age population over the next 40 years is projected to occur in the four slowest growing states. Slow reforms would leave growth closer to its recent historical average of 6 percent. The fiscal outlook would worsen in such a scenario, with the general government deficit rising, and the positive growth-interest differential fading by 2010/11. The resulting rise in debt from already high levels would increase vulnerabilities, and continued high deficits could stunt financial sector reform and capital account liberalization, and crowd-out private investment.

III. Policy Discussions

15. Discussions focused on the policies needed to address inflationary pressures and to achieve India’s medium-term growth potential. Staff noted that, while short-term prospects are favorable, risks have increased since the last Article IV consultation, with higher oil prices, rising inflation and current account deficits, and fast credit growth. In this light, macroeconomic policy in the near term needed to be geared toward keeping inflationary pressures in check. The authorities were in broad agreement regarding the economic outlook, but were somewhat less concerned about domestic demand pressures, arguing that India’s potential growth had increased in the last several years. Over the medium term, far-reaching structural reforms would also be needed to address long-standing constraints on growth and absorptive capacity. Acknowledging political constraints, the staff sought to focus on issues where near-term progress is most likely, and to bring value added by presenting international experience in specific areas, including tax base broadening, energy policy, and dealing with risks from rapid credit growth.

A. How Can India Deal with Short-Term Risks?

Fiscal Policy

16. Overperformance on the 2005/06 budget would be appropriate. Staff stressed that this would not only counter demand pressures and help achieve a more balanced policy mix to address inflationary risks, but also allow the authorities to meet targets envisaged by the FRBMA and strengthen its credibility. The authorities noted that they were seeking to do so, pointing to the potential for revenue overperformance and limited expenditure savings. In particular, VAT introduction on April 1 in 20 states has proceeded well so far, and compensation needs are expected to be less-than-budgeted.9 However, they noted that expenditure pressures, including higher social and infrastructure outlays and transfers to states mandated by the TFC, would likely limit the reduction in the overall deficit to about 0.2 percentage points of GDP, maintaining a downward trend in the deficit as a percent of GDP, but not sufficient to meet FRBMA targets.

17. Staff argued that incomplete oil price pass-through was adding to budgetary pressures and preventing adjustment of demand to permanent price changes. With high oil prices likely to be permanent, a move to full pass-through with adequate compensation mechanisms for the poor would serve India well by curbing rising quasi-fiscal costs, 10 and encouraging improvements in energy efficiency, which would also help preserve India’s competitiveness over time. Staff supported the recommendations of the government’s 2004 report on central subsidies to phase-out LPG subsidies, which are regressive, and to improve the targeting of kerosene subsidies, given large leakages. In the short run, the latter could be achieved by restricting subsidies to below-poverty-line (BPL) households under the existing ration card system. Over time, staff encouraged the authorities to replace subsidies with targeted support, such as cash transfers to the poor. Together with the reintroduction of an automatic pricing mechanism (APM) for petroleum products, these steps would pave the way to eventual full price liberalization. To avoid high ad valorem taxes amplifying price shocks, staff advised a switch to specific petroleum taxation, in a revenue neutral manner and with annual automatic inflation indexation.

18. The authorities recognized that high oil prices were likely to last, something to which policies had to adjust. A committee headed by the chairman of the Prime Minister’s Economic Council is looking into the issue of petroleum pricing and taxation. However, such measures faced political obstacles in the near-term, and compensating the poor could be technically difficult. In the interim, ad hoc and partial adjustments were likely to continue and the central government was considering compensating oil companies for part of their losses by issuing them bonds. The authorities also called for more transparency in world oil markets. Over time, acquisition of oil assets abroad by state-owned oil companies and efforts to develop alternative energy sources would help India bolster energy security. Staff cautioned against quasi-fiscal risks arising from asset acquisitions and pressed the need to record the oil bond transaction transparently as a budgetary subsidy.

Monetary and Exchange Rate Policy

19. A monetary policy response was needed to ward off inflationary pressures. Staff suggested that a modest interest rate hike would help keep inflation expectations in check, and allow India to adjust to an environment of rising global interest rates. The RBI acknowledged that the oil price rise made it difficult to contain inflation in the range of 5–5½ percent projected earlier without an appropriate policy response, and stood ready to respond to evolving circumstances as warranted. In the event, RBI raised the reverse repo rate, its key policy rate, to 5¼ percent at its mid-term October policy review, pointing to upside inflationary pressures from oil prices in the context of incomplete pass-through, and also noting higher world interest rates. With risks to demand and inflation still on the upside, the RBI needs to monitor conditions closely and stand ready to tighten further if needed.

20. There was agreement that appreciation of the rupee over the past year had not undermined competitiveness. In particular, staff estimates of the real equilibrium exchange rate derived using an extended PPP approach suggest that the exchange rate was fairly valued at end-2004 and India’s rising share in global export markets suggests that competitiveness is not a problem.11 Staff welcomed the RBI’s commitment to two-way flexibility in the exchange rate—as demonstrated by its absence from foreign exchange markets for much of 2005—which should boost incentives for corporates to hedge foreign exchange exposures. The large stock of reserves had enabled India to weather successfully a number of exogenous shocks and the RBI did not see the current level of reserves as excessive. Given increased reliance on more volatile capital inflows and a widening current account deficit, staff agreed that the current level of reserves provided a useful buffer shock against potential reversals, but underscored that given increased openness continued progress in structural reforms and supporting macroeconomic policies were also needed to underpin investor confidence.

B. How Will the Targeted Fiscal Adjustment Be Achieved?

21. The authorities’ medium-term fiscal roadmap provides a good framework for reform, but accelerated implementation is key to achieve FRBMA targets. The authorities envisage a revenue-led adjustment, as large spending needs—in particular for infrastructure and priority social spending—limit the scope for closing the fiscal gap by compressing outlays. On the spending side, the emphasis would be on improving efficiency, including via the publication of an outcomes budget. Staff supported the revenue-led adjustment, but noted that implementation of the 2004 FRBMA roadmap for raising tax revenue had fallen behind schedule and that subsidy reform, as envisaged in a 2004 government report on subsidies, was stalled.12 Full implementation of these reforms in the 2006/07 budget would be critical to prevent a deteriorating fiscal outlook. With only gradual tax base broadening, staff baseline projections suggest that the medium-term rise in tax revenue would be more modest than targeted by the authorities. As a result, an additional ¾ percent of GDP in non-interest current expenditure savings would be required to meet FRBM targets.

A01ufig17

India: Central Government Gross Tax Revenue

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Real Effective Exchange Rate

India’s real effective exchange rate (REER) has been rising, prompting some analysts to argue that the rupee is overvalued. The RBI’s new REER index, which was revised in December to reflect changes in goods trade patterns, has risen by 7.6 percent since 2003–04, and by 6.4 percent since 1993–94. Staff’s own broader based measure of the REER that, in addition to changes in goods trade also reflects trade in services and the competition Indian goods face from its trading partners in its export markets, has appreciated by 7 percent since 1993.

Revised RBI and IMF Country Weights

in REER Indices

article image
Source: RBI December Bulletin, Bayoumi, Lee and Jayanthi (2005).

Existing methodologies yield a wide range of estimates of the “equilibrium” level of the rupee, with large uncertainties associated with each of these estimates. Determining the equilibrium exchange rate is a daunting task particularly for an economy like India that is undergoing structural change. Staff investigations using vector-error-correction models are a case in point. A specification that incorporates trends in relative productivity, openness, and net foreign assets suggests that at end-2004 the rupee was undervalued by about 15 percent. However, a similar specification that includes a control for the 1991 balance of payments crises finds the rupee fairly valued at end-2004 (the latter specification is shown in the chart below). In sum, the small sample size and the instability of the results to changes in specification suggest these estimates should be treated with a great degree of caution. The estimates are lower than those from other studies that use a panel-based extended PPP approach. Davoodi (2005) found the rupee to be 40 percent undervalued at end-2000; Benassy-Quere et al (2005) 16 percent undervalued at end-2001; and Milesi-Ferretti, Ricci, Lee and Jayanthi (2005) 30 percent undervalued at end-2004.

A01ufig16

India: Estimates of the Equilibrium REER

(Index 1995=100)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

In sum, empirical investigations find little evidence of overvaluation. Moreover, India’s export performance in goods and services suggests that the exchange rate has not undermined competitiveness. 1/

1/

See Chapter 2 in the Selected Issues.

22. The authorities agreed that expanding India’s narrow tax base was a key priority of their medium-term fiscal strategy. While the 2004 roadmap envisaged front-loaded measures—including the quick removal of exemptions and early introduction of a national goods and services tax (GST)—the authorities have adopted a more gradual approach. They would allow existing exemptions to lapse over the next four years, while taking steps to track and publish tax expenditure estimates. In addition, ongoing expansion of the services tax base and efforts at strengthening compliance via IT enhancements for tax administration were already boosting revenue. The introduction of GST remained a medium-term objective, which would require bringing remaining states into the VAT. Noting that exemptions were pervasive,13 staff underscored that their removal—with grandfathering if needed—and limits on the scope of tax incentives under the Special Economic Zones Act 2005 were key to meet revenue needs. Given the necessary lead time, preparations for the introduction of a GST with few exemptions should be accelerated, including by phasing-out as planned the inter-state sales tax (CST) and by reaching agreement with states on sharing of GST revenues. In the medium-run, staff advised a lowering of the personal income tax exemption threshold, which is high compared to higher-income emerging markets.

23. Expenditure restructuring would be needed to create fiscal space for priority social and infrastructure spending. The government recently approved a rural employment program (REGS) guaranteeing 100 days of public works employment per year per family head.14 In addition, the 2005/06 budget provides for continued increases in education and health spending, and a four-year program to provide basic infrastructure for the poor. The staff pointed out that to make room for these priority expenditures, more progress was needed in reforming subsidies, as recommended in the government’s 2004 report.15 The authorities explained that these reforms face strong public resistance, and that they intended to keep a lid on subsidies through efficiency improvements. They also remained committed to containing the wage bill, although wage pressures were increasing, with the last civil service pay awards in 1998. Although the REGS was not explicitly targeted to the poor, the authorities’ plan to start the program on a pilot basis and ensure self-targeting through low wages and strict work requirements. Over time, the staff suggested that consideration be given to replacing the large number of welfare programs and implicit and explicit subsidies—many of which are not well targeted—with a more formal social safety net.

24. Center-state fiscal relations are being reformed to strengthen states finances. The authorities expected that new debt relief incentives would induce states to pass and implement fiscal responsibility laws targeting current balance by 2009, consistent with the center’s own law. In addition, the center intended to enforce a global borrowing constraint and promote greater reliance on market borrowing. While welcoming these measures, staff noted that some states would remain under fiscal stress even after reaching deficit reduction targets, while others would have difficulty achieving the targets.16 Addressing this would require stronger adjustment paths for some states and tighter borrowing caps, supported by better fiscal reporting by the states and a tighter link between grants and fiscal performance. Recent steps to curb the growth of small savings deposits—against which states can borrow without restrictions—are welcome.17 The staff also advised linking administered interest rates on these savings schemes to market rates—something advocated by a series of government reports—as a move toward their eventual elimination. The authorities agreed that incentives were only part of the solution to state fiscal problems, in particular as conditional grants were limited under India’s federal system. Nevertheless, harder budget constraints would force states to undertake adjustment.

25. The pending passage of a Pension Bill will help improve long-term fiscal sustainability and contribute to the development of the financial sector. In January 2004, a mandatory defined contribution scheme for newly-recruited central government civil servants was introduced, which 15 state governments have joined so far. The Pension Bill would set up a new pensions regulator, and set guidelines for pension fund managers, prudential norms, investments, and capital requirements. Pension coverage is expected to increase over time as the system is extended on a voluntary basis to all states and parts of the private sector. While welcoming these measures, staff pointed out that parametric changes to the existing defined benefit pension system for civil servants—recommended in earlier government reports—are also needed to ease the fiscal burden of budgetary pension outlays and to control the size of unfunded pension liabilities.18 The authorities acknowledged the fast growth of pension payments, and noted that some states had already undertaken parametric reforms; but the central government favored waiting until the NPS was well established before making changes.

C. How Can the Government Ease Infrastructure Bottlenecks?

26. The government is attempting to close part of India’s infrastructure gap through public-private partnerships (PPPs). The pace of infrastructure development has recently increased in some sectors—including telecommunications, ports, and roads in and around major cities. To encourage further private sector involvement, the authorities have issued new sectoral guidelines, including model concessionary agreements for roads and ports; and set up a special purpose vehicle (SPV) to help address the lack of long-term infrastructure financing. The SPV would borrow domestically with government guarantee to finance commercially viable projects with private participation.19 Staff welcomed these measures, while emphasizing that better and more consistent regulatory practices, including independent regulators in all sectors, would be key to increase private participation. While the SPV provides a partial solution, it should be accompanied by financial reforms to expand the investor base. In this context, key steps to develop long-term corporate debt markets would include greater transparency in the issuance process, streamlining of registration procedures and tax provisions, lower barriers to domestic and foreign institutional participation, and development of derivatives trading.20 Staff also underscored the need to reflect in the fiscal accounts all future fiscal risks, including those related to guarantees.

27. Power bottlenecks remain a key constraint on growth. Technical and commercial losses remain high, electricity shortages widespread, and tariff rates for industrial users are not internationally competitive. Losses of state utilities, although diminishing, remain a large drain on state finances. The government has continued implementation of the 2003 Electricity Act, which would allow for private operators in the sector but reforms have been uneven at state-level, with a few states recently reintroducing free power for farmers. The staff pressed the need for faster implementation of the Act—including the introduction of regulatory guidelines to catalyze the restructuring of State Electricity Boards and increase private participation. Although investor interest appears to be increasing recently, especially in generation, regulatory uncertainties and doubts about the independence of state regulators remain important constraints. The authorities were confident that the introduction of the National Electricity Tariff Policy—which will set pricing rules and provide guidelines on phasing out cross-subsidy surcharges—would help clarify the regulatory environment, and that good outcomes in reforming states would put pressure on other states to enact reforms.

D. How Can India Develop a World Class Banking System?

28. Enhancing financial intermediation and ensuring broader access to financial services are key to promoting growth and poverty reduction in India. The health of the banking system has improved dramatically in recent years. However, private credit at under 40 percent of GDP remains low, compared to over 100 percent for countries such as Korea and Malaysia. Moreover, while a large branch network ensures an overall level of access to banking services comparable with other developing countries in the region, large segments of the population lack any such access.21 Indian banks continue to have one of the largest exposures to government securities in the world, and the banking sector is dominated by public sector banks (PSBs) whose prudential indicators, despite recent improvements, remain less favorable than those of new private and foreign banks.

A01ufig18

Demographic Branch Penetration

(In number of branches per 100,000 people)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Source: World Bank Picy Research Working Paper 3754, October 2005

29. While the pickup in credit growth is a welcome sign of financial deepening, it also raises concerns about credit quality. The authorities were well aware of risks from rapid credit growth, and had taken steps to tighten prudential regulations. They noted that banks have continued to show strong profitability and low impaired loans, the latter reflecting improvements in risk management. The risks for banks’ asset quality from surging asset prices were being handled with prudential measures, notably by tightening capital market exposure limits and prudential norms on housing loans. Staff advised additional prudential measures in selected sectors to bring regulations in line with best international practices and raising risk weights on “priority sector” lending where NPLs were higher than the average.22 Staff also expressed concern about fast-rising credit card debt and the high delinquency rates in the sector. While welcoming the RBI’s close monitoring and steps to curb unfair lending practices, staff stressed the need for greater consumer education. Following the mission, the RBI announced an increase in general provisioning (with an exemption for agricultural and SME sectors) and tighter supervision on lending to real estate and other high risk sectors. The RBI is also considering the scope for additional steps, including the tightening of loan classification norms and for introducing “special mention” loans that would require provisions.

30. The authorities plan to commence implementation of Basel II in 2007. Banks are required to adopt the Standardized Approach for credit risk and Basic Indicator Approach for operational risk by end—March 2007. In preparation for this move, the RBI is taking steps to train supervisors, enhance monitoring of banks’ risk management systems, and improve market discipline and disclosure practices of banks. In particular, the RBI plans to extend the pilot project for risk-based supervision—currently covering 23 banks—to more banks. The RBI also indicated that many banks would need to raise additional capital to satisfy the new capital requirements.23 Staff emphasized that this was a more ambitious schedule than in most other emerging market economies and noted that meeting the 2007 deadline would require a rapid pace of skill advancement in the RBI and commercial banks.

31. Cooperative banks do not present a systemic risk but the failure of a number of such banks could affect confidence in the banking system. Staff urged the authorities to align prudential regulations of urban cooperative banks with those of scheduled commercial banks, which was in line with the RBI’s longer-run objective. Meanwhile, the RBI was negotiating with key states to resolve the problem of dual oversight and developing a supervisory framework for urban coops. Rural cooperative banks also remain in financial distress, with NPAs reaching 35 percent in some banks, more than a third of rural coops under-capitalized, and about a quarter unprofitable. Staff advised quick implementation of recent recommendations to bring such institutions under RBI supervision with the regulatory norms on par with those of scheduled commercial banks.

32. The improving financial soundness of the banking sector provides an opportunity to accelerate banking reforms. To encourage financial development, the RBI has recently initiated banking reforms aimed at increasing public sector banks (PSBs)’ autonomy and gradually lifting restrictions on foreign competition (Box 6). While acknowledging the authorities’ concerns regarding PSBs’ capacity to withstand increased foreign competition in the near term, staff observed that international experience has shown that increased foreign presence can be effective in improving banks’ performance by increasing technical know-how and efficiency. Bringing forward the 2009 target date for expanding FDI in domestic banks to include non-distressed banks and lifting the 10 percent cap on voting rights—the latter contemplated under amendments to the Banking Act currently in Parliament—would help accelerate foreign participation.. More generally, increasing private involvement could spur efficiency gains. In the short run, allowing some PSBs to raise additional capital by reducing their government share below the 51 percent requirement would further this objective.24

33. Greater emphasis should be given to addressing other impediments to the development of the financial system. Staff advised the authorities to shift from a heavy reliance on priority lending to removing roadblocks to lending such as remaining difficulties in recovering assets, lack of well-developed credit registries, and weak accounting practices in SMEs. The Securitization and Debt Recovery Act and the new credit registry were positive developments but collateral requirements and limits on microfinance continue to constrain potential. Measures considered by the RBI to develop the government securities market via primary dealers and introduction of short selling are welcome. However, it will be important to ensure that interest rates are market-determined—the government currently retains the right to determine cut-off rates—and that steps are taken to deepen the market, including expanding the institutional investor base and accelerating the use of derivatives. Recent proposals to permit limited investment by domestic pension funds in local equity markets would also help deepen India’s financial markets.

E. How Can India Benefit More from Globalization?

34. The authorities were committed to decreasing customs duties to ASEAN levels (9 percent) by 2009. Tariff reductions have continued in 2004/05, with the peak non-agricultural tariff rate declining from 20 percent to 15 percent, and average tariffs falling by 5 percentage points to 17 percent. Staff welcomed these developments and encouraged faster liberalization. More rapid convergence to ASEAN levels would enhance competitiveness and help the authorities reach their objective of doubling India’s share in world trade.25 Efforts to streamline customs procedures—notably, through pilot projects to improve risk-based assessments and reduce costly inspections—are also important, and should be expanded together with reduction of nontariff barriers. The authorities supported the Doha Round as the best forum for addressing agricultural issues and expanding market access. However, they noted that the developed countries’ reluctance to reduce farm support in exchange for market access undermined the reaching of an agreement. The authorities saw the South Asian Free Trade Agreement and other regional and bilateral agreements as an important aspect of trade policy, noting that such initiatives enhanced economic cooperation and helped build support for multilateral liberalization. Staff supported efforts to enhance intra-regional trade, but emphasized the need for further MFN-based tariff reductions to minimize the potential for trade diversion associated with preferential trade agreements (PTAs). Staff also cautioned against a potentially complex web of tariff schedules and regulations arising from multiple PTAs, which would be difficult to administer and possibly hinder trade.

India: Recent Regional Trade Agreements and Agreements Under Negotiation

(Partners, nature of agreement, date)

article image
Source: Government of India, Ministry of Commerce and Industry.

Foreign Banks in India

In early 2005, the RBI announced a series of banking reforms, designed to give public banks greater autonomy and to provide guidelines for foreign bank expansion. The authorities see it as a new step in the continuing process of financial market liberalization. The intention of the reforms is to increase public banks’ efficiency, while providing them breathing space by keeping some restrictions on foreign competition until 2009. From 2005, foreign banks are allowed to establish wholly-owned subsidiaries (previously only branches were allowed). In addition, the RBI plans to amend legislation to eliminate the 10 percent cap on the voting rights of foreign banks. However, any acquisition of 5 percent or more by a foreign bank will still require RBI approval, and FDI is limited to private banks identified for restructuring, with a limit of 74 percent. Full national treatment for wholly-owned subsidiaries of foreign banks and the expansion of FDI to non-distressed banks is not envisaged until 2009.

A01ufig19

Credit of Foreign Banks to Total Bank Credit, 2003 1/

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Source: Bank for International Settlements (BIS).1/BIS Reporting banks only.

Foreign banks currently account for about 7 percent of total assets of the banking system, and 5 percent of deposits. Although foreign banks can engage in all financial sector activities, foreign presence in the Indian banking system (as captured by balance sheet data) is lower than in some other emerging Asian countries, and significantly lower than in Latin America and Eastern Europe. In contrast, foreign shareholders account for 21 percent of total trading in the Indian stock market—a level similar to other Asian countries.

Empirical studies show that larger foreign bank presence can enhance the competitiveness of the banking sector, and widen access of qualified borrowers to financing.1 Foreign bank entry may also lower risks through improved risk management techniques and more realistic provisioning against bad loans, and may contribute to making more capital or liquidity available when needed. The key financial soundness indicators of foreign banks in India are somewhat better than for public or domestic private banks.

India: Key Financial Soundness Indicators by Bank Ownership, end-March 2005

article image
1

See e.g., Chapter 6, “The Role of Foreign Banks in Emerging Markets, ”in IMF World Economic and Financial Surveys, International Capital Markets, Developments, Prospects, and Key Policy Issues, 2000, eds. by D. Mathieson, G. Schinasi, and S. Claessens.

35. The authorities aim to continue the gradual liberalization of capital flows. In addition to further liberalization of the FDI regime, proposals are under consideration to progressively ease quantitative limits on foreign investors’ access to domestic equity and debt markets. However, there remains a range of views among the authorities regarding the scope and pace at which such liberalization should take place, reflecting concerns about the origin of the inflows and their potential impact on macroeconomic volatility.26 Liberalization of outflows has been proceeding and further liberalization would be achieved through gradually lifting remaining restrictions.27 While pension funds are not allowed to invest abroad under the draft Pension Bill, the authorities indicated this provision could be reconsidered once the system is well established. Staff underlined the potential benefits from further capital liberalization—including more rapid financial sector development and enhanced risk diversification—but generally supported the authorities’ gradual approach, in particular in view of still-large fiscal imbalances.

India: Selected Capital Account Liberalization Measures, 2005

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Source: Reserve Bank of India.

36. Progress has been made toward liberalizing FDI. Interest in India among investors remains very high— India rates among the top three potential destinations for FDI in a number of surveys—but actual FDI raised remains low relative to many other emerging market economies. In this context, staff welcomed the raising of FDI limits in some sectors, and urged other such increases, including for insurance and retail. Even more important, a continued improvement in the overall business climate could have a large pay-off.28 The authorities are pinning their hopes in the near term on the expansion of Special Economic Zones (SEZs) to spur FDI, pointing that in addition to tax incentives and good infrastructure, businesses in SEZs will have access to a single window clearance office.

37. Less restrictive labor laws would enhance prospects for much needed employment gains. Despite rapid economic growth in recent years, employment has remained flat, and with some 100 million new labor market entrants expected in the next decade, the expansion of labor-intensive manufacturing is critical. However, India’s labor laws are widely perceived as more rigid than in other countries in the region, stalling the development of large-scale manufacturing.29 The authorities acknowledged that restrictive labor laws impeded FDI in manufacturing, but did not see them as the key constraint for most Indian corporates. A move toward “hire and fire” flexibility would face stiff political opposition, in particular in light of the lack of an adequate social safety net. However, the authorities were considering some reforms supported by the staff, including amending the contract labor law to expand the number of industries that can hire contract workers, streamlining labor regulations, and raising the cutoff size for firms exempt from certain labor laws, inspections, and reporting requirements.

38. Staff pointed to the post-MFA performance of the Indian textile sector as evidence both of the potential of Indian manufacturing as well as the need for further reforms. While recent performance is encouraging—textile and clothing production has grown by over 11 percent y/y in January–October, and exports to U.S. markets have grown by 23 percent y/y according to U.S. Bureau of Census data—important roadblocks remain. The private sector points to labor market rigidities—which limit the ability of Indian firms to respond nimbly to rapid changes in demand—as a key issue. In addition, poor infrastructure raises the cost of manufacturing and exporting, while the legacy of small-scale industry reservation has meant that firms typically do not benefit from economies of scale.

F. Other Issues

39. India eliminated a restriction on payments for current account transactions subject to approval under Article VIII (Annex II, Section VII). However, other restrictions remain in place and the staff encouraged their removal.

40. Staff welcomed progress made in improving economic statistics. In particular, the staff looked forward to the planned publication of a CPI with a 2000 base year and a new producer price index.30 Staff also welcomed the planned creation of a National Statistical Office in 2006, merging the Central Statistical Office with the National Sample Survey Organization. While India’s statistics are adequate for surveillance purposes, weaknesses remain in timeliness and coverage of statistical series (Annex V). The authorities were encouraged to address the main issues identified by the 2004 data ROSC and a recent follow-up technical assistance mission. In light of the significant financial sector reforms that have been implemented in recent years and rapid growth in the insurance sector, an FSAP update would also be welcome. The authorities indicated that for now, they were focused on their self-assessment, on which they welcomed staff comments.

IV. Staff Appraisal

41. The Indian economy is reaping the rewards of the structural reforms introduced since the early 1990s. The economy showed remarkable resilience in 2004/05, with growth nearing 7 percent and becoming increasingly broad-based. Thus far in 2005/06, these trends have continued and, with a near normal monsoon, growth should exceed 7½ percent.

42. Favorable conditions provide an opportunity to fast-forward the government’s structural agenda, allowing it to achieve its own ambitious growth and poverty-reduction targets. The government is rightly placing emphasis on addressing infrastructure bottlenecks, deepening global integration, and accelerating annual growth to 8–10 percent to create jobs and improve the living standards of the rural poor. Steps to improve the business climate and regulatory environment, and reform of restrictive labor laws would potentially have large pay-offs by encouraging needed domestic and foreign private participation and fostering job creation, allowing India to fully benefit from demographic advantages.

43. Macroeconomic policies should remain vigilant in 2005/06, in view of the evolving macroeconomic and financial situation. Strong domestic demand and high world oil prices are contributing to rising inflation and a widening current account deficit.

44. In this context, fiscal policy should counter demand pressures. The authorities should strive to meet the minimum adjustment required under the FRBMA, which would not only be an appropriate macroeconomic policy response, but would also help maintain the credibility of the FRBMA and allow the center to lead by example in efforts to encourage adjustment by the states. In this light, the authorities should direct any revenue overperformance to deficit reduction and work to identify potential expenditure savings.

45. The authorities have understandably sought to share the burden of higher world oil prices, but the Indian economy must now adapt to a higher oil price environment. Together with a move to full pass-through, the government could replace special price subsidies by a system of targeted support for the poor. It would also be desirable to reinstate an APM and shift petroleum taxation further toward a specific basis, in a revenue-neutral manner and with automatic inflation adjustments to protect the real value of collections. The government should consider full liberalization of oil prices in the medium run.

46. Monetary policy needs to remain focused on keeping inflation expectations in check. The recent increase in the reverse repo rate was appropriate, signaling the RBI’s commitment to price stability and helping India adjust to an environment of rising global rates. With indicators suggesting tightening supply-side constraints, and upside risks to domestic demand growth, further interest rate increases may be needed.

47. The RBI should continue its two-way flexibility in exchange rate management. Despite a recent real effective appreciation, competitiveness appears adequate and staff analysis finds that the exchange rate is close to fair value. In this context, two-way exchange rate flexibility will help facilitate economic adjustment and encourage hedging of foreign exchange risk.

48. Despite fiscal adjustment efforts since 2001/02, public debt remains high and the medium-term fiscal environment has turned more challenging. The central government fiscal deficit reached an eight-year low in 2004/05. Notwithstanding this progress, the debt burden remains high. Moreover, the improvement in recent years reflects in part a cyclical upturn and a low interest rate environment, while the impact of high oil prices has been shifted off-budget, and neither tax nor expenditure reform has moved as fast as initially envisaged. Large planned increases in infrastructure and social spending also complicate the center’s efforts to meet its fiscal targets.

49. Further tax base broadening is needed to generate the needed adjustment. Important progress has been made, including the introduction of a VAT in most states and the expansion of the services tax base. In addition, ongoing modernization of tax administration will help bring more taxpayers into the tax net. The central government can broaden further its tax base by trimming exemptions and continuing expansion of the service tax base. The development of tax expenditure estimates would also provide a valuable tool for resisting attempts to introduce inefficient exemptions. Regarding the VAT, initial gains should be consolidated by bringing in remaining states, phasing-out the CST, and agreeing with states on revenue-sharing to lay the ground for introduction of a GST.

50. Sustainable fiscal adjustment will also require greater spending efficiency, in particular improved targeting of support to the needy. Subsidy reform is needed to free resources for infrastructure and social spending as well as deficit reduction. The rural employment program also represents a potentially large expenditure commitment and the government should proceed cautiously while providing appropriate incentives for self-targeting. The center should also consider replacing, over time, the large number of welfare programs and subsidies with a better-targeted social safety net.

51. The pending passage of the Pension Bill would be a welcome step toward broader pension reform. The introduction of fully-funded defined contribution pensions will help provide a secure and sustainable source of retirement income and aid in the development of capital markets. However, the unfunded pension liabilities of existing defined benefit schemes for civil servants require parametric revisions to ease the fiscal burden and make these liabilities manageable.

52. The authorities should build on the important steps taken in recent years to improve states’ fiscal health.

  • States have, in the aggregate, succeeded in reducing their overall and current deficits. But deeper reforms—including tax base broadening and pension, subsidy and power reforms—are needed to sustain and extend these gains. The introduction of a VAT in most states is an important step in this regard.

  • Implementation of TFC recommendations will provide states with greater resources as well as incentives to undertake fiscal reform. However, incentives provided may be too small to ensure that some states with large deficits adjust, and in other states, TFC targets are not sufficiently ambitious. Harder budget constraints—via tight global borrowing ceilings, reform of small savings, and greater reliance on market borrowing—will be key to enhance the effectiveness of the TFC.

53. Ensuring that regulatory and other policies support private investment and productivity growth remains a key challenge. The emphasis on PPPs to ensure greater private participation in infrastructure is welcome, but an improved regulatory framework is also needed. Moreover, the government should evaluate and account for all contingent liabilities associated with infrastructure projects. The SPV for infrastructure should be accompanied by financial reforms to broaden the long-term investor base. In the power sector, the 2003 Electricity Act provides a solid framework for reform and implementation should be accelerated.

54. The Indian financial system has remained resilient. Both the underlying strength of financial regulation and an effective response to recent fast credit growth have contributed to this. However, with a large and growing share of credit directed to higher-risk “priority sectors,” prudential standards may need to be strengthened further and reliance on priority sector lending reduced by addressing impediments to lending. The RBI also needs to monitor carefully credit card debt. While still in its infancy in India, the rapid rise in such debt, as well as the already sizable share of nonperforming loans, point to the need for close supervision and consumer education. The RBI should also continue its efforts to strengthen the regulation of UCBs, which remain in poor health. Finally, the RBI should continue efforts to ensure readiness for the planned move to Basel II, by enhancing relevant skills for bank supervisors, monitoring improvements in commercial banks’ risk management systems, and improving disclosure practices of banks.

55. With financial soundness improving, the authorities should use this opportunity to emphasize underlying financial sector development. In particular, the authorities should consider encouraging more foreign participation in the banking system, which would provide banks the tools and incentives to increase their efficiency. In this context, the RBI should consider accelerating implementation of its banking reforms. Steps to develop the government and corporate securities market are welcome, but certain aspects, such as the introduction of short-selling, could be accelerated.

56. India is already benefiting from its increased integration into the global economy but further opening would allow the country to reach its full growth potential.

  • Given excellent progress already made in reducing tariffs, faster convergence to ASEAN levels should be achievable. The authorities’ pursuit of preferential trade agreements (PTAs) bolsters the case for MFN-based tariff reductions so as to reduce the trade diversion potentially associated with PTAs.

  • Continued loosening of FDI limits, together with efforts to improve the business climate and liberalize labor laws would have a major payoff. Increased FDI would bring technological and managerial know-how to India, while reducing reliance on shorter-term capital flows. Although liberalizing labor laws are a complex and socially contentious issue, some key steps short of fully flexible hiring and firing would seem feasible in the near term.

57. It is recommended that the next Article IV consultation take place within the standard 12-month cycle.

Figure 7.
Figure 7.

India: External Debt Sustainability: Bound Tests 1/

(External debt, in percent of GDP)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Sources: International Monetary Fund; country desk data; and staff estimates.1/Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/Permanent ¼ standard deviation shocks applied to real interest rate, growth rate, and current account balance3/One-time real depreciation of 30 percent occurs in 2006.
Table 10.

India: External Debt Sustainability Framework, 2001/02–2010/11

(In percent of GDP, unless otherwise indicated)

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Derived as [r − g − p(l +g) + εα(l+r)]/(l+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(l+g) + εα(l+r)]/(l+g+ρ+gρ) times previous period debt stock, ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

ANNEX I India—Medium-Term Fiscal Outlook

The government is targeting substantial consolidation by 2009/10. The central and state governments would balance their current deficits by 2008/09 and reduce their overall deficits to 3 percent of GDP or below by 2009/10, meeting the FRBM and TFC targets. These targets require a 3¾ percentage points reduction in the general government’s current deficit by 2008/09.

The baseline scenario envisages that the central government meets FRBM targets but states’ adjustment falls short of the TFC targets. Helped by rising revenue, a continued real wage bill freeze, reform of major subsidies, and the consolidation of low-priority programs, the central government achieves current balance by 2008/09. States sharply reduce their deficits in 2005/06 thanks to higher transfers, but the adjustment stalls in subsequent years as central government transfers decrease. Growth stabilizes at 6½ percent as capital expenditure rises (2½ percentage points cumulatively by 2009/10). While debt declines to 80 percent of GDP by 2009/10, it remains vulnerable to shocks (Table I.1 and Figure I.1).

uA01anxfig01

India: General Government Revenue

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

uA01anxfig02

India: General Government Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Figure I.1.
Figure I.1.

India: Public Debt Sustainability: Bound Tests 1/

(Public debt, in percent of GDP)

Citation: IMF Staff Country Reports 2006, 055; 10.5089/9781451818628.002.A001

Sources: International Monetary Fund; country desk data; and staff estimates.1/ Shaded areas represent actual data Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent ¼ standard deviation shocks applied to real interest rate, growth rate, and primary balance.One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2006, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
Table I.1.

India: Public Sector Debt Sustainability Framework, 2000–2010

(In percent of GDP, unless otherwise indicated)

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General government. Gross debt is used.

Derived as [(r − π(l +g) − g + αε(l +r)]/(l+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r − π (1+g) and the real growth contribution as −g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(l+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

In a best case (reform) scenario, both the center and states meet their medium-term targets. Given spending needs, an adjustment of this magnitude would require annual revenue increases of about 0.9 percent of GDP and improvements in the efficiency of public expenditure. As capital spending increases (3¼ percentage points of GDP cumulatively by 2009/10), growth would accelerate to 8 percent and debt would decline to under 77 percent of GDP.

Without a change in policies debt would rise. General government revenue would rise only moderately (less than ½ percentage point per annum). The primary deficit would remain unchanged at around 2 percent of GDP. Current deficit targets would be missed. Growth would slow to 6 percent and with rising interest rates, the growth-interest differential fades by 2009/10.

ANNEX II India—Fund Relations

(As of October 31, 2005)

I. Membership Status: Joined 12/27/45; Article VIII.

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans: None

V. Financial Arrangements:

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VI. Projected Obligations to Fund (SDR million; based on existing use of resources and present holdings of SDRs):

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VII. Exchange Rate Arrangement:

Since March 1, 1993, the Indian rupee has floated against other currencies, although the Reserve Bank of India intervenes in the market periodically. As per the Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER), the exchange rate in India is classified as managed floating with no pre-announced path for the exchange rate. On August 20, 1994, India accepted the obligations of Article VIII, Sections 2, 3, and 4 of the IMF Articles of Agreement. India maintains some restrictions on the making of payments and transfers for current account transactions which are subject to approval under Article VIII, Section 2(a): restrictions related to nontransferability of balances under the Indo-Russia mutual debt agreement of 1993; restrictions arising from unsettled inoperative bilateral payments agreements with three Eastern European countries; and a restriction on transfer of amortization payments on loans by nonresident relatives. The Executive Board has not granted approval of these measures. A restriction on remittances for overseas TV advertising was removed in February 2004. Staff are seeking clarifications from the authorities regarding certain exchange measures under India’s Foreign Exchange Management (Current Account Transactions) Rules, 2000.

VIII. Article IV Consultation:

The previous Article IV consultation discussions were held in October 2004. The staff report (IMF Country Report No. 05/86) was discussed by the Executive Board on January 24, 2005.

IX. FSAP Participation and ROSCs:

The data model of the ROSC (IMF Country Report No. 04/96) was issued in April 2004; FSSA/FSAP report was issued in January 2001; a fiscal transparency ROSC (www.imf.org) was issued in February 2001.

X. Technical Assistance:

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XI. Outreach and Other Activities:

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XI. Resident Representative:

A resident representative’s office was opened in November 1991. Mr. Michael Wattleworth is the current Senior Resident Representative.

ANNEX III India—Relations with the World Bank Group

The World Bank’s total support to India of $2.89 billion in FY05 was the largest amount received by an individual country, and more than double the $1.4 billion recorded in FY04. As part of this total, India was also the largest recipient of IDA assistance, with credits totaling $1.1 billion. IFC also recorded a strong commitment in FY05 of $412.5 million. The World Bank Group’s program of support combines policy dialogue with diversified IBRD/IDA lending, IFC investments and analytical and advisory activities in the sectors that are important to reducing poverty and sustaining growth.

The Bank Group’s Board of Directors discussed a new Country Strategy (CAS) for India on August 26, 2004. The CAS jointly covers the programs of IBRD/IDA and IFC for the period of FY05–08. With over one-quarter of the world’s poor in India, the overarching challenge is how to scale up the impact of Bank Group assistance in order to help India move closer to achieving its development goals—including the goal of halving poverty by 2015.

Scaling up assistance will entail a strengthened Bank Group program at the Center, as well as more lending to the states compared to recent years. For state level lending, the strategy is to retain an essentially reform and performance-based approach to the states, and to also seek new opportunities for engagement with the largest and poorest states in India in order to help strengthen the environment for reform. The expansion in lending will primarily be for investment in infrastructure development, human development and rural livelihoods. Through adjustment lending, continued emphasis is also being placed on support to fiscal and governance reforms at the state level.

Adjustment lending to finance state level reforms will be limited to 15 percent of total IBRD/IDA lending for the CAS period. Overall lending levels will fall within an upper bound of $2.15 billion per year for IBRD, on average for the four years of the CAS, and the IDA limits for India established by the IDA Deputies. Financial operations since 1998/99 are summarized below.

India: World Bank Group Financial Operations1/

(In millions of U.S. dollars)

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Source: World Bank.

On a fiscal year basis beginning April 1.

Based on loan approval date.

ANNEX IV India—Relations with the Asian Development Bank

The Asian Development Bank (AsDB) operations in India began in 1986. Cumulative public sector loan commitments totaled $14.3 billion as of June 30, 2005 for 80 loans. With an additional $0.4 billion private sector loans (the latter without government guarantee), total loan commitments amounted to $14.7 billion. These funds have been provided from the Bank’s ordinary capital resources (OCR). Also, AsDB has approved 23 equity investments. The AsDB’s lending and equity activities are summarized below.

India: Asian Development Bank Financial Operations

(In millions of U.S. dollars, as of June 30, 2005)

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Source: Asian Development Bank.

AsDB’s core operational strategy in India remains poverty-reduction through infrastructure-led growth. More than 75 percent of its ongoing and proposed assistance focuses on transport (national highways, state roads, and rural roads), urban (water and sanitation, waste management, urban transport, city planning, and municipal reforms), and energy (power sector reforms, investments for upgrading transmission and distribution systems, hydropower generation, and improvement in energy efficiency) sector operations. AsDB’s assistance pipeline for the period 2006–2008 is provided in the Country Strategy and Program Update 2005.

ANNEX V India—Statistical Issues

1. While India’s macroeconomic statistics are adequate for surveillance, weaknesses remain in the timeliness and coverage of certain statistical series. India has an elaborate system for compiling economic and financial statistics and produces a vast quantity of data covering virtually all sectors of the economy. India subscribed to the SDDS on December 27, 1996 and started posting its metadata on the Dissemination Standards Bulletin Board on October 30, 1997. It is currently in observance of the SDDS, and it uses flexibility options for timeliness of data on general government operations and on the periodicity and timeliness of labor market data. The authorities are planning further improvements in the timeliness, periodicity, and coverage of data in a number of statistical areas as detailed below. Many key financial variables are available on a weekly or monthly basis, most of which are published in official documents or disseminated through press releases.

2. The data module of the Report on Observance of Standards and Codes (ROSC, IMF Country Report No. 04/96) was published in April 2004. It assesses India’s data dissemination practices against the SDDS requirements and assesses the quality of six datasets based on the Data Quality Assessment Framework (DQAF) developed by STA. In addition, it lists prioritized recommendations to improve national accounts, consumer and wholesale price indices, fiscal, monetary, and balance of payments statistics. The data ROSC identified issues related to the periodicity, coverage, and quality of statistical series.

  • National accounts: The CSO rebased the annual national accounts statistics and began publishing quarterly data in 1999. The CSO has recently reduced the dissemination lag for quarterly releases to two months from three months and is planning to release a new series of national accounts, with base year 1999–2000 in January 2006. However, quarterly data are only available from 1996Q2 and relate only to production-based data. Information on major expenditure categories is only available with considerable delay (at least ten months after the end of the fiscal year), providing limited guidance for short-term policies. The CSO is planning to disseminate quarterly expenditure-based aggregates starting in 2007 and is aiming to reduce the dissemination lag for the annual expenditure-based estimates to three months.

  • Industrial production index (IPI): In May 2000, the CSO took the welcomed step of releasing a revised time series for IPI, using the new WPI (base year 1993/94) series as a deflator. The government has also contracted a private company, CMIE, to increase the number of respondents and products in the sample, as recommended by the data ROSC.

  • Price statistics: The Consumer Price Indices (CPIs) are based on weights that are at least twenty years old and do not fully capture price developments in the economy. However, the CSO plans to publish shortly a revised CPI with a 2001 base year and a new producer price index. Presently, there are four CPIs, each based on the consumption basket of a narrow category of consumers (namely industrial workers, urban and nonmanual employees, agricultural laborers, and rural laborers). In addition, the CSO is in the process of compiling an all-India CPI covering the general population of urban and rural sectors separately. The CPIs are published with a lag of about one month. The WPI is published weekly with a lag of two weeks and are subject to large revisions, especially in periods of rising inflation. A new WPI series was published in 2000 with updated weights, new categories, and a revised base year (1993/94). However, the representativeness of the index may be undermined by the collection of prices from a relatively small sample of products and the infrequent updating of weights.

  • External sector statistics: While the concepts and definitions used to compile balance of payments statistics are broadly in line with the fifth edition of the Balance of Payments Manual (BPM5), the Reserve Bank of India’s (RBI) presentation does not follow the BPM5. Furthermore, trade data have quality, valuation, timing, and coverage problems, and data on trade prices, volumes, and composition are not regularly available on a timely basis. Starting January 2001, external debt statistics are available on a quarterly basis with a one quarter lag. Estimates of short-term external debt are presented in the debt statistics on an original maturity basis. The short-term maturity attribution on a residual maturity basis is only available annually (and excludes residual maturity of medium- and long-term nonresident Indian accounts). The international investment position (IIP) statistics cover the sectors prescribed in the BPM5 and these data are disseminated within six months of the reference period in respect of annual data. India began disseminating the Data Template on International Reserves and Foreign Currency Liquidity as prescribed under the SDDS in December 2001. The more up-to-date information on certain variables, such as total foreign reserves, foreign currency assets, gold, and SDRs, are available on a weekly basis and are disseminated as part of a weekly statistical supplement on the RBI website.

  • Monetary and financial statistics: The RBI website and the RBI Bulletin publish a wide array of monetary and financial statistics, including interest rates, exchange rates, foreign reserves, the monetary survey, and results of government securities auctions. The frequency and quality of data dissemination have improved substantially in recent years. However, some crucial data, such as the RBI’s forward liabilities and intervention data, are still published with lags of two to three months.

  • The ROSC data module mission of May 2002 found that the concepts and definitions used by the RBI to compile monetary statistics were in broad conformity with the guidelines provided in the Monetary and Financial Statistics Manual (MFSM). Nevertheless, the following concepts and principles deviate from the MFSM: (1) the resident sector data do not provide sufficient information on the sectoral distribution of domestic credit. Specifically, under their present sectorization scheme, the authorities subdivide the resident nonbank sector data by (i) central government, (ii) state government, and (iii) the commercial sector (including other financial corporations, public and other nonfinancial corporations, and other resident sectors); and (2) commercial banks add accrued interest to credit and deposit positions on a quarterly basis only. The mission has recommended that the authorities adopt the full range of sectors prescribed in the MFSM and include accrued interest on a monthly basis instead of reflecting it only on a quarterly basis.

  • Fiscal operations: The Ministry of Finance posts selected central government monthly fiscal data and quarterly debt data on its website. However, no monthly data on fiscal performance at the state level are available, and annual data are available only with an eight to ten month lag. Consolidated information is unavailable on local government operations. In addition, data on the functional and economic classification of expenditures are available with considerable lag, and there is scope to improve the analytical usefulness of the presentation of the fiscal accounts. Reporting to the Fund for publication in the Government Finance Statistics Yearbook (GFSY) is adequate, but only cash data is reported, and the coverage is limited to the central government.

3. In addition to the ROSC recommendations, the authorities are presently addressing a number of data compilation issues which were identified in the August 2001 Report of the National Statistical Commission, including:

  • The revision of statistical and data reporting methods in order to keep pace with the shift to a more market-oriented economy following the elimination of industrial licensing.

  • The need for the Central Statistical Organization (CSO) to initiate procedures through which its interaction with other agencies in the decentralized statistical system is made more proactive as well as effective. The planned establishment of the National Statistical Commission is a first step.

India—Table of Common Indicators Required for Surveillance

As of December 13, 2005

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Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.

Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.

Foreign, domestic bank, and domestic nonbank financing.

The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.

Including currency and maturity composition.

Daily (D), Weekly (W), Biweekly (BW), Monthly (M), Quarterly (Q), Annually (A), Irregular (I); Not Available (NA).

Reflects the assessment provided in the data ROSC (published on April 2, 2004, and based on the findings of the mission that took place during May 13–30, 2002) for the dataset corresponding to the variable in each row. The assessment indicates whether international standards concerning concepts and definitions, scope, classification/sectorization, and basis for recording are fully observed (O), largely observed (LO), largely not observed (LNO), or not observed (NO).

Same as footnote 7, except referring to international standards concerning source data, statistical techniques, assessment and validation of source data, assessment and validation of intermediate data and statistical outputs, and revision studies.
1

Fiscal year April-March.

2

Non-customs imports —in part, defense-related— rose sharply, accounting for about two-thirds of the widening in the trade deficit q/q.

3

Staff estimates that the overall cost of oil subsidies increased by 0.2 percent of GDP to 0.7 percent of GDP in 2004/05. Meanwhile, subsidies borne off-budget doubled from 0.3 percent of GDP to 0.6 percent of GDP.

4

The FRBMA is summarized in India Staff Report for the 2003 Article IV Consultation (unpublished).

5

Public debt estimates include market stabilization bonds used for monetary policy operations of Rs. 655 billion (2.1 percent of GDP) in 2004/05.

6

Finance Commissions are constitutional bodies appointed at least every five years to mediate the sharing of resources between the center and states. The terms of reference for the TFC included measures to restructure public finances and achieve debt reduction.

7

Banks’ recovery of bad loans via the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, debt recovery tribunals, and asset reconstruction companies increased six-fold in 2004/05.

8

See Chapter I of the Selected Issues.

9

VAT receipts rose 14 percent y/y in the first half of 2005/06. These preliminary estimates may overstate revenues as some states’ VAT laws delay provision of refunds by up to a year.

10

Oil companies have suffered ½ percentage points of GDP in revenue losses due to the lack of pass-through in the first half of 2005/06.

11

See Box 5.

12

See Report of the Taskforce on Implementing the Fiscal Responsibility and Budget Management Act, 2003, July 2004, Ministry of Finance, India; and Central Government Subsidies in India, December 2004, Ministry of Finance, India.

13

A recent study by the National Institute of Public Finance and Policy commissioned by the Finance Ministry estimates that the annual cost of key tax exemptions, including for small-scale enterprises, exports, underdeveloped regions, housing, and agriculture, exceeds 1½ percent of GDP. See also Chapter III of the Selected Issues.

14

The annual cost of the program is estimated at about 1 percentage point of GDP once implemented in all states, 90 percent of which would be borne by the central government.

15

The government’s 2004 subsidy report noted that the major subsidies are costly and not well targeted, and advocated fundamental reforms to food and fertilizer subsidies.

16

See Box 3 and Chapter IV of the Selected Issues.

17

See IMF Country Report No. 01/181 for background on the small savings system in India.

18

Following the 1990s civil service pay awards, pension outlays have risen to 2¼ percentage points of GDP in 2004/05. The World Bank estimates that the unfunded pension liability of central and state governments exceeds one-third of GDP.

19

The SPV borrowing limit for 2005/06 is set at Rs. 100 billion ($2.2 billion). The lead banker will be responsible for project appraisal.

20

See also IMF Board paper on Public Investment and Fiscal Policy—Summary of the Pilot Country Studies (http://www.imf.org).

21

See India: Scaling-Up Access to Finance for India’s Rural Poor, World Bank Report No. 30740-IN.

22

See Chapter V in the Selected Issues.

23

Discussions with private sector banks suggest that implementation of Basel II norms would reduce their CAR by 1–2 percentage points, requiring a commensurate increase in their capital.

24

With rapid credit growth and the need to meet Basel II capital norms, a number of public banks with government ownership close to the 51 percent floor would need additional capital.

25

Despite robust export growth in the last several years, India still only accounts for 2½ percent of the global trade in goods and services.

26

See Report of the Expert Group on Encouraging FII Inflows and Checking the Vulnerability of Capital Markets to Speculative Flows, Ministry of Finance, India, November 2005.

27

Recent measures included liberalizing corporate overseas investment, and raising limits on domestic mutual funds and individual investments abroad.

28

India ranks 116 on the overall ease of doing business among 155 countries (World Bank Doing Business in 2006—Creating Jobs), with enforcing contracts, trading across borders, and dealing with licenses highlighted as particular problems.

29

India ranks 116 on the ease of hiring and firing, with indices of employment rigidity, hiring costs, and firing costs all higher than the regional average (World Bank Doing Business in 2006—Creating Jobs).

30

See Chapter VI in the Selected Issues.

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Cover IMF Staff Country Reports
India: 2005 Article IV Consultation—Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion
Author:
International Monetary Fund
Volume/Issue:
Volume 2006: Issue 055
Publisher:
International Monetary Fund
ISBN:
9781451818628
ISSN:
1934-7685
Pages:
68
DOI:
https://doi.org/10.5089/9781451818628.002

Real GDP and Industrial Production: Deviations from Trend

(In percent)

Real GDP Growth for 2004 in Asia

(Year-on-year percent change)
Figure 1.

India: Growth
Figure 2.

India: External Sector

Bilateral Exchange Rates (National currency per U.S. dollar)

(Percent changes from October 2004 to October 2005)

Foreign Exchange Reserve Accumulation

(In billions of U.S. dollars)

Stock Market Indices

(October 2004 to October 2005)

Property Prices in Asia

(Index 1998=100)

India: Current Account, Private Capital Flows and Reserves

(Four Quarter Cumulative Balance, US$ billions)

India: Composition of Capital Inflows

(Four quarter cumulative total, US$ billions)

India: FII Equity Invesment by Type of Investor

India: Inflationary Pressures 1/
Figure 3.

India: Money and Inflation
Figure 4.

India: Infrastructure Indicators

India: Fiscal Impulse

(In percent of GDP)
Figure 5.

India: Fiscal Trends

Economies with Administered Prices: Petroleum Product Price Increase, December 2003-Latest

(Percent change)
Figure 6.

India: Corporate and Financial Sector Soundness

TFC: Resource Implications for the States

(In percent of GDP)

India: Growth in Total Credit and Deposits, 2000–05

Asian Countries with Highest Real Rates of Credit Growth in 2004

India: Central Government Gross Tax Revenue

(In percent of GDP)

India: Estimates of the Equilibrium REER

(Index 1995=100)

Demographic Branch Penetration

(In number of branches per 100,000 people)

Credit of Foreign Banks to Total Bank Credit, 2003 1/
Figure 7.

India: External Debt Sustainability: Bound Tests 1/

(External debt, in percent of GDP)

India: General Government Revenue

(In percent of GDP)

India: General Government Debt

(In percent of GDP)
Figure I.1.

India: Public Debt Sustainability: Bound Tests 1/

(Public debt, in percent of GDP)