India: Staff Report for the 2006 Article IV Consultation

This 2006 Article IV Consultation highlights that India’s economy has continued to grow above trend, with an average growth of 8 percent in the last three years. Growth is broad based, with robust consumption, investment, and exports. With manufacturing expanding at more than 10 percent y/y, industry has joined services as an engine of growth. Net foreign investor inflows rebounded after the May/June 2006 stock market correction, and stock prices recovered smartly, reaching new historical highs. Real estate prices continue to grow at a rapid clip on the back of a credit boom.

Abstract

This 2006 Article IV Consultation highlights that India’s economy has continued to grow above trend, with an average growth of 8 percent in the last three years. Growth is broad based, with robust consumption, investment, and exports. With manufacturing expanding at more than 10 percent y/y, industry has joined services as an engine of growth. Net foreign investor inflows rebounded after the May/June 2006 stock market correction, and stock prices recovered smartly, reaching new historical highs. Real estate prices continue to grow at a rapid clip on the back of a credit boom.

I. Background

[Quoting Victor Hugo], “no power on earth can stop an idea whose time has come”...“and the emergence of India is one such idea. We have come far and this idea...is now an accepted axiom.”

Prime Minister Singh, October 2006

1. India has emerged as one of the world’s fastest-growing economies. GDP growth has ranged around 8 percent for four years running. The expansion has been resilient in the face of volatile oil prices and slowing U.S. growth. Exports market share remains modest, but prospects for brisk export growth bodes well for a rising market share over time. As elsewhere, investors have shrugged off the May/June emerging market turbulence, while Indian corporates are expanding overseas through high-profile acquisitions.

A01ufig01

Growth in Output

(Log, Index at Period t)

Citation: IMF Staff Country Reports 2007, 063; 10.5089/9781451818642.002.A001

2. In contrast to much of East Asia, where rebalancing demand is a policy issue, domestic demand is the main driver of activity. India’s consumption/GDP ratio—nearly two-thirds—is one of the highest in Asia, perhaps reflecting a high share of disposable income in GDP. In addition, following a period of corporate restructuring, investment has rebounded strongly, fed by buoyant corporate profits. Meanwhile, exports are growing apace as well, reflecting India’s increasing integration into the global economy.

A01ufig02

Real GDP Growth for 2005 in Asia

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2007, 063; 10.5089/9781451818642.002.A001

3. Looking to the medium term, prospects are good for a sustained and robust expansion if reform momentum is maintained. India appears to be in the beginning phase of a long-run takeoff that began in the mid-1990s on the heels of structural reforms. Going forward, the coming sharp rise in working-age population will support growth. Continued growth at staff’s estimated trend (7.5 percent annually) would double per capita real income in 13 years, and faster growth could be achievable under decisive reforms. However, sustained reforms and job creation would be needed to take full advantage of the demographic dividend and attain India’s full potential to improve living standards.

4. Building consensus for these reforms will remain challenging, reflecting the need to forge consensus among multiple and diverse coalition partners, as well as between the center and states.1 In this context, progress on reforms is likely to remain steady and gradual, with issues such as labor market reform, privatization, and reducing public ownership of banks difficult.

5. Against this backdrop, the 2006 Article IV consultation focused on the four main policy challenges facing India, which are also priorities in the government’s agenda. They are: achieving fiscal sustainability while financing development; managing price and financial stability; fostering a deeper and broader financial sector; and promoting more job-intensive, inclusive growth. In discussing policies for inclusive growth, as many structural issues are long standing and well covered in prior consultations, this consultation focused on issues in the policy debate that are most macro relevant—special economic zones, infrastructure, and trade.

II. Economic Backdrop

6. Growth remains strong, inflation contained and the current account deficit manageable (Table 2, Figure 1).

Table 1.

India: Millennium Development Goals, 1990–2004 1/

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Source: World Development Indicators database, April 2006.

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 other major diseases.

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 dwellers.

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.

Table 2.

India: Selected Economic Indicators, 1996/97–2006/07 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.

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

Privatization investment proceeds treated as below-the-line financing; FCI and oil bonds excluded from central government total expenditure.

For central government.

Annual data are on balance of payments basis.

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

For projection, 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.

IMF INS calculation.

Issued by the central government to FCI and the state-owned oil refining/distribution companies as compensation for losses incurred from the provision of universal government price subsidies.

Figure 1.
Figure 1.

India: Growth

Citation: IMF Staff Country Reports 2007, 063; 10.5089/9781451818642.002.A001

Sources: Data provided by the Indian authorities; CEIC Data Company Ltd; NCAER; and IMF staff projections.
  • The economy continues to grow above trend. In the first quarter of 2006/07,2 demand accelerated to almost 9 percent y/y, and recent indicators show continued momentum. Growth is broad based, with robust consumption, investment and exports. With manufacturing expanding at over 10 percent y/y, industry has joined services as an engine of growth, and corporate profitability is strong. A normal monsoon is supporting agriculture.

  • WPI inflation is contained, partly reflecting limited-pass through of higher world oil prices to domestic LPG and kerosene (Box 1), cuts in import duties, monetary tightening, administrative steps to dampen food-price pressures, and competition from imports. However, high food prices are contributing to CPI inflation (industrial workers) exceeding 6 percent.

  • The current account deficit is widening. Buoyant imports have offset rising goods and services exports, pushing up the trade deficit (Table 3, Figure 2).

A01ufig03

India: HP Estimate of Deviation from Trend Growth

(Deviation from trend, in percent)

Citation: IMF Staff Country Reports 2007, 063; 10.5089/9781451818642.002.A001

Table 3.

India: Balance of Payments, 2001/02–2006/07 1/

(In billions of U.S. dollars)

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Sources: 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.

Figure 2.
Figure 2.

India: External Sector

Citation: IMF Staff Country Reports 2007, 063; 10.5089/9781451818642.002.A001

Sources: Data provided by the Indian authorities; CMIE Pvt. Ltd.; and, CEIC Data Company Ltd.1/ Customs data, based on U.S. dollar values.
A01ufig04

WPI: Year-on-Year Inflation

(In percent)

Citation: IMF Staff Country Reports 2007, 063; 10.5089/9781451818642.002.A001

Sources: CEIC Data Company Ltd; the authorities; and, IMF staff calculations.

7. Strong capital inflows comfortably financed the current account deficit. Inflows remain dominated by portfolio flows and external commercial borrowings (ECBs, which remain subject to capital controls), particularly convertible bonds. Foreign institutional investor (FII) inflows rebounded after the May/June stock market correction. Gross FDI inflows have begun to rise, partly offset by a pickup in outward investment by Indian corporates (Box 2).3 Reserves rose to $167 billion by end-October 2006, a level equivalent to about 7½ months of imports of goods and services or about 7¼ times short-term external debt. To facilitate the expansion of Indian corporations’ overseas activities, the RBI continues to cautiously raise limits on external commercial borrowings (by $250 million to $750 million) and recently doubled the amount banks can extend in credit to joint ventures abroad to 20 percent of banks’ capital.

A01ufig05

India: Composition of Capital Inflows

(Four quarter cumulative total, in billions of U.S. dollars)

Citation: IMF Staff Country Reports 2007, 063; 10.5089/9781451818642.002.A001

1/ The decline in capital inflows in 2005Q4 relates to $7.1 billion redemption of India millennium deposits.

India: Rangarajan Committee on Pricing and Taxation of Petroleum Products

The Rangarajan report submitted in February 2006 made several major recommendations.

  • A new pricing mechanism for petrol and diesel whereby oil companies have the freedom to set retail prices based on the trade parity price (a weighted average of the import parity and the export parity prices in the ratio of 80:20), which would operate as an indicative ceiling price.

  • For petrol and diesel, reducing the customs duty from 10 percent to 7.5 percent; moving from a combination of ad valorem and specific taxes to specific taxes; and implementing a uniform sales tax.1/

  • Restricting kerosene subsidies to below-poverty-line families, using a single retail price and passing subsidies through mechanisms such as debit cards, and financed through the budget.

  • Gradually eliminating the subsidy on LPG (a one-time increase in cooking gas followed by further increases toward market level), which the Committee saw no merit in as it is used mainly by above-poverty-line families.

If implemented, according to the report these measures would eliminate subsidies on petrol and diesel, and reduce the subsidies on kerosene and LPG from 0.8 percent to 0.4 percent of 2005/06 GDP. The report also suggested that subsidies should be financed through specific taxes with the remainder through the budget, rather than financed through under-recoveries of upstream companies and the issuance of oil bonds.

Since the report was issued, the government has reduced the customs duty for petrol and diesel. While the trade parity price has been adopted, the automatic pricing mechanism for petrol and diesel has not become operational. In addition, reforms on kerosene and LPG subsidies have yet to be implemented.

India: Pricing of Petroleum Products (Delhi) 1/

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Sources: Bloomberg L.P.; Indian Oil Corporation Ltd.; and IMF staff estimates.

In Indian rupees.

Full pass-through prices are estimated by adding international prices, freight and insurance costs, import duties, excise taxes, distribution and marketing costs, and state sales taxes with information provided by the Ministry of Petroleum.

1/

At the central level, taxation of petrol and diesel is already largely specific, but at the state level, it is largely ad valorem and varies widely across states.

India Goes Global—The Boom in Overseas Acquisitions

The emergence of globally-competitive private corporates in India has triggered an unusual boom: its corporates have started to acquire foreign firms. Such acquisitions amounted to $7.2 billion in the first three quarters of 2006,1/ then doubled in a single deal in October, when Tata Steel announced it would be spending $8–9 billion to take over Corus, a U.K./Dutch steelmaker. Such large acquisitions mark a coming of age for Indian companies. If sustained, they could also rewrite the development textbook. For when Japan and Korea began their overseas investment drives, their GDP per capita was ten times higher that that of India today. And although China and Russia have begun expanding overseas at a much earlier stage of development, their GDP per capita is still much higher than India’s. Equally striking, India’s outward FDI is exceptionally large relative to its still-small inward FDI. So, what explains India’s sudden surge in acquisitions?

To begin with, Indian corporates have been taking over foreign firms, primarily in Europe and the United States, to gain direct access to advanced markets and technology. In other words, while other countries have imported technology through inward FDI, India is obtaining it through acquisitions. One reason why Indian corporates have been able to do this is that their business models are very similar to western ones, both in terms of framework and governance, and they have managers who have been trained in western universities and speak English.

A second factor has to do with finance. After a decade of restructuring, the profitability of Indian corporates is very high, while their leverage—unlike in East Asia—is quite low. Consequently, international financial firms have been willing to help fund these acquisitions, especially given the current benign global financial environment. In many cases, acquisitions have taken the form of leveraged buy-outs, whereby a special purpose vehicle (SPV) is incorporated in the country of acquisition, and then borrows against the cash flow and assets of the acquired company. This mechanism not only allows the Indian company to take over foreign companies of much large scale, but also leaves financial room for the parent company to make further acquisitions abroad and expand domestically.

A third factor has to do with competitiveness. India’s shopping list belies the conventional perception that India has a comparative advantage only in information technology and related services. Initially, the overseas boom was indeed triggered by software companies, which wanted to enlarge and diversify their customer base, establish an on-site presence for their clients, and move up the value chain. But over the past few years, as manufacturing companies have also emerged as internationally efficient and low-cost producers, they have also started to acquire foreign firms, including in the textiles, auto parts, chemicals, and now steel sectors. Further, these acquisitions are not confined to large corporates: smaller manufactures have now joined the race overseas, too.

Better information is needed to monitor and manage any attendant risks. Banks should be aware of their clients’ worldwide financial exposures, including leverage taken on through overseas financial activities. In addition, macroeconomic data on outward FDI can be improved, specifically to include outflows financed through offshore vehicles.

1/

According to Dealogic.

8. The rupee has fluctuated against the U.S. dollar and its real effective value is broadly around its 2004–2005 level. The rupee depreciated against the U.S. dollar in the first half of 2006, against a backdrop of tightening global liquidity and a widening current account deficit. In addition, the RBI intervened in the foreign exchange market, easing exchange-rate volatility and smoothing domestic liquidity pressures that arose following the redemption of Indian Millennium Development Bonds.4 Since then, the rupee has regained ground against the dollar and the RBI has intervened only occasionally, both buying and selling dollars.

9. Since October 2005, the RBI has gradually raised policy rates. The reverse repo (borrowing) rate has risen 100 bps to 6 percent, while the repo (lending) rate has risen 125 bps to 7.25 percent (Table 4, Figure 3). High credit growth prompted the RBI to tighten prudential standards, including by raising general provisioning requirements and boosting risk weights in the high-growth areas, including real estate, to above Basel norms. Indicators of financial soundness (while backward looking) suggest that banks’ balance sheets and income remain healthy.

Table 4.

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.

Figures include the impact of conversion of a non-banking entity into a banking entity with effect from October 11, 2004.

Figure 3.
Figure 3.

India: Money and Inflation

Citation: IMF Staff Country Reports 2007, 063; 10.5089/9781451818642.002.A001

Sources: Data provided by the Indian authorities; CEIC Data Company Ltd; and IMF staff projections.1/ Deflated by the WPI.2/ Average of call, CBLO, and repo market.
A01ufig06

Real Effective Exchange Rates

(Percent changes, August 2005-August 2006)

Citation: IMF Staff Country Reports 2007, 063; 10.5089/9781451818642.002.A001

Source: IMF, INS database.

10. Financial markets continue to soar. Stock prices recovered smartly from the May/June turbulence, reaching new historical highs on the back of strong foreign and domestic purchases. PE ratios are now high relative to other countries and India’s recent past. Meanwhile, real estate prices continue to grow at a rapid clip (Figure 4).

Figure 4.
Figure 4.

India: Asset Market

Citation: IMF Staff Country Reports 2007, 063; 10.5089/9781451818642.002.A001

Sources: Data provided by the Indian authorities; Bloomberg, Datastream International Ltd; and, Colliers International.1/ Nondeliverable forwards.
A01ufig07

India: Stock Market and Foreign Institutional Investment

(SENSEX, Oct. 2005=100; inflows, in USD billions)

Citation: IMF Staff Country Reports 2007, 063; 10.5089/9781451818642.002.A001

Sources: CEIC Data Company Ltd and IMF staff calculations.
A01ufig08

Emerging Markets: Price Earnings Ratios

Citation: IMF Staff Country Reports 2007, 063; 10.5089/9781451818642.002.A001

11. Fiscal consolidation paused in FY 2005/06. The general government deficit was broadly unchanged at 7.4 percent of GDP (Tables 56, Figure 5), with a modestly rising central government deficit broadly offset by a falling state deficit. General government debt remains high—over 80 percent of GDP—reflecting both budget deficits and off-budget subsidies.5

Table 5.

India: Central Government Operations, 2002/03–2006/07

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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, but excluding FCI and oil bond issuances.

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.

Treats divestment receipts as a below the line financing item.

Authorities’ definition treats divestment as a receipt item until 2005/06 included.

Staff’s definition treats divestment receipts as a below the line financing item and treats bond issuance by the central government to oil companies and FCI as current expenditure, in accordance with GFSM 2001.

External debt measured at historical exchange rates.

Issued by the central government to FCI and the state-owned oil refining/distribution companies as compensation for losses incurred from the provision of universal government price subsidies.

Table 6.

India: General Government Operations, 2002/03–2006/07 1/

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

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

Based on RBI’s estimate of provisional outturn for state finances.

Based on central government provisional unaudited outturn and staff’s 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 (authorities’ definition excluding FCI and oil bonds), 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 and the RBI Annual Report 2006 ; the authorities treat disinvestment proceeds above-the-line as capital receipts. From 2005/06, disinvestment receipts of the central government are transferred to the National Investment Fund (off-budget).

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