India’s financial system compares favorably internationally, but rising credit risk and liquidity pressures are putting it under strain. The staff report for India’s 2008 Article IV Consultation discusses economic developments and policies. The authorities have already taken numerous welcome measures in response to the crisis. The Reserve Bank of India has been quick in reversing its policy stance and the reductions in interest rates, the cash reserve ratio, and the statutory liquidity requirement together with stepped-up open market operations have been fully warranted.
February 6, 2009
1. This statement contains information that has become available since the staff report was circulated to the Executive Board on January 23, 2009. This information does not alter the thrust of the staff appraisal.
Economic and financial developments
2. Indicators of economic activity have remained soft. While exports (in dollar terms) contracted by 1 percent y/y in December, better than the 11 percent contraction recorded in October-November, based on preliminary shipment data the government announced that January exports will likely decline by 22 percent. Furthermore, the commerce ministry now expects exports to fall in 2009/10. Finally, the manufacturing sector PMI (ABN Amro) indicated continued contractions in output, new orders, and employment in January, although at a slower pace than in December.
3. Inflation continues to fall on the back of lower fuel prices. WPI inflation decelerated to an average 5.5 percent (y/y) during the first three weeks of January compared to 5.9 percent (y/y) in December. The three-month moving average of WPI changes remained negative. Consumer price inflation (industrial workers) has also decelerated but remains high at 9.7 percent (y/y) in December.
4. Tax collections have continued to weaken. During April-December, they rose only 5 percent (y/y), compared to 26 percent (y/y) for the April-September period. With expenditure also rising faster than projected, further market borrowing will likely be announced in February. In its January review, the Prime Minister's Economic Advisory Council forecast that the 2008/09 general government fiscal deficit (including subsidy-related bonds) at about 10 percent of GDP, the same as projected by staff.
5. Overall credit growth is decelerating, but public banks' credit has picked up and lending rates have declined somewhat. The growth of non-food credit to the private sector slowed to 23 percent y/y in mid-January and was negative in seasonally adjusted, month-on-month terms. Recently published data show that lending has differed significantly by bank ownership. While total lending during 2008 rose by 21 percent, that of private and foreign banks slowed sharply to 12 percent and 17 percent, respectively, while that of public sector banks rose to 29 percent. Commercial lending rates remain much higher than the policy rate, though reductions are starting to occur, particular in state-owned banks.
6. Recent financial results suggest that banks' profits are holding up well, but corporates performance is weakening. Earnings for the September-December 2008 quarter held up reasonably well with SBI and ICICI reporting increases of 51 percent and 3.4 percent in their consolidated profits. These results exceeded market expectations, but were less than in the same period last year. Reflecting these results and in line with global trends, the CDS spreads on these banks have declined by about 30-80 basis points compared to end-December. In contrast, corporate profits have continued to decline: a sample of about 2,400 companies indicates that after-tax profits declined by 8 percent y/y in the June-September quarter. Initial results for the October-December quarter and corporate tax revenue suggest continued weak performance.
7. Financial markets have stabilized, but remain volatile. The equity market declined about 5 percent during January, while the rupee/U.S. dollar rate held steady at about 49. In credit markets, commercial paper rates have eased somewhat. The yield curve for government securities has steepened with long yields rising in recent weeks (by about 50-100 bps), reflecting expectations of significant debt issuance. Portfolio investment registered net outflows of about $1 billion in January, and reserves fell by $2.8 billion to US$248 billion as of January 23, 2009 compared to end-December.
8. The Reserve Bank of India (RBI) kept monetary policy on hold at its quarterly policy meeting on January 27. The central bank cut its GDP growth forecast to 7 percent for 2008/09 (from the 7½-8 percent range announced at the last quarterly meeting), noting that downside risks have increased. It also reduced its forecast for headline inflation (WPI) for end-March to below 3 percent (y/y), from 7 percent previously. In explaining its decision to leave policy rates unchanged, the RBI noted that CPI inflation has yet to moderate and that liquidity in the financial system is already ample. It also noted delays in the transmission from policy to commercial bank rates. Looking ahead, the authorities expressed their desire to keep some measures in reserve, while indicating its readiness to act if the situation worsens. On the liquidity front, the RBI extended its facility for banks to onlend to mutual funds, non-bank financial corporations, and housing finance companies from June to September 2009.
9. On January 29, the government reduced the prices of gasoline, diesel, and LPG by an average 8 percent. The direct impact of these cuts on WPI inflation is estimated at about 0.4 percentage point. At present gasoline and diesel prices are in line with international comparators, while those for LPG and kerosene remain about 60 and 120 percent higher, respectively, than international prices.
10. The government has announced that it will not bail out private companies. In contrast to financial institutions, which are subject to regulation, the authorities have emphasized that a private company producing goods or services, competing in a competitive market should not be treated on the same basis as banks.
11. On January 23, 2009, the authorities announced a 6-month ban on imports of toys from China.