India’s economy has slowed substantially before and after the global financial crisis. The economy is in a weaker position than before the crisis. With investment particularly hard-hit, potential GDP is likely to be lower than estimated. Inflation is constraining the room for monetary policy easing. Banks’ capital ratios have fallen slightly, but asset quality is deteriorating considerably. The current account deficit registered a record high in 2011–12. Delivering on structural reforms, fiscal consolidation, and low inflation are critical for a sustained recovery.


India’s economy has slowed substantially before and after the global financial crisis. The economy is in a weaker position than before the crisis. With investment particularly hard-hit, potential GDP is likely to be lower than estimated. Inflation is constraining the room for monetary policy easing. Banks’ capital ratios have fallen slightly, but asset quality is deteriorating considerably. The current account deficit registered a record high in 2011–12. Delivering on structural reforms, fiscal consolidation, and low inflation are critical for a sustained recovery.


1. After growing strongly before and after the Global Financial Crisis (GFC), India’s economy has slowed substantially. Growth averaging 8½ percent and expanding social programs lowered the poverty rate by 1.5 percentage points per year in 2004–09, double the rate of the preceding decade, as shown by the latest quinquennial household survey. Growth returned to this level for two years after the GFC, but decelerated throughout 2011, slumping to only 5.4 percent in the first three quarters of 2012.1 Though India’s growth remains among the highest in the world, the recent slowdown—due to structural factors such as supply constraints and an unsupportive policy environment, with cyclical and global factors also contributing—is unusual among emerging markets (EMs) for its still-high inflation. Nevertheless, the 12th Five Year Plan, expected to be published by end-2012, will likely continue to aspire to growth above 8 percent and to significant improvements in social indicators.


GDP Growth

(In percent, yoy)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: Haver Analytics and staff calculations


(In percent year on year)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: Haver Analytics and staff calculations1/CPI Industrial Workers2/ Brazil, Russia, China, South Africa, Indonesia, Turkey, Mexico

2. The economy is in a weaker position than before the GFC, with strictly circumscribed policy space and greater domestic and external vulnerabilities. Inflation and the fiscal deficit remain among the highest in EMs. At the same time, the financial positions of banks and corporates, both strong before 2009, have deteriorated. The current account deficit (CAD) widened to 4.2 percent of GDP in 2011/12 and other external vulnerability indicators have deteriorated, which led to a sharp depreciation of the rupee in 2011 and early 2012.

3. The authorities are keenly aware of the situation and have moved in recent months to reverse the slowdown and lower vulnerabilities. Measures taken include higher diesel prices and quantity limits on subsidized LPG, two challenging but essential measures to rein in the fiscal deficit. The government announced further liberalization of FDI and a plan to restructure the debts and reduce the losses of state power distribution companies (discoms), and has just announced a Cabinet Committee on Investment (CCI), enabling single-window approval for large projects. The new Finance Minister (FM) is strongly committed to a medium-term deficit reduction plan. These and other measures have achieved a remarkable turnaround in market sentiment, but all eyes are on the government to deliver on its commitments before the national elections due by May 2014.

Recent Developments

A. Growth Slowdown

4. GDP growth has slowed more than external factors can explain. Falling infrastructure and corporate investment led the slowdown, though exports and private consumption are now also suffering (Figure 1). Global factors have hurt exports and weighed on investment, but India’s growth has slowed by more than the decline in trading partners’ growth would imply. Capital inflows remain resilient and international financing conditions favorable, suggesting that so far the financial channel has not been prominent in the transmission of external shocks (Figure 2).

Figure 1.
Figure 1.

India: Growth Slowdown

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: Haver Data Analytic; CEIC Data Company Ltd; and IMF staff calculations.
Figure 2.
Figure 2.

India: Financial Markets

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: Bloomberg Data LP; CEIC Data Company Ltd.; and IMF staff calculations.

The 2012 Slowdown: More than External Spillover

(In percent)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: IMF, World Economic Outlook; and IMF staff calculations.Note: Unexpected growth denotes real GDP growth in 2012 (Sept 2012 WEO) minus the forecast (Sept 2011 WEO). Partners growth is export weighted average.

5. Fiscal and monetary policies have neither aggravated nor significantly alleviated the slowdown. The slow consolidation following the large crisis-period stimulus means that fiscal policy has not tightened, and this year’s impulse will be around ½ percent of GDP (Figure 3). After remaining mostly negative since the GFC, the tightening of monetary policy in 2010–11 has increased short-term real interest rates to levels similar to those seen before the GFC (Figure 4). But with the Reserve Bank of India’s (RBI) 50 basis point (bp) cut in April 2012, a cash reserve ratio (CRR) now 150 bp lower than at end-2011, and the depreciation of the rupee, monetary conditions have eased.

Figure 3.
Figure 3.

Fiscal Sector Developments

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: Country authorities; and IMF staff calculations.
Figure 4.
Figure 4.

India: Monetary Policy

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: CEIC Data Company; Bloomberg Data LP.; and IMF staff calculations.

6. Market sentiment has improved, but elevated inflation and twin deficits weigh on investor confidence. Financial markets rallied following the government’s recent measures, but market participants are looking for progress on implementation and additional policy actions to sustain momentum. Also, concerns remain about inflation persistently above the RBI’s objectives, repeated fiscal slippages, the widening CAD, and a possible credit rating downgrade.2

7. Several causes of the weaker growth seem to be of a supply-side nature.

  • Rising policy uncertainty. In particular, high profile tax policy decisions announced in the 2012/13 Budget have reduced foreign investors’ interest in India, while the increasing difficulty of obtaining land use and environmental permits have raised regulatory uncertainty for infrastructure and other large-scale projects.3

  • Delayed project approvals and implementation. As a reaction to recent high-profile governance scandals, project approvals, clearances, and implementation have slowed sharply.

  • Supply bottlenecks are particularly pronounced in mining and power, with attendant consequences for the broader economy, especially manufacturing (Box 1).

8. With investment particularly hard-hit, potential GDP is likely to be lower than previously estimated. High frequency indicators have stabilized, but new investment project announcements are sharply down and more projects are being stalled or shelved. Increasingly, analysts and policymakers are marking down India’s growth potential. IMF estimates are in the 6–7 percent range, from 7.5 to 8 percent in recent years’ consultations (Box 2). Further, elevated inflation points to still-binding supply constraints.



(In billions of Rupees)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Source: CMIE.

9. The domestic implications of India’s slower growth could be far-reaching, though potential international spillovers are likely limited. Scant data on employment notwithstanding, lower medium-term growth might not generate sufficient jobs to absorb labor market entrants. Weaker growth also entails a slower reduction in poverty. IMF research suggests that 35 million more people would remain below the $1.25/day line compared to a scenario in which growth returns to the 2004–09 average (Box 3). On the other hand, India’s imports account for 2.6 percent of global imports, so direct spillovers to other countries are likely to be contained. Estimates from a three-region Global Integrated Monetary and Fiscal (GIMF) model suggest a 2.5 percentage point growth slowdown in India (equal to this year’s projected growth compared to the 8 percent average of 2007–11) is likely to have a 0.05 percent impact on Euro area growth and 0.03 on the growth of the rest of the world. The impact, however, is likely to be larger for some low-income countries and the South Asian economies, especially Nepal. Staff estimate that growth in South Asian economies could decline by about 1 percentage point in response to a decline of 2.5 percentage point in India.4 Though trade and financial flows between South Asia and India are relatively small, these growth estimates suggest that other linkages, for example sharing of human capital and confidence effects, are important.

India’s Energy Sector

India has a substantial electricity deficit. Electricity demand growth has outstripped growth in energy generation.1 Along with underinvestment in transmission and distribution, this has led to frequent blackouts, and occasional large blackouts such as the near-nationwide event of July 2012. Investment in generation capacity has risen by about half since 2006/07, but some of the new plants have not been commissioned, as securing coal supplies has become increasingly difficult and their customers, local power utilities (discoms), cannot afford market rates for power. As a result, power deficits have continued to rise and are estimated at about 8–9 percent.


Installed Electricity Generation Capacity by Source, 2012

(In Percent)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Source: Indian Ministry of Power

Difficulties in getting coal to power plants have magnified these challenges. Coal accounts for nearly 60 percent of India’s electricity production. Slow development of new coalfields by Coal India Limited (CIL), the monopoly coal producer, along with regulatory delays (mainly environmental clearances) have resulted in a widening gap between coal production and demand. Despite having the world’s fifth-largest coal reserves, India imports around one-fourth of its coal. Some coal fields are also allocated to specific power plants, but even in these cases, supplies are often underutilized. In addition, domestic coal prices are fixed by CIL well below international prices, reducing the profits of generation plants planned on domestic coal, but which now depend on imports, whose prices have risen to pre-crisis highs.

Electricity distributors are generally loss-making. Discoms, almost all of which are publicly owned, buy electricity from producers at market prices. But discoms’ tariffs, which need to be approved by state regulatory bodies, are for the most part below cost-recovery levels even after this year’s tariff increases, leading to large and long-standing losses. Discoms’ losses also result from high transmission losses and other inefficiencies.

These distortions have had knock-on effects on the economy. The slowdown in energy and coal projects has been a key cause of weak infrastructure and corporate investment. Resulting electricity shortages have lowered production and added to companies’ costs. Delayed or shelved power projects and discoms’ difficulties—though restructuring of their debts has now begun—have contributed to deteriorating asset quality at banks.

1 See World Bank “India Economic Update,” September 2012 for a detailed analysis.

Potential Growth

Slowing growth coupled with elevated inflation has raised questions about India’s growth story. Consensus Forecast growth projections for this year and next have been lowered substantially, while inflation projections have been raised. Even though some have attributed this slowdown to global conditions and demand-side factors, increasingly, analysts, observers, and policymakers are questioning India’s potential growth. Only a year ago, estimates of India’s potential growth were in the 8–9 percent range, with some forecasting India overtaking China. JP Morgan has put potential growth at 6–6.5 percent and other analysts have also suggested a decline. The RBI, acknowledging the impact of structural factors, has lowered its estimate of potential growth to 7 percent from its earlier 8 percent, and the Prime Minister Economic Advisory Council estimates a fall of over 1 percentage point in potential growth. However, the forthcoming 12th Plan is likely to aim at 8 percent growth.


India Consensus GDP Growth and Inflation Forecasts

(In percent)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Source: Consensus Economics Inc.

Table. India: Summary of Potential Ouput Estimates

article image
Source: IMF staff estimates

Staff estimates across a range of methods suggest that potential growth has declined to about 6½ percent. The highest estimate at 6.8 percent is obtained with the HP filter, while the lowest at 6.2 percent is estimated with the Christiano-Fitzgerald filter.1


Potential output growth

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: WEO and staff estimates

Even though statistical estimates of potential growth have limitations, there is growing evidence that the current slowdown has an important structural component. Inflation continues to be elevated. Surveys indicate that despite declining growth, delivery times have not improved and work backlogs have risen. Also, binding supply constraints are translating into higher imports (coal is the most obvious example). As the decline in investment trend growth affects potential growth with a lag of around eight quarters, unless investment revives soon, GDP growth over the next five years is likely to be affected. Also, the sharp decline in infrastructure investment is likely to lower productivity growth in many sectors, keeping potential growth relatively subdued.

1 Staff did not estimate the potential growth using the production function approach due to the lack of reliable employment data.

The Evolution and Outlook for Poverty1

High growth during 2004–09 accelerated poverty reduction. Compared to the previous decade, the rate of poverty reduction doubled, with the share of the population living below the poverty line falling from 41½ percent in 2003/04 to 32½ percent in 2009/10—more than during the previous decade.2 As shown by the most recent quinquennial household survey by the National Sample Survey Office (NSSO), poverty declined sharply in both rural and urban areas. Although the average annual rate of poverty reduction was ½ percentage point higher in rural areas, the gap between the rural and urban areas widened with the ratio of rural to urban average per capita consumption declining from 0.53 in 2004/05 to 0.49 in 2009/10. Also rural inequality declined marginally, but urban inequality increased.


The evolution of poverty and inequality in India

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: Povcalnet, NSSO 66th Round and staff calculations.

The current slowdown in growth, if protracted, would severely hamper poverty reduction. Using the long-term estimate of the growth elasticity of poverty reduction (proportional change in poverty per unit growth in GDP per capita) of 0.5, which is lower than other EMs, the current subdued economic outlook implies a 30 percent lower reduction in the poverty headcount ratio by 2015 compared to a scenario in which growth remains at the 2004–09 average.

Table 1.

India: Growth and Poverty Reduction

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Source: IMF staff estimates

High food price inflation can also jeopardize poverty reduction. A 10 percent increase in relative food prices would put more than 50 million below the poverty line. As poor households spend more on food, their purchasing power would be eroded more. In the case of a 10 percent increase in relative food prices, the purchasing power of the poorest households would decline by over 6 percent.

Table 2.

Impact of Food Price Increases on Poverty

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Source: IMF staff estimates.
1 Based on a forthcoming IMF working paper by Rahul Anand, Naresh Kumar, and Volodymyr Tulin.2 The poverty line used here refers to $1.25 a day, while the national poverty line refers to the poverty line computed using Tendulkar committee methodology, according to which poverty was 29.8 percent in 2009/10.

B. Limited Policy Space

10. High deficits and debt limit fiscal policy space. Weak activity has hurt tax receipts, and measures to contain subsidies will only have full-year effects beginning in 2013/14. While the government has begun to rein in expenditure, this year’s modified budget target of 5.3 percent under the authorities’ definition is still likely to be breached by 0.3 percentage points. The resulting 9.0 percent of GDP general government deficit represents only a slow pace of consolidation from the 2008/09 peak of 10 percent. With high nominal GDP growth, the debt to GDP ratio has fallen from 75 to 67 percent in recent years, but a shock to growth or continued high deficits would cause the burden to rise. In addition, public bank recapitalization and the assumption of discoms’ debts will add to public debt. The Statutory Liquidity Ratio (SLR) requires banks to hold at least 23 percent of their liabilities in the form of government securities, moderating interest rates, but a rise in the deficit could crowd out private investment.


Inflation and Fiscal Balance, 2012

(In percent)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: IMF, World Economic Outlook; and IMF staff calculations.

11. Entrenched inflation is constraining the room for monetary policy easing. Despite some moderation, WPI inflation is still at 7.25 percent and CPI inflation at 9.9 percent.5 After easing in early 2012, momentum, including for core, remains strong. Wage growth is still reported in double digits, and household inflation expectations have softened, but are still at 11–12 percent. The effects of the recent fuel and energy price increases and rupee depreciation have not yet been fully felt. High inertia is likely to keep inflationary pressures strong until the output gap widens sufficiently to ease them.

C. Weaker Financial Positions of Corporates and Banks

12. Corporate financial positions have weakened considerably, further dimming the outlook for investment and heightening vulnerabilities. Profitability, which had recovered after the GFC, has weakened mainly due to weaker internal and export demand, bottlenecks, slow permits for infrastructure projects, and rising interest rates (Annex I). At 65.5 percent of equity at end-2011, the median debt is above pre-crisis levels and high compared to EM peers. Restructuring of corporate debt has risen significantly and rating agencies expect further increases.


Corporates: Median Debt to Equity

(In percent)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Source: IMF, Corporate Vulnerability Utility.

13. Banks’ capital ratios have fallen slightly, but asset quality is deteriorating considerably. System CAR was at 13.7 percent in June 2012, while gross nonperforming assets (NPAs) have increased by 44 percent year-on-year to 3.2 percent of total advances (Figure 5). Restructured loans, which under Indian regulation are not counted toward NPAs, rose to 5.4 percent of loans in June 2012 from 3.7 percent in March 2011. The position is worse among public banks, where lending is particularly focused on weak areas, such as infrastructure (especially the power sector), aviation, agriculture, steel, and textiles. Reflecting lower provision coverage, public banks’ net NPAs were at 1.75 percent in June 2012 compared to about 0.5 percent for private banks. In addition, banking sector loans to 10 of India’s largest conglomerates have been reported to account for almost 100 percent of banks’ net worth. These groups, many of which are highly leveraged, are in turn also exposed to the vulnerable power and infrastructure sectors. Weaker credit quality has contributed to decelerating nonfood credit growth and prompted the RBI in October 2012 to require banks to increase provisioning for restructured advances as recommended by the Mahapatra Working Group (WG) and to improve information sharing on credit, derivatives, and unhedged foreign exchange (FX) exposures.6

Figure 5.
Figure 5.

India: Banking Sector

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: Country authorities; Bloomberg Data LP.; Bankscope; CEIC Data Company; Thompson Reuters Datastream; and IMF staff calculations.

Outstanding Restructured Advances

(In percent of gross advances)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001


Non Performing Loans

(In percent to total gross loans)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: IMF, Financial Soundness Indicators; Country authorities; and CEIC Data Company.

14. Bank capital needs will increase for Basel III implementation, and rising NPAs could push them higher. India is among the first G20 countries to have developed Basel III-compliant regulations. The government has injected capital into its banks, but the RBI projects that full implementation of Basel III by 2018, without dilution of government ownership and assuming 20 percent growth in risk weighted assets, could necessitate government capital injections of about 1 percent of GDP.7 In addition, the October 2012 GFSR noted that India, together with other EMs, is in the late stages of the credit cycle, suggesting NPAs and debt restructurings are likely to continue rising. And with growth likely to be weaker for a longer period than after 2008/09 and the loan composition of banks more skewed toward large loans, more restructured advances are likely to slip into NPAs compared to the historical average of 15 percent.

D. Rising External Vulnerability

15. The current account deficit registered a record high of 4.2 percent of GDP in 2011/12. After a period of strong performance, exports decelerated sharply from late 2011, while imports have slowed only moderately. Gold imports, used partly as an inflation hedge, rose by 60 percent. Binding supply constraints have encouraged imports, but constrained exports. As a result, despite RBI intervention, the NEER depreciated by 9 percent in 2011/12, partly reversing a 21 percent real appreciation over the previous two years. The Pilot External Sector Report and the updated external balance assessment suggest that India’s current account and the value of the rupee are broadly consistent with medium-term fundamentals (Box 4).


Effective Exchange Rates

(Index, 2005=100)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Source: IMF, Information Notice System.

16. The widening of the current account deficit has increased market concerns over external vulnerabilities. A current account deficit of 3–3.5 percent of GDP is broadly consistent with India’s relatively high growth and low capital-to-worker ratio. In the medium term, as supply-side constraints are eased and external demand recovers, the highly diversified and fairly sophisticated nature of Indian exports should lower the CAD, while the flexible exchange rate should continue to offset inflation differentials. In the near term, however, the widening of the CAD at a time when growth and investment are weakening has increased market concerns about external vulnerabilities and led to pressures on the exchange rate. These concerns are partly related to the steady increase in recent years in debt liabilities in the overall international investment position (IIP).

17. Capital flows are shifting toward debt and reserve coverage is falling, but currently overall external vulnerability remains manageable. Before the GFC, inward FDI more than financed the CAD, but in 2011/12 covered only half (Figure 6). Debt flows, particularly short-term and in the form of non-resident Indian (NRI) deposits, have partly compensated, but rising corporate foreign borrowing, reportedly mostly unhedged, is a concern. The net IIP has deteriorated. While both assets and liabilities have risen, external debt has increased by 53 percent in the past three years and is concentrated among corporates, even if external debt at 20 percent of GDP remains moderate compared to other EMs. Reserves coverage has fallen to 1.6 of the gross financing requirement from 4.3 in 2007 and 6 months of imports from 12 months in 2007, but the IMF composite reserve measure suggests that India’s reserves remain adequate, taking into account the forward position and other country-specific circumstances.

Figure 6.
Figure 6.

India: External Vulnerabilities

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: CEIC Data Company; Bloomberg Data LP; IMF, updated and extended version of the Lane and Milesi-Ferretti (LMF) dataset; and IMF staff calculations.

External Balance Assessment

The External Balance Assessment (EBA) comprises three different methods for assessing the appropriate current account and exchange rate compared to medium-term fundamentals and appropriate policies.1

  • The EBA current account regression estimates India’s cyclically-adjusted current account norm, i.e., the current account compatible with fundamentals and desired policies, to be -3.4 percent of GDP. The projected 2012 CAD of 4 percent of GDP corresponds to a cyclically adjusted CAD of 2.7 percent of GDP, implying a current account gap of 0.7 percent of GDP. The cyclically adjusted CAD is much lower than the actual as the output gap is small relative to the rest of the world’s output gap and the terms-of-trade gap is large. These results suggest that the real exchange rate is undervalued by 3.5–4.5 percent if the current account gap is to be closed only through real effective exchange rate (REER) adjustment.

  • The second method based on a REER regression derives the deviation of the REER from its estimated equilibrium level, based on a set of fundamentals. This suggests that India’s REER is overvalued by around 12 percent.

  • The third method is the External Sustainability approach, which computes the current account balance that stabilizes the net foreign asset (NFA) position. According to this approach, India’s current account norm is -2.3 percent of GDP, which is slightly lower compared to staff’s CAD projection for 2017 (the outer year of the medium-term horizon when output gaps are generally assumed to be closed). This is similar to the RBI’s finding that India’s sustainably-financed current account deficit is around 2.5 percent of GDP.2 Using this approach, the real exchange rate is broadly in line with its medium-term equilibrium value.

Table. External Balance Assessment Results

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Positive values indicate overvaluation.

1 See the 2012 Pilot External Sector Report ( for a discussion of EBA methodologies.2 Rajan Goyal, 2012, “Sustainable Level of India’s Current Account Deficit,” RBI Working Paper Series.

Outlook and Risks

18. Growth is projected at 5.4 percent this year, but should pick up to 6 percent in 2013/14. No legislative changes are assumed in the baseline, but continued implementation of measures to facilitate investment and slightly stronger global growth should deliver a modest rebound in the near term and raise medium-term growth to the upper range of potential estimates. WPI inflation is projected at 7.8 percent by March 2013 and 7.2 percent by March 2014, above the RBI’s comfort zone of 4–4.5 percent, given that supply constraints will ease only gradually. The CAD should narrow marginally this year to 3.9 percent of GDP, aided by falling gold imports, a weaker rupee, and broadly stable oil prices. Though the market share of Indian exports has declined in recent quarters, with reduced domestic constraints, India’s well-diversified and sophisticated exports are expected to pick up and reduce the CAD over the medium term.

19. Global risks are on the downside, while recent government action has mitigated domestic risks (Box 5). According to the October 2012 World Economic Outlook, the probability of global growth falling below 2 percent has risen to one in six. A major global financial shock would present serious funding and liquidity risks for India. A sovereign downgrade would severely complicate the financing of the CAD and debt refinancing. Higher oil prices remain an additional downside risk, though one linked mainly to geopolitical developments. On the domestic front, insufficient follow-through on recent reforms would be highly damaging as confidence has just begun to revive. Failure to ease supply constraints, especially for power, would further weigh down growth. Resorting to expansionary fiscal policy would exacerbate inflation and worsen the CAD. On the upside, going beyond announced reforms or legislative progress, especially a comprehensive subsidy reform, the Goods and Services Tax (GST), or land acquisition, would lead to higher growth than in the baseline.

20. The weaker macroeconomic environment magnifies the damage that potential negative shocks might cause. While presently manageable, India’s CAD and its rising dependence on debt finance amplify potential damage from a renewed bout of global financial turmoil or insufficient fiscal consolidation. The scope for lower policy rates and especially wider fiscal deficits to cushion the blow of a potential shock is small. Likewise, a boost in public banks’ credit, as happened in the aftermath of the GFC, is inadvisable given the outlook for NPAs. If banks’ and companies’ balance sheets are not strengthened, they can exert downward drag on the recovery over the medium term.

Authorities’ Views

21. While supply-side factors might have had some role, the authorities emphasize the role of cyclical and global factors in the current growth slowdown. They noted that India’s slowdown is not that different from that experienced by other emerging economies. RBI’s analytical work suggests that around a third of the slowdown in GDP growth can be accounted for by higher interest rates, though they note that this is a recent phenomenon and agree that supply-side factors, too, have played an important role in the recent investment slump. Also, the authorities believe that long-term productive capacity has been less affected.


India: Risk Assessment Matrix

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“L”=Low; “M”=Medium; “H”=High.This matrix shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline. The Risk Assessment Matrix reflects staff views on the source of risks and overall level of concern as of the time of discussions with authorities.

Implications for India of Global Risk Scenarios

The global environment remains highly unsettled, with significant risks for India. Global growth remains subdued, and risks are weighted toward the downside. Since earlier this year, the probability of recession in the euro area and Japan has risen, while risks have receded only marginally or remain the same in other regions. The IMF’s October 2012 World Economic Outlook explores possible risk scenarios in detail, including some which might be expected to have significant repercussions for India.


Probability of Recession in Major Markets

(in percent)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

A continued or broadened stagnation in global growth would weigh heavily on Indian growth. India’s diversified trade patterns would not insulate it from global stagnation. India’s growth, though not as export-dependent as that of EMs in other regions, would remain sluggish—staff estimates indicate that for every percentage point of lower global growth, India’s growth would be 0.5 percentage point lower. The current account deficit would widen slightly due to growth differentials, while slower growth would weigh heavily on India’s large fiscal deficit.


Impact of Growth Stagnation on EM Growth, Fiscal and External Sectors

(percent of GDP)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Source: IMF Staff CalculationsRegional averages are GDP weighted.

Alternatively, a sudden intensification of euro area risks would amplify financial sector risks with a greater growth impact. The impact of a euro area crisis would likely be similar to that of the global financial crisis, but the quick rebound of 2009 is unlikely, given the weaker macroeconomic environment and more constrained policy space. Given India’s greater dependence on capital inflows compared to countries in the region, the financial channel would have strong negative effects. The growth effect, mostly through the effect of financing constraints on investment, would be large compared to regional EM peers, weighing on the fiscal deficit, though import compression due to financing constraints would likely bring down the current account deficit.


Impact of Euro Area Shock on EM Growth, Fiscal and External Sectors

(percent of GDP)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Source: IMF Staff CalculationsRegional averages are GDP weighted.

22. The authorities expect a stronger recovery than staff. While the differences for 2012/13 are small, they view staff’s 2013/14 forecast as too cautious, pointing to several initiatives that should spur investment and lead to higher growth and lower inflation. They remain concerned about the CAD, due to weak global growth and inelastic demand for oil imports.

23. The balance of risks has shifted away from the domestic economy and toward the globe. With the reform momentum gathering pace, downside risks emanating from India have receded, as has the possibility of a rating downgrade. Continued slow growth in developed economies and the potential for serious disruptions in the U.S. and euro area are deemed the main risks.

Policy Discussions

A. Structural Policies and Supply Bottlenecks

24. Addressing structural challenges in the power sector and in natural resources is key. Almost all discoms have raised tariffs this year, but much more needs to be done to eliminate losses as tariffs remain on average below cost recovery and inefficiencies high. Infrastructure connecting fuel sources with power plants is an urgent problem hampering electricity generation. More broadly, the pricing and allocation of a wide range of natural resources or goods immediately produced from them such as coal, natural gas, electricity, and fertilizers, are subject to complex mechanisms and regulations and are highly inefficient.

25. Ensuring government decisions are expedited and improving governance are important next steps. The new CCI, by facilitating environmental clearances and streamlining approval processes, should help fast-track infrastructure projects. Greater policy predictability and uniform enforcement, and simpler and more transparent administrative procedures are essential to revive investment. The FM’s commitment to clarify tax provisions that added to policy uncertainty earlier this year is welcome.

26. Ensuring more rapid and inclusive growth will require building support for legislative action. Reforming land acquisition and the GST are the priorities. Easing strict labor regulations will be difficult, but is key to increase formal sector employment.8 Progress on state-center GST negotiations and the New Manufacturing Policy are encouraging in this regard. In addition, reforms in agriculture, improving health and education, and addressing skills mismatches are needed to increase productivity and make growth more inclusive. These, along with infrastructure, are rightly emphasized in the 12th Plan.

Authorities’ Views

27. The authorities are taking important measures to tackle supply-side problems. Noting the boost to market confidence, the authorities emphasize that recent measures have sent an unequivocal signal of their determination to reverse the growth slowdown. Supply-side constraints will gradually be eased through the many initiatives under way, as well as through the newly created CCI. With most states having raised energy tariffs this year, discoms’ losses have diminished and their improved financial health paves the way for resolving the problems of power producers. The authorities also recognize that market-based pricing and allocation mechanisms would have to play a bigger role in the area of natural resources.

B. Fiscal Policy

28. As fiscal consolidation remains essential, the FM’s medium-term plan is encouraging. Lower deficits will support monetary policy in fighting inflation, free resources for investment, and lessen vulnerabilities. However, if revenue improvements and subsidy reform do not materialize, either debt will begin to rise or capital spending will be compressed and important social programs underfunded, undermining growth and social goals. At around 0.6–0.7 percent a year, the FM’s planned deficit reduction will be slower than that envisaged in early 2010 by the 13th Finance Commission, but given slower growth, this is reasonable. The FM’s three percent of GDP medium-term central government deficit is close to that proposed by the 13th Finance Commission and will help rebuild credibility by establishing a fiscal anchor which, if public investment rises as envisaged under the 12th Plan, will approximate a golden rule target. However, reaching this medium-term target will likely take until 2016. The states’ deficit is likely to remain around 3 percent of GDP.


General Government Revenue and GDP per capita, 2012

(excluding oil exporters and microstates)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Source: IMF, World Economic Outlook.

29. A focus on sustainable reforms would rebuild confidence more than reaching deficit targets with one-off measures. The FM has acknowledged that absent serious measures, consolidation is unlikely, and endorsed the Kelkar Committee’s recommendations on improving tax administration and disinvestment. However, reforming fuel and fertilizer subsidies should be the central plank of expenditure rationalization as the Kelkar committee has recommended. With spending pressures, such as for the National Food Security Bill, likely to rise under the 12th Plan, the need to reorient expenditure toward socially and economically productive areas is vital.

30. Raising revenues to pre-crisis levels has so far proved elusive. India’s revenue-to-GDP ratio has fallen below peers’. The GST would be the most important reform, and would boost growth through the creation of a single Indian market. While there are encouraging signs of a possible GST compromise, the needed legislative changes require a qualified majority, and implementation is not feasible even in 2013/14. For this reason, at the end of this fiscal year, if the economy has begun to recover and no agreement is reached, it would be appropriate to raise excise taxes. Approving a new Direct Tax Code with streamlined and smaller deductions will also help.

31. Ensuring that consolidation supports growth and social goals will require comprehensive subsidy reform. Recent staff analysis underscores that reorienting expenditure away from untargeted transfers, such as India’s fuel subsidies, and government consumption and toward targeted transfers and investment can have strong positive effects on growth (Annex II). On fuel subsidies alone, which are broadly regressive, India currently spends around 2 percent of GDP, including amounts covered by upstream oil companies (Annex III). Introducing market pricing for fuel while protecting the poor would also help reduce fiscal vulnerabilities to oil prices and the exchange rate and lower the CAD. Recognizing the importance of raising spending efficiency, the government has announced a plan to gradually implement direct cash transfers using India’s impressive Unique Identification Number (UID), beginning in 2013 in selected districts. As this capability is broadened and targeting improved, the resulting fiscal space should free resources for investment and strengthening the social safety net.

32. Cross-country experience highlights key elements of successful subsidy reform. Embedding subsidy reform within a comprehensive structural reform agenda aimed at addressing supply-side inefficiencies and bottlenecks can generate broad public support. Successful subsidy reforms in Brazil, the Philippines, South Africa, and Turkey were part of broad overhauls of the energy sector. An effective public information campaign should clearly identify the shortcomings of subsidies and explicitly link planned increases in priority public spending to savings from subsidy reform. Subsidies should also be one component of a comprehensive agenda aimed at strengthening the safety net, including specific mechanisms for compensating the poor.

Authorities’ Views

33. The government is strongly committed to reaching this year’s 5.3 percent of GDP modified budget deficit target. Recognizing the overhang from the 2008/09 crisis, they stress that the political risk taken in raising diesel prices indicates clearly their commitment to fiscal consolidation. While acknowledging that tax revenues are likely to be affected by the slowing economy, they believe that this, as well as potential overruns in subsidies, can be countered by identified savings on Plan spending, stronger tax administration efforts, and innovative disinvestment modalities, containing this year’s overrun to around ¼ percent of GDP compared to the budget.

34. The medium-term consolidation plan is also attainable. The FM’s medium-term consolidation roadmap demonstrates that the government attaches the highest priority to lowering deficits to bring the economy back on a high growth trajectory. The authorities believe that stronger growth will buoy tax revenues, allowing fiscal consolidation to be accompanied by a pro-growth and pro-poor reorientation of spending. On subsidy reform, various pilot schemes are under way to move toward direct cash transfers and the use of the UID to replace current delivery mechanisms. They expect that by 2016/17 cash transfers are expected to be in place for key subsidies, which will reduce the fuel and fertilizer subsidy bill. The authorities also remain focused on introducing the GST, which should greatly improve efficiency and support revenues.

C. Monetary and Exchange Rate Policy

35. With inflation still high, monetary policy can best support growth by staying the course. Growth has slowed more than expected and is below even the lowest estimates of potential growth, with sizable downside risks. Also, as high nominal lending rates are hurting highly leveraged corporates, there is a strong expectation for the RBI to cut policy rates further to support growth. However, interest rates do not seem to be a major cause of the investment slowdown, and it is unlikely that lowering them before other roadblocks are removed would spur investment (Box 6). Despite some moderation, inflation pressures remain significant, and short-term real interest rates are barely positive. Inflation inertia is strong, and a disinflation to 5–6 percent, a level not associated with detrimental effects on growth, would require perseverance with a sustained period of relatively subdued aggregate demand.9 Hence, on balance, it is appropriate to keep policy rates at current levels until the inflation decline is clear and sustainable.

36. Consideration could be given to measures that could help anchor inflation expectations. The RBI’s WPI projections announced at the beginning of the fiscal year have been exceeded for the past three years. The higher weight of food in household expenditure has kept CPI, which informs household expectations, consistently above WPI. In addition, food price shocks propagate strongly into nonfood inflation. Hence, it would be desirable for the RBI to express its projections and objectives in terms of the national CPI as soon as the data allow. Additionally, the RBI could maintain rolling one-year projections, and, while taking high inertia into account, explain a credible path toward the RBI’s longer-term goal of 3 percent.


Inflation Expectation

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Source: Reserve Bank of India1/ Inflation expectation for next FY

37. The floating rupee is an important shock absorber. Rupee flexibility has offset inflation differentials and prevented exchange rate misalignment. Such flexibility would be particularly important in case of renewed global financial stresses. Going forward, lower inflation and a lower fiscal deficit would reduce external vulnerabilities, as will easing supply bottlenecks that would reduce import demand and spur exports. Consideration could also be given to promoting financial instruments—such as inflation-indexed bonds—to reduce gold demand as an inflation hedge.

The Role of Interest Rates in the Current Investment Slowdown1

The recent investment slowdown has sparked an intense debate in India about the role of interest rates. Economists typically argue that real interest rates have been low, even though nominal rates have gradually risen after the substantial easing of 2008/09. On the other hand, some representatives of the business community maintain that high nominal lending interest rates have been an important cause of the investment slump. Not surprisingly, the two groups argue for different courses of monetary policy.


Nominal Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Where are interest rates in India? Money market rates, including bank CDs, yields on government bonds and highly-rated corporate bonds, and commercial paper are barely above WPI inflation. In real terms, these rates are significantly lower compared to the mid-2000s when investment boomed. Real bank lending rates appear only about 20 bp higher.2 An RBI report suggests that the real weighted average lending rate is 300 bp lower than the average in 2003/04 to 2007/08. However, for certain sectors of the economy, where structural or cyclical factors impede output price adjustments, sector-specific real interest rates exceed real interest rates based on aggregate inflation expectations.


Real Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Staff analysis suggests that real interest rates explain economy-wide investment activity better than nominal interest rates.3 The overall fit of the investment equation improves when real interest rates are included relative to the nominal interest rate specification.

Also, once nominal interest rates and inflation expectations are included together as explanatory variables, they appear to have statistically indistinguishable impact on investment with opposite signs after controlling for other relevant explanatory variables, which corroborates the economic importance of real interest rates. Finally, when real interest rate and inflation expectations are included in the same specification, the latter does not improve the explanatory power of the regression.

Staff estimate that about one quarter of the explained slowdown in investment growth can be attributed to higher real interest rates. Importantly, the regression analysis explains over half of the total investment slowdown witnessed during this period, but systematically over-predicts investment in the past two years, suggesting that other factors, such as supply bottlenecks, are also at play. An alternative estimate, based on a structural VAR, confirms these findings.

Table 1.

Regression Analysis of Investments

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Source: IMF staff estimates.Note: Interest rate corresponds to the average prime lending rate. Real interest rate is based on inflation expectations for the next fiscal year from Consensus Economics surveys.Note: Robust standard errors in parenthesis.Note: ***, **, * indicates 1, 5, 10 percent statistical significance, respectively.
1 Based on a forthcoming IMF working paper by Rahul Anand and Volodymyr Tulin.2This is based on the prime lending rate. This is the longest data series available, and these rates are higher than the upper end of the median lending rates. The base rate, introduced in July 2010, is at 10.5 percent.3 A similar set of corporate investment determinants is identified in Tokuoka (2012), IMF WP/12/70, “Does the Business Environment Affect Corporate Investment in India?”

38. Further opening of FDI and local capital markets is welcome, but certain relaxations of external commercial borrowing (ECB) can increase external vulnerabilities. Greater FDI liberalization could increase this more stable funding source. In addition, continuing to raise the Foreign Institutional Investor (FII) debt quotas contributes to deepening domestic capital markets. While this may increase domestic interest rate volatility, it provides financing with foreign investors bearing the FX risk. The authorities have also relaxed several ECB regulations, including for sectors without natural FX hedges. And the lower withholding tax on rupee corporate bonds is a positive step, but the framework is still skewed toward ECBs, especially loans. Finally, the flexible rupee has increased incentives to hedge, but with corporates still reported to have substantial unhedged FX exposures, some easing of restrictions that have reduced the depth of the onshore FX forwards and futures markets would be beneficial. In the longer run, inclusion of Indian bonds in global indices would attract funds from long-term investors, and the requirements for this could be explored.

Authorities’ Views

39. The RBI emphasizes that inflation and inflation expectations have moderated, but remains concerned about the level of inflation. The RBI deems that pricing power has diminished, that much of the inflationary effects of the rupee depreciation have worked through the economy, and that the pass-through from food and other commodity prices to broader inflation is relatively weak, making inflation dynamics more favorable going forward. However, the RBI views the persistence of inflation, which it attributes in part to supply constraints, in the face of weak growth as a key challenge.

40. As inflation eases further, the RBI sees an opportunity for monetary policy to be eased. The RBI sees contrasting forces shaping the inflation outlook. Slower growth and excess capacity in some sectors are expected to lower inflation, while supply bottlenecks and wage increases could keep inflation pressures elevated. On balance, the RBI expects inflation to recede after the administrative price increases to fuel and electricity have fully passed through and has provided guidance for policy easing in the first quarter of 2013.

41. The RBI will continue its multiple-indicator approach and does not see an immediate need for broadening inflation guidance. Communication has recently been shifted toward the CPI, but the RBI will continue to use its multiple-indicator approach in assessing inflation dynamics and trends. While acknowledging this complicates effective communication, they note that the short time series for the CPI makes it as yet inadequate as a headline measure, though its role is expected to increase over time. Uncertainty about the patterns and magnitude of seasonal effects, such as the monsoon, complicates both rolling y/y projections and momentum indicators, which can be biased by miss-estimation of underlying seasonal factors and would undermine the credibility of the RBI.

42. The authorities are concerned about external vulnerabilities. While they agree that the current account for the time being can be financed, they deem that with GDP growth at about 7 percent, the sustainable current account is -2.5 percent of GDP. They point to still-high commodity prices, especially for oil, and strong demand for gold as significant risks to the external outlook. The authorities note that the RBI’s policy of allowing the rupee to float freely means that reserves are no longer being accumulated, and that while reserves ratios are therefore falling, they remain adequate to face sudden stops in capital flows and counter increased exchange rate volatility.

43. The rupee will continue to float, and further capital account liberalization will be undertaken cautiously. The RBI remains committed to allowing the rupee to float. The authorities plan to continue their focus on liberalizing capital inflows with a view to facilitating the financing of infrastructure and building the corporate bond market while paying attention to prudential aspects. Similarly, some relaxation of restrictions on FX forwards might be considered, but will depend on the volatility of the exchange rate.

D. Financial Policies

44. With credit risks rising, mechanisms for addressing deteriorating asset quality should be tightened. The RBI is considering the Mahapatra WG’s recommendations, which would constitute improvement. These, however, would still leave India’s treatment of restructured assets relatively lenient, as best practices suggest bank portfolios should recognize true asset quality. Restructured loans should generally be classified as nonperforming upon restructuring, and categorized as performing only after a period of satisfactory performance. This would likely require greater loss write-offs and higher provisions. Favored sectors, such as infrastructure, should not receive preferential treatment. In addition, strengthening the credit culture could reduce the incidence of NPAs in priority sector lending, which are now responsible for about 50 percent of total public banks’ NPAs. Finally, the FSAP recommended improving the performance and financial strength of public financial institutions and subjecting them to full supervision and regulation.

45. Medium-term capital requirements for public banks could be higher than currently estimated. The table below shows the results from converting 15, 30, and 45 percent of restructured assets into NPAs, with these assets provisioned at each institution’s current provisioning rate, but at a minimum of 70 percent. In the 45 percent case, public banks’ average tier 1 capital adequacy ratio would fall to 7.4 percent, below the 8 percent required for a bank to be considered well-capitalized under Basel III as of January 2015. The percentage of public sector banks below 8 percent Tier 1 capital would be 90 percent of the total, with 10 percent of public sector banks below the 10 percent threshold for well-capitalized banks’ Tier 1 and Tier 2 ratio. If capitalization needs for public banks prove challenging, consideration should be given to reducing the government’s stake.

Table. Stressing Indian Banks’ Balance Sheets

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Sources: RBI and staff calculations.

Impaired loans after provisions over outstanding loans.

46. Reducing concentration risk is necessary to support higher growth and broader access to credit. Large and related party concentration exposure limits remain inconsistent with international practices, and resulting high exposures curtail the ability of banks to underwrite new investment, especially in large projects such as infrastructure (Annex IV). To reduce concentration risks, advances and commitments to interrelated companies should be appropriately measured and limited, and these limits enforced. Further development of the corporate bond market, which requires domestic institutional investors’ greater participation and greater liquidity—most likely from FII participation—would advance this goal by supporting securitization and providing alternative long-term financing. Further development of infrastructure debt funds should free space on balance sheets, as would greater take-out financing, and credit enhancements for project financing.

47. Strengthening creditor rights and the insolvency framework, as proposed by the FSAP, has become more urgent. Stronger creditor rights would increase lenders’ leverage, providing creditors with greater certainty of repayment and increasing recoveries, which now average well below advanced-economy levels. This would also constitute a step toward a better functioning corporate bond market and distressed asset market. Additional incentives that could facilitate deeper corporate restructuring as opposed to debt rescheduling and induce the resolution of impaired assets could be considered.

48. Over the medium term, other financial sector reforms, especially lowering the SLR, are important to lower the cost of capital for companies and broaden access to financial services. The SLR lowers borrowing costs for the government while keeping them high for private companies (Box 7). As fiscal deficits decline, the SLR should also be gradually reduced, freeing financial institutions’ funds for loans to companies and households. Lowering the SLR, along with reducing similar mandates on institutional investors, will also help develop the corporate bond market. Approval of the Pension Fund Reform and Development Authority Law and modifying insurance regulations would also encourage the growth of domestic institutional investors and deepen markets for long-term borrowing.

Authorities’ Views

49. The authorities agree that balance sheets have worsened, but believe that they do not represent a systemic risk. Recent RBI stress tests for banks show that even under a scenario in which 30 percent of restructured advances become NPAs, which the authorities view as extreme, bank stress remains contained and banks sufficiently capitalized. The authorities also underscore banks’ improved risk management and supervisory authorities’ assiduous monitoring and strict enforcement. The RBI also notes that from their extensive surveys the leverage of the broad corporate sector has not risen and the increase in leverage concerns mainly large companies with relatively safe access to finance. Hence, while the authorities are monitoring developments, they do not see this as an immediate risk.

50. The regulatory framework for restructured assets continues to be refined. The authorities have increased provisioning and focused on improved information sharing among banks. They emphasize that debt restructurings most often follow unforeseen external developments that have delayed project implementation, and are approved only when the bank determines that the account become viable after restructuring. Further, loans in sensitive sectors (capital markets exposure, personal loans, and commercial real estate) cannot be restructured in this way, due to higher potential risks. The authorities agree, though, that the rising level of NPAs warrants further provisioning, and note that further recommendations of the Mahapatra WG are under consideration.

India’s Statutory Liquidity Ratio1

The Statutory Liquidity Ratio (SLR) in India entails large holdings of government securities on financial institutions’ balance sheets. After being reduced over time, the SLR currently requires banks to invest 23 percent of net demand and time liabilities (NDTL) in government securities (G-Sec). Also, banks can keep 25 percent of NDTL in G-Sec without marking to market. In addition, insurance companies and pension funds have similar but higher requirements. Based on these restrictions on portfolios, the effective SLR for the whole economy is around 50 percent of financial sector liabilities, providing an assured source of financing for the government.


Statutory Liquidity Ratio (for banks)

(In percent)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: Bloomberg

An estimated DSGE model is used to analyze the SLR impact on the economy. The model assumes that the SLR is binding and financial institutions are profit-maximizing. Banks’ holding of G-Sec has exceeded the mandated SLR requirement because only G-Sec in excess of SLR can be repoed for liquidity management. While it is difficult to determine whether the SLR binds in practice, there are indications that it is binding at least for some institutions, especially private ones. Even if banks were to continue holding G-Sec once the SLR is lowered, they would likely do so at a higher yield.


Investment Under Different SLRs

(As a ratio of investment at current SLR)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: Staff estimates.

The model suggests that lowering the SLR could result in higher investment over the medium term. The SLR is found to lower government borrowing costs, while increasing those for the private sector. A 10 point reduction in the effective SLR is likely to lower the borrowing costs for the private sector by around 100 bp, while increasing the borrowing costs for the government by 50 bp over the medium term. Lower borrowing costs could result in a 5 percent increase in investment over the medium term. Similarly, in terms of welfare, a 10 point reduction in the effective SLR should improve welfare by 0.2 percent. In addition, the SLR is found to have increased external borrowing. The model suggests that increased domestic borrowing costs and lowered availability of domestic financing due to the SLR have encouraged corporates to borrow abroad. Staff’s model suggests that reducing the effective SLR by 10 percentage points would reduce foreign borrowing by corporate by around 4 percent in the medium term.


Foreign Borrowing Under Different SLRs

(As a ratio of foreign borrowing at current SLR)

Citation: IMF Staff Country Reports 2013, 037; 10.5089/9781475594225.002.A001

Sources: Staff estimates.
1 Based on a forthcoming IMF working paper by Rahul Anand, Hautahi Kingi, James P. Walsh, and Tianli Zhou.

51. Capital market reform retains its high priority on the reform agenda. The authorities remain committed to promoting the development of the corporate bond market, facilitating ways to free banks’ balance sheets to enable them to finance new infrastructure projects, and to broadening access to financial services. They are planning to ease asset allocation norms for insurance companies and pension funds and allow greater FDI in these sectors. They also expect that the planned infrastructure debt funds, take-out financing, and the credit enhancement schemes being considered can help lower concentration and sectoral exposures. The authorities note that the SLR has been lowered this year and that it could be further recalibrated in accordance with evolving monetary and fiscal conditions.

Staff Appraisal

52. The near-term outlook is for subdued growth and elevated inflation. Recognizing the economy’s challenges, the authorities have announced measures to revive growth, and reiterated their commitments to lowering the fiscal deficit and inflation. Nevertheless, as investment has been particularly hit and supply constraints will likely be eased only gradually, the recovery is likely to be muted and inflation and the current account deficit are expected to fall only gradually.

53. Risks are on the downside, but upside risks have emerged. The uncertain global situation could present serious challenges to India. At the same time, the macroeconomic environment reduces the scope for policy response. Ongoing structural reforms present both upside and downside opportunities: a faster pace of reform could entail higher growth, while insufficient follow-through would weigh heavily on the outlook.

54. Delivering on structural reforms, fiscal consolidation, and low inflation are critical for a sustained recovery. Weak demand is not the main cause of the slowdown and, with little space for countercyclical action, policy stimulus through fiscal or monetary expansion is inadvisable. Maintaining reform momentum, delivering durable fiscal adjustment, lowering inflation, and addressing vulnerabilities will return India to high growth, even against the backdrop of lackluster global growth.

55. The government has put the reform process in motion, and the next steps should aim at issues in energy and natural resources. Measures taken have begun to improve the business climate. Further boosting growth will require addressing shortcomings in the energy sector, such as through full cost-recovery pricing and greater efficiency of electricity distribution companies and addressing power plants’ fuel linkages. More broadly, moving the pricing and allocation of natural resources toward a market basis would improve transparency and efficiency, boosting investment.

56. Addressing additional structural roadblocks and long-term challenges is also crucial. The newly created CCI is expected to accelerate approvals for large investment projects. Greater policy predictability is needed to boost investor confidence. Legislative action such as the Goods and Services Tax (GST) and an effective land acquisition law are priorities. In addition, easing restrictive labor laws, as well as measures to support agricultural productivity, improve health and education outcomes, and address skills mismatches, would contribute to making growth more inclusive.

57. The government’s fiscal roadmap is welcome, but the quality and sustainability of consolidation are more important than meeting short-term targets. The pace of consolidation, particularly given the slowing economy, and the medium-term budget deficit target are appropriate. Reaching the target will require revenue to rise to pre-crisis levels, through more efficient taxation and ideally also through the GST. Though recent initiatives tying India’s safety net to the impressive UID Program are encouraging, reorienting spending toward 12th Plan priorities without endangering deficit targets requires comprehensive reform to fuel and fertilizer subsidies.

58. The RBI’s vigilance on inflation will pay dividends for long-term growth. With financial conditions still relatively easy, it is appropriate to maintain the current level of policy rates until inflation is clearly on a downward trend. As data improve, shifting projections and guidance to the new CPI will help anchor expectations, but in the meantime, the RBI should consider providing rolling one-year ahead inflation projections.

59. Rupee flexibility and continued gradual opening of the capital account are welcome, though policies could be optimized to lower external vulnerability. From a medium-term perspective, India’s external position is broadly in line with fundamentals and desired policies, but the recent deterioration of the CAD exposes India to sudden stops in capital inflows and calls for policy tightening, especially of fiscal policy, to reduce overall external vulnerability. Rupee flexibility will remain important to offset inflation differentials and help absorb external shocks. Continued capital account opening, particularly if focused on FDI and rupee bonds, would improve the current account deficit financing mix and deepen domestic capital markets. But relaxation of external commercial borrowing should be allowed cautiously, especially for sectors without natural FX hedges.

60. Unless rising financial sector risks, especially concerning asset quality and concentration, are decisively addressed, banks may be unable to support higher medium-term growth. Full implementation of the RBI working group’s recommendations on restructured assets is needed, as well as stricter classification, and higher provisions and loss write-offs without making exceptions for favored sectors. Consideration should also be given to measures to facilitate deeper corporate restructuring and to strengthen the insolvency framework. Large and related party concentration exposure norms should be brought in line with international practices and interrelated companies and FX exposures keenly monitored. As the FSAP recommended, improving the financial strength of public banks is particularly important.

61. Other financial sector reforms are needed to strengthen the financial system’s contribution to growth. While currently well-capitalized, public banks will likely require substantial capital injections. In addition, concentration of bank lending and the need to broaden access to credit point to the need to deepen corporate bond markets. Over the longer term and as the fiscal deficit falls, the statutory liquidity ratio should also be lowered.

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

Table 1.

India: Millennium Development Goals, 1990–2011 1/

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Source: World Bank, World Development Indicators, 2012.

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 1.25 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, 2008/09–2013/14 1/

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Sources: Data provided by the Indian authorities; CEIC Data Company Ltd; Bloomberg L.P.; World Bank, World Development Indicators; and IMF staff estimates and projections.

Data are for April–March fiscal years.

Differs from official data, calculated with gross investment and current account. Gross investment includes errors and omissions.

Divestment and license auction proceeds treated as below-the-line financing. Subsidy related bond issuance classified as expenditure.

Includes combined domestic liabilities of the center and the states, inclusive of MSS bonds, and external debt at year-end exchange rates.

For 2012/13, as of October 2012.

On balance of payments basis.

Imports of goods and services projected over the following 12 months.

Short-term debt on residual maturity basis, including estimated short-term NRI deposits on residual maturity basis.

In percent of current account receipts, excluding grants.

Table 3.

India: Balance of Payments, 2008/09–2013/14 1/

(In billions of U.S. dollars)

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

Data are for April-March fiscal years.

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

Calculated as difference between the stock of reserves and the overall balance of BOP.

Table 4.

India: Reserve Money and Monetary Survey, 2008/09–2012/13 1/

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Sources: CEIC Data Company Ltd.; IMF International Financial Statistics; and Fund staff calculations.

Data are for April–March fiscal years.