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.
This statement contains information that has become available since the staff report was circulated to the Executive Board. This information does not alter the thrust of the staff appraisal.
Economic and financial developments
1. Recent activity data point to a modest recovery. In sequential terms, industrial production (IP) has grown for two consecutive months since October, but capital goods production remains weak. PMI data indicate a further improvement in December. Negative growth in mining and low electricity output growth suggest that supply-side bottlenecks persist.
2. Headline WPI inflation has moderated, but CPI inflation has risen. In December, headline and core WPI inflation declined to 7.2 percent y/y and 4.2 percent y/y, respectively. National CPI inflation, however, accelerated to 10.6 percent y/y due to food and fuel prices. The decline in WPI may be short-lived, as CPI trends inform inflation expectations and wages. Market participants expect the RBI to cut rates in its January 29 review.
3. The 2012Q3 current account deficit widened to 5.4 percent of GDP, but the financing mix improved. Merchandise exports fell by 12.2 percent y/y and imports by 4.8 percent y/y. Moderate growth in remittances, weaker services, and a rise in net outflows of investment income contributed to the increase in the current account deficit (CAD). Though the trade deficit narrowed marginally in December, risks have increased that the 2012/13 CAD could exceed staff projections by ¼–½ percent of GDP. With net capital inflows rising to US$24 billion in 2012Q3 from US$16 billion in Q2 mainly due to higher FDI and a turnaround in portfolio flows, the balance of payments recorded a small deficit in 2012 Q3. The authorities have extended interest subsidies for exports until March 2014 and introduced measures to enhance the flow of credit to the sector.
4. Banks’ asset quality continued to deteriorate. Gross nonperforming assets (NPAs) increased to 3.6 percent of total advances in September 2012 from 3.2 percent in June 2012, while net NPAs increased to 1.7 percent from 1.5 percent in June 2012. Restructured loans rose to 5.9 percent of loans in September 2012 from 5.4 percent in June 2012, with the public sector banks continuing to experience the highest degree of deterioration in asset quality.
5. Recent subsidy measures bode well provided implementation is sustained. On January 17, 2013, the government increased flexibility in diesel pricing leading oil companies to raise prices by half a rupee, and announced that bulk users of diesel would no longer receive the subsidized price. At the same time, the number of cooking fuel cylinders eligible for subsidized purchase was increased. The net impact for the current year would be slightly less than 0.1 percent of GDP, but if diesel prices continue to be raised by the same amount every month, these changes would result in savings of up to ¾ percent of GDP in 2013/14. Additionally, the government has begun implementation of direct cash transfers for some social programs in 20 districts and has announced that it will expand these pilots as well as the programs covered.
6. Nevertheless, some overrun of the central government deficit target remains likely. The budget deficit in the first eight months of 2012/13 reached 4.1 percent of GDP and remains likely to overrun the government’s 5.3 percent full-year target, despite tightened expenditure control. On the other hand, data also show that the deficit position of state governments is better than previously estimated. Finally, the government announced changes to its rules aimed at preventing tax avoidance, which will delay implementation until 2016 and reduce the impact on most institutional investors, reducing uncertainty.