India: Staff Report for the 2014 Article IV Consultation

This 2014 Article IV Consultation highlights that India’s growth has slowed markedly, reflecting global developments and domestic supply constraints, while inflation remains stubbornly high. Led by falling infrastructure and corporate investment, the slowdown has generalized to other sectors of the economy. The financial positions of banks and corporate have deteriorated. The principal risk facing India is the inward spillover from global financial market volatility. Growth is projected at 4.6 percent for fiscal year 2013/14, and should pick up to 5.4 percent in 2014/15 (at factor cost).


This 2014 Article IV Consultation highlights that India’s growth has slowed markedly, reflecting global developments and domestic supply constraints, while inflation remains stubbornly high. Led by falling infrastructure and corporate investment, the slowdown has generalized to other sectors of the economy. The financial positions of banks and corporate have deteriorated. The principal risk facing India is the inward spillover from global financial market volatility. Growth is projected at 4.6 percent for fiscal year 2013/14, and should pick up to 5.4 percent in 2014/15 (at factor cost).


1. Growth has fallen sharply. Growth averaged 8½ percent before and for two years after the global financial crisis but has decelerated throughout 2011 and 2012 (Figure 1), reaching 4.6 percent in FY2013:H1. Initially a problem of stalled infrastructure and corporate investment, the slowdown has become generalized across sectors. India’s growth slowdown is unusual among emerging markets (EMs) both in its severity and the fact it has coincided with elevated inflation. Global factors have certainly hurt exports and weighed on investment. However, staff analysis indicates that about two-thirds of the slowdown can be explained by domestic factors, including supply bottlenecks, delayed project approval and implementation, and heightened policy uncertainty.

Figure 1.
Figure 1.

India: Growth and Activity

Growth remains subdued and will likely recover only slowly.

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001


India’s Growth Forecast Revisions

(In percent)

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Sources: IMF; and Consensus Economics.

2. Balance of payment pressures intensified during the summer of 2013 as external shocks interacted with domestic macroeconomic vulnerabilities. As global liquidity conditions tightened, India was faced with significant portfolio debt outflows, and pressures on currency, equity, and bond markets. Investor concerns were amplified by India’s persistently-high inflation, weakening growth prospects, large current account and fiscal deficits, and domestic political uncertainty (Figure 2). In response, liquidity conditions were tightened, limits on FDI and external borrowing were loosened, capital flow measures were introduced, and gold import duties were increased sharply (see Selected Issues Chapter I).

Figure 2:
Figure 2:

India: Recent Developments: International Perspective

Among emerging market economies, India was among those affected by recent global liquidity tightening.

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Sources: Bloomberg, IMF World Economic Outlook, Haver Analytics, and IMF staff calculations.

3. Over the past four months, a combination of improving external conditions and domestic policy efforts have calmed markets. Externally, global financial markets improved as the U.S. Fed decided not to advance the reduction in its monthly asset purchases. Domestically, the central bank increased its headline policy rate and intervened in FX markets by offering USD swaps to oil companies and to banks, with the latter leading to sizeable nonresident Indian (NRI) deposit inflows. In addition, the parliament passed the land acquisition, pension and companies bills, and thus far in 2013 the Cabinet Committee on Investment (CCI) has approved previously-stalled projects worth around 5 percent of GDP. On the fiscal front, measures were implemented to continue to raise diesel prices, to shrink the financial losses of state electricity boards, and to contain central government spending. As external pressures eased, the government was able to unwind the earlier steps taken to tighten liquidity and partly reverse restrictions on capital outflows (Annex I).

4. Against the background of parliamentary elections (expected by May 2014) and prospective global liquidity tightening, policy discussions centered on mitigating risks associated with the challenging domestic and external economic environment. Discussions focused on strengthening the macroeconomic position and containing vulnerabilities by narrowing fiscal and external imbalances to create space for countercyclical policies (see text chart), the appropriate stance for monetary policy to decisively tackle high and persistent inflation, and the policy response to renewed global market volatility.

5. Past Fund advice and the authorities’ macroeconomic policies have been broadly aligned, but progress on structural reforms has been slow. Fiscal expenditure was lowered in 2012/13, consistent with Fund advice, and staff supports the authorities’ intentions regarding the pace of medium-term consolidation. The stance of monetary policy has been looser than staff recommended in 2012/13, but has been progressively tightened in 2013/14, consistent with Fund advice. Also, the central bank has allowed the currency to adjust flexibly to market conditions and intervened sparingly to counter excessive volatility in the exchange rate. Almost all key recommendations of the 2012 FSAP Update have been implemented (Annex II) and progress has been made in improving electricity pricing, and in achieving passage of the land acquisition, pension, and companies bills. Progress on product and labor market reforms has, however, been limited.


Macroeconomic Policy Procyclicality (1960–2009)

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Source: Vegh and Vuletin (June 2012).Notes: A positive (negative) Correlation (Government Expenditure, Real GDP) indicates procyclical (counter-cyclical) fiscal policy. A positive (negative) Correlation (Short-Term Interest Rate, Real GDP) indicates counter-cyclical (pro-cyclical) monetary policy.

Outlook and Risks

6. The near-term outlook is characterized by relatively weak growth and high and persistent inflation. Growth is projected at 4.6 percent this year and 5.4 percent in 2014/15 (at factor cost).1 No further policy changes are assumed in the baseline, but slightly stronger global growth, improving export competitiveness, a favorable monsoon, and a confidence boost from recent policy actions should deliver a modest growth rebound in the near term. However, fiscal restraint and higher interest rates will act as headwinds, slowing the recovery. India’s trend growth is currently estimated at around 5½ percent but is expected to rise to its medium-term growth potential of around 6¾ percent (under current policies) as unblocked investments are implemented and global growth improves. As a result of the weak economy the output gap has been widening, and is now estimated at about 1 percent of GDP.


Household Inflation Expectations and Food Inflation

(In percent)

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Sources: CEIC, Haver Analytics and IMF staff calculations.

7. Despite the growing output gap, monthly CPI inflation (yoy) is expected to remain near double-digits well into next year. The high headline inflation is a result of a number of factors, including: food inflation feeding quickly into wages and core inflation; entrenched inflation expectations; cost-push shocks from binding sector-specific supply constraints (particularly in agriculture, energy, and transportation); the pass through from a weaker rupee; and ongoing energy price increases. WPI inflation is expected to rise to 7.4 percent by March 2014, remaining well above the RBI’s comfort zone and falling only slowly (to 6.3 percent by March 2015).

8. The current account deficit is narrowing fast. The current account deficit reached a record 4.8 percent of GDP in 2012/13 due to sharply weaker exports, higher imports of oil and gold, and binding supply constraints (particularly in coal and iron ore). India’s external vulnerabilities have fallen significantly in recent months, helped by policy actions taken to shrink the current account and strengthen capital flows. In particular, the current account deficit has been on a marked downward trajectory as exports improved, remittance inflows remained solid, and higher import duties and quantitative restrictions discouraged gold imports.2 In addition, non-oil, non-gold imports have declined in line with weak domestic demand, and capital inflows have strengthened.

9. Staff expect the current account deficit to fall to around US$61 billion (3.3 percent of GDP) in 2013/14. The current account deficit is expected to continue declining over the medium-term as domestic mining constraints ease, external demand improves, and the competitiveness-enhancing effects of depreciation are fully realized. This smaller deficit is expected to be financed by a combination of FDI and an increased reliance on debt, including inflows of deposits from nonresident Indians. There are, however, risks that the current account deficit could be higher depending on: (i) the ability to successfully lower CPI inflation (which will be essential to generate the sustained reduction in gold imports and increase in households financial savings that is assumed in the forecasts); (ii) the potential for higher oil prices; and (iii) the pace of recovery of external demand. India’s gross international reserves are comfortable (at US$296 billion at end-December 2013, or 145 percent of the Fund’s reserve adequacy metric) and are expected to rise steadily to US$314 billion by March 2015 (Figure 3).

Figure 3.
Figure 3.

India: External Vulnerabilities

External risks have abated somewhat and are manageable.

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Sources: IMF, International Financial Statistics; and IMF staff calculations.

CPI Inflation and Fiscal Balance, 2012

(In percent)

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

10. The principal risk facing India is the inward spillover from a tightening of global liquidity interacting with domestic vulnerabilities (Annex III). International reserves are ample, but recent experience highlights that, with U.S. monetary policy normalizing, the impact from global financial market volatility could be disruptive (Figure 4). With a still-significant external financing need, India is exposed to higher global interest rates and a reversal of capital flows. Such pressures could tighten domestic financial conditions, weaken corporate and bank balance sheets, curtail credit growth, and force a further procyclical tightening of monetary and fiscal policy. This could further raise borrowing costs, trigger portfolio outflows, and create the potential for disorderly adjustments in exchange rate and asset prices. Potential upsides to the outlook would arise from healthier global growth or lower oil prices.

Figure 4.
Figure 4.

India: Financial Markets

Global financial market volatility led to capital outflows, but flows have stabilized lately.

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Sources: Bloomberg, CEIC, and IMF staff calculations.

11. On the domestic front, risks stem from slow progress in addressing infrastructure and supply-side constraints (particularly in the power and transportation sectors). Unless binding supply constraints are decisively addressed, high inflation and slow growth will continue to undermine macroeconomic and financial stability, necessitating a tighter monetary policy stance (Box 1). Given the commitment to medium-term fiscal consolidation, fiscal policy will not be able to provide support to domestic demand, which will also weigh on growth. On the other hand, growth upsides could arise from further investor-confidence-boosting policy actions (for example, if diesel price increases were accelerated), a greater-than-expected response of exports to the weaker currency, or faster implementation of CCI-approved projects. Outward spillovers from an output shock in India would have modest global implications (given the scale of India’s trade and financial flows), but would affect some neighboring countries in South Asia through trade, remittances and FDI channels (see Selected Issues Chapter II).

Authorities’ Views

12. The authorities were more sanguine than staff about India’s near-term growth prospects. Citing green shoots in the data for power generation and exports, good agricultural performance and robust rural demand, they consider a growth projection of 5 percent to be reasonable for FY13/14, rising to 8 percent in 2–3 years. Order books are filling up, iron ore projects have been unlocked, and thus far in 2013 the CCI has cleared projects worth US$95 billion, which should translate into a pickup in activity in the final months of FY 2013/14. The authorities noted that final GDP data, using the broader-based Annual Survey of Industries, would be higher than the preliminary, industrial production-based quarterly GDP figures. They were also of the view that fiscal expenditure restraint would not have a material effect on near-term growth.

13. The authorities agreed that a sharp adverse swing in market sentiment prompted by a scaling back of unconventional monetary policies (UMP) in advanced economies is the main risk currently facing India. They pointed to the need for greater clarity and communication by policy-makers in advanced economies in regard to the planned pace of UMP tapering. At the same time, they considered that India’s domestic fundamentals were strong (reflected in the oversubscription of the IFC’s first off-shore issuance of rupee-linked bonds), and that vulnerabilities had been addressed, particularly on the external side. The authorities stated that the recent decline in gold imports can be sustained, given the introduction of inflation-indexed bonds—offering households an alternative inflation hedge to gold—and further stabilization of the macroeconomic situation. They agreed with staff that exchange rate flexibility is an important policy feature that helps to contain external risks, and considered the RBI’s stock of international reserves to be broadly adequate to address any need to smooth short-term volatility.

14. The authorities noted that India has demonstrated its ability to respond to shocks and market concerns. While recognizing that more chronic problems—such as persistent inflation—have been allowed to linger, the authorities argued that vigorous policy responses had been forthcoming when actions were urgently needed. For example, when the fiscal deficit became a matter of concern in FY 2012/13, the Ministry of Finance delivered on restraining spending to meet the deficit target. Similarly, when markets feared the current account deficit was becoming excessive, the government put in place effective measures to rein it in and to mobilize over $34 billion in net capital inflows (largely through NRI deposits).3

Policy Priorities

India has very little space for countercyclical policy stimulus. Monetary policy will need to be tightened to durably reduce inflation, and high budget deficits afford little scope for fiscal support to the economy. As a result, expediting structural reforms is the only feasible option to boost both actual and potential growth, create jobs to absorb India’s rapidly-growing labor force, and reduce poverty.

A. Monetary Policy

15. In the summer, in the midst of exchange market pressures, the RBI took a number of steps to tighten domestic liquidity and support the exchange rate (Annex IV). India’s monetary policy response relied on a tightening of money market liquidity engineered by:

  • Limiting the provision of liquidity under the Liquidity Adjustment Facility (LAF) to 0.5 percent of bank’s own net demand and time deposit liabilities (NTDL).4

  • Increasing the Marginal Standing Facility (MSF) interest rate by 200 bps to 10.25 percent, thereby increasing the wedge between the interest rates on the LAF and the MSF from 100 to 300 basis points.5

  • Tightening the averaging rules for the cash reserve ratio (CRR) by requiring banks to meet at least 99 percent of CRR on daily basis (up from 70 percent earlier).

  • Undertaking open market sales of Government of India Securities by the RBI (of around INR 150 billion during July-August 2013).


Policy and Call Market Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Sources: RBI and IMF staff calculations.

As a result, the interbank call money market rate was increased by some 300 basis points with the MSF rate becoming the effective policy rate, money market and three-month t-bill rates rose by about 300 basis points, and there were lesser increases in rates further out the yield curve. The preference for these liquidity-tightening measures to increase short-term interest rates (rather than increase the policy rate) was due to the fact they could be put in place quickly and be easily unwound as pressures eased. In addition, these measures were more targeted at supporting the rupee by significantly raising the short-term costs of shorting the currency. A comparable tightening (of 300 bps) undertaken through increases in the repo rate would have been unprecedented, likely had a larger impact on growth, and been politically difficult to achieve.

16. As external pressures have abated, the RBI has moved to normalize monetary policy. Since September, the RBI has gradually unwound the liquidity measures by lowering both the MSF rate (by 150 bps) and daily CRR requirement (to 95 percent) and expanding access to term repos. At the same time, the repo rate was increased by 50 bps (to 7.75 percent), restoring the interest rate corridor to the 100 bps that existed prior to mid-July. As pressures on the currency have eased and markets have normalized, the RBI’s strategy to restore the repo rate as its primary policy instrument has been fully appropriate.


RBI’s Daily Liquidity Operations

(In billions of Rupees)

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Sources: RBI and IMF staff calculations.

17. However, inflation remains too high and the RBI will need to continue raising policy rates in the coming months. High and persistent inflation is a key vulnerability that has caused household inflation expectations to continuously exceed actual inflation and become embedded in behaviors. This, in turn, has driven a rising demand for gold and is adding to downward pressures on the rupee. The RBI’s resolve to pay greater attention to headline CPI in monetary policy formulation and to strengthen its anti-inflationary efforts are commendable. However, the ingrained nature of inflation and inflation expectations mean that reducing inflation—even over a protracted horizon—will require significant increases in policy rates, which will weigh on growth.6 Given uncertainties surrounding the strength and lags associated with the monetary transmission mechanism, an incremental approach to monetary tightening is warranted. However, it will be important to communicate the RBI’s policy reaction function and the shift in its tolerance for high CPI inflation through clear forward guidance on the direction and intent of policy. In addition, should high inflation expectations persist and inflation remain sticky, a more front-loaded path of interest rate increases may be needed (Figure 5).

Figure 5.
Figure 5.

India: Monetary Developments

Inflation has picked up even as the output gap has widened. Upside risks to inflation emanating from elevated food inflation, rupee depreciation, and inflation expectations remain high.

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

18. Sustainably lowering inflation will require a simpler monetary framework with clear objectives and operational autonomy for the RBI:

  • The RBI should move towards adopting the containment of inflation as its primary objective, with headline CPI inflation providing the principal nominal anchor for monetary policy.7 The evolution of the CPI plays a key role in influencing both inflation expectations and wage formation.8 While the RBI should see through the impact of transitory shocks, the current evolution of food prices, rising at a rapid pace for several years, is not a transitory phenomenon and reflects both consumption demand and supply constraints. In addition, empirically, food price shocks propagate strongly and rapidly into non-food, non-fuel (core) prices.

  • To further enhance the effectiveness of monetary policy, the RBI should clearly communicate how it intends to meet its stated inflation objectives and, as part of that process, should publish rolling one-year-ahead projections of both the CPI and WPI.

  • In terms of monetary operations, the overnight repo rate should remain the principal policy tool, deployed in the context of a fully flexible exchange rate.

  • In the context of implementation of the Financial Sector Legislative Reform Commission’s (FSLRC) recommendations (Box 2), legislative changes should be made to underpin the RBI’s operational autonomy.

Authorities’ Views

19. The authorities agreed that inflation was too high, and that monetary policy would need to remain vigilant over the near term. At the same time, they noted that supply-driven, food inflation is a key driver of the headline number. With the good monsoon this year, they believed food inflation should fall and that, in any case, monetary policy has a limited role in tackling food inflation. The authorities agreed that the output gap remains significantly negative and should help lower inflation going forward. As a result, they consider that the growth - inflation tradeoff will need to be carefully managed and there was a significant risk of overtightening, particularly in light of the need to create jobs to absorb India’s growing labor force.9 The central bank noted that, given the risks of derailing the ongoing economic recovery and uncertainties surrounding monetary transmission, a gradualist approach was needed to disinflate the economy over an extended period. They were less persuaded of the need for a further, significant increase in policy rates to lower inflation and inflationary expectations. Instead, they believed it would be prudent to give some time for the effects of the recent interest rate increases to feed through before revising the policy stance.

20. The authorities indicated they would take a view on possible changes to the monetary policy framework only after the Patel Committee issues its report (expected in early 2014). They emphasize that they have been working, through their communications strategy, to shift the dialog with markets toward the CPI, which they consider will enhance the RBI’s credibility on inflation issues over the medium term. They are not persuaded of the need to release rolling, year ahead forecasts of inflation, but they made it clear that significant internal and public conversations are still to be had before the authorities settle on any change in the basic monetary policy set-up.

B. Addressing External Vulnerabilities

21. Recent experience has shown that exchange rate flexibility is an essential tool in coping with volatile capital flows. The flexible rupee has been an important shock absorber and should continue to play that role. The RBI has ample reserves and, if needed, is able to provide foreign currency liquidity, through both swaps and spot intervention, to prevent disruptive movements in the exchange rate and check any self-fulfilling momentum that is divorced from exchange rate fundamentals. Based on a range of empirical methodologies, the FY 2013/14-average real effective exchange rate appears to be slightly over-valued (Annex V).10 As such, and given the sizable inflation differential with trading partners, some further modest nominal depreciation from current levels should not be a cause for concern.


Nominal and Real Effective Exchange Rates

(Index, 2005=100)

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Sources: IMF, Information Notice System and IMF staff estimates.

22. Recent policy measures have been targeted at improving the environment for capital inflows. India has shifted from a pre-Lehman Brothers era where FDI flows more-than-financed the CAD, to a situation where FDI covered only around one quarter of the deficit in 2012/13, with a corresponding increased reliance on debt flows. Over the past year the authorities have taken multiple steps to bolster capital inflows, including liberalizing the caps on FDI inflows; relaxing restrictions on external commercial borrowing; offering FX swaps to banks to attract more NRI deposits and increase banks’ ability to borrow; and working with the IFC in its US$1 billion bond program directed at offshore investors. The authorities have also supported the currency by providing dollars directly to oil importers through FX swaps (see Annex IV for details of FX swaps to banks and oil importers and their impact).11 In addition, a swap line with the Ministry of Finance Japan has been increased from $15 billion to $50 billion, and the government is considering increasing imports of cheaper Iranian oil, which can be partly settled in rupees.

23. Further opening up of the capital account should, however, be undertaken prudently. The opening to FDI and portfolio flows which occurred in 2013 will help finance the current account deficit. However, given the potential risks to corporate balance sheets, a further relaxation of external commercial borrowing (ECB) rules should be undertaken only incrementally and cautiously alongside a deeper domestic financial market. Options of issuing a maiden international sovereign bond, if market conditions permit, and of seeking entry into global bond indices, should be explored. The authorities could also look into increasing the availability of bilateral swap lines. The flexible rupee and recent movements in the currency have increased incentives to hedge FX exposures. As such, the relaxation of restrictions that reduce the depth of the onshore forwards and futures markets would be beneficial.12

24. If external pressures re-emerge, a well-communicated package of policy measures should be put in place to minimize disruptive movements in the currency and bolster confidence. Going forward, an improving export environment, an easing of supply bottlenecks to shrink import demand, and a smaller fiscal deficit should help reduce external vulnerabilities. Nevertheless, if capital account pressures were to resurface, continuing to allow the rupee to adjust flexibly to market conditions will be essential. In addition, a comprehensive plan should be announced to:

  • Tighten monetary conditions through both an increase in the repo rate and a renewal of liquidity tightening measures to make it more costly to short the rupee. Such measures would help contain the inflationary impact of exchange rate depreciation and, temporarily, bolster the capital account position. However, liquidity tightening should be seen as a complement to, not an expedient substitute for, raising the repo rate. In following this approach, it will be essential to clearly communicate the central bank’s intentions and its motivations for using the range of tools it has in its monetary toolkit.

  • Deploy India’s ample FX reserves, including by again taking oil marketing companies out of the spot market and offering them a short-term bilateral FX swap window priced at market rates. Recent experience indicates that this has been an effective strategy in changing market expectations and, as such, should be used again.

  • Similarly, FX swaps for NRI deposits (at market-based rates and without the subsidy embedded in the recent NRI swaps) should again be offered if needed.

  • A clear package of fiscal measures, in addition to those needed to achieve fiscal targets, would help support confidence and lessen the burden on the central bank in reacting to market pressures. These could include administrative action to raise diesel prices at a faster pace, and further limit the subsidized consumption of LPG.

  • Measures to further restrict capital outflows should be avoided, not least because recent experience suggests that they could well be counterproductive, potentially catalyzing capital flight through different routes. The renunciation of such measures should be clearly communicated to bolster investor confidence.

The mission noted that it would be important for the government to develop an agreed set of contingency plans—along the lines described above—so as to be ready to react to heightened market pressures. These plans should be fully coordinated across the relevant government agencies and would constitute a highly valuable preparatory exercise.

Authorities’ Views

25. The authorities argued that external vulnerabilities have been greatly reduced, owing in large part to strong policy actions taken. Gold imports have been sharply curtailed, and goods and services exports are starting to pick up even before the full impact of rupee depreciation is felt. FII debt inflows have been negative since May but equity investment flows have remained resilient. With only a relatively small amount of FII debt remaining, the mix of FII money now present on Indian markets has become more durable. The authorities noted the effectiveness of the FX-swap scheme for oil marketing companies in stabilizing the currency market and shifting market sentiment. They also pointed to the success of their efforts to mobilize durable capital inflows, particularly from NRIs and FDI.

26. The authorities agreed that exchange rate flexibility would continue to be a key pillar of their response to external volatility. In their view, the broad thrust of the liquidity tightening and FX intervention policies employed during July-September had been correct. They argued that with the Reserve Bank of India moving towards improved communication of its views, the risk of volatility would be further reduced. Looking ahead, if faced with a similar round of capital flow volatility, they indicated that the thrust of their response would likely be similar, using a combination of exchange rate flexibility, some monetary tightening, and, if needed, limited use of foreign exchange reserves.

27. The authorities indicated that a new crisis management framework has been established under the management of the inter-regulatory Financial Stability and Development Council (FSDC). The authorities argued that this group, which has met regularly over the past few months, should enhance India’s ability to respond to shocks threatening the Indian financial system. At the same time, they recognized this was a work-in-progress and agreed with staff’s suggestion to test the FSDC crisis management system, potentially in a “war game exercise” setting.

C. Fiscal Policy

28. There is a firm commitment to meet the 2013/14 fiscal deficit target, but achieving this goal will be challenging. The authorities demonstrated their commitment to fiscal consolidation by meeting the Budget deficit target for 2012/13, despite a slowing economy (Figure 6). Politically difficult steps were taken to raise fuel and retail electricity prices, target direct cash transfers using the expanding Unique Identification (UID) program (Box 3), and restructure the debt of public electricity distribution companies. For 2013/14, the Budget deficit target of 4.8 percent of GDP appears achievable.13 However, weak revenue growth, higher global oil prices, rupee depreciation, and higher interest rates, mean that achieving this near-term goal will entail significant reductions in spending. For this fiscal year, in addition to the announced measures to rationalize non-plan expenditure, the target is expected to be met by requiring agencies to give up un-utilized spending allocations, and to not release further budgeted amounts to such agencies. In addition, cash-rich public sector enterprises are being asked to transfer higher dividends to the central government. Such efforts, however, will create a substantial additional drag on growth, particularly given that fiscal multipliers on such spending are relatively large in India. 14 Additional fiscal reforms (including better-targeted subsidies, introduction of a GST and direct tax code) are unlikely to be introduced before the May 2014 general elections, although there is some discussion of raising diesel prices at a somewhat faster pace in the remainder of this fiscal year.

Figure 6.
Figure 6.

India: Fiscal Sector Developments

Fiscal consolidation after the financial crisis continues. Ensuring stable debt dynamics will require measures to contain current expenditure and raise revenue.

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Sources: Indian authorities; and IMF staff calculations.

29. The government’s goal of a 3 percent of GDP deficit target by 2016/17 represents a reasonable medium-term consolidation plan, but the policies to achieve that outcome have yet to be articulated.15 A better quality of fiscal adjustment could be achieved through a more balanced package of revenue measures and expenditure reductions. In particular, the staff would recommend the following package of fiscal reforms to meet the authorities’ medium-term fiscal target:

  • Approving the goods and services tax. This represents the single most important revenue reform and will help boost growth by lessening distortions and creating a single Indian market for goods and services.

  • Approving a new direct tax code with streamlined and smaller deductions, raising excise taxes back to pre-GFC levels, and improving tax administration.

  • Reforming untargeted subsidies on fuel and fertilizer. Continuing the ongoing move toward targeted transfers will have strong beneficial effects on growth and the distribution of income. This should be the central plank of expenditure rationalization and will allow spending to be redirected toward more socially- and economically-productive areas (including greater investment in health and education). An important step would be to raise diesel prices at a more accelerated pace, so as to ensure full cost recovery by mid-2014 (and thereafter link domestic fuel prices to movements in international prices).

  • Targeting food subsidies. The recently-passed Food Security Act—which aims to provide subsidized rice, wheat and coarse cereals to 67 percent of the population—is expected to add significantly to the fiscal subsidy burden going forward (Box 4). Efforts should be made to convert these subsidies to a system of targeted, direct cash transfers as quickly as possible. In addition, governance and transparency in the allocation of subsidized food should be strengthened and the efficiency of the Public Distribution System enhanced.

  • Adhering to the Fiscal Responsibility and Budget Management Act (2003) by the central government. This would imply that the central government commits and adheres to a credible path of fiscal consolidation, reaching a central government deficit of 3 percent of GDP by FY 2016/17.

  • Minimizing additional pressures on the fiscal position from future bank recapitalization needs (including by increased bank provisioning) and the liabilities of electricity distribution companies (by continuing to raise tariffs to cost recovery levels).

Focusing on the implementation of a more sustainable package of fiscal reforms, as described above, would build confidence, support monetary policy in fighting inflation, free resources for investment, lessen vulnerabilities and generate a positive dynamic of lower financing costs and improved economic and social prospects. Without such measures, the composition of fiscal adjustment will likely be met through a compression in needed capital spending or an underfunding of important social programs, which would undermine growth and the government’s laudable pro-poor and inclusive growth goals (see Selected Issues Chapter IV).

30. Even without medium-term fiscal adjustment, government debt remains on a sustainable trajectory, and is projected to stabilize at around 64 percent of GDP in 2017/18. The public debt sustainability analysis (DSA) using the Fund’s new DSA template suggests that India’s public debt burden remains manageable. While the baseline scenario already uses conservative real GDP growth assumptions, further negative growth shocks represent one of the major risks to the debt outlook, with shocks to real interest rates and contingent liabilities posing additional risks (see Annex VI).

Authorities’ Views

31. The government has reiterated the importance of meeting its FY13/14 Budget deficit target. The authorities stated that this was a “redline” with strong credibility implications if not met. As such, no slippage will be permitted. They argued that revenue performance this year is on track, and they emphasized that meeting the deficit target does not entail an expenditure cut, but only involves expenditure rationalization by recalling unspent balances with spending units and not releasing further budgeted amounts to them. Fiscal accounting in India is done on a cash, not accrual basis, so the authorities recognize the risk that some spending pressure from this year could spill into next year. However, they point to the fact that similar spillovers happen every year, and they argue that there is no evidence that the size of this carryover is growing from year to year.

32. The authorities agreed that fiscal consolidation was needed over the medium term. In their eyes, the goal of reducing the central government deficit to 3 percent of GDP (authorities’ definition) by 2016/17 is achievable, but they did not believe there was a need to re-invigorate the Fiscal Responsibility and Budget Management (FRBM) process. The FRBM Act has recently been amended to adopt this target, therefore, revising the Act at this stage may not be needed. Revenue enhancement is key, particularly through better tax administration, and the authorities were hopeful that the goods and services tax (GST) and the direct tax code (DTC) bills will be passed by next year. The authorities are also optimistic that direct cash transfers—combined with the unique identification (Aadhaar) system—will generate significant fiscal savings through de-duplication of subsidy recipient rolls. The authorities do not see significant risks to fiscal consolidation from implementation of the Food Security Act, and underlined the importance of the Act in tackling poverty and hunger and ensuring improved social outcomes.

D. Financial and Corporate Sector Issues

33. Strains are building as corporate financial positions deteriorate and bank asset quality weakens (Figure 7). Slowing growth, the delayed authorization of permits for infrastructure projects, and rising costs of capital are placing pressure on corporate profitability. Average corporate leverage and debt payment capacity are not markedly worse than during the global financial crisis, but default probabilities of the most vulnerable 10 percent of firms are far greater than in 2009. This vulnerability is further aggravated by concentration risk: banking sector loans to India’s ten largest conglomerates account for almost 100 percent of banks’ net worth.16 The banking system is well capitalized (the capital adequacy ratio was 13.8 percent in March 2013), but nonperforming assets (4.2 percent of total advances) and restructured loans (an additional 5.7 percent of gross advances) are expected to continue to rise. The deterioration in credit quality has been worse among public banks where lending is concentrated in poorer-performing sectors such as infrastructure (especially power), aviation, agriculture, steel, and textiles. However, despite the sizeable recent depreciation in the exchange rate, there has, as yet, been little apparent additional strain on corporate balance sheets arising from currency mismatches (see Selected Issues Chapter V). In addition, new capital injections for India’s banks (to meet Basle III requirements and additional capital requirements due to restructured loans being reclassified as NPAs) are likely to be manageable (Box 5).

Figure 7.
Figure 7.

India: Corporate and Banking Sectors

Corporate sector stresses remain high, causing a further deterioration of banks’ asset quality.

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

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

34. Enhanced financial sector supervision and monitoring, and increased bank provisioning, are warranted. To tackle rising strains in the financial system, and improve the functioning of financial intermediation more broadly, the RBI has outlined its plans to further enhance the monitoring and supervision of banks’ credit quality and require banks to further increase provisioning. In particular, the RBI’s recently-introduced incremental provisioning and capital requirements for bank lending to corporates with foreign-currency exposures are steps in the right direction. As recommended in the FSAP, advances and commitments to interrelated companies should be appropriately measured and limited, and the existing ceilings fully enforced—this is a critical measure and should be undertaken prior to issuing new banking licenses (see Annex II). A further priority should be to gather information on, and analyze, the inter-linkages between corporate vulnerabilities and the health of the banking system, particularly on the extent of unhedged FX exposures of large firms with international operations.

35. Strengthening prudential regulation for banks’ asset quality classification and concentration risks are needed. Implementation of the Mahapatra Committee’s recommendations (to more rigorously classify restructured advances) is a step in the right direction, but further measures in the areas of asset quality recognition and concentration risks are needed. The objective should be to fully recognize the true asset quality of banks’ portfolios, with restructured loans counted toward nonperforming assets immediately after a restructuring, and then moved to the performing bucket only after a period of satisfactory performance. This is of particular importance for the public sector banks. Moreover, all sectors of the economy (including infrastructure and real estate) should be subject to the same loan quality classification rules.17

36. Enhancing the institutional and legal framework for debt recovery is an important step. This will require improvements in the legal and institutional insolvency framework, the regime for insolvency professionals, the functioning of the distressed asset market, and out-of-court settlement procedures. Initial steps by the FSLRC to explore updating India’s financial regulatory architecture should be intensified, to bring the institutional and legal framework in line with India’s fast-growing and complex financial system.

37. Various financial sector reforms should increase credit availability and broaden access to financial services. Recently-announced plans to simplify bank branch licensing, create inclusiveness criteria for underserved areas, and enhance competition in the banking sector—including by accelerating the approval process for new private sector banks and opening the Indian market further to foreign banks—will expand access. The December 2013 introduction of CPI-indexed bonds (particularly those sold to retail clients) is a further positive step and will help reduce the demand for gold and divert savings to productive uses, intermediated by the domestic financial system. Other welcome reforms already underway include: introduction of a ten-year bond futures contract; improvement in the recovery mechanism for distressed debt; and establishing the central large borrowers’ database, which will improve the supervision of large exposures. In addition to these efforts, gradually reducing the Statutory Liquidity Requirement, concomitant with a decline in the fiscal deficit, will help free up resources for lending to the private sector rather than channeling savings into government securities. On the financial inclusion side, the Governor’s call for a feasibility study on mobile banking offers the possibility to integrate currently un-banked segments of India’s population into the financial system.

Authorities’ Views

38. The authorities recognize that corporate profitability has fallen, putting pressure on financial sector balance sheets. They agreed with staff that these pressures, while manageable at present, will need to be carefully monitored going forward, and noted that other major EMs are facing similar strains. The RBI is keen to find ways to incentivize the early recognition of problem assets by banks, and the authorities feel that the newly-adopted Companies Act should over time facilitate a clearer insolvency framework. The authorities also acknowledge that the foreign exchange exposure of Indian corporates is not fully clear, but they believe that most such borrowing has either a formal or natural hedge.

39. The authorities emphasized the potential impact of a range of reforms to strengthen financial intermediation and advance financial inclusion. In particular, the RBI laid out the five pillars of its planned developmental measures to improve the Indian financial system. These include: (i) strengthening the monetary policy framework; (ii) enhancing banking structure (through new bank entry, branch expansion, encouraging new varieties of banks); (iii) broadening financial markets (by improving the liquidity and depth of government securities, money, derivatives, and corporate debt markets); (iv) expanding financial inclusion (involving better access to finance for SMEs, the underserved parts of the population, through technology (such as mobile banking) and business practices (for example, maintaining the requirement that banks open at least 25 percent of their branches in unbanked rural centers); and (v) improving the financial system’s ability to handle corporate and financial institution distress (by strengthening financial restructuring, procedures for rescue of viable businesses, and insolvency practices).

E. Structural Policies to Boost Growth

40. Key structural reforms are needed to reduce supply bottlenecks, bolster employment growth, improve medium-term growth prospects, enhance growth inclusiveness, and reduce poverty. While major policy actions may understandably be difficult to implement ahead of the general elections expected by May 2014, any positive steps taken would enhance investment, improve the supply response of the economy, and help raise potential growth.

41. Nonetheless, slow action on key structural reforms (introduction of GST, comprehensive energy and fertilizer subsidy reforms, agricultural reforms, and power sector reforms) continues to adversely affect sentiment and domestic investment (see Selected Issues Chapter VI). Needed inclusive growth-promoting measures include:

  • Addressing structural challenges in the power sector and in natural resources. State Electricity Boards (SEBs) have raised tariffs but much more needs to do be done to eliminate losses. The pricing and allocation of a wide range of natural resources (including coal, natural gas, electricity, and fertilizers) are subject to complex and cumbersome mechanisms and regulations, which need to be addressed. Moving the pricing and allocation of natural resources toward a market basis would make them more transparent and raise investment.

  • Easing strict labor regulations and addressing skills mismatches. These will be vital to raise productivity, increase formal sector employment, and improve potential growth. Raising educational attainments and enhanced focus on vocational training are required to ease India’s skill mismatch (see also Selected Issues Chapter VII).

  • Reforming the agriculture sector, particularly reducing administrative inefficiencies in food distribution, pricing, and storage, and boosting productivity in agricultural production.

  • Enhancing health and education outcomes by sustainably increasing spending, improving their quality, raising the efficiency of social programs and focusing on inclusiveness (as emphasized in the 12th Five-Year Plan).

  • Strengthening the business, trade, and investment climate and enhancing governance. According to a range of business environment indicators, India underperforms in areas necessary to run a business (e.g. trading across borders, enforcing contracts, and resolving insolvency) but performs better in the areas of obtaining credit and protecting investors (Figure 8).

Figure 8.
Figure 8.

India: Business Environment and Governance

India compares poorly with other emerging market economies in various competitiveness surveys.

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Authorities’ Views

42. There is consensus that structural reforms are going to be the lynchpin of an eventual rebound in growth. The authorities note that a number of long-awaited legislative measures have been passed recently, and that the Cabinet Committee on Investment is now seeing success in unlocking key infrastructure projects. Power linkages are well-understood as a bottleneck, and more effective health and education spending will be key to ensuring that the “demographic dividend” pays off. At the same time, there is not the same level of consensus on the need for labor market reform, and the authorities do not agree with India’s ranking on the World Bank’s ease of doing business indicators, questioning the methodology used in arriving at these rankings. They pointed instead to the recent Ernst and Young Global Confidence Barometer (issued October 2013), which ranked India among the most favored of global investment destinations.

Staff Appraisal

43. India presently faces a challenging macroeconomic landscape. A weakening risk appetite toward major emerging market economies, along with global liquidity tightening, have placed pressure on India’s balance of payments. However, there is little room for countercyclical macroeconomic policies to respond. Rather, a tightening of fiscal and monetary policies is needed to narrow macroeconomic imbalances, supported by actions to relieve supply-side bottlenecks. The key near-term risk arises from a sudden stop in external capital inflows, emanating from either domestic or external triggers.

44. The immediate outlook is for a gradual growth recovery and persistently-high inflation. Growth will reach its nadir in 2013 on weaker domestic investment and tepid external demand. India’s growth has underperformed in recent years, largely due to domestic factors (chief among them policy uncertainty and supply-side bottlenecks). Headline CPI inflation will remain near double digits for the remainder of the fiscal year, as second-round effects of high food price inflation continue to drive inflation momentum.

45. Recent policy initiatives have reduced vulnerabilities. The authorities have taken substantive measures in recent months to narrow external and fiscal imbalances, raise policy interest rates, move forward on structural reforms, accelerate project approvals, and manage market volatility. Of particular importance have been measures to shrink energy subsidies, allow the exchange rate to adjust, bolster capital inflows, and alleviate supply-side constraints. Continued clear communication of these policy initiatives will enhance their effectiveness.

46. The principal risk facing India remains the inward spillover from global financial market volatility, involving a reversal of capital flows. If capital account pressures re-emerge, then rupee flexibility should continue to be the first line of defense, complimented by the use of reserves, tightening of monetary conditions, additional fiscal consolidation efforts, and further easing of constraints on capital inflows. In addition, to prepare for further global financial market volatility, the government should design a contingency plan and communication strategy that is well-coordinated across agencies and can be rolled out in the event conditions deteriorate.

47. High and persistent inflation remains a central macroeconomic challenge. High inflation over the past several years has induced double-digit inflation expectations, driven a rising demand for gold, and placed downward pressure on the exchange rate. Achieving a sustained reduction in inflation will require a tightening of the monetary stance, possibly over a protracted period, which inevitably will weigh on growth prospects. Headline CPI should provide the principal nominal anchor for monetary policy, as food and fuel price shocks propagate rapidly into core inflation, and inflation expectations and wage formation are closely linked to CPI inflation.

48. The continued opening of the capital account and rupee flexibility are welcome. The current account deficit financing mix would be improved by enhancing the environment for FDI. However, given the potential risks to corporate balance sheets, further relaxation of limits on external commercial borrowing (especially for sectors without natural hedges) should be implemented cautiously. India’s flexible exchange rate will remain important to offset substantial inflation differentials and respond to external shocks.

49. Fiscal consolidation is essential and there is scope to improve the quality of that fiscal adjustment. The authorities commitment to adhering to its near-term budget target is commendable. While the medium-term fiscal targets and resulting pace of consolidation are broadly appropriate, measures still need to be articulated and implemented to underpin the targeted fiscal adjustment. Achieving this adjustment will require more efficient taxation (including through introduction of the GST) and expenditure (including through reforms to fuel and fertilizer subsidies). Steps taken to tie India’s social safety net to the UID program are welcome. Reorienting spending toward 12th Plan priorities in health and education will require further reforms to fuel and fertilizer subsidies.

50. India’s financial system is well capitalized and supervised, but slowing growth has highlighted corporate vulnerabilities and led to deteriorating bank asset quality. The RBI’s recent initiatives to increase provisioning and capital requirements for bank lending to corporates with foreign currency exposures are welcome steps, as is the improved loan classification of restructured advances. A key information gap concerns the extent of unhedged foreign currency exposure of large corporates, which should be rectified. Improvements in the legal and institutional insolvency framework would also help deepen domestic capital markets.

51. Broader structural reforms are needed to raise potential growth, particularly improvements in the pricing of natural resources. While power distribution companies have started raising tariffs and are being restructured, the pricing of natural resources (including coal, natural gas, and fertilizer) should move toward a market basis to boost investment. In addition, removing infrastructure constraints, easing restrictive labor laws and reforming agriculture production and marketing will boost potential growth.

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

Debt, Inflation, and Growth1

Containing persistently-high inflation and a firm commitment to reducing the debt-generating fiscal deficits are critical for achieving higher long-term growth. The conventional view in the literature is that public debt can stimulate aggregate demand and output in the short run, but crowds out capital and reduces output in the long run. Likewise, persistently-high inflation can be detrimental for growth. There are also possible non-linear effects where the build-up of debt or persistently-elevated inflation above a certain threshold can harm growth.

We provide a re-examination of the debt-inflation-growth relationship using recent developments in dynamic heterogeneous panels, in a sample of 40 countries over the period 1966–2010. Cross-country experience shows that some economies have run into debt difficulties and experienced subdued growth at relatively low debt levels, while others have been able to sustain high levels of indebtedness for prolonged periods and grow strongly without experiencing debt distress. This suggests that the effect of public debt on growth varies across countries, depending critically on country-specific factors and institutions. The estimation strategy takes into account, jointly, all three key features of panel data (i.e. dynamics, heterogeneity and cross-sectional dependence).

Public debt and inflation are found to have significant negative long-run effects on growth. The results indicate that, if the debt-to-GDP ratio is raised and this increase turns out to be permanent, then it will have negative effects on economic growth in the long run. However, if the increase is temporary and debt-to-GDP is subsequently brought back to its normal level, then there are no long-run growth effects. Similarly, persistently-high inflation has a negative impact on long-run growth. A universally-applicable threshold effect in the relationship between either public debt or inflation and growth is not found, although a statistically-significant threshold effect for countries that have rising debt-to-GDP ratios is found. For India specifically, the estimated coefficients of debt/GDP and inflation on economic growth are -0.206 and -0.191, respectively.


Average GDP Growth and Inflation (1966–2010) 1/

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Sources: Chudik, Mohaddes, Pesaran and Raissi (2013).1/ ARG, BRA, CHI, IDN, PER, and TUR were identified as outliers.

Average GDP Growth and Debt/GDP (1966–2010)

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Sources: Chudik, Mohaddes, Pesaran and Raissi (2013).
1 Prepared by Mehdi Raissi. Based on A. Chudik, K. Mohaddes, M. H. Pesaran, and M. Raissi (2013). Debt, Inflation and Growth: Robust Estimation of Long-Run Effects in Dynamic Panel Data Models. Federal Reserve Bank of Dallas Working Paper No. 162.

Financial Sector Legislative Reform Commission (FSLRC)1

Motivation and reform strategy

In recognition of the fact that India’s financial regulatory architecture dates back to the 1930s, the Ministry of Finance in March 2011 convened the FSLRC to propose reform of financial sector legislation. The aim was to identify gaps and overlaps in existing law which—combined with financial and technical innovation—could give rise to regulatory arbitrage, forum shopping, and other inefficiencies. The Commission, which submitted its report ( in March 2013, proposed a new Indian Financial Code (IFC), the aim of which is to establish a single, unified legislative framework that could survive for the next 20–30 years. The principles of independence, accountability and transparency underpin the design of the IFC; for example, all new regulations would need to be justified by demonstration of the market failure they correct, and include a formal cost-benefit analysis.

Monetary policy

The draft IFC does not specify the objective of monetary policy, but rather leaves it to the Ministry of Finance (MoF), which would issue a statement to this effect from time to time. While not enshrined in law, the objectives would be quantitative, publicly disclosed, and once set, the RBI would have instrument independence to achieve them. A formal, decision-making Monetary Policy Committee (MPC), appointed by the government and RBI, would be accountable to an empowered RBI Board (but not to parliament), with regular publication of MPC minutes. An independent debt management office would be established. Coordination between the MoF, RBI and new agencies would be handled by an upgraded Financial Sector Development Council which would have statutory authority. Capital controls would be regulated asymmetrically: MoF would regulate foreign exchange inflows while RBI would regulate outflows.

Financial sector regulation and supervision

Given the lack of international consensus on best practice, the FSLRC settled on a model whereby a new Unified Financial Agency (UFA) would undertake consolidated supervision of the entire nonbank financial sector, including those NBFIs now supervised by the RBI. (RBI would continue to supervise banks.) The Commission felt that this approach offered the best hope of avoiding the kind of regulatory lacunae that have led to a series of challenges in recent years: unsupervised chit funds (Ponzi schemes, in effect); under-regulated credit cooperatives; unit linked insurance plans which straddle insurance and investment products; and most recently the poorly-supervised National Spot Exchange, which illegally allowed forward derivatives to be traded on its platform. Enhanced consumer protection is also a key objective of the FSLRC reforms.

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Assessment and next steps

The FSLRC report is not uncontroversial. It has generated much debate, and some of its recommendations were the subject of formal dissents by some members of the Commission. The FSLRC report is expected to be a fulcrum for discussions on financial sector reforms for the period ahead.

1 Prepared by Thomas Richardson.

Aadhaar: India’s Unique Identification Number1

The inability or complexity of proving who you are causes many Indian citizens to lose out on public benefits, and makes access to financial services costly or unavailable. To address this challenge, India’s Unique Identification Authority began to issue biometric identification numbers to residents in August 2010. The goal is simple, yet India’s scale makes it a challenge.

The strategy is to issue 600 million unique identification (UID or “Aadhaar”) numbers by 2014, and to reach more or less full coverage by 2018 (see Aadhaar aims to leverage technology to eliminate ghosts and duplicates in subsidy rolls. Registration sites have been set up in most localities, and they can register applicants even if power is temporarily off-line. Aadhaar establishes identity but not citizenship, and signing up is voluntary. Only basic information is collected: name, date of birth, gender, parents’ names (and UIDs, if available), address, and importantly biometric data: all ten fingerprints and an iris scan.

It is the biometric data which renders introduction of Aadhaar at India’s scale difficult. Each new applicant must be verified not to be one of the existing Aadhaar holders—a simple task when the number of Aadhaar holders is small, but the computational challenge grows as registration rolls out across India. Each new applicant must be biometrically checked against all those existing Aadhaar holders. As of September 2013, over 400 million Indians had Aadhaar numbers, and as many as 800,000 to 1 million new enrollees are added daily.


Roll-out of Aadhaar

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001


Potential fiscal gains from introduction of Aadhaar include savings on subsidies due to “de-duplication” of beneficiary rolls (e.g., elimination of ghosts), particularly as benefits are meant to be deposited directly into special “no-frills” bank accounts for beneficiaries. Thus far, 23 million bank accounts have been linked to Aadhaar numbers, but that figure is expected to rise to 100 million by end-2013. Eventually Aadhaar will also contribute to better revenue performance when it is integrated with direct and indirect tax databases.

Financial inclusion is an important objective of Aadhaar. As of 2010, only about 200–250 million Indian citizens had bank accounts. Aadhaar has been approved by the RBI as a way to satisfy “know your customer” (KYC) norms, and the UID Authority is working with financial regulators to enable electronic, or e-KYC, platforms. Among other things, it is expected that Aadhaar will enhance the coverage and therefore usefulness of the Credit Bureau, making access to financial products more readily available to Indian citizens.

1 Prepared by Thomas Richardson.

Food Security Act: Fiscal Implications1

The National Food Security Act is an important effort to ensure that the majority of India’s population has access to adequate quantities of food at affordable prices. The legislation is a landmark, representing the largest food security program in the world, involving the distribution of subsidized grain to two-thirds of India’s population of 1.2 billion persons. It proposes to cover up to 75 percent of the rural population, and up to 50 percent of the urban population, with an entitlement of 5 kg per person per month of food grains at issue prices of Rs. 2 and 3 per kg for wheat and rice, respectively. Nonetheless, the Act has been introduced at a time when international experience indicates that conditional cash transfers, rather than physical distribution of subsidized food, have been found to be a more efficient means of achieving food and nutritional security.

The fiscal implications of the Food Security Act (FSA) are likely to be significant. The food subsidy cost of implementing the FSA is estimated at Rs. 124,502 crores (about 1.1 percent of GDP) for fiscal year 2013/14. The food subsidy is calculated as [economic cost-issue price]*foodgrain requirement. The “economic cost” (as computed by the Food Corporation of India) includes, in addition to the minimum support price (MSP) paid to farmers, handling, storage and distribution costs. The “issue price” is the sale price of grain to consumers; the “foodgrain requirement” is the quantity of foodgrains required under the FSA. Food subsidy costs are estimated to increase to Rs. 140,192 and Rs. 157,701 crores, both about 1.1 percent of GDP, respectively, in FY 2014/15 and FY 2015/16. The “incremental” food subsidy under the FSA—over and above the subsidy that is already provided under the existing Targeted Public Distribution System (TPDS, see details below)—is estimated at Rs. 23,951 crores (equivalent to about 0.2 percent of FY 2013/14 GDP).

However, the FSA needs to be carefully evaluated to take into account not only the cost of the food subsidy, but also three additional cost dimensions, which can potentially magnify the fiscal implications of the FSA (see Table 1).

Table 1.

Summary Table: Incremental Cost of Food Security Act Relative to Targeted Public Distribution, 2013–14 (Rs. Crores)

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Source: Mishra (2013).
  • First, if implementation of the FSA includes “grandfathering” of existing beneficiaries, even when their income levels may imply that they no longer qualify for the FSA program, then the estimated fiscal cost could be higher.

  • Second, if implementation of the FSA requires merging the current classification under the TPDS with new and more careful identification schemes, then there may be misclassifications which could raise costs. For example, there may be pressure to expand the size of those classified as “covered” under FSA to include those who are not truly poor, but are misclassified as such under the current scheme.

  • Third, the open-ended procurement policies of the government (whereby the government commits to buying unlimited quantities of wheat and rice at the MSP) have implied that procurement has typically been much higher than the required quantity of food grains needed for public distribution programs. For example, on average over the last 10 years (between 2002–03 and 2011–12), procurement has been 40 percent higher than the off-take from the public distribution system. If we add these costs of additional procurement to the incremental food grain requirement in the FSA, the estimated fiscal cost can increase substantially. The carrying cost of excessive grain stocks is large and increasing.


Grain Stocks Held in Central Pool by Food Corporation of India 1/

(In millions of tons)

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Source: Food Corporation of India.1/ Data as of 1st of July for each year.2/ Includes buffer norms and strategic reserve for rice and wheat.

These estimates of the incremental costs of the FSA should be seen as tentative, as the precise costs of the current TPDS (and additional welfare) schemes are not easy to calculate. Given the experience that off take increases when grain is offered at very low prices, and that the estimates do not include various additional expenditures stated in the Act which are difficult to quantify, the calculations here are likely to be underestimates. Indeed, other sources have estimated higher fiscal costs of the FSA.2 Nonetheless, full implementation of the FSA is unlikely to happen in FY 2013/14, hence the immediate implications for the government’s fiscal position will likely be more limited.


Economic Cost and Minimum Support Price (MSP) 1/

In Rs. Per Quintal (100 kilograms)

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Sources: Food Corporation of India; and Commission for Agricultural Costs and Prices.1/ The economic cost is the sum of the distribution cost and acquisition cost (comprising pooled cost incl. imports and procurement incidentals).
1 Prepared by Prachi Mishra (MCM) and Paul Cashin. This Box draws on P. Mishra (2013), “Financial and Distributional Implications of the Food Security Law”, Economic and Political Weekly, Vol. XLVIII, No. 39, September 28, 2013.2 See A. Gulati, J. Gujral, and T. Nandakumar, 2012, “National Food Security Bill: Challenges and Options”, Discussion Paper No. 2, Commission for Agricultural Costs and Prices, Ministry of Agriculture.

The Potential Capital Needs of India’s Commercial Banking Sector1

Although manageable, India’s banks are likely to require significant new capital injections over the next few years, based on the challenging operating environment, combined with the new Basel III capital requirements. The challenges on the business front are embodied in the fast-increasing restructured advances, which now (as of March 2013) comprise 5.7 percent of the banking systems’ gross advances, and 7.1 percent of the Public Sector Banks’ (PSBs) advances. Restructured assets are usually not considered ‘non-performing’ in India, and their rapid rise has led some observers to doubt the publicly displayed financial strength of many Indian banks. Here we stress-test the banks’ capital position with regard to sudden deterioration in loan quality, and evaluate the impact of Basel III requirements via a dynamic simulation approach.

A stress test of banks’ balance sheets found the PSBs in particular vulnerable to a change in classification on a significant share of restructured loans to non-performing assets (NPAs). Each bank’s balance sheet was stressed individually, based on 45 percent of restructured advances moving to NPAs, and those NPAs being provisioned against loss at a minimum 60 percent.2 3 All banks are compared with regards to their Tier 1 capital ratio and their ratio of impaired loans after provisions. As of March 2013, the average Tier 1 ratio is more than 3 percent higher for private sector banks than for public banks, with private banks’ impaired-loans-to-provisions ratio almost 1.4 percent lower. Moving from the March 2013 data points to the post-stress data, the average Tier 1 ratio decreased by about 1.7 percent for the PSBs, and less than 0.4 percent for the private sector banks, respectively. Mean impaired loans after provisions increased by almost 1.4 percent for PSBs, and less than 0.3 percent for private banks. The figure below also shows how the banks location in Tier 1 - Impaired Loans after Provisions space shifts, with the PSBs moving significantly to the right.


Loan Impairments across India’s Private and Public Sector Banks

(As of March 2013 and post-stress event)

Citation: IMF Staff Country Reports 2014, 057; 10.5089/9781484308257.002.A001

Employing more severe scenario assumptions illustrates the potential for significantly higher potential recapitalization costs for the government. Assuming that both the PSBs’ NPAs and their restructured loans double, with three alternative provisioning ratio scenarios assumed (restructured loans provisioned at 50 percent, both restructured loans and the existing NPAs at 75 percent, and both at 100 percent), and under a 7 percent Tier 1 target capital ratio for all PSBs, Table 1 illustrates these results. In the most severe case, the government’s share of the recapitalization cost would amount to 5 percent of FY2012–13 GDP.

Table 1.

Cost of PSB Recapitalization under Severe Stress

(In percent of 2012–13 GDP)

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Source: Bankscope and IMF staff calculations.

The additional bank capital that will need to be raised for the PSB’s based on Basel III capital requirements will likely be moderate (Table 2). The capital needs of banks will increase with faster credit growth, and with the amount that banks desire to hold above the March 2018 Tier 1 capital ratio of 7 percent. For alternative values of this cushion—0, 1, and 2 percent—and using return on assets (ROA) or return on equity (ROE) as the profit driver, the cost for the central government does not exceed 2 percent of FY 2017–18 GDP.4 The cells reflecting results of scenarios deemed more plausible are highlighted in Table 2.

Table 2.

Indian Banks’ Recapitalization Costs under Basel III: Additional Capital Requirements as Percent of 2018 GDP1/2/

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Source: RBI, BankScope, Staff calculations

Simulations based on 2012 data (except ROA and ROE, where 2011 & 2012 averages are used)

A 15 percent transition rate from restructured loans to NPAs is assumed

Numbers equal Equity Tier 1 ratio plus Capital Conversation Buffer plus additional cushio of 0, 1, or 2 percentage points

1 Prepared by Peter Lindner (MCM).2 The average provisioning ratio of private sector banks is slightly above 60 percent; this provisioning ratio was used as a minimum. If a bank’s provisioning ratio for 2012/13 exceeded that number, its actual number was used.3 Historically, about 15 percent of restructured advances have moved into NPAs, with the authorities having used a maximum 30 percent transition rate in their stress tests.4 Simulations are based on stock values at end-March 2013; returns and other flow variables are averaged across fiscal years 2012 and 2013.
Table 1.

India: Millennium Development Goals, 1990–2012 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, 2009/10–2014/15 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 2013/14, as of December 5, 2013.

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, 2009/10–2014/15 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, 2009/10–2013/14 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.

Table 5.

India: Central Government Operations, 2009/10–2014/15 1/

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

Data for April - March fiscal years

In 2010/11 and subsequent years, auctions for wireless spectrum are classified as sale of nonfinancial assets.

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

Pensions are included under expense not otherwise classified.

Includes subsidy-related bond issuance.

Other expense includes purchases of goods and services.

Debt securities include bonds and short-term bills, as well as loans.

External debt measured at historical exchange rates. Inclusive of MSS bonds.