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 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 continued weakness in economic activity. Industrial production (IP) shrank by 2.1 percent y/y in November, following a 1.6 percent decline in October, as consumer durables contracted by double-digits. Capital goods production and mining remain weak. Both manufacturing and services PMIs declined in December, with services PMI remaining in a contractionary zone for six consecutive months.
2. Headline CPI inflation has moderated, but core CPI inflation remained flat. In December, headline CPI inflation declined to 9.9 percent y/y due largely to easing vegetable prices, while core CPI inflation remained flat at about 8 percent y/y. WPI inflation also declined to 6.2 percent y/y due to a moderation in food prices, even as core WPI inflation ticked up to 2.8 percent y/y. Market participants appear evenly split between those expecting higher rates, and those expecting unchanged rates, at the Reserve Bank of India’s (RBI) January 28 monetary policy review.
3. The trade deficit widened in December, but robust capital inflows have allowed a build up in international reserves. The trade deficit widened to US$10.1 billion from US$ 9.2 billion in November. Imports continued to contract (15.2 percent decline y/y in December) reflecting weak domestic demand, while export growth slowed to 3.5 percent y/y from 5.9 percent y/y in November. International reserves now stand at US$ 293 billion, about US$ 3 billion higher than the stock of reserves held on May 22, 2013. This rise in reserves can largely be attributed to flows obtained through the RBI’s foreign exchange swap window (non-resident Indian foreign currency deposits and banks’ foreign currency borrowings) and equity inflows. Furthermore, net portfolio investment inflows (both equity and debt) have been about US$ 7 billion since early-December.
4. The Patel Committee (PC) in its report submitted to the Governor of the RBI on January 21, 2014, has called for a complete overhaul of the monetary policy framework in India. It has recommended that inflation, as measured by all-India headline CPI inflation, should be the nominal anchor for the monetary policy framework. The focus on headline CPI, despite a large weight on food and fuel inflation in CPI, is considered a critical prerequisite for reducing and anchoring inflation expectations. Subject to the establishment and achievement of the nominal anchor, monetary policy should be consistent with a sustainable economic growth and financial stability. The PC’s recommended target for inflation is 4 percent with a +/- 2 percent band around it, with the target to be formally adopted after inflation is brought down to 8 percent over a period not exceeding the next 12 months and to 6 percent over a period not exceeding the next 24 months.
5. To enhance monetary policy transmission, the PC report recommends a phased refinement of the current operating framework of monetary policy, liquidity management and its instruments in particular. The overnight repo rate should continue to be a single policy rate, and the weighted average call rate the operating target. However, RBI’s liquidity operations should be geared toward greater use of auctioned term repos (tenors up to three months) and as they gain acceptance among market participants for liquidity management, the 14-day term repo rate should serve as the operating target. In addition, the PC has recommended reducing the Statutory Liquidity Ratio, consistent with the path of fiscal consolidation, to a level fitting the requirements of the liquidity coverage ratio prescribed under the Basel III framework. The PC report proposes establishing a monetary policy committee (MPC), to enhance formulation, transparency, and accountability of monetary policy. The MPC would be chaired by the RBI Governor and comprise both internal and external members. The report also identifies the need to reduce the fiscal deficit to 3 percent of GDP by 2016/17, and calls for a commitment from the Government to eliminate administered setting of prices, wages, and interest rates as key institutional requirements for effective monetary policy transmission.
6. The RBI has mandated banks to make additional provisions for unhedged foreign currency exposures from April 2014. The RBI will require banks to make additional provisions if the estimated loss from unhedged exposure exceeds 15 percent of the company’s earnings before tax, interest and depreciation (EBITDA), progressively raising the provision as estimated losses increase.