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. On behalf of our authorities, we would like to thank staff for a thoughtful, comprehensive and balanced assessment of recent macroeconomic and financial sector developments in India and the evolving outlook. The report reflects the constructive and candid discussions that the Mission had with our authorities. Our authorities broadly share the staff’s assessment.
2. India was impacted by the turmoil in the global financial markets on the back of tapering concerns in mid-2013. With a swift and decisive policy response, India was able to minimize the fallout on the real economy and maintain financial stability. The authorities acted to contain the current account deficit significantly, which is expected to be financed comfortably through sustainable capital flows. The fiscal deficit has also been reduced and our authorities are committed to pursuing the path of fiscal consolidation. The country continues to face a challenging domestic macroeconomic situation as growth has slowed down while inflation remains elevated. However, supply side pressures are easing due to the good monsoon during 2013-14.
3. Our authorities are determined to tame inflation, revive the growth impulses in the short run and put the economy back on a high growth trajectory over the medium term.
Recent Macroeconomic Developments
GDP Growth and Short-term Outlook
4. GDP growth picked up, though modestly, to 4.8 per cent in Q2 (July-September) of the fiscal year 2013-14 (the Indian fiscal year is from April to March). Growth in the first half of the fiscal year has been placed at 4.6 per cent. This is indeed disappointing when seen against India’s growth record averaging around 8 per cent in the previous 10 years. However, indications are that the growth has bottomed out and our authorities expect it to be better in the second half on account of rebound in agriculture and improved export performance. The early and good monsoon will have a positive impact on rural demand, besides boosting hydro electricity generation. A fuller recovery is likely to start taking shape towards the end of the fiscal year when the recent measures initiated to clear the logjam constraining economic activity and investment work through the various inter-sectoral linkages in the economy. India’s exports during 2013-14 are expected to grow in double digits, benefiting from the improved global growth prospects. The market sentiment has also improved, which is reflected in a sharp rise in stock markets. The Reserve Bank of India has projected GDP growth at 5 per cent for 2013-14.
5. The near term outlook beyond the current year is expected to improve on account of several factors. Many of the constraints to growth such as bottlenecks in project implementation, shortage of coal and iron ore, and delay in environmental and regulatory clearances are being actively addressed. The Cabinet Committee on Investment (CCI) has cleared projects amounting to about 5 per cent of GDP. Most of the liquidity tightening measures taken during July-August 2013 in the wake of financial markets turbulence, which possibly had some impact on growth, have by and large been rolled back. All these developments should have a positive impact on the near term outlook.
6. One data issue has had an impact on ongoing growth estimation. Contemporaneous estimates of industrial production are dependent on the Index of Industrial Production (IIP). The preliminary data from this index have, in recent years, been found to underestimate industrial growth as exhibited by the more comprehensive Annual Survey of Industries (ASI), and hence, overall GDP growth. Whereas the IIP is compiled contemporaneously on a monthly basis, the ASI is an annual survey whose results become available with a lag. For instance, the results from the comprehensive ASI, which have now become available for 2011-12, suggest that industrial production increased by over 10 per cent as compared with the preliminary data indicating a growth of 3 per cent. Likewise, industrial production based on ASI during 2010-11 and 2009-10 increased by around 13 per cent and 10 per cent respectively as compared with the IIP estimates of 8 per cent and 5 per cent, respectively. Consequently, the GDP estimates for 2009-10 and 2010-2011 were revised - from 7.2 per cent to 8.6 per cent for 2009-10 and from 8.6 per cent to 9.3 per cent for 2010-11. Our authorities, therefore, believe that final GDP growth estimate for 2011-12 and following years will also be higher than the current estimates.
7. The World Bank in its recently released Global Economic Prospects (GEP) projects India’s GDP growth for 2014-15 at 6.2 per cent vis-a-vis 5.4 per cent by the IMF in its January 2014 WEO Update as also in the 2014 Article IV Report. The IMF’s WEO and World Bank’s GEP estimates for almost all large countries are similar, except for India. Also, as per the projections of GEP, India will see the strongest recovery among major developing economies between 2013-16.
8. Elevated and persistent inflation remains a cause of serious concern. While wholesale price inflation has exhibited some moderation, retail inflation, which is dominated by food items, has continued to remain high. To contain inflation and anchor inflation expectations, the Reserve Bank of India (RBI) raised the policy repo rate by 50 basis points during August-October 2013 even when growth had slowed down. However, the RBI decided to pause in December 2013 to avoid over-tightening given a weak state of the economy and the significant output gap. It is comforting that most recent data suggest moderation in both wholesale and retail inflation. As supply pressures ease, and supply management improves, food inflation is expected to moderate further.
9. With the availability of the new all India consumer price index (CPI), the Reserve Bank is now endeavoring to move the dialogue in favor of CPI as a part of its communication strategy. The Expert Committee to Revise and Strengthen the Monetary Policy Framework set up by the RBI, submitted its report recently. It has made many recommendations. These, among others, include the proposal that inflation should be the nominal anchor for RBI’s monetary policy framework. Consequently, it suggests that RBI should adopt the new CPI (combined) as the measure of the nominal anchor for policy communications.
10. As the elevated fiscal deficit posed a major challenge to the economy, our authorities have committed to reduce it in a calibrated manner and have taken some politically tough decisions. The government has persevered with regular monthly increases in diesel prices to reduce the diesel subsidies in a phased manner. The fiscal performance in 2012-13 was better as the actual gross fiscal deficit declined to 4.9 per cent of GDP in 2012-13 as against the budgeted level of 5.1 per cent. For 2013-14, our authorities have budgeted the gross fiscal deficit at 4.8 per cent of GDP. Our authorities remain committed to contain the gross fiscal deficit to the budgeted level.
11. The Unique Identification Number (UID) or Aadhar is expected to avoid leakages and hence savings on subsidies. So far, over 400 million Indians have been issued Aadhar numbers. Over 23 million bank accounts have been linked to Aadhar numbers.
12. The fiscal implications of the Food Security Act entail an incremental budgetary allocation of Rs 100 billion in budget estimates (BE) for 2013-14, which is the first year of its implementation. The legislation came into effect during the current year, hence only a partial roll out could be put in effect. The food subsidy costs calculations in the Report assume full implementation in the entire country in the current year. For this to happen the State Governments need to adopt it and they also have to prepare the implementation mechanism. The Central Government would be providing adequate funds in a caliberated manner depending upon field level requirements. Presently, it is estimated that the FY 2014-15 requirement would be limited to Rs 1,200 billion, as compared with the full estimated food subsidy of Rs 900 billion in 2013-14.
Monetary and Exchange Rate Policies
13. India’s forex market came under pressure during May-August 2013 on account of capital outflows following the talk of tapering of quantitative easing. The forex market has since stabilized. As a result, most of the measures taken to stabilize the forex market have been rolled back. Responding to the various policy measures taken by the authorities to contain gold imports and improved export performance, the current account deficit narrowed down sharply to 1.2 per cent of GDP in Q2 of 2013-14 from 4.9 per cent of GDP in Q1 of 2013-14 and 5.0 per cent of GDP in Q2 of 2012-13. Our authorities believe that the CAD in 2013-14 will be less than the staff estimate of US $ 61 billion (3.3 per cent of GDP) for 2013-14. The recent narrowing of the trade deficit should bring the CAD to a more sustainable level, i.e., less than US $ 50 billion (less than 3 per cent of GDP) for the year as a whole.
14. In addition to containing the current account deficit, efforts have also been made to make the Indian economy more resilient by building buffers. Foreign exchange reserves have been replenished by mobilizing US $ 34 billion by way of non-resident Indian (NRI) deposits and bank borrowings in the international market. India’s foreign exchange reserves, now at US $ 292 billion, are comfortable in terms of various reserve adequacy criteria. While India may still be vulnerable to debt outflows on account of disorderly exit from quantitative easing by major central banks, this risk has been mitigated due to the containment of the current account deficit, reduction in the stock of the volatile component of capital flows, and an increase in foreign exchange reserves. Therefore, India is now in a much better position to deal with capital outflows should they take place. The enhanced currency swap arrangement with Japan for US $ 50 billion provides India an additional buffer to deal with any potential external sector shock.
15. It needs to be recognized that bulk of the outflows by Foreign Institutional Investors (FIIs) of over US $ 10 billion during June-August 2013 were of debt, out of a debt stock of US$ 37 billion (as at end-May 2013). Equity portfolio outflows were much lower at US $ 3.8 billion, out of a stock of US $ 141 billion (as at end-May 2013). Significantly, equity outflows have been more than offset by large inflows in the subsequent period. In the past five years, foreign institutional investors have invested over US$ 90 billion in the equity market. FDI flows to India have also remained stable in the recent period. This clearly suggests that long-term investors continue to have faith in India’s growth prospects, and it is debt investors who are more fickle. This observation has relevance for the general IMF advice related to the opening of debt flows.
16. India’s banking sector continues to be sound and healthy. Although NPLs of the banking sector have risen in the recent period, they still remain at a manageable level. Moreover, banks are maintaining adequate provisions. In order to ensure that NPLs do not grow further, banks have been advised to put in place a robust mechanism for early detection of signs of distress. Banks in India remain adequately capitalized. The stress tests conducted by the IMF assume that 45 per cent of all restructured advances would turn into NPAs. This assumption is unrealistic as the past historical average is at around 15 per cent. The stress scenario should not only be severe but also plausible. Similarly, the restructured to substandard NPA category conversion should attract the specific provisioning requirement as applicable to sub-standard assets instead of average provisioning of 60 per cent assumed by staff. Therefore, our authorities feel that the RBI’s approach whereby 30 per cent of restructured assets turn into NPAs, which is twice the historical average, is conservative enough. Based on this assumption, the capital needs of banks will be significantly lower.
17. Concerns have been expressed regarding the treatment of restructured assets. The RBI has announced that asset classification/provisioning relaxations in respect of restructured assets will be phased out by April 1, 2015. As a prudential measure, banks are now also required to have capital and provisioning requirements for their exposures to entities with unhedged foreign currency exposure.
18. Staff has indicated that the vulnerability of the banking sector is aggravated by concentration risk: their report mentions that banking sector loans to India’s ten largest conglomerates account for almost 100 per cent of banks’ net worth. The source of this market sensitive information is not the RBI. Therefore, one is not sure as to how much reliance can be placed on the inference drawn based on this information, which is not in the public domain. In any case, such a number becomes relevant only under the premise of correlated default. However, most of the large corporates are well diversified as a result of which they are in a better position to face the business cycle swings.
19. Several measures have been initiated to strengthen the regulatory and supervisory framework of banks. The Basel III capital regulation has been implemented in India from April 1, 2013 in phases. Additional capital requirements on account of Basel III, as is also estimated by staff, are likely to be manageable. It may be noted that in order to ensure that the public ownership of banks does not in any way hamper the growth of public sector banks, our authorities have capitalized public sector banks to the extent of Rs. 477 billion over last five years and another Rs. 140 billion will be infused during 2013-14.
20. The spread of financial inclusion among the uncovered segments of households and businesses has been a major policy objective for a long time. The Reserve Bank is examining the recommendations of the Committee on Comprehensive Financial Services for Small Businesses and Low Income Households, which submitted its report recently.
21. To raise the long-term growth potential of the economy, our authorities have introduced several structural reforms. The projects cleared by the CCI, as alluded to earlier, should improve the overall investment climate. We have moved a step closer to the introduction of the Goods and Services Tax with the Ministry of Finance having accepted all the recommendations of the Parliament Standing Committee on Finance. Some long-pending bills in the Parliament have been passed. FDI policy has been liberalized. The investment policy regime has been improved across a number of sectors. New land policy guidelines have been formulated for 12 major ports in the country that will help them to undertake various development projects. Construction work on the railways’ dedicated freight corridor has been initiated. To encourage financial savings by the household sector, Inflation Index Bonds (IIB) have been introduced. The National Transport Development Policy Committee (NTDPC) set by the Government is likely to submit its report shortly. This should pave the way for wide-ranging reforms in the transport sector.
22. Notwithstanding the recent growth slowdown, India’s long-term productive capacity and potential have not been much affected. It is only some supply bottlenecks that have temporarily affected the investment activity. These bottlenecks as alluded to earlier have been addressed to a significant extent. Once investment activity revives, India should be able to quickly regain its long-term growth potential. We reiterate that staff’s estimates of potential growth seem to focus on the very near-term growth prospects of the economy. They, therefore, vary annually and are sensitive to choice of methodology. Potential growth is a medium to longer-term concept. As such, potential growth reflects underlying structural trends rather than cyclical variations and year-to-year shifts and events.
23. The recent period has been challenging for the Indian economy. Even as our authorities were grappling with slow growth and persistent inflation, our economy, like many other emerging market economies, had to contend with the turbulence in financial markets. In particular, India’s currency came under pressure due to its high current account deficit. However, through deft handling, India was able to quickly restore stability in the forex market. India’s elevated current account deficit has been addressed, while the fiscal deficit is on a downward path. Swift and quick policy response during difficult times has been the hallmark of India’s policy making. Our authorities, however, have been conscious of the several challenges that remain. Elevated and persistent inflation continues to pose a major macroeconomic challenge. Another major challenge is to revive investment activity and put the Indian economy back on a high growth trajectory.