India: Staff Report for the 2016 Article IV Consultation

International Monetary Fund. Asia and Pacific Dept

doi:10.5089/9781513524306.002.A001

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India: Staff Report for the 2016 Article IV Consultation

Author: International Monetary Fund. Asia and Pacific Dept

Publication Date:: 02 Mar 2016

eISBN:: 9781513524306

ISBN:: 9781513524306

Language:: English

Keywords:: ISCR; CR; net portfolio investment outflow; market price; outflow; food inflation; short-term debt; U.S. dollar; buffer stock; crowding in; commercial bank

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The Indian economy is on a recovery path, helped by a large terms of trade gain, positive policy actions, improved confidence, and reduced external vulnerabilities. A faster-than-expected decline in inflation created space for nominal policy rate cuts. Persistently high inflation expectations and large fiscal deficits remain key macroeconomic challenges, resulting in limited policy space to support growth through demand management measures. In addition, supply bottlenecks and structural challenges constrain medium-term growth and hinder job creation. Risks are weighted to the downside, with external risks mainly from intensified global financial market volatility and slower global growth. On the domestic side, a further weakening of bank and corporate balance sheets could pose risks to economic recovery and weigh on financial stability, while setbacks in the pace of structural reforms could dampen growth and undermine sentiment. In contrast, lower-for-longer global energy prices constitute an upside risk for India.

Abstract

Context

1. The Indian economy is on a recovery path, supported by a large terms of trade gain (about 2½ percent of GDP) and reduced external vulnerabilities, though downside risks remain. After bottoming at 5.1 percent in FY2012/13, the economy has been on a gradual cyclical recovery, reaching 7.3 percent growth in FY2014/15 with a revival of sentiment. ¹ ² Since late 2014, a halving of global oil prices has boosted economic activity in India and underpinned a further improvement in its current account and fiscal positions, and engendered a sharp decline in inflation (Boxes 1 and 2).³ As a result of further-reduced external vulnerabilities, improved growth prospects, and continued monetary accommodation in advanced economies, India has experienced large FDI and portfolio capital inflows, a real appreciation of the rupee, and a robust rebound in foreign exchange reserves in FY2014/15. Nonetheless, despite better growth prospects, India faces the risk of capital flow reversals and should guard against the buildup of domestic vulnerabilities.

2. Important economic and structural reforms have been initiated, but further reforms are needed to boost India’s growth potential. Following its election victory in May 2014, the Bharatiya Janata Party (BJP)-led government of Prime Minister Narendra Modi has gradually introduced numerous economic reforms (see Annex I and Box 3), including subsidy reforms, steps to create more flexible labor and product markets, agricultural reforms (including the new crop insurance scheme), enhancing financial inclusion, relaxing FDI limits in several key sectors and improving the ease of doing business, raising Foreign Portfolio Investment limits in public debt securities, and increasing public infrastructure spending. Flexible inflation targeting was also adopted by the Reserve Bank of India (RBI) in February 2015. Nonetheless, in the last two sessions of Parliament the passage of key legislation, including the long-planned goods and services tax, was not secured given the lack of BJP control of the upper house of Parliament.

3. Notwithstanding the cyclical pickup, medium-term growth continues to be constrained by supply-side bottlenecks and weaknesses in the corporate and banking sectors. Past weak economic growth and delays in implementing infrastructure projects have placed pressure on banks’ asset quality (particularly at state-owned banks that lent heavily to infrastructure companies). Corporate vulnerability indicators remain elevated. Long-standing supply-side bottlenecks, especially in the energy, mining and power sectors, continue to weigh on India’s growth potential.

4. Past Fund advice and the authorities’ macroeconomic policies have been broadly aligned, but progress on structural reforms has been partial. There has been substantial fiscal consolidation in recent years (although it has paused in FY2015/16), and staff supports the improvement in quality of fiscal adjustment this year with its welcome emphasis on public investment. Excise duties on petrol and diesel have been raised, important kerosene and LPG subsidy allocation and distribution reforms have been pursued, and some progress has been made on reducing and rationalizing fertilizer subsidies, broadly in line with previous IMF advice. The stance of monetary policy was appropriately tight in 2014/15 to reduce inflation along the RBI’s “glide path”, consistent with Fund advice. The RBI has adopted a flexible inflation targeting regime, with headline CPI inflation the principal nominal anchor for monetary policy. Progress on land and labor market reforms has been limited, though some market reforms have been initiated by the center and a few states.

Outlook And Risks

5. India’s growth outlook has improved, despite new headwinds. In the near term, economic recovery is expected to continue to be underpinned by private consumption (which has benefited from lower energy prices and higher real wages). Policy credibility has also strengthened, with continued fiscal consolidation and a tight monetary stance. With the revival of sentiment and picking up of industrial activity, an incipient recovery of private investment is expected to help broaden the recovery. Higher public infrastructure investment and government initiatives to unclog stalled investment projects and support the lending capacity of state-owned banks should also help crowd-in private investment (Box 4).⁴ ⁵ Real GDP growth is forecast at 7.3 percent in FY2015/16, further accelerating to 7.5 percent in FY2016/17, supported by recovery in domestic demand. Nonetheless, anemic exports as well as headwinds from weaknesses in India’s corporate financial positions and public bank balance sheets will weigh on the economy. In the presence of continued supply-side bottlenecks, and assuming no substantial legislative initiatives, medium-term growth is projected to remain at around 7¾ percent.

6. Despite a sharp reduction in inflation over the past year, medium-term inflationary pressures and upside risks to inflation remain. Headline CPI inflation declined to 5.6 percent in December 2015, down from an average of 10 percent during 2009-13, reflecting economic slack, the RBI’s tight monetary policy stance, lower global commodity prices and government efforts to contain food inflation (through release of surplus grain buffer stocks and low minimum support price increases in agriculture) (see Box 5). Although the 6 percent inflation target for January 2016 is expected to be met, upside risks to inflation for FY2016/17 stem from an unfavorable monsoon and implementation of the pay review of government employees.⁶⁷ Given food supply constraints and the ingrained nature of household inflation expectations (which remain near double-digits), inflation is expected to remain close to the upper limit of the RBI’s medium-term inflation target band (4 percent CPI inflation ± 2 percent).

7. The current account deficit (CAD) has narrowed further, helped by sharply lower commodity import prices. From a high of 4.8 percent of GDP in FY2012/13, the CAD has compressed sharply to an average of 1.5 percent of GDP in the past two years. This narrowing was helped by a policy-induced fall in the volume of gold imports and, more recently, by lower commodity prices (see Box 6).⁸ Notwithstanding the recent export slowdown, continued low global oil prices should help contain the CAD.⁹ The CAD is expected to widen to 2½ percent of GDP over the medium term as domestic demand strengthens further and commodity prices gradually rebound. However, the sluggish global economic growth outlook and recent rupee appreciation in real effective terms pose headwinds to an export growth recovery for India (see Box 7).

8. Bank credit growth remains anemic, reflecting demand and supply factors, including high corporate leverage and weak bank asset quality. Although private banks (one-quarter of banking system assets) are well capitalized, profitable, and have low NPAs and limited exposure to troubled sectors, low profitability and further asset quality deterioration in public sector banks (PSBs) constrain the banking system’s capacity to expand credit. In addition, a thin investment pipeline, reflecting still low capacity utilization in core sectors and areas of high corporate leverage (and recourse of higher-quality borrowers to capital markets), have reduced the demand for bank credit. Further deterioration in asset quality could lower capital levels and thereby weigh on credit supply and the investment recovery. In addition, although capital markets have partly substituted for bank credit, their ability to provide adequate, stable financing for the growth recovery will hinge on investor sentiment, and on further policy measures to deepen capital market liquidity.¹⁰

9. While the balance of risks has clearly improved, economic risks remain tilted to the downside. On the external side, despite the reduction in imbalances and strengthening of buffers, the impact from intensified global financial market volatility could be disruptive, including from unexpected developments in the course of U.S. monetary policy normalization or China’s growth slowdown, particularly against the backdrop of recent large capital inflows.¹¹ Absent disruptive global financial market volatility, slower growth in China would have only modest adverse spillovers to India, given weak trade linkages (see Box 8). Domestic risks include continued weaknesses in corporate financial positions and public bank asset quality, as well as setbacks in the reform process, which could weigh on growth, accelerate inflation and undermine sentiment. On the upside, further structural reforms could lead to stronger growth, as would a sustained period of low global energy prices (see Annex II: Risk Assessment Matrix).

Authorities’ Views

10. The authorities broadly agreed with the staff’s view on the outlook. They agreed that the Indian economy is in the early stage of recovery with some areas of weakness, and—in view of the recovering investment pipeline—project real growth for the current fiscal year at about 7½ percent, rising slightly in FY2016/17. They acknowledged that some indicators, such as the growth of indirect tax receipts, are consistent with economic growth in the 7½ percent range, but they also noted that other high-frequency data, including corporate profitability and capacity utilization, do not corroborate this rate. The RBI estimates the output gap at about -½ of one percent.

11. Nevertheless, the authorities feel they are well prepared to weather any surge in global financial market volatility. The RBI has adequate reserves, including after adjustment for forward contracts, and there remains scope for monetary policy action. There was agreement with staff that exchange rate flexibility has served India well, and the authorities noted that corporate hedging ratios have risen over the past year. Finally, a part of the oil price decline windfall was saved by the government in the form of higher petroleum product excise taxes, and this represents a potential buffer against a spike in global commodity prices.

Key Policy Issues

A. Bolstering Robustness of the Financial Sector

12. Elevated corporate sector risks and weakened bank balance sheets, especially for PSBs, pose headwinds for economic growth. With the corporate sector (non-household lending) accounting for over 80 percent of banks’ credit portfolios, banking sector soundness and its ability to finance investment and growth rest on the financial health of the domestic corporate sector.¹² Corporate vulnerabilities remain elevated, reflecting implementation delays and cost overruns in infrastructure projects, and challenges to effective debt restructuring. The share of debt held by firms with weak debt repayment capacity (interest coverage ratio below one) remains close to a decade-long high, at about 11 percent as of end-March 2015 (see Selected Issues Chapter I). Corporate leverage—particularly among large firms and in a few key sectors—is one of the highest across EMs, reflecting increased reliance on bank funding to meet high capital investment requirements in the late 2000s. Industries subject to greater stress, particularly those with weakened debt servicing capacity—including infrastructure, textiles, iron and steel, and mining—account for nearly one third of banks’ total loans and more than half of banks’ stressed assets. The vulnerability of corporate balance sheets to a sharp rupee depreciation remains elevated (see Box 9), but it is partly mitigated by increased hedging against FX movements.¹³

13. Public sector banks continue to face asset quality difficulties, contributing to a slowdown in credit expansion. The share of PSBs’ stressed assets—including gross non-performing assets (NPAs) and restructured assets—in total advances continued to increase to 14.1 percent at end-September 2015 (of which NPAs stand at 6.2 percent), from 12.9 percent a year earlier.¹⁴ Weaker credit quality, due in part to poor governance and lack of commercial incentives, has kept PSBs’ profitability depressed, with ROA of around 0.4 percent in the past two fiscal years, below the 0.8 percent average in the preceding three years, and well below the 1.7 percent ROA of private sector banks. While provisioning for stressed assets has increased gradually over time, there are still concerns about possible underprovisioning, with average NPA provisioning of about 40 percent. In addition, the need for capital preservation, given eroding asset quality, has accounted for a marked slowdown in credit growth at PSBs to 6.1 percent year-on-year as of end-June 2015 (alternatively 7.4 percent as of end-FY2014/15), down from 14.0 percent at end-FY2013/14. While PSBs’ credit growth is expected to remain muted, its impact on growth is lessened by the relatively low credit intensity of the Indian economy and the pick-up in nonbank financing.¹⁵

14. PSBs’ capital augmentation needs are expected to be manageable, but may require further fiscal outlays. Under a stress scenario assuming a transition of 15 percent of restructured loans to NPAs and an extra capital cushion of 2 percentage points, PSBs’ capital needs are estimated to account for 2.9 percent of FY2018/19 GDP (cumulatively over the next four years), with a government share of 1.9 percent of FY2018/19 GDP (see Box 9, Annex III, and Selected Issues Chapter I).¹⁶

15. Full recognition of risks on PSBs’ balance sheets, adequate capitalization, and further governance reforms are critical for strengthening the banking sector going forward. In this regard, staff recommends the following policy measures:

Phasing out remaining forbearance. New regulations (as of April 1, 2015) curb considerably banks’ ability to resort to forbearance by requiring banks to classify new restructured loans as NPAs, and hence provision appropriately. However, there are still certain exemptions, including on postponing reclassifications of restructured loans on projects with delayed implementation schedules (projects deemed to be viable but with temporary problems), and on extending amortization schedules of classes of loans (provided there is no change in present value terms).
Bank recapitalization. To support PSBs’ current lending capacity, the authorities should consider larger government capital injections in PSBs and some divestments of banks’ non-core assets. The government’s capital injections in PSBs per the Indradhanush plan (August 2015) are quite modest in scale (0.3 percent of FY2018/19 GDP cumulatively over the next four years), and largely leave recapitalizations up to the ability of affected PSBs to raise capital in the markets.
Corporate debt restructuring. To boost corporate loan recovery, banks are now allowed (under the Strategic Debt Restructuring (SDR) scheme) to convert corporate loans into equity if debtors cannot meet debt restructuring plans. Debt-to-equity conversions are only a partial solution, given high corporate leverage ratios and hence limits on debt recovery. The authorities should continue to place priority on improving corporate debt restructuring mechanisms, including the formal insolvency framework (passage of the new Insolvency and Bankruptcy Bill and the Company Law Tribunals) and out-of-court debt restructuring (introduction of robust mechanisms for both operational and financial restructuring). These initiatives would build upon the LEG-provided capacity building assistance in these areas.
PSB governance reforms. The authorities should follow through on the Indradhanush plan’s commitment to structural reforms, including on enhancing PSBs’ corporate governance, risk management practices and accountability.

16. The Indian government remains fully committed to enhancing financial inclusion. Its financial inclusion agenda has broadened over the past year (see Box 10). The government’s proposed introduction of gold monetization schemes is also, in part, meant to boost financial intermediation by channeling domestic gold holdings to gold savings accounts (see Selected Issues Chapter III). Continued emphasis on increasing transactional volumes on Pradhan Mantri Jan-Dhan Yojana (PMJDY) accounts by expanding the range of provided financial services (including Aadhaar-supported¹⁷ direct benefit transfers), and linking these to new technologies (e.g., via use of mobile solutions), and potentially provided by the newly-formed payments banks, would support financial inclusion.

17. Additional measures would help maintain financial stability and enhance the contribution of the financial sector to growth. Staff supports the following measures:

Facilitating further deepening of the domestic corporate bond market, including, among others, by developing robust bondholder protection mechanisms, improving liquidity in the secondary market, and rationalizing stamp duties on bond issuances. Easing investment restrictions on domestic institutional investor classes would be important to support the development of a broader investor base.
Enacting a further gradual reduction of banks’ statutory liquidity requirement (SLR), as the government’s fiscal deficit declines, to facilitate more private sector lending. The Indian government has been gradually reducing the SLR rate (currently at 21.5 percent, down from 25 percent of deposit liabilities in mid-2008), and plans to reduce the ratio to 20.5 percent by January 2017.¹⁸

Authorities’ Views

18. The authorities recognized the challenges of addressing corporate balance sheet stress. They emphasized their efforts to strike a balance between creating room on bank balance sheets and instilling payment discipline. Several schemes have been introduced to promote debt restructuring, including the recent Ujwal Discom Assurance Yojana (UDAY) power sector scheme¹⁹ for electricity distribution companies (November 2015), while forbearance has been phased out, with any debt restructured under the Corporate Debt Restructuring (CDR) window now requiring provisioning at the same level as NPAs. The emphasis on labeling loan nonpayers as “willful defaulters” has had some effect, and mergers and acquisitions activity is beginning to pick up. Finally, they were very optimistic that the new Bankruptcy Bill (introduced in parliament in December 2015) will close a loophole in the corporate finance architecture, and took note of staff views that the formal bankruptcy set-up needs to be complemented by an appropriate out-of-court settlement framework.

19. There was, however, a general view that the cause of anemic credit growth is mainly inadequate demand. To some extent the commercial paper market and non-bank financial intermediaries have taken up some of the slack, but anemic investment and the slow recovery of private sector borrowing suggest that the investment cycle has yet to definitively turn. The authorities also agreed with staff’s view that the fiscal cost of recapitalizing PSBs will be modest. They noted that strong steps are being taken to improve corporate governance in PSBs, which should help to reduce the flow of new bad assets going forward. Finally, the authorities are looking forward to the upcoming 2016/17 FSAP for inputs on how to continue building a financial system that is efficient and inclusive. They also urged staff to carefully review the upcoming Financial Stability Board (FSB) Peer Review of India (due by September 2016), to avoid duplication of effort in the FSAP.

20. The authorities also noted that, in the presence of elevated corporate and banking sector strains, they have taken extensive measures to safeguard financial stability. These include: the withdrawal of forbearance by requiring banks to classify and provision restructured loans as NPAs; monitoring closely likely NPAs via the Central Repository of Information on Large Credits (CRILC); and encouraging corporate debt restructuring and strategic debt restructuring. They underscored that extensions of loan amortization schedules under current regulations should not be construed as forbearance, given that these pertain to the refinancing of projects (in infrastructure and core industries) that do face any credit weakness. Overall, the authorities emphasized that the recent policy measures seek to induce a structural change in project financing, including a shift to long-term structured financing and a change in banks’ mindset to ensure that project financing is carried out per international best practices.

B. Complement the New Monetary Policy Framework with Structural Policies to Durably Reduce Inflation

21. The collapse in global commodity prices, a range of supply-side measures, and a relatively tight monetary stance have resulted in a faster-than-expected decline in inflation. Although core inflation declined from an average of 9½ percent during 2011–13 to around 5 percent by mid-2014, it has remained relatively sticky since. Near-term headline CPI inflation dynamics will continue to be underpinned by supply-side factors which, despite the subpar crop outlook, should help achieve the RBI’s 6 percent inflation target for early 2016. Notwithstanding the 125 basis points nominal policy rate cut in 2015, monetary conditions remain consistent with achieving the inflation target of 5 percent by March 2017.²⁰ However, in light of upside risks to inflation, the authorities should stand ready to raise the policy rate if inflationary pressures gather pace.

22. Adoption of a flexible inflation targeting regime by the RBI provides a robust institutional foundation for maintaining price stability in an increasingly complex economy. With the formal adoption of flexible inflation targeting in February 2015, the presence of a well-defined nominal anchor and a clear policy objective has strengthened policy formulation. The RBI also took further steps to improve communication, and to enhance monetary transmission²¹ and structural liquidity management. Nonetheless, bringing down inflation expectations of the general public and anchoring them at a lower level has proven challenging, as food inflation propagates rapidly into non-food inflation, and household inflation expectations remain near double digits.²² Breaking away from the adaptive nature of Indian inflation expectations will likely require a prolonged period of low inflation, underpinned by a continued anti-inflationary monetary policy stance.²³

23. Introducing durable supply side measures, continued fiscal consolidation, relieving impediments to monetary transmission, and finalizing a robust Monetary Policy Committee (MPC) are prerequisites for low inflation in the medium term. Staff views the medium-term 4 percent inflation target adopted by the RBI as broadly appropriate. However, in view of India’s large weight on food in its CPI basket and structurally-high food inflation, achieving this target on a sustained basis will require ramping up food supply commensurate with strong consumption demand. Further structural reforms to increase food production are needed, particularly to accommodate dietary shifts towards more nutritious and protein-based foods associated with growing incomes.²⁴ Staff sees scope for improving food grain buffer stock management, and for increasing investment in storage and distribution infrastructure for perishable produce. A strong institutional design of the RBI’s MPC, supporting credible monetary policy making, remains paramount for the success of the new monetary framework, as does further reducing impediments to monetary transmission (including administered interest rates on small savings schemes) and continued fiscal consolidation.²⁵

Authorities’ Views

24. The authorities acknowledged that achieving their medium-term inflation target of 4 percent would be a challenge in the absence of structural reforms, particularly in agriculture. They agreed with staff that the January 2016 target will be met, and were optimistic that inflation will fall to 5 percent by early 2017. In addition the authorities viewed household inflation expectations as on a declining trend. In their view, by reducing the policy rate by 125 basis points in 2015 they had implemented an accommodative monetary stance, but emphasized that these rate cuts had been front loaded and further cuts would be contingent on inflation developments and ongoing fiscal consolidation. The authorities also recognized that the recent windfall of lower world oil prices will not be repeated. They pointed out that some portion of food inflation during the past year stemmed from the subpar monsoon, and that it would be unlikely for three monsoons in a row to be so poor. They pointed out that a range of supply side reforms are being undertaken in the agricultural sector that should raise productivity and facilitate price stability.

C. Consolidating the Fiscal Position

25. Although near-term fiscal consolidation has paused, the spending mix has improved. While FY2014/15 Union Budget execution outperformed the target, this was largely achieved as a result of cuts in capital spending to make up for overly optimistic revenue assumptions in the budget. The FY2015/16 Budget targets a fiscal deficit of 3.9 percent of GDP (equivalent to about 4¼ percent of GDP in IMF terms), and will likely be achieved. This deficit is 0.3 percentage points of GDP higher than envisaged in the previous roadmap for fiscal consolidation. While staff would have preferred a deficit path in line with the roadmap, the FY2015/16 Budget contains a welcome emphasis on public investment (0.25 percent of GDP increase over FY2014/15) and a further reduction in fuel subsidies (see Annex V: Subsidy Reform Progress). Nonetheless, given a possible shortfall in disinvestment proceeds, expenditure may again come under pressure. As the expenditure side gains from declining global oil prices have been largely exhausted, the authorities should take the opportunity to continue to raise petroleum-related revenues. Staff recommends that any increased expenditure arising from the Seventh Pay Commission be phased over time.

26. Medium-term fiscal targets have been delayed and appear to be challenging. The achievement of the medium-term Union deficit target of 3 percent of GDP has been deferred to FY2017/18, one year later than previously planned. ²⁶ India’s overall fiscal position remains vulnerable, given that at the general government level the deficit is expected to remain around 6–7 percent of GDP, which is high by global standards, and could pose challenges to durably reducing inflation. Moreover, with the increase in net transfers to states and no offsetting consolidation expected from the states, measures at the center need to be further articulated. Given the absence of clear medium-term fiscal plans, staff’s projections (which are on the basis of current policies and assume no major legislative changes) suggest that the central government will underperform against its fiscal adjustment targets. Also, the lack of a binding medium-term fiscal framework raises questions about the credibility of medium-term consolidation plans. Nonetheless, India’s public debt (with a favorable maturity structure and currency composition, as well as a captive domestic investor base) remains on a downward path and is sustainable (see Annex III: Debt Sustainability Analysis). As in the 2015 Article IV consultation, staff recommends that when fiscal space is rebuilt, future fiscal responsibility legislation should be underpinned by a rule that provides room for counter-cyclical fiscal policy. In the meantime, pro-growth fiscal policy could be practiced by further improving the quality and efficiency of public expenditure.

27. Implementing a robust goods and services tax (GST), improving revenue administration, and undertaking further subsidy reforms are policy priorities. Specifically, staff recommends the following measures:

Tax reform. India’s revenue-to-GDP ratio remains considerably below its emerging market peers. The long-awaited GST should be implemented, as it would create a single national market, enhance the efficiency of intra-Indian movement of goods and services and boost GDP growth. As envisaged by the authorities in the recent Subramanian Committee recommendations, the GST should have minimal exemptions and a moderate single rate. Progress towards a new direct tax code, with smaller and streamlined deductions, would also help. Efforts to improve tax administration (as envisaged in the Tax Administration Reform Commission reports) should be stepped up as the scope for revenue gains is large. Staff supports the Finance Minister’s plans to lower the corporate income tax rate while eliminating exemptions.
Subsidy reform. Overhauling India’s subsidy regime should continue via better targeting, improving efficiency, and reducing distortions. Untargeted food subsidies should be pared back, including by rationalizing the list of eligible beneficiaries and reforming the inefficient Food Corporation of India (FCI)—see Box 5 and Selected Issues Chapter VI. The current approach to non-food subsidy payments, namely direct benefit transfers, increased financial inclusion, and use of the Aadhaar system to better identify beneficiaries, should continue to yield large fiscal savings.

Authorities’ Views

28. The authorities were confident that the central government fiscal deficit target for this year will be met. They noted that revenue performance has been healthy, and reforms to the timing of public infrastructure spending make bunching of expenditures at the end of the fiscal year somewhat less likely. Lower world oil prices have given India the opportunity to recast its fuel subsidy architecture, eliminating waste while focusing scarce resources more effectively on the truly needy. The authorities pointed to high-quality reforms to gasoline, diesel, LPG, kerosene and fertilizer subsidy programs that, even as recently as three or four years ago, were unimaginable.

29. While acknowledging that meeting the deficit targets for FY2016/17 and beyond will be challenging, the authorities did not agree that fiscal adjustment has paused this year. They noted that the Seventh Pay Commission mandate, combined with the need to kick-start the investment cycle with public infrastructure spending, could make it difficult to achieve the deficit target of 3½ percent of GDP for FY2016/17. The GST is not likely to be implemented quickly, certainly not from the previously-planned April 2016, although it will support revenue performance over time. Even though the rate structure of the GST is likely to be revenue neutral, the authorities anticipated that a good GST design will support revenue administration improvements by encouraging firms to join the formal economy to take advantage of input tax credits. The authorities took note of staff’s view that continued fiscal adjustment remains appropriate, given India’s still-high general government deficit, even after recent consolidation efforts, though they argued that India’s revenue/GDP ratio is comparable with countries having a similar level of per capita GDP.

D. Maintaining External Stability

30. India’s external position is broadly consistent with medium-term fundamentals and desirable policy settings, and reserves are assessed to be adequate (Box 11 and Annex IV: Assessing Reserve Adequacy). International reserves have increased by $48 billion since April 2014, standing at US$352 billion at end-December 2015 (slightly above 150 percent of the Fund’s reserve adequacy metric and around 8 months of import cover).²⁷ The build-up of reserves was driven by robust capital inflows (both FDI and FPI flows), although these have tapered off since April 2015. Foreign exchange (FX) intervention continues to be guided by the need to limit excessive volatility. Notwithstanding the reduction in external vulnerabilities, there is a need for vigilance given sharp movements in global commodity prices, potential volatility of global financial market conditions, and the deterioration in India’s export performance.

31. In the event of a surge in global financial market volatility, India should continue to rely on exchange rate flexibility as a key shock absorber. To minimize disruptive movements in the currency divorced from fundamentals, continued exchange rate flexibility could be accompanied by judicious FX intervention (which can be in spot and forward markets, and via liquidity provision through swaps).

32. India faces a challenge in increasing exports. The contraction in merchandise exports has been partly due to the collapse in commodity prices, as refined petroleum products made up about 20 percent of the value of goods exports in 2014/15. The slowdown in global demand has also affected India’s exports, as potentially has the appreciation of the rupee real effective exchange rate.²⁸ Achieving a significant export acceleration (as envisaged in the Foreign Trade Policy blueprint) would need to be underpinned by measures to reduce barriers to trade and lower the cost of doing business. Continued progress on alleviating supply-side bottlenecks would help enhance the effectiveness of exchange rate flexibility in lessening the impact of adverse external shocks, as well as in boosting exports in the long-term.

33. While India’s external financing requirements have declined, further enhancing the environment for attracting stable, non-debt creating capital flows, particularly FDI, remains important. In the past year, several steps toward this goal have been taken, including by liberalizing caps on FDI inflows in several sectors (among them railways infrastructure, construction, defense, and insurance). This has resulted in US$35 billion of FDI flows in calendar 2015 to October, up from US$29 billion during the same period in 2014, more than counterbalancing the CAD. In addition, limits for foreign portfolio investors’ (FPI) purchases of government bonds have been increased from January 1, 2016, which have the potential to bring in an additional US$2.5 billion of inflows in the bond market in Q1 of 2016, if fully taken up. Nonetheless, a more conducive business environment is necessary to attract greater FDI and help the success of the “Make in India” initiative. Debt inflows, particularly in the form of external commercial borrowings (ECBs) by Indian corporates, have increased in recent years (though not in 2014/15), nonetheless India’s external debt remains low at 24 percent of GDP at end-September 2015. Further liberalization of ECBs should proceed cautiously and be carefully monitored by the RBI, given the vulnerabilities of corporate balance sheets.²⁹³⁰

Authorities’ Views

34. The authorities agreed that external vulnerabilities are now much lower. Like staff, they foresee a current account deficit of about 1½ percent of GDP for 2015/16, easily financed by FDI. They also agreed that reserves are at a healthy level, and the exchange rate is both flexible and broadly fairly valued. The recent slowdown in exports notwithstanding, the authorities were not overly concerned about near-term competitiveness. Nonetheless, they emphasized the importance of structural reforms, ease of doing business, and infrastructure investments to ensure that India’s external outlook remains healthy over the medium term.

E. Structural Policies to Boost Growth and Employment

35. Priority areas for reforms are well known: addressing long-standing supply bottlenecks, labor and product market reforms, and improving the business climate. Building on recent progress, key measures include:

Power reforms. Strengthening the UDAY scheme for state power distribution companies to mitigate the risk of moral hazard, including through strong conditionality aimed at reducing transmission losses and raising power tariffs when needed. Additional reforms should also be informed by India’s commitments under the Paris climate change agreement (see Box 12).
Land reforms. Streamlining and expediting land acquisition and simplification of procedures, at both the center and state levels.
Labor market reforms. Greater labor market flexibility and product market competition remain essential to create jobs and raise growth. Recent steps by several states to increase labor market flexibility are welcome. Such reforms are key for increasing employment in the formal sector and employment of women, broadening the manufacturing base, and taking advantage of India’s favorable demographics (see Selected Issues Chapter VII).
Strengthening the business climate. Efforts to improve India’s business climate should continue. Staff welcomes the authorities’ efforts to improve India’s ranking on the World Bank’s Doing Business indicators, particularly in the underperforming areas of resolving insolvency and enforcing contracts. Staff supports the recent introduction of state-based doing business indicators, which will encourage cross-state competition in attracting investment.

Other reforms. As elaborated in the 2015 India Article IV Staff Report, other key reform areas include: (i) rationalizing natural resource allocation; (ii) reorienting public expenditure towards growth-enhancing and social spending; and (iii) agricultural sector reforms, including reform of the Food Corporation of India (see the recommendations of the FCI Committee and Box 5). The above reforms are needed to raise potential growth, which is critical for poverty reduction in India.³¹

Authorities’ Views

36. The authorities concurred with staff that structural reforms are critical to boosting India’s growth prospects. They felt that the UDAY power sector debt restructuring scheme would not give rise to moral hazard, and they noted that coal sector reforms had been successful, including the transparent re-auctioning of coal blocks. They welcomed the progress that has been made in improving India’s ranking in the World Bank Ease of Doing Business survey. Major international partners, notably Japan, have accelerated efforts to boost the Prime Minister’s “Make in India” campaign. Finally, the authorities noted that “cooperative federalism” is allowing some states to introduce major reforms—such as to land, labor, and agricultural markets—which are not yet politically feasible at the all-India level. Over time, they expected these reforms to fructify into healthy and inclusive job creation and growth.

Staff Appraisal

37. The Indian economy is on a recovery path, helped by a large terms of trade gain, positive policy actions, improved confidence, and strengthened external buffers. After bottoming out in 2012, growth has risen steadily with a revival of sentiment. Since late 2014, a halving of global oil prices has boosted economic activity, underpinned a further improvement in the current account and fiscal positions, and engendered a sharp decline in inflation. The important structural reforms that have been initiated will support growth prospects and enhance the resilience of the Indian economy. At present, however, there remains limited space for countercyclical macroeconomic policies to counteract the remaining economic slack and respond to domestic and external shocks.

38. India’s growth outlook remains favorable, but faces difficult challenges. The economic recovery is expected to continue to be underpinned by private consumption. Higher public infrastructure investment and government initiatives to tackle supply-side bottlenecks and to repair corporate and financial sector strains should help crowd-in private investment. Nonetheless, risks are tilted to the downside. The main risks relate to weak corporate and bank balance sheets, and renewed global financial market volatility. Continued anemic growth of India’s trading partners could also weaken the sustainability of the growth recovery. On the upside, further structural reforms could lead to stronger growth, as would a sustained period of low global energy prices.

39. India’s financial system is generally sound, but public sector banks continue to face asset quality difficulties. The RBI should continue to strengthen asset quality recognition and increase banks’ provisioning as needed, and continue to monitor corporates’ FX exposures. Augmenting capital buffers in public banks and implementing corporate governance reforms are of key importance to ensure the durability of the Indian growth recovery. The introduction of a Bankruptcy Bill is welcome which, together with strengthening out-of-court debt restructuring, should pave the way to a robust insolvency resolution regime and also help deepen domestic capital markets. Efforts should continue to build on India’s commendable progress in financial inclusion, underpinned by new technologies and expanding the range of financial services.

40. The monetary stance remains appropriately tight for achieving near-term inflation objectives. Following the formal adoption of the flexible inflation targeting regime in early 2015, progress to enhance communication and improve policy transmission continues. Favorable inflation dynamics gave the RBI room to cut the policy rate, while maintaining positive real interest rates broadly consistent with the “glide path” towards the medium-term inflation target. Given upside risks to inflation, a re-emergence of inflationary pressures may require monetary tightening. Reducing still-high household inflation expectations will require a long period of low inflation which, unless underpinned by durable measures to boost food supply, may require a tight monetary stance for longer.

41. Fiscal consolidation needs to be underpinned by revenue-raising reforms. Although fiscal consolidation has paused, enhanced capital outlays and important fuel subsidy reforms are welcome. The medium-term fiscal targets are broadly appropriate, but to achieve them more efficient taxation (including through introduction of the GST) and further rationalization of subsidies (fertilizer and food) are essential. While public debt is sustainable, the general government deficit remains high and constrains the space for much-needed public investments.

42. International reserves are assessed to be adequate and the external position is broadly consistent with medium-term fundamentals. Notwithstanding the reduction in India’s external vulnerabilities, there is a need for vigilance given potential volatility in global financial markets, and the deterioration in India’s export performance. If global financial market volatility resurfaces, continued exchange rate flexibility could be accompanied by judicious foreign exchange intervention given India’s increased and adequate reserve buffers. Achieving a significant export acceleration would need to be underpinned by measures to reduce barriers to trade and lower the cost of doing business. Further liberalization of external commercial borrowing should proceed cautiously, given the potential vulnerabilities of corporate balance sheets.

43. Addressing long-standing supply bottlenecks, labor and product market reforms, and improving the business climate are crucial to achieving faster and more inclusive growth. Enduring improvements in power distribution and natural resource allocation and pricing will be important in raising potential growth. Further reforms to increase labor market flexibility and facilitate land acquisition, including at the state level, are key to increasing employment in the formal sector and broadening India’s manufacturing base.

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

Box 1.

Oil Price Collapse: Impact on Indian Inflation¹

The collapse of oil prices accounts for close to half of the 3½ percentage point decline in Indian CPI inflation since the first half of 2014. Monetary policy should be watchful of the likely transitory nature of this decline in inflation.

Since mid-2014, a halving of global oil prices has boosted economic activity in India and underpinned further improvement in the current account and fiscal positions and a sharp decline in inflation. India’s terms of trade have improved by about 9½ percent, largely reflecting the reduction in imported oil prices (net petroleum imports were 5 percent of GDP in 2013/14). With deregulation of diesel prices in late 2014, the fuel subsidy bill has been reduced from about ¾ of one percent of GDP to just 0.1 percent of GDP, while the excise duties on petrol and diesel have been increased on multiple occasions since late 2014, with fiscal revenue impact of about 0.2 percent of GDP. Finally, with gasoline and diesel prices now free to move in line with international prices, their retail prices have declined by around 15–20 percent from mid-2014 levels.

Staff analysis suggests that the collapse of oil prices could have contributed up to 1¾ percentage points to the decline in headline CPI inflation since mid-2014. Assuming the full pass-through of lower petroleum-related production costs onto the domestic prices of goods and services, the direct impact of the 20-percent decline in domestic petroleum product prices on headline CPI inflation is estimated at about 1 percentage point.² Half of this is due to the contribution of lower consumer expenditure on petroleum products, which have a weight of about 2.5 percent in the CPI basket. The other half is due to the direct impact of lower petroleum prices on the production costs of various goods and services. Finally, the indirect impact (from lower oil prices reducing the cost of all other, i.e. non-petroleum, intermediate inputs) is estimated at nearly ¾ of one percentage point. In addition, the total impact of a reduction in petroleum products cost on the WPI inflation is estimated to be significantly larger, at about 3½ percentage points, reflecting the WPI product basket.

The assessed disinflationary impact should be seen as an upper bound. The implicit assumption of zero demand price elasticity implies that the decline in petroleum costs is fully passed on to producer prices rather than into profit margins. Notwithstanding some pickup in FY2015/16 advance tax payments by India’s largest firms, the underlying improvement in profits may reflect not only better margins from lower input costs, but also incipient demand recovery, resulting in part from an oil drop boost to real disposable incomes, in addition to reduced interest costs on account of recent policy rate cuts. Overall, the oil price drop has clearly led to a significant drop in Indian inflation. Monetary policy should take this into account, given the likely transitory nature of this decline.

¹Prepared by Volodymyr Tulin.²Estimates are obtained using India’s 2007/08 Input-Output Tables, which provide information about the share of different inputs in the production cost structure of goods and services. The direct impact is estimated using the commodity-x-commodity flow matrix; the indirect impact is estimated using the Leontief Inverse matrix for commodities.

Box 2.

Oil Glut and the Indian Economy¹

Following a positive supply-driven oil price shock (with prices falling by about half), growth is estimated to increase by about 0.3 percentage points and inflation to fall by 80 basis points after one year.

This Box investigates the macroeconomic consequences of the recent oil glut for the Indian economy in terms of its effects on oil prices, real output, inflation and financial markets. To do this, Mohaddes and Raissi (2015) integrate an oil price equation, which takes account of developments in the world economy as well as the prevailing oil supply conditions, within a reduced-form quarterly model of the global economy (the GVAR model for short).² To distinguish the oil glut shock (mainly driven by the U.S. oil revolution) from oil demand disturbances, they employ a set of dynamic sign restrictions on the impulse responses of their GVAR-Oil model (estimated over 1979Q2–2011Q2). More specifically, they require the oil glut to be associated with: (i) a decline in oil prices; (ii) an increase in oil production; and (iii) an increase in the sum of real GDPs across all major oil importers in their sample.

The results indicate that the collapse of oil prices (which is equivalent to a 2.5 percent of GDP terms of trade gain for India) leads to higher growth and equity prices, and lower inflation. Figure 1 shows the estimated median (blue solid) and median-target (black long-dashed) impulse responses for up to 40 quarters of key macroeconomic variables of India to a supply-driven negative oil-price shock, together with the 5th and 95th percentile bands.³ The results suggest that following the U.S. oil revolution, with oil prices falling by 51 percent in the first year, Indian growth increases by about 0.3 percentage point after one year—either directly through higher urban consumption spending and lower input cost for corporate sector or indirectly from trade with the rest of the world (as global growth increases by 0.2–0.4 percentage point). The oil glut also creates a moderate temporary disinflation pressure in India (80 basis points on an annualized basis over 4 quarters) and boosts equity prices over the medium-term.

¹ Prepared by Mehdi Raissi.² See K. Mohaddes and M. Raissi (2015), “The U.S. Oil Supply Revolution and the Global Economy” IMF WP 15/259.³ The bands refer to the fact that there are many structural models with identified parameters that provide the same fit to the data. They have nothing to do with sampling uncertainty and do not show statistical significance. The median-target impulse responses track a single structural model.

Box 3.

India’s Progress on Structural Reforms¹

Progress on structural reforms has been made in recent years, and India has done more than several other emerging market countries and many advanced economies. Still, expedited progress on structural reforms will be important to achieving stronger growth.

India faces several structural impediments to growth. These include: rigidities in product and labor markets; inefficient pricing and allocation of natural resources; an uncertain and burdensome business environment, including difficulties in acquiring land and regulatory clearances; and inefficient agricultural markets, including in the public system for food procurement, distribution, and storage.

The OECD produces a reform responsiveness indicator that measures the extent of reform in five broad areas: (i) product and labor market regulations; (ii) human capital formation; (iii) tax and benefits systems; (iv) trade and investment regulation; and (v) innovation policies. The “responsiveness rate” indicator is constructed as the share of total policy recommendations from the OECD’s “Going for Growth” reports on which the government of the country has taken significant action over the following year. ² It considers only legislated actions, and not announcements. Compared to OECD countries, BRIICS (Brazil, Russia, India, Indonesia, China, and South Africa) countries were active in financial market reform.

The indicator shows that India has achieved more of the recommended reforms from 2011 to 2014 than other BRIICS. India has taken steps to ease barriers to domestic and foreign competition in the banking sector. Recent actions to increase banking competition in India include issuing new bank licenses, liberalizing branch licensing, and guidelines on differentiated licenses for payment banks and small banks. In addition, a process of reviewing the current regulatory architecture and replacing most of the existing financial laws began in 2011, and a revised draft of a new Indian Financial Code was recently completed. In response to the slowdown in infrastructure investment in 2011/12, a process of reforms began which include: setting up a Cabinet Committee on Investments to streamline approvals, streamlining coal block auctioning, financial restructuring of state electricity distribution companies, allowing FDI of up to 100 percent in railway infrastructure, and tax-free infrastructure bonds for projects in the rail, road and irrigation sectors. The overall trend has been to increase the caps on allowed foreign investment, simplify regulations, and to move towards market-based pricing of natural resources. For example, gasoline and diesel prices were deregulated in 2010 and 2014 and the formula that fixes the price of natural gas is now revised every six months. First steps on labor market flexibility have been taken by the center—making it easier to comply with labor regulations and removing certain restrictions on overtime and women working night shifts—and in several Indian states.

¹ Prepared by Sonali Das.² See OECD, 2015, “Economic Policy Reforms 2015 Going for Growth”, chapter 1. The sample of countries covered is: the OECD countries (since 2005); Brazil, China, India, Indonesia, Russia, and South Africa (since 2011); and Colombia and Latvia (since 2015).

Box 4.

Crowding-Out or Crowding-In? Public and Private Investment In India¹

Since the mid-1990s, public investment, especially in infrastructure, has a significant positive impact on private investment in India.

Reviving public investment, as a key engine of growth, is an important objective of Indian policy-making. The FY2015/16 Budget, in particular, focuses on investment in infrastructure, both through higher on-budget outlays as well as initiatives to facilitate off-balance sheet financing—including implementation of the National Investment and Infrastructure Fund and permitting tax-free infrastructure bonds. Moreover, recognizing the subdued private investment outlook, the rationale for the public investment thrust is not only to enhance long-term productive capacity of the economy but also to complement the private investment revival in the short-term.

Staff research suggests that public investment has a long-lasting impact on output and has become complementary to private investment in India. First, using a theory-based structural vector error-correction model differentiating long-run and short-run dynamics, it is shown that a policy-induced change in public investments has a statistically significant positive impact on output. Second, reflecting major structural changes that the Indian economy has undergone during the 1980s and early 1990s, the interaction between private and public investment during the past three decades has changed from “crowding out” to “crowding in”, see Figure 1. Third, public investment initiatives that target the infrastructure sector and those that result in completion tend to have more pronounced positive impact on both economic output and private investment.²

Notwithstanding a strong public investment impetus, policy challenges remain. Interim multiplier estimates suggest that one additional rupee in public investment leads to an increase of about 1.1–1.25 rupee in private investment after 8 quarters. Notwithstanding recent improvement in new investment project announcements, broad-based private investment recovery will hinge on progress in resolving corporate balance-sheet stress and enhancing banking system buffers commensurate with an investment-driven economic recovery. In addition, durable solutions to supply-side bottlenecks, such as energy availability and natural resource allocation, are needed to ensure viability of future public and private investment.³ Finally, public sector challenges remain relating to implementation capacity and adequate and stable fiscal space.

¹ Prepared by Mehdi Raissi and Volodymyr Tulin.² See G. Bahal, M. Raissi, and V. Tulin (2015), “Crowding Out or Crowding In? Public and Private Investment in India,” IMF WP 15/264 for details. Results are based on a novel data-set of quarterly aggregate public and private investment in India over 1996Q2–2015Q1 of investment-project-level data from the CapEx-CMIE database which distinguishes projects by sectors and completion/implementation progress.³ See Das and Tulin (2015) and Anand and Tulin (2014).

Box 5.

India: Reorienting the Role of the Food Corporation of India (FCI)¹

FCI reform is needed to reduce the rate and volatility of food inflation, incentivize growth of agricultural productivity, raise efficiency of grain markets, and better serve economically vulnerable households.

In the past few years, the FCI’s dominant role² in the market of cereals has come under increasing public criticism which pinpointed market distortions, large leakages in the Public Distribution System (PDS),³ and operating inefficiencies. The FCI was established in 1965 as India faced major shortages of grains to stabilize markets through procurement, distribution, and maintenance of buffer stocks for food security and price stability purposes. Over time, as production increased substantially, India has emerged as a net cereal exporter and the largest exporter of rice in the world, while it has also built a cushion of massive buffer stocks of cereals. In addition, a particular area of policy criticism has been FCI’s buffer stock practices which, as a result of essentially open-ended procurement and strong price incentives, have resulted in excessive buffer stocks that have been accompanied by high food inflation. The recommendations of the Shanta Kumar Committee Report on Reorienting the Role and Restructuring of FCI aim at refitting the PDS and revisiting the National Food Security Act (NFSA) to better serve the economically vulnerable households, improving operational efficiency, and implementing a pro-active buffer stock liquidation policy.

Excessive cereal stock hoarding and a lack of pro-active buffer stock liquidation resulted in sustained inflationary pressures. Although government’s proactive response to a surge in global food prices during 2007-08 helped limit the impact on domestic food prices, cereals buffer stocks fell significantly below the norms. In subsequent years, however, excessive stock hoarding took place, supported in part by effectively open-ended procurement and strong growth of minimum support prices. Rice and wheat intake into the Central Pool between 2007/08 and 2012/13 averaged around 4 and 7 percent of annual output, respectively, while growth of minimum support prices averaged about 13 percent per year. As a result, during the last five years actual buffer stocks held with the Food Corporation of India (FCI) averaged more than double the norms. Substantial increases in the minimum support price were generally followed by rising inflation in key agricultural crops, fueling inflationary pressures. In addition, the inefficiencies of the buffer stock policy have been aggravated by the significant costs of carrying excess stocks, as the FCI’s costs of acquiring, storing, and distributing food grains have been 40 to 50 percent more than the procurement prices.

Staff research suggests that pro-active intake and liquidation of stocks can smooth consumption and stabilize prices. A counter-factual buffer stock policy scenario entailing (i) lower cumulative buffer stock intake during 2007–2012 in accordance with the revised buffer stock norms, and (ii) pro-active buffer stock intake and liquidation policy (smoothing the growth rate of cereal consumption at around 1½ percent per year), could have directly reduced the standard deviation of relative food inflation during this period by half—from about 3¼ percentage points to about 1⅔ percentage points. Anti-inflationary benefits would likely have been larger given the strong second-round effects from elevated food inflation on core inflation. These results also imply that a potential buffer stock of pulses, if feasible, may be effective in stabilizing markets and containing inflation volatility.

¹ Prepared by Volodymyr Tulin.² The share of public procurement has risen substantially in recent years, from an average of about 25 percent during 2002/03–2007/08 to about 32 percent during 2008/09–2013/14. The share of PDS purchases in consumption has also increased considerably.³ Estimated leakages (subsidized grains not reaching poor households) range from 40 to 60 percent, but are much higher in some states.

Box 6.

Gold: Macro-Financial Linkages¹

While import demand for gold is mainly affected by inflation, international gold prices, and financial inclusion, the Government of India’s recently announced gold schemes could lower gold imports by about 10 percent annually if implemented successfully.

Persistently-high inflation (depressing real returns) prompted a surge in gold imports in FY2011/12, which subsequently led to a marked deterioration in India’s current account balance. India is the world’s second-largest consumer of gold (about a quarter of world demand), and depends heavily on imported gold which meets about 90 percent of its domestic demand.² Gold imports reached a record high in FY2011/12 (US$56 billion, or 3 percent of GDP) and remained elevated in FY2012/13, contributing to the widening of current account deficit to 4.8 percent of GDP in FY2012/13. They were sharply curtailed in FY2013/14 before partially rebounding in FY2014/15 with the liberalization of administrative restrictions on their import.³ As domestic inflation and international gold prices have fallen, and financial inclusion has been improved, import demand for gold has remained below the FY2011/12 highs.

Indian Gold Imports

	Volume	Price	Value
	(mt)	($/oz)	(US$ bn)
FY2003/04	612	378	7
FY2004/05	878	414	10
FY2005/06	826	477	11
FY2006/07	818	628	14
FY2007/08	797	766	16
FY2008/09	880	868	21
FY2009/10	982	1024	29
FY2010/11	1106	1295	41
FY2011/12	1219	1647	56
FY2012/13	1141	1654	54
FY2013/14	731	1328	28
FY2014/15	890	1240	35

Indian Gold Imports

	Volume	Price	Value
	(mt)	($/oz)	(US$ bn)
FY2003/04	612	378	7
FY2004/05	878	414	10
FY2005/06	826	477	11
FY2006/07	818	628	14
FY2007/08	797	766	16
FY2008/09	880	868	21
FY2009/10	982	1024	29
FY2010/11	1106	1295	41
FY2011/12	1219	1647	56
FY2012/13	1141	1654	54
FY2013/14	731	1328	28
FY2014/15	890	1240	35

The government has recently announced two schemes to reduce gold imports: a Gold Monetization Scheme (GMS) and a Sovereign Gold Bonds (SGBs) scheme. While the GMS intends to bring the private holdings of gold into circulation, and reduce the reliance on gold imports (as domestic recycling improves), the SGBs scheme aims at converting the investment demand for gold (estimated at about 300 tons annually) into paper demand. If successful (see Selected Issues Chapter III for pre-requisites), these schemes could lower gold imports by about 10 percent annually.

¹ Prepared by Mehdi Raissi and Silvia Iorgova.² This reflects a deep cultural affinity for gold and residents’ perception of gold as a “safe” asset. The perception of safety, coupled with limited availability of alternative investment opportunities, has contributed to a concentration of household savings in gold-related investments.³ On May 13, 2013, the Reserve Bank of India restricted the import of gold by banks on a consignment basis, followed by the 20:80 scheme on July 22, 2013 under which all nominated banks/agencies were to ensure that at least 20 percent of every lot of imported gold was exclusively made available for the purpose of exports.

Box 7.

India: Export Elasticities and the Role of Supply Rigidities¹

India’s exports are constrained by sluggish external demand. Alleviating supply-side bottlenecks, in the energy sector in particular, is vital for better export performance in the long-run and also for enhancing the effectiveness of exchange rate flexibility as a shock-absorber in the short-run.

While Indian exports are sensitive to international relative-price competitiveness and external demand, binding supply-side constraints (notably energy shortages) dampen price responsiveness in the short term. Export performance is affected by short-term fluctuations in international relative prices, with an estimated average elasticity of about -0.5 (see Table 1). Furthermore, non-manufacturing exports appear to be slightly more demand elastic in the long run, but significantly less price-elastic in comparison to manufacturing exports. The negative sign of the average short-run income elasticity on crude materials and chemical products likely reflects India’s net commodity importer status. Finally, energy shortages may reduce the responsiveness of Indian exports to real depreciation while they appear not to matter when relative price changes are unfavorable.

Table 1.

Pooled Mean Group Estimates of the Long-run and Short-run Export The Role of Supply-Side Constraints

Source: M. Raissi and V. Tulin, 2015, “Price and Income Elasticity of Indian Exports—The Role of Supply-Side Bottlenecks”, IMF WP 15/161.Note: Standard errors are reported in parenthesis. ***, **, * denote significance at 1, 5, and 10 percent, respectively.

^{^1/}Includes food, crude materials, minerals and chemicals.

^{^2/}Product-specific world imports, volume index.

^{^3/}India’s trade-weighted product-specific export price (in partner’s currency) relative to partners’ product price, index. Increase signifies appreciation.

^{^4/}Energy deficit is defined as peak energy demand deficit, weighted by sector-specific energy intensity. One unit corresponds to a sector with energy share in gross output of one percent and a situation of one percent economy-wide peak demand energy deficit.

Table 1.

Pooled Mean Group Estimates of the Long-run and Short-run Export The Role of Supply-Side Constraints

Dependent variable: India’s sector-specific export volume
		All industries	Manufacturing	Non-manufacturing ^1/
*Long-run coefficients*
Global demand volume ^2/		1.34 ***	1.29 ***	1.48 ***
		(0.05)	(0.07)	(0.06)
Relative price ^3/		−0.99 ***	−1.11 ***	−0.84 ***
		(0.11)	(0.16)	(0.16)
Energy deficit ^4/		−0.005 ***	−0.008 ***	−0.002 ***
		(0.001)	(0.002)	(0.001)
*Short-run coefficients*
	Error-correction term	−0.19 ***	−0.17 ***	−0.22 ***
		(0.03)	(0.03)	(0.05)
	Δ Global demand volume	−0.03	0.28 ***	−0.33 ***
		(0.07)	(0.08)	(0.08)
	Δ Relative price	−0.57 ***	−0.65 ***	−0.47 ***
		(0.09)	(0.10)	(0.16)
	Energy deficit * min[0, Δrelative price]	0.004 *	0.004 **	0.003
		(0.002)	(0.002)	(0.004)
	NxT	1012	483	529

^{^1/}Includes food, crude materials, minerals and chemicals.

^{^2/}Product-specific world imports, volume index.

^{^3/}India’s trade-weighted product-specific export price (in partner’s currency) relative to partners’ product price, index. Increase signifies appreciation.

Table 1.

Pooled Mean Group Estimates of the Long-run and Short-run Export The Role of Supply-Side Constraints

Dependent variable: India’s sector-specific export volume
		All industries	Manufacturing	Non-manufacturing ^1/
*Long-run coefficients*
Global demand volume ^2/		1.34 ***	1.29 ***	1.48 ***
		(0.05)	(0.07)	(0.06)
Relative price ^3/		−0.99 ***	−1.11 ***	−0.84 ***
		(0.11)	(0.16)	(0.16)
Energy deficit ^4/		−0.005 ***	−0.008 ***	−0.002 ***
		(0.001)	(0.002)	(0.001)
*Short-run coefficients*
	Error-correction term	−0.19 ***	−0.17 ***	−0.22 ***
		(0.03)	(0.03)	(0.05)
	Δ Global demand volume	−0.03	0.28 ***	−0.33 ***
		(0.07)	(0.08)	(0.08)
	Δ Relative price	−0.57 ***	−0.65 ***	−0.47 ***
		(0.09)	(0.10)	(0.16)
	Energy deficit * min[0, Δrelative price]	0.004 *	0.004 **	0.003
		(0.002)	(0.002)	(0.004)
	NxT	1012	483	529

^{^1/}Includes food, crude materials, minerals and chemicals.

^{^2/}Product-specific world imports, volume index.

^{^3/}India’s trade-weighted product-specific export price (in partner’s currency) relative to partners’ product price, index. Increase signifies appreciation.

Sluggish global economic growth prospects present a challenge for India in achieving significant export growth acceleration in the coming years. The volume growth of non-oil import demand in India’s major trading partners is expected at about 5½ percent during the next five years, significantly below the near 10 percent growth rate recorded during 2001–08. In the absence of further measures to enhance competiveness, India’s merchandize export growth rates will likely remain in single digits. Consolidating the recent gains in inflation reduction, alleviating supply-side bottlenecks, and improving the business climate will be key to ensuring competitiveness in the long term.

Continued exchange rate flexiblity, as well as further structural reforms to ease supply-side bottlenecks, are important for facilitating exports. In the face of external shocks, international relative price flexibility, with the exchange rate as a shock absorber, can help increase India’s exports in the short run. In addition, continued progress on alleviating supply-side bottlenecks, in the energy sector in particular, would help enhance the effectiveness of exchange rate flexibility in lessening the impact of adverse external shocks as well as in boosting exports in the long-term.

¹ Prepared by Mehdi Raissi and Volodymyr Tulin.

Box 8.

Spillovers to India from China’s Rebalancing¹

A one percent permanent negative GDP shock in China could have major global macroeconomic repercussions (with world growth falling by ¼ of one percentage point), but its impact on India is limited.

This Box investigates empirically how shocks to GDP in China are transmitted to India, conditional on alternative configurations of cross-country linkages in the global economy. A dynamic multi-country model (Global VAR) is used to determine the size and speed of the transmission of China GDP shocks to India. This framework consists of 26 region-specific models (including a single Euro Area region comprising 8 of the 11 countries that adopted the euro in 1999). These individual models are solved in a global setting where core macroeconomic variables of each economy are related to corresponding foreign variables (constructed exclusively to capture each country’s bilateral exposures to the other countries due to trade and financial linkages). Spillovers are transmitted across economies via trade, financial, and commodity price channels. The model has both real and financial variables: real GDP, inflation, the real equity price, the real exchange rate, short and long-term interest rates, and the price of oil. All data are quarterly in frequency, for the period 1979Q2 to 2013Q1.

The results show that output shocks emanating in China have important global effects, but their impact on India is limited (likely due to India’s narrow trade/financial exposures to China). A permanent one percent decline in China’s real GDP would translate into lower overall growth globally. Countries most heavily exposed to China’s growth slowdown are those within the Asian regional supply chain and commodity exporters (following the China shock, the price of oil falls by about 6½ percent). After one year, the China shock would reduce output in Malaysia and Singapore by about 0.35 percent and in Indonesia and Thailand by about 0.3 percent. The effects on the GDP of the Euro Area, Japan, UK, and the United States are generally smaller. Output in India would be affected by less than 0.1 percent after one year, as the positive impact of the fall in the price of oil partly offsets the decline in demand from China (with which India has weak trade links) and that of India’s other trading partners (which are themselves adversely affected by the GDP shock in China). Note that the approach taken here not only accounts for direct exposures of countries to shocks but also indirect effects through secondary or tertiary channels. Nonetheless, if the shock to China’s GDP is combined with a spike in global financial market volatility (leading to exchange rate pressures, higher bond yields and lower equity prices), the impact on most countries, including India, would be significantly larger.²

¹ Prepared by Mehdi Raissi.² See Cashin, Mohaddes and Raissi (2016), forthcoming IMF working paper for details.

Box 9.

Corporate and Banking Sector Vulnerabilities¹

Past deterioration in macroeconomic conditions and supply-side bottlenecks, particularly in infrastructure, have led to the build-up of high corporate vulnerabilities, with a strong negative impact on banks’ asset quality. Banks face potential recapitalization needs. Staff estimates that these should be manageable, but may require further fiscal outlays.

The vulnerabilities of the Indian corporate sector remain high, reflected in profitability pressures and high leverage, particularly among large corporates. Supply side bottlenecks—particularly in infrastructure, and the iron and steel sectors—continue to affect negatively corporate profitability. The median return on assets (ROA) of Indian corporates has continued to decline and at 4.6 percent in FY2014/15 was the lowest over the past decade. Corporate leverage is now one of the highest across emerging market economies, with leverage of the largest corporates (top 1 percent) persistently higher than for other firms. The median debt-to-equity ratio of the top corporates (on a gross debt basis) has been at more than 175 percent each year since FY2008/09, relative to less than 130 percent for other firms (245 percent and 113 percent at end-FY2015, respectively; see Selected Issues Chapter I).

Stress tests of corporate balance sheets confirm that exposure to potential shocks is high. Corporates’ debt repayment capacity, after improving in FY2013/14, showed signs of marginal deterioration in FY2014/15. Corporate debt-at-risk—the share of debt owed by firms with an interest coverage ratio (ICR) below one—edged up to 10.8 percent, following an improvement to 10.2 percent in FY2013/14 (Figure).² An upward shift in domestic interest rates continues to be a key risk for Indian corporates, with the share of debt-at-risk estimated to increase to 17 percent in case of a 250 basis point rise in domestic rates. Indian firms are now also more vulnerable to profitability, foreign currency and foreign interest rate shocks. In extreme stress conditions—captured by an unprecedented combination of extreme adverse shocks calibrated to India’s experience in the aftermath of the global financial crisis and the 2013 ‘taper tantrum’—the corporate sector’s debt-at-risk can reach 42 percent.³ Importantly, corporate sector risks continue to be considerably higher than in the aftermath of the global financial crisis, when debt-at-risk even under the largest risk factor (domestic interest rates) was at levels comparable to the FY2014/15 baseline.

The weaker position of domestic corporates has translated into substantial deterioration of banks’ asset quality in view of the strong bank-corporate nexus in India. The share of stressed assets at public sector banks (PSBs)—including gross non-performing assets (NPAs) and restructured assets—in total advances increased to 13.5 percent at end-March 2015 from 11.9 percent a year earlier. A significant share of stressed loans—more than 41 percent—are concentrated in the infrastructure and iron and steel sectors, which have been impacted adversely by the domestic supply-side issues and by export headwinds. With reform measures to address structural bottlenecks, new NPA formation may decelerate. However, the accumulation of restructured loans, which accounted for 8.1 percent of PSBs’ total loans at end-FY2014/15, poses a challenge. These loans, while not classified as non-performing, have modified terms to ameliorate possible borrower debt repayment difficulties, and hence imply substandard quality. Further transition of restructured loans to NPA status, and the need to provision new restructured loans at the NPA provisioning rate, coupled with the phase-in of Basel III capital requirements by March 2019, are expected to necessitate additional capital injections in the PSBs in the coming years.

Banking sector stress-test simulations suggest that potential recapitalization needs should be manageable, but may require further fiscal outlays. The simulations evaluated the impact of further deterioration in loan quality on banks’ capital base, assuming a 15 percent transition of restructured advances to NPAs in each year to end-FY2018/19, and minimum 60 percent provisioning against NPAs. The analysis was carried out on a bank-by-bank basis, with slippage, recovery and write-off rates calibrated on banks’ recent performance, and using the Tier 1 capital ratio as a hurdle rate (including the 2.5 percent capital conservation buffer (CCB) and additional buffers of up to 2 percent). Even in a severe scenario of continuous deterioration of PSBs’ asset quality on a scale commensurate with their recent experience, recapitalization costs should be manageable, at 2.9 percent of FY2018/19 GDP (cumulative over four years, including a 2 percent extra buffer; left Table).⁴ Costs are more modest, at 1.8 percent of FY2019 GDP, in the case of further reforms (right Table). Such milder stress is associated with an about 4 percentage-point decline in PSBs’ median Tier 1 ratio and a 1.7 percentage-point rise in the median NPL ratio. However, these estimates may be subject to downward bias, given remaining forbearance on the classification of certain loans as restructured.

Public Sector Banks: Capitalization Needs under Severe Stress

(In percent of 2018/19 GDP)

(Minimum Common Equity Tier 1 (CET-1) Capital + CCB)