Abstract
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.
1. On behalf of our authorities, we would like to thank staff for presenting a comprehensive and balanced assessment of recent macroeconomic and financial sector developments in India and the evolving outlook. The mission team had broad-based and open discussions with our authorities, who broadly share the staff’s assessment.
2. The Indian economy has embarked on a steady growth path during the past two years. During FY2014-15, India’s GVA (gross value added at basic prices) growth recovered to 7.1 per cent from 6.3 per cent recorded in the previous fiscal year. The same year, India’s services sector grew by 10.3 per cent, manufacturing by 5.4 per cent, and agriculture by 1.3 per cent. More recently, India’s GVA (at basic prices) growth during October-December 2015 (FY 2015-16) stood at 7.1 per cent, making it the fastest growing major economy. Our authorities took advantage of the sharp decline in the global oil and commodity prices to significantly reduce fuel subsidies and increase excise taxes on petroleum products. Resources obtained from lower subsidies and higher excise taxes have helped in lowering deficits and increasing capital expenditure. Inflation is expected to remain within the target band set under the new monetary policy framework put in place in February 2015. This would also be supported by a sustainable medium-term fiscal consolidation strategy being pursued by our authorities.
3. While the recovery in various sectors of the economy has not been uniform, our authorities have taken swift and effective policy measures to address the challenges facing the economy. Progress is visible in several areas, particularly in the ease of doing business. Some key reforms on the anvil, most notably the Goods and Services Tax (GST), would further spur economic activity and exert a downward pressure on inflation. Export growth and foreign capital inflows, however, face some risks from the slowdown in global demand and heightened volatility in global financial markets. The authorities recognize that bank balance sheets need to be strengthened and have taken action in this direction.
Recent Macroeconomic Developments
GDP growth and Short-term Outlook
4. The Indian economy recorded a growth of 7.3 per cent in the first three quarters (April-December) of FY2015-16 as compared with 7.4 per cent during the same period last year. The Advance Estimates have placed India’s FY2015-16 GDP growth at 7.6 per cent as compared with 7.2 per cent last year. Despite rainfall deficiency, rural incomes have been supported by allied activities such as dairy and horticulture leading to a marginal increase in agricultural growth. While manufacturing has recorded acceleration in output growth during the first three quarters, other industrial sectors have decelerated, due to weak investment demand with some slowdown in capital goods production. This is being sought to be corrected by several major policy initiatives by the authorities which are supported by a pick-up in corporate profitability on account of declining input costs. Overall, the Reserve Bank of India’s (RBI’s) industrial outlook survey indicates expansion of activity at an accelerated pace in Q4. In January 2016, activity in India’s services sector, as reflected in Nikkei purchasing managers’ index, increased at its fastest pace in over a year and a half. While the current growth impetus is steady, it remains below the medium-term potential. Our authorities recognize the need for reviving private investment to put the economy durably on a higher growth trajectory.
5. The outlook for the Indian economy beyond the current year has also improved significantly. Several positive factors such as steady disinflation, a modest current account deficit, fiscal rectitude, improvement in regulatory environment for business, and scaling up of infrastructure, have contributed to this improvement. However, the slowdown in global growth and trade accompanied by higher volatility in global financial markets could impose some constraints on growth.
Fiscal Policy
6. India continues on a path of steady fiscal consolidation. The GFD of the Central Government, which was contained at 4.0 per cent of GDP in FY2014-15 against the budgeted target of 4.1 per cent of GDP, is targeted to decline further to 3.9 per cent of GDP in FY2015-16. During April-December 2015, the fiscal position of the Central Government was considerably better than in the corresponding period of the previous year as reflected in key deficit indicators. Although the authorities have slightly extended the timeframe for reaching the GFD-GDP goal-post of 3 per cent upto 2017-18, they have, at the same time, expressed a binding commitment for a path of medium-term fiscal consolidation. Tax collections, and especially indirect taxes, have been buoyant. The authorities have taken several administrative and technological initiatives to further boost revenues. They have made concerted efforts to usher in the GST regime. Based on recommendations of the Tax Administration Reforms Commission, the government has set up a Tax Council to obtain multidisciplinary inputs and bring about greater coherence in formulation of tax policy. On the expenditure side, the growth in capital expenditure at 33.54 per cent reflects the Government’s commitment to support investment. Other measures for expenditure management, subsidy reforms, and direct benefits transfer (DBT) have also yielded substantial benefits. As a result, so far during FY2015-16 (up to January 29, 2016), net market borrowings have been lower than in the corresponding period of the previous year.
7. There are three broad emergent trends that are likely to have a strong positive impact on the fiscal situation over the medium term.
The GST implementation would contribute to an efficiency-enhancing centralization of the indirect tax system. Apart from the revenue potential of a self-enforcing tax, as powerfully demonstrated by the experience of states which had implemented the Value Added Tax (VAT) regime in 2005, there are significant efficiency gains to be obtained from lower transportation and logistics costs. It is also likely to increase the indirect tax base.
The recommendations of the Fourteenth Finance Commission1 (FFC) will contribute to a significant decentralization of expenditure from the centre to the states. Based on the premise that state governments will be better able to target expenditures to meet their social and economic objectives, this should lead to greater efficiency of public expenditure.
The country’s infrastructure deficit requires significantly large resources to be bridged. While the state has to play a much larger role in accelerating investment into infrastructure especially in provision of resources, private sector skills in execution and operation can contribute in delivering effective infrastructure services. This re-framing of the notion of Public-Private Partnerships is manifest in the recently constituted National Investment and Infrastructure Fund (NIIF).
The changes in the fiscal dynamics mentioned above are expected to incentivize buoyancy and efficiency in the taxation system, increase public spending in infrastructure and other key sectors and improve public accountability.
Inflation and Monetary and Exchange Rate Policies
8. Inflation, which had moderated significantly since 2014, has stayed along the projected trajectory during FY2015-16 so far. CPI inflation rose to 5.6 per cent in December 2015 from 5.4 per cent in November 2015, with inflation in all major groups registering an increase. To manage food inflation, the authorities have implemented supply side measures, allowed imports and released stocks through PDS. A Price Stabilization Fund has been established to support market interventions in perishable agri-horticultural commodities, with the aim of managing non-cereal food inflation. Inflation is likely to remain range-bound in the remaining months of FY2015-16. Both near-term and longer-term inflation expectations of households have moderated but are still in the low double digits. In the latest round of Inflation Expectations Survey of Households, the proportion of respondents expecting price rise by ‘more than current rate’ for prices in general has decreased marginally as compared with the previous rounds of both 3 month and 1 year ahead periods. Regarding the medium-term inflation target of 4 per cent, the Reserve Bank’s endeavor is to keep the economy anchored to the projected disinflation path that should take inflation down to 5 per cent by March 2017.
9. Owing to the easing of inflationary pressures, RBI has been able to reduce the policy rate by 125 basis points since January 2015. Overall, the monetary policy stance continues to be accommodative while awaiting further data on inflation. Further monetary policy measures will depend on developments in both the disinflationary process and forthcoming Union Budget.
10. India’s current account deficit (CAD) declined sharply from 4.8 per cent of GDP in FY2012-13 to 1.7 per cent in FY2013-14. It has declined further to 1.6 per cent during July-September 2015 aided mainly by a sharp decline in oil prices. While year-on-year exports have contracted for the thirteenth successive month in December 2015, there has been positive growth on a month-on-month basis. The decline in imports has slowed down in December 2015. India’s trade deficit has widened to USD 11.7 billion in December 2015 from USD 9.8 billion in November 2015. Financing of the CAD has been facilitated by the large inflow in FDI – USD 28.65 billion during FY2015-16 so far (April-November 2015), despite net outflows from the Foreign Portfolio Investors (FPIs), reflecting global financial volatility. India’s foreign exchange reserves, which are now at USD 349 billion (as of January 29, 2016), are up by USD 7.5 billion from the level at end-March 2015.
11. India has successfully weathered large capital outflows and currency volatility in emerging markets caused by uncertainty about the normalization of US monetary policy in 2015. The nominal exchange rate of the Indian rupee remained stable among only a few such currencies of other emerging markets in 2015 even as forward-looking market liberalization policies have attracted a good deal of foreign capital in recent years.
Financial Sector
12. Credit growth has generally remained above 10 per cent with some pick-up in the recent month’s incremental credit growth. Strong growth has been observed in personal loans and non-bank flows from both domestic and foreign sources, which is expected to support recovery going forward. The recent period has also seen stabilization of corporate leverage that would improve credit growth going forward.
13. Indian banks continue to be well-capitalized at the system level and above the regulatory minimum. The capital to risk-weighted assets ratio (CRAR) of SCBs at the system level declined moderately to 12.7 per cent from 13.0 per cent between March and September 2015, whereas the Tier-I leverage ratio increased to 6.5 per cent from 6.4 per cent during the same period.
14. Our authorities also plan to increase the capital of public sector banks (PSBs) by Rs.700 billion funded by the budget in the four year period leading up to FY2018-19, in addition to introducing differentiated capital support based on parameters of efficiency and business growth. Further, managerial autonomy in decision making would be assured. Although, weaker credit quality has somewhat depressed the profitability of PSBs and has resulted in lower credit growth, the impact on GDP growth remains muted due to the relatively low credit intensity of the Indian economy. Meanwhile, our authorities have created institutions for reconstruction/resolution of bad assets.
15. Though the elevated level of NPAs continues to be a key concern, the stress test for credit risk conducted by the RBI suggests that, under the baseline macroeconomic scenario, the GNPA ratio may rise to 5.4 per cent by September 2016 from 5.1 per cent seen in September 2015, but it is expected to subsequently improve to 5.2 per cent by March 2017. However, current indications about improvements in the corporate operating profits margins are expected to provide an impetus for deleveraging and reduction in NPAs going forward. RBI is taking steps to contain the strains on banking sector. These steps include:
i. deciding that all restructured loans (with minor exceptions) will be classified as non-performing assets (NPAs), thus attracting provisioning;
ii. introducing strategic debt restructuring that, inter alia, allows banks to convert their loans into equity, thus enabling faster recovery of bad loans by quicker sale of assets;
iii. increasing the ceiling on FDI in Asset Reconstruction Companies (ARCs);
iv. Establishing a Central Registry of Information on Large Credits (CRILC); and
v. bringing out guidelines for early intervention through Joint Lenders Forum (JLF) and Corrective Action Plan (CAP).
16. The predominance of bank finance in India even as banks face challenges on asset quality, profitability and capital, implies a need for diligent governance, review of business models, and strong capital planning and dividend policies. The Reserve Bank has taken steps the arrest the deterioration of asset quality by tightening the norms for recognition of impaired assets and permitting viability based restructuring, while asking banks to be proactive in better credit management and early recognition of stress. The ‘Indradhanush’ initiative to revamp the functioning of PSBs aims at a multi-pronged approach that includes setting up of Banks Board Bureau for making senior appointments, capitalization, de-stressing, empowerment and framework for accountability and governance reforms.
17. A number of initiatives have been taken by our authorities to expand financial inclusion, including the scheme for disbursal of direct benefits into bank accounts, payments banks and small finance banks (SFBs) for small payments/finance needs in the economy, revising the priority sector guidelines with a specific focus on small and marginal farmers and micro-enterprises and refinancing of loans to micro/small business entities engaged in manufacturing, trading and service activities.
Structural Reforms
18. Our authorities have initiated a number of reform measures to raise the potential growth of the economy. These include progressive liberalization of FDI limits in several sectors to improve access to capital. The setting up of the NIIF for financing infrastructure and measures to ease supply constraints in the mining sector are expected to boost infrastructure development. Efforts are also being made to improve operational efficiency in power generation. In the agriculture sector, which is critical to inflation management, our authorities have operationalized an irrigation scheme to ensure irrigation to all cultivated lands and have recently launched a new Crop Insurance Scheme for farmers. Labor skilling and reforms of inflexible labor regulations are underway in some states. The Digital India program is aimed at enabling improved access to information and services/facilities to enhance transparency and efficiency. The recently launched ‘Start-up India, Stand-up India’ aims at encouraging startup-entrepreneurial ventures to give impetus to employment generation and wealth creation. Our authorities have also announced a funding corpus for start-ups and fiscal incentives to enable these ventures to take quick roots.
Conclusion
19. The Indian economy is on the path of steady progress despite adverse headwinds from the global growth slowdown, weak investment demand and structural issues from the past. Headline inflation has been on a downward trend and fiscal and external balances have improved over time. Our authorities are committed to the fiscal consolidation path stated in the Union Budget 2015-16. Adequate foreign exchange reserves provide a buffer in the event of unwarranted turmoil in the global financial system. The IMF has retained the growth forecast for India at the same level that was projected earlier. With these enabling macroeconomic conditions, combined with broad-based structural reforms, the Indian economy is poised to achieve a higher sustainable growth path going forward.
The Constitution of India requires the setting up of a Finance Commission every five years, or earlier. The Finance Commission recommends the distribution of the net proceeds of taxes of the Union between the Union and the states. The report of the Fourteenth Finance Commission was submitted to the Parliament in February 2015. The states’ share in the net proceeds of the Union tax revenues would now be 42 per cent, up from the current level of 32 per cent (which was recommended by the previous Finance Commission). This is the largest ever change in the percentage of devolution to the states. In the past, when Finance Commissions have recommended an increase, it has been in the range of 1-2 per cent increase. As compared to the total devolutions in 2014-15, the total devolution of the States in 2015-16 is expected to increase by over 45 percent.