Statement by Arvind Virmani, Executive Director for India and Parthay Ray, Advisor to Executive Director
January 25, 2010
1. Our Indian Authorities appreciate the value of the open and constructive policy dialogue with the Fund. There has been convergence of views between the staff and the Authorities on many issues, and the Authorities’ stance on specific aspects of the assessment already finds a place in the staff report. For the sake of emphasis, completeness and clarity comments on some key issues are detailed below.
2. The Indian economy is among the first in the world to recover from the global crisis. While the current GDP growth is still lower than the average annual growth rate of 8.8 per cent during the five-year period from 2003-04 (i.e., April 2003 to March 2004) to 2007-08, challenges remain in respect of a broad-based recovery. While food prices have experienced a spurt, increases in prices of manufactured products (as reflected in the movements of the wholesale price index of manufactured products, year-on-year) have been benign. The recovery has been induced by conventional and unconventional fiscal and monetary-banking policy responses. With the gradual return of normalcy to the global economy, the unwinding of monetary and fiscal measures and their timing remains a challenge. The management of the spurt in portfolio flows, which is now being increasingly recognized for its negative externalities, is a renewed challenge. Financing infrastructure is another area that has drawn attention of Indian policy makers.
Recent Turnaround and Future Expectations
3. It may be pertinent to note that the Economic Survey, 2008-09 of the Government of India (released in July 2009) stated categorically,
“If the US economy bottoms out by September 2009, there could be good possibility for the Indian economy repeating its 2008-09 performance, i.e. around 7.0 ±0.75 per cent in the fiscal 2009-10 (assuming a normal monsoon). The pattern of fiscal 2008-09 may be repeated in that case, though in an inverse sequence, with two not so good quarters followed by two good quarters making a ‘U’-shaped revival of the growth path” (page 27).
4. In line with these expectations, during the second quarter of 2009-10 (i.e., July–September, 2009), the economy rebounded with a real GDP growth of 7.9 percent. In fact, continuation of these trends could make it possible for the economy to grow at 7–7.75 percent in 2009-10. For the more recent period, industrial production grew by 11.7 percent in November 2009 on a year-on-year basis. Almost all segments of the financial markets continued to remain stable and there has also been a pickup in net capital inflows, particularly from the foreign institutional investors. All these bear testimony to the inherent strength of the economy, experiencing a rapid and strong recovery from the knock-on effects of the global crisis.
5. Interestingly, the staff projections indicate a deceleration in the growth rate during 2011 - 2013 (Table in page 3). However, our expectation is that in the medium-term, India should be back on the new (post 2003-04) trend growth path of 8.5 to 9 percent per annum, with efforts being geared towards removal of critical policy and institutional bottlenecks.
Return to the Path of Fiscal Consolidation
6. Welcoming the Authorities’ intention to lower the Central Government’s deficit, the staff has emphasized discretionary measures. In this context, it may be noted that the path of fiscal consolidation in India has been governed by the Fiscal Responsibility and Budget Management Act (FRBMA), 2003. Since then, India has made impressive reductions in deficits both at the Central Government and the State Government levels. However, as a fallout of the global crisis, and despite some automatic stabilizers, fiscal policy in India, as elsewhere in the world, has played the main role of boosting demand. Consequently, there were a number of fiscal stimulus packages. The fiscal stimulus included both tax relief to boost demand and increased expenditure on public projects to create employment and public assets. These unusual developments during 2008-09 necessitated deviation from the FRBMA. The Budget for 2009-10 has carried forward this policy through a fiscal expansion of 4.1 per cent of GDP (over 2007-08 levels).
7. While such fiscal expansion as a crisis management measure is in line with internationally adopted policies at that juncture, going forward, a strategy of fiscal consolidation will be of paramount importance. The Medium Term Fiscal Policy Statement, 2009-10 has provided the roadmap with the fiscal deficit declining to 5.5 per cent of GDP in 2010-11 and further to 4.0 per cent of GDP in 2011-12. In this process, both revenue augmentation as well as rationalization of expenditure are important. In particular, the reform of the subsidy regime, as envisaged in the Budget for 2009-10, could provide a more sustainable base for fiscal consolidation.
8. In order to further the process of fiscal consolidation initiated through the FRBMA, one of the terms of reference of the Thirteenth Finance Commission (TFC), whose report is expected to be released shortly, has been to assess the impact of various obligations of the Central Government on the deficit targets, and to suggest, “ … a suitably revised roadmap with a view to maintaining the gains of fiscal consolidation through 2010 to 2015.” Going forward, the Report of the TFC and the proposed goods and services tax coupled with the initiative on Direct Taxes Code would provide the impetus to a rule-based fiscal consolidation process.
Balance of Payments and Capital Inflows
9. As per the latest data on India’s balance of payments (BoP) for the second quarter (July-September 2009) of 2009-10, while growth in exports and imports continued their declining trend, trade deficit was lower reflecting larger fall in imports, especially oil imports, on account of lower oil prices. Despite lower trade deficit, current account deficit at US$ 12.6 billion in Q2 of 2009-10 was almost at the same level as last year, mainly on account of lower net invisibles surplus.
10. As far as capital inflows are concerned, more recent data are available and during the financial year 2009-10 so far, accruals on account of foreign direct investment, deposits of non-resident Indians and portfolio investment were significantly higher as compared to those of the previous year. In particular, investments of Foreign Institutional Investors went up by as much as US $ 22.8 billion during April 1, 2009–January 8, 2010, as against a net withdrawal of US $ 11.9 billion during the corresponding period of the previous financial year. The Indian rupee appreciated by 11.24 percent against the US dollar as on January 8, 2010 over end-March 2009.
11. The volatility of capital flows and the exchange rate has its attendant implications for the monetary policy. Though the consequences of capital inflows during 2009-10 are manageable, macro management could become more challenging as the growth expectations approach the trend (8.5–9 percent) levels leading to more capital inflows. The negative externalities arising from volatility in capital flows will need to be thought through and appropriately addressed.
Monetary Policy Challenges
12. An important challenge facing India at the current juncture is the build-up of inflationary pressures, particularly in respect of food prices. In this context, the nature of monetary policy response has generated considerable debate in India. First, it is generally agreed that monetary policy is not an efficient instrument for reining in sectoral inflation. In India, prices of primary articles have risen by 14.9 percent, prices of fuel and manufactures rose by 4.3 percent and 5.2 percent, respectively in December 2009 (year-on-year). Accordingly, the overall rate of inflation, which was in negative territory during June-August 2009 and around 1 percent in September-October 2009, has edged above the threshold of 5 percent which is monitored for monetary policy purposes. Second, India like many other EMEs suffered the knock-on effects of the global crisis and in response, monetary and fiscal policies had to switch to an unusually high accommodative stance, including through unconventional modes. Overall GDP growth remains well below the pre-crisis average of 8.8 percent and bank credit growth has decelerated to around 14 percent as against around 24 percent a year ago. Consequently, the trade-off facing monetary policy is sharp–too early an exit from accommodation risks jeopardizing the recovery; too delayed an exit may allow current inflationary pressures to get embedded in inflation expectations. Obviously, a judgment call has to be made, but fully sensitive that either side is weighed down by large risks. So far, on a careful balancing of the trade-off and the existing slack in resource utilization in the economy, the conduct of monetary policy has been supporting the recovery while allowing supply-side management measures to work through and correct shortages in specific commodities.
13. In the face of incipient signs of generalized inflation, it would be an error to assume that monetary policy in India will continue to remain accommodative. Indeed, against the backdrop of developments in sectoral inflation conditions, the October 2009 review of monetary policy affirmed its resolve to “keep a vigil on the trends in inflation and be prepared to respond swiftly and effectively through policy adjustments to stabilise inflation expectations”. It further stated: “….it bears emphasis that the Reserve Bank is mindful of its fundamental commitment to price stability. It will continue to monitor the price situation in its entirety and will take measures as warranted by the evolving macroeconomic conditions swiftly and effectively.” Furthermore, it is important to note that a calibrated withdrawal of accommodation has already commenced in the form of restoring of secondary reserve requirements (the Statutory Liquidity Ratio) to 25 percent (after a temporary lowering of 1 percent during the crisis), closure of special liquidity facilities for non-bank finance companies and mutual funds, increasing provisioning requirements on commercial real estate and generally, raising all provisioning cushions consisting of specific provisions against NPAs as well as floating provisions.
14. The Indian banking sector turned out to be resilient in the backdrop of the global financial crisis. Apart from minimal exposure to toxic assets, the Indian banking sector has greatly benefited from the initiatives relating to adoption of counter-cyclical prudential regulations framework. Net non-performing assets (NPA) as a ratio to net advances of commercial banks as at end March 2009 remained at last year’s level of 1.1 per cent. While it is not unusual to expect NPAs to increase in a downturn, Indian banks are well capitalized to cushion the impact of any possible increase in NPAs. Given the increase in banks’ net worth over the past ten years and steady reduction in their NPAs, capital coverage for NPAs is at a prudent level. Furthermore, to arrest any possible increase in non-performing loans, the RBI has recently decided to increase the provisioning requirement for advances to the commercial real estate sector classified as ‘standard assets’ from the present level of 0.40 per cent to 1 per cent.
15. As far as long-term funding for growth is concerned, financing for infrastructure has attracted attention of the policy makers in India. The staff report has mentioned a number of new initiatives, such as, take-out financing and credit enhancements being worked on by the India Infrastructure Finance Company Limited (IIFCL). Prime Minister Dr. Manmohan Singh has aptly identified the course of reforms as,
“We need to develop long-term debt markets and to deepen corporate bond markets. This in turn calls for a strong insurance and pension sub-sectors. Some of the reforms needed, especially in insurance, involve legislative changes. We have taken initiatives in this area and will strive to build the political consensus needed for these legislative actions to be completed. We need to improve futures markets for better price discovery and regulation. We also need to remove institutional hurdles to facilitate better intermediation” (Indian Prime Minister’s address at the Inauguration of India Economic Summit on November 8, 2009; available at http://pmindia.nic.in/speeches.htm).