Public Information Notice No. 02/95

Public Information Notice: IMF Concludes 2002 Article IV Consultation with India

August 29, 2002

On June 28, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with India.¹

Background

Within the context of the slowdown in trend growth, the economy experienced a modest recovery during 2001/02. The economy grew by around 4 percent in 2000/01, reflecting both weak agricultural growth and a significant slowdown in the service sector. In 2001/02, growth recovered to around 5½ percent, largely driven by the rebound in agriculture. In contrast, industrial growth continued to decelerate during 2001/02.

During the past year, inflationary pressures subsided. WPI inflation, which peaked at over 8½ percent (y/y) in early 2001, declined to 2 percent in early June 2002—near the lowest rate in a decade. This reflected waning effects of earlier energy price hikes and flat manufactured goods prices—which account for over 60 percent of the index—owing both to greater competitive pressures from trade liberalization and weak demand. In contrast, CPI inflation rose to over 5 percent in recent months, from under 2½ percent earlier in the year, reflecting a pickup in food prices, which had been stable in recent years.

The external position remains comfortable, notwithstanding the slowdown in export demand and the pickup in non-oil imports. The current account deficit narrowed to near balance in the first three quarters of the fiscal year, reflecting declining world oil prices—the oil import bill fell by $2 billion in 2001/02. Transfers from Indians working abroad also remained buoyant and are reported to have increased after September 11. On the capital account, Foreign direct investment (FDI) inflows—especially in the telecom sector—grew strongly, and Non-resident Indian (NRI) deposit inflows picked up. During 2001/02, these factors resulted in a $12 billion increase in foreign exchange reserves, which stood at $56½ billion (over 8 months of goods and services imports and five times short-term external debt) in mid-June 2002.

Market sentiment was volatile during the past year, reflecting both economic and political factors. After falling during 2001, the stock market staged a rally in February 2002, largely reflecting the stepped-up pace of privatization, but has since declined markedly. The main stock market index has fallen by about 10 percent since early April, and net foreign institutional investment flows have turned negative. Recent developments—including the escalation of border tensions with Pakistan and the communal violence in Gujarat—have weakened sentiment, in part because of their implications for the much-needed acceleration of economic reforms. Rating agencies cut their ratings in 2001 and are maintaining negative outlooks, citing chronic fiscal deficits and weak progress on structural reforms.

In response to continued economic weakness, monetary policy began to be eased in early 2001 and an easing bias has been maintained to date. Overall, the cash reserve ratio was lowered in stages by a total of 3½ percentage points to 5 percent, and the bank rate—the key signaling rate—was reduced by 150 basis points and now stands at 6½ percent, its lowest level since May 1973. Market interest rates on government securities also fell sharply at all maturities. The exchange rate—which is closely managed—depreciated by about 5 percent against the U.S. dollar in the 12 months through end-April but was broadly constant in real effective terms. During most of this period, the Reserve Bank of India (RBI) took advantage of balance of payments inflows to accumulate reserves through partially sterilized intervention.

Despite the cuts in the policy interest rate, lending rates did not fall commensurately and domestic credit growth continued to decelerate. Bank lending and deposit rates fell by only about 100-150 basis points, and the prime lending rate remained virtually unchanged, reflecting in part the rigidities arising from administered small savings rates, which push up the cost of bank deposits, and high levels of nonperforming assets. The growth of credit to the commercial sector declined to about 12 percent (y/y) in recent months, reflecting the overall weakness in private sector demand. Thus, monetary easing has resulted in commercial banks holding government securities far in excess of statutory liquidity requirements.

Public finances continued to deteriorate in 2001/02. The central government deficit (on the authorities' definition, which treats privatization receipts as revenues) is estimated to have risen from 5¾ percent of GDP in 2000/01 to over 6 percent of GDP in 2001/02—more than 1 percent of GDP higher than the budget target. This outcome reflects severe tax shortfalls, due, in part, to the economic slowdown, and optimistic budget targets. While nominal spending was kept within the budget, there were overruns in food subsidies. The states' deficit is expected to be some 4½ percent of GDP—above the budget target of around 4 percent of GDP—largely owing to shortfalls in revenue transfers from the center and notwithstanding the states' efforts to contain expenditures. The general government deficit is thus estimated to be 10¼ percent of GDP, and the stock of general government debt over 80 percent of GDP. Including the public sector enterprises, the consolidated public sector deficit is estimated to have exceeded 11.7 percent of GDP and public sector gross debt over 90 percent of GDP.

The budget for 2002/03, announced in late February 2002, aimed to reduce the central government deficit to 5¼ percent of GDP, about ½ percent of GDP less than the authorities' expected outturn for 2001/02. On the revenue side, key initiatives included an increase in the income tax surcharge from 2 percent to 5 percent, a rationalization of excise duties, and an extension of service taxes. On the expenditure side, the main initiatives were a modest cut in fertilizer subsidies and reductions in surplus manpower, including through continuing limits on new recruitment of central government staff. In addition, the budget increased the proportion of funding from the center to the states that is conditional on fiscal and structural reforms, expanding the scope of reform-linked transfers that were initiated in 2001/02.

During the year, progress was made in several aspects of structural reform. In particular, bold and pragmatic steps were taken to accelerate the pace of disinvestment. Another key achievement was the dismantling of the Administered Price Mechanism for petroleum products in April 2002, together with bringing remaining subsidies on kerosene and LPG on budget and announcing a timetable for the elimination of these subsidies. Pump prices for petrol and diesel were increased twice in June. Administered interest rates were lowered and future changes are to be linked to market rates. Related to trade liberalization, statutory peak tariff rates were reduced, and the budget announced a commitment to reduce these rates further and move to a two-tier rate structure in the medium term. In the financial sector, loan classification and provisioning regulations were tightened, and foreign entry to the banking system was further liberalized through the lifting of limits on FDI and Foreign institutional investment. Actions were taken to strengthen capital markets, including restructuring Unit Trust of India, the largest mutual fund, which also adopted net asset value-based pricing, and switching to rolling settlement in the stock market. In addition, a start was made in reforms in agriculture and industry through the removal of some commodities from the Essential Commodities Act and steps to further reduce the scope of small-scale sector reservation. In the area of infrastructure, progress was achieved in the National Highway Development program.

The economy is projected to grow at 5½ percent in 2002/03, assuming a modest recovery in the industrial sector to 4½ percent as global demand recovers and as earlier strong rural income growth translates to domestic demand. It also incorporates the fact that leading indicators of activity are mixed and suggest only a modest recovery in the period ahead. The projection is based on a deceleration in the agricultural sector to its historical trend growth rate of 3 percent, and a leveling-off of service sector growth at about 7¼ percent. Provided oil prices do not remain high on a sustained basis, inflation pressures are expected to remain subdued with both WPI and CPI inflation tracking in the range of 4 percent, and the current account deficit is expected to stay at about ½ percent of GDP.

Executive Board Assessment

Executive Directors highlighted the great potential of the Indian economy, as demonstrated by the growth momentum achieved in the wake of the ambitious reform program of the early 1990s. This has produced one of the highest economic growth rates in the world during the past decade, a considerable improvement in poverty and other social indicators, low inflation, a substantial reduction in external vulnerability, and progress in strengthening the financial sector. Nevertheless, Directors noted that the recent slowdown in economic growth highlights the serious policy challenges that remain in the period ahead. They stressed that attainment of the authorities' 8 percent economic growth objective, which is the key to sustained poverty reduction, will depend critically on the pace of progress with fiscal consolidation and structural reform.

Directors expressed concern about the sustainability of India's fiscal situation, noting that the general government deficit is among the highest in the world and that general government debt (even excluding sizable contingent liabilities) now stands at over 80 percent of GDP. They were particularly concerned that recent trends—large primary deficits, growing debt, and the sharp narrowing of the growth rate-interest rate differential—are creating conditions for potentially unsustainable debt dynamics. The weak fiscal situation leaves little room for maneuver in macroeconomic policies and could entrench the cycle of decelerating growth and deteriorating fiscal balances. In particular, Directors regretted the compression of priority spending on social and economic infrastructure, with adverse effects on private investment. They also noted the risks to the financial sector, which is dominated by public sector owned institutions, with a large amount of non-performing loans.

Directors cautioned against further fiscal slippages in the current year—given the pattern of revenue shortfalls in recent years and the rollback of some measures announced in the budget. They urged the authorities to take early measures to achieve, or even exceed, this year's fiscal targets. Directors welcomed the steps taken on excise taxes and tax administration. However, they noted that India's tax-to-GDP ratio is low by international standards, and advised that the focus be placed on raising revenues, especially through broadening the tax base and strengthening tax administration. Directors urged a widening of the service tax net and the establishment of a large taxpayer unit—which has proven to be beneficial in improving compliance and raising revenues in other countries. On the spending side, priority should be given to reducing subsidies and the wage bill, for which further progress on downsizing the civil service will be necessary.

Directors stressed the need for a clear and explicit medium-term fiscal consolidation path, and urged the authorities to pursue ambitious consolidation through the identification and strict implementation of a credible set of measures. They supported the objectives specified in the original draft Fiscal Responsibility and Budget Management bill—to reduce the central government deficit to 2 percent of GDP by 2006 and the central government debt to 50 percent of GDP by 2011. They also looked forward to the quick passage of the bill, which will advance achievement of the authorities' goal of a world-class fiscal system with enhanced accountability and transparency. A few Directors urged the authorities to opt for a more accelerated consolidation path that would stabilize the debt stock at an early stage.

Directors welcomed the efforts being made to strengthen the states' finances, particularly through the high priority placed on power sector reforms and the use of conditional transfers. Directors noted that the introduction of a state-level VAT could be a watershed reform of the tax regime. The breathing space gained from the postponement of its introduction to April  2003 should be used to press ahead with preparations to ensure that the tax will be implemented as scheduled.

Directors commended the Reserve Bank of India (RBI) for its prudent conduct of monetary policy in a difficult economic and policy environment. They agreed that subdued inflation and uncertainty about the strength of the recovery provide a good case for maintaining the current environment, and that there is little need to ease monetary conditions further. Directors felt that the strategy on exchange rate management and sterilized intervention—whereby balance of payments inflows have been used to accumulate reserves while paying due attention to the real effective exchange rate—has been broadly appropriate, especially given the expected hump in maturing bonds and bank deposits in the next 3-4 years.

Directors reiterated that in the period ahead, greater exchange rate flexibility would benefit India as it would facilitate adjustment in the context of the trade and capital account liberalization and structural changes underway, as well as the development of a deeper foreign exchange market, including for hedging instruments. In this context, they encouraged the RBI to take advantage of the favorable external position to begin to allow for greater flexibility in the exchange rate.

Directors welcomed the recent reduction in administered interest rates and their linking to market rates. In the period ahead, Directors urged the authorities to take advantage of the current low inflation environment to cut administered rates to further narrow the wedge with market determined rates.

Directors stressed that improving the performance of the public sector banks (PSBs) and financial institutions is critical to ensuring medium-term financial stability, and to financing India's developmental needs. In particular, effective divestment of control in PSBs and the introduction of greater commercial orientation should be accorded priority. They encouraged the exploration of alternative approaches to ensuring access to credit in rural areas and for priority sectors, while ensuring that all associated subsidies are transparent and on-budget. This would allow commercial banks to focus their efforts on developing into modern and efficient vehicles of financial intermediation. Directors also encouraged the authorities to consider bringing forward the introduction of the tighter loan classification rules from 2004 and 2005; to strengthen provisioning regulations; and, without delay, to adopt a prompt corrective action framework for all banks, including PSBs.

Directors welcomed the establishment of an asset reconstruction company (ARC), and noted that accompanying laws to strengthen creditor rights and streamline bankruptcy procedures will be necessary for it to be effective. In addition, the ARC should be given operational independence and a commercial orientation so that transfer and sale prices are market-determined.

Directors welcomed the progress in several areas of structural reforms. They particularly applauded the bold and pragmatic approach taken to accelerate the pace of disinvestment and noted the importance of maintaining the momentum that has been built up. However, there is a large unfinished agenda, and Directors stressed the importance of achieving sufficient momentum in structural reforms to sustain confidence and return India to a more rapid growth path.

Directors welcomed strongly the dismantling of the administered price mechanism for petroleum products. They were also encouraged by the recent decision to raise pump prices in the face of the increase in global oil prices. Directors cautioned that the difficult fiscal situation leaves little or no scope to use reductions in oil and petroleum taxes to limit the impact on pump prices when oil prices temporarily move out of a normal range.

Directors welcomed the steps taken to increase trade openness and the outward orientation of the Indian economy. They noted, however, that the trade regime remains relatively restrictive and that further steps are needed to foster a more friendly environment for trade. Directors noted that the planned private sector-led Special Economic Zones (SEZs) could be helpful in attracting FDI and promoting exports, particularly if close links are developed with the rest of the economy, but they stressed that care is needed to avoid a complex and biased tax incentive system that could also lead to substantial revenue losses. They stressed that strong prudential measures should be put in place to prevent offshore banking units from becoming conduits for short-term capital flows that could increase the vulnerability of the domestic financial sector. Some Directors also called on the industrial countries to improve market access for India's exports—particularly by reducing trade-distorting subsidies and tariff and nontariff restrictions on textiles, agriculture, and skill-intensive services—thereby generating considerable welfare gains not only for India, but also for consumers and tax payers in advanced economies.

Directors encouraged the authorities to remove the remaining exchange restrictions which are subject to approval under Article VIII, Section 2 as soon as possible.

Directors observed that India's own experience demonstrated that its industries can compete globally, in a more liberal trade environment, if they are free to do so, unshackled from heavy regulation. In particular, they noted that the extension of small scale dereservation would enable Indian industries to realize their natural scale advantages, reform of labor laws would facilitate greater labor mobility and generate larger employment opportunities, and reforms of bankruptcy laws and procedures would enable critical industrial restructuring.

In the context of further liberalizing agriculture product markets, Directors noted that it was now essential to reform the system of Minimum Support Prices and the Public Distribution System, both for budgetary reasons and to encourage the much-needed diversification within the agricultural sector. They encouraged the authorities to reexamine the size of food stocks in light of the very large maintenance costs, the increasing access to imports, and the comfortable level of foreign exchange reserves.

Directors commended India's active participation in the standards and codes initiatives. With the recent participation in the Statistics ROSC, India has completed most key assessments. In light of the remaining weakness in data that impede economic analysis and policy making, Directors strongly encouraged the authorities to give priority to improving the quality and timeliness of macroeconomic statistics. In view of the rapid growth in the insurance sector since liberalization of entry in 2000, Directors encouraged the authorities to participate in an assessment of the observation of the IAIS core principles for the supervision of the insurance sector. Directors commended the priority given by the Indian authorities to formulating policies and laws to prevent money laundering and the financing of terrorist activities, and applauded the authorities' recent decision to forgive debt owed by HIPC countries.