Public Information Notice No. 06/17

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with India

February 21, 2006

On February 6, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with India.¹

Background

India's growth has remained robust in 2005/06 following a strong performance last year. With rapid growth in services broadening to encompass industry, GDP growth in 2004/05, at 7½ percent (recently revised upward from 6.9 percent) was above the historical trend. Strong momentum in manufacturing and services has continued, resulting in rising capacity utilization and soaring business confidence. Staff projects growth of over 7½ percent this year, led by strong domestic demand, and broadly in line with the Reserve Bank of India (RBI) and consensus forecasts. In 2006/07, growth is expected to decline slightly as the economy further adjusts to higher oil prices and domestic and world interest rates rise.

While inflation remains low, underlying pressures from buoyant domestic demand and higher international energy prices remain strong. Steps taken by the RBI to tighten liquidity in 2004/05, including raising reserve requirements and policy interest rates, and incomplete pass-through of higher oil prices helped keep WPI inflation low. With headline inflation hovering around 4½ percent year on year, the RBI raised overnight repo rates again in October 2005 and January of 2006, by a cumulative 50 basis points, citing concerns about the rapid pace of aggregate demand and monetary growth and high oil prices. Staff projects inflation to rise from an average of about 4¾ percent in 2005/06 to 5½ percent in 2006/07, in part reflecting the adjustment of administered fuel prices.

After several years of current account surpluses and growing reserves, the investment recovery and consumption boom have pushed the external current account into deficit. In 2004/05, the trade deficit widened to over 5½ percent of GDP and the current account reverted into deficit for the first time in three years, notwithstanding high growth in services income. While export growth continues to be strong, a large increase in both oil and non-oil imports caused the trade deficit to widen further this year, and contribute to a sharp deterioration in the current account deficit. Staff projects it to reach 3 percent of GDP in 2005/06.

The balance of payments position remains comfortable with strong capital inflows helping finance the growing current account deficit. In 2004/05, close to half of all capital inflows were debt creating, as Indian corporates took advantage of favorable global interest rates, an appreciating rupee, and the liberalization of restrictions on external commercial borrowings to borrow abroad. While portfolio flows have continued to gain importance, FDI inflows remained weak. So far this fiscal year, capital inflows have remained strong and reserves have only fallen modestly as a result of the redemption of the India Millennium Deposits. While more reliance on debt and portfolio inflows has increased India's susceptibility to changes in investor sentiment, ample reserves and remaining capital controls limit risks of potential reversals.

Asset markets have strengthened. Net foreign investor inflows have accelerated since mid-2005, as equity prices soared. Equity prices are up around 50 percent from end-April. Ample liquidity and historically low interest rates also helped fuel property prices, which have risen in major cities by over 20 percent annually over the past two years. Concerned with speculative pressures, the RBI has raised risk-weights on housing and real estate loans and imposed controls on real estate investments aimed at curbing speculative FDI inflows.

The exchange rate has exhibited increased two-way flexibility. In the eight months to June 2005, the RBI scaled back intervention in foreign exchange markets and the rupee appreciated by 4 percent against the dollar (6½ percent in real effective terms). In the second half of 2005,—with the exception of a six-week period following China's July 21 revaluation, when the RBI intervened to stem appreciation pressures—the rupee depreciated, reflecting pressures from the growing current account deficit and renewed U.S. dollar strength.

Following three years of declining fiscal deficits, a "pause" in deficit reduction was announced for 2005/06. The central government deficit came in below target in 2004/05 for the second consecutive year at 4.1 percent of GDP (authorities' definition, including privatization receipts as revenue), helped by a cyclical rebound in revenue and expenditure compression, but also reflecting greater recourse to off-budget petroleum subsidies. This, together with a 0.8 percentage points reduction in subnational deficits, contributed to a fall in the general government deficit to under 7½ percent of GDP, enough to stabilize public debt at about 86 percent of GDP. The 2005/06 Budget deficit target of 4.3 percent of GDP falls short of the minimum reduction required by the Fiscal Responsibility and Budget Management Act. This reflected significant spending increases for key social and infrastructure needs and higher transfers to the states. The general government deficit is projected by staff to rise, for the first time in four years, to 7¾ percent of GDP.

The banking sector has continued to strengthen but some risks remain. Commercial banks have continued to reduce nonperforming assets, and aggregate capital adequacy remains high. Banks have reduced their exposure to interest rate risks, decreasing their holdings of government paper and shortening maturity. Declining profitability due to rising interest rates has been in part offset by higher credit growth. However, interest rate risk remains a concern with bank holdings of government paper (at 38 percent of assets) still high and in excess of statutory requirements. At the same time, rapid credit growth raises concerns about credit quality and cooperative banks, accounting for about 6 percent of banking system assets, remain in poor health.

Executive Board Assessment

Executive Directors noted that the Indian economy is continuing to reap the rewards of more than 15 years of reforms. Notwithstanding high world oil prices and a weak monsoon, the economy showed remarkable resilience in 2004/05, with growth remaining robust and becoming broader-based. These trends have continued in 2005/06, and growth of more than 7½ percent for the full year is expected.

Directors supported the broad objectives of the government's economic program, in particular addressing infrastructure bottlenecks, alleviating rural poverty, and deepening global integration. They noted that current favorable economic conditions provide a good opportunity to speed structural reforms. In particular, measures to improve the business climate and reform labor laws would have a large pay-off by fostering private and foreign investment and job creation. With an acceleration of the reform process, India would be able to achieve sustained economic growth of 8-10 percent, in line with the objectives of the authorities.

Directors emphasized that macroeconomic policies should remain vigilant, in view of the evolving macroeconomic situation. Although inflation has remained contained, underlying pressures point to upside risks. In particular, domestic demand remains strong, as evidenced by a widening current account deficit and rapid credit growth. In this context, Directors recommended that fiscal policy should counter demand pressures, and they underlined the importance of overperforming on the budget and meeting the minimum adjustment required under the Fiscal Responsibility and Budget Management Act. This would not only be an appropriate macroeconomic policy response, but would also bolster the credibility of the Act and allow the central government to lead by example in efforts to encourage adjustment at the state level. In this regard, some Directors cautioned that markets might interpret the pause in deficit reduction in the current fiscal year as a weakening of the commitment to reform.

Directors underscored the need for the Indian economy to adapt to permanently higher international oil prices. They recommended moving gradually to the full pass-through of oil prices—with targeted support for the poor—which would help limit fiscal and quasi-fiscal losses and provide incentives for more efficient energy use, thus aiding competitiveness in the medium term.

Directors considered that monetary policy should remain focused on keeping inflation expectations in check. The increases in the reverse repo rate by the Reserve Bank of India in October 2005 and January 2006 were seen as appropriate, signaling the RBI's commitment to price stability and helping the adjustment to higher global interest rates. Directors welcomed the RBI's continued two-way flexibility in exchange rate management.

Directors noted that, notwithstanding the deficit reduction achieved since 2001/02, India's large public debt remains a key constraint on growth. Without further enhancing tax revenues and reducing lower-priority spending, it will be difficult to create fiscal space for the planned large and crucial increases in infrastructure and social spending. In addition, with credit to the private sector rising fast, the risk that government borrowing needs will crowd-out the private sector has increased. Directors observed that fiscal consolidation is a prerequisite for more complete financial sector development and further opening up of the capital account.

Directors viewed an acceleration of tax reform as critical to achieve the government's deficit reduction targets. They welcomed the introduction of the value-added tax in most states and steps to widen the services tax base and modernize tax administration. Directors underscored the need to further broaden the tax base by trimming existing exemptions and eventually introducing a goods and services tax with few exemptions. Directors looked forward to the planned development of tax expenditure estimates, which would provide a valuable tool for resisting attempts to introduce new inefficient tax incentives.

Directors observed that greater spending efficiency, in particular improved targeting of subsidies, would be required to generate the needed fiscal adjustment. They viewed the government's 2004 subsidy reform blueprint as appropriate, and urged its rapid implementation. Directors underlined that the new rural employment program represents a potentially large expenditure commitment, and advised the government to proceed cautiously with it.

Directors welcomed the initiation of pension reform. The passage of the Pension Bill would allow the introduction of fully funded, defined contribution pensions, which in turn would help ensure a secure source of retirement income and aid in the development of capital markets. However, Directors pointed out that revisions to the existing defined benefit schemes for civil servants are also required to reduce large unfunded pension liabilities.

Directors noted that states have succeeded, in the aggregate, in reducing their deficits in recent years, and they welcomed recent reforms undertaken in the context of the Twelfth Finance Commission to further strengthen state finances. These reforms provide states with greater resources and incentives to undertake fiscal reform. However, Directors emphasized that state finances could be further strengthened by increasing conditionality and hardening budget constraints, including via tighter global borrowing ceilings. They called for consolidating the recent gains through tax base broadening and further reforms in the pension, subsidy, and state electric utility areas. Directors were encouraged that a number of states have already shifted to defined contribution pension systems and enacted fiscal responsibility laws.

Directors supported the government's emphasis on public-private partnerships to ensure greater private participation in investments in infrastructure. However, they cautioned that an improved regulatory framework and financial reforms to broaden the investor base are also needed. Directors viewed the 2003 Electricity Act as a solid framework for reform, and advised that it be implemented quickly.

Directors commended the underlying strength of financial regulation and the effective response to recent rapid credit growth. They advised close monitoring of fast-growing credit card debt. A further strengthening of prudential standards could be considered, where appropriate. Reliance on priority sector lending floors to deliver credit to agriculture and small and medium-sized enterprises could be reduced by addressing needed structural reforms in lending. Regulation should also be strengthened for cooperative banks. Directors urged the RBI to ensure readiness for the planned move to Basel II by continuing to enhance monitoring of banks' risk management systems, upgrade supervisory skills, and strengthen disclosure requirements. Directors considered that the current sound position of the financial system provides a good basis for its further deepening, in particular through increasing private and foreign participation in the banking sector, including by accelerating implementation of the RBI's banking reform roadmap.

Directors emphasized that further opening of the economy would allow it to reach its full growth potential. While they commended the progress already made in bringing down tariff levels, they noted that faster convergence to ASEAN levels would be desirable. Broad-based tariff reductions would also help minimize the trade diversion potentially associated with preferential trade arrangements. Also, continued loosening of sectoral limits on foreign direct investment, together with efforts to improve the business climate and liberalize labor laws, could foster growth and job creation, while reducing India's reliance on shorter-term capital flows. Some Directors noted that further privatization could spur efficiency gains and provide resources to reduce the public debt. Directors urged the authorities to consider labor market reforms, including expanded contract employment and streamlined labor regulations and reporting requirements. Such flexibility would be key to ensuring that India can generate jobs for its rapidly expanding labor force.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.