Public Information Notice No. 97/11

Press Information Notice: Press Information Notice: IMF Concludes Article IV Consultation with India

July 16, 1997

The IMF Executive Board concluded the 1997 Article IV consultation¹ with India on July 2, 1997.

Background

India's GDP increased around 6 1/2 percent in 1996/97, implying an average growth rate of close to 7 percent over the past three years (India's fiscal year begins April 1). This robust growth together with rising saving and investment rates point to a continuing strong response to the economic reforms initiated in 1991. Nevertheless, the growth momentum weakened during the year, as indicated by slowdowns in industrial output and investment. Contributing factors have been high real lending rates implied by the still large fiscal deficit, slow growth in commercial credit, and increasing infrastructural bottlenecks (e.g., in port capacity, road transport, and power supply). Wholesale price inflation increased to 71/2 percent during 1996/97, responding to an unexpected shortfall in food grain production, but has moderated to 6 percent in May as grain price pressures have subsided.

The external situation strengthened considerably during 1996/97. Despite a sharp fall in export growth, the current account deficit declined to just over 1 percent of GDP, reflecting a marked deceleration of non-oil import growth. The export slowdown was partly explained by temporary special factors and weaker growth of external demand, but it also reflected a dwindling of the impulse from trade liberalization and exchange rate depreciation in the early 1990s as well as infrastructural bottlenecks. The capital account benefitted from strong inflows of private capital, although foreign direct investment remained low by East Asian standards. The Reserve Bank of India (RBI) responded to upward pressures on the exchange rate with substantial foreign exchange purchases, and international reserves rose to $24 1/4 billion (the equivalent of over 6 months of imports) by end-May 1997.

Despite some reduction at the central level, the overall public sector deficit (comprising the central government, state governments, the oil pool account, and central public enterprises) is estimated to have increased slightly to 9 1/4 percent in 1996/97. The central government deficit declined to 5 percent of GDP, in line with the budget target, but the deficit on the oil pool account rose sharply, mainly because increasing oil import prices were not passed fully on to consumers. The budget for 1997/98 aims at lowering the central government deficit further to 4 1/2 percent of GDP. Significant cuts in income tax rates and customs tariffs were implemented in the budget, but the impact on revenue is assumed to be offset by improved tax compliance.

The stance of monetary policy was progressively relaxed in 1996/97 in response to mounting evidence of an industrial slowdown, and the yield curve steepened as short-term interest rates declined markedly. However, despite increasing bank liquidity, commercial credit growth slackened during the year, partly in response to banks' efforts to improve their balance sheets. The RBI has announced a broad money target range of 15-15 1/2 percent for 1997/98, slightly lower than in 1996/97, and broadly consistent with their objective of holding inflation to 6 percent. Steps were also taken to ease cumbersome controls on bank lending practices and to promote the development of foreign exchange and money markets. In addition, the mechanism that provided automatic financing for the government through issuance of ad hoc treasury bills has been eliminated and replaced by a system of temporary ways and means advances, which should enhance the RBI's autonomy in setting monetary policy.

The government that took office in June 1996 has given renewed impetus to structural reforms. In addition to the substantial tax cuts in the 1997/98 budget, foreign investment regulations have been liberalized, restrictions in the trade regime have been eased, banking regulations and supervision have been strengthened, and there have been a series of reforms to industrial and infrastructural policies. Nevertheless, the consequences of the incomplete nature of the reforms are increasingly evident, for example, in the export slowdown and in the relatively slow pace of new investment in infrastructure sectors now open to the private sector.

Executive Board Assessment

Executive Directors noted that India's overall economic performance had remained broadly favorable, despite a recent slowdown in industrial production and exports. The continuation of strong economic growth without major signs of an acceleration in inflation and with a strengthened external position was welcome evidence of the continuing robust supply response to the structural reforms initiated in the early 1990s. Directors commended the authorities for pursuing policies that had set the Indian economy on a new course of modernization to meet the challenges of globalization, and they encouraged the authorities to sustain the renewed momentum of reform. Directors reiterated that, to sustain high growth, reduce poverty, and realize India's economic potential, it would be necessary to make decisive progress toward fiscal consolidation and push forward with the still long remaining agenda for structural reforms.

Regarding short-term macroeconomic management, Directors considered that vigilance was required to avoid a buildup in demand pressures. They generally shared the staff's view that the recent slowdown in industrial production and exports was, to a considerable extent, a consequence of the partial nature of the reforms, which had contributed to infrastructure bottlenecks and continuing constraints in the financial sector. In view of the uncertainties associated with the short-term outlook, Directors stressed the need to monitor developments carefully and to tighten the policy stance promptly should inflationary pressures intensify. Some Directors cautioned against stimulative macroeconomic policies in the face of the moderate growth slowdown.

Directors noted that the large public sector deficit was a drag on economic performance. The fiscal deficit not only reduced national saving and crowded out investment, but also placed an excessive burden on monetary policy in maintaining macroeconomic stability. Directors expressed concern that even the modest deficit reduction targeted in the 1997/98 central government budget might not be achieved. Since there was a significant risk that revenues would not respond to recent bold tax cuts as buoyantly as anticipated by the authorities, Directors stressed the need to be ready to implement contingency measures. They also underlined the need to accelerate the disinvestment program, the urgency of implementing a substantial increase in petroleum prices, and the need to phase out fertilizer subsidies.

Beyond the present fiscal year, Directors welcomed the authorities' target of lowering the central government deficit to 3 percent of GDP by the turn of the century, but emphasized that there was a need for more ambitious efforts to reduce the overall public sector deficit decisively from its present level of about 9 percent of GDP. At the central government level, the recent tax rate cuts needed to be complemented with measures to expand the base, reduce tax exemptions, and improve tax administration. It would also be important to reduce civil service employment and cut and better target subsidies. Many Directors also called for improvements in the composition of expenditure to reorient spending from unproductive spending, such as subsidies, toward infrastructure and social spending on health and education; while a point was made that the authorities had reduced defense spending as a proportion of GDP, a few speakers referred to the need to reorient such spending toward infrastructure and the social sector. Directors welcomed the authorities' approach of promoting public discussion on the issue of subsidies through the issuance of a "white paper." More vigorous efforts were needed to improve public enterprise performance--including full privatization of many of those companies. Directors stressed that adjustment was also needed at the state level to lower deficits and to improve the composition of state spending. They emphasized the importance of following through with recent state-level initiatives, and they suggested that the center could encourage that process by enhancing the incentives for adjustment at the state level.

Directors observed that while surging private capital inflows signaled growing confidence in the Indian economy, such inflows could lead to an unintended loosening of monetary policy unless the exchange rate were managed flexibly. Directors welcomed indications that the authorities were prepared to adopt a more flexible approach to exchange rate management. They emphasized that the most effective means for mitigating upward pressures on the real exchange rate in the face of rising capital flows was through a faster pace of trade liberalization, accelerated fiscal consolidation, and the easing of restrictions on capital outflows.

Directors called for a cautious stance on monetary policy. Noting the present high level of liquidity in the banking system, they cautioned particularly against the possibility of rapid rates of credit creation. They stressed that the authorities should not resist increases in interest rates--particularly at the short end--in the event of a pickup in credit demand. Directors welcomed the ending of the system of automatic RBI financing of the government budget deficit, but stressed that this would have to be accompanied by further measures to enhance the RBI's operational independence.

Discussing the agenda for reforms, Directors emphasized the importance of further trade liberalization--including further tariff cuts and a more rapid elimination of remaining quantitative restrictions on consumer goods--and a more comprehensive easing of small-scale sector reservations. A few Directors expressed disappointment that agreement was not reached with the WTO Committee on Balance of Payments Restrictions on the phasing out of quantitative restrictions. Directors called for an acceleration of financial sector reforms, supported by further efforts to strengthen banking prudential norms and supervision. Directors stressed that the best prospects for achieving a fundamental improvement in the banks' operating efficiency would result from an increase in the private sector's role in bank management. Some Directors also called for an easing of the restrictions on the operation of foreign banks in India. Another key priority for structural reform should be to establish more effective exit policies in order to facilitate the redeployment of resources across sectors. Some Directors pointed to the need for labor market reforms to increase the flexibility of those markets.

Directors recognized the considerable potential efficiency benefits India would gain from capital account liberalization and welcomed the forward-looking proposals put forward by the Committee on Capital Account Convertibility. They considered that it was important to ensure that liberalization was phased carefully and dovetailed with the necessary domestic adjustments. In particular, Directors stressed the need for fiscal consolidation and trade reforms to reduce the risks that resources could be misallocated internally. They also emphasized the need for the further strengthening of the domestic banking system to prepare it for a more competitive financial environment. Directors noted that there was considerable scope to move forward at an early stage to liberalize further equity inflows and foreign direct investment. The Committee on Capital Account Convertibility's proposal on the establishment of transparent guidelines for foreign direct and portfolio investment was welcomed.

Directors urged that the remaining exchange restrictions subject to approval under Article VIII be eliminated as quickly as possible. They welcomed the authorities' decision to subscribe to the Special Data Dissemination Standard and underlined the need to improve India's economic statistics to provide more timely and reliable guidance for macroeconomic policy decisions.