Public Information Notice No. 98/75

Public Information Notice: IMF Concludes Article IV Consultation with India

September 22, 1998

On August 31, 1998, the Executive Board concluded the Article IV consultation with India¹.

Background

Since the early 1990s, the Indian authorities have made considerable progress in addressing the underlying structural distortions in the economy and encouraging private sector activity. Trade and tariff reforms, financial sector liberalization, and the opening of the investment regime prompted a strong supply response. Real GDP grew at an annual rate of 7½ percent between 1994/95 and 1996/97; exports increased at an average rate of 20 percent per annum in U.S. dollar terms during this period; and foreign trade almost doubled in relation to GDP (to 22 percent). With the current account deficit declining and foreign direct and portfolio investment inflows increasing strongly, the external position strengthened considerably and foreign exchange reserves were built up to comfortable levels. However, the rapid pace of economic growth, which was partly cyclical, could not be sustained as insufficient fiscal adjustment kept pressure on real interest rates, and infrastructure bottlenecks and incomplete reforms in a number of key areas—including the financial sector, public enterprises, the small-scale sector and agriculture—constrained output and export growth.

Real GDP growth moderated to 5 percent in 1997/98 as agricultural output declined and industrial growth remained subdued. Inflation began to pick up in 1998 reflecting in part temporary factors affecting food prices: by mid-year WPI inflation had increased to 8 percent, and CPI inflation reached 12½ percent. Although the balance of payments position remained comfortable in 1997/98, with the current account deficit remaining low (1.6 percent of GDP) and the capital account recording a sizable surplus, strains have emerged. Export growth has declined in U.S. dollar terms due to weaker world demand—particularly from East Asia which accounts for 20 percent of India’s exports—and structural and specific sectoral problems. Amidst changes in broader investor sentiment toward emerging markets following the Asian crisis, portfolio investment flows began to turn negative in the second half of 1997/98 after sustained, large inflows for many years. Moreover, increasing spreads on India’s corporate debt abroad discouraged external borrowing. The announcement of economic sanctions in May 1998 added to negative market sentiment. Nevertheless, foreign exchange reserves are comfortable and stood at US$26½ billion (including gold and SDRs) at mid-August 1998, equivalent to about 6 months of imports and more than double maturing debt obligations in 1998/99. In addition, the successful launch of a five–year Resurgent India Bond in August 1998 (at a spread of about 215 basis points over LIBOR) has attracted over $4 billion from non–resident Indians.

The underlying fiscal position weakened in 1997/98. The central government deficit (excluding divestment receipts) increased by 1 percent of GDP to 6.2 percent mostly on account of a major shortfall in tax collections. Moreover, the slow progress toward expenditure reform was evident by the continued high burden of subsidies and wage payments. Fiscal imbalance also remained serious at the state level, impairing the states’ ability to develop their infrastructure and effectively tackle social issues. The consolidated public sector deficit, therefore, remained high at about 9½ percent of GDP.

With the fiscal policy constraints, and faced with an increasingly unfavorable external environment, the burden of adjustment fell largely on monetary and exchange rate policies. In 1997/98, broad money increased by 17½ percent, exceeding the RBI target range of 15–15½ percent. In response to pressures on the rupee, and after initial intervention in the foreign exchange market, the Reserve Bank of India (RBI) tightened monetary conditions in January 1998 by hiking short–term interest rates and raising the cash reserve ratio. As relative stability returned to the foreign exchange market in March and April, the measures were gradually reversed. However, with pressure on the rupee reemerging, monetary policy was tightened again in August 1998. Overall, the rupee has depreciated by 17 percent against the dollar between the onset of the Asian crisis in July 1997 and late August 1998.

The policies of the new government are broadly geared toward maintaining domestic demand and providing a boost to growth by increasing public investment, particularly on infrastructure. The central government budget deficit (excluding divestment receipts) is targeted to decline by 0.3 percent of GDP to 5.9 percent. Despite the tightening at the short-end, overall monetary conditions have been kept relatively easy to support a revival of economic activity. The government has also announced structural reform measures to enhance growth, including a strengthening of the divestment process, accelerating foreign direct investment, preparatory steps to address the weaknesses of the banking system and open the insurance industry toprivate investors, as well as several legislative measures (e.g., related to introducing a new Foreign Exchange Management Act and repealing the Urban Land Ceiling Regulation Act).

Executive Board Assessment

Executive Directors noted that, following three years of impressive performance, output and export growth had slowed, and inflation had increased. However, notwithstanding these increased strains and despite the Asian financial crisis, real GDP growth remained significantly positive, the balance of payments position satisfactory, and foreign exchange reserves relatively comfortable. Directors, therefore, commended the authorities for these achievements, welcoming especially the increased flexibility of monetary policy and the authorities’ intention of proceeding with the economic liberalization process, after some recent loss of momentum.

Directors stressed, however, that the near–term situation still contained substantial risks, and that the reform agenda was far from complete. Although contagion from the regional crisis and cyclical factors had contributed to the recent slowdown in industrial production and exports, Directors also pointed to a number of fundamental structural constraints affecting growth; these were compounded by uncertainties created by the political situation and international economic sanctions. Against this background, Directors cautioned that the authorities’ strategy of orienting fiscal and monetary policies toward supporting domestic demand could risk further straining macroeconomic stability, and suggested that a stronger macroeconomic stance would help restore low inflation and improve market sentiment. They also emphasized that reinvigorating the momentum of investment and growth would require bold policy steps to convince markets of the comprehensive character and consistency of reforms.

In this context, Directors expressed concern that the public sector deficit cannot be sustained at its current high level without heavy costs to the country’s long–term economic prospects. They also expressed doubts whether the modest reduction in the fiscal deficit targeted for this year will be achieved, pointing to possible slippages in both the revenue and expenditure estimates. Moreover, they observed that the reversal of certain budgetary initiatives run the risk of further undermining the credibility of the fiscal policy stance. Thus, Directors welcomed the authorities’ commitment to take additional steps to ensure that the 1998/99 fiscal objectives are met, and stressed that this should be done through measures that would also strengthen the medium–term fiscal reform process.

Looking beyond the 1998/99 budget, Directors urged the authorities to launch an ambitious and front–loaded medium–term fiscal adjustment program, involving actions not only by the center, but importantly also, by the states. Reviving the fiscal reform process would help lower real interest rates, improve debt dynamics, create room for meeting essential social and infrastructure spending, and reduce the drag on growth. While supportive of the reduction intax rates implemented over the last few years, Directors noted that these reductions were not matched by an expansion of the tax base. In this regard, Directors saw considerable scope for improving tax administration and widening the tax base, in particular by eliminating costly tax exemptions mainly in the agricultural and export sectors. Directors noted the importance of reducing unproductive expenditures, by curtailing subsidies and reducing public sector employment, as well as generally improving cost recovery and public expenditure management. In this context, they also stressed the critical importance of improving expenditure allocation toward priority social sectors, especially primary education and health, and away from unproductive spending. Expressing concern about the lack of any perceptible fiscal adjustment by the states as a group, Directors stressed that states will need to intensify and broaden efforts to lower deficits, and also improve the composition of spending. In this connection, Directors commended the actions taken recently by the government of Andhra Pradesh and a few other states, in conjunction with the World Bank, to strengthen their finances, and hoped that other states would emulate them. They saw scope for the central government to encourage the process by enhancing incentives for adjustment, and welcomed the government’s commitment to changing the present revenue–sharing formula.

With the fiscal deficit still too high, Directors noted that monetary policy would continue to bear a heavy burden in ensuring macroeconomic stability. Directors stressed that monetary policy should be firmly focused on a low inflation objective and, from this perspective, they cautioned against a premature easing of the recently tightened monetary stance and further monetization of the deficit.

Directors commended the authorities for maintaining orderly conditions in the foreign exchange market, while allowing market forces to determine the exchange rate. They emphasized, however, that if significant and sustained downward pressure on the rupee were to re–emerge, interest rate policy should again be actively used to resist overshooting of the exchange rate. Directors also cautioned against relying on administrative measures to limit foreign exchange demand and curb speculation.

Directors welcomed the new government’s intention to push the reform agenda across a range of fronts, including privatization, infrastructure, insurance, and foreign direct investment, and urged quick implementation of these initiatives. Directors noted the room that still exists for simplifying the regulatory framework, enhancing transparency, and thereby facilitating investment decisions. Noting the still high level of protection in India, Directors underscored that considerable efficiency gains could be reaped by accelerating trade liberalization, including through further tariff cuts and a more rapid elimination of remaining quantitative restrictions on consumer goods. In this connection, they strongly urged the removal of the additional 4 percent import duty imposed in the recent budget. Directors also strongly encouraged the authorities to develop a consensus to allow the elimination of the policy of reserving items for production by the small-scale sector which acts as a drag on accelerating exports, revise existing labor laws, and set in place an effective exit policy to facilitate not only the redeployment of resources across sectors, but also encourage employment generating activities.

Directors welcomed the strategy for financial sector reforms outlined in the recent Narasimham Committee report. They urged the authorities to accelerate implementation of these reforms, noting that the experience of other Asian countries had shown that the costs of delaying such reforms could be extremely high, and recommended the early adoption of internationally accepted standards. Directors also stressed that far–reaching changes in public control and management of state-owned banks would be required to facilitate the entry of private capital, and thus to avoid further burdening the public debt outlook. Furthermore, it will be critical to establish effective procedures for containing and addressing the difficulties of weak financial institutions. Some Directors emphasized the crucial importance of a fully independent Reserve Bank of India. Directors encouraged the authorities to persevere with the phased opening of the capital account, particularly the further liberalization of foreign direct investment and portfolio equity flows.

Directors urged that the remaining exchange restrictions subject to approval under Article VIII be eliminated without delay. Directors welcomed the stepped–up efforts to address data shortcomings with the decision to subscribe to the Special Data Dissemination Standard. They underscored that updating statistical methods and enhancing the coverage and general quality of many data series will be critical to providing more timely and reliable guidance for macroeconomic policy decisions.