Public Information Notice No. 05/12

Public Information Notice: IMF Executive Board Concludes  2004 Article IV Consultation with India

February 3, 2005

On January 24, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with India.¹

Background

India is on track for another year of robust growth in 2004/05. Supported by a strong monsoon, growth rebounded to 8½ percent in 2003/04, the highest level in over a decade. This year, firms appear to have embarked on a new investment cycle, underpinned by strong credit growth. In spite of high world oil prices and a disappointing monsoon, staff projects growth of 6½ percent this year, buoyed by the dynamism of industry and services. In 2005/06, a recovery in agriculture on normal monsoons should support growth in the range of 6½ percent.

Inflation has been running higher, driven largely by supply-side factors. With rising international oil and steel prices, and the weak monsoon temporarily affecting food prices, Wholesale Price Index (WPI) inflation accelerated to 8.7 percent in August (year-on-year), before decelerating to 5½-6 percent more recently. With demand pressures remaining strong, capacity utilization high and liquidity ample, WPI Inflation is projected to end 2004/05 around 6½ percent, before declining to an average of 5½ percent in 2005/06.

The balance of payments position remains comfortable notwithstanding the higher oil prices. In 2003/04, strong growth in remittances and services contributed to a current account surplus of 1.7 percent of GDP. While export growth continues to be strong, high oil prices and strong investment demand have led to a widening the trade deficit (2.6 percent of GDP in the fiscal year to end-December). However, continued gains in services and strong remittances are expected to help sustain the current account in broad balance in 2004/05. Capital account developments appear to be driven by renewed optimism about the Indian economy following a post-election lull. Rising portfolio inflows are accompanying a pickup in FDI. Reserves remain comfortable, having reached US$129 billion by mid-January.

Financial market confidence in India remains strong. After posting one of the highest returns among emerging markets in 2003/04 (83 percent), the stock market experienced a short period of turbulence at the start of the fiscal year, reflecting election-related uncertainty and expectations of interest rate tightening in the United States. However, buoyed by renewed foreign investor inflows, the stock market more than regained the ground lost, rising by close to 30 percent between June and mid-January.

Monetary policy was aimed at curbing inflation pressures while ensuring sufficient liquidity to support growth. Starting last April, the Reserve Bank of India (RBI) has issued Market Stabilization Bonds to sterilize capital inflows. In October 2004, the RBI also raised banks' reserve requirements by 50 basis points and increased the reverse repo rate by 25 basis points. These steps, combined with the increase in credit, have reduced excess liquidity. At the same time, the RBI has encouraged banks to protect against interest rate risk on their large holdings of government securities including by building investment fluctuation reserves.

Exchange rate policy has become increasingly flexible, with the RBI intervening to smooth volatility. In the post-election period, the slowdown in capital inflows and downward pressure on the rupee led the RBI to sell dollars to limit the depreciation. In recent months, however, the rupee-dollar exchange rate has recovered the lost ground.

The deterioration in central government finances appears to have been reversed. For the first time since the mid-1990s, the central government deficit (IMF definition)² came in below target in 2003/04 at 5.1 percent of GDP reflecting strong revenues and economic growth. However, this improvement appears to have been offset by overruns on subnational budgets, causing the general government deficit to rise to an estimated 9.7 percent of GDP in 2003/04.

Further improvement in general government finances is budgeted for 2004/05. The central government budget for 2004/05 envisages an overall deficit (IMF definition) of 4.5 percent of GDP. The budget, which was delayed until after the elections, introduced some tax base broadening measures, but major tax reform initiatives and significant spending increases for key social or infrastructure needs were postponed to next year. The fiscal deficit for the first half of the year was in line with budget plans although achieving the ambitious revenue targets will require strong efforts. With an improvement expected in state finances as a result of ongoing reform efforts, the general government deficit for 2004/05 is projected at 9.3 percent of GDP.

The authorities have agreed to publish the Article IV consultation report.

Executive Board Assessment

Executive Directors expressed their sympathies to the Indian people for the tragic loss of life resulting from the recent tsunami. Directors viewed the resilience of the Indian economy in recent years as testimony to the benefits of more than a decade of reforms. They noted that, in spite of high world oil prices and a weak monsoon, India is on track for another year of robust growth in 2004/05, following the strong performance of 2003/04, when growth exceeded 8 percent. Directors welcomed the new government's ambitious reform agenda—especially the renewed emphasis on creating jobs and reducing rural poverty—and its commitment to addressing India's fiscal imbalances. They emphasized that rapid progress on a broad range of reforms will be required to build on recent successes and for India to achieve its full potential. Directors considered that the present favorable economic environment provides a good opportunity for India to make a bold push towards achieving its reform agenda, and encouraged the authorities to garner the necessary political consensus for it.

Directors emphasized that India's large fiscal deficits and public debt remain a key constraint on sustained rapid growth. Directors noted that, with credit to the private sector on the rise, the government's large financing needs can increasingly crowd out private investment. Moreover, they underlined that, without enhancing tax revenues and reducing lower-priority spending, it will be very difficult to adequately address India's large infrastructure needs. Directors also pointed out that fiscal consolidation is a prerequisite for more complete financial sector development and further opening up of the external sector.

Directors viewed the new Fiscal Responsibility and Budget Management Act (FRBMA) as a good framework for restoring fiscal sustainability. They also viewed as broadly appropriate the government's roadmap for achieving the targets of the FRBMA—notably, the elimination of the current deficit by 2008/09—citing, in particular, the emphasis on frontloaded tax reform and improvements in the quality of spending. In this context, Directors underlined the importance of introducing the state value-added tax (VAT) as planned on April 1, broadening the personal and corporate income tax bases and strengthening tax administration, and appropriate targeting of subsidies. Directors supported the authorities' intention to move toward a national goods and services tax over time. They emphasized the importance of the government meeting its fiscal targets in this, the first year of the FRBMA, in order to firmly establish its credibility. Directors also advised vigilance regarding central- and state-government contingent liabilities.

Directors recognized that reforms have been undertaken to strengthen state finances, noting that these steps have so far not led to a decisive turnaround. They emphasized that more needs to be done. Directors were encouraged that a number of states have enacted their own fiscal responsibility legislation. In this regard, they emphasized that states still account for about half of the general government deficit. Directors pointed to the importance of states introducing the VAT, strengthening their pension systems, and accelerating progress on power sector reforms. They also urged the central government to make more effective use of its leverage over the states—including via its approval of all state borrowings—to encourage needed reforms.

Directors supported the government's emphasis on closing India's infrastructure gap, but expressed serious concerns with the proposal to use foreign exchange reserves to finance infrastructure spending. Directors emphasized the importance of undertaking any increases in infrastructure spending within the limits of the FRBMA. They noted as well that significant private sector participation in infrastructure will likely be forthcoming if India will step up its efforts to improve the investment climate and enhance the regulatory framework for public-private partnerships. Directors also noted that using reserves in this manner has the potential to compromise perceptions of central bank independence and increase inflation.

Directors viewed continued progress on structural reforms as critical to sustaining rapid growth in India. They noted that the recent reduction in small-scale reservation and the relaxation of some sectoral caps on foreign direct investment are important advances. Directors emphasized, however, that to generate the large number of new jobs needed to meet the rising working age population, the authorities should enhance the business climate, including by easing the burden of regulation, and liberalize restrictive labor laws. Directors noted that agricultural reform is critical to growth and poverty reduction. In this context, they emphasized that the government's commitment to improving rural infrastructure is appropriate, but that eliminating structural impediments to growth—including by reforming the current system of price supports, guaranteed procurement, and large subsidies for fertilizer and power—is equally important.

Directors saw the continued strength in India's balance of payments as an excellent opportunity to accelerate trade liberalization. Directors welcomed India's progress in bringing down tariff rates last year and their commitment to further reductions to ASEAN levels over the medium term. However, they underlined that more rapid progress on reducing tariffs, together with a lowering of administrative barriers to trade, will help unleash a potentially powerful engine of growth.

Directors commended the continued progress made in strengthening the financial sector, but observed that risks remain. They noted that nonperforming loans of banks have declined, despite a tightening of loan classification norms, and that capital adequacy ratios are well above the 9 percent minimum. Directors noted, however, that the recent rise in private sector lending—while generally welcome—requires close scrutiny by the RBI. In this context, Directors welcomed the recent RBI decision to increase the risk weight on consumer and housing loans, and encouraged supervisors to strengthen risk-based prudential requirements. Directors also pointed to the large bank holdings of government securities as a significant potential risk in a rising interest rate environment, and emphasized the need to monitor more closely risk management practices of banks. Directors viewed recent steps to merge Development Finance Institutions with large nonperforming loans and a high cost of funds with public commercial banks as potentially helpful. However, they underlined the importance of ensuring that lending decisions by the new institutions be made on purely commercial principles. Directors commended the authorities for addressing problems of governance in urban cooperative banks.

Directors emphasized that more remains to be done, over the medium term, to build a strong and globally competitive financial sector and improve resource allocation. In this context, Directors encouraged the authorities to open further the banking system to private and foreign investors, including by raising the FDI cap for private banks and eliminating the 10 percent limit on voting rights for foreign investors.

Directors viewed the authorities' burden-sharing approach to bearing the costs of sharp increases in international oil prices as understandable, but cautioned that it may not be sustainable. They emphasized that, with oil prices potentially remaining high and volatile for some time, it is important for the authorities to allow their automatic pricing mechanism to work. This would protect government revenues, limit losses to state-owned petroleum companies, and provide incentives for more efficient energy use.

Directors viewed monetary policy as generally appropriate. They noted that the RBI's timely increase in the reverse repo rate in October signals its commitment to price stability, stabilizes inflation expectations, and avoids the need for a more aggressive move later. Directors emphasized that, while inflation has recently trended downward, strong domestic demand, comfortable liquidity, and the potential for further commodity price increases will require the RBI to continue to monitor inflation developments carefully.

Directors welcomed the efforts by the RBI to increase exchange rate flexibility, and encouraged the RBI to continue to support this policy going forward. They noted that, should capital inflows remain strong, increased flexibility will reduce inflationary pressures, facilitate economic adjustment, and encourage hedging of foreign exchange risk.

Directors supported the Indian authorities' gradual approach to capital account liberalization. They commended steps taken during the past year to relax restrictions on capital outflows for individuals, ease corporate access to international capital markets, and raise the cap on foreign investor holdings of government securities. Directors encouraged the authorities to continue to eliminate restrictions on foreign direct investment, which tend to be longer-term in nature.

Directors urged the authorities to continue to improve the quality of their statistics. They urged that priority be given to developing more timely and comprehensive indicators of inflation; and more timely data on state finances. In this light, they welcomed recent Fund technical assistance to develop an integrated state fiscal data base and debt register.