Public Information Notice No. 08/09

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with India

February 4, 2008

On January 23, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with India.¹

Background

India's economy continues to expand at a robust pace, with the growth rate averaging about 8½ percent in the four years through 2006/07 (April 2006-March 2007). Growth is fueled by strong momentum in investment reflecting high capacity utilization, buoyant corporate profits and business confidence, and a rise in productivity, within Asia surpassed only by China. A favorable monsoon should deliver above average agricultural growth. Staff projects growth of 8¾ percent in 2007/08, moderating toward potential in the near term as external demand weakens and past increases in interest rates dampen consumption growth.

After rising sharply in early 2007, Wholesale Price Index (WPI) inflation has ebbed to 3¼ percent due to decelerating food and manufacturing prices. While core inflation (excluding food and energy) is also contained, Consumer Price Index (CPI) inflation exceeds WPI inflation by over 2 percentage points. Staff projects WPI inflation to remain in the 3½−4 percent range in the near term, though inflation risks are to the upside due to rising international food and fuel prices, ample domestic liquidity, tight capacity utilizations, and rising skill premia.

Export growth remains robust at over 20 percent year-on-year in U.S. dollar value, but buoyant imports boosted by strong investment growth are projected to widen the trade deficit and raise the current account deficit to 1½ percent of GDP in 2007/08.

Swelling capital inflows more than finance the current account deficit. Capital inflows reached a record US$45 billion in 2006/07, and (as in other emerging markets) accelerated appreciably this fiscal year, pushing the capital account into a projected surplus of 9½ percent of GDP in 2007/08. Given India's vibrant growth outlook and sizeable capital demands, inflows will likely remain strong. Nevertheless, with low levels of external debt, ample reserves and limits on the amount and end-use of foreign debt financing, India's external position is sustainable and robust to significant shocks.

Capital inflows have lifted financial markets. Equity markets recovered quickly from the effects of the U.S. subprime crisis. The real estate market in India has been buoyant, although lending to this sector has been cooling recently reflecting past prudential measures by the Reserve Bank of India (RBI) to curb speculative pressures.

Strong capital inflows have put upward pressure on the rupee. After remaining roughly stable since 2000, the rupee appreciated by 7 percent in real effective terms between December 2006 and August 2007, with most of the appreciation occurring in the first half of the year. The RBI has accrued US$73 billion in reserves between end-March and end-November 2007, intervening (purchasing foreign currency) to smooth volatility under the managed float. Rupee flexibility is around a level comparable to other large emerging-markets currencies and the level of the rupee remains in line with fundamentals.

Large capital inflows are complicating the conduct of monetary policy, creating excess liquidity and pressuring the rupee. In addition to the exchange rate appreciation, several steps were taken to tighten monetary conditions. Since October 2006, the cash reserve ratio (CRR) has risen 200 basis points, while the repo (lending) rate was hiked twice by 25 basis points in the 12 months prior to the October 2007 policy meeting. With WPI inflation ebbing and real estate prices and credit growth slowing, the RBI left policy rates on hold at its October 2007 policy meeting, but raised the CRR by 50 basis points to 7.5 percent. As capital inflows swell, tensions in the monetary policy framework between exchange rate stability, monetary independence and financial openness are beginning to emerge.

Fiscal consolidation has been mixed, and slowed in 2006/07. Including off-budget bond issuance, the general government deficit held steady at about 7¼ percent of GDP. The central government deficit remained at 4½ percent of GDP, with buoyant tax revenue offset by higher expenditure. The states' aggregate fiscal deficit rose marginally to 2¾ percent of GDP. Revenues performed well, though expenditure rose faster on the back of rising public investment. Public debt remains high, at nearly 80 percent of GDP in March 2007.

Banks' balance sheets remain healthy according to standard indicators of financial soundness. While retail and real estate credit have grown significantly, risk measures have improved and banks' sizeable capital buffers indicate that the credit cycle is likely to be manageable. Corporate leverage is rising but remains low.

Executive Board Assessment

Executive Directors commended India's outstanding economic performance and its success in reducing poverty, a tribute to the authorities' sound macroeconomic policies and structural reforms. India's economy has been resilient in the face of heightened global uncertainties, slowing U.S. growth, and high world oil prices, and is expected to expand by 8¾ percent this fiscal year as a result of rising productivity and investment. India's favorable outlook has attracted record capital inflows, which help finance investment but also present challenges to managing capital markets integration.

The key challenge facing the authorities is to sustain rapid and inclusive growth, foster job creation, and maintain macroeconomic and financial stability in the context of large capital inflows. Directors endorsed the authorities' policy priorities, which are to manage financial globalization and tackle supply constraints through an enhanced monetary framework, financial sector development, fiscal consolidation, and removal of structural bottlenecks.

Directors commended the authorities' success in containing inflation and maintaining domestic financial stability. They observed that large capital inflows have exacerbated tensions among exchange rate stability, monetary independence, and financial openness. They supported the central bank's active management of liquidity and accommodation of increased exchange rate volatility, while noting the appreciation pressures on the rupee. Directors concurred that rupee appreciation reflected strong fundamentals and increasing productivity, and saw the policy of a managed float as remaining appropriate. A number of Directors, however, expressed concern that rupee appreciation has adversely affected India's external competitiveness in certain labor-intensive sectors. These Directors supported the authorities' cautious and pragmatic approach to managing capital flows, including through temporary capital controls, while commending the authorities' intention to move to fuller capital account convertibility gradually over the medium term. Some Directors cautioned against restrictions on capital inflows, emphasizing that increased exchange rate flexibility, strengthened monetary operations, and more effective communication with markets could be a better way to increase monetary policy effectiveness in a more financially open environment.

Directors emphasized that broader and deeper financial markets could better intermediate capital inflows, accommodate exchange rate volatility, and support financial stability and economic growth. They encouraged the authorities to press ahead with developing domestic corporate bond and derivatives markets, and to implement more market-based monetary operations. Enhancing banks' efficiency can also improve financial intermediation.

Directors welcomed the Reserve Bank of India's focus on preserving financial stability through close scrutiny of banks and efforts to improve banks' risk management. While they commended the overall soundness of the financial system, Directors called for continued vigilance, particularly in light of the rapid growth of real estate credit. Directors welcomed the forthcoming implementation of the Basel II supervisory framework, and looked forward to the publication of the authorities' self-assessment of financial stability and development.

On the fiscal front, Directors welcomed the continued buoyancy of tax revenues, but noted that with public expenditure and debt still relatively high, more rapid fiscal consolidation is warranted. A tighter fiscal stance could also help offset the liquidity impact of buoyant capital inflows and thus relieve appreciation pressures. Directors stressed that expenditure reforms are needed to create space for priority spending. In this connection, they noted the growing fuel subsidy burden and the need to adapt to higher international oil prices through a phased reduction in subsidies for most fuel products, while ensuring that adequate and well-targeted safety nets are in place to protect the poor. Directors welcomed plans for a national goods and services tax, and noted that cutting tax exemptions, increasing user fees and further improving tax administration would improve the tax base.

Directors urged greater progress in structural reforms to ease real sector rigidities, boost productivity and competitiveness, and ensure that the benefits of growth are widely shared. They concurred with the priorities identified in the government's "inclusive growth" agenda: bridging infrastructure gaps with private sector participation, ensuring access to social services, and promoting a competitive environment that supports private sector investment and job creation. Toward these goals, Directors emphasized that more flexible labor regulations can facilitate the reallocation of labor to stronger sectors, while higher and more effective public spending on education is needed to address the skills gap.

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.