Report No: AUS5757 October 2013 India Development Update Economic Policy and Poverty Team South Asia Region The World Bank Group India Development Update October 2013 Standard Disclaimer: . This volume is a product of the staff of the International Bank for Reconstruction and Development/ The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. . Copyright Statement: . The material in this publication is copyrighted. 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India Development Update October 2013 Table of Contents Executive Summary ....................................................................................................................................... i 1. Recent economic developments ............................................................................................................ 1 1.1 Real sector activity ........................................................................................................................ 1 1.2 Balance of payments ..................................................................................................................... 2 1.3 Inflation ......................................................................................................................................... 4 1.4 Financial sector ............................................................................................................................. 5 1.5 Fiscal developments ...................................................................................................................... 7 1.6 Poverty and income distribution ................................................................................................... 8 1.7 Reform actions .............................................................................................................................. 9 2. Outlook ............................................................................................................................................... 11 3. Depreciation of the rupee .................................................................................................................... 15 This update was prepared by Denis Medvedev and Smriti Seth (SASEP) under the guidance of Vinaya Swaroop (Sector Manager, SASEP), Deepak Bhattasali (Lead Economist, SASEP), and Zahid Hussain (Lead Economist, SASEP), and on the basis of discussions with experts in New Delhi’s think tanks and policy making circles. Neeti Katoch, Varsha Marathe, and Niraj Verma (SASFP) authored the financial sector analysis, while Maria Mini Jos and Rinku Murgai (SASEP) authored the analysis of employment and poverty trends. The analysis of the currency developments was prepared by Ernesto May (SASPM), Denis Medvedev (SASEP), and Martin Rama (SARCE) with inputs from Poonam Gupta (DECOS), Yuki Ikeda (EASHS), Neeti Katoch (SASFP), Sujata Lamba (FCDDR), Sanket Mohapatra (DECPG), Rinku Murgai (SASEP), and Niraj Verma (SASFP). The team benefitted from valuable comments and contributions by Martin Rama (SARCE), Sanket Mohapatra (DECPG), and Andrew Burns (DECPG). Onno Ruhl (Country Director, SACIN) and Ernesto May (Sector Director, SASPM) linked the team to the Bank’s overall strategy and steered them in that direction. The updates are published twice yearly and give an overview of developments in the Indian economy in a global context, and also highlight topics related to medium- and long-term growth which are in the public debate at the time of writing. A special topic of the current update is the recent depreciation in the rupee, its causes, and potential consequences for the economy. India Development Update October 2013 Executive Summary Although the recent market turmoil has been The rupee depreciated sharply in May – driven primarily by external factors, it has August 2013, mainly caused by market fears magnified India’s macroeconomic of an early end to the Federal Reserve’s vulnerabilities. India was just one of a large stimulus program. As global investors shifted number of emerging market economies whose funds into US treasuries, the May-August fall in currency and capital account were adversely the rupee closely mirrored movements in other affected by a large outflow of portfolio emerging market currencies and US T-bonds. investment this summer. While these portfolio Although India’s macroeconomic vulnerabilities flows have been driven largely by investor fears are high – as reflected in large current account of a shift in the US monetary policy, countries and fiscal deficits – the market sentiment has with greater macroeconomic vulnerabilities have recently improved, in response to the Fed’s come under greater scrutiny. India’s below- decision to delay tapering as well as a clearer potential GDP growth, due to continued articulation of long-term policy goals by the slowdown in investment, high current account Indian authorities. deficit with growing structural vulnerabilities, rising food and fuel prices, and an improving but The current account deficit moderated and still elevated fiscal deficit, have added to exports performance improved. After reaching investor fears about the economy’s ability to a record high of 6.5 percent of GDP in the third cope well with external shocks. quarter FY2013, the current account deficit improved to 3.6 percent of GDP in the fourth The current downturn presents an quarter. Although the merchandise trade deficit opportunity to push ahead with critical worsened in the first few months of the current reforms. The current situation is unlikely to fiscal year, imports began to contract and export place an insurmountable stress on the economy, performance improved substantially in the past but it does offer an opportunity for measures to few months, aided by rupee depreciation. strengthen the business environment, attract more FDI, and increase productivity. These Core inflation has retreated to well below the measures could include steps to reinforce the RBI comfort threshold. Core inflation has financial sector via capitalization and broader fallen to 2.4 percent – well within the 4 percent banking/financial sector reforms, simplify the comfort range of the Reserve Bank – and has regulatory environment for firms, and strengthen brought down overall WPI inflation to 5.3 fiscal balances through continued fiscal percent for the current fiscal year. CPI inflation, discipline and the adoption of GST. The reform on the other hand, remained above 9 percent, momentum has accelerated in the last several pushed by rising prices of food and fuel. months, and possible further steps in the above directions by the authorities could bode well for Vulnerabilities in the corporate sector are on stronger growth in the medium and long-term. the rise. While corporate debt levels have risen, earnings and profitability remained under The growth rate of the Indian economy pressure, pushing up debt coverage ratios. These decelerated to 4.4 percent in the first quarter vulnerabilities were transmitted to the banking of FY2014. A sharp slowdown in manufacturing sector, with a concomitant increase in non- and continued weakness in the mining sector performing assets, particularly among public were offset by a small acceleration in services – sector banks. The banking system remains particularly public services – and a strong robust overall, although stress levels are elevated rebound in agriculture, supported by early and and rising rapidly, meriting close attention. plentiful monsoons. On balance, however, growth remains muted and business confidence Fiscal performance improved in FY2013, but has fallen below the contraction threshold for the fiscal targets have come under stress. While past two months. the FY2013 central government deficit of 4.9 i India Development Update October 2013 percent of GDP is well below budget estimates, budgets, real income losses – particularly in the this year’s target of 4.8 percent is likely to come rural areas – could well be offset by a favorable under pressure. In the first four months of the monsoon. The greatest risks are in the corporate current fiscal year, the central government has and banking sector, where depreciation has already incurred a deficit equivalent to 62.8 exacerbated pressures from falling profitability percent of the target for the entire year, as tax and rising non-performing assets. Overall, collections remain subdued in line with weak however, the situation is likely to be manageable economic activity whereas subsidy spending has and instead offers the authorities a window of risen sharply with the depreciation in the rupee. opportunity to further boost competitiveness through reform actions. The decline in poverty has accelerated, but vulnerability remains high. Between 2005 and The macroeconomic environment is expected 2012, India lifted 137 million people out of to improve and growth is expected to poverty and reduced the poverty headcount (at accelerate gradually over the next two years. the national poverty line) to 22 percent of the The baseline scenario in this Update is population. The pace of poverty reduction has conditional on further improvements in the been accelerating over the years, and a much macroeconomic framework, benign global larger fraction of the decline is taking place in conditions, and continued efforts by the low-income states. On the other hand, inequality authorities to strengthen the business continues to rise – albeit at a decelerating rate – environment and improve fiscal sustainability. and more than half of India’s population remains Under these assumptions, the pace of economic vulnerable, living between one and two poverty activity is expected to accelerate appreciably in lines. the second half of FY2014, bringing economic growth to 4.7 percent for the entire fiscal year. The depreciation in the rupee is unlikely to Growth is expected to improve further to 6.2 have major adverse effects and provides an percent in FY2015 as manufacturing growth opportunity to accelerate growth through accelerates and new and existing investment further progress on the reform agenda. projects come on stream. The acceleration in Adverse impacts of the depreciation on growth is unlikely to create inflationary investment growth are likely to be somewhat pressures as several years of growth below offset by gains in export performance due to potential have opened a positive output gap, and improved external competitiveness. Even with inflation is expected to decelerate to 5.3 percent new pressure on fiscal balances, external and and 5.2 percent in FY2014 and FY2015. The domestic financing needs are likely to be pick-up in exports bodes well for closing of the financed without much difficulty as real interest current account gap, but the merchandise trade rates are close to zero and government short- deficit is likely to remain elevated in the short- term debt is around 1 percent of GDP. Although and medium-term as fuel imports, which tend to external short-term debt at residual maturity is be relatively less sensitive to price changes, relatively high at 9 percent of GDP (44 percent account for more than one-third of the total of total external debt), short-term sovereign import basket. In addition, the acceleration of external debt is just 0.3 percent of GDP and the growth in the second half of FY2014 and vast majority of the remainder is accounted for FY2015 is likely to require higher imports of by deposits by Indians abroad (which have a capital goods. Under these assumptions, the reasonable likelihood of being rolled over) and current account deficit is expected to decline to short-term trade credits (which are implicitly 4.1 percent of GDP in FY2014 and 3.7 percent hedged, to an extent). Increases in inflation are of GDP in FY2015. Financing of the gap is likely to be limited by a small share of imported expected to come in roughly equal parts from food in the overall consumption basket and the FDI and institutional flows in FY2014, with a diesel pricing mechanism which limits increases growing contribution from FDI in FY2015. to Rs.0.50 per liter per month. While rising prices will put some pressure on household ii India Development Update October 2013 1. Recent Economic Developments discretionary consumer goods, such as vehicles and televisions; and essential industrial goods, 1.1 Real sector activity such as basic metals and machines. In June, however, the pace of decline slowed to -2.9 Economic growth decelerated to 4.4 percent percent saar, suggesting that the downward in the first quarter of the new fiscal year. momentum was abating. In July, industrial Growth in real GDP at factor cost came in below output rebounded strongly by 2.6 percent y-o-y 5 percent for the third quarter in a row in Q1 (58.1 percent saar), led by a 3.0 percent y-o-y FY2014, slowing to 4.4 percent from 4.8 percent increase in manufacturing and particularly 15.6 in Q4 FY2013.1,2 This marks a sixth consecutive percent y-o-y growth in the production of capital quarter of sub-6 percent growth, making the goods. current episode the most persistent slowdown in nearly two decades. On a seasonally adjusted annual (saar) basis, GDP growth fell to a seventeen-quarter low of 4.2 percent, its worst performance since the onset of the global financial crisis in FY2009.3 Output in mining continued to contract, while growth in manufacturing – which had already shrunk by 0.1 percent saar in the previous quarter – fell sharply to -9.4 percent saar. On the other hand, growth in services strengthened somewhat to 8.0 percent saar, and growth in agriculture more than doubled to 3.7 percent saar due to a favorable monsoon. Business and consumer sentiment remain Industrial output contracted in Q1 FY2014 subdued. Reflecting weakness in the but rebounded strongly in the beginning of manufacturing sector, investment contracted by Q2. Growth in industrial output started 1.2 percent y-o-y in Q1 FY2014 after registering weakening in FY2012 as mining activity stalled single-digit growth during the previous three and manufacturing output decelerated. These quarters. Business confidence, as captured by weaknesses deepened in Q1 FY2014, as the pace the HSBC Composite Purchasing Managers’ of decline in the industrial production (IP) index Index which surveys private manufacturing and accelerated from -3.1 percent saar in March service firms, has fallen to 47.6 in August, 2013 to -18.0 percent saar in April and -24.9 marking the worst outturn in over four years and percent saar in May. The slowdown has been a second consecutive month below the most pronounced in the production of contraction threshold of 50. Similarly, the business expectations index, as estimated by the 1 Throughout the document, FY2014 refers to fiscal Reserve Bank of India (RBI) industrial outlook year ending March 31, 2014. survey, fell by 4.4 percent for Q1 FY2014 to its 2 In accordance with standard practice in India, GDP lowest level in three financial years. Consumers growth is reported at factor cost rather than market are also hesitant, as domestic passenger car prices. Growth rates of the two aggregates are nearly sales, which declined during FY2013 for the identical over long periods (e.g., annual average first time in more than a decade, continued the growth of 4.92 percent for factor cost vs. 4.93 percent downward slide during Q1 FY2014. Overall, for market prices between 1951 and 2013), but can growth in private consumption expenditure deviate from year to year as sectors which attract higher/lower rates of indirect taxation grow at decelerated sharply to 1.3 percent saar in Q1 different rates. Growth in GDP at market prices FY2014 from 3.5 percent saar the previous slowed to 2.4 percent y-o-y in Q1 FY2014. quarter. For the first time since FY2004 3 Seasonally adjusted using the TRAMO-SEATS consumption grew at less than 2.0 percent saar. method (developed by the Bank of Spain). Government expenditure, on the other hand, 1 India Development Update October 2013 accelerated sharply to 39 percent saar (10.5 the public sector. Growth in logistical services percent y-o-y) in Q1 FY2014, following a related to trade, communication, transportation squeeze on spending during the second half of and financial services declined from 7.7 to 5.8 FY2013. In fact, public spending accounted for percent saar in Q1 FY2014, as these sectors the majority of growth in aggregate demand were affected by the slowdown in industrial during the quarter. activity. On the other hand, growth of community, social and personal services – primarily provided by the public sector – accelerated sharply to 16.5 percent saar. The contribution from this sector was sufficient to raise the growth rate of the services sector from 7.5 percent saar in the last quarter of FY2013 to 8.0 percent saar in Q1 FY2014. 1.2 Balance of payments After reaching a record high in Q3 FY2013, the current account deficit improved in the fourth quarter. The current account balance has gone through a major shift in the past decade, deteriorating from a surplus of 0.2 percent of Agriculture staged a strong rebound. GDP in the five years before the global crisis Supported by favorable monsoons, agricultural (FY2003-2007) to an average deficit of 2.6 production –which grew by just 1.9 percent in percent of GDP during FY2008-2012, and FY2013 – picked up the pace to 3.7 percent saar reaching consecutive record highs of 4.2 and 4.8 in the first quarter of FY2014. As of end- percent of GDP in FY2012 and FY2013. Most September 2013, India benefitted from 5 percent of the deterioration in FY2013, however, took higher rainfall than normal, encouraging farmers place during the first three quarters when the to increase total sown area by 5 percent y-o-y to current account deficit rose to 5.2 percent of over 100 million ha for the kharif (summer) GDP. As merchandise exports strengthened in cropping season. Although the improved Q4 FY2013, the current account deficit weather is good news for the incomes of the improved to 3.6 percent of GDP. Strong rural population, the relatively small portfolio inflows – which rose from 0.9 to 1.5 contribution of agriculture to total output (13 percent of GDP during the fiscal year – played percent) limits the extent to which better an increasingly important role in financing the agricultural performance can support growth. deficit while external commercial borrowing (ECB) remained stable at 0.5 percent of GDP. Even with a 10 percent y-o-y decrease in FDI (in US$), total capital inflows rose by nearly 32 percent, comfortably financing the current account deficit and adding almost US$4 billion to the stock of international reserves. The growing trade deficit accounted for the majority of the widening in the current account gap. The merchandise trade deficit rose to 10.6 percent of GDP in FY2013 from 10.2 percent in the previous year as merchandise exports (in US$) fell by 1.1 percent y-o-y while imports increased by 0.5 percent. Weak demand Growth in services remained robust, mainly from China, Indonesia, Japan, Hong Kong, and on the back of a greater contribution from 2 India Development Update October 2013 Singapore – exports to which account for 17 entire decline took place in the first six months percent of India’s international shipments – of the fiscal year and the share of gold in total resulted in exports to these destinations falling merchandise import basket remains high at by more than 16 percent in FY2013. Imports almost 11 percent. After increasing by almost 40 growth decelerated markedly from 32.3 percent percent y-o-y in Q3 FY2013, growth in gold in FY2012 but remained positive primarily on imports moderated to 7 percent in Q4 after the account of petroleum imports, which rose by 9.3 authorities raised import duties from 4 to 6 percent despite a decline in international prices. percent and doubled the duty on raw gold to 5 Most of the deterioration in the trade balance, percent in January. However, as international however, occurred during April-December 2012, gold prices declined by more than 13 percent in while Q4 FY2013 was characterized by a pickup Q1 FY2014, gold imports spiked by 79 percent in merchandise exports and moderation in y-o-y (3 percent q-o-q). The authorities took imports. A worsening in the balance on income further steps in June and July to increase gold account (net repatriation of profits) added duties, now at 10 percent, as well as limit coin another 0.3 percent of GDP to the current and medallion purchases and link imports to account deficit, while remittances increased export volumes (gold is an important input to marginally by 0.1 percent of GDP. India’s jewelry sector, which accounts for 14 percent of total merchandise exports). Financing of the current account deficit has shifted towards portfolio investment and trade credits. Compared with FY2012, when FDI financed 28 percent of the current account deficit, the share of FDI in financing the current account gap declined to 22.5 percent in FY2013, replaced by greater contributions from portfolio flows, trade credits, and deposits by non-resident Indians (NRI). In order to encourage new FDI, the central government has raised caps and eased norms for FDI in retail, power exchanges, insurance, aviation, defense, and broadcasting. The slowdown in mining exacerbated the However, the authorities left the adoption of widening of the trade deficit. India’s exports of new rules in multi-brand retail to individual iron ore grew rapidly in the early 2000s, making states, and no new multinational retailers have the country one of the largest global exporters entered the Indian market as of yet. by the end of the decade. However, even as India’s total exports grew from US$179 billion Foreign exchange cover of external liabilities in FY2010 to US$300 billion in FY2013, its weakened somewhat. Total external debt exports of iron ore fell from US$6 billion to increased by 12.9 percent to US$390 billion (or under US$2 billion. Meanwhile, imports of coal 21.2 percent of GDP) during FY2013, bringing increased by more than 75 percent in the last two down the ratio of foreign exchange reserves-to- fiscal years compared with the previous two, total external debt to 74.9 percent, its lowest reaching US$15 billion in FY2013. The level in a decade. The increase in total debt was combination of changing trade flows in these driven mostly by a rise in short term-trade credit, two commodities alone was responsible for 9 external commercial borrowings and NRI percent of the total deterioration in the deposits, which grew by 33.3 percent, 15.4 merchandise trade deficit between FY2010 and percent, and 20.8 percent. Consequently, FY2013. external short-term debt (residual maturity) increased to 44.2 percent of total external debt Appetite for gold remains high. In FY2013, from 42.7 percent in FY2012. Sovereign imports of gold fell by 4.7 percent y-o-y, but the external debt remained a small portion of total 3 India Development Update October 2013 external debt, decreasing by US$0.2 billion to Imports, which already fell by 0.4 percent in 4.4 percent of GDP. June, contracted further by 3.6 percent y-o-y in July-August. Consequently, the increase in the Market fears of an early end to the Federal trade deficit for the fiscal year-to-date was Reserve’s quantitative easing program put limited to just 0.7 percent (US$74.4 billion). the rupee under stress this summer as investors pulled back sharply from emerging markets. Similar to other emerging markets, the Indian rupee came under stress following the Fed Chairman’s Congressional testimony on May 22, which raised speculation of an early “tapering” of the quantitative easing or asset purchasing program. As global investors withdrew US$15 billion of portfolio investment from Indian markets in June-August, the rupee fell by 18 percent vis-à-vis the US$ during this period and touched an all-time low of 68.4/ US$ on August 28, 2013. However, the rupee recovered more than a third of its losses in 1.3 Inflation September as market fears were allayed by the Continued downward momentum in core Fed’s September decision to continue asset inflation has limited price increases. On a purchases as well as the appointment of a new fiscal year-to-date basis, headline wholesale RBI Governor and an improvement in India’s (WPI) inflation fell to 5.3 percent y-o-y, after export performance. The real effective exchange averaging 7.4 percent in FY2013. Core inflation, rate (REER) mostly mirrored the movement of measured as price growth of manufactured non- the nominal exchange rate: it fell by 11.6 percent food products and used as a proxy for price between May and August, remaining below its elastic consumption demand by the RBI, long-term average, and is expected to have decelerated to 2.4 percent y-o-y over the same recovered somewhat in September. period. This represents a major improvement compared with average core inflation of 4.9 percent during FY2013, and places core inflation well within the RBI comfort level of 4 percent. The rupee’s depreciation helped improve export competitiveness and close the merchandise trade gap. Although exports did not seem to respond to the rupee’s depreciation Food and fuel price growth accelerated. in June, export performance recovered strongly Growth in food prices appeared to be slowing at in July and August. During these two months, the start of FY2014, as WPI food inflation merchandise exports (in US$) grew at an decelerated to 7.1 percent y-o-y in April-May eighteen month high of 12.3 percent y-o-y. from an average of 9.3 percent during FY2013. 4 India Development Update October 2013 However, starting in June, food price growth proactively to the expectations of the Fed’s ticked up again to 10.3 percent y-o-y due to “tapering.” higher vegetable and cereals prices. Growth in fuel prices has also accelerated with gradual deregulation of diesel prices and mark-to-market petrol prices which have been affected by the depreciation in the rupee. Fuel prices began accelerating in April and fuel inflation gradually increased to 11.3 percent y-o-y in August 2013 from an average of 10.3 percent in FY2013. As a result, growth in consumer prices – where food and fuel account for nearly 60 percent of the entire basket – remained elevated at 9.5 percent in the current fiscal year (although down from an average of 10.2 percent in FY2013). 1.4 Financial sector Corporate debt levels increased, even as profitability remained stressed. A recent report by Credit Suisse shows that ten large corporates, accounting for about 13 percent of banking loans and nearly all of banking system’s net worth (about 98 percent), have a combined debt level in excess of US$100 billion. The debt coverage ratios are under pressure, with some groups having an interest cover well below 1. Given the high leverage levels, poor profitability and lender pressure, virtually all of the ten debt- Accelerating prices and depreciating rupee heavy groups have initiated processes to divest led to reversal of earlier monetary loosening. part of their assets (cement plants/power/road The RBI reduced the policy repo rate by 25 bps projects). In the context of an over-leveraged in each of its January, March and May meetings, domestic infrastructure sector, this trend is bringing the rate down to 7.25 percent after worrying as demand for such assets is likely to holding it constant for the previous seven be limited. meetings. However, in the two meetings since May the RBI refrained from further monetary policy easing on account of high food inflation and depreciating rupee and its potential pass- through to overall inflation. Beginning in July, the monetary policy began to tighten. First, the RBI increased short-term wholesale interest rates from 8.25 percent to 10.25 percent and imposed caps on banks’ short-term borrowings, pushing up short-term interest rates and yields on short-term government securities. In September, the RBI moderated short-term rates by 75 bps to 9.5 percent but also raised the policy repo rate by 25 bps to 7.5 percent. These moves were motivated by an improvement in the Depreciation of the rupee has added to the external environment as well as the need to corporate and financial sector stress. India’s anchor inflationary expectations and respond foreign debt has risen by 12 percent annually in 5 India Development Update October 2013 last five years, with the share of its largest exposure. However, high debt levels could component, external commercial borrowings, exacerbate risk stemming from FX translation steadily growing during the period. The spurt in adjustments, particularly for companies with foreign exchange borrowings in recent years was substantial foreign currency-denominated debt driven by historically low rates (0.80 percent in which is typically held at offshore subsidiaries.4 2010) for Libor US$ borrowings, while peak Higher reported debt levels will have a negative base rate for rupee borrowings was about 10 impact on a number of key credit metrics percent, encouraging arbitrage particularly for including financial leverage. In addition, the the capital-intensive infrastructure sector. With combination of a sluggish economy, higher foreign currency debt becoming an important interest rates and a depreciating rupee is likely to source of funding for many corporates and impact the corporate sector’s debt servicing financial institutions, non-government external capability. debt constituted around 16 percent of GDP and 80 percent of total external debt in FY2013. The falling rupee could thus impose higher repayment costs on the private sector and add to the already existing stress of decelerating revenue growth. Such corporate stresses could in turn exert stress on the financial sector through slippages in rupee exposures of the banks to such corporates. A report by Credit Suisse indicates that in FY2013, 40-70 percent of debt burden of the large corporates was foreign- currency denominated. Corporate vulnerabilities were transmitted to the banking sector, affecting asset quality. Gross non-performing assets (NPAs) of commercial banks recorded an average increase of 24.7 percent during the last six years and reached US$30 billion in FY2013. Public sector banks (which account for 73 percent of banking assets) share a disproportionate burden of this increase. While restructured advances (some of which are expected to translate into NPAs) stood at 6 percent of standard advances for all commercial banks, the figure was around 9 percent for nationalized banks at end-March High debt levels and limited hedging 2013. NPAs saw a decline in Q4 of FY2013, practices could exacerbate risks faced by the owing to improved recovery, lower slippages corporate sector. Although explicit hedging by and higher write-offs. However, this corporates in India is limited – a recent study by improvement was short-lived, as gross NPAs Fitch of 290 investment-grade corporates shows and restructured assets of scheduled commercial that only 42 percent of the corporates with banks rose again, reaching around 10 percent in foreign-exchange exposure followed hedging June 2013. The deterioration was due mainly to practices – the majority of debt held by internationally rated industrial corporates in 4 India is either naturally hedged through import- FX translation adjustments refer to converting the parity pricing or has hedging arrangements of figures related to accounting stated as per one around 50 percent of their FX (foreign currency) particular currency to another currency to meet the finance reporting-related requirements 6 India Development Update October 2013 slippages with the public sector banks. Latest mainly to lower net interest income growth, estimates indicate that gross non-performing which declined from a high of 35 percent in loans (NPLs) are expected to increase from 3.4 FY2011 to 11 percent in FY2013. A report by percent in March 2013 to possibly 4.4 percent by the ICRA indicates that the decline in March 2014. profitability is due mainly to lower net interest margins, provisions for wage revisions and The deteriorating asset quality has elevated credit costs of public sector banks, exacerbated risk aversion among banks, and whereas profitability of private banks has has likely played a role in the slowing in remained stable. However, with a decline in 10- credit growth. Growth in total bank credits year government security yields between March decelerated to 14.9 percent y-o-y by end-July and June 2013, net profitability is partly 2013, from an average growth of 16.6 percent y- cushioned by sale of investments. o-y during FY2012. In particular, credit growth declined significantly in industries such as 1.5 Fiscal developments petroleum, chemicals, mining and metals. Although the bank-corporate balance sheet The central government’s FY2013 fiscal nexus appears to be putting pressure on banks’ deficit came in better than expected. Revised asset quality, the RBI’s proposed measures to data show that the central government’s fiscal collate large common exposures across banks deficit in FY2013 reached 4.9 percent of GDP, are expected to contain potential issues, to a well below last October’s target of 5.3 percent significant extent. Funding pressure on banks is and better than the 5.2 percent estimate in likely to be minimal as deposit growth remains March. Lower current expenditures and higher broadly consistent with credit growth. While the non-tax revenue were the main components capital adequacy of banks is comfortably above responsible for the reduction.5 the regulatory levels required, the public sector Despite the improved fiscal performance, the banks have large capital infusion needs. This is decline in the debt-to-GDP ratio has lost vital in order for them to contribute to sustaining momentum. The central government’s debt-to- credit growth to support an economic recovery GDP ratio inched up marginally to 53 percent in and for weathering the current stress build up. FY2013 from 52.9 percent in the previous year, reversing the strong downward trend seen during the second half of the 2000s.6 Following the adoption of the Fiscal Responsibility and Budget Management Act in 2003, the ratio of central government’s debt-to-GDP fell by more than 10 percentage points. This decline in the debt ratio, however, can be attributed mostly to a favorable macroeconomic environment: rapid GDP growth and, in the later period, very low real interest rates. A deceleration in growth and increase in the primary deficit slowed the decline in debt-to- GDP and the internal liabilities ratio of the central government rose for the first time in The worsening asset quality is also putting 5 pressure on banks’ profitability. RBI Excluding one-time divestment proceeds from estimates reveal that loss to banks due to NPAs revenues, the overall deficit in FY2013 came down to 5.1 percent of GDP from the earlier estimate of 5.4 has amounted to more than 60 per cent of their percent. net profit since 2010. Furthermore, yield on 6 Central government debt refers to its total liabilities advances would have improved by an average of which include market loans, treasury bills, 124 basis points in the last five years, if it were borrowings from small savings, provident and reserve not for the NPAs. Lower profits are attributed funds, etc., and external borrowings. 7 India Development Update October 2013 eight years from 48.3 in FY2012 to 48.6 percent budget estimates anticipated a decline in fuel in FY2013. External sovereign debt, however, subsides to Rs.650 billion or 0.6 percent of GDP declined marginally (in US$) by 0.3 percent to from 1 percent of GDP during the previous year. US$81.7 billion in FY2013. Under-recoveries – the difference between international fuel prices and costs of production that arise due to regulated domestic fuel prices – were expected to decline substantially in FY2014 as the authorities introduced a cap of nine cylinders per year on the sale of subsidized LPG and a Rs.0.50 per liter monthly increase in diesel prices until losses by the oil marketing companies (OMCs) are covered. However, since May 2013, the depreciation in the rupee has sharply pushed up the under-recoveries incurred by OMCs on imported crude. Diesel under- recoveries had risen to Rs.14.50 per liter by 15th September 2013, well above the average level of Rs.11.4 per liter during FY2013. Combined Deficit targets have come under pressure in OMC under-recoveries on the sale of diesel, FY2014. According to the Controller General of kerosene and LPG have risen by 39.3 percent Accounts, the central government incurred a since the beginning of FY2014 to Rs.4.9 billion fiscal deficit of 3 percent of GDP during the first per day in September. As international oil prices four months of FY2014, equivalent to 62.8 remain high and the rupee, despite recent percent of its fiscal deficit target for the year. In improvements, continues to trade well below last comparison, fiscal performance during the first year’s levels, the total fuel subsidy cost is likely four months of FY2013 was closer to target as to exceed budget estimates in the absence of the authorities ran a fiscal deficit of 51.5 percent further steps to link domestic and global prices. of the total budget estimate during that time. A significant portion of the shortfall can be 1.6 Poverty and income distribution attributed to lower tax collection due to a slower The pace of decline in poverty has pace of economic activity: the central accelerated. Between 2005 and 2012, India government collected just 16.4 percent of its lifted 137 million people out of poverty. Poverty total budgeted tax revenue between April and declined by 2.2 percentage points per year, as July 2013, compared with 18.5 percent of budget the poverty rate (based on the national poverty estimates over the same period last year. line of US$1.17 (PPP) per person per day) fell sharply from 37 percent to 22 percent during this period. Compared with 1994-2005, when poverty fell at a rate of 0.7 percentage points per year, the later episode represents a significant increase in the rate of poverty reduction. At this pace, accelerated progress against poverty since economic reforms began in earnest in the early 1990s signals the emergence of a (statistically) robust new trend. Poverty decline has been widespread, with both rural and urban poverty rates falling to 26 percent and 14 percent in 2012. Rising fuel under-recoveries are likely to The ability of growth to drive down poverty stress the budgeted subsidy bill. FY2014 has increased. Since 2005, alongside faster 8 India Development Update October 2013 growth, a much stronger link between growth states (LIS).7 Decompositions show that whereas and poverty reduction is evident. Per capita only a quarter of the poverty decline in the 1994 income growth has picked up during the period to 2005 period was due to the LIS, better over which poverty is measured – from 4.2 performance in these states now accounts for percent GDP growth in the previous decade nearly half of the decline. (1994-2005) to 6.7 percent annually from 2005 to 2012. However, prior to 2005, data Many of India’s newly non-poor remain uncertainties clouded our assessment of whether vulnerable and minor shocks could easily the growth process had become more or less push them below the poverty line. Three out of pro-poor in the post-reform period. Recent data every five Indians are not poor but live suggest that the poverty elasticity to growth has dangerously close to poverty (between one and risen markedly regardless of which measure of two poverty lines). Considering that the current growth (in mean household consumption or poverty line is equivalent to US$1.17 in PPP growth based on the national accounts) is used. terms, individuals living below a threshold of two poverty lines remain precariously vulnerable to shocks which could push them into poverty. The poorest 40 percent are increasingly sharing the benefits of growth. Although consumption growth of the poorest 40 percent 1.7 Reform actions continues to lag behind the India average, the The reform momentum has picked up in the gap has been closing over time. Between 1994 last year with authorities putting forth a and 2005, per capita consumption of the bottom number of important reform initiatives. These 40 percent grew only 61 percent as fast as that of reforms include a major expansion of social the average Indian; between 2005 and 2012, that protection coverage with the passage of the ratio rose to 86 percent as consumption growth National Food Security Act, a new Land rates for the poor started catching up with the Acquisition Bill that replaced more than 100- mean. Although the ratio remained below one, year-old legislation, a new Pension Bill that implying that inequality has continued to allows foreigners to invest in Indian pension increase – the Gini coefficient rose from 30.9 fund companies, a Banking Laws Bill that in 2005 to 32.3 in 2012 – the pace of the allows for new banking licenses, a Companies increase has slowed and the absolute widening Bill that replaces sixty-year old legislation and of inequality has been small. increases transparency and corporate The geography of poverty reduction is accountability, and the raising of ceilings and/or changing towards low income states. Notably, FDI-easing reforms in a number of sectors. a much larger fraction of the overall poverty reduction is now taking place in the low income 7 Low income states include Bihar, Chhattisgarh, Jharkhand, Madhya Pradesh, Orissa, Rajasthan, and Uttar Pradesh. 9 India Development Update October 2013 Together with new policy announcements by the government to set up grievance redress offices new RBI Governor and a 10-point action plan to and State Food Commissions. However, accelerate growth by the Finance Minister, these provisions to reform the TPDS by introducing developments send a strong signal about a doorstep delivery of food grains, end-to-end recovery in reform momentum. computerization, identification of beneficiaries using the Aadhar number, and cash transfers, The National Food Security Act entitles two- food coupons, or other schemes for targeted thirds of the population to subsidized food beneficiaries in lieu of food grains could grains. The National Food Security legislation improve efficiency and reduce costs over the was cleared by the Parliament and approved by long term. the President in September 2013, making access to food a legal right. The Act entitles 67 percent The new Land Acquisition Bill proposes to of the country’s population to five kilograms of reduce uncertainty and address structural subsidized food grains per person per month, constraints to growth. Replacing the Land procured and distributed through the existing Acquisition Act of 1894, a new Land Targeted Public Distribution System (TPDS). Acquisition, Rehabilitation, and Resettlement Central issue prices of rice, wheat, and coarse Bill was passed by the Parliament in September grains have been fixed at Rs.3, Rs.2 and Rs.1 for 2013. The Bill proposes to reduce uncertainty in the next three years, against the economic cost land acquisitions by outlining clear guidelines of Rs.23.5 and Rs.18 for rice and wheat in on the process of acquiring land and fair FY2013 according to estimates by the Food compensation to those displaced. At the same Corporation of India (FCI). Comparing current time, however, instances when several rounds of TPDS usage (as reported by households in the impact assessments and evaluations might be 2011-12 round of the National Sample Survey) required could prolong the acquisition process. with the Act targets suggests that the take-up of the system may rise by one and a half times in The Pension Bill allows foreigners to invest in rural areas and nearly two times in urban areas, Indian pension fund companies. The Pension while food purchase prices could decline by Fund Regulatory and Development Authority about half for an average below-poverty-line (PFRDA) Bill was passed by the Parliament in (BPL) household. On the other hand, a shift September 2013, nearly a decade after the New from household to individual entitlements could Pension System – now rechristened the National reduce the endowment of an average BPL family Pension System (NPS) – was implemented in of five from 35 kg to 25 kg. Implementation of 2004. The Bill grants statutory status to the the Act over the course of a full fiscal year is PFRDA – which was established through an expected to raise the food subsidy bill to 1.1 ordinance in 2003 – and the presence of a percent of GDP from an average of 0.8 percent statutory regulatory authority is expected to help of GDP in FY2012-13.8 However, the fiscal enhance the quality of products and services impact in FY2014 is likely to be limited as the available in the pension sector. The NPS, which Act was passed in the middle of the year and is mandatory for all central government entails certain follow up action in various states; employees and voluntary for all other employed furthermore, the FY014 budget already included citizens, is based on a pay-as-you-go principle. an additional allocation of Rs.100 billion for the The Bill amends the existing system by allowing incremental costs of the Act in FY2014. In up to 26 percent foreign investment in the addition to these costs, further expenditures will pension sector (which could rise to 49 percent, be incurred by the states and the central in line with the insurance threshold), thereby widening the potential set of available pension products, schemes, and fund managers. The Bill 8 These estimates are based on calculations by the also lays down rules that would allow foreign Ministry of Consumer Affairs, Food and Public companies to invest in reinsurance companies. Distribution and they assume full coverage and no leakages. 10 India Development Update October 2013 The amended Banking Laws Bill paves the sale terminals by non-bank entities, a new online way for new bank licenses. The Banking Laws national bill payment system and mobile (Amendment) Bill 2011 was passed in payments, were also announced. Finally, new December 2012 by both Houses of Parliament. expert committees were proposed to look at the The Bill strengthens the regulatory powers of the monetary policy framework, screen bank license RBI and paves the way for new bank licenses, applicants and restructuring and recovery leading to the opening of new banks and processes of banks. branches. It also enables nationalized banks to raise capital by issue of preference shares or The authorities reaffirmed their plan for rights issue or issue of bonus shares. Banks can capital infusion to public sector banks to ease now increase or decrease the authorized capital balance sheet stresses. A Rs.140 billion with approval of the Government and the RBI, capitalization plan for public sector banks was without being limited by Rs.30 billion ceiling. announced earlier this year. The capital infusion will be vital to help the stressed public sector The new Companies Act increases banks meet Tier 1 capital requirement. A similar transparency and corporate accountability. capitalization effort in 2009 helped the banks The Companies Bill became a law in August sustain credit growth in the post-global financial 2013, replacing a six-decade old Act. The Bill crisis period, and thereby, contribute to a faster seeks to bring sweeping changes in transparency economic recovery from the crisis. and accountability of companies, encourages self-regulation and makes contribution towards The authorities took further steps to ease Corporate Social Responsibility mandatory, policies regulating foreign direct investment. among other things. In September 2012, the government raised caps on FDI in several sectors such as multi and The new RBI Governor proposed several single brand retail, aviation, broadcasting and reforms to liberalize financial markets and power exchanges in order to attract robust facilitate financial inclusion. The Governor, capital inflows. However, the decision to allow who was appointed in September, announced a FDI in multi-brand retail carried several caveats, comprehensive financial reform agenda on the such as prior state approval and procurement and day of his induction. First, opening of new bank investment requirements, and no foreign multi- branches would no longer require RBI approval, brand retailers has yet taken advantage of the subject to certain conditions. The RBI will also new rules to enter the Indian market. In gradually reduce the current requirements for September 2013, the authorities took further banks to invest in government securities. steps to ease the investment and procurement Second, to facilitate the inflow of non-resident requirements. In addition, the Government deposits, Indian banks will be allowed to swap recently raised the FDI limit in telecom to 100 forex liabilities against FCNR(B) (Foreign percent, defense to 26 percent (on a case-by-case Currency Non-Resident, Bank) deposits at a basis), and put several sectors on an automatic fixed cost of 3.5 percent per annum, compared route which allows firms to invest without prior to market rates of around 6-8 percent. In government approval. addition, the current overseas borrowing limit of 50 per cent of the unimpaired Tier I capital will 2. Outlook be raised to 100 per cent and borrowings mobilized under this provision can be swapped The economy is likely to expand by 4.7 with the RBI at a concessional rate. Third, to percent in the current fiscal year. The encourage household savings in financial expected outturn would bring growth to its instruments, the RBI proposed to introduce lowest point since FY2003, when real GDP Inflation Indexed Savings Certificates linked to increased by 3.9 percent. The pace of economic the new consumer price index by November activity in FY2014 will be hampered by a weak 2013. Furthermore, in the spirit of financial outturn during the first quarter; furthermore, two inclusion, proposals for “mini-ATMs”, point-of- consecutive months (July-August) of negative 11 India Development Update October 2013 business sentiment and higher interest rates are during the forecast period. Food prices, which likely to limit the potential for recovery in Q2 have pushed inflation in the current calendar FY2014 despite a strong rebound in year, are also expected to moderate as manufacturing output in July. However, as agricultural output improves. Fuel prices, on the financial markets stabilize, exporters continue to other hand, will continue to add to the take advantage of improvements in external inflationary momentum as international oil competitiveness following the depreciation bout prices are likely to remain elevated throughout in the rupee, recovery in the manufacturing the forecast period. Altogether, WPI inflation is sector continues, and delayed investment expected to average 5.3 percent in the current projects begin to come on stream, activity is fiscal year and decelerate further to 5.2 percent expected to pick up strongly in the last six in FY2015 as pressure from food prices declines months of the fiscal year, rising above 6.0 due to an improvement in agricultural output. percent saar in Q4 FY2014. The recovery will also be supported by a pick-up in agricultural The current account deficit is expected to activity due to heavy and early monsoon rains narrow. The first quarter of FY2014 witnessed which – while damaging some crops like coffee a widening of the trade deficit as the – have resulted in higher summer planting of depreciation in the rupee and inelastic demand rice, corn, barley, cotton, and soybeans. This is for imported oil – which accounts for more than expected to result in a bumper summer crop as one-third of total merchandise imports – have well as improved agricultural output in winter kept imports elevated while the exports response due to higher soil moisture levels. was subdued. Exports, however, rebounded strongly in July and August while imports came Growth is expected to accelerate further in down, and a continuation of these trends is FY2015. The anticipated pick-up in activity in expected to bring down the trade deficit in the the second half of FY2014 is expected to carry coming quarters. Although exports are expected over into the next fiscal year, with quarterly to rise overall, export response in the growth accelerating to around 6.5 percent saar in manufacturing sector could be somewhat muted the second half of FY2015. As a result, real by rising costs of imported intermediate inputs, GDP growth is expected to reach 6.2 percent in especially as metal prices are expected to remain FY2015. On the one hand, continued high oil elevated throughout the forecast period. prices – expected to average just above Similarly, while the summer bout of US$100/barrel in calendar 2013 and just below depreciation in the rupee is likely to dampen that level in 2014 – are likely to somewhat demand for imports, scope for import dampen the recovery potential. On the other compression is limited by a high (45 percent) hand, strengthening performance in the US and share of fuel and raw material imports in total. Europe – India’s major export markets – is These factors suggest that while the trade deficit expected to support the growth momentum. is likely to narrow in FY2014, the improvement Domestically, the recovery will need to be will be gradual. Beyond the trade deficit, buttressed by stronger investment, which is improving labor market conditions in the US expected to return to levels above 30 percent of could further support the current account GDP in FY2015 after falling below this balance via stronger remittances: the US threshold in FY2013. generates nearly one-third of total remittance inflows into India and the recovery in US Inflationary pressures are likely to moderate migrant employment has been much stronger further. The downward momentum in core WPI than for native workers. The combination of inflation, observed throughout calendar 2013, is these trends is likely to result in the current expected to continue in FY2014. Six consecutive account deficit narrowing to 4.1 percent of GDP quarters of sub-6 percent growth have allowed in FY2014 and improving further to 3.7 percent for an opening of the output gap, which is likely of GDP in FY2015. to limit inflationary pressures even with the expected acceleration in economic activity 12 India Development Update October 2013 Financing of the current account deficit is proceeds – which are included above-the-line unlikely to present major challenges. In under the national accounting practices and are FY2014, the financing mix is expected to be expected to generate revenues of 0.6 percent of similar to the average performance of the last GDP in FY2014 – were to come in below few years: FDI is expected to improve expectations. marginally from FY2013 (a down year) while FII would come down somewhat from the highs The debt-to-GDP ratio could rise for a second of last fiscal. As long as NRI deposits – which year in a row, but is expected to resume a mainly represent savings for future spending in downward path in the medium term. Most of India – remain similar to last year and under the decline in the debt-to-GDP ratio over the varying assumptions about the availability of past decade can be attributed to a favorable trade credits, the remaining FY2014 external macroeconomic environment and particularly financing requirements would range between rapid GDP growth. As growth slowed markedly US$3-10 billion, which ought to be relatively in FY2013, the general government debt-to- comfortably financed via foreign borrowing. GDP ratio is estimated to have risen by one International reserves could decline somewhat in percentage point to 68.7 percent of GDP. Under FY2014 but would still amount to a comfortable the growth, inflation, and fiscal deficit scenario import cover of approximately five months. delineated in the previous discussion, the debt- to-GDP ratio is likely to rise further in FY2014, Achievement of fiscal targets is likely to reaching 71 percent of GDP. Thereafter, under require further expenditure restraint. A the assumption that growth accelerates, the repeat of better-than-expected FY2013 fiscal central government continues its fiscal performance by the central government is likely consolidation efforts, and state governments to be more challenging in FY2014 as the remain on the adjustment path recommended by headroom gained through diesel subsidy reform the 13th Finance Commission (see Box 1), the thus far has been wiped out by the depreciation debt-to-GDP ratio is expected to resume its in the rupee. In addition, the roll-out of the earlier downward trend, albeit at a slower pace National Food Security Bill is expected to raise than before. Even if real interest rates rise, a expenditure by an additional 0.1 percent of GDP recovery in growth and continued commitment relative to the budgeted PDS allocation, to fiscal discipline are expected to offset any although the full effect of implementing the act potential adverse effects on debt sustainability. will not be felt in FY2014. The authorities are On the other hand, risks to improvements in the likely to realize some savings from the primary balance or growth recovery could have continued widening of Direct Benefit Transfer substantial negative implications for the debt-to- schemes in scope and district coverage. GDP trajectory: if economic growth were to fall However, some of the larger gains, such as below the baseline projections in each of efficiency improvements from direct transfers of forecasting years by one standard deviation of LPG subsidies into Aadhar-linked bank accounts the historical distribution, the general of beneficiaries, are likely to start materializing government’s debt-to-GDP ratio could rise to only towards the end of FY2014. As the scope nearly 76 percent of GDP by FY2016. for improved tax collection is likely to be limited given the subdued pace of activity in the The largely positive near- and medium-term first half of FY2014, expenditure restraint – outlook is conditional on continued particularly further progress to contain the fuel improvements in the policy environment and subsidy bill – will be key to maintaining good is subject to important downside risks. The fiscal performance. Under these assumptions, current macroeconomic environment of a trough the general government deficit is likely to rise in growth and rising external vulnerabilities somewhat to 7.3 percent of GDP in FY2014 offers a window of opportunity for the before declining to 7.1 percent of GDP in authorities to strengthen the foundations for FY2015. Pressure on deficit targets could rise higher long-term growth. The baseline scenario further if the central government’s divestment of acceleration in growth in the second half of 13 India Development Update October 2013 Box 1: Fiscal Consolidation and the 13th Finance Commission Fiscal Performance Targets Although fiscal deficits at all levels of government have been on the decline for the past two years, only the state governments have been able to meet the fiscal consolidation targets of the 13th Finance Commission (FC), a constitutional body tasked with making recommendations on resource transfers between different levels of government and setting targets for fiscal sustainability. According to the targets laid out in a 2009 report by the 13th FC, both the central and general government are off track with regard to fiscal deficit goals. However, both levels of government were able to achieve the debt/GDP targets set by the 13th FC, partly because of a revision in the national accounts series in 2010 which increased the level of the denominator (GDP) by approximately 3 percent Despite lagging behind the FC fiscal adjustment targets, central and general government deficits remain on a sustainable path thus far. One way to assess fiscal sustainability is with a model-based approach, which determines whether the government systematically responds to an increase in government debt by reducing primary deficits so as to prevent the debt path from becoming explosive. Bohn (1998, 2005) showed that in a regression of the primary deficit on public debt, the cyclical position of the economy, and the transitory component of government spending, a negative regression coefficient on the debt variable is sufficient to establish that fiscal policy is responsible. Analysis using state and central government data between FY1991 and FY2012 shows a negative, highly statistically significant relationship between general and central governments’ primary deficit and debt-GDP ratio, while results for state governments are correctly signed but not statistically significant. These results are robust to various ways for correcting for serial correlation, and the data do not exhibit strong evidence of non-stationarity. Dependent variable: primary budget deficit (percent of GDP) General Government Central Government State Government OLS Newey-West Prais-Winsten OLS Newey-West Prais-Winsten OLS Newey-West Prais-Winsten Lagged government debt, -0.253*** -0.253*** -0.230*** -0.154** -0.154** -0.139** -0.0464 -0.0464 -0.0520 percent of GDP (0.0486) (0.0373) (0.0560) (0.0554) (0.0723) (0.0583) (0.0282) (0.0375) (0.0561) Cyclical component of government spending, 1.509*** 1.509*** 1.422*** 0.708* 0.708 0.764** 0.776* 0.776* 0.445 percent of trend GDP (0.304) (0.294) (0.323) (0.389) (0.489) (0.298) (0.417) (0.393) (0.301) Cyclical component of GDP, -0.322*** -0.322*** -0.273** 0.0447 0.0447 -0.0107 -0.428*** -0.428*** -0.404** percent of trend GDP (0.102) (0.0817) (0.0982) (0.0910) (0.105) (0.0726) (0.141) (0.114) (0.141) Observations 21 21 21 21 21 21 21 21 21 R-squared 0.805 0.805 0.735 0.462 0.462 0.501 0.394 0.394 0.240 Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1 FY2014 and further improvements thereafter authorities to clear the pipeline of stalled and builds in the assumptions of continued progress shelved investment projects – e.g., by setting up on the policy reform agenda as well as a benign the Cabinet Committee on Investment in global environment. Steps taken by the December 2012 and, more recently, a special 14 India Development Update October 2013 project-monitoring group which removed last- against the US dollar. After stabilizing around mile hurdles to 28 large infrastructure Rs.54 per US dollar during the first five months investment projects worth just over 1 percent of of 2013, the rupee fell to a record low of Rs.68.4 GDP – will need to be followed up with on August 28, 2013, as portfolio investors additional actions and close monitoring of withdrew a combined US$13 billion from Indian delays in project preparation to ensure that the equity and debt markets in June-August 2013. In rebound in investment envisioned in the forecast September, however – buoyed by a series of materializes. A set of banking sector reform positive news including the Federal Reserve’s measures announced by the new RBI Governor decision to continue the asset purchasing are likely to improve flexibility in the banking program, the appointment of a new RBI system and facilitate financial inclusion and Governor, and improved export performance – penetration through expansion of point-of-sale the rupee recovered about a third of its recent terminals and mini-ATM usage. However, losses and retreated to the Rs.62/US$ range. growing vulnerabilities in the corporate and banking sector must be watched closely, as the baseline scenario assumes no further substantial deterioration in asset quality. Although the depreciation of the rupee has boosted the competitiveness of Indian exporters, many other emerging economies have also seen their currencies weaken against the dollar. Lasting, substantial improvements in export competitiveness will require policy efforts to narrow the infrastructure gap and ease the restrictive regulatory environment which creates strong incentives for Indian firms to remain small (see The depreciation in the rupee closely followed Box 2). While the authorities have made movements in other emerging market important progress on fiscal consolidation, the currencies. Foreign investors have been positive fiscal and debt sustainability outlook in withdrawing resources from emerging markets the baseline scenario is conditional on further on fears that the US Federal Reserve steps to reduce distortions and lower subsidy Quantitative Easing (QE) program may be costs, particularly the under-recoveries on diesel. pulled back quicker than expected. In this Furthermore, expenditure restraint alone is regard, weaker-than-expected US job creation in unlikely to be a solution given the large August and a downward revision to July infrastructure and social protection needs. In this employment numbers have supported markets regard, progress on the long-delayed Goods and by adding to the sentiment that the Fed’s Services Tax (GST) agenda – which could ‘tapering’ may be postponed. The portfolio improve domestic market integration, reduce reallocation spurred by fears of ‘tapering’ has cascading tax inefficiencies, and boost revenue pushed down the values of a number of collection in the long term – is particularly currencies across the globe, including the South important to long-run fiscal sustainability and African rand, the Brazilian real, and the high growth. Indonesian rupiah. Movements in these currencies – and in particular the Indian rupee – 3. Depreciation of the Rupee mirror closely the movement of yields on 10- year US Treasury bonds. The Indian rupee fell to historic lows in August 2013 before staging a recovery in Only about two-thirds of the depreciation September. Since the beginning of May 2013, bout can be explained by underlying the currency lost more than 20 percent in value fundamentals. An econometric model which 15 India Development Update October 2013 considers short-term financial market dynamics rupee-US dollar exchange rate quite well over around a long-term cointegrating relationship the past five years. However, the model’s ability between the nominal exchange rate, relative to track exchange rate movements during the prices, and gold prices, fits the behavior of the most recent depreciation bout is much weaker, Box 2: Facilitating Growth of Small Businesses‡ Indian firms operate within a complex web of laws, rules, and inspections that interact with a vast array of incentives. These may hold back firms from operating on a level playing field and at appropriate scales in unified domestic markets and abroad. In particular, firms in India face specific challenges in the areas of insolvency, inspections & compliance, labor, and land acquisition. Insolvency: Smaller enterprises in India are overwhelmingly single proprietorships or partnerships, subject to largely outdated personal bankruptcy laws – Provisional Insolvency Act (1920), Presidency Towns Insolvency Act (1908), and Sick Industrial Companies Act (1965) – that make it virtually impossible for entrepreneurs to restructure and work towards solvency. Moreover, several criminal statutes apply to events that typically occur during periods of financial stress, such as late payments of statutory liabilities. As a result, entrepreneurs do not have access to adequate stay, discharge, and rehabilitation mechanisms, and liquidation proceedings can take two to ten years. Inspections & compliance: Operational compliances are required individually for almost all the steps in running firms, with the central government providing the overall legal framework and state governments formulating and implementing the specific regulations. A basic set of compliances for a small manufacturing firm would consist of 8-10 central and an additional 15-20 state and municipal clearances. As a result, compliance costs are high, delays are endemic and prolonged, and there is a high level of inspections which requires management time that could be used productively in running the firm. Multiple regulations have separate inspection regimes, creating incentives for firms to remain small or risk becoming subject to repeated and unpredictable visits. Labor: Labor regulations are widely recognized by both firms and analysts to be a constraint on the growth of formal employment as well as a factor in the expansion in use of contract labor as a regulatory avoidance strategy. While relatively few firms are subject to the provisions of the Industrial Disputes Act (1947), the interaction of the compliance and reporting requirements of the Factories Act (1948) with the penalties to growing past size limits defined in the benefits packages under the MSME Act (2006), create a powerful impetus for firms to stay small to avoid highly burdensome hiring and firing rules. Land: As the operation of land markets is a concurrent responsibility of the central and state governments in India’s federal structure, there is a mass of complex derivative and subordinate regulation in this area. For many small firms, the two key stress points regarding land relate to very significant procedural delays due to substantial variations among localities in the interpretation of existing laws, and the chronic shortage and high price of industrial land, especially in urban areas. Time-consuming procedures for the registration of real property, transfer of titles, disputes related to base rates for property valuation and taxation and obtaining construction permits add to time and money compliance costs for small firms. A number of states have taken steps to ease these burdens, creating a mosaic of ‘best-practice’ examples across states in different areas. Some have simplified tax administration processes, including the introduction of e-filing and e-returns. Others have established joint inspections by various departments, easing the administrative burden on firms. Other states having simplified labor registers across Acts to maintain a common/single labor register to store all records. With regards to land, some states have taken steps to reduce the time taken to grant land conversion or to allot land in industrial estates, in some cases to less than 30 days. ‡ This box summarizes some of the findings of a background note “Regulations Restricting the Growth of Non - Farm Enterprises” by Deepak Bhattasali, Luke Simon Jordan, and Neeti Katoch. 16 India Development Update October 2013 explaining only two-thirds of the observed not buttressed investor confidence, the focus variation. This suggests that expectational shifted towards a more strategic communication factors, driven chiefly by the tapering concerns, with a longer-term perspective. Announcements seem to have created greater volatility than by the Finance Minister and the new RBI would normally be expected. At the same time, Governor have focused on the need for structural however, many of the semi-structural factors reforms to accelerate growth and reduce underpinning the depreciation (relative price and macroeconomic vulnerabilities. Policy actions interest rate differentials, central bank balance by the RBI have focused on improving banking sheet size, etc.) remain prevalent and may sector flexibility and making it easier for require further attention by the authorities. exporters and banks to access foreign exchange. The markets have reacted favorably to these recent developments as the rupee recovered and equity markets rebounded sharply in September, even prior to the Fed’s calming announcement at the end of the month. The initial response by the authorities could not allay market fears. While the monetary tightening in July propped up short-term interest rates, it also increased borrowing costs and added further stress to the corporate and banking sector profitability. Steps to attract additional foreign investment in August – through issuance Depreciation episodes in recent history have of quasi-sovereign dollar denominated bonds not been accompanied by large shocks to and liberalization of external commercial price or output growth. India’s recent history borrowings and non-resident deposit schemes – provides some clues on the potential impact of were announced at the same time as restrictions the rupee depreciation on economic activity. In on capital flows out of India, including overseas late 2008 the rupee fell from around Rs.40 to direct investment, outward remittances, and Rs.50 per US$ (later recovering to around purchase of immovable property. Increases to Rs.45), and in late 2011-early 2012 it dropped import duties on gold and electronic items have from around Rs.45 to Rs.55. Both episodes curbed (official) imports but are unlikely to be a coincided with substantial global uncertainty: long-term solution. The authorities also reduced the global financial crisis and the euro-zone minimum land requirements for special crisis. Therefore, any deceleration in economic economic zones (SEZ) and announced new activity could be equally attributed to slowing of export promotion schemes, but these measures partner country growth as to the direct impacts are likely to be less effective than some of the of the exchange rate movements on output. deeper competitiveness reforms which could However, what is remarkable is that none of the significantly increase export potential. two episodes was characterized by a dramatic change in the main economic trends. If Since then, the authorities have shifted anything, inflation appears to have slowed in attention to longer-term solutions. As the line with the decelerating pace of activity. With authorities became aware that earlier actions had regard to trade, it is difficult to identify a clear 17 India Development Update October 2013 pattern in export performance during the While vulnerabilities in the financial sector previous episodes, although imports decelerated rose, nominal depreciation also fostered an substantially both times. However, this pattern improvement in external competitiveness. could be a reflection of a slowdown in global Following movements in the nominal exchange trade flows as much as developments caused by rate, India’s real effective exchange rate (REER) currency movements. depreciated by 12 percent this calendar year. However, unlike many other developing countries, the recent depreciation comes on the back of previous REER movements which had already resulted in the REER being below its long-term average prior to the May-August nominal depreciation. As a result, India’s competitiveness has received a substantial boost due to recent exchange rate movements. India’s real exchange rate depreciation has outpaced the developing country average Real effective exchange rates (Jan. 2000=100) 130 125 120 115 The corporate and banking sector is likely to 110 feel substantial adverse effects of the recent 105 depreciation. A larger number of corporates are 100 hedged either explicitly or implicitly (through 95 Developing countries import-parity pricing). Nonetheless, in instances 90 Developing countries excl. China where companies have not properly hedged or 85 India 80 are unable to perfectly pass through the rising costs of imports, depreciation is likely to reduce corporate profitability and could lead to a growing share of non-performing loans (NPLs). Exports and the trade balance are likely to A slowing economy, high corporate leverage, benefit. Imports have substantially risen in lower corporate profitability, and problems in importance in the Indian economy, increasing sectors with delayed investment projects were from just over 13 percent of GDP at the already posing significant challenges to banks. beginning of the 2000s to over 31.5 percent of Further pressure on NPLs could exacerbate GDP last year as globalization, rising incomes, problems but is unlikely to put overall health of and growing demand for fuel have driven the banking sector at risk. demand for imported goods. Exports growth has not kept pace with imports and, consequently, the trade deficit has gradually widened from less than 1 percent of GDP in 2000-01 to 7.1 percent of GDP last year. The depreciation of the rupee, however, has helped compress the trade deficit to US$10.9 billion in August, a 23 percent reduction from last year. It is often argued that India’s export response is muted, partly because primary products and especially refined petroleum account for roughly one quarter of total sales abroad and partly because manufacturing exports have a strong import component. However, empirical studies show 18 India Development Update October 2013 that the exports of modern services – which on current expenditure through higher interest account for nearly a third of total exports – are rates is likely to be limited. Total central highly elastic to exchange rate depreciation. As government debt is 53 percent of GDP and the export response ramps up further, the goods interest payments amount to 3.2 percent of GDP. and services trade balance is likely to continue External debt is relatively small and largely to improve. bilateral/multilateral with low interest rates, while domestically, the central government paid Impacts on overall external sustainability are approximately 8 percent on its bonds in auctions likely to be minor. Short-term external debt has of the last two months (near-zero real rates). been on the rise, with the largest share of that Total central government debt maturing in the debt held by the private sector. Potential current fiscal year amounts to 1.1 percent of difficulties in rolling over this debt may GDP (Rs.840 billion of domestic debt and represent a substantial vulnerability to those US$5.6 billion in external debt), but the vast corporates and importers who have not majority of the domestic debt (Rs.680 billion) adequately hedged their borrowings or trade has already been paid back or rolled over. credits. On the other hand, to the extent that Therefore, total financing needs are likely to be importers find it difficult to access short-term relatively low and could be comfortably trade credits (US$87 billion at end-March 2013), financed at a range of plausible interest rate imports would likely decline and financing assumptions. needs would be smaller. Furthermore, the next largest component of external debt due to mature Inflation could accelerate somewhat but in the current fiscal year (US$49 billion) is overall pass-through will be limited. Although deposits by NRIs, which have been rising over retail inflation eased marginally in August, it time and – given that much of these represent remains high at above 9 percent and further savings for future spending in India – are likely shocks to the prices of pulses (lentils) and to be rolled over into new deposits, especially as vegetable oils – which account for 7 percent of interest rates have been on the rise. Financing the CPI consumption basket – could push retail needs could be brought down further if the inflation into double-digits. However, price strengthening dollar and improving growth in increases of fuel and transportation – which the US incentivize higher worker remittance account for much higher 17 percent of the CPI inflows, which last year amounted to US$30 basket – are likely to be limited as long as the billion or 1.6 percent of GDP (around 30 percent authorities maintain the current practice of of remittances come from the US and another 20 allowing Rs.0.50/month increases in the price of percent from Europe). diesel. Pressure on fiscal balances is likely to rise but Some household budgets will come under financing needs should be met adequately. stress but the overall impact on poverty is The rupee depreciation would impact likely to be muted. Higher prices of pulses and government balances directly through higher edible oils – which account for 7 percent of costs of subsidies and indirectly through the household spending in rural areas – and pressure on interest rates. Last year, the central transportation – which accounts for 4 percent of government’s subsidy bill rose to 2.5 percent of household expenditure in rural areas and 6 GDP, of which 1.1 percent was spent on percent in urban – could put pressure on imported fuel and fertilizer (0.97 percent fuel household budgets, particularly those of the poor and 0.15 percent fertilizer). Despite steps taken and vulnerable. While labor earnings may suffer by the authorities to liberalize diesel prices, if the pace of economic activity remains muted, under-recoveries have now surpassed pre-reform job losses are unlikely to be sizeable as levels and, instead of declining to 0.6 percent of unemployment rates are very low on account of GDP as envisioned in the budget, fuel subsidies lack of broad-based social safety nets and low are likely to rise without additional reform steps. female labor force participation. Both the Beyond subsidy costs, impact of the depreciation decline in labor earnings and the increase in 19 India Development Update October 2013 household expenditure in rural areas could be underlying vulnerabilities remain, underscoring compensated by a good monsoon, although there the importance of prudent macroeconomic could be a substantial diversity of outcomes policies and continued progress on the reform across groups. Furthermore, some of the sectors agenda to set strong foundations for accelerated most likely to benefit from the depreciation – growth in the future. e.g., agriculture and textile – are labor-intensive, which may cushion the adverse effects of weak economic activity on wages. Households that purchase gold could be worse off, but they amount to just 2.6 percent of rural households and 4.1 percent of urban households and are also likely to see the value of their existing gold holdings increase. Economic growth is likely to be supported by continued positive export response, but could be hurt if the availability of foreign investment declines further. The overall impact of the depreciation on economic growth will be a balance between positive contributions from greater export revenues and the negative impacts of higher costs of intermediate inputs as well as reduced availability of foreign investment inflows. A weaker rupee could make it more difficult for firms to purchase imported inputs (among which capital goods are a very important component) and to access foreign financing (as the depreciation is being driven by capital outflows. As a result, there could be further downward pressure on investment growth – which has already fallen to -1.2 percent y-o-y (-11 percent saar) in Q1 FY2014 from double-digit growth recorded in earlier years – although the extent of this pressure is likely to be limited by the fact that most investment in India is financed through domestic savings, which have averaged more than 33 percent of GDP between FY2005 and FY2012. Rupee depreciation has highlighted India’s growing macroeconomic vulnerabilities but offers a window of opportunity to improve competitiveness and accelerate growth. Amidst the withdrawal of funds from emerging markets, global investors have focused more intensely on large emerging economies with greater current account and fiscal deficits. In this risk-averse environment, India’s large twin deficits and slowing growth momentum have added to investors’ fears. While the sentiment did improve in the first half of September, the 20 India Development Update October 2013 India: Selected Economic Indicators 2008/09 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 Est. Proj. Proj. Real Income and Prices (% change) Real GDP (at factor cost) 6.7 8.6 9.3 6.2 5.0 4.7 6.2 Agriculture 0.1 0.8 7.9 3.6 1.9 3.4 2.0 Industry 4.4 9.2 9.2 3.5 2.1 1.0 5.2 Of which : Manufacturing 4.3 11.3 9.7 2.7 1.0 0.2 4.4 Services 10.0 10.5 9.8 8.2 7.1 6.7 7.6 Real GDP (at market prices) 3.9 8.5 10.5 6.3 3.2 4.0 6.7 Prices (average) Wholesale Price Index 8.1 3.8 9.6 8.9 7.4 5.3 5.2 Consumer Price Index 9.1 12.4 10.4 8.4 10.4 … … GDP Deflator 8.7 6.1 8.9 8.3 8.2 5.3 5.2 Consumption, Investment and Savings (% of GDP) Consumption 1/ 70.8 70.9 69.5 73.7 74.6 74.4 72.7 Public 10.9 11.9 11.4 11.6 11.8 12.2 12.2 Private 59.9 59.0 58.0 62.1 62.7 62.3 60.5 Investment 2/ 32.3 31.7 31.7 30.6 29.6 29.6 30.7 External Sector Total Exports (% change in current US) 15.0 -5.8 37.5 17.9 0.3 15.7 21.9 Goods 13.7 -3.6 37.5 23.6 -1.1 17.1 23.7 Services 17.3 -9.7 37.5 7.1 3.4 12.9 18.3 Total Imports (% change in current US) 16.6 -0.1 28.8 24.2 1.1 7.8 18.2 Goods 19.8 -2.6 26.7 31.1 0.5 8.8 19.5 Services 1.1 14.4 39.4 -7.3 5.0 1.8 9.5 Current Account Balance (% of GDP) -2.3 -2.8 -2.7 -4.2 -4.8 -4.1 -3.7 Foreign Investment (US billion) 8.3 47.0 37.6 38.6 46.5 41.6 47.5 Direct Investment, net 22.4 18.0 9.4 22.1 19.8 20.0 26.5 Portfolio Investment, net -14.0 29.1 28.2 16.6 26.7 21.6 21.0 Foreign Exchange Reserves (US billion) 3/ 241.4 254.7 274.3 260.1 259.7 257.2 263.2 General Government Finances (% of GDP) Revenue 4/ 19.4 18.6 20.2 18.6 19.5 19.7 19.7 Expenditure 27.8 28.0 27.8 26.7 26.5 27.0 26.8 Deficit 8.4 9.4 7.6 8.1 7.0 7.3 7.1 Total Debt 5/ 74.9 73.3 67.9 67.9 68.7 70.8 70.5 Domestic 69.8 68.6 63.4 63.2 64.3 66.4 66.7 External 5.1 4.7 4.5 4.7 4.4 4.5 3.8 Notes: 1/ Consumption is equal to final consumption expenditure plus valuables. History includes national accounts' discrepancies. 2/ Gross fixed capital formation 3/ Excluding gold, SDR and IMF reserve position 4/ Includes receipts from 3G spectrum auctions and disinvestment 5/ General government liabilities include states' holding of short-term central govt securities Sources: Central Statistics Office, Reserve Bank of India, and World Bank Staff Estimates. 21