India Economic Update - World Bank · global financial crisis and the sudden halt in capital...

September, 2009

Economic Policy and Poverty Team

South Asia Region

The World Bank

India Economic Update

Recovery Underway There are signs that the Indian economy is coming out of the downturn into which it entered in the second half of the fiscal year 2008-09. 2 Monthly data show that industrial sector growth is positive, credit offtake has improved, and trade is stabilizing. The external sector is helping growth in a national accounting sense, because imports fell faster than exports. Financial markets are back to normal with a recovery of the Bombay Stock Exchange to a 18-month high, and near re-adjustment of the risk spread on Indian debt instruments. Inflation is resurfacing because the base effect of high energy prices last year is diminishing, and food price inflation is high, not least because of a deficient monsoon. Fiscal stimulus supported aggregate demand to the tune of 3.5 percent of GDP during 2008-09 because of the 6th pay commission awards and three fiscal stimulus packages. Monetary policy appears to be at a crossroad, with interest rates held stable due to the dilemma between high CPI and low WPI inflation indicators. Looking forward, the external economic environment is stabilizing, but difficulties continue and Indian economic growth will have to rely more on domestic factors. The short-term forecast for India is cautiously optimistic, with growth in the current year projected at 6 percent, and a sharper recovery to 7.5 percent next fiscal year. Fiscal policy provides more stimulus with an increase in the overall deficit to about 10.3 percent of GDP envisaged for 2009-10, 1 percent of GDP higher than the already high deficit of 2008-09. Monetary policy walks the tightrope between accommodation and vigilance, as the RBI aims to ensure that the high government borrowing requirement does not crowd out private sector borrowing on one hand, and does not cause the reemergence of inflation on the other. The paper concludes with a discussion of the role of capital flows and the exchange rate, highlighting the constraints on policies in an economy that has become more and more open to international trade and capital flows.

1 This report was prepared by Ulrich Bartsch, Abhijit Sen Gupta, and Monika Sharma.

2 Indian fiscal-year is 1 April-30 March

India Economic Update1 September 2009

Industrial production growth has resumed at around 5 percent since March 2009 (as shown by the Index of Industrial Production,

IIP, in the first chart on the right). This comes after a slump that started in the summer of 2008, even before what many observers regarded as the “re-coupling” event — the collapse of Lehman Bros — when the global crisis was assumed to have hit India. This early start of the slowdown highlights that there were domestic cyclical reasons already operating when global contagion hit. Non-food credit offtake, which had nearly come to a halt in the last quarter of FY 2008-09, staged a resurgence that took it to 17 percent growth in the latest two months. The picture is less clear for exports, where annualized seasonally adjusted monthly growth rates do not suggest any clear direction. Nevertheless, even this constitutes an important improvement compared with the steep fall in exports witnessed in the second half of FY2008-09. While year-on-year growth rates — the most frequently used indicators in India — still show a mixed picture with the 12 months of cumulative developments they embody, the turnaround is more visible in the seasonally adjusted monthly data shown on the right.3

Growth reached an estimated 6.1 percent in the first quarter of the 2009-10 fiscal year (April 2009-March 2010), only slightly

higher than the 5.8 percent growth recorded in the second half of 2008-09. The industrial sector showed more robust signs of revival, growing at 4.2 percent compared with -0.5 percent and 1.6 percent in the previous two quarters.

3 The first two charts show 3-month moving averages of the annualized monthly growth rates (determined as [ln(t)-ln(t-1))12] ). The third graph shows month-on-month changes in percent.

The last five months show solid growth in industrial production…

Driven by a resurgence in lending…

While export growth is oscillating, and imports outpace exports.

Source: NIPFP India SA Macro Database.

Industrial Production, 2005‐09

Note: 3‐month moving aver. of annualized monthly growth of seasonally adjusted index.

Non‐food credit

Note: 3‐month moving aver. of annualized monthly growth of seasonally adjusted index.

Exports and Imports (m‐o‐m percentage change, seasonally adjusted)

Exports Imports

After a low point at the

beginning of the current

fiscal year, the Indian

economy is exhibiting

promising signs of revival

So far, the upturn is

fragile, and the growth

estimate for overall GDP

shows only a small pick

The Indian Economy is Coming Out of the Downturn

I. Recent Economic Developments

Consumption growth slowed to 2.6 percent, year-on-year, compared with 6.1 percent in Q4 2008-09, driven

largely by a slump in private consumption growth to 1.6 percent—the lowest in seven years. In contrast, due to the fiscal stimulus packages, government consumption increased by 10.2 percent. Investment growth also headed downwards, and at 4.5 percent was the lowest since Q1 2002-03. The credit crunch in the aftermath of the bankruptcy of Lehman Bros adversely affected the capital expenditure plans of the corporate sector. Highlighting the macro-financial feedback loop that became apparent in this global crisis, financing constraints and a loss of confidence reduced aggregate demand, and the manufacturing sector struggled with dwindling sales and rising inventories post-September 2008. As a result, companies drew down inventories and slowed their capital expenditure plans.

While the contribution of net trade to GDP was negative over the last four years, because imports were growing faster than exports, the drop in imports during

the last two quarters was steeper than the drop in exports, and the trade balance improved. However, this welcome development may be coming to an end, with imports growing faster than exports in June and July 2009. Of course, the negative overall contribution of trade to GDP growth masks the efficiency effects of international competition and improved availability of inputs, which have spurred Indian growth.

Consumption and invest‐

ment growth is sluggish,

despite a marked rise in

government consumption

The buoyancy in GDP

growth was partly due to

an improvement in the

trade balance, but this is

again widening

The overall Balance of Payments turned positive…

On the back of a strong improvement of the Trade Balance…

While capital flows are still negative.

Source: Reserve Bank of India.

‐30,000

‐20,000

‐10,000

10,000

20,000

30,000

40,000

11/200

12/200

10/200

11/200

Current Account, Capital Account, and Overall Balance

Overall Balance Current Account Capital Account

‐50,000

‐40,000

‐30,000

‐20,000

‐10,000

10,000

20,000

11/200

12/200

10/200

11/200

Current Account, Trade, and Services Balances

Current Account Trade Balance Service Balance

‐10,000

‐5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

11/200

12/200

10/200

11/200

Capital Account, Foreign Direct and Portfolio Investment

Capital Account FDI FII

The overall balance reached positive territory in the last quarter of FY 2008-09 after showing a deficit for the preceding two

quarters. The current account developed a small surplus after three quarters of deficit numbers. The capital account, however, remained in deficit despite a turnaround in foreign investment.

As a result of valuation gains, net foreign reserves increased to US$276 billion at end-August 2009, up from

US$252 billion at end-March. The Reserve Bank of India (RBI) intervened very little in the forex market in this period. India’s reserves covered about 11 months worth of imports, significantly more than those of neighbouring countries.

Rupee stability follows a strong depreciation in the aftermath of the global financial crisis and the sudden halt in capital inflows. Both the

earlier depreciation and the rebound were mirrored by portfolio investment flows in the equity market: from April 2009, there was a resurgence of portfolio capital inflows to India. Compared to a net FII investment outflow of US$7.2 billion through equity between October 2008 and March 2009, there was a net inflow of US$9.7 billion during April-August 2009. FDI equity inflows have also staged a modest revival with US$10.5 billion coming into the country during April to August 2009, compared to US$10 billion during the previous six months. Sectors which attracted the bulk of foreign investment included telecommunications, real estate and housing, construction and power.

The Balance of Payments

improved on the back of

an improving trade

balance

The Reserve Bank of

India’s foreign reserves

recovered strongly

The Indian rupee showed

some gains after the May

2009 elections and has

remained relatively stable

The External Sector is Helping, Despite the Collapse in Global Trade

Sources: Reserve Bank of India, IMF IFS.

FDI Inflow and Exchange Rate

FDI Equity Inflows ($ Billion)

INR/USD Exchange Rate (Right Axis)

Jan‐02

May‐02

Sep‐02

Jan‐03

May‐03

Sep‐03

Jan‐04

May‐04

Sep‐04

Jan‐05

May‐05

Sep‐05

Jan‐06

May‐06

Sep‐06

Jan‐07

May‐07

Sep‐07

Jan‐08

May‐08

Sep‐08

Jan‐09

Import Cover of International reserves (in months)

Bangladesh India Indonesia Malaysia Pakistan Sri Lanka

10,000

12,000

14,000

16,000

18,000

20,000

22,000

BSE Sensex and Net FII Investment

Net FII Investment ($ Billion) BSE Sensex (Right Axis)

The Bombay Stock Exchange Sensex recovered from a low of 8,200 in early March 2009 to come close to 17,000 and reached a

16-month high in mid-September 2009. The Sensex outperformed global markets since March 2009. Better-than-expected first-quarter results for several corporate firms boosted the Sensex, which started a strong rally after the announcement of the May 2009 election results.

Credit default swap spreads for Indian banks have fallen. Spreads for ICICI Bank, a large private sector bank, is back to about 300 basis points,

after reaching a peak of 1,800 basis points in February 2009.

The stock market has

recovered from a steep

downturn during the

crisis

External financing con‐

straints have eased

substantially with a

return of risk spreads to

pre‐crisis levels

Financial Markets are Back to Normal

Labor Markets

Although there is very little hard data, there are indicators of an emergent improvement in the labor market. While the near-complete absence of up-to-date employment data makes a thorough evaluation impossible, survey data shows that headhunters experienced a 50 percent increase in the number of recruitment queries issued by companies in April compared to February 2009. Similarly, according to the Manpower Employment Outlook Survey by Manpower Inc., covering 35 countries, employer hiring expectations in India were the most optimistic. At 25 percent, the Net Employment Outlook for Q4 2009 was considerably higher compared to China (8 percent), Australia (7 percent), Canada (5%), the United States (-3%) and United Kingdom (-2 percent). Sectors such as finance and insurance, wholesale and trade, mining, construction, and public administration and education are set to have the most favorable hiring environment.

In addition to the renewed rise in commodity prices from their low of late 2008, weak agricultural

performance is contributing to a rise in primary product prices. While year-on-year inflation based on the wholesale price index (WPI) is still in negative territory, seasonally adjusted monthly data show that inflationary pressure is building. The renewed rise in prices of primary products shows more clearly in the consumer price indices (CPIs), which assign higher weights to primary products. CPI year-on-year inflation hovers around 12.5 percent. Commodities impacted by the price rise include pulses, rice, fruits and vegetables, cereals, and sugar. In part, prices already incorporate anticipated effects of deficient rains. The recent uptick in monthly WPI inflation reduced the gap between WPI and CPI measures of inflation, which is posing a dilemma for monetary policy makers (see below).

A resurgence of inflation

is becoming a topic for

discussion

Inflation is resurfacing

Developments in selected sectors Mining, electricity and manufacturing. Growth rates were high in the last two quarters with 7.7 percent and 5.6 percent, compared to 1.4 percent and 2.9 percent in the previous two. Manufacturing also witnessed a revival and grew at 4.3 percent compared to 0.4 percent in the previous half year. Wood products, rubber and plastic, metal and alloys and transport equipment experienced a revival of growth. The growth rate of consumer durables reached double digits. Steel, cement, automobiles, and port traffic. After witnessing a dip in the growth rate in January and February 2009, cement dispatches grew at a healthy 11.8 percent during the last quarter. Similarly, the steel production growth rate entered into positive territory in April and May 2009 after recording negative growth through most of November 2008 to March 2009. Commercial vehicles sales recorded their first increase in July 2009, after declining consistently since October 2008. Port traffic increased by 8.1 percent in June 2009, after contracting for five consecutive months between January and May 2009. Some service sectors also witnessed a revival in growth rates. Although overall the services sector witnessed a marginal decline in growth in Q1 2009-10 to 7.8 percent from 8.6 percent in Q4 2008-09, certain sectors such as finance and insurance, trade, transport and communication experienced robust growth rates of 8.1 percent. While community services’ (including public administration) growth dipped sharply from 22.5 percent in Q3 2008-09 and 12 percent in Q4 2008-09 to 6.8 percent in Q1 2009-10, with 60 percent of Sixth Pay Commission arrears to be paid out in the current year, the growth rate in this sector is set to be high.

Fiscal stimulus measures worth 3.5 percent of GDP (including higher wage payments in the wake of the pronouncements

of the Sixth Pay Commission) led to a worsening of the deficit to 6.1 percent of GDP for FY 2008-09. The worsening was due to increased social-sector and plan spending, higher subsidies, higher investment financing on the spending side, and on the revenue side, removal of some surcharges and reduction in customs duties. Associated with the rise in the fiscal deficit was a comparable increase in revenue deficit, which rose from a budgeted estimate of 1.1 percent for 2008-09 to a revised estimate of 4.4 percent, and is further expected to increase to 4.8 percent of GDP in 2009-10. The rise in revenue deficit was attributable to an increase in defense expenditure and subsidies, especially fertilizer subsidies. As a result of a weakening economy and lowering tax rates, there was a decline in the amount of tax revenue collected from corporation tax, income tax, customs and excise duties compared to the originally budgeted amount. In addition, revenue from interest receipts as well as dividends and profits of public sector enterprises also witnessed a decline.

In the first quarter of the current fiscal year, between April and July

2009, total revenue receipts were down 10.2 percent, while expenditure increased by 13.0 percent, compared to the previous year. As a result the fiscal deficit increased by 37 percent. On the other hand, advance tax payments by Indian corporates were up 14.7 percent during Q2 of FY2009-10 over the same quarter last year, while income tax collections were up 1.7 percent. Note however that advance tax payments are actually down by firms that would normally be considered leading indicators for a recovery, e.g. steel, cement, infrastructure. In fact, the advance tax payment numbers are signaling an uncertain period ahead, with declines and advances about evenly balanced.

Fiscal Stimulus Supports Aggregate Demand

Fiscal stimulus and

payment of wage arrears

widened the fiscal deficit

during the last fiscal year

Indicators for the current

year are mixed

Impacts of a Deficient Monsoon There are increasing concerns that the nascent recovery in growth may be arrested by the adverse impact on agricultural growth emanating from a truant monsoon. With 278 out of 593 districts in India declared drought hit, agricultural growth is likely to suffer a setback. Most estimates expect a reduction in agricultural growth. The deficient monsoon has resulted in a decline in the area sown for a number of crops. The adverse impact on the agriculture could further worsen the export performance, which is already quite weak, as agricultural exports account for over 10 percent of total exports. A substantial fall in domestic production could lead to the government dissuading exports and imposing export taxes and export bans on specific items.

Summer Crop Sown Area (Million Hectares)

2008 2009 Change

Paddy 37.1 30.9 -16.8% Jowar 2.8 2.9 2.2% Bajra 7.3 6.9 -5.9% Maize 6.9 7.0 1.5% Total Coarse Cereals

19.1 18.6 -2.4%

Arhar 3.3 3.4 1.6% Urad 2.0 2.2 9.1% Moong 2.2 2.4 7.7% Total Pulses 9.2 9.6 4.6% Groundnut 5.1 4.3 -16.0% Soybean 9.6 9.5 -0.5% Total Oilseeds 17.8 16.6 -6.6%

Source: Ministry of Agriculture

State governments are likely to seek assistance from the National Calamity Contingent Fund and the Calamity Relief

Fund. A decline in agricultural activity is also likely to increase the demand for employment under the National Rural Employment Guarantee Schemes (NREGS). In addition, the government is likely to assist farmers in a number of ways that could include directing banks to re-schedule loan recoveries, extending crop insurance and the government subsidizing imports or reduction in import duties. On the other hand, on a cash basis the budget would benefit from sales of food stocks aimed at stabilizing prices of staples.

While the economy was subjected to large shocks from commodity prices, capital flows, cyclical factors, and financial contagion, money

(M3) growth has been remarkably stable. Since the beginning of 2007, money growth has hovered between 20-25 percent year-on-year. This is particularly remarkable in light of the volatility in inflation, as it implies that real money balances have been equally volatile. The government’s share in the outstanding amount of overall domestic credit increased to 29.6 percent in July 2009 from less than 25 percent in the first quarter of 2008. And while the government had maintained positive balances with the RBI through the first half of FY 2008-09, large borrowing requirements for the payment of arrears to oil and fertilizer companies led to the emergence of liabilities to the RBI in March 2009 to the tune of Rs. 600 billion (US$12 billion). Since then, however, the government reduced outstanding amounts to less than half this amount.

Monetary Policy Appears to be at a Crossroad

Money growth is remark‐

ably stable

Measures to mitigate the

impact of a deficient

monsoon could further

exacerbate fiscal stress

Widening fiscal deficits

are reflected in a rising

share of credit to the

government in overall

domestic credit

11/200

Credit to Government and Private Sector (in % of domestic credit)

Credit to Gov. Credit to Priv.

11/200

Credit to Government and Private Sector (in Rs. trillion)

Credit to Gov. Credit to Priv.

Impacts of a Deficient Monsoon (continued) Despite the hit to agriculture growth, the overall impact on GDP growth is likely to be muted. Although agriculture’s share in overall GDP has been dwindling and currently stands at 17 percent, nearly 65 percent of the population continues to be associated with it. Nevertheless, the overall impact of a slowdown in the agricultural sector on GDP is likely to be muted due to ongoing measures like the NREGA, a large stock of food grains, and a comfortable reserve position if the need to import food grain arises.

Overall financing from bank and non-bank sources declined to a little over half the amount provided over Q1 2009-10 compared with the same period

last year. Partially, the weakening of credit is the result of lower commodity prices. During the quarter, credit to petroleum and fertilizer companies declined by about Rs. 188 billion as opposed to an increase of Rs. 65 billion in the same quarter of 2008-09. In fact, credit for other uses than petroleum and fertilizer was nearly constant. Non-bank sources, in particular foreign sources, made up the bulk of the decline in non-subsidy related financing. However, there was an increase in activity in the private placement market where the incremental funding in Q1 2009-10 increased to Rs. 291 billion from Rs. 169 billion last year.

A decomposition of the credit growth rate according to bank group type indicates the deceleration in credit growth since

November 2008 is largely due to lower lending activities by the foreign and domestic private banks. Foreign banks, which account for 5.9 percent of gross bank credit, witnessed a decline in credit growth rate to 3.5 percent in March 2009, compared to 27.8 percent a year back. ‘Other Commercial Banks’, which include private Indian banks, also saw their credit growth rate shrinking from 18.8 percent in Q4 2007-08 to 10.2 percent in Q4 2008-09. Credit growth rate has been relatively healthy for the nationalized banks as well as State Bank of India and its associates, which recorded growth rates of 24.7 and 21 percent, respectively, in Q4 2008-09, marginally lower than 25 and 20.8 percent, respectively, in the previous year.

Credit demand from the corporate sector has been subdued in the last few months as companies have adopted a wait-and-see stance. However, with

Flow of Resources to the Commercial Sector

April-June 2008 2009 Change

A. Non-food Bank Credit by Banks 306 57 -81% 1. Non-Food Credit 374 117 -69% of which: petroleum and fertilizer credit 65 -188 -389% 2. Non-SLR Investment by Banks -67 -60 -10% B. Flow from Other Major Sources 1,285 850 -34% B1.Domestic Sources 771 640 -17% 1. Public issues 20 2 -90% 2. Gross pvt. placements 170 291 71% 3. Net Issuance of CPs to non-banks 251 355 41% 4. Housing finance companies 107 -38 -135% 6. Imp. non-deposit-taking NBFCs 219 19 -91% 7. LIC's Gross Invstm 11 65 491% B2. Foreign Sources 514 210 -59% 1 ECBs / FCCB 61 -15 -125% 2 ADR/GDR Issues 41 2 -95% 3 Short-term Credit 96 4 -96% 4 FDI 315 219 -30%

C. Total Credit 1,591 907 -43%

The recent pick‐up in non‐

food credit offtake masks

a significant decline in

financing for the private

sector

Foreign and domestic

private banks account for

the bulk of the slowdown

in credit growth

Moderation in credit

growth is also attributed

to a slump in credit

demand by the corporate

sector

Credit Growth Rate: Bank Group Wise

Foreign Banks Nationalized BanksOther Commercial Banks Regional Rural BanksSBI and Associates

a modest revival in the industrial growth there is an increasing likelihood that credit growth rate would start increasing in the next few months. The late arrival of the monsoon in some parts of the country is also likely to bolster agricultural credit demand.

At its July 2009 Policy Review, the Reserve Bank of India main-tained its policy inter-est rates unchanged. It had lowered its policy rates in four steps by a

cumulative 425 basis points starting in September 2009. The repo rate was maintained at 4.75 percent, and the reverse repo rate at 3.25 percent. The RBI took the decision to hold in the face of the dilemma of high and stubborn CPI inflation, and (at the time) negative WPI inflation.

Liquidity injections by the RBI through open market operations and loosening prudential regulation and slow credit offtake have

resulted in excess liquidity in the banking system. Since May 2009, the interbank call rate has therefore remained at the bottom of the RBI’s policy rate band as banks deposited large amounts with the RBI. While liquidity is high, however, it should be noted that some public sector banks are facing constraints on credit expansion due to limited access to capital.

Lending and deposit rates have come down significantly since they reached highs in October 2008. Bank Prime Lending Rates (BPLR) since then have been reduced by 275 basis points, while deposit rates fell 250 basis points. BPLRs show some stickiness in downward adjustment, because floating rate loans are priced using BPLRs, while new customers often negotiate rates below BPLR. They do not provide a true picture of average lending rates.

On the short-term end of the market, treasury bill yields increased by about 100 basis points since the delivery of the budget. The 10 year bench-mark bond yield has also increased to more than 7.4 percent in August 2009 from around 6.8 percent in early July 2009.

Caught in a dilemma

between high CPI and

negative WPI inflation,

the RBI maintained its

policy rates unchanged

11/200

Lending and Deposit Rates (in %)

Lending Deposit

The monetary policy

transmission channel via

commercial bank rates is

working

In light of the increased

government borrowing

requirement, government

borrowing costs have

recently firmed

Liquidity in the banking

system is high and banks

are parking money in the

RBI reverse repo facility

As in India, the global economy is coming out of a deep trough. Financial markets are stabilizing, and global industrial production is turning around as inventories have been mostly depleted. Adding further to evidence of a turnaround are a pickup in trade notably in East Asia, and strong second quarter GDPs for a number of middle income countries in Asia and Latin America. It should be noted, however, that economies are still saddled with large idle capacity and unemployment, and it will take sustained strong growth to reabsorb those capacities and workers and for GDPs to come up to levels seen before the crisis.4 GDP growth in India’s export markets is projected to contract sharply in 2009. U.S. GDP appears poised to grow 3-4 percent during the third quarter (seasonally adjusted annualized rate), but near-term prospects for Europe and Japan may be less encouraging, as renewed impetus from a revival of exports for the latter have yet to spill over to household and business demand. In all cases, growth momentum is anticipated to ease into 2010, as fading fiscal stimuli, and widespread excess capacity and large output gaps induced by the crisis may dampen capital spending and trade. Commodity prices declined precipitously, but bottomed out in early-2009. Crude oil prices have been supported by continued OPEC production restraint and its stated desire to have prices reach a comfortable level of near US$75/bbl. Agriculture prices are up 20 percent since end-2008, with recent strong gains in a few commodities. Price increases in vegetable oils due to lower production in Asia were offset by lower grains prices, tied to expectations of abundant U.S. crops. Metals prices have risen sharply in 2009, with copper more than doubling due to strong imports by China during the first half of the year. Gold prices rose above US$1,000/oz this month, the first since March 2008. Remittances are projected to shrink in South Asia, but the region has not been as hard-hit as elsewhere. Remittance flows were supported by return migration as jobs were lost in the industrialized countries during 2008 and early 2009. With those migrants not sending funds anymore, remittance flows are expected to be sharply

4 This section summarizes “The external Environment for Developing Countries – September 2009” by the World Bank’s Development Prospects Group.

External Economic Environment is Stabilizing, But Difficulties Continue 1

GDP composite indicator for India's export partners (2007=100), annual percent change

Export partner weighted GDP growth

Consensus forecast - June 2009 survey

Consensus forecast - March 2009 survey

Sources: Consensus Economics, IMF (DOT) and World Bank

Forecast

Major Commodity Price IndicesIndices of nominal US$ prices (2000=100)

Metals and minerals

Energy

Agriculture

Sources: Datastream Thomson and World Bank

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008e 2010f

Remittances inflowsannal percent change

All developing

South Asia

Source: World Bank

Forecast

II. Looking Forward

lower in 2009 compared with previous years. The South Asia region, however, is not expected to be as strongly affected, as the job losses in the region’s migrant labor markets were not as strongly affected.

There are indications that Indian GDP growth is set to recover in the second half of the current fiscal year. Growth is projected to reach 5.5-6 percent in 2009-10, and range around 7.5 percent and 8.5 percent in the next two fiscal years. The current quarter (Q3 of CY 2009) is unlikely to show strong growth because of the relatively high base of Q3 of 2008 (year-on-year). This base effect, however, will reverse thereafter and year-on-year growth rates would be higher. However, the base effect is not the only reason for optimism for the second half. Policy measures initiated in the early days of the global crisis in September last year are still feeding through to domestic demand, and consumers and investors seem to be reviving their appetite for spending. While the weak and delayed monsoon will most likely constrain growth in agriculture, industry and services are expected to recover strongly.

We project a pronounced recovery for the coming fiscal year and beyond. Despite a continuing slow pace of the global economy — associated with subdued export demand and higher external financing costs — India’s very own cyclical factors and renewed optimism should support higher growth rates. Support will also be provided by the expected impacts of the fiscal stimulus and monetary easing measures put in place during the last few months, which will allow the Indian economy to catch up with its potential growth rate of around 8 percent by temporarily growing faster and then converging.5

The recovery of the manufacturing sector is projected to make up for slow agricultural growth. The agricultural sector is projected to grow by 1 percent only, after an already slow previous year, in which it grew by 1.6 percent. Industrial production, which showed y-o-y growth of 7 percent in the months of June and July 2009, is projected to expand its value-added by 4 percent for the year as a whole

5 Projections are based on a small, quarterly macroeconometric model estimated using actual data up to Q2 of CY 2009. The India Forecasting and Policy Analysis System is described more fully in the annex. The upper chart shows output gap and growth rates. The output gap was positive during the high-growth years 2006-08 (i.e. output grew faster then potential, leading to overheating). Output fell below potential in Q4 of CY 2008. According to our projections, negative output gaps will continue until the end of CY 2012, because it takes some years of high growth to catch up. Growth is calculated as the change between the sum of four quarters of GDP over the corresponding period in the preceding year, and the rate for the last quarter of each fiscal year is the same as annual growth for that year.

The Short‐ to Medium‐term Forecast for India is Cautiously Optimistic

Source: India FPAS Macro Model.

Inflation, Exchange Rate, and Interest Rate

Y-o-y Inflation Real Interest Rate Exchange Rate Gap

Forecast

0.01.02.03.04.05.06.07.08.09.010.0

-5.0-4.0-3.0-2.0-1.00.01.02.03.04.05.0

Output Gap and Growth (in %)

Output gap, l.h.s. y-o-y growth, rolling sum of 4Q, r.h.s.

Forecast

Fiscal year annual

(up from 3.9 percent in 2008/09). Slower credit offtake and services exports are expected to reduce growth in the service sector to 8.4 percent, down from 9.7 percent in 2008/09.

Inflation is projected to pick up in the second half of the fiscal year. The reversal of the base effect, which has depressed the WPI in recent months, means that WPI inflation will rebound toward the end of FY 2009-10 to 6-7 percent (end-of-period). It will then still be below inflation as measured by the various CPIs, but a convergence of the separate measures will be well under way.

The RBI is expected to wait some time with monetary tightening. Governor Subbarao has reassured the country that he will not raise rates before the recovery of the economy is clearly under way. This will help the recovery with several quarters of very low real interest rates. These rates will be comparable to those in India’s trading partners, and international capital flows will remain subdued for some time, which should result in a stable exchange rate for the rupee.

In the Government’s words, the budget for the current fiscal year 2009-10 is aimed at minimizing the impact of the global recession and achieving 8 to 9 percent growth in the medium term. It expands allocations for infrastructure, social safety, and agriculture, while announcing only minor changes on the revenue side. The central government deficit is therefore projected to reach 6.8 percent of GDP as compared with 6.1 percent in 2008/09. Along with the fiscal expansion in the Center, the Finance Minister also increased the borrowing limits for states. The deficit limit for states was expanded by 0.5 percentage points to 4 percent of Gross State Domestic Product (GSDP), after it had been expanded already in December 2008 with the announcement of fiscal stimulus measures. Under the fiscal responsibility and budget management (FRBM) legislation, states were allowed to borrow up to 3 percent of GSDP, and in December 2008, this was increased to 3.5 percent of GSDP. The new target of 4 percent of GSDP is equivalent to about 3.5 percent of GDP. If states exhausted their borrowing limits, the general government deficit therefore would be around 10.3 percent of GDP, implying an additional fiscal stimulus of about 1 percent of GDP over 2008/09.

The 2009-10 budget therefore provides an additional fiscal stimulus of 1 percent of GDP relative to the estimated outcome for the last fiscal year 2008/09. Stimulus in that year was 3.5 percent of GDP at the central government level, and 1 percent of GDP at the state level. Quasi-fiscal spending on under-recovery of costs of petroleum products and fertilizer added another 1.8 percent of GDP during 2008-09, but in macroeconomic terms this cannot really be counted as fiscal stimulus as it did not increase disposable income, and only prevented higher international prices from being passed on to consumers. In

Fiscal Policy Provides More Stimulus

Central Government Fiscal Operations(estimates for 2006/07-2008/09, Budget 2009/10)

2006/07 2007/08 2008/09 2009/10

(in % of GDP)

Total revenue and grants 10.5 11.5 10.6 10.5Net tax revenue 8.5 9.3 8.8 8.1

Gross Tax Revenue 11.5 12.6 11.8 10.9Less: States' share 2.9 3.2 3.0 2.8

Non tax revenue 2.0 2.2 1.8 2.4

Total expenditure and net lending 14.0 15.0 16.7 17.4Current expenditure 12.5 12.6 15.1 15.3

of which: Interest payments 3.6 3.6 3.6 3.9Subsidies 1.4 1.5 2.4 1.9Defense expenditure 1.3 1.1 1.4 1.5

Capital expenditure and net lending 1.5 2.4 1.7 2.0

Gross fiscal deficit 1/ 3.5 3.5 6.2 6.87

Disinvestment receipts 0.01 0.82 0.05 0.02Gross fiscal deficit 2/ 3.5 2.7 6.1 6.8

Memorandum itemsRevenue deficit 1.9 1.1 4.5 4.8Primary deficit 1/ -0.2 -0.1 2.6 3.0Primary deficit 2/ -0.2 -0.9 2.5 3.0Central government debt 61.5 60.1 58.9 59.7

Subsidies and off-budget bondsFood 0.58 0.66 0.82 0.90Fertilizer 0.64 0.69 1.43 0.85Fertilizer Bonds 0.00 0.16 0.41 0.00Oil Bonds 0.58 0.44 1.43 0.18

(in Rs. Billions)Flagship Schemes

Sarva Shiksha Abhiyan (SSA) 111.0 131.7 131.0 131.0Integrated Child Development Services 40.9 48.6 56.7 60.3NREGS 128.7 142.2 367.5 391.0National Rural Health Mission 71.9 96.4 108.0 125.3National Urban Renewal Mission 36.0 54.9 104.5 128.9GDP (market prices, Rs. Billions) 41,292 47,234 53,218 58,566

Source: Government of India.1/ World Bank definition; excludes divestment proceeds.2/ Government of India definition includes divestment proceeds.

the same vein, the discontinuation of these subsidies in light of lower prices does not increase disposable income. Going forward, a renewed rise in oil and other commodity prices could necessitate further bond issues to finance under-recovery.

The budget is built on a conservative revenue projection. Tax buoyancy is assumed to be low with collections envisaged to increase by only 2 percent over the revised estimate for 2008-09. Nontax revenue, in contrast, is projected to show a sharp increase with the anticipated sale of 3G telecom licenses. The tax-to-GDP ratio declines by about 0.5 percentage points of GDP. Tax revenue increase is much below the increase in nominal GDP, with assumptions of 6.5 percent real GDP growth, and an average inflation of 3.5 percent, resulting in a nominal GDP increase of 10 percent.

Salaries, social protection measures, and investment outlays expand expenditures. Expenditures are projected to increase by 14.5 percent, of which current spending 12 percent and capital spending 36 percent over the revised estimates for 2008/09. Capital spending expands by 0.3 percentage points of GDP from 1.7 percent to 2 percent.

Regarding medium-term sustainability, the Finance Minister voiced his intention to return to the Fiscal Responsibility and Budget Management (FRBM) Act target for the fiscal deficit at the earliest, once the negative impact of the global crisis dissipates. Policy documents released along with the Budget show 5.5 percent and 4.0 percent budget targets for 2010-11 and 2011-12. Widening of the fiscal deficit has led to a sharp spike in government borrowing, with the total borrowing at the central government level in 2009-10 pegged at Rs. 4,500 billion. According to the revised issuance calendar for first half of 2009-10, the government is set to borrow Rs. 2,990 billion. There is an increasing concern that this would lead to a sharp increase in money supply, further exacerbating the inflationary pressures. More recently, the government has tried to allay concerns over government borrowing by indicating that the budgetary targets could be improved upon. The government, therefore, has embarked on a well-publicized austerity drive aimed at cutting administrative expenditure (mainly on official travel and housing), and the Finance Minister has indicated that tax revenue would be raised well above the targeted level. The government has also given renewed impetus to its divestment program, and divestment receipts could ultimately become much larger than budgeted. The domestic borrowing requirements envisaged under the 2009-10 budget require careful management. Borrowing requirements at the center are budgeted at Rs. 4 trillion, one-third higher than the estimated actual in 2008-09, and more than three times as high as in 2007-08, before the global crisis and domestic slowdown. In addition, the expanded borrowing limit for states would allow them to borrow another Rs. 1.4 trillion. Financial markets clearly expect government borrowing to put a strain on liquidity, as evidenced by the increase in yields on government paper immediately after the announcement of the budget. Higher bond yields have led to concerns that government borrowing costs could rise, and that the government could crowd out private investment, thereby choking off the nascent recovery. In its First-Quarter Review of Monetary Policy published in July 2009, the RBI confirms that it will absorb a major portion of the government borrowing. The Review lays out the monetary policy stance for the coming quarter. Policy rates and the CRR were left unchanged. The RBI projects growth in 2009-

Monetary Policy Walks the Tightrope Between Accommodation and Vigilance

10 to reach 6.0 percent, and WPI inflation to reach 5.0 percent (y-o-y) by end-March 2010. It projects M3 money to grow by 18 percent, and credit to the private sector by 20 percent. The RBI suggests that the greatest challenges are 1) to manage the balance between providing ample liquidity and the potential build-up of inflationary pressure; 2) to manage the government’s borrowing program for 2009-10; 3) to spur private investment demand which has been dented by the crisis; over the medium term, 4) to return to a path of fiscal consolidation; and 5) to improve the investment climate and expand the absorptive capacity of the economy. The massive expansion in domestic assets of the banking system envisaged by RBI could only be accommodated if foreign assets contracted substantially at the same time. The RBI suggests that credit to the private sector should grow by 20 percent in 2009-10. If the non-banking public picked up government debt in line with last year, government borrowing from the banking sector would amount to about Rs. 4.4 trillion. With this, overall credit growth would reach 24 percent. This rate of growth would constitute a significant increase from 2008-09. The feasibility of RBI’s targets relies crucially on developments in capital flows. If capital flows pick up again as indicated by developments since March 2009, an intervention by RBI in the foreign exchange market to avoid an appreciation of the rupee would expand the money base further by inflating foreign assets in addition to the expansion of domestic assets coming from credit growth. This would greatly constrain the RBI’s ability to absorb some of the government borrowing, require higher interest rates, and heighten the risk of crowding out the private sector. This highlights the need to develop alternatives to domestic debt financing so as not to constrain private credit expansion. Mobilizing external financing could alleviate pressure on domestic savings. In addition, while the budget has a very cautious projection of divestment receipts, the government has subsequently indicated that it could mobilize substantially more by selling shares in profit-making PSUs. Monetary policy is constrained by developments in capital flows and the exchange rate, as in any other open economy. If inflows pick up and the RBI intervenes more actively to avoid appreciation of the rupee, the need for sterilization of liquidity creation could be significant. On the other hand, letting the exchange rate appreciate could allow the RBI to take up some of the government borrowing, but at the cost of loss of competitiveness of Indian exports and a falling reserve cover.

The openness of the Indian economy has increased tremendously over the past decades. This applies to imports and exports of goods and services as well as capital flows, including both portfolio flows and foreign direct investment. Economic policy has to take openness into account; the exchange rate determines competitiveness of domestic production, in export markets as well as in the domestic market where Indian products are competing much more than before with imports. The exchange rate itself is influenced by trade and capital flows. Openness also means that the Indian economy is hit by shocks in the international economic environment much more than before. In this section, we first discuss how India was hit by the international upheavals during 2008 – first a rally in international commodity prices and then the near-collapse of the international financial system. Contrary to what is often believed, we conclude that much of the slowdown in the Indian economy was home-made, rather than induced. Using counterfactual simulations with the India FPAS model, we highlight the relation between the exchange rate, interest rates, and output.6 In the second part, we explore further the response of the economy to changes in the exchange rate. Impulse response functions show how shocks to the exchange rate are transmitted to output, inflation, and interest rates. This highlights the fact that the RBI’s monetary policy faces a well-known “trilemma”: it cannot independently target interest rates, exchange rate, and inflation. What would have happened without the shocks? Without the unprecedented external shocks that hit the Indian economy in 2008 — first the increase in commodity prices and then the international financial crisis — would the Indian economy have continued to grow at high rates, or was a cyclical downturn on its way? A counterfactual, in-sample simulation using the India forecasting and policy analysis system (FPAS) macroeconometric model shows that the downturn would probably have started earlier, and could have been more pronounced than what we have witnessed so far. In the panel below, we compare macroeconomic indicators for India in the baseline scenario (with actual data up to the second quarter of 2009) with indicators resulting from a counterfactual simulation starting in the second quarter of 2008 (last actual data shown is for Q1 2008). Underlying the simulation, but not shown explicitly in the charts, is the global recession in the baseline, and continuation of trend growth in the counterfactual. The baseline series show that an inflationary spike hit the economy in mid-2008, pushed by international commodity prices (see Inflation chart below). Falling real interest rates and capital inflows resulting in appreciation of the rupee were exacerbated by fiscal expansion in the run-up to the 2009 election to push growth and postpone the cyclical downturn. In the second half of 2008, then, the RBI reacted to increasing inflation by raising interest rates, putting the brakes on output. At the same time, however, capital inflows first stopped, and then reversed. The RBI allowed the exchange rate to depreciate, which reduced the impact of higher interest rates on growth (see Real Interest Rate and Exchange Rate charts below).

6 Model described in Annex.

The Role of Capital Flows and the Exchange Rate

III. Topic of Discussion

In the counterfactual, inflation rises from below 4 percent to more than 5 percent in early 2008, then remains around 5-6 percent throughout 2008 and then falls slowly (Chart 1). With inflation on an uptick and output above potential, the RBI raises real interest rates to around 4 percent in Q2 2008, one quarter earlier than in the baseline. Higher interest rates and a continuation of capital inflows (with continuing trend global growth) lead to further appreciation of the rupee. The baseline series shows that the slowdown in 2008 eroded the positive output gap that existed during much of 2007 (see Output Gap chart below). The output gap widens going forward and a recovery sets in after Q2 2011. In the counterfactual series, the output gap turns negative already in the second half of 2008, two quarters earlier than what actually occurred. Output then recovers more quickly and is back to potential by end 2011, as against end 2012 in the baseline. The exchange rate is key for the interpretation of the simulation results: in the baseline, the economy received a boost from the depreciation; in the counterfactual, this does not happen. In short, the negative cyclical forces that were gaining momentum toward the end of 2007 would have led to a downturn in the Indian economy earlier without the buoyancy provided by negative real interest rates and exchange rate depreciation, but the downturn would have been shorter than what we can now expect with the global crisis weighing down on the Indian economy.

What is the transmission of exchange rate shocks to the rest of the economy? To explore the importance of exchange rate further, we show below the impulse response functions of a 5 percent appreciation shock to the exchange rate. A disturbance of the exchange rate, for example by a sudden, large capital inflow has medium-term effects. In fact, after a one-quarter disturbance in the exchange rate shown in the first chart (Real Exchange Rate), it only reverts to pre-shock equilibrium after about four years. Appreciation of the exchange rate is partially passed through to the domestic price level as shown in the second chart (Year-on-Year Inflation). The full effect is reached with a lag of about two quarters, and amounts to about 1.2 percentage points, or about one quarter of the exchange rate shock. Lower inflation prevails for four quarters before converging to normal. The reduction in inflation is answered with a gradual lowering of policy interest rates. As a result, the real interest rate falls 120 basis points after six quarters, as shown in the third chart (Real Interest Rate). For the real interest rate to fall to this extent, policy rates would have been lowered by about double this to make up for lower inflation. Despite lower interest rates, output growth slows below potential because of the loss of competitiveness of domestic production brought about by the appreciation of the exchange rate, as shown in the fourth chart (Output Gap). Note that the reduction in inflation here is a result of both the pass-through of lower import prices and the emergence of a negative output gap.

What are the policy implications? The simulations highlight the feedbacks between exchange rate, interest rate, inflation, and output. Monetary policy aimed at maintaining low and stable inflation and a high rate of capacity utilization cannot at the same time target a stable exchange rate. For example, if inflation rises above target and the RBI hikes interest rates, capital inflows will surge. If the RBI then intervenes in the foreign exchange market to stabilize the exchange rate, it injects liquidity in the domestic financial system (by exchanging

dollars for rupees), causing interest rates to fall and inflation to remain above target. On the other hand, sterilization of forex interventions through the sale of Market Stabilization Bonds risks raising interest rates and pulling in more foreign capital, which leads to a spiral that will force the RBI to eventually abandon its exchange rate peg. Investors would anticipate that the rupee would have to rise eventually, which would cause them to invest even more in Indian assets and bring about the anticipated outcome more quickly. In an open economy, monetary policy looses instrument independence and the power to fight overheating on its own. In response to the slowdown of the economy, the Indian government significantly expanded the fiscal deficit in line with other governments around the world. A Keynesian fiscal expansion was regarded as necessary to counteract a sharp fall in private demand brought on by a credit crunch, higher risk aversion, and higher private savings rates. The government is banking on the RBI to provide a large part of the financing of the fiscal deficit in order to not crowd out private sector credit. If such monetization of the deficit ties RBI’s hands and prevents it from intervening in the forex market, an appreciation of the rupee with negative consequences on domestic output could be the result. Later on, when private demand picks up again, and public demand is not scaled back at the same time, overheating becomes once more a concern. In the past, the RBI had some leeway in deflating the economy in the face of high public deficits by running a tight monetary policy. With greater openness, its powers to do so are diminished and fiscal consolidation is the only way out to avoid a resurgence of inflation.

India: Selected Economic Indicators

This paper uses simulation results from a small model for the Indian economy, which is in line with others in the forecasting and policy analysis system (FPAS) tradition.7 It is a highly aggregated two-country model with four endogenous variables for India and three for a composite “rest of the world”. The model parameters (coefficients in the equations) are based on Bayesian estimation techniques using quarterly data for the period Q1 1991— Q2 2009. The smallness of the model allows for a straightforward interpretation of results, in contrast to many richer, more complicated dynamic stochastic general equilibrium (DSGE) models that often become “black boxes”. However, because of its aggregate nature it should be understood more as a coherent framework to think about macroeconomic policy questions rather than as a dependable forecasting instrument.

The model is based on the New Keynesian school of thought, in which monetary policy has a role, as opposed to older, neoclassical models in which markets continuously clear. This world view acknowledges: (1) the existence of nominal and real rigidities in the economy; (2) the importance of expectations for inflation and output; (3) the determination of output by aggregate demand in the short run, and; (4) the role of monetary policy to provide an anchor for inflation and inflation expectations.8 The model’s endogenous variables are: the output gap, inflation, exchange rate, and policy interest rate. All the equations are made up of forward- and backward-looking elements. The model is formulated in gaps, i.e. deviations of variables from long-run equilibrium levels. It is based on log-levels and it is linear.

The equations in detail:

The Output Gap is determined by: lead and lag on output gap itself, real interest rate gap, and exchange rate gap (determinants of aggregate demand),

IndROWIndInd Y

IndEqt

Indt YERRRRYYY 1

,1111 )(

where the the β are coefficients, Y stands for the output gap, RR for the real interest rate, E for the real exchange-rate gap, and ε is a stochastic residual. Indian output depends on the output gap in the rest of the world, whereas the output-gap equation for the rest of the world omits an India term.

Inflation is determined by: a forward looking price setting mechanism, price indexation (backward-looking inflation term), output gap (capacity utilization), and exchange rate pass-through,

IndIndIndtE

IndIndt

IndIndt EY

114 4)1(4

where the α are coefficients, π is the annualized quarter-on-quarter inflation rate, and π4 is the year-on-year inflation rate. This Phillips curve formulation assumes that firms take past inflation, year-ahead

7 For a more complete description of the type of model used here, see Berg, A., P. Karam, and D. Laxton, 2006, A Practical Model-Based Approach to Monetary Policy Analysis—Overview, IMF Working Paper, WP06/80. 8 The following publications provide theoretical background and literature overview: Clarida, R., J. Gali, and M. Gertler, 1999, "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, Vol. 37, No. 4, pp. 1661-1707; Lane, P., 2001, "The New Open Economy Macroeconomics: A Survey," Journal of International Economics (August); Woodford, M., 2003, Interest and Prices: Foundations of a Monetary Theory (Princeton, New Jersey: Princeton University Press).

Annex: The Forecasting and Policy Analysis System for India

expected inflation, capacity utilization, and exchange-rate pass-through into account in setting prices for some time (i.e., they cannot adjust prices instantaneously to clear markets).

The policy interest rate is determined by a Taylor rule (i.e., policy rate setting aims at minimizing deviation of inflation utilization from target, with some rate smoothing and regard for the output gap,

IndInd RS

IndetTt

IndIndt

Indt YRRRSRS ))4(4)(1( ,arg

where the γ are coefficients, and RS is the nominal interest rate).

The exchange rate is determined by differences in risk adjusted real interest rates between India and the rest of the world (uncovered interest parity),

eIndEq

leadet

leadet RRRReee )()1( .

Where the δ are coefficients, e is the real exchange rate, and σ is the country-specific risk premium. No exchange rate equation is needed for the “rest of the world” part of the model. ■

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