Document o f The World Bank

FOR OFFICIAL USE O N L Y

Report No. 482 1 1 -IN

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT FOR A PROPOSED LOAN

IN THE AMOUNT OF US$2.0 BILLION

TO THE

REPUBLIC OF INDIA

FOR A

BANKING SECTOR SUPPORT LOAN

August 21,2009

PREM, Finance and Private Sector Development Department South Asia Region

This document has a restricted distribution and may be used by recipients only in the performance o f their off icial duties. I t s contents may not otherwise be disclosed without World Bank authorization.

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CURRENCY EQUIVALENTS (Exchange Rate Effective July 3 1,2009)

1 IFYP ALM BACSI BSSL CAAA

CAS CLTV CPI-IW

CRAR

CRR DPL ECB

FII FRBM

GDP Go1 IBRD

Currency Unit = Indian Rupees (Rs) Rs48.16 = US$1 US$1.55 = SDR 1

FISCAL YEAR April 1 - March 31

ABBREVIATIONS AND ACRONYMS

Eleventh Five-Year Plan Asset-Liability Management Consumer Sentiment Index Banking Sector Support Loan Office o f the Controller o f Aid, Accounts, and Audit Country Strategy Cumulative Loan to Value Ratio Consumer Price Index-for Industrial Workers Capital to Risk-weighted Assets Ratios Cash Reserve Ratio Development Policy Loans External Commercial Borrowings Foreign Institutional Investors Fiscal Responsibility and Budget Management Act (2003) Gross Domestic Product Government o f India International Bank for Reconstruction and Development

IFC

IMF LAF M&E MOF NABARD

NBFC NDTL

NHB NPA NRI PPP PSB RBI ROA SIDBI

SLR SME WPI

International Finance Corporation International Monetary Fund Liquidity Adjustment Facility Monitoring and Evaluation Ministry o f Finance National Bank for Agriculture and Rural Development Non Bank Financial Companies Ne t Demand and Time Liabilities National Housing Bank Non-Performing Assets Non Resident Indian Public Private Partnership Public Sector Commercial Banks Reserve Bank o f India Return On Assets Small Industries Development Bank o f India Statutory Liquidity Ratio Small and Medium Enterprises Wholesale Price Index

Vice President: Isabel Guerrero Country Director: N. Roberto Zagha

Sector Director: Ernest0 M a y Sector Manager (Acting): Kiatchai Sophastienphong

Task Team Leaders: Deepak Bhattasali and Thomas A. Rose

FOR OFFICIAL USE ONLY

INDIA

BANKING SECTOR SUPPORT LOAN

TABLE OF CONTENTS

LOAN

I . I1 .

A . B . C .

I11 . A . B . C .

I V . A . B .

V . A . B . C .

V I . A . B . C . D . E . F . G .

AND PROGRAM SUMMARY ...................................................................................................................... 1

INTRODUCTION ......................................................................................................................................... 3

RECENT POLITICAL AND ECONOMIC DEVELOPMENTS ............................................................. 5

RECENT POLITICAL DEVELOPMENTS ............................................................................................................... 5 ECONOMIC DEVELOPMENTS ............................................................................................................................ 6 EFFECTS OF THE GLOBAL CRISIS ..................................................................................................................... 9

THE BANKING SECTOR ......................................................................................................................... 17

DEVELOPMENT OF THE BANKING SECTOR ..................................................................................................... 17 REGULATORY FRAMEWORK AND CORPORATE GOVERNANCE ........................................................................ 19 CONDITION OF INDIAN BANKS . ................................................................................................................. 22

BANK GROUP SUPPORT TO THE GOVERNMENT’S PROGRAM ................................................ 26

LINKS TO THE CAS ........................................................................................................................................ 26 RELATIONSHIP TO OTHER BANK OPERATIONS ............................................................................................... 27

THE PROPOSED OPERATION .............................................................................................................. 28

RATIONALE .................................................................................................................................................... 28 PRIOR ACTIONS AND TRIGGERS ..................................................................................................................... 33 SCENARIOS AND MSTRUMENTS ...................................................................................................................... 36

OPERATION IMPLEMENTATION ....................................................................................................... 39

POVERTY AND SOCIAL IMPACT ....................................................................................................................... 39

DISBURSEMENT AND AUDITS ......................................................................................................................... 43 ENVIRONMENTAL ASPECTS ........................................................................................................................... 44 CONSULTATION ............................................................................................................................................. 45 IMPLEMENTATION. MONITORING AND EVALUATION ..................................................................................... 45 RISKS AND RISK MITIGATION ......................................................................................................................... 46

FIDUCIARY ASPECTS ...................................................................................................................................... 42

Annex 1: Letter of Development Policy ......................................................................................................... 48 Annex 2: Medium-Term Banking Policy Framework 50 Annex 3: Program Policy Matrix: Conditions. Triggers. Milestones. and Outcomes ................................... 63

............................ 71 Annex 6: Risk and Risk Mitigation Matrix .................................................................................................... 76 Annex 7: Application of Good Practice Principles on Conditionality Annex 8: India at Glance ........ Annex 9: Key Social Indicators Annex I O : Key Economic Indicators ............................................................................................................. 85

........................................................................... 88

Annex 4: Recent Financial Sector Policy Initiatives., ......................................................... Annex 5: Bank Lending and Capital-Scenario Analysis

Annex 11: Key Exposure Indicators .................................................................................... Annex 12: India Operation Portfolio.. ..... Annex 13: Bank Portfolio and Annex 14: IFC and MIGA Program Annex 15: IMF Relations .............................................................................................................................. 95

This document has a restricted distribution and may be used by recipients only in the performance o f their off icial duties . I t s contents may not be otherwise disclosed without Wor ld Bank authorization .

The task team i s led by: Deepak Bhattasali (Lead Economist, SASEP) and Thomas A. Rose (Lead Financial Sector Specialist, EASFP).

The team includes: Addepalli Ramakrishna (Environment Specialist, SASDI), Gabi George Afkam (Financial Economist, SASFP), James A. Hanson (Consultant), Kumar Amarendra Narayan Singh (Social Development Specialist, SASDI), Mohan Gopalakrishnan (Senior Financial Management Specialist, SARFM), Niraj Verma (Senior Financial Sector Specialist, SASFP), Rabin Indradjad Hattari (Research Analyst, SASEP), Sakm Abdul Hye (Program Assistant, SASFP), Suhail Kassim (Private Sector Development Specialist, SASFP), Giovanna Prennushi (Economic Adviser, SASEP), Sumriti Singh (Team Assistant, SASFP), and Vinod Satpathy (Program Assistant, SASFP).

The peer reviewers are: Priya Basu (Manager, CFPMI), Robert B. Kahn (Senior Adviser, FPDFS), and Roberto R. Rocha (Senior Advisor, MNSED).

LOAN AND PROGRAM SUMMARY

THE REPUBLIC OF INDIA BANKING SECTOR SUPPORT L O A N

Borrower:

Implementing Agency: Financing Data

Operation Type

Main Policy Areas

GOVERNMENT OF INDIA

Ministry o f Finance (MOF), Government o f India

IBRD Loan Front end fee: 0.25% o f the loan amount Loan terms total maturity o f 30 years including a five year grace period and level repayments Amount : US$2.0 bi l l ion

: IBRD Flexible Loan with Variable Spread option and a

First o f a programmatic set o f two single tranche operations

Despite stable policies, increasing efficiency, strong factor endowments and a dynamic financial market, India’s economic growth slowed from 9.7 percent in 2006-07 to 5-6 percent in the second hal f o f 2008-09 and i s projected to remain in the 5.5-6.5 percent range in 2009-10. The decline reflects the external shock brought about by the global financial and economic crisis. Since late 2008, the Government has implemented a series o f measures to stimulate the economy with monetary, fiscal, trade and financial sector instruments that safeguard economic activity levels and assist vulnerable sectors. The Government has requested financial support for this program, which i s being provided through the proposed set o f two programmatic loans from the World Bank.

One component o f the Government’s overall program i s the provision o f capital to sound public sector banks to help them maintain credit growth to contain the adverse effects o f the slowdown on employment and poverty, broaden financial inclusion, and to enable India’s production and trade sectors to continue to sharpen their competitiveness and prepare for recovery. Capital buffers for the banks at this stage-taking them beyond the 9 percent ratio recommended under Base1 2 (no bank i s currently below this level) to around 12 percent-will also serve as a precautionary shield against possible adverse developments in financial markets. Capital for the banks wil l come from the Government’s budget, the banks’ own resources and, if financial market conditions improve, from public issues.

1

1 Key Outcome Indicators

Program Development Objectives and Contribution to

Risk and Risk Mitigation:

rzz- Number:

The operation will help Government contain the slowdown in the economy by maintaining credit growth, maintain the confidence o f the public in the banking system, and provide a buffer to public sector banks against adverse developments in the economy and financial markets. Besides overall macroeconomic stability and growth, the outcome indicators o f the operations are: (a) credit growth by public banks without a major increase in non-performing assets (NPA); (b) continued strength and stability o f the banking sector and improved supervision; (c) implementation and adoption o f strengthened prudential norms; (d) adoption o f improved corporate governance practices in public banks; (e) adoption o f action plans for improved productivity o f public banks. Progress towards outcomes will be assessed through trends in indicators related to these areas.

Support to Indian economic growth and employment during a period o f global slowdown and financial crisis by helping maintaining credit expansion at a reasonable rate. The CAS supports the achievement o f rapid, inclusive growth in India through studies and lending operations that address both cyclical and structural factors. Buttressing macroeconomic, fiscal and financial stability at both the central and state levels i s a key focus o f the CAS. The CAS recognizes that recent global developments pose important challenges to the achievement o f the Eleventh Plan goals. I t also envisages the World Bank and other development partners to coming up with creative solutions in a timely manner and scaling up funding support. The CAS flagged the expansion o f development policy lending beyond the identified projects and their extension to the national level (that is, beyond the state-level D P L that have characterized the India program).

Key r isks are continued deterioration o f the global economy with a more significant spill over impact on the Indian economy, and the inability o f the banks to maintain high quality credit growth and a buffer to absorb the likely increase in NPA. The Government’s multi-pronged stimulus program may help contain the effects o f a prolonged crisis. The supervisory authorities monitor the quality o f bank portfolios closely and have a record o f accomplishment on helping maintain banking system stability. In addition, there i s increased emphasis on risk management and improved capacity by banks in credit appraisal, and the regulator has implemented stronger prudential norms in recent years. Thus, healthy credit growth i s likely to be maintained’through this operation.

P116020

2

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT FOR

A PROPOSED BANKING SECTOR SUPPORT LOAN TO THE REPUBLIC OF INDIA

I. INTRODUCTION

1. This Program Document presents the first Banking Sector Support Loan (BSSL) in a~ proposed set of two programmatic development policy loans (DPL) to the Republic o f India. The amount o f this loan i s US$2.0 bi l l ion equivalent. I t responds to a request from the Government to provide financial support to enable the authorities to continue implementing their economic stimulus program, which i s intended to contain the effects o f the global economic crisis on the Indian economy. An important part o f the overall stimulus program i s the provision o f capital support to public sector banks (PSB). This will help maintain the confidence o f the public in the banking sector, prevent shortages o f capital from leading to a slowdown in credit growth, and provide a capital buffer to public sector banks to absorb the possible increase in non- performin assets (NPA) resulting from the global financial crisis and i t s impact on India’s economy. ’ India’s GDP growth slowed from a peak 9.7 percent in 2006-07 to about 5-6 percent in the third and fourth quarters o f 2008-09, and is projected to remain in the 5.5-6.5 percent range in 2009-1 0, a sharp drop with adverse implications for employment and poverty reduction, and on investment for long-term growth. The f i rs t BSSL will address needs arising from the current economic slowdown. Continued credit expansion by the banking system will complement the comprehensive stimulus measures that the Government has put in place since mid-2008, which include monetary, trade, fiscal, and financial sector actions, and will limit the slowdown before i t becomes too deep.

2. Following the economic reforms first introduced during the 1980s and accelerated in subsequent years, India has raced to the top of the world league tables in terms of aggregate economic performance. There i s l i t t le doubt that, until the global economic downturn, the Indian economy had settled into a new, more rapid growth trajectory. Stable macroeconomic management, outward orientation, high savings and investment rates and, since 199 1 , rapid increases in productivity that accompanied economic liberalization account for the good economic performance and more efficient use o f i t s endowments. Comprehensive reforms o f India’s financial systems and institutions and, until recently, i t s access to the international financial market, have supported this performance. The outcome o f India’s well-managed financial sector reforms, and the rapid growth and diversification o f the economy i s a stable banking sector, with high profitability and adequate capital, combined with an ability to expand credit at an average annual rate o f above 20 percent over the past three years, while reducing N P A sharply to below 2 percent. Thus, unlike the currently distressed banking systems o f several developed and emerging market countries, India’s banking system i s starting from a strong position.

’ Non-performing assets means those assets o f banks and financial institutions that are considered non-performing under applicable guidelines o f the Reserve Bank o f India.

3

3. However, going forward, the Government estimates that India’s public sector banks will require an injection of at least $4.8 billion during 2009-2011 to maintain credit expansion and help contain the effects o f the global slowdown, while preserving financial soundness and confidence in the stability o f the banking system. The proposed program o f two DPL, totaling about US$3 billion, will provide budgetary support to the Government equivalent to over hal f o f this requirement before June 2010. The second loan in this set will be calibrated to reflect the specific financing needs, as real and financial market conditions evolve during 2009-10. In addition, it will include a program o f policy and regulatory measures designed to further strengthen the effectiveness o f the banks in achieving the objectives o f the Government’s economic program.

4. Bank credit growth in the Indian economy was 17.3 percent in 2008-09 and banks were sound and profitable, reflecting the Government’s efforts to make banking competitive and put the PSB on a sound footing.2 The 27 PSB reported capital adequacy ratios averaging 12.3 percent, a net non-performing assets (NPA) ratio o f just 0.9 percent, and return on assets o f 0.9 percent as o f March 2009. The equivalent ratios for private banks were 15.1 percent, 1.4 percent, and 1.1 percent.

5. Nonetheless, the availability of funding slowed in 2008-09, and credit growth was largely due to the PSB. India’s large equity market fel l sharply during the year, along with equity markets throughout the world. Private and foreign banks found their external funding drying up as the international crisis deepened in the second hal f o f 2008. However, the PSB, who have a large and relatively stable deposit base upon which to leverage lending, managed to maintain their credit growth at 20.4 percent for 2008-2009 (compared to 4 percent for foreign banks and 10.9 percent for domestic private banks).

6. The PSB have indicated that, if they had the necessary capital in place, they would be able to maintain credit growth at appropriate levels. This would occur mainly through loans to (a) infrastructure, which i s widely seen by Indian banks as a good countercyclical asset class in an economic downturn; (b) under-served segments o f the rural economy; (c) f i rms, particularly small and medium enterprises, to meet working capital needs; and (d) some large creditworthy corporate borrowers-previously clients o f the private and foreign banks-who have found it increasingly difficult to obtain funds from those sources because o f supply side constraints.

7. However, current and prospective capital market and international liquidity conditions make it difficult for banks to obtain new funding to expand credit. Some private banks are also constrained by the retreat o f foreign investors from emerging markets, partly by a switch o f deposits to the PSB after problems appeared for the foreign banks in their home

* There are 27 public sector banks today, including 19 nationalized banks (following one merger), the flagship State Bank o f India and i t s six associated banks, and the IDBI Bank. In addition, there are 15 old private sector banks, 8 new private sector banks (that is, post-1994), and 28 foreign banks. Together, these banks are called scheduled commercial banks. There are also a large number o f regional rural banks and cooperative banks, and some developmental and non-bank financial institutions, such as housing banks and state financial development institutions. Urban cooperative banks play a vital role in financing the consumption o f durable goods.

4

countries and partly by their own decision to limit new deposits. However, in general, and especially because o f the drop in credit from such banks, their capital positions are strong and will not be a constraint in undertaking future credit expansion. For PSB, although capital i s also not a problem at present, their ability to obtain capital for future credit expansion from the equity and bond markets i s limited by the decline in these markets, and in some PSB on account o f the Government’s requirement to maintain majority government ownership. Given their size, credit market dominance, extensive branch network and market momentum, the PSB are l ikely to have pressing needs for capital. The main objective o f the proposed BSSL i s to ensure that, together with other critical stimulus and recovery spending needs, the Government i s able to meet such requirements and that capital does not emerge as the constraint on their credit growth during the current economic downturn, or during the early stage o f India’s economic recovery.

11. RECENT POLITICAL AND ECONOMIC DEVELOPMENTS

A. RECENT POLITICAL DEVELOPMENTS

8. Voting in the general elections ended in May. The incumbent Congress Party returned to power within a reconfigured coalition. I t moved swiftly to name the prime minister and new national cabinet, to reaffirm key national policies i t had initiated and implemented earlier, and to begin preparations for the national budget for the remainder o f 2009- 10, which it subsequently presented in July. The budget for 2009-10 reinforces the inclusive growth orientation o f the Government, while addressing the need to restore economic growth to the pre-2008 level. Since taking office, the Government has also made several high level pronouncements about i t s intentions to provide other forms o f stimulus to contain the effects o f the global crisis on the Indian economy, including through the provision o f capital to PSB to enable them to maintain credit growth.

Box 1: Eleventh Five-Year Plan (2007-2012)

The Government o f India’s Plan contains 27 interlinked national targets to address the challenge o f inclusive growth. They cover the most important constraints affecting education, health, women and children, infrastructure, and the environment, besides the overarching issues related to income expansion and the reduction o f poverty and unemployment. I t provides a stable framework within which policy adjustments w i l l occur during the period o f implementation o f the proposed loan. The focus o f the Plan i s to maintain an average economic growth rate o f 9 percent for the five-year period, shared broadly across income groups, especially poor households. An average agriculture growth rate o f 4 percent i s considered vital to achieving the Government’s poverty reduction objective o f a decline in the head-count ratio o f consumption poverty o f 10 percentage points.

Increasing the reach o f formal financial institutions for crop finance and for micro-, small- and medium enterprise funding w i l l support the rising monetization o f India’s rural economy, increased market-orientation o f farm output by both intensifying and expanding production-trading chains, and greater opportunities for off-farm employment to support agricultural income.

Another key plank o f the Plan i s to fill the large gaps in infrastructure that hold back achievement o f India’s economic growth potential. Expanded and better-quality infrastructure services w i l l permit Indian f i rms to continue sharpening their competitiveness.

The Plan has set targets for employment creation (58 mil l ion new jobs), reduction o f unemployment among the educated (by 5 percent), and an increase (by 20 percent) in the real wage o f unskilled workers. Credit expansion plays a central role in the Government’s policies for the Plan period. The current situation o f the global and domestic financial markets has placed al l the Plan targets in jeopardy. The Government intends through i t s stimulus program and related policy measures to ensure that, as far as feasible, the economy remains on track to reach the Plan outcomes and deviations from the desired path are small.

9. The outcome o f the recent elections assures the continuity o f basic economic policies. The Eleventh Five-Year Plan (2007-20 12)-with i t s emphasis on inclusive, sustainable growth and delivery o f public services-provides the overall strategic thrust for economic policy for the duration o f this programmatic series o f D P L (Box 1). Adjustments in macroeconomic management policies and targets to address the effects o f the current global crisis are unlikely to make a fundamental change in this framework. The Government and RBI intend to stay the course they embarked upon several years ago to further strengthen the financial sector-the important role o f capital markets, the emphasis on competition, prudential supervision o f the banking sector, and the governing framework for the PSB-all o f which have contributed favorably to India’s growth, stability and financial sector development.

B. ECONOMIC DEVELOPMENTS

10. In the past few years, India has emerged as one o f the world’s fastest growing economies. Since 1990, i t s economic growth rate has more than doubled, rising from 1.9 percent per capita during 1961-1990 to 4.6 percent in 1991-2008. Growth accelerated to 7.4 percent over the five years preceding the 2008 global slowdown. As a result, India has gone from the world’s 50th ranked economy in nominal U S Dollar terms in 1980 to the loth largest economy today (and the 4th largest in PPP terms). The real growth rate reached 9 percent in 2007/08 after peaking at 9.7 percent in the revious year, and real per capita income stood at US$950, more than double the 1993/94 level. t3 1 1. Increasing investment, savings and a falling fiscal deficit characterized India’s growth until 2008. The investment rate increased to 38 percent in 2007/08, up from 24 percent in 2001/02, while domestic savings rose to 36 percent o f GDP, from 23 percent. The surge in investment had a positive effect on India’s corporate profits. Profitability has recorded growth in the 25 to 60 percent range on a year-to-year basis since 2001/02. An important factor in both the increase in investment and savings was the buoyancy o f private corporate sector savings (which rose from 3.4 percent o f GDP in 2001/02 to 8.8 percent in 2007/08). O n the government side, fiscal consolidation, enhancement in revenues and restructuring o f selected expenditures at both federal and state levels increased India’s public savings from -2 percent o f GDP to 4.5 percent. I t helped reduce the general government fiscal deficit from 10.1 percent to 6.2 percent o f GDP between 2001/02 and 2007/08 (central government deficit from 6.7 percent to 3.5 percent).

Wor ld Bank & methodology that adjusts nominal local currency values with a three year average o f real exchange rates for the country in order to reduce the volati l i ty o f the US$ estimate

6

Figure 1: India's GDP Composition Over the Years 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% i----

Figure 2: India's Real GDP Growth, IIP, and C P I 14.0 1 I 12.0 -

m 10.0 -

2 8.0 -

2 6.0 -

2 4.0

2.0

e, M C

.c U

8 L

- m

s

I A Industrial Production Index,

w , - T -

CPI - Industrial Workers

12. The ma jo r engines o f India's recent r a p i d growth have been manufactur ing and services-contributing roughly 29 and 54 percent o f the national output, respectively (Figures 1 and 2)-supported by stable macroeconomic management, a young and increasingly well- educated workforce, and a dynamic entrepreneurial class. A sharp reduction in licensing after 199 1 and the establishment o f increasingly contestable domestic markets has permitted Indian f i r m s and farms to sharpen their competitive edge, while taking better advantage o f the opportunities created by the new dynamism o f the economy. The rapid growth reflects increased productivity growth, not just greater use o f inputs. A simple growth accounting analysis showed that half the growth o f output per worker in India during 1993 and 2004 resulted from gains in total factor productivity (TFP).4 This feature, together with the structural transformation o f India's economy towards manufacturing and services, has been important in raising India's underlying trend growth rate. Growth in India has been less capital intensive than in other countries, partially because it has relied more on the services sector, which put heavy emphasis

The study attributed the rest o f the gains to physical capital expansion (40 percent) and higher education levels (10 percent). Barry Bosworth, Susan Collins and Arvind Virmani, Sources of Growth in the Indian Economy, NBER Working Paper W 1290 1, February 2007.

7

on labor inputs and, in most cases, less on capital. The productivity o f capital use, as measured by the incremental capital output ratio, has been high by Asian standards.

13. India's rapid growth also reflects i t s increased integration with the world economy. The emergence o f export-oriented sectors, increasing access to financing from international financial markets by Indian f irms, who also invested globally, the growing presence o f foreign institutional investor (FII) investments in India, and growing remittances and income from services exports are some examples o f stronger linkages with the international economy. The share o f goods trade increased from 17 percent o f GDP in 1993/94 to 34 percent in 2007/08. In addition to i t s widely recognized success in services exports, India has been able to show considerable prowess in manufactured exports (for example, chemicals, pharmaceuticals, light engineering goods, and textiles) in addition to i t s traditional strengths in areas such as handicrafts and jewelry. Capital flows also benefited from robust FDI and increased portfolio investment in real estate, banking and equities in the financial sector.

14. As the economy grew, the demand for credit increased, and was met both from internal and external sources. The ratio o f domestic bank credit to GDP has been growing steadily, f rom 29 percent in 2000 to 54.5 percent in 2008, although it i s still l o w by comparison to middle-income countries and East Asia.' This growth was inevitable with a growing middle class with high disposable income, wider choice o f consumer durables, increased acceptance o f credit cards, and increased demand for housing loans. India's corporate sector seized the opportunities provided by rapid growth and expanded rapidly, with some o f i t s financing coming from external borrowing. Even as other segments o f the domestic financial market develop, the potential long-term demand prospects for credit are high. Net external commercial borrowings have averaged US$8.6 bi l l ion over the past five years, or 0.8 percent o f GDP, rising to US$22.2 bi l l ion (1.9 percent o f GDP) in 2007/08. Strong capital inflows, besides demonstrating the attractiveness o f the Indian economy as an investment destination, resulted in an increase in foreign reserves to US$315 billion by May 2008 (one o f the highest levels in the world and equivalent to 12 months o f imports). In 2007/08, the reserve cover o f short-term debt was a comfortable 3.1 times. The total stock o f external debt reached US$221 billion, or 18.8 percent o f GDP, significantly below the middle-income country average o f 24.8 percent.

Figure 3: India's Inflation Rates

CPI - Industrial

--i---> a I , ' 1 ' ' a ' Q\." \\." %\." ?\." 3.'' $\." b\.'' ,\." %\..' 9\." Q\." >\..' %\." %\." b\.\." $\." b\.'' ,\." %\.e.

e9 e9 e9 e9 e9 e' e9 e9 4' +fQ @ %QQ %QQ 9' Source: Central Statistical Office ond Office of Economic Advisor

Reserve Bank o f India's Annual Report 2008

8

15. Despite rapid growth, a recent survey showed that bank credit to the private sector i s low in comparison to other large countries.6 Private credit growth in India reflects the process o f financial deepening against the backdrop o f initially shallow financial markets and a large amount o f government debt. Experience in many countries demonstrates that, although financial development i s a determinant o f aggregate economic growth, i t can easily coincide with the cyclical growth o f lending. Management o f this process i s crucial to avoiding adverse effects on credit quality and the formation o f asset bubbles. In India, RBI took several steps to ensure high credit quality (as seen, for example, in the low level o f NPA noted earlier in paragraphs 2 and 4), and aggressive monetary policy mitigated the development o f asset price imbalances o f the kind seen elsewhere. In fact, as shown in Figure 3, together with rapid economic growth, India has seen a declining rate o f inflation. Headline inflation, measured by the wholesale price index (WPI), fe l l from,an average o f 9.6 percent (y-y) in the 1990s, to 5 percent in the past five years. This decline in WPI inflation resulted from a fall in the prices o f primary commodities, some manufactured goods and, more recently, in hydrocarbons. The consumer price index for industrial workers (CPI-IW), a good measure o f the urban cost o f living, has generally tracked WPI inflation rates with a lag (with the seeming divergence in 1995-96 and 1998 explained by technical measurement changes). Careful monetary management by the RBI, with broad money (M3) growing at an average rate o f 20 percent, has succeeded in supporting the growth of nominal GDP at a high level (14 percent per year) while providing price and exchange rate stability.

c. EFFECTS OF THE GLOBAL CRISIS

16. India, l ike most other emerging market economies, has been affected by the global financial crisis. The decoupling theory, which was being put forward in the initial days o f the crisis, has been proved wrong. The impact o f the financial crisis arose from three main channels.

0 Credit: Financial markets tightened following the collapse o f Lehman Brothers, and there was a sharp increase in the call money rate (to 20 percent). W h i l e some domestic factors, such as the advance payment o f taxes and a withdrawal o f bank deposits for festival period shopping, tightened liquidity conditions, the inter-bank market reacted adversely to uncertainty about the exposure o f Indian banks to toxic assets, and bank credit growth f e l l sharply. In particular, sectors hit hard by the global meltdown-such as SME, textiles, and real estate-faced a serious credit crunch.

Capital flows: While India seems relatively less integrated with the global economy on the external trade account (share o f exports to GDP o f 18 percent), the picture changes considerably if the extent o f financial integration i s measured. The share o f external current account transactions more than doubled from 47 percent o f GDP in 1997-98 to 117 percent in 2007-8. Consequently, the sharp reversal o f capital flows that occurred after the collapse o f Lehman Brothers in September 2008 (Figure 4) had a profound

As a share o f GDP, bank credit rose from 32.1 percent in 2003 to 50.9 percent in 2008. B y contrast, the 2008 shares for emerging markets such as Brazil (58.4 percent), China (125.3 percent), and Korea (118.3) and for developed countries such as Germany (108 percent), Japan (149.9 percent), the UK (210.8 percent) and the U S (189.6 percent) were higher, and in most cases significantly different. Fitch Ratings, Bank Systemic Risk Report, 2009

6

9

impact on the Indian financial market, including private banks and large corporate borrowers.

Trade: The largest impact o f the crisis was through the decline in exports, specifically manufactured goods exports. During October 2008-February 2009 exports f e l l f rom an average annual growth rate o f 35 percent to 12 percent (Figure 4). OECD countries, which received approximately 40 percent o f India's merchandise exports, also accounted for the major part o f the fal l in exports. Worst affected among the manufacturing sectors were labor-intensive gems and jewelry, textiles, leather and products, cotton and yam, tea, marine products and handicrafts, leading to unemployment in many urban centers

Figure 4: Current and Capital Account Balances as % o f GDP 10 7 -

l

I : 8 - -Current account deficit (% of GDP)

I I 1 - - - Net Capital Inflows (%of GDP)

6 -

-4

Source: Reserve Bank of India

17. India's growth rate has fallen sharply. Growth was slowing by early 2008 because o f a cyclical downturn in investment, terms o f trade losses from higher commodity prices o f about 4.5 percent o f GDP, and monetary tightening to combat inflationary pressure. The global crisis triggered a chain o f adverse events, starting with a slowdown in India's exports, which spread to production and investment when capital flows started retreating from emerging markets and stock market valuations began a rapid decline, consistent with the global trends. Growth fell from a peak o f 9.7 percent in 2006/07 to 6.7 percent in 2008-09. In quarterly terms, the year-on- year (y-y) growth rate f e l l to 4.5 percent in the last quarter o f 2008-09, from 10.6 percent in last quarter o f 2005-06. World Bank estimates project i t to fal l further to the 5.5-6.5 percent range during 2009-10. The Government's latest projections are for growth to slow to 6.5 percent.

10

Figure 5. MSCl Indices for India Equity prices ($-'-terms), 15 September 200% = 100

.......I. ................... .l_l ... .... _-_I_.- 1

I

130 120 L L j h m a n &os. goes -India ........................................................................................ i 110 ...................................................................................... 1

G-20 agree to plan to restore global groMh go '

I

..... ................... ........................... !?Z~!~.W.V~S...! India launches fiscal stimulus stlmuius package 1 (0 5% boost to GDPl

I Sources: Bloornbera, IIF, EIU, Economisf and World Bank

Figure 6. Exchange Rates and Net FII Flows

56 ' -30 Jul- Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- 08 08 08 08 08 08 09 09 09 09

~~

Source: Bloomberg

18. The decline accelerated in the third quarter o f 2008-09, as the international crisis worsened and investors withdrew funding massively to cope with liquidity shortages in their home countries. Despite relief on the external current account from falling commodity prices, there was a significant correction o f the earlier appreciation o f the Rupee (1 5 percent by mid-November over the 2007 average). This helped in moderating some o f the loss o f international reserves from the capital outflows, Domestic credit conditions tightened and the money markets showed greater volatility, with spikes and wide swings in call rates and overnight index spreads (Figures 5 and 6). There was a general deterioration in confidence, evidenced for example by the decline in the consumer sentiment index (BACSI) in September and October. Investment activity, which had been the engine of growth, shrank due to tight international credit conditions, heightened uncertainty, and massive capital market declines.

11

19. The slowdown in investment inevitably affected profitability, foreign borrowing and liquidity. Corporate profitability, which had peaked in 2006Q4 and had been a major contributor to India’s growth, started to fall. At the same time, higher interest rates burdened the corporate sector with rising debts. By 2007-08, India’s corporate sector was funding a quarter o f i t s needs from external sources, and another 10 percent f rom the issue o f domestic equity. Their refinancing needs on foreign currency bonds and loans coming due in 2009 are the highest among emerging market countries (about US$14 billion). Because o f this and other risks associated normally with economic .downturns, corporate ratings have been d ~ w n g r a d e d . ~ High profi t growth and declining interest rates that had been providing ample liquidity to Indian f i r m s have started declining. In effect, the interest coverage ratio (ICR)--defined as earnings before interest and taxes over interest expenses, which measures the debt servicing capacity o f a firm- went down sharply. Firms that cannot find additional sources o f funds are l ikely to delay interest payments; if such delays persist, the loans to those companies will show up as non-performing assets in the balance sheets o f banks.

Table 1: Flow o f Non-Bank Resources to the Commercial Sector (Rupees billion)

Domestic sources 2552 2967 771 640 Public issues by non-financial entities Gross private placements by non-financial entities Net issues o f commercial paper Ne t credit by housing finance companies Gross accommodation by NABARD, NHB, SIDBI & EXIM Bank Non-bank financial companies LIC investments in corporate debt and other Foreign sources ECBRCCB ADWGDR Short term credit from abroad FDI to India

515 683 107 418 223

365 243

3324 912 349 689

1374

142 762

56 266 3 14

768 658

1702 3 80

48

1586 -3 12

20 170 25 1 107

-6

219 11

514 61 41 96

3 16

2 29 1 355 -3 8 -5 5

19 65

210 -15

2 4

219

Total Non-Bank Credit 5876 4669 1285 850 Source: RBI, Macroeconomic and Monetary Developments, F i rs t Quarter Review 2009-10

20. This corporate-financial link i s important in India. Almost ha l f o f the total borrowing o f non-financial corporations comes from domestic banks, and two-thirds o f total non-food bank credit (which constitutes 97 percent o f total credit) goes to the corporate sector, including commercial real estate and property developers.8 The remainder goes to agricultural and household sectors in the form o f personal and retail loans. With the slowdown on the real side,

Crisil, the Indian arm o f Standard & Poor’s, reported that ratings downgrades in the past year rose six-fold against a year earlier, and credit defaults rose to 13 in the fiscal year ending March 3 1, 2009 against zero over the previous three years.

International Monetary Fund, “India’s Corporate Sector: Coping With The Global Financial Tsunami”, Selected Issues, 2009

7

12

foreign borrowing experienced a decline o f 34 percent. Funds from public issues, the issue o f commercial paper, and accommodation by Indian financial institutions witnessed a sharp drop compared to earlier years (Table 1). The decline in foreign funds was mitigated by a near- tripling o f FDI flows, but other sources such as external commercial borrowing (ECB), American and Global Depositary Receipts (ADWGDR), and short term credit dropped by 60 percent or more. Against this backdrop, the need to sustain domestic credit growth i s essential to ensure long-term economic growth in India.

I Figure 7 . Policy Rate and Call Rate

19. The macro-policy response of the authorities has been timely and broad-based, including increases in Rupee and foreign exchange liquidity, a fiscal stimulus, and actions in the trade and financial sector^.^ RBI changed i t s monetary pol icy stance once i t became apparent that spillovers f rom the global crisis were l ikely to be worse than expected (Figure 7). Subsequently, the Government introduced three policy packages in December 2008, and in January and February 2009, including fiscal measures (see below). These packages aimed specifically to increase liquidity in the financial market, encourage investment (particularly in infrastructure), support consumer spending, and facilitate trade financing. RBI estimates that i t s actions since mid-September 2008 have resulted in an increase in actual/potential liquidity o f Rs. 4.4 trillion (US$88 billion).

20. There was a deterioration in the central government fiscal balance for FY2008-09.'0 The general government fiscal deficit in FY2008-09 was 9.6 percent o f GDP compared to the budget estimates o f 5.1 percent for the same year.'' Several factors are responsible for the marked deterioration: (a) public salary increases awarded by the Sixth Pay Commission, and loan waivers for farmers; (b) an increase in the subsidy bill because o f the surge in world commodity

Annex 1 presents the details o f the financial sector measures, including regulatory forbearance. India's public debt i s estimated to have reached 76.0 percent o f GDP in 2008-09, o f which three-quarters was

issued by the Central Government. The consolidated government budget deficit has averaged 6.9 percent of GDP over the past five fiscal years, although along a declining path; in 2008-09 i t rose sharply. The high deficit arose from both Central and State Government operations, o f which two-thirds was due to the former. Together, the high debt and deficits reduce the room for fiscal maneuver. However, India's private savings rates has risen to 36 percent o f GDP, and both its external balances and the terms, tenor and currency composition o f i t s debt suggest that the

'I Fiscal deficit numbers reflect the World Bank's definition. The Government treats divestment proceeds as revenue, whereas the Bank definition excludes divestment from revenues.

10

ublic debt i s more manageable than in other countries.

13

prices in the early part o f 2008; and (c) a slowdown in revenue in l ine with the slowdown in growth. As a result, central government revenue for FY2008-09 was about one percentage point o f GDP lower than foreseen in the budget, while current expenditures expanded by 2.2 percent o f GDP. However, capital spending declined from 2.3 percent in FY2007-08 to 1.5 percent in FY2008-09. The widest measure o f fiscal and quasi-fiscal defici t-comprising the general government, and off-budget o i l and fertilizer bonds issued to finance below-cost consumer prices and public company losses-shows a pronounced deterioration in FY2008-09 to 12.9 percent o f GDP, from 7.8 percent in the previous year.

21. Recognizing the slowdown, the government acted swiftly by announcing fiscal stimulus measures. Three packages were launched in December 2008, January 2009, and end-February 2009. The fiscal stimulus packages contained revenue and expenditure measures with a net expansionary impact o f about 3.5 percent o f GDP at the central level, and an additional one percent o f GDP at the state level. The measures included additional public spending, particularly capital expenditure, government guaranteed funds for infrastructure spending, cuts in indirect taxes, expanded guarantee coverage for credit to micro and small enterprises, and additional support to exporters. In addition, some o f the fiscal pol icy measures undertaken prior to the onset o f the crisis will have a significant impact in FY2009- 10 and help boost aggregate demand. These include the increase in public sector salaries, a countrywide extension o f coverage o f the National Rural Employment Guarantee Scheme (NREGS), and higher minimum support prices for farmers. Despite the stimulus packages, the fiscal and quasi-fiscal deficit in FY2009-10 i s unlikely to reach the same level as in the previous year. With international commodity prices projected to be substantially lower in FY2009-10, savings .on subsidies will likely allow the deficit to remain below last year’s level (see below).

22. The budget for 2009-10, announced in July, aims to minimize the impact o f the global recession and achieve 8-9 percent economic growth in the medium term. I t expands allocations for infrastructure, social sectors and agriculture, while containing minor changes on the revenue side. The central government deficit i s projected to reach 6.8 percent o f GDP, compared to 6.1 percent in 2008-09. The deficit limit for state governments was raised to 4 percent o f GDP, which follows the increase from 2.5 to 3.5 percent o f GDP that was permitted in December 2008 (under the fiscal responsibility legislation). The overall deficit implied by the budget i s therefore close to 11 percent o f GDP. The 2009-10 budget provides an additional fiscal stimulus o f 1-1.5 percent o f GDP.

23. In the near term, the global slowdown i s likely to continue, therefore, the ability of the Government to deploy its macroeconomic instruments in a balanced and sustainable manner i s critical. Maintaining liquidity, financial stability and credit growth during the slowdown are essential elements for ensuring that Indian f i r m s continue to sharpen their competitiveness and take advantage o f the global economic recovery, when it occurs. The sectoral pattern o f growth since the third quarter o f 2008 shows that while exports and services bore the brunt o f the adjustment to the external shock, the stimulus measures seem to have contained the damage in areas to which they were directed and helped maintain a healthy, albeit lower, growth in disposable incomes. Looking forward, barring a global slowdown that i s longer than expected and a sharp decline in the growth rate o f agriculture (because o f the poor weather seen across India recently), the World Bank’s baseline scenario describes a path o f strong

14

recovery to the 8 percent growth rate achieved in recent years (Table 2 and Annex lo).‘’ This would be led by domestic consumption, which has been stimulated partly by the Government’s counter-cyclical policies, and the maintenance and possible expansion o f domestic investment growth, should credit conditions permit and capital flows return.13 With i t s l o w levels o f external debt, ample reserves and limits o n the amount and end use o f foreign debt financing, India’s external position i s sustainable. However, uncertainties regarding both the global and domestic economic and financial situations make it difficult to predict the path that other macroeconomic variables are likely to take in the year ahead. While both World Bank and IMF assessments conclude that the macroeconomic framework i s appropriate, Government i s keeping a close watch on macroeconomic developments in view o f the uncertainties involved.

Table 2: Macroeconomic Developments, 2007-2014

Rea l growth rates (YO) GDP (market prices) 9.1 6.1 6.0 8.0 8.5 8.0 8.0 Consumption 5.1 4.5 15.2 4.9 0.6 2.6 2.4 Merchandise exports 28.9 5.4 -5.4 7.8 8.6 8.7 8.0

Consumption 64.8 65.7 67.1 66.5 65.4 64.6 63.8 Investment 38.7 39.7 37.0 37.8 39.8 41.0 42.4 Domestic savings 35.2 34.3 32.9 33.5 34.6 35.4 36.2 National savings 40.7 39.2 39.4 36.5 37.6 38.3 38.8 External current account balance -1.5 -2.6 -0.9 -1.3 -2.3 -2.8 -3.5

GDP (current prices) 1177 1153 1194 1403 1490 1600 1720 International reserves 310 252 283 318 353 390 43 1

Shares (YO o f GDP)

Levels (US$ billions)

Source: World Bank staff estimates and Central Statistical Organization

24. The main downside risk, although low, i s the sustainability o f the current fiscal stance. World Bank simulations illustrate the importance o f high growth and lower interest rates for the outlook for fiscal deficits and fiscal sustainability. Four simulations are presented in Table 3. They include two growth scenarios: “high”, with the GDP growth rate reverting to the mean o f the past five years; and “low”, with growth at 6.5 percent, the government projection for 2009- 10. They also present two policy scenarios. The first “good” scenarios i s one in which the primary fiscal deficit i s reduced from the current 3.5 percent o f GDP to 1.5 percent and the macroeconomic credibility and stability associated with this policy i s assumed to allow for a real interest rate o f 2.5 percent. The “weak” policies scenario i s one where the primary deficit does not adjust, and the real interest rate rises to 4.5 percent).

l2 Recent indicators of below average rainfall imply a more difficult environment for growth. With agriculture growing at 4 percent, it contributes a l i t t le less than one percentage point to the overall growth rate. However, a severe drought like the one in 2003 could turn this into a drag on growth of an equivalent magnitude. l3 India’s growth prospects and a strong economic recovery are likely to attract a higher volume o f capital inflows from abroad than in other developing countries. This i s evidenced by the continued strength o f FDI inflows over the past year, despite an overall global contraction o f such flows.

15

-~ 2008-09 20 19-20 2008-09 2019-20

High Growth (8 percent per year DebtiGDP 76.0 67.0 Debt/GDP 76.0 98.4 over 10 years) DeficitiGDP 9.6 6.7 DeficitiGDP 9.6 12.4

InteresUGDP 6.0 4.6 Interest/GDP 6.0 8.3

~~ 2008-09 2019-20 2008-09 2019-20

74.3 Debt/GDP 76.0 108.9 DeficWGDP 9.6 7.2 DeficitiGDP 9.6 13.3 InteresUGDP 6.0 5.1 InteresUGDP 6.0 9.2

Low Growth (6.5 percent per year Debt/GDp 76.0 over 10 years)

Source: World Bank staff estimates

25. The scenarios demonstrate the importance o f growth and good policies with fiscal adjustment as safeguards against unsustainable positions. India’s recent economic history demonstrates a strong capacity for adroit and effective macroeconomic management, with the authorities moderating their policies to changing contexts. At the same time, the Government has demonstrated an ability to push through steadily on key areas o f rolling reforms to address the most binding constraints on growth. While the Government i s able to afford slightly slower policy responses if the recovery accelerates for autonomous or external reasons, prudent macroeconomic management dictates that it i s necessary to create adequate fiscal space for further stimulus if it does not.

26. The determinants o f fiscal space go beyond those o f borrowing capacity. Gains from improved expenditure efficiency and composition may dwarf those from increasing public sector borrowing to finance government spending at the margin. Over the years, the committed expenditure in the form o f pensions, wages and salaries and interest payments has been falling, from an average o f 9.6 percent o f GDP to 9 percent. The Government has voiced the need for an expansionary fiscal stance to combat the effects of the global crisis and restore economic growth, so it i s unlikely that these categories o f spending will decline, especially at the State level. However, the thrust o f the recent budget, with i t s emphasis on addressing some o f the key constraints on economic growth-such as weak physical infrastructure and availability o f credit-provides grounds for optimism about the trajectory o f fiscal balances. Equally, the Government’s commitment to a credible path o f medium-term fiscal adjustment i s vital. As indicated during the 2009-10 budget discussions, it intends to re in in the central government budget to 5.5 percent in 2010-1 1 and to no more than 4 percent by 2011-12. In addition, it has indicated i t s intention to overhaul the tax system with the introduction o f the Goods and Services Tax, expected in 2010, and the adoption o f the medium-term fiscal responsibility targets for both central and state governments by the Thirteenth Finance Commission.

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1II.THE BANKING SECTOR

Non-Life

A. DEVELOPMENT OF THE BANKING SECTOR

10 66 104 21 513 288

27. India has a long history of financial sector development. After independence in 1947, the Government’s most significant objective for finance was to increase the spread and outreach of the banking system. As in many countries, the desire to speed up the process, address market failures and market dominance by a handful o f institutions, and increase the sector’s contribution to growth and poverty reduction led to an increased State role in the period 1960- 1990. Fourteen banks were nationalized in 1969, and another six in 1980. Outreach did increase over this period-the number o f bank branches rose dramatically from about 9000 in 1969 to 60,000 in 1990. However, until the end o f the 1980s, India’s banking sector remained closed and controlled. The growth o f deposits and amount o f loans to the private sector were limited because o f interest rate controls and regulations. Instead, banks channeled a large proportion o f formal financial savings to agriculture and the public sector, at l o w cost. Nevertheless, the PSB achieved their social objectives through targeted lending to designated priority sectors, such as agriculture, micro-, small- and medium-enterprises, self-help groups, and targeted groups in government-sponsored programs.

28. Since 1991, the Government has reformed India’s banking and non-banking sector significantly, as part of its new, market-based approach to development. Interest rates were liberalized progressively and banks’ required holdings o f public debt reduced, thereby lowering the implici t taxation o f bank operations. Capital markets were deregulated and opened to international flows, Private entry into banking and insurance increased the contestability o f the domestic financial market, Important public sector financial institutions, such as IC IC I and HDFC, were made private. All this put competitive pressure on the PSB. At the same time, RBI carried out a phased introduction o f prudential norms o n capital adequacy, income recognition, asset classification and provisioning to bring Indian banks in l ine with international practices, and strengthened the corporate governance o f banks. A credit bureau was also established and significant changes were made to improve the execution o f collateral. The RBI was strengthened substantially, in both i t s monetary policy functions and i t s regulation o f the banking system, and i s widely regarded as a credible, reputable and expert institution.

. Table 4: Banking, Near-Banking and Insurance

Public Private

17

29. These reforms have proved to be very successful. India's banking sector today i s more open and consists o f several profitable and growing domestic private sector and foreign banks, in addition to the improved public sector banks that s t i l l account for about 70 percent o f the system (Table 4). l4 Financial depth has increased substantially, and regulatory oversight and risk management have been strengthened over the past decade. Outcomes on non-performing assets and capital to risk weighted assets have improved significantly, and are good compared to international benchmarks. Banks have experienced strong balance sheet growth, improved financial health, increased competitiveness and productivity gains through adoption o f technology, wider outreach, and larger allocations o f credit to important productive sectors. Although the stock market (BSE Sensex) reacted negatively to the recent developments in the global financial market and may give the appearance o f thinness, India's capital markets have in fact deepened and matured over time, to become the largest market in developing countries, relative to GDP (Table 5).15 This i s true in terms o f issues too-liquidity in the largest issues i s on a par with developed countries (and with turnover ratios exceeding 100 percent).16 The size o f the government bond market, at about 42 percent o f GDP, i s comparable to many other emerging market economies. India's share o f financial assets to GDP, at around 170 percent, i s higher than in middle-income countries such as Mexico, Indonesia and Brazil.

Turnover in Corporate Bonds

Table 5: Capital Markets

144 I 314

Equity Market BSE Sensex (Base: 1979=100) Market Capitalization (BSE)

Turnover in Central Government Securities Turnover in State Government Securities

Debt market

4,270 5,715

16,42 1 60

16,569 51,380

29,570 3 14

30. While some weaknesses remain, the Government has recognized them and i s moving to address them. For example, the Government i s seeking ways to increase the ratio o f bank credit to the private sector to GDP o f around 55 percent (December 2008), which i s l o w compared to East Asian econ~mies . '~ The RBI and the Government recognize the need to improve levels o f access to finance by underserved segments. l8 Based on major policy documents underpinning recent reforms, the Government is implementing policies that aim to provide stability, effective tools for managing liquidity, savings and investment, and promote financial inclusion. These are described in greater detail in Annex 2: Medium Term Banking Policv Framework. Overall, i t i s

l4 The 27 PSB constitute a declining but still dominant, share of the banking sector. As o f March 3 1, 2008, they accounted for 70 percent of total assets, 74 percent o f aggregate deposits, and 85 percent o f the total bank branches in India, spread across urban and rural India.

Significantly higher than in emerging markets such as China or Mexico This i s comparable to mature markets, such as the U S (with a turnover ratio of 122%) and Germany (130%).

These include small and medium enterprises, agricultural and rural households, urban poor and small account

16

l7 In China, Korea & Malaysia the ratio i s over 100%.

holders, and the infrastructure sector.

18

generally agreed that India’s financial sector reforms have been successful and in keeping with the evolving needs o f one o f the most dynamic economies in the world.

B. REGULATORY FRAMEWORK AND CORPORATE GOVERNANCE

31. A strong enabling framework has underpinned the development of India’s banking sector. The Reserve Bank of India (RBI) lies at the center o f the regulatory architecture. For the small non-bank financial institutions in specific sectors, the RBI has delegated oversight power^.'^ Banking legislation i s extensive. The Banking Regulation Ac t (1 949) governs overall regulation o f the banking sector. Other key pieces o f legislation include the Banking Companies (Acquisition and Transfer o f Undertakings) Act (1980), Legal Services Authority Act (1 987), Securitization and Reconstruction o f Financial Assets and Enforcement o f Security Interest Act (2002), Enforcement o f Security Interest and Recovery o f Debts Laws (Amendment) Act (2004), and Credit Information Companies (Regulation) Act (2005).

32. Accounting and auditing standards for commercial banks have been improved, and the RBI and Government are systematically addressing weaknesses that remain. The recent Financial Sector Assessment (see paragraphs 35-36 and Box 2), which drew extensively on the report o f the Advisory Panel on Institutions and Market Structure and the Accounting and Auditing ROSC report prepared by the World Bank in 2004, concluded that accounting and disclosures and internal control and audit in commercial banks were largely compliant with Base1 2 norms. The Assessment suggested the need for early adoption o f accounting standards AS30 (recognition and measurement o f financial instruments) and AS3 1 (disclosures and presentation o f financial instruments).20 The ROSC report stated that a significant proportion o f the banks and other financial institutions sampled in 2003-2004 were unable to comply fully with the requirements o f the Indian Accounting Standards on “related party transactions” and “segment reporting”. Further, disclosure with respect to “credit exposure for borrowings” was found to be inadequate. Since then, and in l ine with developments in financial markets, RBI has been updating and enforcing guidelines related to disclosures o f financial statements, prudential norms on income recognition, asset classification and provisioning o f advances, and prudential guidelines for the restructuring o f advances.21 Also, in l ine with the autonomy granted by the Government to PSB in December 2005, RBI has rolled out a road map to encourage the PSB to exercise this autonomy with respect to the appointment o f auditors. RBI intends to reduce i t s role from directly appointing auditors to l imit ing i t se l f to prior approval o f the auditors selected by the PSB at the central levels. Moreover, from 2010-1 1 , instead o f RBI providing an approved l i s t o f f i r m s to the PSB, these banks will select the audit f i r m s for statutory audit purposes from the panel o f al l eligible firms prepared by the Office o f the Comptroller and Auditor General.

l 9 The National Bank for Agriculture and Rural Development (NABARD) has oversight o f cooperative and rural banks, the Small Industries Development Bank o f India (SIDBI, which also reports to the Ministry o f Small Scale Industries), oversees state finance corporations. The National Housing Bank (NHB, which i s owned by the RBI), i s responsible for housing finance companies. 2o The Institute o f Chartered Accountants o f India (ICAI) has decided that the implementation o f these standards these wi l l be recommendatory with respect to listed entities and other public interest entities from April 1, 2009 and mandatory from April 1,20 1 1.

RBI circulars DBOP.BP No. 3/21.04.018/2008-09 dated July 1, 2008; DBOD No. BP.BC.No. 12/21.04.048/2007- 08 dated July 2, 2007; and DBOD No. BP.BC.No. 37/21.04.132/2008-09 dated August 27, 2008

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33. The standards of banking sector corporate governance in India have improved over the years. The RBI has issued comprehensive guidelines, related especially to the consistent application o f prudential guidelines for al l commercial banks-public, private and foreign. This i s important to note, as there i s no actual conflict o f interest in Government's role as owner o f banks and i t s relationship with the regulator. The RBI i s an independent regulator, applying the same set o f regulations to al l banks, irrespective o f their ownership, across the board. Government ownership does not decrease i t s powers to regulate PSB, nor i s there any regulatory forbearance exhibited by RBI towards these banks because o f government ownership. All banks are subject to annual financial inspections, and findings are placed before the Board for Financial Supervision. However, there are some government sponsored financial programs implemented by the PSB, for which a part o f the cost, if any, i s borne by the Government. The Government, as the owner o f the PSB, also conducts quarterly reviews o f their performance against the Statement o f Intent (performance contracts) submitted by these banks.

34. Following a trend established since 1991, RBI set up three committees that have come up with recommendations on improving corporate governance for both public and private sector banks. The first, the Advisory Group on Corporate Governance (2001), was part o f an effort undertaken by RBI to benchmark India's financial sector standards and codes to international best practice. The second, the Advisory Group on Banking Supervision (2001), conducted stress tests o f banks and provided recommendations on prudential thresholds, management information systems and internal control mechanisms. The third, the Consultative Group o f Directors o f BankdFinancial Institutions (2002), reviewed the supervisory role o f the boards o f banks and financial institutions. The recommendations o f these groups were particularly relevant to overall risk management and the treatment o f N P A by commercial banks in India. More recently, the Planning Commission established the Committee on Financial Sector Reforms (2008), which issued a report called the Raghuram Rajan report after i t s Chairman, which provided recommendations in several areas, including improving the governance o f the PSB. It observed that, if suitably compensated, al l banks would be willing to assume the social obligations currently managed by the PSB, hence the rationale for continued government ownership o f banks i s weaker today. If privatization i s not an option, and the report recognizes that under present conditions it i s not (e.g. selling large PSB to large private banks raise issues o f concentration), several measures could be taken to improve governance. It emphasized the need for stronger PSB boards, combined with reduced government oversight and the exercise o f (a lower) government ownership share through the establishment o f bank holding companies.

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Box 2: Financial Sector Assessments

India was among the earliest participants in the Financial Sector Assessment Program (FSAP) pilots that were initiated together with the World Bank and IMF in 2000-2001. The assessment identified developmental as well as stability issues. bank financing of the fiscal deficit, establishment o f credit bureaus and improved debt recovery procedures, strengthening regulation and supervision by clarifying and strengthening laws, rules and responsibilities, merging weak banks, implementing automated payments systems, speeding capital markets settlements procedures and reforming margins procedures and the Unit Trust, and improving the framework for development of pension programs and contractual savings.

Progress has since been made on several of these:

In 2002, India undertook a self-assessment of international financial standards and codes, and in 2005, following the publication of the World Bank-IMF Handbook on Financial Sector Assessment, the Government and RBI established a Committee on Financial Sector Assessment in September 2006. This self-assessment was released to the public on March 30,2009.

The Self-Assessment i s comprehensive, candid, and insighthl. I t i s based on three, mutually reinforcing pillars- financial stability assessment and stress testing, institutional and legal infrastructure, and financial standards and codes. It a f f i s India’s long-term potential for maintaining yearly economic growth at above 8 percent, but recognizes that some of the financial sector reforms to achieve this may have to be put on hold during the current global crisis. Using evaluations o f stability and stress tests, the Self-Assessment has found the banking system to be sound, although it identifies some liquidity risks in bank balance sheets and a need for capacity building, especially to strengthen risk management. Among other areas of the financial market that need to be reinforced, the report emphasizes better infrastructure for the payments and settlements, foreign exchange, money and corporate bond markets. I t recommends greater efficiency in the existing, sometimes overlapping, regulatory structure and the importance of filling gaps (e.g., the regulation of fmancial conglomerates). And it calls for an intensification of efforts underway to improve corporate governance, the insolvency regime, and transparency in the areas of fiscal, financial and monetary operations.

35. The regulatory oversight o f the markets has continued to improve in concrete ways, with a focus on improving market integrity. India was among the f i rst countries to undertake a pi lot FSAP in 2000-0 1 (Box 2). In addition, i t also undertook a comprehensive self-assessment o f International Financial Standards and Codes during 2002, and a review in 2004. As a result o f actions taken to fol low up on such reviews, the financial infrastructure i s robust and can adequately address a range o f issues including liquidity, accounting and auditing, payment and settlements, and credit information. There has also been progress on other fronts, such as depositor protection. The prudential supervisory framework functions well, and compliance by the banking sector is high, including in core areas such as capital adequacy, income recognition, asset classification, exposure limits, internal controls, accounting and audit standards, provisioning for bad and doubtful debts, and credithnvestment concentration norms. In particular, the countercyclical prudential norms put into place have helped smooth the adjustment o f the financial sector to shocks.

36. The Government established a Committee on Financial Sector Assessment in September 2006, which assessed progress in these areas, while pointing out weaknesses that need addressing as part o f its long-term financial sector strategy. I ts report, which was released to the public, suggests that Indian banks are broadly compliant with Basel I1 Principles, except in risk management areas, for which it recommends improvements.22 The Se l f

22 Government o f India-Reserve Bank of India, Ind ia s Financial Sector: A n Assessment, Committee on Financial Sector Assessment, March 2009.

21

Assessment carried out an evaluation against OECD Principles for Co orate Governance, and reported that banks fully or broadly implemented most o f the principles. 2 37. However, areas for improvement remain in the corporate governance o f the PSB. Undoubtedly, there are variations among individual banks in terms o f financial transparency and disclosure, management capabilities, and the composition and effectiveness o f their boards. A common issue highlighted i s the effectiveness o f the boards o f the PSB. The Financial Sector Assessment recommends that, as the Government controls the nomination o f directors, i t needs to ensure their quality by adhering to the “fit and proper” criteria, not just in letter but in spirit too. It recommends further flexibility in decision- making power, and it proposes introducing a Corporate Governance Code for unlisted banks, which are outside the corporate governance framework for listed companies. In the light o f recent global banking experience and the need to contain liquidity and contagion risks, the Self Assessment gives special emphasis to integrated risk management by al l commercial banks operating in India, combined with cross-border regulatory cooperation and information sharing. More broadly for the financial sector as a whole, but with direct consequences for the operation o f banks, it points out the slowness o f procedures for completing corporate bankruptcies, and recommends that they be addressed to make the enforcement o f creditor rights and insolvency system effective, while strengthening market efficiency, market integration, and confidence in contract enforcement.

C. CONDITION OF INDIAN BANKS

38. India’s banks are well capitalized, asset quality i s good, and they have recorded impressive levels of profitability (Table 6, and the sections below). The recently concluded Financial Sector S e l f Assessment declares that the banking system i s robust and, over the last decade or so, there has been a significant improvement in the financial performance and condition o f banks in India. Growth -even in the financial year ended March 31, 2009-while slower than last year, has been relatively strong, with credit expanding by over 17 percent and deposits by around 20 percent.

Table 6: Financial Soundness Indicators o f Indian Banks

N e t NPAs to Net Advances Return on Total Assets

Source: GO1 and RBI, India’s Financial Sector: An Assessment, 2009

39. Without exception, all banks are above the R B I ’ s minimum capital adequacy level o f 9 percent. As o f March 31, 2009, the capital to risk-weighted assets ratio (CRAR or capital

See Table V.5, pp. 8 1, India’s Financial Sector: An Assessment, Volume I. 23

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adequacy ratio) for the banking sector stood at 13.2 percent, and no banks had a CRAR o f less than 10 percent. In general, banks took advantage o f good capital market conditions and declining interest rates to make huge gains, using them to reduce the NPA overhang. The PSB are somewhat restricted in their ability to raise capital from the markets, given the need to maintain majority government ownership. However, they too have increased their capital over the years through injections o f government funds, the reinvestment of profits, and, in some cases, the sales o f shares in the equity markets while retaining the Government’s majority ownership. The Government, RBI and the World Bank, as well as analysts such as McKinsey, have carried out stress tests and assessments o f bank capital under alternative scenarios (see Section V (B) for a summary o f various simulation exercises). They reveal that current levels o f capitalization are adequate, but that the banks will need capital support to sustain credit growth at reasonable levels and/or as a precautionary shield. Indian banks have also brought down their non-performing assets (NPA) substantially over the last decade. As o f March 31, 2009, gross NPA for the banking sector stood at 2.33 percent, while net (of provisioning) NPA were 1.05 percent. While NPA have shown only a marginal increase since September 2008, they may increase further due to the economic crisis.

40. The Indian banking sector i s well managed and efficient, and the cost income ratio has fallen by 15.8 percentage points between 2000 and 2009. This improvement in performance i s a reflection o f the quality o f management prevalent in the banking sector. The Government has set clear objectives and targets for the PSB, as illustrated in the annual Statements o f Intent, and holds their top management accountable for results. These efficiency measures and good management practices have resulted in credible profitability performance. The sector has become increasingly profitable, as shown in Figure

Figure 8: Net Profitability o f Indian Banks, by Bank GrouD

Source: RBI “Report o f Trend and Progress o f Banking India 2007-08”

8. Indeed, several balance sheet and profitability indicators suggest that i t compares well with global benchmarks. However, there are indications that the slowing economy i s likely to affect profitability adversely in the wake o f deteriorating asset quality. Financial margins are under increasing strain, and while banks are s t i l l profitable, the coming year i s l ikely to be challenging.

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(Volatile Liabilities-Temporary Assets)/ (Earning Assets -

risk o f funding liquidity.) (Core Deposits)/Total Assets (%) (Extent to which assets are funded through stable deposit base) (Loans + Mandatory CRR + Mandatory SLR + Fixed Assets)/ Total Assets (%) (Embedded illiquidity in the balance sheet) (Loans + Mandatory CRR + Mandatory SLR + Fixed Assets)/ Core Deposits (Dependence on purchased liquidity)

Temporary Assets) (%) (High and positive number implies some 34.7 43.9 49.3

53.8 49.3 47.7

86.3 86.5 75,0

.8 1.8 .4

Source: GO1 and RBI, India’s Financial Sector: An Assessment, 2009

41. I n d i a n banks have largely stable sources o f funds, with deposits accounting for 78 percent o f total resources. The Statutory Liquidity Ratio (SLR) o f 24 percent and the Cash Reserve Ratio (CRR) o f 5 percent (as o f March 3 1 , 2009) provide an additional cushion o f safety for the banking system. While no immediate liquidity constraint i s envisaged, during the recent turmoil, inter-bank money markets have experienced periods o f illiquidity. To assess the banking sector’s funding strategy and the consequent liquidity risk, a set o f liquidity ratios were developed and analyzed in the Financial Sector Assessment (Table 7). The analysis shows that there i s growing dependence on purchased liquidity (from 1.4 to 1.8 times core deposits between March 2005 and September 2008), accompanied by an increase in the illiquid component o f bank balance sheets (from 75 percent o f total assets to 86.5 percent), with greater reliance on more volatile liabilities, such as bulk deposits, to fund asset growth. There i s a need to strengthen liquidity management in this context, as also to shore up the core deposit base and keep an adequate cushion o f liquid assets to meet unforeseen contingencies.

Table 8: Key Performance Indicators by Bank Group (Rupees billion)

81% 6% 7%

79% 6% 7% CRAR(%) 11.2 11.5 11.9 ROA ( O h ) 0.4 0.8 0.6

Gross NPA ( O h ) 12.4 5.1 11.1

Net NPA (YO) 6.7 3.1 7.3

Note: Gross NPA are shown as a ratic Source: Ministry o f Finance and RBI

Advances 4,146 301 379

5 92 6 Yo 429 8 Yo 12.6 0.9

23,567 5,010 73% 16%

16,963 3,593 73% 15% 12.5 14.4 0.9 1.0

1,656 5 y o

1,130 5 y o 14.1 1.0

1,912 30,033 6 Yo 76%

1,629 21,018 7 y o 75% 13.1 12.3 1.8 0.9

6.8 2.2 2.9 2.3 1.9 2.0

1.9 1.0 1.4 0.7 0.8 0.9 3 gross advances; net NPA as a ratio to net advances.

42. I t i s noteworthy that the PSB have comparable performance rat ios to the pr ivate and banks even while they maintain a focus on underserved segments-agriculture, rural and SME finance, and infrastructure, and to smaller account holders. Indian banks have been

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relatively insulated from the direct impacts o f the global financial crisis, given the proactive measures taken by the RBI (Annex 4) and their minimal exposure to structured credit products in the US and other developed markets and to troubled international institutions. As o f March 2009, the PSB reported C U R averaging 12.34 percent, a net N P A ratio averaging 0.9 percent, and return on assets (ROA) averaging 0.9 percent. The private sector banks reported a CRAR o f 15.1 percent, net N P A ratio o f 1.4 percent and R O A o f 1.1 percent (Table S).24

43. However, Ind ian banks now face some important constraints. These arise, in part, from any need to ro l l over foreign and domestic market funding, and in part f rom banks’ exposure to domestic sectors that are likely to face stresses as the economy slows. Credit-to-deposit ratios are high (74 percent on average). Some new private sector banks have high credit to deposit ratios but do not have the same level o f access to stable deposits as have the PSB. Although the average Tier 1 capital ratio for Indian banks i s 8 percent, high by the standards currently found in most other financial markets, there i s a higher proportion o f Tier 2 capital (containing mandatory charges against future income) than 2-3 years ago, reflecting increases in hybrid debt instruments and reserves from the revaluation o f fixed assets. As Tier 1 capital provides the main buffer for asset side risks (common stock and retained earnings providing discretionary power to banks as to the amount o f payouts), going forward banks will need to manage their capital market borrowings more carefully to avoid higher borrowing costs and adequate capital.

44. Credit has tightened since October 2008. Spreads on foreign borrowing have widened sharply in recent months (at one point up to 500-600 basis points for one year credit compared to 100-1 50 prior to the crisis) and short-term capital inflows have weakened considerably, especially hurting the foreign and domestic private banks that had relied on these inflows more than the public sector banks. Although there i s no firm evidence, bankers, analysts and the media have reported that private banks have also seen some part o f their deposits shift to the public sector banks (see Table 7 for aggregate changes in deposit growth). This i s likely to have occurred late last year, during the initial panic in global financial markets about liquidity and the safety o f financial savings. If so, it does not seem to be occurring now.

45. NPA are likely to increase as growth slows. Domestic and foreign private banks were aggressive in lending to the best corporate customers (which included exporters) and real estate, and to households for the purchase o f durables. These fast growth areas have come under varying degrees o f pressure, and are likely to come under greater pressure if current conditions in the real economy persist into the next year. One estimate o f the likely growth o f N P A in retail sectors, where such banks have been active, suggests they could rise between 0.5 point and 4 percentage points during 2009.25 Despite these stresses, the fact that virtuallv no sizeable bank

24 The RBI requires a l l banks to maintain a minimum CRAR o f 9 percent. Under the guidelines to comply with Base1 2, a minimum Tier 1 CRAR o f 6 percent wi l l be required. Banks were permitted to raise Tier 2 capital, some o f whose elements can rise to a level equal to total Tier 1 capital. As raising Tier 1 capital i s more diff icult, banks have increased their Tier 2 capital, sometimes to 40-50 percent o f their total capital. This exposes them to greater refinancing risks on bonds used for Tier 2 capital, and the l ikelihood o f an increase in the costs if interest rates are unfavorable.

Crisil estimates that gross NPA on mortgage loans could rise f rom 2.2 percent in 2007 to 2.7 percent in 2009. For car loans, they estimate an increase f rom 2.3 percent t o 3 percent, for commercial vehicles f rom 4 to 5.5 percent, and for personal loans f rom 8 to 12 percent. Crisil, “Rising Interest Rates Expose Banks t o Credit Slowdown”, Insight, October 2008.

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has been allowed to fai l in Dast decades has underpinned the confidence o f depositors in the banking system.

46. But, assessments by the authorities suggest that demand for credit will remain strong in crop finance, general agriculture and rural diversification, and infrastructure. Moreover, due to changes in market conditions, demand for credit from the PSB has grown and i s likely over the medium term to continue to increase for large corporate borrowers and in some classes o f consumer loans (offsetting part o f the decline in real estate loans in the wake o f weakness in that market). This will add to the need to provide working capital to creditworthy enterprises experiencing a slowdown in foreign or domestic demand. Due to a combination o f factors (sources o f funding, class o f customer, outreach, extent o f branches, etc.), the pattern o f credit growth has varied substantially among the different types o f banks. However, credit demand i s likely to be strongest for the PSB, who have, s6 far, filled the gap created by the sharp drop o f f in private bank lending. A concern is that PSB will not have access to the capital to support the loans needed to underpin even a lower growth rate, and to absorb future losses.

IV. BANK GROUP SUPPORT TO THE GOVERNMENT’S PROGRAM

A. LINKS TO THE CAS

47. The proposed operation i s closely linked and essential to the achievement of the objectives of the first pillar of the Country Strategy for India (FY2009-2012). The World Bank supports the achievement o f rapid, inclusive growth in India through a cooperative program o f diagnostic and advisory studies, and policy-based, investment and TA operations that address both cyclical and structural factors. Buttressing macroeconomic, fiscal and financial stability at both the central and state levels i s a key focus o f the CAS. Moreover, the CAS recognizes that recent global developments pose important challenges to the achievement o f the Eleventh Plan goals, but also opportunities for the World Bank and other development partners to come up with creative solutions in a timely manner and to scale up funding support (paragraph 73 o f the CAS). The CAS flagged the opportunities to expand development policy lending beyond the identified projects and their extension to the national level (that is, beyond the state- level D P L that have characterized the India program).

48. IBRD exposure to India i s approaching the Single Borrower Limit (SBL), which i s currently set at US$15.5 billion. At the end o f 2008 exposure was US$7.4 billion. At the December 2008 discussion o f the Country Strategy for India (covering FY09-12), Directors supported the financial envelope proposed in the CAS, which foresaw US$9.6 bi l l ion in IBRD commitments for FY09-11 , including US$3 bi l l ion o f the US$5.4 bi l l ion in crisis-related lending requested by the Government o f India. Responding to the full request o f the Government, coupled with planned IBRD lending in the CAS, would carry projected exposure over the current SBL by FY13. An operation that would bring projected exposure above the prevailing SBL cannot be presented to the Board for approval. To bring IBRD exposure in line with the SBL and, at the same time, implement lending as planned in the CAS beyond FYlO would require exposure management through a possible increase in the SBL or prepayments or the purchase o f

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special private placement IBRD bonds by India. The latter two options are under active discussion between GO1 and the World Bank.

B. RELATIONSHIP TO OTHER BANK OPERATIONS

49. The CAS lending program has supported the development o f the financial sector with an emphasis on access to finance. The CAS did not directly address the unexpected crisis or the impact on India, but indirectly covers such events. As India moves to take precautionary steps to combat the effects o f the global financial crisis, a number o f operations anticipated within the CAS have been approved or are underway which will support the response o f the authorities and complement this proposed First Banking Sector Support Loan o f US$2 billion equivalent. Among the operations in this envelope are:

Additional financing to the Small Industries Development Bank o f India (SIDBI) o f US$400 mi l l ion (higher than the initially proposed amount o f US$200 million) to facilitate an increased f low o f working capital and te rm lending to India’s SME sector and thereby complement the Government’s and SIDBI’s efforts to buffer bank capital to maintain credit growth. This loan was approved by the Board in April 2009. A financial intermediary loan o f US$1.2 bi l l ion to the India Infrastructure Finance Company Limited (IIFCL), a flagship initiative o f the Government which supplements bank credit going into funding PPP in infrastructure, which i s widely recognized as the major bottleneck to the acceleration o f growth in India. The objective o f the proposed World Bank loan i s to increase the availability o f long-term financing for infrastructure PPP projects in India. This will be achieved through supporting the I IFCL in i t s role to catalyze private financing for infrastructure PPPs and stimulate the development o f a long-term local currency debt financing market for infrastructure in India. This loan i s scheduled to go to the Board in September 2009. A proposed financial intermediary loan o f US$300 mi l l ion to support the Government’s and SIDBI’s efforts to provide liquidity to microfinance institutions and improve access to finance for the underserved through scaling-up sustainable models o f microfinance. This would help contribute to household asset creation and sustainable income generation, poverty reduction, and growth. This loan i s currently scheduled to go to Board in FY 2010. A proposed US$18 mi l l ion operation for capital markets and pensions to broaden and deepen the markets. This loan i s currently scheduled to go to Board in FY 2010.

In addition, prior to current events, an investment loan o f US$600 mi l l ion through the Government to the National Bank for Agriculture and Rural Development (NABARD) for strengthening India’s rural credit cooperatives was approved. The loan supported the Government’s assistance package designed to assist in providing members o f Primary Agricultural Credit Cooperative Societies, including small and marginal farmers, with significantly enhanced access to formal finance (credit, savings, etc.), by ensuring that potentially viable entities are transformed into efficient and commercially sustainable institutions. This loan was approved by the Board in June 2007.

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50. The programs of IBRD-IDA and the IFC are complementary. As o f June 30, 2009, IFC’s outstanding balance in i t s India portfolio consisted o f US$468.6 mi l l ion in equity investment and U S 1 . 5 billion in loans. The financial sector i s an important component o f IFC’s portfolio. Investments in the financial sector account for 26 percent o f the total committed portfolio. The financial sector committed portfolio o f $8 19 mi l l ion (including IFC investments in funds) i s split 53:47 percent between debt (including Upper Tier Capital) and equity. IFC’s financial sector strategy in India aims to encourage growth in the market share o f private sector banks and contribute to financial policies which foster inclusive growth, increased banking penetration, development o f local financial markets, and stability at the national and regional levels (including in the aftermath o f the global financial crisis).

5 1. IFC has responded to the impact of global crisis on India’s financial sector by:

Organizing Risk Management workshops to foster dialogue and encourage financial institutions to adopt best practices Working closely with client companies to adapt and respond to the new economic environment Providing advisory services in key areas such as corporate governance, loan portfolio workout, and risk management Continuing to commit new financial market investments (an estimated 5 projects by end FY09) Continuing to disburse o n existing financial market commitments in a difficult market environment. Leveraging i t s unique position to bring additional financing while remaining within existing country exposure limits. This will include making effective use o f IFC’s global crisis response facilities (especially the Microfinance Enhancement Facility), working with other DFIs, and mobil izing as much funding as possible.

V. THE PROPOSED OPERATION

A. RATIONALE

52. The objective of the proposed operation i s to provide support to the Government to enable it to maintain its economic stimulus program to contain the effects of the global crisis. An important component o f the broader stimulus and recovery program i s the provision o f capital support to public sector banks. This wil l help to maintain confidence in the banking sector, prevent a slowdown in credit growth that could result from shortages o f capital, and will provide a capital buffer to absorb the possible increase in N P A resulting from the global financial crisis. In turn, this will help al l banks (both public and private) maintain their portfolio quality. Such funding support would complement the Government’s macroeconomic policy stimulus and other measures taken to minimize the impact o f the global crisis on the Indian economy. The additional capital buffers will serve as a precautionary shield to absorb losses, which could become crucial in the context o f the ongoing global economic slowdown. The Government’s provision o f more capital to banks cannot guarantee they will increase lending, as seen in the United States and United Kingdom. However, recent credit growth trends, financial

28

deepening, and the continued lack o f access to external borrowing by the large corporate borrowers make it likely that this i s not the situation faced by Indian public sector banks. In addition, the annual targets set for the PSB in performance contracts (“Statements o f Intent on Annual Goals”) with the MOF, and the governance and supervision frameworks in use today make i t more likely that these banks will maintain the growth o f lending. It i s worth noting that India’s reaction to the crisis so far shows two major differences compared, for example, to the United States. These are (a) a lack o f central bank involvement in direct lending to the private sector (the RBI has l e f t credit decisions to public and private banks), and (b) the PSB maintaining credit growth at levels that, so far, are supporting economic activity.

Table 9: Domestic Financial Markets at a Glance

Apri l 2008 8.10 40.02 1707.3 26.4 1629 1 May2008 8.04 42.13 1755.7 11.8 16946 June 2008 8.43 42.82 1744.3 -8.6 14997 July 2008 9.18 42.84 1721.7 -28.0 13716

August 2008 9.06 42.94 1719.4 -22.6 14722 September 2008 8.45 45.56 1756.7 -42.6 13943 October 2008 7.85 48.66 1691.2 -45.6 10550

November 2008 7.41 49.00 1476.5 -8.0 9454 December 2008 5.55 48.63 1248.5 22.3 95 14

January 2009 5.84 48.83 1135.4 45.5 9350 February 2009 5.98 49.26 1029.3 50.7 9188 March 2009 6.59 5 1.23 880.8 33.4 8995 Apri l 2009 6.55 50.06 751.5 101.6 1091 1 May 2009 6.4 1 48.53 459.6 125.7 13046 June 2009 6.83 47.77 27 1.4 123.4 14782

Source: RBI, Macroeconomic and Monetary Developments, First Quarter Review 2009-10 Abbreviations: LAF: Liquidity Adjustment Facility, where (-) indicates injection o f liquidity; MSS: Market Stabilization Scheme, BSE: Bombay Stock Exchange Limited.

53. While India’s banking sector had little exposure to the sub-prime mortgage assets o r the large troubled financial institutions o f the developed financial markets, it has felt the impact. Table 9 shows early and continuing indications o f strains. I t shows the pattern o f liquidity stresses in the economy, falling yields on government securities, widening differences between the price o f AAA corporate bonds and equivalent maturity government securities (from 130 basis points in July 2008 to nearly 300 basis points in December 2008), reduced market transaction levels, and a collapse in equity valuations. Lately, some o f the effects have been muted by RBI’s actions and its ability to maintain confidence in the financial market. Nevertheless, it i s evident that financial market conditions are s t i l l unsettled and likely to remain so in the period ahead.

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54. India’s corporate sector, which had relied heavily on foreign financing that suddenly was no longer available, was the first to feel the liquidity stresses in the financial markets. This resulted in a shift to the domestic banking sector to fill funding needs. This substitution in their sources of funding put pressure on the domestic money and credit markets. At the same time, the foreign exchange market also came under pressure, just as corporate entities needed foreign currency to meet their external obligations. Financing and substitute financing needs o f corporate borrowers will remain high over the near term. The entry into the domestic borrowing market o f the larger corporate enterprises, who had been borrowing abroad, has put pressure on local small and medium businesses and made borrowing domestically more difficult for them. In addition, banks have become more risk averse at the same time as demands on their limited resources for lending have risen, in an environment characterized by a worldwide increase in demand for liquidity.

55 . Notwithstanding the strong performance o f the Indian economy over the past few years, the global financial crisis has resulted in a slowdown in the real sectors. There i s a risk that, despite the banks’ strong capital positions and recent performance, credit could also slow sharply. There are visible signs o f adverse impacts on real sectors, acting chiefly through the reduction o f available credit and lower demand. These factors could spill over to the banking sector through an increase in NPA, thus potentially affecting the financial sector’s strength. However, the effect on the real sector now goes beyond credit, as pointed out in a recent McKinsey analysis. I t suggests that 10 sectors, contributing 33 percent o f GDP and receiving 41 percent o f total bank credit, are facing falling demand and pressure on prices and urgently need working capital to fund projects that have already started.

Table 10: Growth o f Deposits and Loans o f the Commercial Banks

Public sector banks 22.9 24.1 Foreign banks 29.1 7.8 Private sector banks 19.9 8.0

Total 22.4 19.8

Public sector banks 22.5 20.4 Foreign banks 28.5 4.0 Private sector banks 19.9 10.9

Total 22.3 17.3

Credit

Source: RBI Annual Policy Statement 2009-10; data as of March 27, 2009

56. Despite proactive measures, there has been a slowdown in overall bank credit growth since the last quarter o f 2008, even though it remained positive as the PSB increased credit, offsetting the fal l in credit growth at the private banks (Table 10). The private banks’ credit pullback reflects the decline in their resources, global risk management by banks such as HSBC, and their generally higher risk aversion. The increased risk aversion stems from uncertainty, expectations o f falling demand in the economy and, consequently, lower profitability o f enterprises which, in turn, could potentially result in increases in non-performing loans for the banking sector. Borrower difficulties may increase, especially as related to real estate loans and retail loans to households to finance durables, but also to some extent with loans extended to

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SME. Had the PSB not expanded and exhibited the same lending behavior as the private banks, it i s estimated that the stock o f credit outstanding would have been lower by about 40 percent (that is, about US$47 bi l l ion equivalent, rather than US$79 billion). Credit growth would have fallen even more sharply in the economy, but for the PSB, which increased loan growth. Nonetheless, as noted above, many important sectors o f the economy suffer from a shortage o f credit funding-SME, real estate, the texti le industry and exporters, to name a few. The stimulus expected from the easing o f monetary policy has not yet materialized, as i s the case in industrial countries too.

Table 11: Sectoral Deployment o f Bank Credit

Non-food gross bank credit 22.3 23.9 19.0 9.1 28.8 1.6 Agriculture and allied activities 19.3 19.2 -1.3 39.0 N A N A Industry 23.2 31.0 35.2 7.4 35.0 6.5 Personal loans 15.6 11.6 8.5 7.4 14.5 -8.1

Housing 13.2 10.0 13.5 4.9 -2.1 -4.4 Services 28.6 24.4 28.5 4.5 41.2 6.9’

Real estate 47.9 79. 1 6.9 13.9 -36.0 40.5 N B F C 53.0 44.8 14.0 38. 1 64.0 20.8

Small enterprises 49.0 36.7 209.5 23.2 190.4 59.5 Note: Share o f private banks and foreign banks in credit to agriculture and small enterprises i s small Source: RBI Annual Policy Statement 2009-IO; data as of February 27, 2009

57. The sectoral distribution of non-food credit also reflects the ability o f the PSB to continue supporting economic activity, which draws upon strong deposit growth, extensive branch banking network, past profitability, and adequate capital. As seen in Table 11, the reduction in private and foreign bank lending was sharpest in industry, housing, and other retail loans, which together account for close to 60 percent o f the total credit outstanding. When all credit i s considered-food crop finance as well as non-food-it i s evident that the PSB offset the withdrawal o f private and foreign banks from these critical sectors, at the same time as expanding the amount o f credit going to agriculture by 21.5 percent (compared to a growth rate o f 16.4 percent in the previous year). This has been the main factor preventing a credit crunch in the wake o f the global financial crisis.

58. SME represent a particularly vulnerable group. Sustaining economic growth while making it more inclusive will require a sharp step up in industrial and services growth, spurred by small and medium industries, which have the greatest potential to provide employment for the two-thirds o f the labor force st i l l working in agriculture. India has 13 mi l l ion SME in the manufacturing and services sector, which are facing tight credit conditions today. Including the SME retail sector brings the count to around 30 mi l l ion f i rms. The latest RBI statistics show that the year-on-year growth rate o f bank credit to SME fe l l sharply, even as the overall y-y growth rate o f bank credit to industry (including large corporations) increased from 24.9 percent to 30.2 percent. The SME are feeling the effects o f the credit crunch in two ways. First, until recently, large f i r m s have had access to financing through both the capital markets and the banks. Since

31

the decline in the capital market and the related reduction in liquidity, large f i r m s have resorted relatively more to bank lending. Essentially, this offers banks a new l ine o f business that i s sometimes more lucrative than lending to SME. Second, SME in India are typically o f three types: (i) f i r m s supplying larger f i r m s as part o f the supply chain (business to business, or B2B), (ii) f i r m s producing goods and services for final consumption (business to consumer, or B2C), and (iii) start-up entrepreneurs. Although the second group has not, as yet, seen a significant slowdown, as India’s growth has slowed but i s s t i l l respectable and consumption growth remains robust, the first group i s facing problems o f reduced orders, increased inventories and, thus, higher working capital requirements as a result o f the global downturn. These SME have not yet experienced big decreases in profits (since input prices have gone down). Nevertheless, their access to funding has been constrained, which i s affecting their ability to invest in capital goods, environmentally friendly technologies, and job creation. The capital support being provided by the Government as a result o f this loan, in combination with the financing to the Small Industries Development Bank o f India, should help to alleviate some o f the financing difficulties o f SMEs.

59. Current levels o f bank capitalization and asset quality can protect against a more severe economic slowdown, but cannot fully offset the effects of the global crisis. The strong capital position o f Indian banks indicates that, initially, they will be able to absorb significant losses on their loan portfolios. The banks are solvent, and without exception above the R B I ’ s minimum capital adequacy level o f 9 percent. As o f March 31, 2009, no bank had a C U R o f less than 10 percent. However, corporate distress and declining economic activity levels will raise banking sector NPA. Indian banks will need to maintain high capital ratios to avoid any concerns on the part o f the public regarding the strength o f the banks, and to underpin loan growth. With stock prices depressed, banks face difficulties in raising funds from the capital market. With the finances o f the Government stretched, the absence o f this capital i s likely to be a very important constraint on credit growth and on India’s ability to weather the economic slowdown.

60. India’s medium-term vision for the development of its banking sector i s evolving. The Government has provided a strategy note (Annex 2) that details recent policy developments and the direction o f future banking development. It emphasizes the strong relationship that exists between banking services and real economic growth, especially in the current context o f an economic slowdown. The Government recognizes the vital role played by India’s PSB in supporting growth and financial inclusion, and does not foresee disinvestment in them in the immediate future beyond the legally mandated thresholds o f 51 percent o f government ownership. However, the Government views consolidation o f the PSB to be a timely response for raising efficiency through the better management o f risks, leveraging economies o f scale, and an improved ability to face competition. It expects, however, that the initiative for consolidation should come from the management o f the individual PSB, with the Government playing a supportive role as a common shareholder. Further, while supporting merger proposals, the Government intends to keep in view the interest o f the shareholders and employees o f the merging banks. 61. In addition to maintaining credi,t growth, the Government identifies financial stability and a reduction in lending interest rates as two important challenges during this period. It has emphasized that, despite the need to adjust to the effects o f the global financial crisis, the medium-term banking sector development program remains on track. The Government has noted, however, that the current policy and procedures governing the presence o f foreign banks

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in India will remain unchanged, given their general withdrawal from lending in most emerging markets, including India, and the absence o f an agreed regulatory and supervisory architecture for such banks around the world. Other priorities identified in the Government’s strategy are the containment o f operating expenses, better risk management by banks, introducing technology, improved governance and removing bottlenecks in the credit delivery mechanism for agriculture/rural/SME sectors. With the exception o f the last o f these, this and the next D P L include actions that address these priorities through prior actions and triggers. However, several o f the other operations identified in paragraph 49, which complement the two proposed DPL, address issues o f service delivery to specific market groups.

B. PRIOR ACTIONS AND TRIGGERS

62. The institutional and policy development o f the Indian banking system remains on a steady path. As described in the Government’s strategy document in Annex 2, this has resulted in steadily broadening financial inclusion and the diversity o f banking instruments, and strengthening banks while helping establish more competitive markets and maintaining financial stability. A number o f additional measures have been completed by the authorities recently, following up on the recommendations o f several task forces (see paragraphs 34-36) and policy initiatives to cope with the external shock. Additional details on the responses to the recent crisis are contained in Annex 4: Recent Financial Sector Policv Initiatives. Together they represent a comprehensive response to recent developments embedded within the Government’s stated medium-term banking and financial sector strategy.

63. The Government has maintained an adequate macroeconomic policy framework. The key element i s fiscal sustainability, with control o f the government budget deficit to ensure medium-term alignment with the Government’s fiscal responsibility framework. The central government budget deficit for 2009-10 i s projected to reach 6.8 percent o f GDP, up from 6.1 percent in 2008-09. For general government, the comparable numbers are 11 percent and 9.6 percent, respectively. During the July 2009 presentation o f i t s budget for 2009-10, the Government stated i t s intention to reduce the central government deficit to 5.5 percent o f GDP during 2010-1 1 , and further to 4 percent during 201 1-12. RBI has announced that monetary policy i s likely to remain accommodative until there are robust signs o f recovery, and that i t would reverse expansionary measures in time to anchor inflationary expectations. The wholesale price index shows a decline in inflation from 5.4 to 2 percent. However, due to adverse rainfall concerns there i s uncertainty about food prices, which have started rising, which i s likely to put upward pressure on the consumer price index. The current account deficit for 2009-2010 i s projected to decline to below one percent o f GDP, from 2.6 percent last year, mainly from a sharp fa l l in imports. Foreign exchange reserves have increased slightly, and the Rupee i s stable.

64. Prior Actions for Release of the First DPL.

Maintain credit growth

The Government of India has executed Statements of Intent with each of its PSB. The agreement with each PSB i s done in the context o f the annual performance contracts

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(SOI-Statements o f Intent on Annual Goals). SO1 are agreed between the Government and each PSB. They contain a number o f quantitative criteria, including an appropriate increase in gross credit that each bank i s expected to achieve during a fiscal year and an indicative level o f NPA for each such bank. The process for 2009- 10 was completed in July, 2009. The SO1 for 2009-10 indicate that credit growth for the PSB as a whole would be around 20 percent. SO1 are reviewed every quarter and may be revised as required. The quality o f credit i s also supervised by RBI, which regulates PSB on an equal footing with private banks. The gross NPA levels have been brought down to around 2 percent.

Overall financial sector actions

The Government of India and the Reserve Bank of India have prepared a comprehensive Financial Sector Assessment and publicly released this document. The six-volume Assessment, conducted joint ly by the Government o f India and the Reserve Bank o f India, consists o f a financial stability and stress testing component, and components related to the institutional and legal infrastructure and an assessment o f financial standards and codes. It was released to the public on March 30,2009.

The Reserve Bank of India has taken necessary measures to improve the supervision of all Scheduled Commercial Banks, including (i) improving arrangements and procedures for on-site supervision; (ii) requiring Public Sector Banks to ensure that certain important returns are filed on-line; and implementing the use of early warning systems for banking distress. RBI employs a supervisory approach that i s a combination o f an on- site-inspection system with an off-site surveillance system. In August 2008, RBI moved to an Online Returns Filing System (ORFS) for submission o f certain important returns by banks. The returns to be filed under Base1 IIrelated guidelines would also be implemented on ORFS. RBI also initiated an exercise for the rationalization o f returns, with the number o f returns to be submitted by banks reduced from 291 to 223.

The Reserve Bank of India has taken necessary actions to proactively manage liquidity as a response to the financial crisis by reducing policy rates and reserve ratios and creating temporary, special purpose refinance facilities. Actions since mid-September 2008 are estimated to have resulted in an increase in actual/potential liquidity o f approximately US$%? billion. The cash reserve ratio requirement was reduced by 400 basis points, and the statutory liquidity ratio was reduced from 25 percent to 24 percent. Between October 2008 and April 2009, the rep0 rate was reduced from 9.0 percent to 4.75 percent, and the reverse rep0 rate was reduced by 275 basis points to 3.25 percent. Several special purpose vehicles and liquidity facilities were established after September 2008-for banks to access additional liquidity support, foreign exchange requirements o f o i l marketing companies, export credit finance, small industry and housing finance, foreign exchange swap facilities for banks with overseas branches, and other areas.

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Banking sector actions

Strengthen prudential norms:

The Reserve Bank of India has taken necessary actions to strengthen prudential norms for the banking sector, including, among others: (i) issuing prudential guidelines regarding capital adequacy pursuant to the Basel Committee on Banking Supervision’s “International Convergence of Capital Measurement and Capital Standards: A Revised Framework”; (ii) adopting prudential norms on off-balance sheet exposures for Scheduled Commercial Banks; and (iii) strengthening prudential norms for valuation, classification, and operation of commercial banks ’ investment portfolios. Updated guidelines were issued in July 2008 requiring al l banks to migrate to the Revised Framework on March 3 1 , 2009, with the requirement to maintain a minimum CRAR o f 9 percent. New guidelines on prudential norms for off-balance sheet items were issued in August 2008, These included directives on provisioning norms for derivative exposures and on computation o f credit exposure on account o f derivatives. The norms for valuation, classification and investment portfolios were updated and issued in July 2008, and covered issues such as internal controls and accounting.

Improve risk management:

The Reserve Bank of India has issued revised guidelines to govern credit made available by Scheduled Commercial Banks to individual and group borrowers and for capital market transactions. In July 2008, RBI issued an updated circular related to exposure norms. The circular focused on promoting better risk management and avoiding the concentration o f credit risk. It provides limits on exposures to individual and group borrowers and capital markets. Some relaxation in risk weights to exposures in selected sectors, such as real estate, was allowed in November 2008 as a counter-cyclical measure.

Improve governance:

The Government of India, in coordination with the Reserve Bank of India, has ensured that elections of directors to Public Sector Banks were in compliance with the Reserve Bank of India’s ‘Pt and proper” criteria for such elections. The Financial Sector Assessment re-emphasized in March 2009 the need for implementing “fit and proper” guidelines issued in 2008, in both letter and spirit, and increasing professional representation on Boards. Banks have initiated measures as the terms o f directors expired and, in the few cases where gaps were evident, ensured increasingly professional boards.

65. Triggers for the Second DPL:

Maintain credit growth

PSB have achieved a level of credit growth that is consistent with the growth of nominal GDP, while containing NPA within reasonable limits

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Overall financial sector actions

At least 90% of the PSB have commencedfiling key returns through the Online Returns Filing System, which is part of the off-site monitoring and supervision system Based on the Statements of Intent, the Government has undertaken periodic monitoring of the financial health of PSB, including on capital adequacy, earnings, and asset quality Government has carried out a study of the impact of the various policy and regulatory initiatives instituted in the banking sector since mid-2008

Banking sector actions

The Government has ensured that all PSB have adequate capital to comply with the Basel II framework Government has reviewed key banking sector reform proposals from recent task forces and committees and prepared a report on actions taken and those being considered for implementation during 201 0-201 I Government has taken necessary actions to ensure that not less than 90% of the PSB have adopted stress test frameworks approved by their boards. Government has completed a study on the practices followed by PSB for assessing environmental and social risks Government has adopted ‘ p t and proper criteria in nominating non-official directors for all PSB Government has required those PSB with significantly lower than average productivity levels to prepare action plans to improve productivity

c. SCENARIOS AND INSTRUMENTS

66. Increased capital will be needed by several PSB for a variety o f reasons. Foremost among these i s to enable PSB to continue to meet the expected demand for credit. All PSB have now migrated to Basel 2 norms, and the Government program aims to ensure that al l PSB have a CRAR o f at least 12 percent (which i s 3 percentage points above the mandatory Basel 2 guidelines adopted by the authorities) by March 3 1, 20 1 1. Moreover, within this aggregate, the program targets Tier 1 CRAR at a healthy level o f at least 8 percent. In addition, banks are concerned about rising delinquencies in some market segments-arising, for example, from higher receivables and inventories in SME and mid-sized corporate, the reluctance or inability o f some farmers to pay o f f their balances under the agricultural loan waiver scheme, and weak cash flows o f over-leveraged large corporate borrowers. Some additional capital will also be required for agreed salary revisions and pensions, branch expansion and the adoption o f new technology.

67. The Government ha,s requested a program o f about US$3 billion o f budgetary support from the World Bank for i t s stimulus program, which i s equivalent to more than hal f o f the estimated requirements for a banking support program that would facilitate continued credit growth, high capital, and no loss o f confidence during the crisis, while the PSB continue to be wel l provisioned. The Government has provided an indicative l i s t o f PSB which are in l ine for

36

Tier 1 capital support under i t s program. The specific capital arrangements (amounts and timing) required for each PSB will vary, based on the budgetary situation, the share o f Government ownership, retained earnings, relative strength in the equity markets, growth plans and overall headroom with regard to other capital sources-innovative perpetual debt instruments, perpetual non-cumulative preference shares, hybrid debt capital instruments, preference shares, subordinated bonds, etc. The Government program will provide Tier 1 capital to the PSB out o f i t s budget v ia cash, which would increase the lending limits ‘o f the banks, making additional funds available immediately for on-lending. This i s aimed at meeting al l or part o f the requirements for Tier 1 capital, while at the same time encouraging the PSB to raise capital, if possible, through other means if and when market conditions permit.

68. Based on March 2009 baseline data, the Government estimates the total capital shortfall for the PSB to be Rs 22,489 crore (US$4.8 billion) by 2011, and the Tier 1 capital shortfall to be Rs 18,483 crore (US$3.9 billion), The Government has requested Rs 14,100 crore (US$3.0 billion) o f budgetary support from the World Bank. It i s proposed that this amount be split across two loans o f US$2 bi l l ion and US$1 bi l l ion respectively. The Government intends to provide budgetary funds to the PSB as Tier 1 capital. . In addition, it proposes to infuse approximately Rs 2,000 crore (US$425 million) into the PSB as Tier 1 capital. The Government estimates that the remainder o f the Tier 1 capital shortfall o f US$0.5 billion, as well as the Tier 2 capital shortfall o f US$0.9 billion, could come from the market and other innovative funding sources in the outer years. This i s likely to take place through the PSB using headroom in Tier I and Tier I1 capital to raise the balance, while complying with the 51 percent government ownership requirement. The l i s t o f PSB eligible for capital support, as well as the amounts and timing o f capital infusion into each PSB, might change over time depending on dynamic internal and external factors. The Government will modify i t s program accordingly, but changes in capital requirements are likely to be small, given that there i s greater certainty about the near te rm needs, which constitute the bulk o f the capital injection. This form o f capital buffering would be a significantly stronger support for commercial bank lending than if the Government provided additional capital in the form o f non-tradable bonds.

69. World Bank support to the Government’s budget, while only a small sum in relation to total development and stimulus needs and the size of the financial market, has the added advantage o f not displacing other borrowers in the capital market, which could occur if the Government floated bonds to provide capital to the banks. In addition, the World Bank’s loan would be a strong signal o f support to the economy and, specifically, to the banking sector. Although the operation i s being delivered in the context o f a growing economy and a sound banking sector-it i s not a financial crisis loan-it i s dealing with some o f the fallout from the global financial crisis, therefore the proposed operation i s being fast-trackedi Maintaining credit growth against the backdrop o f a slowing economy could mean that N P A rise. This risk will need to be mitigated through appropriate allocation o f credit to sectors that are viable (as the banking sector has ably done since the early 1990s) as well as through continued close supervision by the RBI to ensure that the gains from high credit growth are not annulled by an excessive concomitant increase in NPA.

70. Government and RBI forecasts regarding the capital requirements o f the PSB are broadly in line with World Bank estimates. As mentioned earlier, while the level o f

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capitalization o f Indian banks i s high and the current CRAR levels are adequate for the near future, they will need additional capital support to sustain credit growth and have capital buffers as a precautionary shield against adverse financial and real sector contingencies. Two sets o f simulation and scenario exercises, with baseline data as o f March 3 1 , 2009 to estimate the capital requirement o f Indian banks, have been carried out by the Government and RBI and developed further by the World Bank team. These are summarized below, with details in Annex 5 .

Table 12: Increase in CRAR for 16 PSB - Simulation Results

DFS Projections 11.78% 10.62% 4.8 3.9

Scenario 1 (NPA amounts increase by 30-60, Credit Growth=l2%) 12.43% 11.69% 2.0 [Low:Low]

40-80, Credit Growth=l7%) [Mid- 11.86% 10.63% 4.5 Scenario 2 (NPA amounts increase by 13.08%

2.4

4.3 Mid]

Scenario 3 (NPA amounts increase by 80-150, Credit Growth=25%) 10.90% 8.89% 11.6 9.7 [High-High]

71. Simulation Exercise 1: Building upon the estimates o f capital requirements by the Department o f Financial Services o f the Ministry o f Finance (MOF), World Bank staff undertook multiple simulation exercises for the future under slightly varying assumptions.26 Table 12 summarizes the results for the PSB that are likely to participate in the program because o f Tier 1 capital needs. While these scenarios are indicative, the key finding i s that the Government’s estimates o f the shortfall in capital for PSB, in order to reach a CRAR level o f 12 percent and a Tier 1 CRAR o f 8 percent, are o f a similar order o f magnitude as the team’s simulation exercises, as shown in Scenario 2 (base case). The results reflect the fact that a significant proportion o f the capital needs are on account o f the problems in raising capital to sustain credit growth. This i s in the context o f a financial environment affected by the global crisis, where capital valuations are unattractive and capital markets difficult to access.27

72. Simulation Exercise 2: T o evaluate the impact o f likely growth in NPA, the Financial Sector Assessment of the authorities stress tested for credit risk in M a r c h and September

Key government assumptions include: Profits o f PSB in 2010 and 201 1 remain at 2009 levels, provisions on standard assets remain at 2009 levels, risk weighted assets grow at 20 percent each year, and until 2010 some banks would not be able to access capital markets for raising equity capital by diluting government equity. Key World Bank simulation assumptions include: Risk weighted assets (proxy for growth in advances) increase yearly by 12, 17 or 25 percent, Gross NPA rise by varying amounts (from 30 percent to 150 percent) in different scenarios, and a provisioning rate of 50 percent has been applied to the overall NPA amount to estimate the provisioning amount.

An analysis o f five large private sector banks under Simulation Exercise 2 shows that, cumulatively, they require no additional capital to meet the 12 percent CRAR and the 8 percent Tier 1 CRAR levels. The overall CRAR o f the five banks in 201 1 would be a very healthy 13.53 percent.

26

27

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2008. The Financial Sector Assessment undertook a single factor-stress test o f al l classes o f banks in the Indian banking system. I t focused on an estimation o f capital requirements in a situation where N P A levels rise. It assumed that, instead o f the actual N P A ratio at end-March and end-September 2008, it would be higher by 100 percent and 150 percent on those dates. The World Bank team built o n this, and undertook an identical estimation for March 2009, that is, by assuming that the N P A ratio at end-March 2009 was 100 percent and 150 percent higher than the actual level on that date. Annex 5 presents the details o f the methodology and assumptions. Table 13 summarizes the results o f this static, stock model calculation for various groups o f banks. They show that, even under significant stress (150 percent increase in NPA), private banks do not experience a reduction in their CRAR below 12 percent. This i s in contrast to public sector banks, which are likely to face an immediate reduction in their CRAR to below 12 percent even in a situation where N P A increase by a lower level o f 100 percent. Since the baseline data are for March 2009, they incorporate to some extent the effect o f RBI forbearance on N P A and provisioning, and the effects o f other restructuring measures resulting from the various forbearance measures initiated since August 2008.

Table 13: Increase in CRAR for all Banks Using

CRAR 12.3 1 15.05 13.20 CRAR with 100 percent increase in NPA 11.10 13.49 11.91 CRAR with 150 percent increase in NPA 10.49 12.71 11.27

VI. OPERATION IMPLEMENTATION

A. POVERTYAND SOCIAL IMPACT

73. The proposed operation-by helping maintain a stable macroeconomic framework and enabling commercial banks to maintain credit growth in support o f economic activity, employment and poverty reduction [Prior Actions 1,2]-will mute the effect of the current economic slowdown on vulnerable groups, as well as permit the PSB to continue deepening programs for greater financial inclusion. The recent experience o f several countries such as the United States and United Kingdom, the lessons o f Japan in the “lost decade”, and the Asian Crisis o f 1996-98 show both banking system imprudence and instability as well as a credit crunch can have seriously deleterious and long-lasting effects on glJ economic activity and investment. It can magnify greatly the effects o f economic slowdowns that emanate from the real side, mainly by transmitting financial distress throughout the economy and undermining confidence in the payments system. The effects o f credit cutbacks can be even more adverse in India than in other countries because India’s banks play a direct role in the achievement o f a wide range o f national objectives directed at l ow income and vulnerable groups. Targeted lending has proven to be very effective in alleviating poverty in India. The Government intends to provide funds out o f i t s budget to the banks so that a lack o f capital does not cause them to cut back on existing priority and general lending programs or on new lending to viable proj ects/proposals, while exercising the degree o f prudence required to retain public confidence

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in banking and the viability o f banks [Prior Action 2, 31. Unlike financial intermediary operations with lines o f credit targeted at specific vulnerable groups, this operation enables the Government to sustain i t s efforts to support India’s economy-wide inclusive growth programs, in which bank credit plays a central role, especially the mandate for greater financial inclusion. To the extent that the PSB are able to expand lending across sectors at the rate agreed with the Government, there i s likely to be continued progress on overall growth, employment, and poverty alleviation.28

74. Trends in Indian poverty make it imperative that general credit growth and, within the totals, priority sector lending i s maintained. In 1983, 47 percent o f the people in rural areas and 42 percent in urban areas l ived below the official poverty line. By 2004-2005, these proportions had fallen to 28 percent and 25.8 percent, respectively. The draft 2009 World Bank poverty assessment for India shows that the depth and severity o f poverty declined even faster.29 With population growth, however, it has proven difficult to reduce the number o f poor at a comparably rapid pace. Therefore, despite India’s success in bringing down the poverty rate, over 300 mil l ion people were living in poverty at the time o f the last comprehensive survey in 2004/05. However, the dynamics o f growth and poverty reduction have changed dramatically, increasing the importance o f the relatively credit-dependent non-agricultural sectors. Urban and rural poverty rates have been converging and urban poverty i s deeper and more severe than rural poverty. As urban and peri-urban areas produce most o f India’s output, the health o f the manufacturing and services sectors, based largely in towns and cities, i s key to maintaining India’s aggregate growth rate and employment as well as in assisting the Government with i t s poverty reduction effort. Despite this, given the slow pace o f urbanization in India, poverty i s l ikely to remain a predominantly rural problem, with nearly three o f every four poor persons living in India’s villages. But the link between urban economic growth and rural poverty reduction i s much stronger than before the 1990s. The spillover effects work through rural-to- urban migration (and the reverse financial transfers) as wel l as trade in goods.

75. The proposed project, together with the operations identified in paragraph 47, will help mitigate the impact of the economic slowdown on employment and the pace of job- creation, mainly in the urban and peri-urban areas most affected by the global economic crisis. As many o f the sectors that are vulnerable employ a higher proportion o f workers clustered around the poverty line, there i s a high risk they will fa l l into poverty if the slowdown i s severe or prolonged. Unskilled service sector workers, a number o f whom are migrants f rom the poorer rural areas and form a large part o f the urban poor, would be an example. Even semi- skilled and some skilled workers in urban areas who have been laid o f f or face the prospect o f unemployment are vulnerable. An estimate f rom the first quarter o f 2009 showed that the

In addition to the program o f support for the PSB that i s expected to increase general credit by at least 20 percent this year, allocations for programs that directly support employment, business creation and economic growth have been expanded. These include, for example, R B I ’ s enhancements o f the M S M E (Refinance) Fund and Rural Housing Fund, by Rs. 20 b i l l i on and Rs. 10 bil l ion, respectively. Other examples are the 2009/10 interim budget allocations o f Rs. 140 b i l l i on for the rural infrastructure development f h d (RIDF), a separate window under the same RIDF for Rs. 40 b i l l ion for rural roads, and interest rate subsidies for short term crop loans. The recently re- elected Government’s budget for 2009- 10, presented in July 2009 expands allocations for infrastructure, agriculture, and social safety nets, including an increase in allocations to the National Rural Employment Guarantee Scheme and rural infrastructure and rural roads schemes. 29 Perspectives on Poverty in India: Stylized Factsfrom Survey Data, M a y 18,2009

28

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number of urban jobs lost since October 2008, mainly from the export slowdown but also because o f a downturn in the construction sector, was 5.9 million; the number i s l ikely to be higher Rural areas have been largely protected from the immediate effect o f the global slowdown, reflecting recent government policies to energize the rural agricultural and non-farm sectors, but even they are increasingly dependent on financial services in the economy, which makes vital economic sectors vulnerable to shortages in credit.31

76. Social banking i s a core function o f the PSB in India, therefore safeguarding priority sector credit growth, which i s a key objective o f the government’s program for providing capital to the PSB, i s vital. According to government guidelines, priority sector lending-for example loans to SME, artisans and village and cottage industries, self-help groups, and direct and indirect finance to agriculture-is targeted at 40 percent o f the total lending o f the commercial banks. In addition, major banking programs exist for: (a) facilitating payments by farmers (for example, the Kisan Credit Card scheme mentioned above); (b) supporting banking outreach (for example, the S e l f Help Group-Bank linkage program); (c) promoting general employment and economic diversification activities among women, disabled and vulnerable groups (for example, the Prime Minister’s Rozgar Yojana, the Swarnajayanti Gram Swarozgar Yojana (a rural livelihoods scheme), and the Scheme for the Liberation and Rehabilitation o f Scavengers programs), in addition to the agricultural debt waiver and other debt and interest payment measures that took place in 2008.32 Among other factors, the expansion o f such programs to address poverty concerns depends on the ability o f the PSB to grow their portfolios. For example, about 60 percent o f the Self Help Promoting Institutions in India receive their funding from banks and NABARD.33

77. The proposed operation will also help in deepening government ‘programs for the financial inclusion o f the poor and vulnerable groups in the formal financial system. RBI

30 Surveys by the Ministry of Labor and Employment and the Associated Chambers of Commerce and Industry show that several urban-based sectors-gems and jewelry, metals, textiles, business process outsourcing units, software, transport and construction-have so far borne the brunt o f the adjustment. In addition, there has also been a severe impact on mining and associated businesses. 3 1 The evidence from India i s strong that finance enables business expansion and employment. A recent study based on randomized trials in Hyderabad found that credit helps expand business and household expenditure, although in the short run there did not seem to be discernible effects on other social indicators, such as education or health (Abhijit Banerjee, Esther Duflo, Rachel Glennerster and Cynthia Kinna, The Miracle of Microfinance? Evidencefrom a Randomized Evaluation, MIT Poverty Action Lab, May 30, 2009. The recent investment climate assessment for India showed that households and micro enterprises consider access to finance to be the single biggest obstacle to their growth and that firms able to borrow in formal markets had 38 percent higher labor productivity than other firms. Aurora Ferrari and Inderbir Singh Dhingra, India’s Investment Climate: Voices of Indian Business, World Bank, 2009. 32 There i s a vast body o f evidence that social banking has been beneficial in India on various fronts. Studies show that increased access to financial services in India’s rural areas has reduced poverty by both increasing the sensitivity o f poverty to economic growth and by directly encouraging economic growth (Timothy Besley, Robin Burgess and Berta Esteve-Volart, Operationalising Pro-Poor Growth: India Case Study, London School o f Economics, January 2005). Another study showed that the expansion o f PSB branches into rural unbanked locations reduced poverty across Indian states. In addition, the enforcement o f priority lending requirements was associated with increased bank borrowing among the poor, in particular low caste and tribal groups (Robin Burgess, Rohini Pande and Grace Wong, “Banking for the Poor: Evidence from India”, Journal of the European Economic Association, April-May 2005, 3(2-3): pp. 268-278).

Impact and Sustainability of SHG Bank Linkage Programme, National Council o f Applied Economic Research, New Delhi, July 2008. 33

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estimates that only 59 percent of the adult urban population and 39 percent o f the adult rural population have access to bank accounts, with the North Eastern and Eastern regions o f India with even lower access.34 The PSB typically undertake the bulk o f lending to underserved segments so capital support to the PSB ensures that such segments stand a better chance o f sustaining access to credit in the coming years.35 The forward plans for the PSB include ambitious goals for the expansion o f branches and non-branch access points, such as ATMs, for FY2009-10, based on their agreements with the M O F on targeted levels o f overall and priority credit-growth. In addition, 344 districts are included in the plans o f the State Level Bankers’ Committees, convened by the PSB, to reach 100 percent financial inclusion. O f these, 175 districts, across 21 States and 7 Union Territories have achieved their targets.36 The PSB intend to maintain, but not complete, this program during the period o f implementation o f the proposed operation, provided neither household incomes nor credit growth decline sharply. The PSB focus on financial inclusion not merely for social development, but also from a business perspective, as the “bottom o f the pyramid” market i s very large in India.37 The proposed operation would support action on the part o f the PSB to continue to increase financial services to the poor through relatively recent initiatives, such as “no f r i l ls ” accounts-that is, accounts without minimum balance requirements, which have proved a powerful vehicle for spreading the banking habit among lower income and vulnerable populations subject to income volatility.

B. FIDUCIARYASPECTS

78. The Reserve Bank o f India (RBI) manages the foreign exchange reserves o f India. Based on the RBI audit report and the outcomes o f other World Bank operations that have been disbursed through RBI, the World Bank has reasonable assurance that the control environment for foreign exchange i s satisfactory for the purposes o f this operation.. The IMF does not carry out a Safeguard Assessment o f the Reserve Bank o f India (RBI). As part o f the appraisal for the D P L operation, World Bank staff reviewed the RBI audit report and i t s published annual financial statements for the year ended June 30, 2008. The audit report by jo int auditors appointed by the Government has an unqualified opinion. The financial statements are prepared in accordance with the Reserve Bank o f India Act 1934, the notifications issued under the Act, and in the form prescribed by the RBI General Regulations 1949. The audit follows the standards generally accepted in India.

Usha Thorat, Financial Inclusion - The Indian Experience, Presentation by the RBI Deputy Governor to the HMT-DflD Financial Inclusion Conference, London, June 19, 2007. The Invest India Market Solution Survey of 34

2007 showed that just 14 percent of agricultural wage laborers had a bank account, compared to 95 percent o f people in business. Although indebtedness to formal financial institutions i s low, there were five times as many

’’ For example, under the Kisan Credit Card scheme PSB have extended more than 35 million credit cards (with a total debit amount o f Rs. 1.8 trillion) to farmers to enable them to purchase agricultural inputs and draw working capital. 36 Reserve Bank o f India, Annual Policy Statement 2009-1 0, Mumbai, April 2 1,2009. 37 India’s National Council o f Applied Economic Research estimated that this market covers 15.6 percent o f the 222 million households in the country with annual incomes below Rs. 45,000 (US$ 900) per year. There are another 80 million households, with annual incomes in the Rs. 45,000-90,000 range, which banks and f i rms are trying to reach whose consumption patterns are likely to overlap on some products with the bottom-of-the-pyramid households.

eople with bank loans in the top quartile (by income) compared to the bottom quartile o f those surveyed.

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79. While there has not been any formal diagnostic assessment (such as the Country Financial Accountability Assessment o r the Public Financial Management Report) of public financial management (PFM) at the Union level in India, focused studies o f public accountability issues on selected areas, such as the Centrally Sponsored Schemes (CSS), have been carried out. The Bank has also carried out FM assessments in ten States3* as well as in ULB and PRI,39 and one State has carried out a self-asse~sment.~~ These have provided a basis for enhanced knowledge and understanding o f the strengths and weaknesses o f the P F M systems at the union level. The Government has initiated various actions in the area o f PFM, including (a) enactment o f the Fiscal Responsibility and Budget Management Act; (b) passage o f the Right to Information Act; (c) recognizing the need to improve the quality o f financial disclosure and moving progressively to align disclosures with international public sector accounting standards; and (d) recognizing the need for better financial monitoring o f Centrally Funded Schemes by initiating the Central Plan Monitoring Scheme.

80. The Government has recognized that there are significant opportunities for strengthening FM at the union level. It has accepted a recommendation o f the 12th Finance Commission to move gradually from a cash basis to an accrual basis o f accounting. It has also shown interest in benchmarking an array o f FM practices to international standards and good practices, including cash management, debt management, accounting for contingent liabilities, and internal and external audit. The Government seems interested in designing and implementing integrated financial management information systems (IFMIS)--or at least in modernizing existing Treasury systems-at State and possibly union levels.

C. DISBURSEMENT AND AUDITS

81. A Loan Agreement between India (as the borrower) and the Bank reflects the financing terms and conditions for the IBRD loan that will support this operation. The loan proceeds will be available for disbursement in a single tranche o f US$2.0 bi l l ion after effectiveness. As part o f the program supported by this operation, the Government o f India has taken a number o f policy and institutional actions (see paragraphs 63-64). The Loan Agreement between the Bank and India l i s ts these “prior actions” and these actions constitute the legal basis for the Bank to disburse the loan after effectiveness. The preparation o f the second loan and i t s amount will be determined by: (a) the estimated funding needs, and (b) a set o f policy and institutional measures to continue implementation o f the banking strategy o f the Government to achieve the objectives o f this programmatic set.

38 “FM assessments” i s a term used here to include State Financial Accountability Assessments, State Public Financial Management Assessments, Public Financial Management and Accountability Studies, and Notes on selected issues. They have been carried out in Tamil Nadu (2003), Orissa (2004), Karnataka (2004), Uttar Pradesh (2004), Bihar (2005), Rajasthan (2005), Punjab (2006), Jharkhand (2007), Maharashtra (draft report), Himachal Pradesh (draft report). 39 See Goel, P. and Beazley, I., “Synthesis Study of Public Financial Management and Accountability in Urban Local Bodies (Urban Local Governments at the Third Tier o f Government in India).” Financial Management Unit South Asia Region, World Bank, March 2007. See also Goel, P., and Mamak, M., “Public Financial Management and Accountability in Panchayati Raj Institutions (Rural Local Governments), Synthesis Study.” Report M p l 3 8557- IN, Financial Management Unit South Asia Region, World Bank, April 2007.

Andhra Pradesh: State Financial Accountability Assessment (State Government), Center for Good Governance, 2004. 40

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82. Upon effectiveness of the loan, the borrower i s expected to submit to the Bank a withdrawal application to draw down the loan proceeds. The Bank will disburse the loan proceeds in US Dollars to the RBI, and the RBI will credit on the same day the rupee equivalent to the Consolidated Fund o f the Government with the RBI. The Government o f India will confirm receipt o f the funds into this account. The funds provided by the Bank are not linked to capital injections into any specific PSB, consequently the transfer o f funds to the Consolidated Fund will be considered “end use” and there will be no fiduciary requirement to trace the transfer o f funds to specific banks.

83. Pursuant to the Loan Agreements for this operation, India (in i t s capacity as the borrower o f the IBRD loan) will undertake not to use the loans proceeds to finance any excluded expenditures. If the borrower uses any amount o f the loan proceeds to finance excluded expenditures, the Loan Agreement authorizes the World Bank to seek a refund o f that amount.

D. ENVIRONMENTAL ASPECTS

84. The proposed lending operation i s to provide PSB with the necessary Tier 1 capital such that credit growth i s not impeded by a lack of capital. According to our analysis, the policy measures supported by this operation are not likely to have a significant effect on India’s environment, forests and other natural resources. Nonetheless, banking involves lending to various sectors, including some which may not be environmentally benign and which, in turn, could pose credit risks. Recognizing this, on December 20, 2007, RBI issued guidelines to al l scheduled commercial banks on “Corporate Social Responsibility, Sustainable Development and Non-Financial Reporting” [RBI/2007-08/216, DBOD.No.Dir. BC.58/13.27.00/2007-081. The intent o f the guidelines i s to sensitize banks to the need for and the potential risks that could arise out o f insufficient attention to environmental and social issues (such as increased loan defaults, decreased asset value, liability for damages, and loss o f reputation). The PSB have indicated during discussions with the World Bank team that their internal guidelines prohibit lending to sectors determined to have adverse environmental effects (for example, production o f ozone depleting substances). For medium and large projects, their internal guidelines provide for credit approvals only upon submission o f the formal environmental clearances required o f project promoters by the appropriate authorities, such as the Ministry o f Environment and Forests and State Pollution Control Boards. With respect to post-environmental clearance compliance, which i s the responsibility o f project developers, the clearing agency i s mandated to monitor compliance. The team has engaged with the authorities on this topic, including institutional practices and procedures on post-loan approval environmental compliance reporting by borrowers from the PSB. The Government has indicated i t s intention to study the practices o f the PSB in these areas before the next loan in this programmatic set o f two D P L to support India’s banking sector.

44

E. CONSUL TA TION

85. The Government has conducted public consultations on its plans to inject budgetary resources to buffer the capital of the PSB. Since January 2009, such consultations have occurred at several levels. The Government has publicized i t s intentions and objectives for injecting capital into the PSB in official notifications to the public issued through the Press Information Bureau. Moreover, it made allocations for a f i rs t round o f capital infusions into the PSB in the Interim Budget presented to parliament on February 16, 2009, held discussions with industry associations, and made official statements regarding its intentions at the level o f the President and Finance Minister. For the purposes of this Program Document, the Government has also provided a strategy paper that elucidates the principles and objectives o f banking reform in India, including the place o f the capital injections for PSB within the framework o f India’s multi-pronged response to the global economic crisis (see Annex 2 : Medium Term Banking Strategy). This document draws on the Financial Sector Assessment and the RBI Annual Policy Statement, both o f which are public documents. World Bank teams have also discussed on more than one occasion the objectives and scope o f the programmatic D P L with a number o f India’s external development partners (outside o f the World Bank Group) that are active in the financial sector. These included the IMF, ADB, DfID, KfW and JICA.

F. IMPLEMENTATION, MONITORING AND EVALUATION

86. Monitoring and evaluation i s critical to measure outcomes and benchmark progress on achieving the objectives of the operation. The existing governance framework for banks consists o f two parts: (i) lending policy guidance, performance contracts, and majority ownership o f PSB, implemented through the Department o f Financial Services o f MOF, and (ii) prudential supervision by the RBI.

87. The Ministry of Finance will carry out the implementation, monitoring, and evaluation of the proposed program. The Department o f Financial Services in M O F will be the key nodal and coordinating agency for this operation. The outcome indicators identified in Table 14 will be monitored quarterly, with the Department o f Financial Services responsible for data analysis and reporting formats.

macroeconomic stance (central and general

framework o f the Government o f India

and international reserves for medium term

Annually, MOF

45

Credit Growth

Financial Sector Actions

Banking Sector Actions

(short and long term real interest rates, money growth, and stock market indices)

1. Growth o f PSB credit *

1. Increase in PSB filing returns through the online system

2. Maintenance o f appropriate capital adequacy level in PSB

1. Improved risk management through adoption o f stress testing frameworks in PSB

2. Improved corporate governance in PSB

*For monitoring purposes 21 PSB will be covered for these ind

Credit outstanding at PSB was Rs.20,082 billion at end-March 2009 Initiation o f filing online returns by PSB in 2008-09

Tier 1 CRAR o f minimum 6% and overall CRAR o f minimum 9% in PSB by end-March 2009 Initiation o f stress testing framework in PSB in 2008-09

Government has adopted “fit and proper” criteria for elected directors in all PSB in 2008-09 tors, excluding the six associ

Credit outstanding o f PSB i s consistent with the growth of nominal GDP Not less than 90% o f PSB filing online returns

Tier 1 CRAR of minimum 8% and overall CRAR o f 12% in at least 80% of PSB Not less than 90% o f PSB adopt stress testing framework

Government has adopted “fit and proper” criteria for nominated directors in all PSB ; banks of the State Bank of I

Quarterly, DFS

Annually, DFS

Semi- Annually, DFS

Annually, DFS

Annually, DFS

a

G. RISKS AND RISK MITIGATION

88. As the global financial downturn continues to unfold, the greatest risk to India i s to do nothing until it feels the full impact. India i s fortunate to be able to learn from the unfolding events in other countries and assess the ways in which countries have responded. In addition, the link between finance, confidence, and real sector impacts has become apparent, as well as the need for speedy action o n al l fronts. Through a series o f measures, one o f which i s this program, the Government o f India seeks to be proactive rather than reactive. Preemptively addressing the needs o f the economy and the financial sector should at the very least help to contain harm resulting from the downturn. That said, the project does face a number o f real and potential risks. A risk and risk mitigation matrix can be found at Annex 6.

89. Thus far, India has escaped much o f the slowdown felt in other countries, but continued weakness in the global environment could have a more adverse effect in the months ahead. India i s not immune. The risk o f further deterioration i s one the Government i s attempting to address through measures designed to keep the economy growing. However, there i s limited room for fiscal maneuver. Therefore, it i s important that budgetary resources to contain the slowdown in the economy adequately support the Government’s vigilance regarding economic and financial sector developments. I t s recent Financial Sector Assessment, based upon

46

the FSAP program o f the IMF and World Bank, addresses areas requiring greater attention. The results o f the assessment also demonstrate the strength o f the banking sector and the bank supervisor to operate and monitor PSB in a commercially based manner. However, the risks identified are, for the most part, ones for which the Government i s adequately prepared. The current situation presents more than usual risks because o f higher levels o f uncertainty and global linkages. I t i s r isks that rollover from this environment that are hardest for the country to address preemptively.

90. The specific macroeconomic and financial r isks relate to the effects o f the global slowdown and its domestic transmission. In addition to specific risks, external ratings agencies could downgrade India if concerns about the external payments or fiscal/domestic debt sustainability situations rise, especially in the context o f a prolonged global downturn. So far, the direct effect on the external accounts has been small on the real side, and l ikely to remain so, as a sharp drop in imports, resulting partly f rom the decline in price o f hydro-carbons, has offset the slowdown in goods and services exports. FDI inflows have picked up over the past few months, and there has been a return o f foreign institutional investor interest over the past few weeks, although s t i l l tentative and unreliable. The three uncertainties in the external payments situation pertain to (a) the effect o f a prolonged global slowdown on workers’ remittances; (b) adverse price movements in the markets for energy and food; and (c) the rollover r isk in external financial markets faced by large corporate borrowers. However, despite a decline in international reserves since late last year, their level i s s t i l l among the highest in the world. The domesticfiscal deficit, on the other hand, has widened, and the ability o f the Government to use fiscal policy tools to combat the slowdown i s more limited than before. Much before 2008, the Government had embarked on a program o f fiscal consolidation, revenue reform, and greater selectivity in expenditures (including subsidies). Parts o f this program have been affected by the need for macroeconomic stimulus and, as the Government has stated in i t s budget for 2009/10, some o f the earlier plans for fiscal consolidation are unlikely to be resumed as long as there i s a need for containing the effects o f the global crisis on India’s economy.

91. There i s a risk that the quality o f lending will deteriorate faster than projected. This risk i s associated closely with the depth and duration o f the broader economic slowdown. However, it also depends on the ability o f the PSB not only to maintain lending to support economic activity, but also to do this without a sharp deterioration in the quality o f their portfolios. Often, the incentives to push lending are greater than those for managing credit quality. Government owned banks in many economies, while capable o f quickly supporting national plans for economic growth and macroeconomic stimulus, often find themselves suffering from financial distress a few years later due to poor underwriting and risk management standards applied to loan portfolios. The Government o f India has shown over the past years the ability to include social pol icy lending in i t s PSB, while at the same time pushing for high quality loans. The incentives are much the same today. However, there i s likely to be an increase in NPA as a result o f corporate and consumer distress. The Government has conducted stress tests, confirmed by the World Bank and others, based upon assumptions regarding different levels o f NPA appearing during 2009-201 1 in PSB balance sheets. These stress tests have been used to estimate the capital needs o f the PSB. Annex 6 identifies the specific risks associated with lending and portfolio quality, and the measures in place or to be put in place to address them.

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Annex 1: Letter o f Development Policy

To S M Robert 6. Zoellick President The World Bank 1818 H Street, NW Washington, DC 20433 USA

Sub: Letter of Development Pollcy

Sir

On behalf of the Government of India. 1 am writing to request you far the Worid Bank's support for our economic stimulus program in the face 3f the currenl global economic crisis. Over the past several months, the Government and the World Rank have been collaborating in an effort to process a Development Policy Loan, the Firs1 Banking Sector Support Loan (BSSL). Wilh extraordinary collaborative efforts on both sdes, the Program Document for the proposed BSSL has been completed. The BSSL wll play an intqral and Irne'y part in the Government's cveratl r e s p s e Lo the current global crisis and Its impact On India.

Over the past several years India has experlenced strong economic growth leading to R now being among the top 10 largest economies. This cbccmxnic growth has been suppofted by increasing investment and savngs. Corporate profitability has grown very strongly since early 2001. The growth also reflects India's increased integration witti the world economy. This integration helped to prowde the exlernal resources needed to supplement the internal financral resources far supporting rapid economic growth.

The financial crisis, which began in the developed world, has had en impact on India Although lndi has continued to experience economic growth. the speed of growth has slowed Access to international financing by many of aur corporate entities, who employ a sizeable number of people and contribute in many other ways to the economy, has become diffrarlt to obtatn. Domestically. private banks have sigrnficantly reduced their lending, which has resuited in many busrnesses and people fmdtng it difficult to access credit

She Government has responded rapidly and aggressively lo the external shocks through a series of monetary, fiscal trade and financial sedar measures !hat safeguard econanic activity levels and assist vulnerable 8ectors. The policy initlarives of the Government and the Reserve Bank of India (RBI) have been directed at providing adequate rupee liquidity ensurmg a comfortable level of dollar liquid&. safeguarding public expenditures in core souat and economic sub-sectors and maintaining a market environment amenable to the continued R o w of credit to pmductive SW~OK

Following the onset of the current global crisis. lndra experienced a slowdown in credit growlh The slawdown wes most apparent among our foreign and doiyiestic private sector banks thst for several reasons, have experienced a reduction in the growth of lending and

48

deposit taking. The risk to scmomic grawth became readily apparent in the tast half of 2008- 09 One component of the Government's overall stimulus program seeks to address this weakness through the provision o i capital to sound pubk sector banks to he@ maintain credit growth. This, we believe, will contain the possible adverse effects on employment and poverty and enable India's businesses to contrnue to enhance their competitiveness and prepare for recovery.

The proposed BSSL is an integral component of the Government's overall response, It will provide budgetary support la fufiher implement our economic stimufus prqram and will enable us to wntinue our program of providing deeper capital buffers for the public banks to maintain the high confidence of the public in the banking sector, prevent shortages of capital ftom leading to a further slowdown in credii growth, and provide a buffer to absorb non- performing assets (NPA) that may result from the slowdown.

With regard to the progressive development d !he banklng sector md fmancial service delivery. which are a key poky focus of the Government we have made significant progress over the past decade This is strongly evidenced by the current strength and diversfition of Uie banking sector, and the increase in finanaal inclusion. India's banking sector has undertaken comprehensive refonns under the leaderahip of the RBI. The result has been a stable banking sector, with high proftabrfity and adequate capital, combined with the ability to expand credit in line with the needs of the growing economy. Measiires were intraduGed to commercialire the pubfic sector banks, resulting in much stronger balance sheets, stronget lending practices and a significant reducm in their NPA.

In addition to helping maintein an appropriate macroeconomic stance, the BSSL win facw an implementing measures in several areas that will bolster the effectiveness of capital injections to the banks. These we: I) ensuring quality credit growth: it) strengthenin0 prudentfal norms for the banking W o r ; i t i ) improving govemmm; and tu) improving fisk management at banks.

The BSSL will play an important role by providing budgetary support to the Government's pmgm to contain the impact of the current global crisis. Th8 year will likely bring ditkultbs but, despite the circumstances, the Government of India remains committed to restoring high economic growth and continuing further devefopment of the bankrng sector. We have recently taken steps which will help to guide future banking development, including a review 61 the needs of the banking sector and a self assessment based upon the prlnciples of the formal FSAP of the IMF and World Bank. In addition, Included in the program document is OUT strategy note, which furlher points io our continued suppor: for reform and strengthening of the banking sector.

Therefore, I slncere'ly hope the Government of India's request for a collaborative approach through a Development Policy Loan will be considered fawrabty and promptly by the World Bank.

Yuur kind cooperakin is, a8 always, very mwh appreciated.

Yours faithfully,

$32325 (Tarun Bajaj)

Joint Secreta;

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Annex 2: Medium-Term Banking Policy Framework41

A. K e y Banking Sector Reforms o f the Past

The main objective o f the financial sector reforms in India initiated in the early 1990s was to create an efficient, competitive and stable financial sector that could then contribute in greater measure to stimulate growth while not losing sight o f the need for financial inclusion o f the under-privileged. Concomitantly, the monetary pol icy framework made a phased shift from direct instruments o f monetary management to an increasing reliance on indirect instruments. However, as appropriate monetary transmission cannot take place without efficient price discovery o f interest rates and exchange rates in the overall functioning o f financial markets, the corresponding development o f the money market, Government securities market and the foreign exchange market became necessary. Reforms in the various segments, therefore, had to be coordinated. In this process, growing integration o f the Indian economy with the rest o f the world also had to be recognized and provided for.

The reforms process also initiated measures for improving the productivity, efficiency and profitability o f the banking system. The operational rigidities in credit delivery system were addressed to ensure allocational efficiency and achievement o f social objectives.

Banking sector reforms in India have been based on five fundamentals: strengthening o f prudential norms and market discipline, appropriate adoption o f international benchmarks, management o f organisational change and consolidation, technological upgradation, and human resource development. A hallmark o f the entire financial sector reform process has been the element o f “considered calibration”, with due consideration o f timing, pacing and sequencing, fol lowing extensive consultations with the stakeholders at each stage. Deregulation, technological upgradation and increased market integration have been the key factors driving change in the financial sector.

The sustained reform measures over a period o f last fifteen years have resulted in the transformation o f the Indian banking sector into a reasonably strong, diverse and resil ient system. The major initiatives undertaken may be categorised under deregulation, prudential measures and approach to supervision, competition and enabling measures.

Government o f India and the Reserve Bank o f India have initiated a number o f steps to bring wide-spread reforms in the banking sector to enable the Indian banking system to grow and become more competitive. RBI has prescribed measures for strengthening prudential supervision coupled with wide ranging steps undertaken by the Government to improve the health o f the banking sector. After initiation o f reforms in early 1990s, financial performance of the banking sector in general and public sector banks in particular has improved significantly. Balance sheet and profitability indicators viz. funding volatility ratio, return on assets, net interest margin, post income ratio, N P A ratio, provisioning and classification norms for NPAs,

This framework has been prepared by the Ministry o f Finance, Government o f India. 41

50

capital adequacy ratio etc. suggest that the Indian banking sector now compares wel l with the global benchmarks. To facilitate quick and efficient decision-making and to provide flexibility needed for them to compete internationally, the Government announced an Autonomy Package on 22.02.2005 for the public sector banks (PSB). Further, the Government has put in place a mechanism to monitor the performance o f al l PSB on the basis o f the ‘Statement o f Intent on Annual Goals’ submitted by them.

A number of steps have been taken to make banking more customer friendly viz. introduction o f Core Banking Solutions (CBS), installation o f ATMs, enhanced working hours, simplification o f procedure and forms, IBA guidelines on Fair Practices Code, RBI guidelines on credit card operations etc. The Recovery o f Debts Due to Banks & Financial Institutions (DRT) Act, 1993, and the Securitisation and Reconstruction o f Financial Assets and Enforcement o f Security Interest (SARFAESI) Act, 2002 has been enacted to facilitate quick and effective recovery o f non-performing assets. The Credit Information Companies (Regulation) Act, 2005 has been enacted to facilitate setting up o f credit information companies for collection, sharing and dissemination o f credit information, which will help in arresting the fresh accretion o f N P A and to significantly improve the quality o f credit appraisals and decisions.

For the orderly presence and growth o f foreign and private sector banks in India, RBI issued guidelines titled “Road Map for Presence o f Foreign Banks in India” and “Ownership and Governance o f Private Sector Banks” on 28..02.2005. RBI has also issued guidelines for consolidation in the banking sector to facilitate voluntary merger among private sector banks, and between NBFCs and the private sector banks. To further accelerate the process o f reforms in the banking sector, the Government has amended the RBI Act, 1934 and the Banking Companies (Acquisition & Transfer o f Undertakings) Act, 1970/80. Amendments have also been proposed in the Banking Regulation Act, 1949.

B. Broader Financial Sector Development

The most notable impact o f financial sector reforms i s clearly discernible in the development o f various segments o f financial markets in India. The reforms since the early 1990s have led to a regime characterised by market-determined interest and exchange rates, price-based instruments o f monetary policy, current account convertibility, substantial capital account liberalisation and vibrant government securities and capital markets. Derivative instruments have been cautiously introduced in a phased manner, both for product diversity and, more importantly, as a risk management tool. All these developments have facilitated the process o f price discovery in various financial market segments.

It i s widely recognised that the Indian financial sector over the last decade has been transformed into a reasonably sophisticated, diverse and resilient system. I t delivers a wide variety o f financial services efficiently and profitably, with a spectrum o f financial market segments in which financial institutions are able to participate with operational and functional autonomy in an environment o f increasing deregulation and international competition. The acceleration o f growth in the real economy suggests that the financial system has served wel l the overall needs o f the economy. During this period, the global financial environment has become more risky because o f new instruments and participants, and there have been rapid advances in

51

communication technology that integrate markets worldwide. A unique feature o f the Indian reform process i s that it has been instituted and carried forward with the objective o f sustaining ' and accelerating the growth momentum while containing risk and entrenching financial stability.

C. Current Structure of the Banking Sector

In the post-reform period, banks have experienced strong growth o f business in an environment o f operational flexibility. Concomitantly, the financial health o f banks has improved significantly, both in terms o f capital adequacy and asset quality. Moreover, this progress has been achieved while setting the groundwork for the adoption o f international best practices in prudential and accounting norms. Increased competitiveness and productivity gains have also been enabled by proactive technological deepening and flexible human resource management. These significant gains have been achieved even while renewing our commitment to social banking viz., maintaining the wide reach o f the banking system and directing credit towards important but disadvantaged sectors o f society. The banking system's wide reach, judged in terms o f expansion o f branches and the growth o f credit and deposits indicates continued financial deepening.

Restoration o f the health o f the banking system has involved:

0

0

0

0

0

e

0

e

0

0

..

Restoration o f public sector banks' net worth achieved through recapitalization where needed (total cost less than one per cent o f GDP). Competition increased through entry o f new private sector banks and foreign banks. Higher levels and standards o f disclosure achieved to enhance market transparency. Bank regulation and supervision strengthened towards international best practice. Micro prudential measures instituted. Supervision process streamlined with combination o f on-site and off-site surveillance along with external auditing. Risk based supervision introduced. Process o f structured and discretionary intervention introduced for problem banks through a prompt corrective action mechanism. Ownership o f public sector banks has been broadened through disinvestment up to 49 per cent, and banks have been listed. Mechanism for greater regulatory coordination instituted for regulation and supervision o f financial conglomerates. Measures taken to strengthen creditor rights.

In consonance with the objective o f enhancing efficiency and productivity o f banks through greater competition, there has been a consistent decline in the share o f public sector banks in total assets o f commercial banks. Nevertheless, public sector banks appear to have responded to the new challenges o f competition, as reflected in their increased share in the overall prof i t of the banking sector. This suggests that, with operational flexibility, public sector banks are competing relatively effectively with private sector and foreign banks. Shares o f Indian private sector banks, especially new private sector banks established in the 1990s, in the total income and assets o f the banking system have considerably increased over time.

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Significant improvement in the performance o f public sector banks has been witnessed over the past decade or so, facilitated by the phased introduction o f wide-ranging financial sector reforms since the early 1990s. Gradual introduction o f best international practices and norms, refinements in the supervisory practices, tightening o f risk weights/provisioning norms in regard to sectors witnessing high credit growth, greater market discipline brought about by raising o f capital from the capital markets and listing on the stock exchanges, interest rate deregulation, and scaling down o f statutory pre-emptions are amongst the key factors that have led to better performance. Concomitantly, greater competition has been induced in the domestic banking sector by successful introduction o f new generation private sector banks. Despite strong growth in balance sheets o f the new banks, the banking system has exhibited remarkable stability.

D. Current Performance of the Banking Sector

O n the liability side, deposits continue to account for about 80 per cent o f the total while on the asset side, the shares o f loans and advances and investments have seen marked cycles, reflecting banks' portfolio preferences as well as growth cycles in the economy. In this regard, while the share o f loans and advances declined in the second hal f o f 1990s on account o f the industrial slowdown as well as tightening o f prudential norms, banks' credit portfolio has witnessed sharp growth in the period 2003-07. The overall capital position o f commercial banks has witnessed a marked improvement during the reform period (Table 1). Illustratively, as at end-March 2009, al l 81 scheduled commercial banks operating in India maintained CRAR at or above 9 per cent relative to the Basel I norm o f 8 per cent. For the Indian banking system, the ratio o f capital to risk weighted assets works out to 13 per cent currently. While improved capitalization o f public sector banks was initially brought through infusion o f funds by government to recapitalize these banks, subsequently, public sector banks were allowed to raise funds from the market through equity issuance subject to the maintenance o f 51 per cent public ownership. As a result, ownership in public sector banks i s now wel l diversified.

Table 1: Distribution o f Commercial Banks According to Risk-weighted Adequacy

1996 8 9 33 42 92 2001 3 2 11 84 100 2007 2 79 81 20093' 81 81 l' Relates to 4 4 % before 1999-2000.

Relates to &lo% before 1999-2000. - As per Basel 2 norms. 31

Despite tightening prudential norms in terms o f classification o f non-performing assets, the resulting measured asset quality o f banks has improved considerably as the share o f non- performing loans (NPLs) (as ratios o f both total advances and assets) have declined substantially and consistently since the mid-1 990s. In fact, the ratio o f net NPLs to net advances at 1 .O per cent in India i s now comparable to that o f several advanced economies. Improvement in the credit appraisal process, upturn o f the business cycle, new initiatives for resolution o f NPLs

53

(including promulgation o f the Securitization and Reconstruction o f Financial Assets and Enforcement o f Security Interest (SARFAESI) Act), and greater provisioning and wr i te o f f o f NPLs enabled by greater profitability, have contributed to the reduction in incremental NPLs.

Among the banks groups, the balance sheets o f foreign and new private sector banks expanded at a higher rate as compared with other bank groups. As a result, the combined share o f foreign and new private sector bank groups in total assets o f SCBs increased further to 25.6 per cent at end- March 2008 from 24.8 per cent at end-March 2007. The growth rates in the assets o f public sector banks and old private sector banks during 2007-08 at 23.9 per cent and 21.2 per cent, respectively, were higher than those during the previous year. However, their assets grew at a lower rate than those o f SCBs as a whole. The impact o f differential growth rate across different banks groups was broadly reflected in their market shares in terms o f major indicators o f balance sheets.

E. Strategy During the Recent and On-Going Global Financial Crisis

The genesis o f the present global financial crisis l ies in the housing sector meltdown in the US since mid-2005. Against the backdrop o f the US sub-prime crisis and i t s spillover in global financial markets and, eventually, the global trading system, the Reserve Bank o f India (RBI) initiated a series o f meetings with fifteen major banks in the month o f September 2007, to assess i t s impact on banks in India and take necessary remedial measures. Further, to ensure uninterrupted and adequate credit to the productive sectors o f economy, RBI and the Government have taken some pro-active measures to provide rupee and foreign exchange liquidity as well as credit to the production and trade sectors, and three fiscal stimulus packages.

The detailed notifications/press releases issued by Government and RBI that describe these measures, are available at websites www.pib.nic.in and www.rbi.ora.in respectively.

In the context o f a slowdown o f the economic growth in 2008-09 due to global financial crisis, a major challenge i s to support the drivers o f aggregate demand to enable the economy to return to i t s high growth path.

The second challenge i s to ensure that the credit needs o f the non-food sector are adequately met. Although, for the year 2008-09 as a whole, credit by the banking sector expanded, the pace o f credit f low decelerated rapidly from i t s peak in October 2008. This deceleration has occurred alongside a significant decline in the f low o f resources from non-bank domestic and external sources. The deceleration in total resource f low partly reflects slowdown in demand, drawdown o f inventories by the corporates and decline in commodity prices. There i s an urgent need to increase the f low o f credit to al l productive sectors o f the economy, particularly to MSMEs, to support the process o f economic recovery. The Reserve Bank o f India continues to maintain and will maintain ample liquidity in the system. I t should be the endeavor o f commercial banks to ensure that every creditworthy borrower i s financed at a reasonable cost while, at the same time, ensuring that credit quality i s maintained.

We will have to address the key challenge o f ensuring an interest rate environment that supports revival o f investment demand. Since October 2008, as the inflation rate has decelerated and the

54

policy rates have been reduced, market interest rates have also come down. However, the reduction in interest rates across the te rm structure and across markets has not been uniform. Given the cost plus pricing structure, banks have been slow in reducing their lending rates citing high cost o f deposits. There i s scope for the overall interest rate structure to move down within the pol icy rate easing already effected by the Reserve Bank o f India. Further action on policy rates i s now being taken to reinforce this process. Recently several commercial banks have announced cuts in the lending rates.

A continued challenge i s to preserve financial stability. A sound banking sector, well- functioning financial markets and robust payment and settlement infrastructure are the pre- requisites for financial stability. The banking sector in India i s sound, adequately capitalised and well-regulated. By al l counts, Indian financial and economic conditions are much better than in many other countries o f the world. The single factor stress tests carried out as part o f the report o f the Committee on Financial Sector Assessment (CFSA) have revealed that the banking system in India can withstand significant shocks arising from large potential changes in credit quality, interest rate and liquidity conditions. These stress tests for credit, market and liquidity risk show that Indian banks are generally resilient.

Keeping in view both international and domestic initiatives in the financial sector, RBI has proposed the fol lowing in the Annual Policy Statement for 2009-10:

To constitute a Task Force to look into al l the issues that have arisen with regard to the G-20 Working Groups and the report o f the CFSA and suggest follow-up actions relevant for the Reserve Bank in the domestic context on an on-going basis, for every quarter; In consultation with al l regulators and the Government to consider the setting up of a Working Group to implement the recommendations o f the CFSA; To set up a Financial Stability Unit in the Reserve Bank drawing upon inter-disciplinary expertise from supervisory, regulatory, statistics, economics and financial markets departments for carrying out periodic stress testing and for preparing financial stability reports.

In February 2005, the Government o f India and the Reserve Bank released the ‘Roadmap for Presence o f Foreign Banks in India’ laying out a two-track and gradualist approach aimed at increasing the efficiency and stability o f the banking sector in India. One track was the consolidation o f the domestic banking system, both in private and public sectors, and the second track was the gradual enhancement o f the presence o f foreign banks in a synchronized manner. The roadmap was divided into two phases, the f i rs t phase spanning the period March 2005 - March 2009, and the second phase beginning April 2009 after a review o f the experience gained in the first phase.

In view o f the current global financial market turmoil, there are uncertainties surrounding the financial strength o f banks around the world. Further, the regulatory and supervisory policies at national and international levels are under review. In view o f this, it i s considered advisable, for the time being, to continue with the current policy and procedures governing the presence o f foreign banks in India. The proposed review will be taken up after due consultation with the stakeholders once there i s greater clarity regarding stability, recovery o f the global financial

55

system, and a shared understanding on the regulatory and supervisory architecture around the world.

The G-20 Working Group on Enhancing Sound Regulation and Strengthening Transparency has recommended, as a part o f measures to mitigate procyclicality that capital buffers above minimum requirements and loan loss provisions should be built up in good times in order to enhance the ability o f the regulated financial institutions to withstand large shocks. This would require modification in the Reserve Bank’s circular o f June 22, 2006. The Reserve Bank has been encouraging banks to build floating provisions as a buffer for the possible stress on asset quality later. The following i s proposed in the Annual Policy Statement for 2009-10:

To issue further detailed guidelines on mitigating procyclicality later this year after FSB, BCBS and Committee on Global Financial System (CGFS) finalize their recommendations in this regard.

In the Mid-Term Review o f October 2008 by RBI, it was indicated that the Reserve Bank o f India would be upgrading the stress testing guidelines. Subsequently, the BCBS has issued a paper o n ‘Principles for Sound Stress Testing Practices and Supervision’ in January 2009 for comments. The paper draws lessons for banks and supervisors emerging from the financial crisis and addresses weaknesses in stress testing, including the specific areas o f risk mitigation and risk transfer. In this context, the CFSA has recommended that there i s a need for the banks themselves to carry out such periodic stress testing. It i s proposed to upgrade the stress testing guidelines once BCBS finalizes the paper based o n comments received.

F. Long T e r m Strategy for the Banking Sector

Banking sector reforms initiated by the Government have been directed towards enhancing efficiency and productivity o f banks, providing additional options for augmentation o f capital o f banks for smooth transition to Basel I1 norms, ensuring smooth and risk free functioning o f payment and settlements system, encouraging use o f advance technology in banking operations with minimum risks and according priority to financial inclusion. The operational rigidities in credit, delivery system were addressed to ensure allocational efficiency and achievement o f social objectives.

The long term strategy for the banking sector includes further strengthening o f prudential guidelines, supervision for growth o f healthier banking system in India. For orderly growth, a calibrated approach has been adopted by Government and RBI to diversify ownership, improve corporate governance, minimize fragmentation and increase accountability. The strategy will broadly proceed on the already carved growth trajectory.

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G. Priorities

Some o f the priorities and challenges for banking sector could be given as follows:

Containment o f operating expenses

Cost containment i s a key to sustainability o f bank profits as wel l as their long-term viability. In 2005, operating costs o f banks as a proportion o f total average assets was less than 2 per cent in major European economies like Sweden, Austria, Germany and France. In India, however, in 2006, operating costs as proportion o f total assets o f scheduled commercial banks stood at 2.1 per cent. The tasks ahead are thus clear and within reach. The operating cost o f banks would further come down with the increased use o f technology, branch and office network rationalization as also by increasing productivity by way o f rationalization o f manpower and tasks.

Pricing o f credit

While there i s intense competition among banks to lend to large top-rated borrowers, other borrowers with long standing relationship with banks and good credit record do not get the benefit o f lower rates. I t i s desirable that banks should align the pricing o f credit to assessment of credit risk so that credit delivery and credit culture i s improved. As such, risk profiling o f borrowers i s also required for allocation o f capital under Base1 I1 apart f rom being desirable from the point o f view o f risk management and efficient use o f capital. Hence, banks were asked to take steps for putting in place comprehensive and rigorous risk assessment o f borrowers using the database available with them, as also other internal and external factors so that the pricing o f credit i s related to risk more appropriately. The rating models o f the banks are being strengthened, based on experience and data mining. Further, external ratings are being increasingly used in appraising the risk o f borrowers.

Credit delivery

I t has been the endeavor o f RBI to improve the agricultural/rural/SSI sector credit delivery mechanism by bridging the gap between banking institutions and the demand for timely credit. RBI had initiated several measures to create a conducive environment for banks to provide adequate and timely finance at reasonable rates to different sectors o f the economy, and to remove bottlenecks in credit delivery mechanism. The measures include, inter alia, simplifying procedures, encouraging decentralized decision-making and enhancing competition. RBI has been acting as a catalytic agent in initiating appropriate changes in institutional and procedural arrangements for the smooth f low o f credit to agriculture and S S I sector. The Government has embarked upon a very ambitious programme o f strengthening the rural credit structure through amalgamation and mergers o f RFU3s and strengthening o f the co-operative credit structure through recapitalization and governance and institutional reforms. Further, credit to the agricultural sector i s being ensured through credit targets and finance and refinance support.

NPA management

This i s a key to the stability o f the banking sector. Indian banks have done a remarkable job in containment o f non-performing loans (NPL) considering the overhang issues and overall difficult

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environment. The low net NPL ratio for the Indian scheduled commercial banks at 1.2 per cent i s ample testimony to the impressive efforts made by our banking system. NPAs have two components: the overhang component and the incremental component. The overhang component arises due to in f i rmi t ies in structural and institutional environments while incremental component arises from factors internal to banks' management and credit culture. Appropriate legal, institutional and judicial framework i s essential for resolution o f the overhang component o f the NPAs and this holds the key to health and competitiveness o f the Indian banks. The recent legal initiatives to put in place effective Debt Recovery Tribunals (DRTs) and ARCS and credit information companies are expected to bear fruits over the next few years as they will adequately strengthen creditors' rights and enthuse the lenders to meet the credit needs o f the productive sectors based purely on merit o f credit proposals.

In order that there is no dilution in credit discipline and international best practices in income recognition, asset classification and provisioning are followed by banks in India, RBI and Government o f India have been consistently advocating market-based solutions for resolution o f overhang o f impaired assets. Market participants are being encouraged to seek resolution through creation o f privately held asset reconstructiodsecuritization companies.

Technology in banking

Issues relating to technology in banking are o f paramount importance in view o f their relationship with productivity, efficiency, and customer satisfaction. Technology has brought about manifold changes in a number o f major areas o f bank functioning, such as management o f risks, reduction in trysact ion costs, diversification o f portfolio, improvements in credit delivery, efficient MIS and providing value added service to customers. The Reserve Bank o f India has been playing a pivotal role in the upgradation o f technology in the banking sector with the objective o f putting in place a safe, robust, efficient and integrated payment and settlement system. Notwithstanding the rapid strides made over the last few years, the percentage o f customers using online banking i s less in India compared with 6-30 per cent range in developed economies. I t is wise for Indian banks to exploit the global state-of-art expertise, domestically available, to their ful lest advantage.

Risk management

Banking in modern economies i s al l about risk management. The successful implementation o f Basel I1 i s likely to lead to an even sharper focus on risk management at the institutional level. The Basel Committee has, through i t s various publications, provided useful guidelines on managing the various facets o f risk. The institution o f sound risk management practices would be an essential pre-requisite for staying ahead o f the competition. Banks are encouraged to focus on capacity building and undertake analyses o f their risk exposures and their risk management systems. O n the basis o f the outcome o f the analyses, banks may redefine their business strategy and risk management strategy with a view to altering their profile o f risk exposures or adopt a combination o f both.

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Governance

New private banks and foreign banks have been granted licenses in order to allow the financial system to benefit from greater competition through better technology, specialized skills, better risk management practices, greater portfolio diversification relating to treasury operations and deepening of the financial markets. The concentrated shareholding in banks controlling substantial amount of public funds poses the risk o f concentration o f ownership given the moral hazard problem and linkages o f owners with businesses. Corporate governance in banks has therefore become a major issue. Diversified ownership becomes necessary to provide balancing stakes. I t has been our experience that broad-based ownership o f banks leads to increased representation o f institutional and individual shareholders and encourages better corporate governance. The quality o f corporate governance in the banks becomes critical as competition intensifies, banks strive to retain their client base, and regulators move out o f micro-regulation. Banks are special as they not only accept and deploy large amount o f uncollateralized public funds in fiduciary capacity, but they also leverage such funds through credit creation. The RBI has, on i t s part, made significant efforts to improve governance practices in banks, drawing upon international best practices. RBI had based on the feedback received from the public on draft guidelines and in consultation with the Government issued final guidelines on the policy framework for ownership and governance in private sector banks. These guidelines focus on ensuring 'fit and proper' criteria for directors and shareholders, on a continuous basis, restructuring and consolidation in the banking sector and provide for observance o f sound corporate governance principles. Corporate governance presently finds explicit mention in the annual reports o f several banks. The improved corporate governance practice would also provide an opportunity to accord greater freedom to the banks' boards and move away from micro regulation to macro management.

Ownership

The current statutory and other provisions require that the Government shall not hold, at any time, less than 51% o f the equity capital o f nationalized banks and IDBI Ltd, and 55% o f the equity capital o f SBI. Further, the provisions contained in Section 3(2D) o f the Banking Companies (Acquisition and Transfer o f Undertaking) Act, 1970/80 provide that the shares o f the Central Government in nationalized banks are not transferable. There i s presently no proposal to disinvest Government shareholding in public sector banks beyond the legally mandated permissible minimum thresholds, and this situation i s not foreseen to change in the near future. In the medium term, a calibrated approach has been adopted by Government and RBI to diversify ownership, primarily with a view to allow these banks to raise capital from the capital markets.

Consolidation

The Narasimhan Committee on Financial Sector Reforms, in i t s report in 1991 , had suggested consolidation in the banking sector and had, inter alia, suggested that India should have 4-5 large banks, 6-8 medium size banks and 10-12 regional banks. The Government views consolidation as a timely response to augment efficiency through better management o f risks, leveraging economies o f scale in terms o f manpower and footprint, and improved ability to face

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competition. Raising o f funds i s not the major criteria for consolidation o f banks, rather the major considerations are generally o f the nature o f systemic benefits and advantages accruing to the residual entity, business considerations such as synergies and need for increasing market share. However, the Government i s o f the view that the initiatives for consolidation emanate from the management o f the individual banks with the Government playing a supportive role as a common shareholder. While supporting any merger proposal, the Government will keep in view the interests o f the shareholders and employees o f the merging banks.

H. Uncertainties, Risks and Mitigation Plans

In the Report on Trend and Progress of Banking in India 2007-08 released on 17.12.2008, the Reserve Bank o f India (RBI) indicated that while the financial system as a whole i s quite robust, there i s a need to be aware o f certain downside r isks in certain areas, which could have a bearing on the stability o f the financial system in the near future, such as adverse international developments, moderation in growth and asset prices. The adverse global developments have led to moderation o f growth in industrial and services sectors in the f i r s t ha l f o f 2008-09. O n the growth front, it i s important to ensure that credit requirements for productive purposes are adequately met so as to support the growth momentum. The Report indicated that the RBI has kept a close vigil on the entire financial system to prevent pressures f rom building up in the financial markets. This included liquidity enhancing measures to ease liquidity pressures.

Developments in the global financial system have heightened the uncertainty in the global economy. The banking sector in India does not have any direct exposure to the US sub-prime market. Some banks have an indirect albeit not very significant exposure to the distressed assets and financial institutions. However, there are indications o f some impact o f the global developments on the Indian economy. There are indications that current crisis could raise funding costs and difficulties in raising external finance particularly for l o w rated f i rms. Further, there has been an impact o f the crisis on the capital account o f the Indian economy. During April to October 2008, there were net outflows o f portfolio investments by Foreign Institutional Investors. The slowdown in capital flows could affect the economy through several ways, such as (1) decline in equity markets and resultant difficulty in raising capital f rom the market; (2) sharp realignment o f exchange rates; (3) tightening o f liquidity conditions; (4) hard lending o f credit cycle.

The recent global financial turmoil caused by the crisis in the mortgage market in the U S has once again brought into focus the linkages among real estate cycles, bank crisis and the ultimate threat to financial stability. The major portion o f real estate exposure consists o f mortgage related assets, which are long-term in nature having dynamic cash f low characteristics, which render them as risky ventures. The Report indicated that it i s therefore imperative that banks manage the balance sheet risks associated with real estate exposure, particularly in the current scenario o f slowdown in the economy with i t s expected ramifications on real estate prices. In India, asset prices both, real estate and equity, rose sharply since the beginning o f 2005. Over the years, banks in India have enlarged their exposure to real estate market. The rapid increase in real estate loans raises concerns about asset quality and potential systemic risks. The Reserve Bank alerted banks about early signs o f overheating o f the Indian economy during 2006-07 on the back o f some evidence o f firming up o f demand pressures, in particular, the combination o f

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higher growth and consumer inflation coupled with escalating asset prices and tightening infrastructural bottlenecks,

In view o f the risks posed by accelerated exposure to real estate sector, the Reserve Bank initiated several regulatory measures including prescribing higher risk weights, disclosure and reporting o f real estate exposure in balance sheets and even revising the definition o f real estate exposure. Several measures were taken to prevent/contain the frauds in the area o f housing loans.

I. Overall Assessment o f Banking Sector in India

The assessment o f the Indian financial system during 2007-08 indicates that the banking sector in India continues to be healthy, sound and resilient. The profitability o f the banking sector, which has shown remarkable resilience in the last few years, improved further during the year. Their capital position i s also strong and they are less leveraged than they were a few years ago. The performance indicators such as operational efficiency, asset quality and soundness indicators o f the Indian banking system currently compare well with the global standards. Although non- performing loans in absolute terms increased during the year, showing a reversal o f the trend observed during the last few years, the gross N P A ratio (gross NPAs as percentage o f gross advances) continued to decline. Even though the credit risk environment i s becoming somewhat uncertain, highlighting the significance o f NPA management, banks with comfortable capital buffers appear to be in a better position to withstand any shock on their balance sheets arising out o f evolving macro-economic environment.

Financial Stability in India

As per assessment o f RBI in i t s Report, Financial stability in India has been achieved through perseverance o f prudential policies which prevent institutions from excessive risk taking, and financial markets from becoming extremely volatile and turbulent. The policy stance o f the Reserve Bank i s aimed at assuring financial stability, while maintaining the growth momentum at reasonable levels and giving a high priority to price stability. The relative stability in domestic financial markets, despite extreme turmoil in the global financial markets, i s reflective o f prudent practices, strengthened reserves and the strong growth performance in recent years in an environment o f flexibility in the conduct o f policies. Active liquidity management i s a key element o f the current monetary policy stance. Liquidity modulation through a flexible use o f a combination o f instruments has, to a significant extent, cushioned the impact o f the international financial turbulence on domestic financial markets by absorbing excessive market pressures and ensuring orderly conditions. India, with i t s strong drivers o f growth, may escape the worst consequences o f the global financial crisis. Once the global situation i s stabilized, and calm and confidence are restored, India would return to the high growth trajectory. The Government o f India and Reserve Bank o f India are well poised to adequately address any uncertainty arising out o f the current global financial crisis and associated risks.

Outlook

The Reserve Bank would continue with various regulatory and supervisory initiatives to strengthen the domestic financial sector in order to maintain financial stability. In consonance with the aim o f benchmarking the Indian financial sector with the international best practices,

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commercial banks in India have begun implementing Basel I 1 from March 2008 onwards. In order to strengthen the risk management in banks, the credit derivatives are being introduced in a calibrated manner, taking into account the risk management systems in banks and their state o f preparedness for Basel 11. The principles for accounting o f derivatives are also being finalized. In view o f the fast pace o f deregulation, liberalization and the emergence o f financial conglomerates, the supervisory process i s being constantly fine-tuned to ensure that adequate cognizance i s given to the complexities o f organizational structures, business processes and risk positions o f the banks. The focus i s on risk based supervisory framework and smooth migration to Basel I1 that will require appropriate capacity building in the Reserve Bank as well as in the banks. While strengthening the regulatory and the supervisory framework, the Reserve Bank will continue to persevere with i t s efforts towards greater financial inclusion and improvement in customer services provided by the banking sector.

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Annex 4: Recent Financial Sector Policy Initiatives4*

1. India has exhibited clear signs o f stress as a result o f the crisis. The Interim Budget for 2009-10 has revised the revenue deficit estimate for 2008-09 to 4.4 per cent o f GDP as against the budget estimate o f 1.0 per cent, and the fiscal deficit to 6.0 per cent o f GDP as against the budget estimate o f 2.5 per cent. Further, the revenue deficit and the fiscal deficit are projected to decline only moderately to 4.0 per cent and 5.5 per cent respectively during 2009-10. The year- on-year growth in reserve money, as wel l as annual M3 growth, was much lower in 2008-09 than in 2007-08. The combined market borrowings o f the Central and State Governments in 2008-09 were nearly two and hal f times their net borrowings in 2007-08.

2. As a result, since the onset o f the crisis, India has changed i t s stance from supporting expansion to moderating inflation and preserving financial stability while arresting the economic slowdown. The Government and RBI have undertaken a series o f measured monetary and fiscal pol icy responses since September 2008 which were designed largely to mitigate the adverse impact o f the global financial crisis and slowdown.in OECD demand on the Indian economy. Consequently, the thrust o f the various pol icy initiatives by the Government and RBI has been on providing adequate rupee liquidity, ensuring comfortable dollar liquidity and maintaining a market environment amenable to the continued f low o f credit to productive sectors.43 The key pol icy initiatives are as follows:

Monetary policy measures

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Policy Rate cuts

The rep0 rate under the liquidity adjustment facility (LAF) was reduced by 400 basis points in five steps - from 9.0 per cent in October 2008 to 5.0 per cent in March 2009. The reverse rep0 rate under the LAF was reduced by 250 basis points in three steps - from 6.0 per cent in December 2008 to 3.5 per cent in March 2009.

Rupee Liquidity

The cash reserve ratio (CRR) requirement was reduced by 400 basis points in three steps - from 9.0 per cent o f net demand and time liabilities (NDTL) o f banks in October 2008 to 5.0 per cent in January 2009. The statutory liquidity ratio (SLR) requirement was reduced from 25.0 per cent o f NDTL to 24.0 per cent in November 2008. The export credit refinance limit for commercial banks was enhanced to 50.0 per cent from 15.0 per cent o f outstanding export credit.

42 M u c h o f the material in this Annex i s based o n the RBI Annual Pol icy Statement 2009-10. 43 RBI has mult iple instruments at its command such as rep0 and reverse rep0 rates, cash reserve ratio (CRR), statutory liquidity ratio (SLR), open market operations, including the market stabilization scheme (MSS) and the LAF, special market operations, and sector-specific liquidity facilities. In addition, RBI also uses prudential tools to modulate f l ow o f credit t o certain sectors consistent with financial stability. The availability o f mult iple instruments and flexible use o f these instruments in the implementation o f monetary pol icy has enabled RBI to modulate the liquidity and interest rate conditions amidst uncertain global macroeconomic conditions.

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A special 14-day term rep0 facility was instituted for commercial banks up to 1.5 per cent o f NDTL for addressing the liquidity concerns o f mutual funds, non banking finance companies and housing finance companies. A special refinance facility was instituted for scheduled commercial banks up to 1 .O per cent o f each bank's NDTL as on October 24,2008. Special refinance facilities were instituted for financial institutions involved in small industry finance, housing, and external trade (SIDBI, NHB and Exim Bank).

Forex Liquidity

RBI sold foreign exchange (primarily US dollars) and made available a forex swap facility to banks. The interest rate ceiling on Non-Resident Indian (NRI) deposits was raised by 75 basis points. The all-in (total) cost ceiling for external commercial borrowings (ECBs) o f average maturity period o f three years and up to five years was raised to 300 basis points, and over five years to 500 basis points, above 6-month LIBOR. The facility o f providing liquidity support for eligible nonbanking non-deposit taking systematically important financial companies, which was initially available for any paper issued up to March 31, 2009 was extended for any paper issued up to June 30, 2009. This would help them meet any temporary liquidity mismatches.

Liquidity Impact The actions o f RBI since mid-September 2008 have resulted in increase o f liquidity by Rs 4,228 bi l l ion (7.8% o f GDP). In addition, the permanent reduction in the SLR by 1.0 per cent o f NDTL gave an extra liquidity o f Rs. 400 bi l l ion (0.74% o f GDP) available for credit expansion (Table A. 1).

1 CRR Reduction 1,600 2 Unwinding/BuybackDe-sequestering o f M S S Securities 978 3 Term Rep0 Facil ity 600 4 Increase in Export Credit Refinance 255 5 Special Refinance Facility for SCBs (Non-RRBs) 3 8 5 6 Refinance Facil ity for SIDBI/NHB/EXIM Bank 160 7 Liquidity Facil ity for NBFCs through SPV 250* Total (1 to 7) 4,228 Percent of 2008-09 GDP (%) 7.8% Memo: Statutory Liquidi ty Ratio (SLR) Reduction 400 * The total support from RBI i s limited to Rs.200 billion with an option to raise it by a further Rs.50 billion.

9 The much needed liquidity significantly improved the overnight call market rates and other money market rates. Overnight call market rates fe l l from a high o f 19.5 percent on October' 31,2008 to a low 3.25 percent on April 25,2009 (Figure A.l).

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Figure A.l: Call Money and Policy Rates

20 18

Rep0 -Reserve Rep0

14 -Call Rate

2 1 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09

Source: Bloomberg . The softening o f overnight money market rates causes commercial banks to turn into the LAF window since mid-November 2008. In effect, liquidity constraints that mutual funds faced have since eased considerably, commercial banks have reduced their benchmark prime lending rates,the total utilization under the recent refinance/liquidity facilities introduced by RBI has been low, and the overall liquidity conditions remain comfortable. However, their availability has provided comfort to the banks/FIs, which can fal l back on them in case o f need.

Regulatory forbearance measures

7. There have been several changes on regulatory forbearance since August 2008, including on restructuring o f advances and o f f balance sheet exposures. Prudential norms on off-balance sheet exposures for commercial banks were amended in October 2008. Prudential norms for valuation, classification and operation o f investment portfolio o f commercial banks were strengthened in July 2008. The most significant change has been on restructuring o f stressed loans, identified as a one-time activity with a cutoff date o f March 31, 2009. It is noteworthy that, despite this restructuring, provisioning by banks on the loans will continue, so the P&L account of the banks wil l continue to reflect these expenses as was the case before. Further, income recognition on the restructured portfolio will continue to be on cash basis and not on accrual basis, as was the case before. Therefore, this forbearance measure i s relatively prudent and will not reduce the transparency o f PSB portfolios.

Adoption of Basel I1 framework

8. An important recent development has been the adoption o f the Basel I1 framework by foreign banks operating in India and Indian banks having an operational presence outside India. Guidelines on the Revised Framework were issued on April 27, 2007. Foreign banks operating in India and Indian banks having an operational presence outside India migrated to the Revised Framework with effect f rom March 3 1 , 2008, while al l other banks migrated on March 3 1 , 2009.

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Banks are required to maintain a minimum CRAR o f 9 percent on an ongoing basis. Detailed guidelines relating to Pillar 2 were also issued. In 2007/08 RBI reviewed the exposure norms and risk weights for a few classes o f loans extended by banks.

Risk management

9. Several initiatives were taken by RBI during the year to further strengthen risk management systems in banks, such as modifications in the asset-liability management (ALM) guidelines, adoption o f guidelines on managing r isks in outsourced financial services, and strengthening o f the guidelines for exposure norms for commercial bank credit to individuals/groups, industry and capital markets. Banks were also advised to avoid equity funding o f projects. Comprehensive guidelines were issued to banks to do a proper risk assessment and accounting for the letters o f credit issued by them. Guidelines on stress testing for commercial banks, K n o w Your Customer and Anti-Money Laundering were also issued.

Deepening Financial Inclusion

10. Operative guidelines for mobile payments were issued on October 8, 2008. With the objective o f achieving greater financial inclusion and increasing the outreach o f the banking sector, banks were permitted to use the services o f NGOs/MFIs set up as societies, trusts, Section 25 companies, post offices, co-operative societies and more recently retired bank employees, ex- servicemen and retired government employees as banking correspondents; a working group has been constituted to examine how to scale up this model.

Capital Injections in PSB

11. A part o f the Government’s comprehensive stimulus program has included financial sector and, specifically, banking sector measures. One component o f the program adopted by the Government i s to provide budgetary resources to meet PSB capital requirements and to attain their CRAR at 12 percent. Other components included actions with respect to SME finance, housing finance, and steps to ensure the continued provision o f finance in other priority sectors. To fill the need for budgetary resources, in December 2008 the Government o f India requested the World Bank for financing o f Rs. 170 bi l l ion (US$ 3.4 billion), initially to help inject capital into 19 PSB and NHB. The current market condition, limited market availability for Innovative Perpetual Debt Instruments (IPDI)/ perpetual non-cumulative preference shares (PNCPS), and limited scope for dilution o f equity by banks, had led to the Government request. By providing capital buffers, the Government aims to ensure adequate capital for PSB to continue to support the credit requirements o f the economy to achieve higher levels o f economic growth.

12. Since December 2008, Government has announced a series o f capital infusions to the PSB. The following are such infusions: . In February 2009, the Government announced a capital injection o f Rs. 38 billion (US$760

million) for three PSB (UCO Bank, Central Bank o f India and Vijaya Bank), o f which the f i rs t tranche worth Rs. 19 bi l l ion (US$380 million) was released in March 2009. This action i s broadly in l ine with the Government request to the World Bank dated December 3 1 , 2008,

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where these three PSB had been listed as cumulatively qualifying for Rs. 30 bi l l ion (US$600 million) capital support in 2008-09. . In. March 2009, the Government announced a capital infusion o f Rs. 8 billion (US$160 million) for the United Bank o f India, a part o f which has already been released. This action i s broadly in l ine with the Government request letter dated December 3 1 , 2008, where this PSB had been listed as qualifying for Rs. 5 billion (US$lOO million) capital support in 2009- 10.

Complementary fiscal and financial measures

13. Three fiscal stimulus packages announced between December 2008 and February 2009 complemented the measures described above. The f irst package, at Rs. 320 billion, or 0.65 percent o f India’s GDP, included (i) a Rs. 200 bi l l ion (US$4 billion) o f extra spending primarily aimed at galvanizing rural infrastructure; (ii) Central VAT rate cuts on al l non-petroleum products by 4 percent, which would reduce tax revenues by Rs. 87 billion; (iii) specific measures worth Rs. 18 bi l l ion for exporters in textiles, leather and jewelry sectors; and (iv) authorization for I IFCL to raise Rs. 100 bi l l ion through tax-free bonds by end-March 2009 to facilitate the availability o f long-term financing for infrastructure PPPs in India. The second fiscal stimulus package included measures such as (i) permitting states to raise additional borrowing to the tune o f Rs. 300 bi l l ion (US$6 billion) for capital expenditure, (ii) relaxing external commercial borrowing norms, (iii) providing capital to PSB to the tune o f Rs. 200 bi l l ion (US$4 billion) over 2 years, (iv) increasing foreign institutional investment limits in corporate debt from US$6 billion to US$15 bi l l ion in February 2009, and (v) sector specific measures focusing on reviving the markets for automobiles, real estate, exports, NBFC and infrastructure. These measures have eased the problems o f liquidity, as reflected in money market rates and the easing o f liquidity positions o f mutual funds, banks and NBFC. It i s noteworthy that India’s reaction to the crisis so far shows two major differences compared, for example, to the US: lack o f central bank involvement in direct lending to the private sector (RBI has left credit decisions to private and public banks), and PSB maintaining credit growth at near to earlier levels.

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Annex 5: Bank Lending and Capital-Scenario Analysis

Two sets o f simulation exercises to estimate the capital requirements o f Indian banks have been carried out by the Government and developed further by the World Bank team:

1. The simulation exercises by the Government for projecting the future capital needs o f 16 PSB which are likely to receive Tier 1 capital support.

2. The stress test exercise for al l banks (using the methodology o f the Financial Sector Assessment),

The assumptions and methodology underpinning these two sets o f simulation exercises are described in this Annex.

Simulation Exercise 1: DFS Methodology

Assumptions and Methodology

The Department o f Financial Services (DFS) o f M O F undertook an estimation o f capital requirements o f PSB that were identified by them as requiring Tier 1 capital support. The estimates are based on actual data as o f March 2009 for each PSB. Capital requirements are forecast until 201 1 under the following DFS assumptions:

a

a Profits o f PSB in 2010 and 201 1 remain at 2009 levels in terms o f absolute amounts. Provisions on standard assets in 2010 and 2011 remain at 2009 levels in terms o f absolute amounts. Risk weighted assets grow at 20 percent each year. 80 percent o f net prof i t i s plowed back as incremental Tier 1 capital. Incremental Tier 2 capital equals incremental provisioning on standard assets. Tier 1 headroom i s not considered. Tier 2 headroom i s not considered. Even PSB with government shareholding well above 51 percent (the minimum government share requirement) will not access capital markets for raising Tier 1 equity capital by diluting government equity, as this option i s unattractive in the short-to-medium term on account of l ikely l o w valuations.

The World Bank team undertook an independent simulation exercise based on the fol lowing assumptions:

Risk weighted assets grow at 17 percent each year in the base case (in l ine with the growth in overall banking sector credit o f 17.3 percent in 2008-09), at 12 percent in the “low” case and at 25 percent in the “high” case. The growth rate o f assets and advances i s equal to growth rate o f risk weighted assets. .

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. Gross N P A amounts rise by 40 percent in 2010 and 80 percent in 201 1 in the base case; by 30 percent in 2010 and 60 percent in 201 1 in the “low” case; and by 80 percent in 2010 and 150 percent in 201 1 in the “high” case.44 Asset provisioning ratios are in l ine with the stipulated RBI provisioning norms based on ageing, and are assumed to be 0.40 percent for standard assets, 10 percent for sub-standard assets, 50 percent for doubtful assets, and 100 percent for the loss category. Where the N P A amounts for an N P A category are not available, a provisioning rate o f 50 percent has been applied to the overall N P A amount to estimate the total provisioning. 80 percent o f net prof i t i s plowed back as incremental Tier 1 capital. Incremental Tier 2 capital equals incremental provisioning on standard assets. Tier 1 headroom i s not considered. Tier-2 headroom i s not considered. Even PSB with a government shareholding level well above 51 percent (the minimum government share requirement) will not access the capital markets for raising Tier 1 equity capital by diluting government equity, as this option i s unattractive in the short to medium term on account o f likely low valuations.

.

. . . . .

Scenarios and Results

In the methodology described above, two parameters which could affect the final capital requirements are allowed to change and their effects simulated-the yearly increase in Gross NPA, and the yearly growth rate o f risk-weighted assets (a proxy for credit growth). While the N P A growth levels are not strictly calibrated to different levels o f non-financial sector corporate distress, they draw on similar scenarios used by other research f i r m s in their modeling exercises. Varying these two parameters-Gross N P A and risk-weighted assets-provides a range o f possible capital adequacy simulations for the period until 201 1. The results o f four o f these simulations (ranging from optimistic to adverse, and including the simulation by DFS) have been presented, using the following assumptions: . Scenario 1: Gross N P A amounts increase by 30-60 percent in 2010-1 1 over 2009; risk

weighted assets grow by 12 percent (Low NPA-Low Credit Growth case).

44 A basis for these growth rates i s provided by an analysis o f the impact o f the restructuring measures undertaken by the Government since August 2008. The analysis reveals that if ha l f o f a l l the restructured loans are considered to be NPA, it would increase the N P A o f public sector banks by 38 percent (various scenarios are summarized in the Table below).

YO o f restructured loans considered as NPA YO increase in NPA amounts 25 19 50 75 100

38 57 77

The Government provided a time-bound window for restructuring standard loans (assets) as a key forbearance measure. Between September 2008 and March 2009, public sector banks restructured approximately Rs. 250 bi l l ion (US$5.3 billion) in standard assets. Since these were standard and not non- performing assets, the calculations assume conservatively that, without restructuring, about ha l f o f them would have been classified as NPA.

72

Scenario 2: Gross N P A amounts r ise by 40-80 percent in 2010-1 1 over 2009; risk weighted assets growth i s 17 percent (Mid NPA-Mid Credit Growth case). Scenario 3: Gross N P A amounts r ise by 80-150 percent in 2010-1 1 over 2009; risk weighted assets growth i s 25 percent (High NPA-High Credit Growth case).

Scenario 2 (NPA amounts 13.08%

11.86% increase by 40-80%, Credit 1 Growth= 17%) [Mid-Mid]

The results o f the simulations are as follows:

10.63% 4.5 4.3

Scenario 1 (NPA amounts I I I I I

Scenario 3 (NPA amounts

Growth=25%) [High-High] increase by 80-150%, Credit

increase by 30-60%, Credit Growth=l2%) [Low-Low]

10.90% 8.89% 11.6 9.7

I 12.43% I 11.69% I 2.0 I 2.4

The results o f the Wor ld Bank team’s simulations are o f the same order o f magnitude as the DFS estimates. The results reflect the fact that a significant proportion o f the capital needs stem from the problems in raising capital t o sustain credit side growth, This i s in the context o f a financial environment affected by the global crisis, where capital valuations are unattractive and capital markets diff icult to access

In addition to the above, separate estimates were made o f the possible effects o n the need for capital when credit growth rates (with an unchanged base NPA amount) were varied, and also when the growth rates of NPA amounts changed over time (with an unchanged base credit growth rate). The objective was to determine the need for capital for sustaining credit growth versus that arising out o f growing NPA. The results are summarized below.

73

Mar-09* Mar-10 Mar-11 Total Total NPA growth: 30-60 (Low) 11.92% 10.79% 4.0 3.8

NPA growth: 80-150 (High) 11.60% 10.01% 6.5 6.3 NPA growth: 40-80 (Mid) 13.08% 11.86% 10.63% 4.5 4.3

Since the baseline data i s from March 2009, it incorporates to some extent the effect o f RBI forbearance on N P A and provisioning, and the effects o f other restructuring measures resulting from the various forbearance measures initiated since August 2008.

Simulation Exercise 2: Financial Sector Assessment Methodology

Assumptions

The Self Assessment undertook a single factor-stress test o f the Indian banking system. It focused on an estimation o f capital requirements o f a l l banks when N P A levels were increased. I t assumed that, instead o f the actual N P A ratio as at end-March and end-September 2008, NPA would be higher by 100 percent and 150 percent o n those dates. The World Bank team built on this and undertook an identical estimation for March 2009, that is, by assuming that the N P A ratio at end-March 2009 was 100 percent and 150 percent higher than the actual as o f that date.

Methodology

The methodology applied was as follows: . 9

The fol lowing groups o f banks were studied: al l PSB, a l l private banks and al l banks. For each group o f banks, the following actual balance sheet data as o f end March 2009 was collected: Assets, Risk Weighted Assets, Advances, Deposits, Tier 1 and Tier 2 capital, CRAR, Net Profit, Return on Assets, Gross NPA, Ne t N P A and Interest Income. For an X percent increase in Gross N P A (where X was 100 or 150 percent), the incremental provisioning amount was determined by using a 60 percent ratio o f Gross N P A . To reflect the reduced yield on the loan portfolio, Interest Income was reduced by an amount equal to the Gross NPA amount. The new equity capital was estimated by reducing the original equity capital by the incremental provisioning amount and the reduction in Interest Income. The CRAR was re-computed based on the new equity capital and the original risk-weighted assets.

.

.

. Results

The results o f this static stock model calculation on various groups o f banks are as follows:

CRAR 12.3 1 15.05 13.20

CRAR under 150 percent increase in NPA 10.49 12.71 1 1.27 CRAR under 100 percent increase in NPA 11.10 13.49 11.91

74

The results show the overall financial robustness o f the Indian banking sector. Given the larger capital ratios o f the private sector banks (mainly on account o f their relatively slower credit growth last year), it i s not surprising that, even under significant stress (150 percent increase in NPA), private banks do not experience a reduction in their CRAR below 12 percent. In contrast, public sector banks, which also have a healthy 12.3 percent C R A R currently, witness an immediate reduction in their CRAR to below 12 percent even under a lower 100 percent increase in NPA.

75

Annex 6: Risk and Risk Mitigation Matr ix

Internal imbalances

Deeper and longer global crisis

Access to capital by banks

counf Fiscal deficit i s high and likely to increase because o f stimulus package, requiring higher level o f domestic finance with adverse consequences on debt servicing burden and financial market.

External account deficit has been manageable, in part due to growing exports, large foreign direct investments and large remittances. A prolonged global down turn could adversely impact both exports and the level o f remittances

The estimated capital needs o f the PSB have been based upon consensus forecasts for both India as well as the global economy. Should deterioration deepen in either, the capital needs may have been underestimated, leaving the banks short o f capital, limiting their ability to lend. The Government anticipates that some banks wi l l be able to access other sources o f funding in the outer years o f the program. However, financial market conditions may not be conducive.

and Sector Risks Close monitoring by GO1

o f FRBMA targets Government commitment

to keep reducing subsidy b i l l 0 Compliance and base- broadening measures on revenue front

Government has put in place a comprehensive stimulus program-monetary, fiscal, trade, financial and other measures-which are expected to mute the effects o f the global slowdown on real sectors. 0 Maintaining credit flow over the program period (especially to priority lending sectors that are relatively protected from credit cutbacks) wi l l permit f i i s to access working capital needs and maintain activity levels.

Bank team has undertaken detailed calculations to affirm the Government’s calculations, as well as estimated capital requirements if more extreme conditions prevail than in current consensus assessments

PSB would have some buffer relative to the minimum CRAR requirement (9%) since the capital support takes them to 12%

Some PSB have a buffer in terms o f having >51% o f Government equity, so if capital were to fall short they could go to the market and raise additional capital 0 Infusion o f tier 1 capital would lead to a leverage effect in enabling PSB to raise additional tier 1 capital from the market, additional tier 2 capital

3

3

3

3

3

2

76

PSB wil l not increase lending despite adequate capital

Credit quality w i l l decline

Description

The Government sees the need for maintaining lending to support economic activity. A s seen in several other countries, simply increasing capital levels in banks does not necessarily result in additional lending to the real sector.

Growing loan portfolios at a t ime o f global economic turmoil and uncertainty on the domestic front could result in an increase in NPLs. Further, growth in loan portfolios at a t ime o f identif ied risk management needs in PSB could result in weak lending and growing NPA.

Mitigation Measures f rom the market as we l l as additional innovative tier 1 capital - upto f ive t ime leverage i s enabled by tier 1 capital injection

Headroom also exists for many PSB in terms o f raising Tier 2 capital - so if government capital falls short CRAR can be increased

PSB currently face a l o t o f opportunities that previously did not exist for them; this enhances the chances for them to grow

PSB management incentives are l inked through the yearly “Statements o f Intent” (performance contracts) to growth and performance; so there is an inbuilt incentive

Desire to earn returns - which are currently highest in case o f allocation towards loans - will help

The Government monitors the performance o f the banks through at least two key methods. First the bank supervisor reviews performance against international standards for safety and soundness, and second, the banks are expected to perform financially as we l l as socially which i s monitored in terms o f compliance with the yearly “Statement o f Intent on Annual Goals”.

Increased emphasis on risk management, better appraisal, etc. has been driven home by the regulator over t ime and is expected to continue. Enhanced risk management is also mentioned as a key action area in the Government’s Financial Sector (Self) Assessment.

Banks have developed capacity t o appraise and lend better over t ime - evidenced in declining NPA ratios across

2

2

77

Banks outside the program wi l l face distress

Public confidence could decline

Political stability

Private sector banks have adequate capital for the near term. In the outer years o f the program there i s a risk one or more private banks may need capital and not be able to raise it in the market. This could have an adverse impact on stability and confidence in the banking sector.

Confidence in the economy remains high. Problems in the real sector, especially large corporates who borrowed heavily abroad and face rollover risk, or a weakening o f individual financial institutions (capital and liquidity), could result in a loss o f confidence, runs on banks and slowdown o f consumer spending.

The May general elections resulted in the return o f a reconfigured Congress Party- led coalition, with an enhanced mandate for i t s social and economic policies. The Government's ability to implement these policies effectively wi l l be challenged by the effects o f the global slowdown, but also by the need for strong Centedtate cooperation on core economic issues linked. to the elimination

Mitigation Measures types o f banks in India and low absolute levels o f NPA

Support to domestic private banks--although not envisaged currently-has not been ruled out by the Government. I t could be considered in the second DPL, if deemed necessary.

The Government has a history of ensuring no bank closures and, given circumstances, could be expected to continue that policy.

Through supporting credit stimulus through the PSB, the operation i s expected to multiplier effects in the economy which would benefit other banks. In addition, new opportunities for lending for other banks, for example through participation in syndicated loans generated and led by PSB, could provide new opportunities for growth for these banks.

The proposed World Bank- supported program i s anticipatory in nature and wi l l help retain confidence in the banking system

The Government's autonomy package (February 22, 2005) provides for quick and eff ic ient decision-making in the PSB to respond flexibly to changes in the economic and financial environment

The new coalition government i s expected to continue the economic policies presented in the Eleventh Five- Year Plan (2007-2012).

Recent budgets and the new 2009-10 budget provide flexibility to lower level governments for the maintenance o f core economic programs and their financing. The recommendations o f the 13" Finance Commission are likely to reinforce this and Drovide an

3 2

78

he overall fiscal

* Risk weight on a scale o f 1-4, with 4 being the highest

79

Annex 7: Application o f Good Practice Principles on Conditionality

The design o f this Development Policy Loan has drawn on the lessons learned by the World Bank on the application o f conditionality. The following are the good practice principles and lessons applied to this DPL.

Principle 1: Reinforce ownership

The D P L supports a set o f measures that i s in line with the government’s priorities. The Government’s financial sector reform program has focused on broadening financial access, promoting efficiency through competition, and ensuring the stable and diversified domestic and global growth o f Indian financial institutions. The programmatic set o f two DPL, o f which this operation i s the first, i s fully aligned with reforms that have been developed by the Government and implemented over the course o f several years. Most recently, the policy actions taken in the area o f monetary, fiscal, trade and financial sector were in direct response to the global financial crisis in an effort to stem the impact o f the crisis in India. These policy actions are consistent with the laws and institutional arrangements already put in place by the Government and further support the economy and the strength o f the banking sector. Policy actions proposed were also presented by the Government and discussed with the World Bank team.

Principle 2: Agree up front with government and partners on a coordinated accountability framework

The policy matrix represents an agreed framework with Government, based on i t s own on-going program. Moreover, the Government has publicized i ts intentions and objectives with regard to injecting capital into the PSB through official notifications f rom the Press Information Bureau, allocations in the Interim Budget, and official statements at the level o f the President and Finance Minister. For the purposes o f this Program Document, the Government has also provided a strategy paper that elucidates the principles and objectives o f banking reform in India, including the place o f the capital injections for PSB within the framework o f India’s multi-pronged response to the global economic crisis (Annex 2: Medium Term Banking Strategy). This DPL has been discussed with a number o f India’s external development partners (outside o f the World Bank Group) that are active in the financial sector. These include the IMF, ADB, DfID, KfW and JICA. The policy matrix also sets out the outcome indicators with targets to be achieved by the Government’s program. The short and medium term program may need to be adjusted based upon changing global events and domestic financial market conditions in the on-going economic downturn.

Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances

The policy matrix includes a subset o f reform measures that are part o f the Government’s broader development program. It does not pretend to capture the totality o f reforms or other measures being implemented. The aim o f the program i s to support the Government’s efforts to ensure continued economic growth through adequate credit flows to contain the effects o f the global economic slowdown on employment and poverty. Although the World Bank i s engaged in

80

a dialogue across a number o f policy areas, many policy actions are le f t outside the scope o f the DPL to allow for specificcountry circumstances and the political economy.

Principle 4: Choose only actions critical for achieving results as conditions for disbursement

The actions supported by the operation are based on joint analytical work and technical discussions with the authorities, the banks, and the private sector, and focus on issues that are central to achieving the goal o f the Government to minimize the social and economic impact o f the global economic downturn.

Principle 5: Conduct transparent reviews conducive to predictable and performance based financial support

The preparation o f this operation i s based on the Governments’ request and need for budgetary support, and based on reviews o f very detailed data provided by the Government. It i s further based upon Government, third party and independent Bank analyses and stress testing directed at meeting the goals set by the authorities.

81

Annex 8: India at Glance

Key Development Indicators

(2@3V

Population, mid-year (millions) Surface area (thousand sq. km) Population growth (%) Urban population (% of total population)

GNI (Atlas method, US$ billions) GNi per capita (Atlas method, US$) GNI per capita (PPP, international $)

GDP growth (%) GDP per capita growth (Oh)

(most recent estimate, 200&2007)

Poverty headcount ratio at $1.25 a day (PPP. %) Poverty headcount ratio at $2.00 a day (PPP. Oh) Life expectancy at birth (years) Infant mortality (per 1,000 live births) Child malnutrition (% of children under 5)

Adult literacy, male (Oh of ages 15 and older) Adult literacy, female (% of ages 15 and older) Gross primary enrollment, male (% of age group) Gross primary enrollment, female (% of age group)

Access to an improved water source (% of population) Access to improved sanitation facilities (% of population)

South India Asia

1,123.3 1,520 3,267 5,140

1.2 1.4 29 29

1,071.2 1,339 950 880

2,740 2,537

9.0 8.5 7.7 6.9

42 40 76 74 64 64 57 62 44 41

73 70 48 46

114 111 109 104

89 67 28 33

Lower middle income

3,437 35,510

1 .o 42

6,485 1,867 4,544

9.7 8.6

69 41 25

93 65

112 109

88 54

Net Aid Flows

(US$ millions) Net ODA and official aid Top 3 donors (in 2006):

United Kingdom European Commission United States

Aid (% of GNI) Aid per capita (US$)

Long-Term Economic Trends

Consumer prices (annual % change) GDP implicit deflator (annual % change)

Exchange rate (annual average, local per US$) Terms of trade index (2000 = 100)

Population, mid-year (millions) GDP (US$ millions)

Agriculture Industry

Sewices

Household final consumption ewenditure General gov't final consumption expenditure Gross capital formation

Exports of goods and services Imports of goods and services Gross savings

Manufacturing

1980 1990

2,186 1,399

134 97 85 58 63 -24

1.2 0.4 3 2

12.3 12.4 11.5 10.7

7.9 17.9

667.3 849.5 183,799 317,467

2000 , 2007'

1,463 1,379

204 349 60 210 15 97

0.3 0.2 1 1

3.7 6.2 3.5 4.3

45.7 40.1 100 88

1,015.9 1,123.3 460,182 1,174,336

(% of GDP) 35.7 29.3 23.4 17.6 24.7 26.9 26.2 29.4 16.7 16.7 15.6 16.4 39.6 43.8 50.5 52.8

74.6 65.6 64.1 56.6 10.0 11.7 12.6 10.1 18.5 24.2 24.2 36.2

6.2 7.1 13.2 21.3 9.4 8.5 14.2 24.4

20.2 22.2 25.4 36.2

Age distribution, 2007

Male Female

75-79

3084

15.40

30-34

15 10 5 0 5 10 15

percent

Jnder-5 mortality rate (per 1,000) 7 120

1w 80

BO

40

20

0 1980 1905 2wo ZOOB

0 India 0 South Asia

Growth of GDP and GDP per capita (Oh)

112 T

+GDP - GDP per capita

1980-90 1990-2000 2000-07 (average annual gmvdh %) 2.1 1.6 1.4 5.5 5.9 7.8

3.1 3.2 3.1 6.0 6.1 6.6 6.0 6.7 8.0 6.6 7.7 9.2

4.7 5.6 6.8 7.3 6.6 3.4 7.2 6.9 14.9

4.9 12.3 15.7 6.1 14.4 19.4

Note: Figures in italics are for years other than those specified. 2007 data are preliminary. ., indicates data are not available. a. Aid data are for 2006.

Development Economics, Development Data Group (DECDG).

82

India

Balance of Payments and Trade

(US$ millions) Total merchandise exports (fob) Total merchandise imports (cif) Net trade in goods and services

Current account balance as a % of GDP

Workers' remittances and compensation of employees (receipts)

Reserves, including gold

Central Government Finance

(% of GDP) Current revenue (including grants)

Current expenditure

Overall surpius/deficit

Highest marginal tax rate (Oh)

Tax revenue

individual Corporate

External Debt and Resource Flows

(US$ millions) Total debt outstanding and disbursed Total debt sewice Debt relief (HIPC, MDRi)

Total debt (% of GDP) Total debt service (% of eqorts)

Foreign direct investment (net inflows) Portfolio equity (net inflows)

2000 2007

45,452 146,632 57,912 248,521 -10,768 -52,510

-2,918 -17,642 -0.6 -1.5

12,690 27,000

42,281 309,287

17.7 23.1 14.6 18.8 24.0 25.4

-9.9 -5.1

30 30 40 30

99,099 220,956 10,668 40,718 - -

21.5 18.6 14.3 13.6

3,584 17,453 2,345 9,549

Composition of total external debt, 2006

I Privata 84534

Private Sector Development 2000 2008

Time required to start a business (days) - 30 Cost to start a business ( O h of GNI per capita) - 70.1 Time required to register property (days) - 45

Ranked as a major wnstraint to business 2000 2007

Electricity .. 30.5 Tax rates .. 12.5

Stock market capitalization (%of GDP) 32.2 154.9 Bank capital to asset ratio (%) 5.7 6.6

(YO of managers surveyed who agreed)

I Governance indicators, 2000 and 2007

Voice and accountability

Political stability

Regulatory quality

Rule of law

Control of comption

0 25 50 75 100

IT# 2007 0 2000

Country's percentile rank (0-100) hwhw values imply belter ratmgs

Source: Kaufmann-Kraay-Mastiuui, World Bank

Technology and Infrastructure

Paved roads (% of total) Fixed line and mobile phone

High technology exports subscribers (per 100 people)

(% of manufactured exports)

Environment

Agricultural land (%of land area) Forest area (% of land area) Nationally protected areas (% of land area)

Freshwater resources per capita (cu. meters) Freshwater withdrawal (% of internal resources)

C 0 2 emissions percapita (mt)

GDP per unit of energy use (2005 PPP $ per kg of oil equivalent)

Energy use per capita (kg of oil equivalent)

2000

47.5

4

5.0

61 22.7

51.2

1.1

3.6

452

2007

24

4.8

61 22.8 5.3

1,152

1.2

4.5

491

Note: Figures in italics are for years other than those specified. 2007 data are preliminaly. .. indicates data are not available. -indicates observation is not applicable.

Development Economics, Development Data Group (DECDG).

11/12/08

83

Annex 9: K e y Social Indicators

POPULATION Total population, mid.year (millions)

Urban population (% ofpopulation) Total fertility rate (births per woman)

POVERTY' (% of ppuiation) National headcount index

Urban headcount index Rural headcount index

Growth rate (% annual average forpenod)

INCOME GNI per capita (US'S) Consumer price index (20CO=100) Food pnce index (2000=1w)

lNCOMECONSUMPTION DISTRIBUTION Share of income or consumption Gini index'

Lowest quintile (% of income or consumption) Highest quintile (Oh of income or consumption)

SOCIAL INDICATORS

Public expenditure' Health (% O f GDP) Education (% of GNI) Social secuIIty and welfare (% of GDPJ

Net prlmary school enrollment rata (% of age group)

Male Female

Total

Access to an improved water source (% of population)

Urban Rural

Totai

Immunlzatlon rate (% of children ages 12-25 months)

Measles DPT

Child malnutrnion (% under 5yearsJ

LIfa expectancy at birth (years)

Total Male Female

Mortality Infant (per 1,000 iive births) Under 5 (per 1,OOOlive births)' Adult (15.59)

Male (per 1,~Opapulation) Female (per 1,000 population)

Maternal (per 100,000 live births) Births attended by skilled health slaff (%)

Latest single year Same regionllncome group Lower-

South mlddle- i980-85 1990-95 200167 Asla Income

765 1 932.2 1.123.3 1,520.4 3,437.1 2.1 1.9 1.4 1.6 1 1

24.3 26.6 29.3 29.2 41.7 4 4 3.4 2.5 2.8 2 3

.. 36.0 27.5

.. 32.4 25.7

.. 37.3 20.3

300 380 950 28 70 138

1 18

57 57 57

97 137

261 279

77 92 71

72 71

61 61 62

74 102

236 241

34

34.9 9 3

27 3

880 140

4.9 0.9 21.8 2.7

2.6

89 85 90 88 87 83

89 87 96 94 86 84

59 65 55 64

41 44

64 64 63 63 66 66

57 62 74 83

260 251 168 173 301 500 47 41

1,887 144

2.0 4.7

90 91 90

88 96 83

77 75 25

69 67 71

41 54

202 128 300 69

CAS Annex 65. Thlr table was produced from the CMU LOB system unless stated olhemise. 11/12100 Note: 0 or 0.0 means zero or less lhan halflhe unit shown. Net enrollment rate: break in Serbs between 1997 and 1998 due to change from ISCED76 to iSCED97 immunization: refers to children ages 12-23 months who receiyed vaccinations before one year of age or at any time before the survey. 1. Source: Poyerty Estimates for 2004.05, New Delhi.Gol, Press Information Bureau, March 2007 2: At 93-94 Reai Price: Source. Calculated from Unn level data, NSS 6151 Round (2004-05), Schedule 1

84

Annex 10: Key Economic Indicators Est imte PfOJ&t€d

Indrcator 2005-06 2006-07 2007-08 2008-09 2009-10 9010-2011 2011-12 2012-13 2013-14 \attonal accounts (as % o f GDP) Gross domestic producta

Agriculture

Industry Services

Total Consumption Gross domestic investment

Government invesbnent Priwte Lnvestment

Exporb (GNFS)b Imporb (GNFS)

Gross domestic savings Gross national savings'

Memorundum i t e m Gross domestic product (US% mll ion at current prices) GNI per capita (US%, Atlas method)

Real annual growth rates (%, calculated from 00 prices) Gross domesic product at market prices Gross Domestic Income

100.0 19.1 28.8 52.2

68.0 34.8

7.6 26.1

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 18.2 18.1 17.5 16.9 16.3 15.6 14.9 14.3 29.5 29.5 28.8 28.1 27.7 27.2 27.1 27.1 52.4 52.4 53.7 55.0 56.0 57.2 58.0 58.5

66.7 64.8 65.7 67.1 66.5 65.4 64.6 63.8 36.4 38.7 39.7 37.0 37.8 39.8 41.0 42.4

8.0 9.1 7.7 7.8 7 .7 8.4 8.8 9 .4 27.2 28.5 31.9 29.2 30.1 31.4 32.2 33.0

19.9 22.2 21.2 22.7 21.9 20.2 20.6 20.9 21.0 22.7 25.2 24.7 28.0 26.0 24.5 25.8 26.5 27.2

32.0 33.3 35.2 34.3 32.9 33.5 34.6 35.4 36.2 36.5 38.3 40.7 39.2 39.4 36.5 37.6 38.3 38.8

810,151 914,892 1,176,890 1,159,171 1,193,615 1,403,243 1,490,323 1,599,801 1,719,886

740.0 820.0 950.0 1040.0 1090.0 1150.0 1250.0 1360.0 1430.0

9.4 9 .7 9 .1 6 .1 6.0 8.0 8.5 8.0 8.0 13.1 10.9 8.7 5.8 7.7 7.8 7.5 7.6 7.6

Real annual per capita growth rates (%, calculated kom 00 prices) Gross domestic product at market prices 7.9 8.2 7 .7 4.6 4.5 6.5 7 .0 6.5 6.5 Total consumption 10.5 8.4 5.1 4.5 15.2 4.9 0 .6 2.6 2.4

1.6 0.9 Priwte consumption 11.7 9.0 4.8 2.2 11.9 8.6 -0.4

Balance o f Paymen$ (US% millions) E X ~ O K ~ (GNFS)~ 162,811 202,668 256,240 276,408 261,212 283,084 307,657 334,915 361,929

Merchandise FOB 105,152 128,888 166,163 175,184 165,649 178,607 193,929 210,799 227,757 Imports (GNFSjb 191,545 234,981 310,301 345,993 309,877 343,786 384,969 424,168 468,119

Merchandise FOB 157,056 190,670 257,789 294,587 256,255 283,480 318,131 351,118 388,293 Resource balance -28,734 -32,313 -54,061 -69,585 -48,665 -60,702 -77,312 -89,253 -106,190 Net current transfers 24,493 30,079 41,944 44,279 50,883 53,937 57,173 60,603 64,239 Current account balance(exc1uding official transfer) -10,096 -9,819 -17,273 -30,049 -10,229 -18,476 -33,891 -44,109 -60,968

Net private foreign direct investment 3,034 7,693 15,401 17,496 24,685 18,577 18,642 18,706 18,771 Long-term loans (net) 4,210 17,878 24,747 10,796 -2,030 17,098 14,909 29,346 33,443 Of ic ia l 1,426 2,437 1,817 2,721 1,959 2,011 2,042 1,969 1,689

Othercapital (net, incl sror&ommrrionr) 17,904 20,854 69,289 -18,323 18,533 17,976 34,735 33,788 49,353 Private 2,784 15,441 22,930 8,075 -3,990 15,087 12,866 27,376 31,755

Change in reservd -15,052 -36,606 -92,164 20,080 -30,958 -35,175 -34,394 -37,731 -40,598

Memorundum items Resource balance (% of GDP) -3.5 -3.5 -4.6 -6.0 -4.1 -4.3 -5.2 -5.6 -6.2 Real annual growth rates ( % change in current US$) Merchandise exports (FOB) 23.4 22.6 28.9 5.4 -5.4 7 .8 8.6 8.7 8,O Merchandise imports (ClF) 32.1 21.4 35.2 14.3 -13.0 10.6 12.2 10.4 10.6

(Contmued)

85

Estimak Projected lndlcatof 2005-06 2006-07 200708 200&09 2009-10 2010-2011 2011-12 2012-13 2013.14

Public finance (as % ofGDP at market prices)e Current revenues Current eqendiures Current account surplus (+) ordeficit (-) Capital expenditure Foreign financing

Monetary indicators M2iGDP Growth of M 2 (%) Pnvate sectorcredt growth/ total credit growth (%)

Price indices( Y R O O =loo) Consumerprice index (% change) GDP deflator (%change)

19.7 20.8 21.9 20.9 20.3 21.1 21.9 22.7 23.4 24.2 24.4 25.2 28.5 28.5 27.8 26.4 26.8 27.0 -4 .5 -3.6 -3.2 -7.6 -8.2 -6.7 -4.5 4 . 1 -3.6 2.3 2.8 3.0 2.1 2.4 2.4 3.0 3.5 4.0 1.2 0.2 0.2 0.2 0.2 0.2 0.2 0.1 0.1

76.1 80.3 85.1 89.8 98.1 100.0 100.0 100.0 100.0 21.2 21.5 21.2 19.0 18.0 15.1 11.8 12.3 12.3 97.7 86.6 86.2 63.5 39.8 57.2 54.1 56.2 56.3

4.2 6.4 6.2 8.0 2.0 4.5 3.0 4.0 4.0 4.1 5.0 4.9 6.2 2.0 4.5 3.0 4.0 4.0

a. GDP at factor cost b. "GNFS" denoes "goods and mnfactor services." c . Includes net unrequited transfers excluding official capital grants. d. Includes use o f I M F resources. e. Consolidated central government. f. "LCU' denotes "local currency units." An imrease inUS$/LCU denotes appreciation.

Sources: Central Statistical Organization, Reserve Bank of India, and World Banks staff estimates

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Annex 11: Key Exposure Indicators

Estimated Projected Indicato? 2005-06 2006-07 200748 2008-09 2009-10 2010-2011 2011-12 2012-13 2013-14

Totil debt oubtandingand disbursed (TDO) (VS%m)a

138,133 169,669 221,212 232,008 230,228 247,450 262,484 294,240 336,597

Net disbursements (US$m)' 4,210 17,878 24,747 10,796 -1,780 17,223 15,034 31,756 42357

Toti1 debt service (TDS) (US$m)a

Debt and debt sewiceindicators ( %)

T W ~ X G S ~ TWiGDP TDSKGS ConcessionallTDO

IBRD exposure indicators (%) BRD DSlpublic DS Preferred aedibsr DSipublic DS (%)' m m DS/XGS mRD TDO(US$m)d Share of BRD portfolio (%) IDA TDO (U S$m)d

IFC (US$m) Loans Equity and quasi-equity i c

20,291 13,961 18,044 19,058 29,244 33,615 26,534 35,777 39,264

72.1 70.8 71.4 69.8 72.0 71.6 70.3 72.7 77.3 17.1 18.5 18.8 20.0 19.3 17.6 17.6 18.4 19.6 10.6 5.8 5.8 5.7 9.1 9.7 7.1 8.8 9.0 29.9 25.8 21.7 21.1 21.6 19.9 18.4 15.8 13.2

2.5 5.8 2.4 5.2 9.3 11.0 14.7 15.0 19.0

8.8 16.8 6.9 16.6 31.8 34.9 40.9 40.5 49.1

0 2 0 3 0 2 0 3 0 2 0 3 0 3 0 3 0 3 5,6516 6,4040 7,1874 8,0116 7,5318 8,7292 10,4208 12,2804 14,1533

4 6 5 3 6 2 7 2 7 2 8 3 10 5 12 1 13 5

23,7979 24,621 6 26,2380 25,9174 25,8959 26,0842 26,491 8 27,045 7 27,5360

644.5 1,134.8 1,239.7 1,522.4 177.8 227.5 432.3 468.6

MIGA MIGA guarantees (US$m)

a. Includes public and publicly guaranteed debt, private nonguaranteed, use of IMF credits and net short-term capital. b. "XGS" denotes exports o f goods and service& including workers remittances c . Preferred creditors are defined as JBRD, IDA, the regional mlltilateral development banks, the IMF, and the Bank for International Settlements d. Includes present value ofguarartees e . Includes equity andqmsi-equity types o f bothloan and equity instrments. f. Debt Reporting System actual data i s as of March 2008,

Sources: WorldBanks Debt Reporting System WoddBank's staffestimates, andReserve Bankof India

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0 m P

n .- E 3

00 00

B 3 m

9 a

2 N

Annex 13: Bank Portfolio and Program Indicators

Selected Indicators* of Bank Portfolio Performance and Management As Of Date 0911 212008

Indicator 2006 2007 2008 2009 Portfolio Assessment Number of Projects Under Implementation a 56 67 59 Average Implementation Period (years) 3.5 ' 3.6 3.7 Percent of Problem Projects by Number 8.9 10.4 22.0 Percent of Problem Projects by Amount 11.3 14.7 21.8 Percent of Projects at Risk by Number 10.7 11.9 23.7 Percent of Projects at Risk by Amount 15.4 17.9 23.2 Disbursement Ratio (%) e 25.2 21.7 18.3 Portfolio Management CPPR during the year (yeslno) Supervision Resources (total US$) Average Supervision (US$/project)

61 3.8

21.3 22.7 21.3 22.7 4.0

Memorandum Item Since FY 80 Last Five FYs Proj Eva1 by OED by Number 321 30 Proj Eva1 by OED by Amt (US$ millions) 42,198.8 5,521.4 % of OED Projects Rated U or HU by Number 25.9 13.3 % of OED Projects Rated U or HU by Amt 23.9 11.7

a. As shown in the Annual Report on Portfolio Performance (except for current FY). b. Average age of projects in the Banks country portfolio. c. Percent of projects rated U or HU on development objectives (DO) andlor implementation progress (IP). d. As defined under the Portfolio Improvement Program. e. Ratio of disbursements during the year to the undisbursed balance of the Banks portfolio at the

beginning of the year: Investment projects only. * All indicators are for projects active in the Portfolio, with the exception of Disbursement Ratio,

which includes all active projects as well as projects which exited during the fiscal year.

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Annex 14: IFC and MIGA Program

IFC’s Financial Sector & Banking Strategy (FY09-11)

I F C supports the World Bank Group India Country Assistance Strategy for FY09-12, especially the Achieving Rapid, Inclusive Growth pillar. During the last few years, private sector banks have grown significantly and have played a major role in the growth o f Indian economy, which has resulted in a decline o f the public sector banks’ market share, to 70% o f total assets and 74% o f deposits as on March 31, 2008. IFC’s financial sector strategy in India aims to encourage growth in the market share o f private sector banks and contribute to financial policies which foster inclusive growth, increased banking penetration, development o f local financial markets, and stability at the national and regional levels (including in the aftermath o f the global financial crisis). IFC makes investments and provides advisory services to build capacity in private financial institutions which contribute to financial deepening and the expansion o f financial services to underserved segments. IFC’s strategic objectives for the financial sector are:

0 Enhance financial sector deepening

0

Increase access to finance for the under-served Improve infrastructure and housing finance

Improve financing for social safety nets, including insurance, pension, education and health Improve financing for environmental and social sustainability

Given regulatory constraint^^^, IFC will focus i t s financial sector strategy through the following cluster o f activities:

Promoting financial inclusion by:

strengthening private commercial banks (especially those serving SMEs, energy efficiency products, health & education, infrastructure) through investment (equity, tier 11, trade finance) and advisory services (microfinance downscaling, strategic planning, risk management) increasing the availability o f microfinance by investing in, and providing advisory services to, microfinance institutions and fimds investment and advisory support to help the development o f l o w income housing pi lot projects and supporting financial institutions to set-up low-income housing finance business lines increasing the availability o f finance in rural areas and l o w income states by supporting NBFCs

45 The type, size and pricing of foreign investments in Indian banks and financial institutions are regulated by the Reserve Bank o f India. In general, IFC and other Multilaterals cannot lend to financial intermediaries due to the external commercial borrowing (ECB) guidelines instituted since 2002. IFC involvement in the sector i s therefore limited (with few exceptions) to making equity investments in financial institutions. Foreign financial institutions (including IFC) are limited to 5% equity stakes in private sector banks.

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Increasing the availability o f financing for activities which mitigate or adapt to climate change, especially renewable/clean energy, energy efficiency, and carbon reduction. Supporting regional integration and south-south cooperation, particularly the expansion o f Indian companies overseas and mobilization o f financial resources for off-shore Indian financial institutions. Capital Market Development to improve the mobilization o f long-term finance for infrastructure and increase the range o f instruments to enhance liquidity - through the development o f the long te rm debt market, and support for specialized financial institutions.

IFC Role in Banking Sector in India: IFC’s support through investments in Indian banks:

Helps adequately capitalize private banks so as to achieve the credit growth needed to sustain India’s economic growth. Enhances, v ia IFC’s trade finance program, the credit profile o f India’s private banks in international markets, especially in the context o f the global crisis which has raised counterparty risks. Facilitates the f low o f information on best practice techniques for bank operations, provided through IFC supported advisory services, with a particular emphasis on SME, rural finance, microfinance and housing finance. In addition IFC provides advisory services support and best practice for operational areas o f the bank such as risk and treasury management, ALM credit processes, and monitoring o f rapidly growing loan portfolios. Creates visibility for the institutions to access international funding and play a catalytic role in attracting other private sector international investors to India’s leading regional banks, thereby supporting increased competitiveness across the banking sector. Assists investee banks develop strategies to expand operations in the rest o f India and help them become pan-India players.

0

0

IFC Response to the Global Financial Crisis: IFC has responded to the impact o f the global financial crisis in India by:

0 Organizing Risk Management workshops to foster dialogue and encourage financial institutions to adopt best practices

0 Working closely with client companies to adapt and respond to the new economic environment

0 Providing advisory services in key areas such as corporate governance, loan portfolio workout, and risk management

0 Continuing to commit new financial market investments (an estimated 5 projects by end FY09)

0 Continuing to disburse on existing financial market commitments in a difficult market environment.

0 Leveraging i t s unique position to bring additional financing while remaining within existing country exposure limits. This will include making effective use o f IFC’s global crisis response facilities (especially the Microfinance Enhancement Facility), working with other DFIs, and mobilizing as much as possible.

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Current Portfolio and Program:

The financial sector is an important component of IFC’s portfolio: Investments in the financial sector account for 26% o f the total committed portfolio o f $3.1 billion as on April 30th, 2009. The financial sector committed portfolio o f $819 million (including IFC investments in funds) i s split between $432 million in debt (including Upper Tier Capital) and $387 million in equity.

Commercial Banking Housing Finance

Securities Markets Private Equity Funds

Fund Management Companies Other Funds

Total *Primarily Upper Tier 2 Capital

342.5 125.8 24.6 321.8

1 .o 3.5

819.2

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Update: September 18,2008

I Population (millions) I 1.1 billion G N I ($ billions) G N I per capita ($)

804 730

# of Projects Guaranteed for Investments in India

Guarantees Gross ExDosure ($m)

Currently active Total 0 1

9.6

I I I I I

Guarantees -- Top sectors Sector 1 Infrastructure

(Telecommunications)

# of Projects Guaranteed to Indian Investors Guarantees Gross Exposure (%m)

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Currently active Total 2 5

14.6 21.5 Guarantees -- Top sectors

Sector 1 Manufacturing 1 Manufacturing

Annex 15: IMF Assessment Letter

August 7,2009

This note provides the IMF staf fs assessment o f India’s macroeconomic conditions, prospects, and policies for the Banking Sector Support Loan that will be considered by the World Bank in September 2009.

India’s macroeconomic conditions have improved since end-2008, but the global crisis has taken a toll on near-term economic prospects.

Growth and Inflation. Real GDP growth slowed to 5.8 percent (y/y) in the second hal f o f 2008/09, a significant deceleration from the pace recorded in recent years. From the supply side, service sector growth has been robust on the back o f resilient domestic demand, partly offsetting the sharp slowdown in m a n ~ f a c t u r i n g . ~ ~ Real GDP growth for 200911 0 i s projected at about 5% percent (from 6.7 percent in 2008/09), as the stimulus supports domestic demand. Weak global growth will continue to weigh on exports. Inflation has been on a declining trend this year, but the momentum has turned. W P I inflation, which turned negative in y/y terms in June, is expected to average 1% percent in 2009/10 and reach about 5% percent y/y by March 20 10 as base effects wane and the economy regains i t s footing. . Financial Markets and Credit. Financial market conditions have improved on the back o f global trends and the M a y elections results, which have boosted sentiment. The stock market i s up about 60 percent so far this year and normalcy has returned to the domestic money market. CDS spreads have receded significantly and stresses in nonbank financial institutions and mutual funds have abated. Private sector credit growth (nonfood) has picked up modestly in sequential terms and stood at 15.8 percent y/y in mid- July. Despite ample liquidity, lending rates have been sticky. The yield curve has steepened considerably, mainly on account o f fiscal concerns and S&P has downgraded the outlook on the sovereign rating to negative, citing concerns about the fiscal deficit.

External Position. The current account deficit rose to 2.6 percent o f GDP in 2008/09 (from 1.5 percent o f GDP in 2007/08) as goods exports plunged in the wake o f the global crisis and o i l prices surged. The current account deficit i s projected to decline (in relation to GDP) in 2009/10 helped by lower o i l imports. Capital inflows have resumed on the back o f rising global risk appetite and improved domestic prospects, but remain well-below pre-crisis levels. The rupee was very volatile earlier this year but has since stabilized somewhat. Gross international reserves (US$268 bi l l ion as o f July 24) are sufficient to cover nearly 9 months o f goods and services imports and are more than 2% times short-term debt by residual maturity.

46 From the demand side growth was 4.1 percent y/y, driven by government consumption reflecting the effect o f the stimulus measures.

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. Banking System. Banks, which dominate the financial system, appear well-capitalized, relatively liquid, and have l o w nonperforming asset ratios. However, over the last few years, a sharp increase in foreign liabilities, combined with rapid domestic credit expansion, has increased banks’ vulnerability to global deleveraging and slowing economic activity.

Policy actions to cushion the blow from the global crisis have been broadly appropriate.

a Monetary Policy. The Reserve Bank o f India (RBI) has cut the pol icy (repo) rate by 425 basis points since October to 4% percent. In addition, the RBI has taken various measures to inject rupee and FX liquidity to ensure the availability o f credit, contributing to a normalization o f the money market. But bank credit has picked up only modestly.

Fiscal Policy. The 2008/09 fiscal deficit reached 11 percent o f GDP (including subsidy- related bonds) owing to the sharp increase in o i l and fertilizer subsidies, a hike in wages, and pre-election spending, as well fiscal stimulus measures to counter the effects o f the global crisis The 2009/10 budget, unveiled on July 6, largely extends the expansionary fiscal stance in place. The central government deficit is targeted at 6% percent o f GDP, up % percentage point from 2008/09 mostly because o f higher pro-poor spending and tax relief measures. The consolidated general government deficit should, however, remain broadly unchanged, largely as a result o f savings on off-budget o i l subsidies. While continued fiscal stimulus was appropriate given the significant slowdown in growth, the budgeted deficit was somewhat larger than anticipated.

Looking ahead, India’s medium-term prospects are favorable, but challenges remain.

As the global economy regains i t s footing, real GDP growth i s projected to return to 7-8 percent over the medium term, driven by private domestic demand.

Fiscal consolidation remains a key challenge. The deterioration in fiscal conditions since FY 2007/08 has made it more difficult to reduce general government debt (about 80 percent o f GDP), while creating room for social and infrastructure spending. Revenue and expenditure reform, notably reforming the subsidy system, remain pivotal to delivering long-lasting fiscal consolidation.

Greater progress on the structural reform agenda i s also needed to spur growth, create jobs, and accelerate poverty reduction. Priorities include improving infrastructure and stepping up financial sector reform.

IMF Relations. The 2009 Article IV Consultation was concluded by the IMF’s Executive Board on February 6, 2009. The next Article IV Consultation i s expected to take place in the regular 12-month cycle.

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