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p. 28 of 81 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia Southeast Asia South Asia Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Central Asian Republics The Pacific III. Preferential Trade Agreements in Asia and the Pacific

Asian Development Outlook 2002 : II. Economic Trends and Prospects in Developing Asia : South Asia

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India

Economic growth improved in 2001, despite deteriorating external demand. While industrial expansion slowed, agriculture recorded a marked improvement due to a favorable monsoon, and services registered accelerated growth. Inflation fell and a comfortable level of foreign exchange reserves was built up. In 2002–2003, a more favorable external environment and stronger domestic demand due to a revival in agriculture should lead to faster economic growth which, to be sustained, must be supported by fiscal and structural reforms.

Macroeconomic Assessment

GDP growth in 2001 is estimated at 5.4%, somewhat stronger than the 4% in 2000 but below the 6.5% average of the previous 5 years. Several factors prevented the economy from achieving growth rates comparable with those of the mid-1990s. The global economic slowdown impacted negatively on exports, which contracted after growing at double-digit rates in 2000. Domestic demand growth remained weak, despite some strengthening in 2001, partly reflecting poor performance in the agriculture sector in 1999 and 2000. These two elements, plus a perception among the business community of slow progress in reforms, eroded business confidence and slowed the pace of growth in fixed investment.

Due to relatively favorable weather conditions, the performance of agriculture is projected to have improved significantly to 5.7% growth in 2001 after a contraction of 0.2% in 2000. This raises expectations of a possible demand-led pickup in economic performance, fueled by higher rural incomes. However, prospects for a continued sustainable agricultural improvement over the medium term depend on investment both to ease infrastructure bottlenecks (irrigation and rural electrification, in particular) and to modernize the sector.

As export demand shrank in 2001, industrial growth slowed significantly. In the first 9 months of the year, the index of industrial production rose by 2.3% compared with 5.1% in the comparable period in 2000. Manufacturing, accounting for the bulk of industrial output, expanded by a mere 2.3% in both the first and second quarters of 2001 after showing growth of 8.1% and 7.1%, respectively, in the corresponding quarters in 2000. However, moderate signs of improvement in growth momentum were evident from the second quarter of 2001 in other subsectors, such as electricity, gas, water supply, and construction. Industrial growth for the whole of 2001 is estimated at around 3.3%, the lowest rate in 5 years.

The performance of the services sector improved moderately in 2001, but fell short of the outstanding growth rates recorded in the 1990s. The sector recorded year-on-year increases of 6.7% and 7.4% in the first two quarters of 2001, respectively, with the figure for the whole year estimated at 6.5%. This represents a substantial improvement over 2000’s 4.8% growth rate and reflects more robust performance in the financial and business services segment, particularly the key ICT and software services sector, which, after growing by a disappointing 2.9% in 2000, expanded by 25% during the third quarter of 2001 compared with the same quarter in 2000.

During 1992–2000, employment growth in the organized private sector averaged 1.3% a year compared with 0.2% in the public sector. In 2000, employment in these sectors rose by 0.6% and 0.5%, respectively. The largest contribution to employment generation is likely to have come from the informal sector, for which data are not available. Stronger agricultural performance is likely to have improved rural labor market conditions somewhat and helped reduce poverty (Box 2.3), while slower growth in industry and a retrenchment in the public sector have likely resulted in a deterioration of labor market conditions in the urban sector (though data are not yet available for 2001).

A low inflation environment accompanied a modest improvement in domestic demand. The annual average inflation rate measured in terms of the wholesale price index (WPI) declined from 7.2% in 2000 to 4.7% in 2001. The drop in WPI inflation stemmed from lower fuel and power prices. However, inflation, as measured by year-on-year variations in the consumer price index for industrial workers, was higher in December 2001 than a year earlier. This resulted from increases in prices of some primary articles, such as fruits and vegetables. However, as long as prospects of agricultural growth are positive, inflation should stay within moderate levels.

In terms of fiscal performance, falling imports and slowing industry hurt central government tax collections, which were down by about 8% through the first 9 months of 2001 relative to the previous year. Overall, revenues, budgeted to increase by 21%, were at about the same level as in 2000 through December 2001 because of better than expected nontax revenues. In order to contain the fiscal deficit, the Government took steps to curtail nondefense expenditure growth, including reducing the size of the civil service through attrition and reductions in capital expenditures. Despite these measures, the central Government is likely to miss its fiscal deficit target of 4.7% of GDP with an actual deficit projected at 5.7%. However, with some improvement in fiscal performance at the state level, the combined government fiscal deficit may not worsen significantly.

The central Government’s lack of progress in reducing its deficit meant more domestic borrowing. Through the first 8 months of 2001 (through November 2001), the market borrowings of the central Government reached Rs719.3 billion, or 93% of the budgeted Rs773.5 billion for the whole fiscal year. This large volume of government borrowing continued to impart an upward bias to the interest rate structure and to increase the complexity of monetary management.

Monetary and financial developments were characterized by relative stability. Nonfood bank credit decelerated considerably in the last quarter of 2000, mirroring the slowdown in economic activity. In the first 9 months of 2001, broad money (M3) growth slowed to 10.5% from 13.2% in the comparable period of the previous year. On an annual basis, M3 growth slowed to 11.2% from 16.7% in the previous year. Bank deposits surged in response to adverse developments in other segments of the financial market, presenting the banking sector with the challenge of deploying these resources in a context of low credit and investment demand. Financial markets experienced some turbulence due to a domestic stock market scandal in March 2001 and the September 11th events in the US, but recovered quickly. Mindful of maintaining price and interest rate stability, the Reserve Bank of India (RBI) took limited countercyclical action. In October 2001, it reduced the bank rate from 7.0% to 6.5%, its lowest level since May 1973. It also reduced the cash reserve ratio in a staggered manner down to 5.5% in December 2001.

Exceptionally strong export performance, together with moderate import growth and a stable capital account, underpinned the attainment of a balance-of-payments surplus in 2000. In contrast, export growth collapsed in 2001 because of the protracted global economic slowdown, while import shrinkage reflected sluggish industrial activity and a substantial easing in oil prices compared with 2000. The trade deficit is projected to record a moderate improvement for the whole of 2001, and the invisibles account is expected to maintain a surplus in line with the 2000 outcome. Overall, the current account deficit is likely to have narrowed slightly to remain less than 1% of GDP in 2001.

The capital account strengthened in the first 8 months of the year (April to November 2001), reflecting mainly an increase in foreign investment inflows: FDI increased by over 61% compared with the same period in 2000, to $2.4 billion from $1.5 billion. This surge can be explained by the delisting of many foreign companies on the Indian bourses, as the money brought in by foreign companies for the purposes of delisting is considered as FDI. In light of these developments, the balance of payments is expected to register a moderate surplus for the sixth consecutive year in 2001.

India’s external debt position is expected to remain manageable in 2001. As of September 2001, external debt rose marginally to $100.4 billion, a 2.1% increase from the previous quarter’s figure of $98.3 billion. The debt service ratio declined from the peak level of 35.3% in 1990 to 17.1% in 2000 as the Government continued to pursue a prudent external debt management strategy. The external debt-to-GDP ratio dropped to 21% in September 2001 from 22.3% in 2000. By the end of September 2001, the share of short-term debt in total debt had declined to 2.8% from 3.2% in June and the ratio of short-term external debt to foreign exchange reserves had fallen to 2.8%.

Policy Developments

In the 2001 budget, the Government announced a comprehensive program of second-generation reforms aimed at fiscal consolidation. The 2002 budget seeks to build on this platform through a two-pronged approach comprising both revenue-generating measures, including a 5% surcharge on all taxpayers, and expenditure-management measures, such as containing growth in public sector employment and reducing subsidies. At the same time, the budget made significant provisions for investment in infrastructure. Consolidating on earlier initiatives such as the State Fiscal Reform Facility, the budget sought to encourage the states to move toward better fiscal management by linking financial assistance to progress in implementing reforms, particularly in the area of tariff adjustment. It also took some steps toward the creation of a nationwide integrated market for goods and services, by presenting a reform framework for the agriculture sector.

Proposed finance sector reforms include implementing measures to strengthen creditor rights, establishing a pilot asset reconstruction company, allowing foreign banks to establish subsidiaries in India, and reforming pensions. The budget also introduced implementing measures to link administered interest rates to the market interest rates on government securities of equal maturity, in a move that should bring down the overall level of interest rates in the economy. With respect to capital markets, sector caps on portfolio investments made by foreign institutional investors were eased. India’s economic prospects depend largely on the extent to which the Government will succeed in implementing these reforms, and particularly on its ability to achieve fiscal adjustment. They will also depend on the enactment of reforms to eliminate existing distortions in the factor market, including the reform of labor laws, as earlier recommended by the Council of Economic Advisors.

While there was some success in addressing fiscal problems in 2000, the deterioration of the fiscal situation in 2001 is a cause for concern. Large fiscal deficits are a chronic condition in India (Figure 2.16) and the cumulative debt burden of central and state governments is substantial. The fiscal situation has clear implications for the performance of the economy and for overall development. The Fiscal Responsibility and Budget Management Bill, under discussion in Parliament, contains a medium-term program of fiscal discipline, which would allow the debt path to converge toward a more sustainable trajectory.

The quality of fiscal deficits has been worsening. The large component of relatively rigid current expenditures—interest payments, subsidies, and public sector salaries and pensions—has risen over time and now accounts for a disproportionately large portion of the gross fiscal deficits at both the central and state levels. As a consequence, there is little money left for development and capital expenditures in physical and human infrastructure. Rationalization of public expenditures is required, but fiscal correction will require stronger revenues and an improvement in the overall efficiency of the tax system as well. In this respect, it is regrettable that the date of one of the key measures, the introduction of VAT, originally planned for 1 April 2002, has now slipped to 2003.

The Government cannot cut fiscal deficits substantially without reducing public sector subsidies, a large share of which is accounted for, directly or indirectly, by public sector undertakings (PSUs). For example, some estimates indicate that power sector subsidies and losses alone are equivalent, on average, to 50% of the states’ deficits. Clearly, reforming PSUs and embracing decisively a disinvestment and privatization program would go a long way toward improving fiscal performance. In the context of the states’ fiscal reform facility (2000–2004), power sector reforms are a key component of the states’ medium-term fiscal reform programs and are included in memorandums of understanding between the central and state governments.

However, progress in disinvestment and privatization has been limited, for two main reasons. First, political economy factors tend to delay the process of PSU reform and results have been slow. Of a targeted disinvestment of Rs100 billion in 2000, only Rs25 billion were realized, while a similar outcome appears likely for 2001. However, the elevation of the Minister of Disinvestment to a cabinet position in October 2001 suggests greater government commitment.

Second, the economy will need the private sector to step in as the Government moves out of certain critical areas. A substantial share of private sector resources will need to come from outside the country. However, as the Enron-Dabhol case shows, the path to successful project implementation based on FDI is fraught with risk. Here, again, the precarious state of public finances, particularly at the state level, plays a role in the dynamics related to specific deals. But fiscal profligacy is also among the factors that contribute to creating an overall investment climate that is not conducive to FDI or to private investment in general. A recent study by the Confederation of Indian Industries and the World Bank found that significant disadvantages in power costs, interest rates, customs delays, infrastructure bottlenecks, and regulatory encumbrances far outweighed the marginal advantage that the economy has in terms of value added per unit of labor cost vis-à-vis other emerging economies.

Increasing the operational efficiency and transparency of the finance sector is also important to the creation of a supportive investment climate. To respond to concerns about the vulnerability of the sector, the financial reforms in 2001 continued to focus on strengthening both banking and nonbanking sector prudential standards. This meant upgrading norms for capital adequacy, income recognition, provisioning for nonperforming assets (NPAs), disclosure and transparency in accounting, and risk management. Specific proposals included new prudential norms for cooperative banks on lending against shares and on access to call money, and an apex supervisory body for the urban cooperative banking sector. RBI examined possible measures to strengthen the supervisory role of the boards of banks and of other financial institutions. Reforms also aimed at developing or strengthening linkages among the various segments of the financial market and at upgrading market practices and technologies. Guidelines were introduced in October 2001 for conversion of commercial paper from physical into dematerialized form. Steps were taken to develop government securities markets further, including measures to facilitate the availability of treasury bonds of varying maturities in the secondary markets, and the introduction of a negotiated dealing system. The amendment of the Securities Contract (Regulation) Act of 1956 better defined the supervisory and regulatory role of RBI with respect to government, money market, and gold-related securities, and related derivatives transactions.

The overhang of NPAs remained a factor in structurally high intermediation costs in the banking and nonbanking sectors, and, together with the high cost of funds and noninterest operating expenses, somewhat limited the downward flexibility of interest rates and, therefore, the effectiveness of monetary policy. Over the period 1996–2000, average gross NPAs as a share of total assets were 6.6% for public sector banks, 4% for private sector banks, and 2.9% for foreign banks. RBI is now moving toward the adoption of international norms for classifying loans as performing and nonperforming by 2004. RBI issued new guidelines for the recovery of NPAs in 2000, which were operative until June 2001. Under these guidelines, public sector banks recovered Rs22 billion. In addition, banks were mandated to include the risk-weighted assets of their subsidiaries in their consolidated balance sheets on a notional basis and to make adequate provisions.

The limits of bank exposure to individual or group borrowers and to capital markets were made more conservative. Prudential norms introduced for banks were, in many cases, extended to nonbank financial institutions as well, in the context of a move toward the consolidated supervision of the whole finance sector. New norms were set for entry of new private sector banks and for eligibility criteria of banks and nonbank financial institutions to enter the insurance business.

The strengthening of prudential and disclosure norms and of supervision remained a major plank of the capital market reforms. Following turbulence in the equity markets in March 2001, a series of capital market reforms was announced in May, including a code of conduct against insider trading.

Outlook for 2002-2003

During 2002, a moderate pickup in domestic demand as well as a rebound in global markets should provide sufficient stimulus for India’s economy to grow at around 6%. Export growth in particular, should return to a double-digit rate, even though it is unlikely to reach the exceptional level of 2000. The current account deficit is expected to remain moderate, under the assumption of fairly stable oil prices, at around 1% of GDP. On account of substantially unutilized industrial capacity, industry sector activity will be able to respond quickly to the increase in demand, without undue inflationary pressure in the short term. Downward pressures on the price level may, in fact, be accentuated by the availability of cheap imports, provided that the positive impact of the removal of quantitative restrictions in compliance with WTO obligations is not offset by other forms of protection. With a stable rupee around the current level of Rs48 to the dollar, inflation is forecast at about 4% in 2002.

However, as the economy approaches full capacity utilization in 2003, and as investment demand recovers, structural impediments, such as high fiscal deficits and high real interest costs, may become binding constraints to economic performance if they are not dealt with. Assuming that visible and effective interventions are made both to address the structural fiscal deficits and to facilitate a further reduction in interest rates, the economy will grow at 6.5–7% in 2003. This requires a solid performance in the agriculture sector, as supported by the effects of reform and modernization. The projected improvement in growth performance also rests on the assumption of continued industrial recovery and strong services sector performance, in a favorable external demand environment. Inflation should still be moderate at around 5%, with the current account deficit in the range of 1–2% of GDP, to the extent that high export growth largely offsets an increase in imports.

Further liberalization of FDI may be required, but for Indian producers to compete effectively with foreign producers both at home and abroad, restrictions on key entrepreneurial decisions concerning scale and factors of production need to be removed. These include small-scale industry reservations that preempt the adoption of the optimal scale of production, and archaic labor laws that substantially hinder the ability of producers to retrench and restructure their businesses when market conditions require them to do this. Only if these necessary policy actions are undertaken can the higher projected growth rate of 2003 be taken as an indicator that the economy is moving onto a higher and sustainable growth path.

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