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p. 30 of 68 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 Asia The Pacific III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia : South Asia

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India

Economic growth slowed in 2002, largely due to a drought-induced drop in agriculture. Large food stocks kept inflation in check. Official reserves rose to record levels, mainly built by large capital inflows. The outlook is for a robust recovery based on resumption of trend agricultural performance and continued buoyancy in industry and services. Nevertheless, sustaining rapid growth will require action to reduce the large fiscal deficit and reinvigorate the economic reforms.

Macroeconomic Assessment

The comprehensive market-oriented reforms pursued in India through the 1990s aimed to rationalize resource allocation, improve productivity and competitiveness in all spheres of economic activity, and move the economy to a sustained rate of higher growth. The reforms ranged from macroeconomic stabilization and fiscal reforms, trade liberalization, and industrial deregulation, to financial sector reforms, disinvestments, and privatization. The economy did in fact attain higher rates of growth in the 1990s, led by services, which is now the largest sector of the economy. However, the trend was not sustained. Compared with an average growth of around 6% through the 1990s, GDP growth was disappointing, at an average of 5.0% in FY2000 and FY2001 and is now estimated to have further declined to 4.4% in FY2002 (ended 31 March 2003).

The slowdown in the initial years of the new millennium is quite evident in the services sector. After growing at an average rate of about 8% in the latter half of the 1990s, the sector's growth rate declined to 7.1% in FY2002. Growth rates in other sectors have fluctuated. Industrial growth slumped from 6.6% in FY2000 to 3.3% in FY2001 and then recovered to 6.1% in FY2002 (Figure 2.15). The agriculture sector recovered from a contraction of 0.4% in FY2000 to an impressive growth rate of 5.7% in FY2001 and then suffered another contraction of 3.1% in FY2002. The primary factors contributing to lower growth in recent years include exogenous effects, such as global recession and drought, as well as the impact of a large and persistent fiscal deficit and slow progress of reforms in some sectors. The Government can help guide the economy back to a high growth path through an aggressive fiscal adjustment program and other reforms. This will revive business confidence as well as public and private investment, including FDI.

The decline in growth in FY2002 is primarily on account of a supply shock in agriculture, resulting from insufficient rainfall. By the end of the monsoon season, 21 out of 36 meteorological subdivisions in the country, covering more than 55% of the total land area, had received less than normal rainfall, with 19 of them in the "deficient" category. During June-November 2002, the shortfall in total rainfall was 20%.

The fall in overall growth in FY2002 masks a recovery in industry, where manufacturing growth at 5.4% during April-December 2002 was higher than the 2.7% growth registered during the same period in the previous year (Figure 2.15). Improved performance was seen across all subsectors. The turnaround in capital goods, especially in transport equipment, occurred despite the high growth in imports of capital goods. The growth rates of nondurable consumer goods, such as food products, beverages, tobacco and other products, and textile products, especially wearing apparel, also rose during FY2002. The upturn in the basic goods sector is attributable to a sharp rise in construction activities. The recovery was also evident in six core infrastructure industries, namely, cement, steel, coal, electricity, crude oil, and petroleum products. These infrastructure industries registered a combined growth rate of 5.4% in April-December 2002 as against 2.5% in the corresponding period of 2001. The industrial recovery is mainly attributable to lower real interest rates, a revival of merchandise export growth, large foreign exchange reserves, and the large foodstocks that have contained inflation despite the supply shock in agriculture. These factors have triggered an upturn in the industrial business cycle. According to the National Council of Applied Economic Research, its index of business confidence, which stayed flat between June and October 2002, showed a marked improvement in January 2003.

Employment data are currently available only up to FY2001. While overall employment grew at a yearly rate of about 1% from FY1993 to FY2001, organized sector employment grew at an even slower rate of only about 0.3%. Employment in the private sector grew at about 2% a year during the period, but public sector employment registered an absolute decline over the same period, due to rightsizing reforms in government. With ongoing restructuring, public sector employment is likely to fall further. The prospects of private sector employment growth are also modest until the economy shifts to a higher growth trajectory. The avenues of future employment growth in the economy lie mainly in the labor-intensive services sector. Employment creation is a major goal of the recently finalized Tenth Five-Year Plan (Box 2.5).

Apart from temporary shocks, the recent slowdown in growth is attributable to structural constraints, arising from fiscal imbalances, which have adversely impacted investment. Recent average investment and savings rates of around 24% and 23%, respectively, are lower than the peak rates of around 27% and 25% achieved in 1995. In the past, economic growth was led by public investment. However, the situation changed significantly during the late 1990s with declining rates of public investment. The growing burden of servicing a burgeoning public debt, a large volume of subsidies, and a sharp increase in the government salary bill following the recommendations of the Fifth Pay Commission eroded public savings, thereby crowding out public investment in infrastructure. The share of public sector investment in GDP declined from 11.2% in FY1986 to 8.2% in FY1993 and further to 6.6% in FY1998, and has now settled at 6.3% of GDP. Private investment failed to fully replace public investment since it was also crowded out by a large transfer of private savings for public expenditures through the financial sector. Private savings amount to about 26.5% of GDP, while private investment amounts to only 16% of GDP, implying that the deficit-prone public sector has effectively siphoned off almost 40% of private savings. The effect of this crowding out has been further exacerbated by policy uncertainties and slow progress of reforms in some sectors.

On the fiscal front, the central government deficit showed a small narrowing to 5.9% of GDP in FY2002 from 6.1% in the previous year; the budgeted target was 5.3%. The deficit would have been higher but for the increase in net tax revenues, which registered an impressive 23% rise in FY2002. In addition to the central government deficit, the estimated combined deficit of the state governments is 4.2%, resulting in a consolidated (net) deficit of 9.3% in FY2002. Though slightly lower compared with the 10% level in FY2001, the overall fiscal deficit remains very large and a major challenge for macroeconomic management. Excessive public borrowing has led to rapid growth of public debt. The combined outstanding public debt of the central and the state governments is estimated at 72.6% of GDP in FY2001; consolidated data are not yet available for FY2002. However, net market borrowings of $23.3 billion or approximately 5% of GDP by the central Government in FY2002 exceeded the budget estimate by 17.7%.

Turning to money and prices, money supply (M3) growth in FY2001 was in line with the projected trajectory at 14.2%. In the following year, money supply grew by 15.7% up to January 2003. Inflation, as measured by the wholesale price index (WPI), declined from 7.2% in FY2000 to 3.6% in FY2001, and further to 2.8% in April-December 2002. This is despite the setback in agriculture, high international oil prices, and a transition to market-determined prices in the hydrocarbon sector. Annual inflation as measured by changes in the CPI for industrial workers was somewhat higher at 4.0% in April-December 2002. The easing of the price situation despite adverse factors is primarily due to the large surplus stock of foodgrains in the country and global deflationary trends.

Through 2001 and 2002, the Reserve Bank of India (RBI) progressively eased its monetary policy stance in an attempt to revive growth. It has also been encouraging commercial banks to reduce their spreads. This was reflected in the Monetary and Credit Policy for 2002 and the midyear review of credit policy. The RBI reduced the cash reserve ratio from 5.0% to 4.75% and the bank rate from 6.5% to 6.25% from 16 November 2002. With a cut in the bank rate, commercial banks lowered both deposit and lending rates. Most banks reduced their prime lending rates by 0.25-0.5 percentage points. The prime lending rates of the major banks were in the range of 10.75-11.5% as of 22 November 2002. This is still very high in real terms, given an inflation rate of less than 3.0%. Commercial banks continued to maintain relatively steep interest rates mainly on account of significant provisioning for NPLs. Also, the cost of money remains very high for nonprime borrowers.

Financial sector reforms, including interest rate deregulation, entry of commercial banks into term lending, and lack of concessional funds have increased the competitive pressure on development financial institutions (DFIs). Consequently, many DFIs are being restructured, following RBI guidelines, to enter retail banking. Thus, for example, the Industrial Credit and Investment Corporation of India has transformed itself into a bank.

On the external front, export growth is showing signs of revival after a poor performance in FY2001. The global slowdown, exacerbated by the events surrounding September 11, had resulted in a slump in exports, which averaged marginal growth of 0.1% in FY2001. Despite this, with imports contracting by 2.8% in FY2001, the trade deficit declined to 2.6% of GDP. The growth of merchandise exports and imports at 11.4% and 6.3%, respectively, in April-September 2002 is a marked improvement over the contraction witnessed in the corresponding period of 2001. The trade deficit narrowed to $6.9 billion in this period from $7.5 billion during April-September 2001. The turnaround in exports was largely due to a partial recovery of global demand, with an upturn in GDP and final consumption expenditures in the US, and a revival of growth in many Asian countries. The rise in consumer expenditures in the US in particular has pushed growth in exports of consumer items, such as textiles and garments, as well as gems and jewelry, to high rates. The growth in imports mainly reflects the recovery of domestic industrial activity. While capital goods imports have revived, those of consumer goods continued to decline. Moreover, with international crude oil prices hardening, the import value of petroleum and its related products has risen sharply.

The current account realized a small surplus of 0.3% of GDP for the first time in 23 years in FY2001, and it continued to improve during the first half of FY2002 with a surplus of $1.7 billion, mainly due to a surplus on the invisibles account. There is a risk that the recent appreciation of the nominal exchange rate might reverse this trend, and lower the current account surplus. Net capital inflows in FY2001 were led by a 67% increase in FDI inflows. However, total foreign investment inflows declined to $1.1 billion during April-September 2002 compared with $2.6 billion during the same period in 2001. This is the result of a drop in FDI inflows to $1.7 billion from $1.8 billion in April-September 2001 and a reversal in net portfolio investment by foreign institutional investors to a net outflow of $0.4 billion in April-September 2002, from a positive net inflow of $1.2 billion during the same period in 2001.

Despite the deceleration of foreign investment inflows, foreign exchange reserves continued to increase steadily from about $40 billion at the end of 2000 to around $51 billion at the end of 2001 and further to nearly $70 billion as of 31 January 2003. The recent accretion of foreign exchange reserves is mainly attributed to banking capital and other capital account transfers induced by a weak dollar and India's positive interest rate differential compared with international rates. Such large increases in reserves caused the exchange rate of the Indian rupee to appreciate by about 0.4% against the dollar in January 2003 over the same month in 2002. Armed with large foreign exchange reserves, the RBI has recently liberalized the foreign exchange market. Moreover, since late FY2002 the Government has embarked on prepayments of high-cost external debt. These moves notwithstanding, India is yet to achieve the conditions for capital account convertibility laid down by the Tarapore Committee on Capital Account Convertibility in 1997, i.e., fiscal consolidation and a strong domestic financial system.

Policy Developments

There were several important policy developments in FY2002 covering tax, the financial sector, trade, and industry.

The Task Forces on Direct and Indirect Taxes recommended wide-ranging reforms in tax policy as well as tax administration. The budget for FY2003 initiated a phased implementation of some of these proposals, starting with a major reform of tax administration for both direct and indirect taxes. Among the important revenue proposals, the taxation of services has been extended to cover a larger number of items, and the tax rate has been revised upward to 8.0%. Moreover, a constitutional amendment has been proposed that will empower state governments to levy a tax on services.

The most important expenditure consolidation measure announced in the FY2003 budget is debt restructuring. High interest public debt will be prepaid to take advantage of the recent decline in nominal interest rates. About $3 billion of external debt to ADB and the World Bank has also been prepaid in this way. Moreover, the Government has announced a $21 billion debt swap scheme for the states to restructure their debt to the central Government over a period of 3 years. Under the scheme, states will borrow from the market at low interest rates to repay high-cost old debt to the central Government. These measures should significantly reduce the debt-servicing burden of the Government. However, India's basic macroeconomic problem of a large fiscal deficit has not been fundamentally addressed. The projected central government fiscal deficit for 2003 is 5.6%. Since the actual deficit usually overshoots the projected deficit by at least 0.5%, it is likely that 2003 will end with a central government deficit of about 6%. After adding the combined deficit of the state governments, the total fiscal deficit in FY2003 is likely to exceed 9.5%.

Reducing the deficit has to focus on both raising revenues and better management of public expenditures. On the revenue side, using the average of Asia-Pacific countries as a benchmark, there is a potential for increasing tax revenues by around 3-5% of GDP. At the central level, there is significant scope for broadening the tax base, especially through taxation of services and reduced exemptions. Improved tax administration and better tax compliance will also help in this direction. Expenditure reforms at the center should aim at a phased reduction of subsidies, rationalization of government staff, and reduction of budgetary support to public enterprises. Finally, keeping in view the burgeoning debt stock of the Government, the associated crowding out of private investment, and the recent decline in interest rates, the Government should examine options for further debt restructuring to reduce the debt service burden.

With regard to fiscal consolidation at the state level, a Medium-Term Fiscal Reform Program for States was negotiated between the central Government and several state governments, which offers incentives for state fiscal reforms through performance-linked transfers from the central Government. However, this scheme needs to be rationalized and considerably strengthened. Also at the level of the states, it is essential to shift expenditures toward better provision of social services, and raise revenues to contain the revenue deficit. The transition to VAT and its effective administration is the crux of tax reforms at the subnational level. States also need to seriously consider untapped revenue sources, such as taxation of agriculture and enforcement of rational user charges for water and power. Restructuring of public expenditures at the state level should attempt to reduce unproductive and poorly targeted expenditures, while making sufficient provision for investment in infrastructure and human capital. Accelerating the pace of reforms of the state electricity boards, road transport corporations, and other public enterprises should be a high priority.

In the financial sector, the Government enacted the landmark Securitisation, Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 that provides a comprehensive legislative framework for foreclosure of assets by lenders, formation of private asset reconstruction companies (ARCs), and securitization of assets with an emphasis on foreclosed assets to address the problem of a high level of NPLs. The new Act empowers banks to foreclose collateral assets for NPLs and it is expected to lead to a significant reduction in NPLs. The Act also creates a framework for ARCs, including capital ownership and issue of securities; regulation under RBI; transfer of ownership and management rights to the ARCs; and creation of a centralized depository for registering securities. In another important development, the Unit Trust of India, the largest mutual fund in the country and hitherto controlled by the Government, has been restructured into two entities, one dealing only with schemes based on net asset values, and the other dealing with assured return schemes. Another major policy development in the financial sector is legislation on money laundering. Parliament has approved a law that allows confiscation of property derived from or involved in money laundering. The law also makes it mandatory for banking companies, financial institutions, and intermediaries to maintain a record of all transactions exceeding a prescribed value and to furnish information to authorized government agencies whenever sought within a prescribed time period.

In foreign trade, the medium-term prospects of merchandise export growth will depend to a large extent on the removal of infrastructure bottlenecks, reduction in transaction costs arising from procedural delays or other bureaucratic impediments, and, most importantly, improvements in competitiveness by exports moving up the value chain to high-value capital goods. The Medium-Term Export Strategy for 2002-07 has attempted to address most of these issues. The Strategy aims at a compound growth rate of 11.9% for exports to achieve a 1% share of world exports by 2007. The Strategy identifies products and markets for potential export growth and suggests product-wise strategies that are beneficial for overall export growth. The instruments discussed in the Strategy include tariffs, FDI, and exchange rate policies, as well as measures for reducing transaction costs and setting up an appropriate environment for export growth. The last point includes special economic zones, marketing support, free trade agreements with potential trade partners, and participation of the states in export promotion.

Improved corporate governance is a major priority in industrial policy. The Competition Bill is an important step in that direction. The Bill is designed to replace the existing Monopolies and Restrictive Trade Practices Act, which has been a barrier to investment by large corporations. The Bill redefines anticompetitive trade practices, such as abuse of a dominant position, cartels, predatory pricing, bid-rigging, and boycotts. The Bill seeks to promote competition by abolishing the requirement to register business agreements, regulating mergers and acquisitions, and prohibiting both horizontal and vertical agreements between firms that affect competition, in accordance with internationally accepted practice. A competition commission has been proposed to ensure effective implementation.

Outlook for 2003-2004

The industry sector is on the upswing of a business cycle, which is expected to continue in FY2003 and lead a moderate revival in GDP growth. Assuming normal monsoon conditions, the economy is projected to grow by 6.0% in FY2003 with agriculture and services growing at average rates. Exports are expected to grow at over 15% in 2003, based on a moderate revival in world demand. The current account surplus should be maintained, assuming fairly stable oil prices, a positive net trade balance in invisibles, and a marginally appreciating currency due to large foreign exchange reserves. However, projections for the external account, especially for oil prices, as well as macro projections, will have to be reviewed to take into account impacts of the conflict in Iraq. Inflation will likely remain moderate at around 5%. Tax measures in the FY2003 budget are expected to enhance buoyancy and raise the revenue-to-GDP ratio. However, in the absence of strong measures to contain the rapid growth in expenditures, the consolidated fiscal deficit is expected to remain at the average level of 9.5% of GDP.

The projected macroeconomic trends of FY2003 are likely to continue through the following year with expected GDP growth of 6.3%. Inflation should remain at around 5%. The current account balance will likely remain positive, despite a higher rate of import growth (again, depending on the effects of the conflict in Iraq).

Strong fiscal consolidation is expected during the postelection phase of the political cycle in the latter half of FY2004, leading to a decline in the consolidated fiscal deficit to 9.0% of GDP. In the medium to long term, sustained high growth will require higher investments in capacity creation for infrastructure development as well as technology development for improvements in competitiveness, removal of various rigidities in labor laws and, especially, strong fiscal consolidation.

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