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p. 35 of 69 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions 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. Foreign Direct Investments in Developing Asia

Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia : South Asia

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India

The economic outlook for India is mixed. GDP is growing strongly, the markets are buoyant, and the balance-of-payments position is comfortable. However the large fiscal deficit, short-term and reversible nature of foreign exchange inflows, poor quality of infrastructure, and slow growth of employment are concerns, as are the poor performance in human development and growing interregional disparities.

Economic Assessment

The consensus growth forecast for India in FY2003 (ended 31 March 2004) is in the range of 7.2% to 7.3%, a sharp increase from average growth of 4.7% in the preceding 3 years. This improvement in aggregate growth reflected an acceleration in services, combined with a strong recovery in agriculture and stronger growth in industry. The key question is whether such high growth is sustainable.

An analysis of growth patterns over the past 50 years since FY1950 indicates that the economy is now on the upswing of a new business cycle (Figure 2.16). This in turn is riding on an underlying long-term trend of accelerating growth, which has increased from 3.5% during the 1950s-1970s to 5.4% in the 1980s and further to 5.9% in the 1990s. Growth acceleration, particularly in the 1990s, stems from a significant step-up in services sector growth.

The variations in trend growth across sectors have led to a major change in the structure of the economy. The share of services in GDP increased from 27.9% to 50.8% between FY1950 and FY2002. The increase in the share of industry during the period was more modest, from 14.7% to 27.2%, and the share of agriculture saw a corresponding decline, from 57.4% to 22.0%. As growth in services is much more stable than in agriculture or industry, the rising share of services in GDP implies that growth volatility is also declining over time.

The growth acceleration in services to become the largest sector in the economy relates to several factors. A growth decomposition exercise shows that it is not just a statistical artifact arising from pay raises and the expansion of the wage bill in public administration. Nor is it attributable to the highly visible growth of software services, since their weight and contribution to total services sector growth is still limited. The two subsectors of trade, hotels, and restaurants, and transport and communications account for just more than half of total services sector growth in recent years, and financial services account for just over one fifth of it. A recent IMF study suggests that growth acceleration in the services sector is explained by high-income elasticity of demand, user industry demand, and rising exports, in addition to reforms and technological advances.

The high trend of growth in services was maintained in FY2003. Industry also recorded robust growth, of about 6.1%, which was broad based among capital, consumer, and intermediate goods. Growth in the country’s core industries, such as petroleum, coal, electricity, cement, and steel, started picking up toward the end of the year. It is expected that, as a consequence of large public investments being undertaken under various national infrastructure programs, the demand for construction intermediates, such as cement and steel, will rise further.

Agriculture also recorded a strong recovery, with estimated growth of 7-8% in FY2003. Excellent monsoon rains, moderate temperatures, and good winter precipitation account for this recovery. However, there is no guarantee that the recovery will be sustained. Agriculture remains a highly unstable sector, dependent on the weather. Average growth is fluctuating around 3% at present compared with 5.3% in the 1980s. Declining growth and continuing instability of agricultural production due to dependence on rain-fed cropping both point to the urgency of raising public investment in irrigation and reducing dependence on rainfall.

It seems therefore that sustaining a high rate of growth will depend primarily on high investment, not only to stimulate aggregate demand in the short term but also to enhance the long-term growth potential of the economy. The investment rate has been stuck at 23-24% in recent years, lower than the peak rate of 26.9% in the mid-1990s. A high rate of growth of over 7%, despite the lower investment rate, implies an improvement in capacity utilization and efficiency of capital use. The incremental capital-output ratio has come down from about 4 to 3.6 as targeted by the 10th Five-Year Plan (FY2002-FY2006). However, as the opportunities for improving capital use efficiency and capacity utilization are exhausted, sustaining high growth will depend on raising the rate of investment, which in turn will critically depend on fiscal consolidation.

A large fiscal deficit in the order of 9-10% over many years has built up a public debt stock amounting to 75.5% of GDP. Interest payments alone eat up 21.3% of consolidated public expenditures of the central Government plus the states. This, together with other current expenditures, especially subsidies and wages of public employees, amounts to 25.8% of GDP, exceeding total revenues that amount to 19.1% of GDP. Thus the Government has to borrow not only to finance the entire public investment program but also a component of current expenditures. However, the large fiscal deficit is a double-edged sword. Although in the short run it stimulates demand and steps up the rate of growth, by directly crowding out public investment, as well as private investment via the financial market, the deficit constrains capacity expansion and the long-term growth potential of the economy on the supply side. It is this long-term risk and nonsustainability of a deficit-financed, public expenditure-led pattern of growth that underlines the urgency of fiscal consolidation.

The Government has so far avoided monetizing the fiscal deficit in order to contain inflationary pressures, especially since large foreign capital inflows are causing a rapid expansion of the monetary base. The deficit has been financed largely through borrowing from the financial sector. As a consequence, lending to the Government has accounted for as much as 41.2% of total commercial bank lending. Such large-scale sovereign borrowing at relatively high interest rates has tended to crowd out private borrowers, especially small and medium enterprises. The Reserve Bank of India (RBI) has been pursuing an accommodative monetary policy and progressively reduced the cash-reserve ratio and the bank rate to contain this tendency. Prime lending rates have accordingly softened marginally and the flow of bank credit to the commercial sector has been rising, growing by 17.1% in FY2003. Total money supply (M3) grew by 13.7% over this period, which is in line with the target rate of 14.0%. Accordingly, inflation, as measured by the wholesale price index, remained moderate in FY2003, fluctuating at around the average rate of 5.3%.

Apart from domestic demand stimulation through expansionary fiscal policy and accommodative monetary policy, aggregate demand has also been stimulated by a positive turnaround in the external sector in recent years. A chronic current account deficit of around 1.6% in the 1980s and 1990s turned into a surplus for the first time in over 20 years in FY2001. This improvement is primarily attributable to the strong growth in the invisibles account, especially the surge in export earnings from IT-associated services. In FY2003, merchandise exports are estimated to have grown by 15.1%. Imports are estimated to have risen by 19.7%, and from a larger base, reflecting the revival of economic activity and larger domestic absorption of certain consumer durables and nondurables. Consequently a trade deficit of $17.9 billion is expected, but after adjusting for receipts from invisibles, a net current account surplus of $4.2 billion is likely.

Along with improvements in the current account position, foreign exchange reserves increased to $107.4 billion as of end-March 2004. However, these gains on the capital account are not without risk, given the rising share of reversible portfolio investments, banking flows, and short-term loans. These components accounted for about half the annual capital inflow of around $21 billion in FY2002. In contrast, of the $33.9 billion foreign exchange accrual in FY2003, as much as $19.5 billion is in the form of net portfolio investments, net short-term loans, and net banking capital inflows. On the other hand, FDI inflows remained low at only $3.6 billion during this period. There is a risk, therefore, that a shift in investor preferences abroad could reverse these flows, and sharply reduce foreign exchange reserves (as observed in many countries during the 1997-98 Asian financial crisis). Moreover, the nominal exchange rate of the rupee vis-à-vis the dollar has appreciated by 7.8% over the past 2 years, though the real effective exchange rate has appreciated by only 1.2%. However, since the US is India’s major trading partner, a further appreciation of the rupee against the dollar could undermine expansion of exports.

Apart from the above macroeconomic risks, the economy faces various social challenges relating to employment, poverty reduction, and human development. Agriculture is critically important for the first two elements. Though the sector now accounts for only 22% of GDP, it still provides about 57% of total employment (as well as supporting the bulk of poor people), despite having seen almost no growth in employment over recent years. The only sector where employment has risen is the industry sector, where annual average employment growth increased from 0.6% during FY1987-FY1992 to 2.4% during FY1993-FY1998. However, the sector accounts for only 17.6% of the work force. The services sector accounts for about 26% of total employment. Average annual employment growth in this sector declined from 3.1% during FY1987-FY1992 to 2.1% during FY1993-FY1998. As a consequence, while GDP grew by 6.6% in FY1993-FY1998 overall employment expanded by less than 1% a year-virtually jobless growth. Set against annual labor force growth of 1.3%, this implies increasing open unemployment or underemployment and a weakening of the poverty-reducing impact of growth. This is clearly a major social challenge. The incidence of income poverty fell from 54.9% in FY1973 to 26.1% in FY1999. However, there is some doubt as to whether this pace of poverty reduction will be sustained over the next decade, despite high growth.

Another major social challenge relates to human poverty. Despite some recent improvements, performance in terms of education, health, and social exclusion indicators remain disappointing. India is still ranked as low as 127 out of 175 countries on the Human Development Index, lower than its per capita income rank of 115. The 10th Five-Year Plan has accordingly identified the strengthening of social service delivery as one of its most urgent tasks. It has proposed a sharp 80% increase in public social spending in this period, along with improved governance to ensure more decentralized and improved delivery of pro-poor public services.

An emerging social challenge relates to accentuation of economic and social disparities between leading states, such as Gujarat, Haryana, Kerala, Maharashtra, Punjab, and Tamil Nadu, and lagging states, such as Assam, Bihar, Madhya Pradesh, Orissa, Rajasthan, and Uttar Pradesh. Such growing interregional disparities can lead to serious sociopolitical tensions in the future if they are not urgently addressed.

Policy Developments

Several policy developments in the past year are significant in the context of the economic assessment presented above. These can be broadly grouped into developments in fiscal policy and monetary policy; policy measures to promote FDI; and policy reforms for infrastructure development, especially power.

As part of its steps to tackle the large fiscal deficit, the Government enacted the Fiscal Responsibility and Budget Management Act, 2003. The main purpose of this act is to ensure effective fiscal management and reduce the deficit of the federal Government, which accounts for about half of the total fiscal deficit. The federal Government has also started introducing IT-enabled services to improve tax administration, which should enhance tax buoyancy and help reduce the deficit. However, in early 2004 it introduced a number of tax exemptions and customs and excise duty reductions that have partly reversed these gains. Had these duty reductions been introduced as part of a planned shift from excessive dependence on indirect taxes to greater reliance on direct taxes, this would have served as a sound tax rationalization measure. Given the ad hoc manner of introducing the rate reductions without a corresponding enhancement of the direct tax base through elimination of exemptions, the tariff adjustments have made it more difficult to accomplish the act’s targets. A fiscal consolidation program for the state governments has also been under implementation since FY2000, though the results of this program have also been mixed.

The main thrust of monetary policy during the year was to contain the inflationary potential of a rapidly expanding monetary base due to large foreign capital inflows, while attempting to contain the crowding-out effect of government borrowing from the financial market. Accordingly, along with sterilization through open market operations to offset the monetary impact of foreign capital inflows, the monetary and credit policy for FY2003 reduced the cash-reserve ratio and the bank rate, respectively, from 4.75% to 4.5% and 6.25% to 6.0%. The central bank also initiated several measures to enhance transparency and disclosure of financial information on capital adequacy and risk exposure of commercial banks. It has also taken steps to strengthen the microcredit system. However, these policy initiatives notwithstanding, lending rates remain high with prime rates of 10.25-11% as against 5-5.5% on deposits of 1-year maturity.

Against a background of remarkably low and declining levels of FDI, and the need for a more attractive policy environment to attract it, the Government has progressively abolished or substantially liberalized the FDI ownership limitations that earlier applied in most sectors. These measures were extended to the hydrocarbon sector and banks during the year.

Other structural weaknesses that have been major disincentives for FDI include nontransparent and cumbersome regulatory procedures; archaic labor, land, and rent control laws; and poor infrastructure. Reforms to correct these structural distortions on a countrywide basis will take years. As an interim measure though, the Government has started establishing a large number of special economic zones through public-private partnerships. Aiming to attract more FDI, these zones provide high-quality infrastructure, simplified implementation of regulatory procedures, exemption from certain legal provisions relating to land and labor, and several tax incentives.

Finally, unreliable and inadequate power supply has been a major impediment to industrial recovery and growth. Continuing and severe shortages of power are as much due to inadequate generation capacity as to huge transmission and distribution losses from theft as well as technical inefficiencies. As these losses amount to nearly one third of power generated, a significant reduction in them would considerably ease power shortages even before new generation capacity comes on stream. Moreover, a reduction in the large subsidies in power distribution would also allow for better demand management and help reduce the demand-supply imbalance.

These issues require improved corporate governance in the power sector, especially the restructuring of public sector state electricity boards. Enactment of the 2003 Electricity Act, based on the principles of promoting competition, efficiency, and commercial viability, is a significant landmark in this direction. The act provides for delicensing thermal power generation, a liberalized captive power policy, open access to transmission and distribution networks, transparency in subsidy management, and the formation of an appellate tribunal for speedy resolution of disputes.

Outlook for 2004-2005

The medium-term economic growth outlook is buoyant. The economy is on the upswing of a business cycle, which is in turn riding on an accelerating long-term growth path. The high growth momentum is likely to be sustained through FY2004-FY2005. This forecast is based on the assumption that sound macroeconomic fundamentals will be maintained, including the expected initiation of a serious fiscal consolidation effort following elections in May 2004; that business sentiment will continue to strengthen inside and outside the country; and that there will be normal monsoons during the period. Based on these positive assumptions, GDP is forecast to grow at 7.4% in 2004, with trend growth of 3.0% and 8.0% in agriculture and services, respectively, and 10.2% in industry, which reflects a peaking of the industrial business cycle that started in FY2002, prior to the upturn of the GDP business cycle. Despite the downturn of the industrial cycle in FY2005, higher services growth of 9.0% is expected to lead to aggregate growth of 7.6%. In terms of the contribution to growth of different components of aggregate demand, consumption growth has the largest estimated share of 52.2% during FY2004-FY2005, followed by 36.3% for investment, 9.5% for government consumption, and 2.0% for net exports. However, over 80% of the change in consumption demand is itself endogenously derived from income growth. Thus, analytically it is the contribution of investment growth that must be regarded as the leading determinant of the rate of GDP growth.

The positive assumptions underlying the projections above have associated risks. If the new Government that takes over in May 2004 fails to come to grips with the fiscal deficit and other urgent reform issues, this will erode business confidence and undermine investment, resulting in reduced growth. A shift in international investor preferences could curb or even reverse the inflow of foreign capital since much of the current capital inflows are easily reversible. This calls for a cautious policy with regard to capital account liberalization. Finally, a setback in agriculture due to poor monsoons could be damaging for growth, and especially for employment and poverty reduction.

Of all these risks, the link between fiscal consolidation, investment, and growth is particularly important. The private sector savings rate is about 26% of GDP, while the private sector investment rate is only around 16%. Thus, over 10% of GDP or 38.5% of private savings is appropriated for the public sector. However, since there is a dissaving of about 2.0% of GDP in the public sector, and a small current account surplus, the investment rate has remained at around 23-24%. The 10th Plan growth target of 8.0% assumes an increase in the investment rate to 28.4% of GDP and a public investment rate of 8.4% of GDP, including financing by public savings of about 0.44% of GDP. These targets and assumptions are unrealistic, since even this modest public sector surplus implies a sharp fiscal turnaround from the dissaving at present. However, assuming that the new Government will launch a serious fiscal consolidation effort and achieve some reduction in public dissaving, the overall savings rate is expected to rise to 24.8% and 25.3% of GDP in FY2004 and FY2005, respectively. The investment rate is projected at 24.5% and 25.0% of GDP during these 2 years, allowing for a small current account surplus of 0.3% of GDP.

Taking advantage of declining interest rates abroad and the large inflow of foreign capital, India has been prepaying some of its high-cost external debt. This process is likely to continue over the medium term, reducing the external debt ratio from about 18.0% in FY2003 to around 16.0% in FY2004 and further to 15.0% in FY2005. Debt prepayment has also moderated the appreciation of the exchange rate and the impact of capital inflows on the monetary base. The central bank is expected to continue the policy of sterilization within an accommodative monetary policy stance. Accordingly, money supply growth is likely to remain in the range of 13.5-13.6% over the forecast period, and inflation will remain moderate at 4.7-5.0%.

Per capita income will be rising through FY2004 and FY2005 because of GDP growth well in excess of low and stable population growth, leading to a decline in the poverty ratio, though its pace will depend on employment growth, especially in the agriculture sector. Even then, the poverty-reducing impact of agricultural growth is expected to be weak because of low employment growth in the sector.

An alternative route to employment growth is through progressive transfer of the work force from agriculture to industry and services. Unfortunately, expansion of the modern services sector has created mainly high-skill, high-productivity jobs rather than mass employment. The observed higher growth of employment in the industry sector is more promising. The employment share of industry, only around 17% at present, will rise if the recent strong growth of industry can be sustained through high investment. More important, with continuing high public investment in transport and communications infrastructure, as the rural and the urban economies become better integrated, this will give an impetus to the growth of industry and services in rural areas. This should in turn lead to rapid growth of rural off-farm employment, rising rural incomes, and further generation of rural employment.

However, the development of this virtuous cycle is a long-term process. Hence it would be unrealistic to expect a major improvement in employment growth or poverty reduction in the medium term. The same applies to the Millennium Development Goals (MDGs), where India’s performance has been mixed. While some targets, such as enrollment for primary education and access to improved water sources, are on track, others, such as female secondary enrollment and reduction in infant mortality, are lagging. The 10th Plan set up its own monitoring targets, which are more demanding than the MDGs, and also called for an 80% increase in social sector spending to speed up social development.

The accomplishment of these goals will depend both on successful fiscal consolidation and on improvements in governance to ensure better delivery of education and health services. Thus, dramatic improvements within the next couple of years are unlikely. However, social indicators are improving, albeit gradually, and the MDGs for 2015 are certainly achievable if the required reforms are pursued with determination.

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