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Country Strategy and Program Update 2003-2005: India

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I. Current Development Trends and Issues

A. Recent Political and Social Developments

1. Several major political developments during fiscal year 2001 (FY2001:1 April 2001 to 31 March 2002) had a significant impact on economic performance. The September 11 terrorist attacks were followed by a spate of terrorist actions in India. The heightened tension between India and Pakistan, and increased military deployments are impacting on the economic environment. At the same time, economic sanctions introduced earlier by some G7 countries have been withdrawn, considerably easing the flow of external assistance. Elections were concluded during February 2002 in 4 states. The National Democratic Alliance of 16 parties led by the Bharatiya Janata Party is now in power in the Central Government and in 8 states. The Congress and other parties are in power in 20 states. This sharing of power between different parties has considerably strengthened the forces of federalism. At the same time it has given rise to new challenges for sound and coordinated macroeconomic management at the national level and in the states.

2. India is one of 11 countries that are on track to meet the Millennium Development Goals.¹ FY2001 also saw several significant developments in social policy. The 83^rd Constitution amendment now recognizes the right to education as a fundamental right, thereby strengthening the legal foundation of education development. A national policy for the empowerment of women is now in place, and this is beginning to be reflected in improvements in the status of women (Appendix 1, Table A1.1). Nevertheless, there is a long way to go in social development with India still ranked 124 out of 173 countries by the United Nations Development Programme (UNDP) human development index. Another cause for concern is the growing disparity across states in their social and demographic indicators.

B. Economic Assessment and Outlook

3. Real gross domestic product (GDP) growth was disappointing at 4.0% in FY2000 and has been estimated at 5.4% in FY2001, compared to average growth of around 6.0% through the 1990s (Appendix 1, Table A1.2). The slow down in growth partly reflects reduced growth in services. High growth in the 1990s in India was led by the services sector, which is now the largest sector in the economy and accounts for 49% of GDP. After growing at an average rate of about 8% in the latter half of the 1990s, growth in services declined to only 4.8% in FY2000. There was a partial recovery to about 6.5% in FY2001. Performance in agriculture was also strong in FY2001. However, industrial growth is estimated to have slumped to only 3.3% during FY2001, compared to 6.7% in FY2000.

4. The principal factors contributing to the decline in growth are the low level of business confidence in the private sector, and the lower rates of public and private investment. All of these are largely attributable to a serious and continuing fiscal imbalance. The consolidated fiscal deficit of the central and state governments together amounts to 9.6% of GDP. The large fiscal deficit puts upward pressure on interest rates and discourages private investment. At the same time the high burden of servicing public debt crowds out public investment. Low investment in turn constrains the expansion of capacity, and especially the development of infrastructure, thereby reducing the growth potential of the economy. Unfortunately, progress in fiscal adjustment has been mixed. The central Government introduced the Fiscal Responsibility and Budget Management Bill aimed at medium-term adjustment, which is still under discussion. Similarly, introduction of the value-added tax (VAT), a key component of tax reforms, has been postponed till 2003. On the positive side, the State Fiscal Reform Facility introduced by the central Government to encourage state fiscal reforms is now operational. Several state governments have signed memoranda of understanding on fiscal reform programs with the central Government. These also include power sector reforms since the huge losses of State Electricity Boards are a major part of the fiscal problem in the states. Finally public sector disinvestment is now gathering momentum.

5. Despite poor harvests, which usually trigger inflation, the consumer price index (CPI) (annual average) rose by only 3.8% in FY2000 and 4.2% in FY 2001 because of low demand. The wholesale price index (WPI) rose by 7.1% in FY2000, but the WPI inflation rate declined significantly during FY2001. This has enabled the central bank to adopt an expansionary monetary stance. The central bank’s recently announced Monetary and Credit Policy for FY2002 has reduced the Cash Reserve Ratio from 5.5% to 5.0% effective 15 June 2002 and indicated that the bank rate may also be reduced. Commercial banks have also been encouraged to enhance the downward flexibility of interest rates. Nevertheless, real interest rates remain high in India at about 9% compared to, say, 3% in the United States.² This is due to (i) the large fiscal deficit; (ii) provisioning for the high level of nonperforming assets of scheduled commercial banks, currently estimated at 11.4% even by prudential norms much less stringent than the Basle conditions; and (iii) a deliberate policy of maintaining real interest rate differentials vis-à-vis international financial markets to attract the flow of foreign exchange.

6. In the external sector, the trade deficit amounted to 3.1% of GDP in FY2000 while the current account deficit amounted to 0.5%. After growing at over 21.0% in dollar terms during FY2000, exports declined by 1.0% during FY2001. The slowdown in exports is mainly due to weak global demand. However, weak domestic demand and a sharp decline in oil imports have also contained import growth to only 0.4% in dollar terms over the same period. Hence the trade deficit has been contained at about 2.7% of GDP, and the current account is now showing a small surplus of 0.3% of GDP. As of 3 May 2002, international reserves amounted to $56.0 billion (excluding gold and special drawing rights [SDR]), equivalent to over 14 months of imports. The sustained increase in reserves is mainly due to India’s large real interest rate differential compared to the international financial market. This gap significantly exceeds the real effective exchange rate depreciation of about 2.5% a year on average. External capital flows are also encouraged by the modest level of external debt at 21% of GDP, with an external debt service ratio of about 17%.

7. The medium-term economic outlook is mixed. The Tenth Plan Approach Paper³ sets a target growth rate of 8% to ensure rapid and continuing reduction of poverty. However, growth of only around 4.0-5.4% in FY2000 and FY2001 indicates that it would be difficult to achieve the 8% growth target without significant structural adjustments, especially fiscal adjustments, over the medium term. In the 2001 budget, the Government announced a comprehensive program of reforms aimed at fiscal consolidation and revival of growth.⁴ The 2002 budget seeks to consolidate this through further structural reforms, especially in agriculture and the financial sector. India’s economic prospects depend largely on the extent to which the Government succeeds in implementing these reforms, significant fiscal adjustment, and the pace of public and private investment in infrastructure development.

C. Implications for the Country Strategy and Program

8. Asian Development Bank (ADB) assistance to India has remained very modest relative to India’s needs and its own efforts in resource mobilization. Despite constraints, India increased its volume of investment by over 50% in the 5-year period to FY2000, reaching an annual level of $104 billion in US dollar terms. ADB assistance has accounted for less than 0.7% of total investment during this period. Going forward, the Tenth Five-Year Plan Approach Paper indicates that the increase in investment will be further accelerated to achieve the 8% growth required to sustain the pace of poverty reduction. Thus, even to maintain ADB’s very modest share of this expanding investment program, ADB’s assistance to India needs to be stepped up significantly. This is also fully justified by India’s economic performance and absorptive capacity (paras. 3-6). In particular its external debt to GDP ratio is a prudent 21%, with a debt service ratio of 17%, and foreign exchange reserves amount to over $56 billion, equivalent to more than 14 months of imports. Against this background the Government has on several occasions requested a significant enhancement of ADB’s assistance to India. The program should also lay greater emphasis on supporting fiscal adjustment programs, both in the center and in the states. Further, ADB needs to extend its state-level operations to some of the less developed states to help contain growing interregional disparities. This will also strengthen the poverty reducing impact of ADB operations.

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