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p. 39 of 77 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. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia : South Asia

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India

The economy remained buoyant, but major challenges included the devastation caused by the tsunami in December, fluctuating agricultural growth, high inflation, and reemergence of a large current account deficit. The medium-term challenges for the economy include meeting the fiscal consolidation targets, stepping up infrastructure investments, managing burgeoning foreign exchange reserves, and reinforcing the economy’s competitive advantage in textiles and garments in the post-MFA world.

Macroeconomic assessment of 2004

In FY2004 (ended 31 March 2005), the economy remained buoyant. GDP grew by 7.0% during the first 2 quarters of the year (Figure 2.16), following 8.5% growth in FY2003. For the year as a whole, the best estimate for growth is 6.5%. (The Government has made a somewhat higher advance estimate of 6.9%.) This strong expansion is on account of marked improvements in investment as reflected in the leading macro indicators, such as production and imports of capital goods, production of commercial vehicles, and nonfood credit offtake. Moreover, strong growth in consumer durables in FY2004 also indicates a pickup in consumption demand.

The major challenges faced during the year include the devastation caused by the 26 December tsunami, a slowdown in agricultural expansion, a high price of oil that is fueling inflation, and the reemergence of a current account deficit. The tsunami, which affected the coastline of some mainland southern states of India besides the entire Andaman and Nicobar Islands, led to large-scale loss of life and displacement, widespread damage to property, destruction of coastal fisheries and agriculture, and temporary disruption to tourism in coastal areas. The adverse impact of the tsunami is, however, localized, and the level of national economic activity has not been significantly affected.

Agricultural expansion slowed sharply to 1.5% during April-September 2004, significantly down from the unprecedented growth of 9.6% in FY2003. This stemmed from below-normal rainfall both during and after the monsoon, which also had a highly skewed geographic distribution pattern. As a result, 2004 kharif (summer) foodgrain production is expected to be 102.9 million tons compared with 112.1 million tons in 2003. The area sown for most rabi (winter) crops has also declined, and consequently the winter crop harvest is also expected to decline. The adverse impact of the tsunami on agriculture due to devastation of standing crops, destruction of irrigation facilities, and depositing of nonfertile sediments may further lower agricultural growth. For the year as a whole, total agricultural production could, at best, rise marginally by 0.6%.

Industrial growth accelerated to a robust 7.5% in April-September 2004 from 6.2% in the same period in FY2003. Manufacturing expansion was broad based, and high growth in different segments of textiles and garments is noteworthy, as the sector needs to maintain its productive efficiency in order to remain competitive in the post-MFA world. Such broad-based manufacturing expansion was supported by strong growth in key infrastructure industries such as energy and cement. Buoyant industrial growth reflects primarily a pickup in investment and consumption demand. The strengthening of business confidence and other leading indicators such as growth in nonfood credit, especially housing credit, as well as other commercial sectors, suggests that the high industrial growth will be sustained during the rest of the year. For the year as a whole, industrial growth is estimated at 8.0%.

The services sector continued to pick up strongly and maintained an average growth rate of 8.8% during the first 2 quarters of FY2004. This was led by accelerating growth in trade, hotels, and restaurants, as well as by transport and communications, which was in turn due to a turnaround in trading and transport services, and strong performance of telecommunications. The two subsectors of financial and business services, and real estate, and of community, social, and personal services also registered high growth during this period. The strong performance in the former is attributable to a buoyant capital market, continuing expansion in exports of IT-enabled services, and a boom in the real estate market. Services sector growth is also expected to remain at above 8.0% in FY2004.

On the fiscal front, the consolidated fiscal deficit of the federal and the state governments is estimated to improve marginally from 9.4% in FY2003 to 9.1% in FY2004. The federal fiscal outcome for FY2004 is somewhat mixed. The major effort at fiscal consolidation notwithstanding, the federal fiscal deficit situation did not show any improvement in FY2004 from the previous year, while the revenue deficit declined from 3.6% of GDP in FY2003 to 2.7% in FY2004. This is in spite of significant expenditure containment and impressive gains in tax revenue collection during the year. However, capital receipts of the federal Government generated by recoveries of loans to state governments and other receipts from disinvestment proceeds have declined. Finances of the states also remained worrisome.

Money supply (M3) growth has started declining in recent months, reaching 13.3% on 4 February 2005, which is lower than the monetary policy target of 14% for the year as a whole. Growth of reserve money remained at above 14.0% as of that date, mainly on account of large inflows of foreign capital and continued buying of dollars by the Reserve Bank of India (RBI) to prevent appreciation of the rupee. Despite high growth in the foreign exchange assets of RBI and a consequent expansion of the monetary base, the excess liquidity scenario reversed as a consequence of the increase in demand for nonfood credit, along with a rise in the cash-reserve ratio and sterilization through the Market Stabilization Scheme. As a result, interest rates started moving up, with yields on 91-day treasury bills increasing from 4.4% to 5.4% in April-December 2004. However, early indications suggest that the liquidity position has been easing since January 2005.

Wholesale price index inflation rose sharply in FY2004. The average inflation rate was 6.9% during April-December 2004. With a decline in recent months, inflation for the year as a whole is expected to be 6.0%. Given the unutilized capacity in some sectors, demand-driven inflation is not a concern at present. Instead, the sharp increase in inflation has been cost-push, mainly due to high world oil prices and rising prices of iron and steel. Inflation based on the Consumer Price Index for Industrial Workers was lower, at 3.7% in April-December 2004.

Bullish expectations, driven by buoyant growth and rising corporate profits, are reflected in the recent boom in stock prices. After declining quite sharply during April-May 2004 in the run-up to elections (and the formation of a new coalition Government), the market has rebounded to reach record levels of market capitalization. Despite fluctuations during the year, the Sensex market index closed at 6,752 on 15 March 2005 to record a 19.3% increase for 50 weeks of FY2004. The volatility of the index during December 2004 and January 2005 reflects the movements in portfolio investments by foreign institutional investors, primarily on account of expectations of an increase in the US Federal Funds rate.

External sector performance was also robust in FY2004. Merchandise exports grew by 23.2% and imports by 39.0% during the first half of FY2004 from the same period a year earlier. With imports outpacing exports during the period, the trade deficit increased. Despite 22.8% growth in net invisibles trade, the current account has recently switched to a deficit of $3.3 billion, having previously been in surplus from the third quarter of FY2000. Greater import growth is the result of higher oil prices and strong domestic absorption. The acceleration in merchandise exports mainly reflects strong growth of world demand, especially in ASEAN+3 countries.

On the capital account, the country received a net capital inflow of $10.1 billion in the first half of FY2004, though net FDI was only around $2.0 billion. The surplus on the capital account was the result of external commercial borrowing and short-term loans, and other capital inflows. Data show an upsurge in foreign institutional investment inflows in later months, which pushed up foreign exchange reserves to $134.6 billion (as of 11 March 2005). The accumulation of large reserves along with the weakening of the US dollar against major international currencies caused the rupee-dollar exchange rate to appreciate on average by about 2.1% during the first 50 weeks of FY2004. This accumulation also led to the expansion of the monetary base and a consequent sharp increase in money supply growth. This latter problem becomes more acute with the limits on sterilization. Thus, for prudent foreign exchange reserves management, the central bank has to make a critical balance between arresting rupee appreciation, on the one hand, and keeping money supply growth within the stipulated target to control inflationary pressures, on the other.

Macroeconomic policy developments

At the policy level, the federal Government intends to carry forward the reform process “with a human face.” Significant policy initiatives bear on the fiscal reform proposals in the FY2005 federal budget and on social and rural development programs, including the rural employment guarantee scheme. Reforms in foreign trade and investment policies, credit policy, and the existing Patents Act were also initiated.

The finance minister presented the FY2005 federal budget to Parliament in February 2005. As expected, this budget marks a major milestone in the revival of growth-promoting fiscal reforms. At the same time, it is an inclusive budget, aimed at promoting equitable growth focusing on the rural sector and social services, in line with the goals of the United Progressive Alliance Government in its Common Minimum Program. The FY2005 budget also marks a major change in federal fiscal relations vis-à-vis the states, based on the recommendations of the Twelfth Finance Commission (Box 2.3). Much of the growth-oriented fiscal reform relates to revenues. Indirect tax rates and direct tax liabilities have been significantly reduced; the tax base has been expanded, especially in terms of the coverage of services taxation; and a slew of exemptions has been abolished. These exemptions had been earlier identified by several committees as one of the major factors accounting for India’s porous tax system and a relatively low tax-to-GDP ratio of only 16%.

Equity concerns have been addressed mainly through the expenditure proposals. The budget has substantially increased the allocation of resources for agriculture and rural development, including water resources management. There is also a significant increase in social expenditures on education, health, and antipoverty programs. The expenditure budget has also addressed key growth constraints through a large increase in allocation for road transport and power infrastructure. Despite this, the total increase in federal expenditure has been contained at 1.7%. This has been possible mainly because of a sharp reduction in federal loan assistance to the states, following the recommendations of the Twelfth Finance Commission. Henceforth, states will have to access the capital market for their borrowing requirements.

This major effort at fiscal consolidation notwithstanding, the fiscal deficit of the federal Government for FY2005 remains high at 4.3% of GDP, with a revenue deficit of 2.7%. This would imply a large overall fiscal deficit of about 8.8% of GDP after the deficits of the state governments are included. The federal fiscal and revenue deficit estimates also fall short of the corresponding targets of 4.0% and 1.8% under the Fiscal Responsibility and Budget Management (FRBM) Act as envisaged in the previous year’s budget. The shortfall in meeting the fiscal deficit target is largely derived from a large reduction in the federal Government’s receipts from recoveries of loans to state governments, primarily due to the expiry of the Debt Swap Scheme in FY2004 in preparation for a complete rescheduling of repayment of state government debts to the federal Government, following the recommendations of the Twelfth Finance Commission. However, the finance minister has indicated that the federal Government will still meet the FRBM targets by FY2008.

Less encouragingly, the budget makes no attempt to cut down subsidies, nor has it announced any major policy initiatives with regard to disinvestment in public enterprises or liberalization of labor laws. However, the federal Government has moved forward with further dereservation and deregulation among SMEs. In addition, there was some move during the year by the Ministry of Finance and RBI with respect to liberalization of foreign equity participation in private sector banks, as well as in the construction, mining, trade, and pensions subsectors.

On the monetary policy front, RBI in its midterm review of the Annual Credit Policy 2004/05 has aimed at provision of adequate liquidity to meet credit demand and support investments, while emphasizing price stability. In this review, RBI increased the repo rate by 25 basis points to 4.75%, while leaving the bank rate unchanged at 6.0%. RBI addressed the issue of the liquidity overhang by raising the Market Stabilization Scheme limit to Rs800 billion, which is expected to mop up the increase in money supply through selling government securities and impounding these resources in a special account of the central bank. Given the prescribed limit of the scheme, RBI has raised the cash reserve ratio by half a percentage point to 5.0% to absorb surplus liquidity and control inflationary pressures.

With regard to rural employment generation, the federal Government introduced a National Rural Employment Guarantee (NREG) Bill 2004, in Parliament. This bill seeks to implement an employment guarantee scheme in 150 of the most backward districts of the country in the first phase, and then extend the coverage in stages to the entire country within 5 years. This provides a legal guarantee of 100 days of employment a year to at least one member of each rural household, and thus provides the rural poor with an effective safety net.

The NREG Bill, which has been criticized on the grounds of its limited scope, leaves room for discretionary interventions by state governments. In addition, it may also be criticized in terms of large leakages and poor delivery systems. However, the beneficial effects of such programs in terms of employment generation and poverty reduction are evident in Maharashtra and were seen in Rajasthan and Gujarat during the droughts of 1987/88. The other important benefits of such programs include expected reduction of rural-urban migration, empowerment of women, creation of useful assets in rural areas, and change of power equations in rural society to foster a more equitable social order.

The 2004 amendment to the Patent Act 1970, which is designed to comply with India’s commitments under the TRIPS Agreement in WTO, marks a departure from the past regime of granting only process patents. The new amendment allows for the introduction of product patents and exclusive marketing rights under certain conditions in the area of chemicals--including agrochemicals and pharmaceuticals--and food. Certain features of the recent amendment have generated controversy: some commentators claim that the new amendment restricts affordable access to various essential drugs.

Outlook for 2005-2007 and medium-term trends

GDP is expected to expand by 6.9%, up from 6.5% in FY2004. Agriculture is projected to grow at a high rate of 4.4%, which is not unusual in a year that follows one with relatively low agricultural growth. In FY2005, industry is predicted to grow at a lower rate of 6.7%, and services sector growth is estimated at 7.7%. A slowdown in industrial growth in FY2005 can be attributed to cost-smoothing behavior of firms to tide themselves over an anticipated cost escalation as reflected in the latest business confidence survey carried out by the National Council for Applied Economic Research, New Delhi. This is corroborated by the fact that firms are very upbeat about capacity utilization but not very optimistic about demand conditions, suggesting the desire to hold larger inventories. The survey indeed shows that the proportion of firms willing to accumulate such inventory levels, especially in consumer goods, has gone up significantly. This explains the beginning of a downturn in the industrial business cycle in FY2005.

In FY2006, GDP growth is predicted to decline to 6.1%, mainly on account of a further decline in the growth of industry and services to 5.2% and 7.3%, respectively. The revival of industry and services growth in FY2007 will drive up overall expansion to 7.0%.

The medium-term challenges for the economy include meeting the fiscal consolidation targets as laid down in the FRBM Act of 2003, stepping up infrastructure investments, managing burgeoning foreign exchange reserves, and reinforcing India’s competitive advantage in textiles and garments since the termination of the MFA.

Inflation is forecast to decline to 4.2% in FY2005, down from 6.0% in FY2004, and then to 3.0% and 3.5% in the following 2 years. The moderation of inflation will be largely attributed to expected stability in prices of fuels as well as prices of manufactured goods through FY2007. The downside risks that could undermine the inflation projections include a weak monsoon and a sharp rise in global oil prices.

Expansion in investment--especially in infrastructure--holds the key to sustaining high growth over the long run. The investment rate increased to 26.3% of GDP in FY2003 and is estimated to have increased to 26.5% in FY2004. However, the current rate of infrastructure investment at 3.5% of GDP is way below the 8.0% of GDP target for FY2005 made by the Expert Group on the Commercialization of Infrastructure Projects.

The current rates of both private and public infrastructure investments have been well below target. The key problem in attracting adequate private capital in infrastructure is the lack of appropriate risk allocation between creditors and investors. One such crucial risk originates in the fact that lenders are paid only from the cash flow generated by an infrastructure project, and they have limited options if investments fail to provide the expected returns because of a shift in policy parameters. Moreover, infrastructure projects usually have long gestation periods and there is usually a maturity mismatch between loans and returns. Developing a domestic market for long-term securities is therefore critical for infrastructure financing. ADB’s recent issue of domestic currency long-term bonds is an important step in this direction.

Thus, in a bid to boost infrastructure investments, the federal Government has proposed financing infrastructure investment in specific areas such as roads, ports, airports, and tourism through a special-purpose vehicle in terms of additional borrowings with longer-term maturities. Therefore, with an anticipated increase in public infrastructure investment using such a vehicle over the medium term, it is expected that there will be a gradual step-up in the overall investment rate to 27.5% in FY2007.

The key factor constraining higher public investment in infrastructure is the large consolidated deficit position of the federal and state governments. Despite expected improvements in the consolidated fiscal deficit over FY2005-FY2007, reflecting tax reforms, improvements in tax administration, and containment of expenditure, the fiscal deficit is expected to remain high at above 8.0% of GDP. The consolidated revenue deficit will also stay high. Therefore, it will remain a challenge for the federal Government to increase public investment in infrastructure through additional borrowings while ensuring compliance with the FRBM targets. This will be possible only if adequate fiscal space is created by initiating effective fiscal consolidation measures.

The external sector is expected to remain buoyant. Growth of merchandise exports is forecast to be 14.1% in FY2005, 13.8% in FY2006, and 13.2% in FY2007. This is despite the strengthening of the rupee-dollar exchange rate over FY2005-FY2006. Anticipated appreciation in the real exchange rate notwithstanding, the projected large increases in merchandise exports are largely due to high growth in world trade. Strong expansion in ASEAN+3 countries in FY2005 (particularly in the PRC), which now accounts for about 23% of India’s total trade, will provide a stimulus to merchandise exports.

Merchandise exports are better diversified than imports, which largely comprise bulk items. The growth in merchandise exports stems from expansion in exports of textiles and garments, automobile parts and ancillaries, and chemicals (including pharmaceuticals). Textile export composition is well diversified, and it has a competitive edge in products ranging from cotton textile items, yarns, and fabrics to knitwear.

The ending of the MFA will have a large impact on India’s textile and garment exports, which account for about 20% of total exports. Even though the high growth of textile and garment exports shows the competitive strength of these products in the international market, it is still too early to assess gains, and the sector’s performance needs to be monitored closely. The benefits from the MFA phaseout will accrue only if India makes substantial improvements in efficiency, reduces unit costs, diversifies to higher value-added products, and consolidates scale economies. Also, to remain competitive, Indian textile and apparel firms need to be a part of the global value chain, and reposition themselves accordingly.

Merchandise import growth is likely to be 19.7% in FY2005 and around 15% in the following 2 years. The anticipated lowering of international oil prices in FY2006 and FY2007 largely explains the declining growth of merchandise imports during these 2 years. With import growth exceeding that of exports during the 3 years, the trade deficit is expected to remain high. Services trade, especially in software and IT-enabled business processes, will continue to rise at a robust rate over this period and expand the positive invisibles balance.

The current account will continue to post a deficit, forecast in the range of 1.0-1.9% of GDP over FY2005-FY2007. This will partly offset the surplus on the capital account. Moreover, with the expected hardening of US interest rates over the next 2 years, there may be a reduction in net portfolio investments, which will lower the capital account surplus. Hence, the rapid accretion to foreign exchange reserves observed since 2001 is likely to moderate over the medium term. Nevertheless, managing foreign exchange reserves and striking an appropriate balance between a competitive exchange rate and internally consistent money supply growth will remain a significant challenge for RBI.

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