For the Year July 1, 2011 to June 30, 2012*
PART ONE: THE ECONOMY - REVIEW AND PROSPECTS
I - ASSESSMENT AND PROSPECTS
Inflation slowed in response to past monetary tightening and growth deceleration in 2011-12. Growth during
2012-13 is expected to stay below trend at around the same level as in the previous year. Inflation is likely to
remain sticky around 7 per cent with upside risks emanating from a deficient monsoon. Concurrently, the risk of
twin deficits has accentuated causing concern for macro-financial stability. With limited fiscal and monetary space
available to provide direct stimulus to growth without stoking inflation, an expenditure switching strategy is needed
that reduces government’s revenue spending by cutting subsidies with a step up in capital expenditure to crowd-in
private investment. Over the medium-term, addressing issues impeding infrastructure investment have become
important for stepping up India’s growth potential which has been dented post-crisis. While the Reserve Bank is
focusing on price stability and sustainable growth over the medium-term keeping in view its welfare implications,
the human face of its financial policy can be buttressed with a greater thrust on effective financial inclusion.
I.1 Growth decelerated in 2011-12 after two
years of relatively good performance and dropped
to below the economy’s potential. The drop in
growth was a result of combination of domestic and
global factors. Global macroeconomic and financial
uncertainty, weak external demand, elevated level
of prices, widening twin deficits and falling
investment combined to adversely impact growth.
The investment climate worsened due to structural
impediments, policy uncertainty, inflation
persistence and rising interest rates.
I.2 Two years of high inflation amidst wide fiscal
and current account deficits would have had
adverse consequence for welfare. It adversely
affected saving and investment, particularly
household saving in financial assets. Inflation
changes the future consumption basket by reducing
the real value of the amount saved today, thus
making current consumption more attractive. Real value of savers’ holdings of cash as well as fixed
income products declines.
I.3 The most serious consequence of inflation
is its adverse distributional impact on the poor,
people without social security and pensioners. Poor
households are unable to maintain the consumption
levels at current prices and therefore, they are
particularly worse off in an inflationary situation.
During 2011-12, growth also slowed down, in part
because of high inflation. This further reduced
welfare of the common man as firstly, it had adverse
impact on employment and incomes and secondly,
with low growth, the trickle down benefits for poor
also reduced.
I.4 In view of the adverse welfare consequences
and its impact on sustainable growth, the Reserve
Bank combated high inflation through monetary
tightening. Several other factors combined with
monetary tightening causing growth to slow down to the lowest in nine years. Even though inflation
moderated later in the year, macroeconomic risks
increased with slowing growth and rising twin
deficits. This posed difficult challenges for macroeconomic
management. First, though India
outperformed most of its peers in terms of growth,
its potential and actual growth slowed. Second, the
investment downturn extended and deepened due
to above mentioned factors. Third, fiscal slippage
put some pressure on interest rates and crowded
out resources for private investment. Fourth,
external sector soundness weakened, especially
as current account deficit (CAD) widened, partly
due to impact of large government spending on
aggregate demand. Fifth, inflation moderation
provided limited comfort given the suppressed
inflation and incomplete pass-through of rupee
depreciation.
I.5 Inflation persistence and widening twin
deficits constrained the Reserve Bank’s ability for
counter-cyclical measures during 2011-12. After
tightening monetary policy till October 2011, the
Reserve Bank paused hiking policy rates as growth
risks accentuated. Excessively tight liquidity
conditions during Q4 of 2011-12 along with
assessment that inflation would fall in line with the
projected path, prompted the Reserve Bank to start
easing monetary and liquidity conditions. Amidst
macro-economic deterioration it used the available
space in April 2012 to cut policy rates.
I.6 Going forward, the priority should be to bring
down the twin deficits so as to support potential
growth even if it means a slower pace of recovery
in the short run. A stable macro-economic
environment, coupled with complimentary macro
and micro-economic policies to support saving,
investment and inclusive growth could help restore
India’s potential to grow at 8-8.5 per cent on a
sustainable basis over the medium term.
ASSESSMENT OF 2011-12
I.7 In 2011-12, growth decelerated in each
successive quarter. On the other hand, average
inflation remained high, though it moderated in the
last four months of the year. In the context of the growth-inflation dynamics, an assessment of the
role of both monetary and fiscal policy and the
impact on growth slowdown on asset quality are
set out below.
Role of monetary and non-monetary factors in
growth slowdown
I.8 After recording a rise of 8.4 per cent during
2009-10 and 2010-11, growth dropped to 6.5 per
cent in 2011-12. Growth in Q4 of 2011-12 of 5.3
per cent was the lowest in 29 quarters. Early
indications are that activity levels continued to be
slow during Q1 of 2012-13, with industrial growth
stagnating, slack persisting in investment activity
and consumption decelerating.
I.9 The Reserve Bank had gradually tightened
monetary policy over last two years through 13
policy rate hikes that began in March 2010 and
continued till October 2011, raising operational
policy rates by 525 basis points (bps) from 3.25 to
8.5 per cent. It also hiked the Cash Reserve Ratio
(CRR) twice, increasing it by 100 bps from 5 to 6
per cent of NDTL. Given these measures, there has
been a perception that the Reserve Bank’s
monetary tightening has been predominantly
behind the growth slowdown. In this context, there
are two important factors to be considered. First,
the initial rounds of increase were more in the
nature of normalisation of policy from its crisis-driven
excessive accommodative stance. Such
normalisation could not have had an adverse
impact on growth. Second, even at the current level
of the policy rate, the real effective lending rates of
banks are relatively lower in comparison with their
pre-crisis levels. This highlights the fact that policy
rates alone cannot explain the sharp growth
slowdown observed in the last few quarters.
I.10 An exercise undertaken by the Reserve
Bank to calculate Weighted Average Lending Rate
(WALR) of scheduled commercial banks using the
accounts-level data from Basic Statistical Returns
(BSR) suggests that this effective lending rate in
nominal terms increased during 2011-12 in
response to monetary tightening. Preliminary data
suggests that the WALR increased to 12.7 per cent, which was slightly higher than the average of 12.4
per cent in the pre-crisis period. Nominal rates had
fallen in the post-crisis period before hardening in
2011-12. Real (net of inflation) WALR also increased
moderately to about 3.8 per cent in 2011-12, but
remained lower than the average of about 7.0 per
cent in the pre-crisis period of 2003-04 to 2007-08,
when an investment boom took place. The fall in
real lending rates in post-crisis period is even
sharper if GDP deflators are used to calculate
inflation instead of WPI. The fact is that real lending
rates have secularly declined since 2003-04. During
this period, investment boomed initially, but stalled
in recent years even though real rates continued to
decline.
I.11 Interest rates are only one of the many
factors in an investment decisions. These decisions
in any case depend on interest rate view over
several cycles. Interest rates increased during
2011-12 and may have impacted investment, but
they are clearly not the primary reason for the
downturn. The decline in investment started earlier
in H2 of 2010-11 for reasons that were linked to
global uncertainties, structural constraints, loss of
pro-reform policy momentum, persistent inflation
and increasing business uncertainties.
I.12 Growth had decelerated in the Indian
economy through successive quarters of 2011-12,
dropping from 9.2 per cent in Q4 of 2010-11 to 5.3
per cent in Q4 of 2011-12. This steep 3.8 percentage
point drop did prompt the Reserve Bank to shift its
policy stance by first pausing and then front-loading
the cut in the repo rate by 50 bps in April 2012.
I.13 Monetary policy is framed on several
considerations of which inflation (the pace at which
general level of prices changes) and growth (the
pace at which national output increases) are the
two main ones. Headline inflation was running at
9-10 per cent rate in each of the first eight months
of 2011-12 – way above the Reserve Bank’s
comfort-level of 4-5 per cent. Thus, the inflation gap
(actual less intended level of inflation) far exceeded
the output gap (actual less potential output). While
these gaps cannot mechanically determine the
policy rate setting, they constitute an important consideration in calibrating monetary policy
response. Any premature easing would have
caused inflation risks to rise thereby adversely
affecting growth over the medium-term.
I.14 In this context, it is important to appreciate
as to what monetary policy can or cannot do. First,
monetary policy can have a strong long-run impact
on inflation, but can influence output in a more
limited way by nudging growth towards potential
when growth operates below or above potential.
Importantly, monetary policy cannot bring about
permanent or long-run changes in the levels of
output, which are mainly driven by technology,
productivity changes and fiscal policy, through its
impact on thrift and investment behaviour.
I.15 Second, the adverse welfare consequences
of high and persistent inflation are large. Slowdown
does raise unemployment and lowers income and
consumption, especially of those who lose jobs. In
a country like India, business cycle fluctuations that
cause output and job losses are more pronounced
in organised than unorganised sector and impacts
agricultural output relatively less. However, a rise
in inflation generally lowers consumption across-the-board in varying degrees. It acts like a
regressive tax and hurts the poor the most as they
are virtually unhedged against inflation.
I.16 Since the April 2012 policy, the growth
outlook has turned weaker, while the inflation path
moved slightly higher. While core inflationary
pressures remained low, they have not fallen
commensurate to the growth slowdown. On the
other hand, food inflation pressures have
re-emerged and are likely to be exacerbated by
drought conditions following the unsatisfactory
monsoon so far. Consequently, monetary policy will
need to be carefully calibrated to the evolving
growth-inflation dynamics.
Fiscal consolidation is needed to sustain
growth and reduce inflation
I.17 After an impressive period of fiscal
consolidation during 2002-03 to 2007-08, there has
been a marked deterioration in the fiscal position.
The gross fiscal deficit (GFD)/GDP ratio that dropped from 5.9 per cent in 2002-03 to 2.5 per
cent in 2007-08 is back at almost the same level.
The improvement in revenue and primary deficits
have been more than reversed. India’s fiscal deficit
has widened both structurally and cyclically. On the
external front, the CAD on the balance of payment
side has averaged about 3.0 per cent during 2008-
09 to 2011-12 after a marginal surplus on current
account on an average basis during 2002-03 to
2007-08. The deterioration partly reflects the impact
of wider fiscal deficits.
I.18 The wide fiscal deficit along with the wide
CAD is symptomatic of macroeconomic
deterioration. These have also dented India’s
relative attractiveness in the eyes of global investors
and prompted some sovereign rating agencies to
put India on a watch list for a possible sovereign
rating downgrade. In this backdrop, it is important
to give priority to the pending subsidies and tax
reforms in India, so that the fiscal position gets
structurally strengthened and it is also possible to
better withstand cyclical downturns.
I.19 There are two main reasons for deterioration
in India’s fiscal deficits. First, expenditures on
subsidies have risen from 1.3 per cent of GDP in
2005-06 to 2.4 per cent of GDP in 2011-12.
Revenue constraints make it impossible to finance
them in a sustainable manner. Second, resource
mobilisation by the government has been rather
insufficient with low tax/GDP ratio, poor non-tax
revenue mobilisations and under-achieved
disinvestment targets. Also, the fiscal stimulus
through tax cuts in the aftermath of the 2008
financial crisis were prolonged and were rolled back
only partially. There has been a structural as well
as cyclical dimension to the rise in fiscal deficits in
India. Stalled tax reforms have made it difficult to
put fiscal consolidation back on rails after the
significant gains made prior to the global financial
crisis got substantially reversed.
I.20 As part of the tax reform agenda, the
Government of India had envisaged introducing
Direct Tax Code (DTC) and the Goods and Services
Tax (GST) in the past few years. However, these reforms have been delayed and could not be carried
out even as part of the 2012-13 union budget. This
has been a setback for fiscal consolidation, even
though some of the tax measures contemplated as
part of these reforms have already been effected
over the past two years to enable a smooth
transition to the new tax regimes.
I.21 As per the study undertaken by the NCAER
for the Thirteenth Finance Commission (ThFC), the
implementation of comprehensive GST will increase
India’s GDP by about 0.9-1.7 per cent. Higher GDP
would widen the tax base and improve tax revenues.
In this context, while the shift towards ‘negative list’
services tax regime is a positive move, the time lag
to phase in GST needs to be minimised so that
cascading of taxation is avoided, and a seamless
GST for Centre and States establishes a proper
input-output network of indirect taxes.
I.22 Tax reforms also need to encompass a clear
policy regime on measures like GAAR (General
Anti Avoidance Rule) that has impacted investors’
confidence. In this context, the recently released
draft guidelines on GAAR are being examined by
a committee and are expected to be finalised after
widespread consultation with all stakeholders.
Bringing about greater clarity in taxation of
international capital flows would facilitate in
financing the current account deficit.
I.23 There is a need to ensure that these
legislations are quickly put in place to support
resource raising efforts with a view to create fiscal
space for financing of initiatives relating to inclusive
growth. Such tax reforms are a positive sum game
and would improve fiscal positions of both Centre
and States.
Maintaining asset quality is important to
financial stability
I.24 The deterioration in asset quality of the
banks emerged as a concern within and outside
the Reserve Bank during 2011-12. In any economic
downturn, asset quality gets impacted and India
was no exception to this. Asset quality deterioration
during 2011-12 was particularly significant in the case of public sector banks. The gross Nonperforming
Assets (NPAs) of the public sector banks
increased to 3.2 per cent of gross advances at the
end of 2011-12 from 2.3 per cent at the end of
2010-11. In net terms, their ratio went up to 1.5 per
cent from 1.0 per cent over the same period. While
the NPA levels are still low by historical trends or
cross-country comparison, the restructured
standard advances in the PSBs increased to 5.7
per cent of gross advances by at the end of 2011-
12 from 4.2 per cent a year ago.
I.25 The slippage ratio increased and recovery
slowed down, reflecting the stress arising in some
sectors such as aviation and power. Deterioration
in macroeconomic conditions put added pressures
on asset quality. While some of these changes
reflect the NPA cycle that generally tracks economic
cycle, the sector-specific issues that include
management and industrial relation issues need to
be resolved. There has also been a significant rise
in restructuring of loans during the year. Several
firms opted for corporate debt restructuring.
Restructuring increased substantially during Q4 of
2011-12, taking the restructured loans at the end
of 2011-12 to about 5 per cent of the loan book of
the scheduled commercial banks (SCBs), up from
3.9 per cent a year ago. Aviation, state electricity
boards (SEBs), textiles, telecom, shipping, power
and steel were amongst the sectors that reported
stress contributing to the restructuring.
I.26 However, the increasing non-performing
assets and restructuring of loans are not a systemic
issue. While, some of strength of the bank balance
sheets may have eroded, they are in line with the
movement in the business cycles that have occurred
before. The balance sheets are far from becoming
fragile. The CRAR of the SCBs at the end of 2011-
12 was 14.1 per cent, way above the prescribed 9
per cent norms and only marginally less than the
14.2 a year ago. Core CRAR, however, increased
to 10.3 per cent at the end of 2011-12 from 10.0
per cent in 2010-11.
I.27 A series of stress tests carried out to study
the impact of various adverse macro-financial shocks on the health of banks showed that the
banking system remained resilient even under
stress scenarios. For instance if macro-stress builds
up during 2012-13 with growth falling to below 6
per cent, inflation remaining above 9 per cent and
GFD/GDP ratio rising to 6.5 per cent in 2012-13,
gross NPA ratios for the SCBs as a whole is
expected to increase to 3.7-4.1 per cent at the end
of the year from 2.9 at the end of the previous year.
Their CRAR is expected to fall to 12.5 per cent from
14.1 per cent. An assessment of the stability of the
banking system conducted through a series of
banking stability measures did indicate that distress
dependencies amongst banks had increased in
recent years but remained well below the levels
observed during the global financial crisis in 2008-
09. This was earlier documented in the Financial
Stability Report of June 2012 and reflects the
collective assessment of the Sub Committee of the
Financial Stability and Development Council
(FSDC).
I.28 Keeping in view the increasing incidence
of restructuring and for reviewing the guidelines
in the light of experience gained, a Working Group
(Chairperson: Shri B. Mahapatra) was constituted
by the Reserve Bank. The group has recommended
doing away with regulatory forbearance regarding
asset classification, provisioning and capital
adequacy on restructuring of loans and advances
gradually over the two-year period. It has
recommended increasing the provisioning
requirement on stock of restructured loans from
existing 2 per cent to 5 per cent in a phased
manner over the two-year period along with the 5
per cent provisioning requirements on all newly
restructured loans. It has also suggested increase
in promoters’ contribution to at least 15 per cent
of the diminution in fair value of the restructured
account or 2 per cent of the restructured debt,
whichever is higher. A principle of higher amount
of promoters’ sacrifice in case of restructuring of
large exposures under CDR mechanism may bring
about an incentive-compatible mechanism for
lending discipline. While the final change in the
regulatory regime will be made after further consultative process in August 2012, there is a
clear intent on the part of the Reserve Bank to
bring about an asset classification regime that
does not allow banking fragilities to build up in the
economic downturn. While the deterioration in
asset quality during 2011-12 has been partly due
to cyclical downturn, inadequate credit writing
standards as well as weak credit administration
has also played a role. The banks need to upgrade
their systems to prevent slippages and improve
post-sanction recovery process.
PROSPECTS FOR 2012-13
Growth Outlook for 2012-13
I.29 The growth outlook for 2012-13 remains
weak as combination of global and domestic macroeconomic
factors that slowed down growth in the
preceding year have persisted and show no signs
of getting resolved. Globally, the sovereign and bank
debt overhang is still keeping the financial markets
under stress. The global trade outlook has
deteriorated as growth in emerging markets is
slowing down in addition to recession taking roots
in euro area and US also headed for a slower
growth.
I.30 On the domestic front, macro-economic
conditions are unlikely to improve in near term as
a spell of policy stasis, structural and cyclical
problems have combined to slow down the
economy. Growth is slowing down, while inflation
remains sticky at above comfort levels. However,
the Government in August 2012, promised to take
several steps to address the macro-economic
weakness. These would include, the return to path
of fiscal consolidation, bringing in a clear and stable
tax regime, encourage saving and investment,
including foreign investments and work towards
generating supply-side responses to lower inflation.
Key decisions to put fiscal consolidation back on
track such as hikes in administered fuel prices,
slashing of other subsidies and introduction of
Goods and Service Tax (GST) have been delayed
and there is urgency to quickly move on the
indicated lines to avert further deepening of
problems. As these steps materialise, growth could gradually start improving later this year and trend
growth can be restored by next year. At the current
juncture there is no scope for complacency as fiscal
slippage is likely during 2012-13 and CAD is likely
to stay above sustainable level. With fluid situation
for the global economy, macro risks from twin
deficits remain large and need to be addressed
forthwith.
I.31 Structural factors that are impeding growth
remain unaddressed. Mining activity continues be
stalled in absence of a streamlined regulatory and
environmental framework. While growth in the
interim may have suffered as a result of attempt at
legal and environmental enforcement, ultimately
an incentive-compatible framework for business
that penalises fraud and encourages ethical
practices while ensuring fair return alone can
provide a conducive investment climate. Somewhat
similar problems also prevail in telecom space. New
power sector investments are falling as coal linkage
and pricing issues are yet to be satisfactorily
resolved and State Electricity Board (SEB) losses
are large. Road projects are confronting multiple
issues that include land acquisition problems as
well as financing constraints for overleveraged road
developers. As a result, road tendering has nearly
stalled during Q1 of 2012-13 after a record pace of
project tendering in 2011-12. These issues need to
be quickly resolved while keeping lending discipline
for banks.
I.32 Newer uncertainties for growth in 2012-13
have emerged from the unsatisfactory progress
of monsoon so far which is likely to result in a
contraction in foodgrains output during 2012-13.
Despite the recent revival, cumulative rainfall up
to August 16, 2012 was 16 per cent deficient. The
Reserve Bank’s production weighted rainfall index
(PRN) showed an even higher deficit of 21 per
cent. The spatial pattern of monsoon suggests that
output losses could be substantial for coarse
cereals and pulses, While this year the drought
conditions in parts of country are marginally less
severe than that during the 2009 drought, the
monsoon has been unsatisfactory to a degree that
has dampened the prospects for agriculture during 2012-13. During 2009-10, Rabi crop reached
record levels, while the Rabi prospects this year
remain uncertain and would depend crucially on
September rains that will determine the soil
moisture content and the reservoir levels.
I.33 Growth during the year is likely to stay below
potential for the second consecutive year. The
Reserve Bank in its First Quarter Review of
Monetary Policy on July 31, 2012, revised
downwards its growth projection for 2012-13 to 6.5
per cent from 7.3 per cent. The downward revision
mainly reflects drought impact on agricultural output
and contraction in IIP during Q1 of 2012-13. Given
the greater integration of the Indian economy with
global economy, decelerating global growth and
trade volumes will adversely impact India’s industry
and services sector growth. In addition, the lagged
impact of weak industrial growth is likely to weigh
on services sector growth.
I.34 The key question, therefore, is: what can
stimulate a recovery? In absence of signs of global
conditions improving, the burden of adjustment
would have to be borne by domestic policies.
Structural impediments impacting business
confidence need to be addressed immediately. This
is particularly true of the mining and infrastructure
sectors. With limited fiscal and monetary space
available to provide a direct stimulus to domestic
growth, an expenditure switching policy is needed
that reduces government’s revenue spending by
cutting subsidies and using the resources so
released to step up public capital expenditures.
Such an action would also provide some space for
monetary policy, but, importantly, lower interest
rates alone are unlikely to jumpstart the investment
cycle. Fast-tracking of infrastructure projects and
pending regulatory clearances will help to boost
investments. The Government has initiated some
steps to augment the production potential of core
sectors, in particular mining, in the recent period.
However, a lot more needs to be done to boost the
performance of core industries and lead revival of
industrial growth.
Inflation Outlook for 2012-13
I.35 The inflation outlook for 2012-13 remains
better than the previous year, though the inflation
trajectory could remain sticky. Headline inflation
averaged 7.3 per cent during April-July 2012, lower
than the 8.9 per cent average for 2011-12. After
dropping moderately in December 2011, headline
inflation has neither risen nor fallen further in a
perceptible manner. The Reserve Bank’s proxy for
core inflation, non-food manufacturing inflation,
averaged 7.8 per cent in the first three quarters of
2011-12 but dropped noticeably to 5.9 per cent in
the last quarter. It has now dropped further and
averaged 5.0 per cent in Q1 of 2012-13, though it
showed some uptick in July 2012 and remained
above its decade average in the 2000s. While
persistence of inflation is still worrisome, some relief
has been provided by the decline in the recent
period.
I.36 The Reserve Bank, in its First Quarter
Review of Monetary Policy on July 31, 2012,
revised upwards its baseline projection for headline
inflation in March 2013 to 7.0 per cent from 6.5 per
cent factoring in the upside risks to inflation. Earlier
projection was based on the assumption of normal
monsoon that has not materialised. Also, the
moderation in non-food manufactured product
inflation has not been commensurate with
moderation in growth. Persistence of inflation, even
as growth is slowing, has emerged as a major
policy challenge.
I.37 Inflation control remains the cornerstone of
monetary policy as upside risk to inflation remain.
This is largely due to unsatisfactory monsoon, large
upward revision in MSPs on back of cost escalation
(averaging 26 per cent for kharif) and exchange
rate depreciation during Q1 of 2012-13. Latest
assessment suggests that there could be
considerable upside pressure on prices of pulses.
Some of this is already in evidence. Except for
Myanmar, pulses crop has failed globally and
options for imports are rather limited. Pressures to
some extent can also emanate in case of edible
oils, though soyabean crop can substantially offset the groundnut shortfall. Risks to global commodity
prices that had fallen in Q1 of 2012-13 also remain.
The prevailing drought in the parts of US, Eurasia
and Australia may add to price pressures on food
in the global markets. Pass-through from moderation
in global commodity prices to domestic inflation has
in any case been partially offset by rupee
deprecation.
I.38 Other upside risks arise from suppressed
inflation in energy, especially diesel, electricity, coal
and fertiliser prices that need to be adjusted
upwards. The path of inflation could thus be
impacted by the timing and magnitude of
administered price revisions, though it must be
emphasised that such adjustments have become
necessary to reduce pressure on medium-term
inflation from an expansionary fiscal policy.
Continued pressure from wages and the structural
nature of protein inflation could keep inflation high
even with moderation in growth.
I.39 So while inflation risks in 2012-13 are on
the upside, there is a need to distinguish between
temporary and permanent supply shocks. Structural
shocks evident in inflation emanating from protein
food, oil and some commodities require appropriate
short and medium-term responses from the supply
side. However, notwithstanding the cause, persistent
inflation, if left unchecked, could unhinge inflation
expectations and lead to eventual generalisation of
inflation as had happened in Q4 of 2010-11.
Furthermore, demand pressures emanating from
high rural wages and growing corporate staff costs
would need to be factored in. In such situation, close
vigil on inflation would be necessary during 2012-13
to prevent re-emergence of inflationary pressures.
Need to address twin deficits to contain risk to
macro-financial stability
I.40 The emergence of twin deficits during 2011-
12 was a major cause for macro-economic
weakness. Current assessment suggest that they
are likely to stay wide in 2012-13 in absence of
sufficient policy response and no improvement in
business cycle conditions.
I.41 With growth remaining slow, budgetary
targets are at risk. On the receipts side, shortfall in
indirect tax revenue is possible if growth remains
low. With decline in corporate earnings, non-tax
revenues from the earnings of public sector units
(PSUs) could also fall short of the target. It would
be hard to meet the divestment target in current
market conditions. More importantly, expenditure
overshooting arising from under-provision of
petroleum subsidies is likely to put fiscal position
under pressure. Consequently, some level of fiscal
slippage may be unavoidable. In fact, estimates
suggest that if no revision is made in administered
fuel prices, this slippage may turn out to be large
at the current level of crude prices (at about 0.4 per
cent of GDP on this account alone). The fiscal policy
for 2012-13 as announced in the Union budget
directionally aims at aiding the growth revival
through higher capital outlays and reducing key
deficits. However, in order to make space for private
credit to help investment cycle picks up a much
stronger switch to capital expenditures is necessary
without further increasing the deficits.
I.42 Restraining deficits is important as the
budget mathematics still leaves fiscal marksmanship
difficult. The focus of the rule-based consolidation,
which seeks to achieve a correction of one
percentage point in RD-GDP ratio and 0.8
percentage point in GFD-GDP ratio in 2012-13 (BE)
critically depends on revenue augmentation through
widening and rationalisation of indirect tax structure.
While the Government has announced its intent to
cap the expenditure on subsides to below 2 per
cent of GDP in 2012-13, credible policy action
without any further delay would be necessary to
achieve this.
I.43 Adherence to expenditure control measures
on the subsidy front would be challenging if
administered fuel price hikes are delayed. The
consequent subsidy burden on the Government
could crowd-out public investment at a time when
reviving investment, both public and private, is a
critical imperative. In addition, the absence of pass-through
from international crude oil prices to domestic prices would prevent the much needed
adjustment in aggregate demand. This could then
spill over to higher inflation and wider CAD.
I.44 The Government has promised to unveil
steps for fiscal consolidation soon. It has asked
three reputed fiscal experts to help formulate plans
for this within weeks and promised to make
adjustments both on revenue and expenditure side,
while sharing fiscal correction burden progressively
in relation to income classes. A clearer and more
stable tax regime with non-adversarial tax
administration is also being worked upon. This
would include a fair mechanism for dispute
resolution. GAAR legal provisions and guidelines
are being re-examined and taxation for IT sector
and Development Centres are also being reviewed.
While these steps should help improve the fiscal
regime, there is an urgent need to evolve a political
consensus on GST and DTC as part of the tax
reforms and also cut subsidies in order to put the
fiscal regime on a firmer footing.
I.45 CAD had widened to unsustainable levels
in 2011-12 as it reached historical high of 4.2 per
cent of GDP. This was mainly due to high imports
of oil and gold. While growth in exports is likely to
be lower in 2012-13 due to slowdown projected in
the global trade volume, the trend in imports will be
contingent on exchange rate pass-through and
upon the pace of growth in domestic economy and
trend in international commodity prices, particularly
oil. Furthermore, measures taken to curb gold
imports may have positive influence on trade
balance.
I.46 Even though merchandise trade balance in
Q1 of 2012-13 narrowed, trends in services trade
in Q1 of 2012-13 are disconcerting. Preliminary
estimates for Q1 of 2012-13 show services exports
at US$33.4 billion, thus contracting 2 per cent y-o-y.
Services imports at US$20.5 billion, increased by
16 per cent. In net terms, services exports at around
US$ 12.9 billion in Q1 of 2012-13 were lower by 22
per cent as compared with those in Q1 of 2011-12.
This indicates that CAD risks are maintained in
2012-13. Software exports are likely to moderate as global IT spending is expected to be lower. Major
software exporters have already made steep
downward revisions in their guidance on expected
revenues during the year. Overall, CAD-GDP ratio
may not correct significantly in 2012-13 unless there
is substantial improvement in global economic
conditions and domestic policy response.
I.47 With a lower growth, the sustainable level
of CAD is now assessed at around 2.5 per cent of
GDP. For minimising the possibility of external
shocks further disrupting India’s growth sustainability
over next few years it is important not only to focus
on financing of CAD, but also on compressing CAD
to lower manageable levels. Otherwise, there are
risks to CAD from both domestic and external
events. In recent period, CAD has been managed
by improving debt inflows. However, this has longterm
costs for debt sustainability and increases
refinancing risk over time. Therefore, there is an
urgent need to step up non-debt creating inflows,
especially in form of FDI. While there are pros and
cons of greater FDI opening, the balance of risks
overwhelmingly suggests the need to augment such
inflows. With appropriate regulation and conditions,
the negative fallout of foreign investments can be
minimised so that net gains can accrue. This should
be seen as part of the process of managing
globalisation and reaping gains from it. India has
become a far more open economy than ever. It is
often not realised that India’s exports and imports,
including services trade now works out to over 55
per cent of GDP. This is much higher than the same
indicator for the US.
MEDIUM-TERM CHALLENGES FOR THE
INDIAN ECONOMY
Preserving India’s growth story through revival
of infrastructure investments
I.48 India’s growth story in recent past has been
substantially driven by large infrastructure
investments. Foreign direct investments in this
sector have not been very large, but large
investments, both in public and private sectors during last 10-years catapulted India to the rank of
second fastest growing economy in the world after
China. Yet, over the past year or two, infrastructure
sector has reached a critical point of entanglement.
I.49 New investments have slowed down
substantially and existing investments are at risk
with elongated gestations and input supply
shortages affecting viabilities of projects going on-stream.
Reserve Bank’s collation from banks and
financial institutions show that envisaged total fixed
investment by large firms in new projects which
were sanctioned financial assistance during 2011-
12 dropped by 46 per cent to about `2.1 trillion from
`3.9 trillion a year ago. This drop was led by
infrastructure and metals. Envisaged investment in
infrastructure declined by 52 per cent to `1.0 trillion
from `2.2 trillion in the previous year, with power
and telecom accounting for most of this fall.
Investment in telecom sector has dried up, while
that in road, ports and airports has also decelerated
sharply. More than half of the envisaged corporate
fixed investment in large projects has been coming
from infrastructure since 2008-09. Its share,
however, dropped to 48.6 per cent in 2011-12 from
54.8 per cent in 2010-11. This has had a ripple
effect on the economy. Order books of capital goods
producing firms have declined as the size of the pie
has reduced. Their share in the pie has also gone
down as they have been outcompeted by cheaper
imports by foreign firms.
I.50 In addition, investment climate in power
sector has been affected by rising losses of public
sector utilities. Though power tariffs has been raised
by many SEBs over last two years and several other
steps have been initiated to improve the financial
health of the SEBs, drought in many parts of the
country could put added pressure on their profit line
during 2012-13. A large amount of bank finance
getting locked in this sector has raised risks that a
significant portion of these loans may require to be
restructured and may even become non-performing.
The exposure of banks to power sector is about
`3.3 trillion as per sector-wise deployment of credit
obtained from 47 scheduled commercial banks that
account for 95 per cent of total non-food credit.
I.51 Lower coal production and supply shortages
has emerged as a major bottleneck in infrastructure
sector. As much as 54 GW of new power capacity
was created during 11th FYP and another 60-75
GW of capacity may be planned during 12th FYP
backed in part by Ultra Mega Power Projects
(UMPPs). A large part of this new capacity is facing
coal linkage issues. As a result, these investments
are at risk due to coal shortages (see also Box II.6).
A significant proportion of new capacity is without
Power Purchase Agreements (PPAs). Besides coal
shortages can affect a large chunk of power
capacities in absence of Fuel Supply Agreements
(FSAs). The current state is the result of inadequate
planning and coordination between power and coal
sectors, as also slow execution of coal projects.
However, steps are now on anvil to resolve the
problems that have impacted the coal and power
sectors. Most of the distribution companies have
raised power tariff over last one year. Even though
in many cases the extent of revision remains below
what is necessary, it would provide a positive
momentum as the regulators are now seen to be
active. Contemplated revisions in FSA structures
and coal pricing pooling mechanism could also
help, but all pending issues in respect of proposed
new FSAs need to be resolved without any further
delay. Private sector has added to the shortages
by a dismal record of producing coal out of the
mining rights given to them. Therefore, unused
mining rights need to attract deterrent penalties.
Coal production projections for the 11th Five Year
Plan had to be revised downward due to delays in
obtaining clearances, land acquisitions, rehabilitation
and law and order problem. Although India has large
coal reserves, demand for coal is outpacing its
domestic availability substantially. Therefore, there
is a need to resolve coal block auction issues in a
fast-track manner, so that green growth objectives
can be pursued in a manner consistent with
economy’s needs.
I.52 It is an anomaly that India with proven coal
reserves of 114 billion tonnes has to import about
70 million tonnes of coal. A major investment
initiative in India’s mining sector is necessary. Steps to attract FDI in this sector would be helpful in this
context. A careful balancing of environmental and
growth needs would be necessary. What are needed
are quick time-bound decisions under a transparent
framework and not necessarily quick clearances.
Provisional clearances do not often help and where
necessary must be accompanied by easily
monitored conditions that can be fulfilled in a short
span. There is a need to make doing business easy
by adopting models like the one in Singapore, where
multiple agencies/Ministries sit together to quickly
give its decision clearing investment projects. The
onus for such clearance clearly rests with the
bureaucratic machinery. Businesses also need to
rejig their strategies that aim at operating in a more
competitive environment earning normal profits
within the legal and environmental framework and
not try to exploit rules and weak regulation to its
advantage at cost of integrity.
I.53 Apart from capital expenditure slowdown in
the power sector, investment in 2012-13 is also at
risk from the falling interest in PPP projects in the
road sector. National Highways Authority of India
(NHAI) undertook a record road tendering during
2011-12, awarding contracts for 6,491 kms of road
length; 28 per cent higher than in previous year
(see also Chart II.10). Estimated spending on NHAI
projects were also higher by 33 per cent at `362
billion. However, the road tendering activity has
suffered significantly during Q1 of 2012-13.
I.54 Road projects have slowed down due to
issues in land acquisition and problems with legal,
procedural and environmental clearances. More
lately, availability of finance has emerged as an
added constraint. Financial conditions have
tightened as road construction firms are already
leveraged and are unable to raise more debt in
absence of fresh equity. In current market conditions
these firms are unable to raise new equity. Credit
to road sector shows a deceleration in Q1 of
2012-13. A significant part of the panned investment
during 2012-13 would materialise even in adverse
condition as NHAI is planning to award tenders for 3,000 kms of road construction on the basis of
Engineering, Procurement, Construction (EPC)
contracts under which the builder procures material
and does construction and is paid for the costs.
However, steps would be needed to preserve
predominance of PPP mode of road investments.
I.55 In respect of infrastructure financing during
the year 2011-12, gross bank credit to infrastructure
outstanding as of April 2012 was `6.2 trillion.
However, the flow of bank credit to infrastructure
has decelerated. Data on sector-wise gross
deployment of bank credit shows that its year-on-year
growth has declined to 14 per cent for 2011-12
as compared to 38 per cent for 2010-11.
I.56 From a macroeconomic perspective, India
faces a huge energy deficit at present which is
constraining its growth process. An estimated 40
per cent of India’s energy requirements would need
to be met through imports during the 12th Plan. As
such, there is a need to expand domestic production
in the critical sub sectors such as petroleum, natural
gas and coal. Equally important is to migrate
towards deregulation of pricing in the energy sector
so as to rationalise and moderate demand and
improve energy efficiency. Furthermore, alternative
sources of energy would have to be developed for
bridging the demand-supply gap and work towards
ensuring energy security in the Indian economy.
I.57 The projected investment requirements for
infrastructure at US$ 1 trillion for the 12th Plan
present a formidable challenge in view of limited
fiscal space available in the public sector. The
Approach Paper for the 12th Plan envisages that
about half of the investment requirements of
infrastructure would have to be met through funding
from the private sector. A notable concern, however,
has been a lack of private sector participation in
certain key sectors such as railways, irrigation,
water supply and sanitation, ports and power
distribution. There is also a need to create a
conducive environment for private sector
participation with a transparent and credible
regulatory mechanism. In this regard, there is a
need to identify the hurdles and weaknesses in
regulatory, financing, and incentive structure (both taxation and debt) and project implementation
related issues that may be inhibiting.
Strengthening banking soundness through
Basel III
I.58 During the year 2011-12, the Reserve Bank
made significant strides towards implementation of
Basel III norms that is intended to enhance the
resilience of bank and strengthen banking system
soundness further. The Basel III framework in India
would be consistent with the new global standards.
The Basel Committee on Banking Supervision that
was first set up in 1974 by a group of central bank
Governors from 10 countries have been providing
such standards since 1988 when the Basel I Accord
was signed. In 2004, a new accord know as
Basel II was suggested with a view to make capital
standards more risk sensitive.
I.59 To address the lesson of the 2008 global
financial crisis, the Basel committee has introduced
comprehensive reforms package through the
Basel III framework to address both firm-specific
and broader systemic risk. Basel III essentially
enhances the regulatory framework introduced by
the Basel II at the level of individual banks. It also
sets up a macro-prudential overlay to limit systemic
risk. The measures relate to enhancing the quality
and quantity of capital, liquidity risk management,
valuation practices dealing with procyclicality issues
and dealing with systemically important banks. It
also covers resolution mechanism, compensation
practices, stress testing, disclosures to enhance
transparency and reducing systemic risk in
derivative markets by moving OTC derivatives to
central clearing and settlement mechanisms etc.
The Reserve Bank issued the guidelines on
Basel III capital regulation, first in the draft form in
December 2011 and then in its final form in May
2012. Banks in India are to begin implementation
of these guidelines beginning January 1, 2013 and
complete it in a phased manner by March 31, 2018.
I.60 In the guidelines, the minimum capital
requirements have been kept one percentage
above the norms laid down by the Basel Committee.
Besides this, a few rules have also been kept tighter
than the norms suggested by the Basel Committee.
I.61 As a prudent measure, the Reserve Bank
has always prescribed 1 per cent higher capital
requirement compared to 8 per cent prescribed by
the Basel Committee under Basel I / Basel II capital
adequacy framework. The higher prescription has
served Indian banking system well over the years.
The higher prescription is essentially on account
of the fact that the Basel Committee norms are
only the minimum norms. A higher norms covers
up the possible inadequacies in the capital
allocation process and model risks in banks. It may
be mentioned that for similar reasons, several other
jurisdictions have also proposed higher capital
adequacy requirements than the minimum
prescribed by the Basel Committee. Additional
capital requirements over and above Basel
minimum have had positive externalities. It has
been noted by credit rating agencies as being
rating positive and are expected to help banks
access funds more easily in the markets. The
higher prescriptions are not expected to put
additional pressure on banks as globally banks
have in fact, always operated at significantly higher
level of capital adequacy than the prescribed
minimum.
I.62 The broad level estimates suggest that in
order to achieve full Basel III implementation by
March 31, 2018, the public sector banks (PSBs)
would require common equity to the tune of `1.4–
1.5 trillion on top of internal accruals, in addition
to `2.65–2.75 trillion in form of non-equity capital.
Similarly, major private sector banks would require
common equity to the tune of `200-250 billion on
top of internal accruals, in addition to and `500-600
billion in form of non-equity capital. These
projections are based on the conservative
assumption of uniform growth in Risk Weighted
Assets of 20 per cent per annum individually for
all banks and individual bank’s assessment of
internal accruals (in the range of 1.0-1.2 per cent
of Risk Weighted Assets). It is important to mention
that banks would have continued to require
additional capital to meet Basel II capital ratios had
Basel III capital ratios not been implemented.
Therefore, in case of PSBs, the incremental equity requirement due to enhanced Basel III capital
ratios is expected to be to the tune of `750-800
billion.
I.63 There have been some arguments whether
the regulatory regime could be softer for public
sector banks given the backstop they enjoy with
the government which is the principal owner and
stakeholder in such banks. However, from the
regulatory standpoint, operating on the basis of
such backstops and not on the basis of prudential
standards would be detrimental of the financial
system besides being unethical. The Reserve Bank
is committed towards developing a level-playing
regime for all banks irrespective of their ownership
patterns.
I.64 Implementation of Basel III would be
challenging but manageable. In this context, the
observation of Mr. Jaime Caruana, General
Manager, Bank for International Settlements is
relevant. During his speech at CAFRAL/BIS
Conference in November 2011, he stated that
globally, banks have been able to improve their
capital ratios, ahead of schedule and this without
any noticeable impact on lending spreads or
tightening of lending terms.
Financial Inclusion led Reserve Bank policies
with a human face
I.65 With the growing dominance of market
economy, the public perception about the Reserve
Bank policies has been increasingly associated
with how they are impacting interest rates and
exchange rates as also the performance and health
of the banking industry. There has been inadequate
recognition of the fact that Reserve Bank is a multiservice
central bank and has been discharging its
responsibilities in a wide array of domains with a
view to supporting long-run growth and enhancing
welfare of the common man. In addition to its pursuit
of inflation control that helps the poor the most, the
human face of Reserve Bank is reflected in its
policies in the area of rural credit and regulation of
banks and non-bank financial intermediaries,
foreign exchange regulation, currency management,
payment and settlement system.
I.66 To impart a human face to the bank lending
policies, the Reserve Bank has supported the
directed lending route as an integral part of its bank
lending policies. This has been mainly through the
stipulation that banks must ensure that at least 40
per cent of their total advances go to the priority
sectors. The prescription in respect of foreign
banks was 32 per cent, but which has now been
raised to 40 per cent in case the bank has twenty
or more branches. The new stipulation is to be
achieved over next five years. The priority sector
lending (PSL) has improved the flow of credit to
certain productive sectors of the economy that
would otherwise have been crowded out of the
bank credit market in presence of information
asymmetries.
I.67 The Reserve Bank has faced criticism from
extreme votaries of strong interventionist policies
to promote financial inclusion and the detractors
who argue that such directed lending leads to
misallocation of resources. In practice, Reserve
Bank has strived to ensure a balance between
equity and efficiency considerations so that financial
inclusion is furthered, but banks financial health is
not hampered and its lending capacities are
preserved.
I.68 Nothing represents the extent of human
face of the banking than the progress it makes on
the goal of financial inclusion. Financial inclusion
was adopted as a formal agenda for Indian
banking following the Report of the Committee on
Financial Inclusion (Chairman: Dr. C. Rangarajan),
2008. The Report noted that 51 per cent of farmer
households did not access credit, either from
institutional or non-institutional sources. Further,
despite the vast network of bank branches, only
27 per cent of total farm households were indebted
to formal sources (of which one-third also borrow
from informal sources). Access to formal
institutional credit amongst farm households was
as low as 4.1 per cent in North-Eastern, 18.2 per
cent in Eastern and 22.4 per cent in Central
Regions.
I.69 A World Bank study by Asli Demirguc-Kunt
and Leora Klapper (April 2012) is revealing about the dismal state of financial inclusion world-wide
and even more so in India. Providing an analysis
from a newly developed Global Financial Inclusion
Database (Global Findex), that is drawn from survey
data covering 148 countries shows that only half of
the world’s population hold accounts with formal
financial institutions and only 9 per cent have taken
out new loans from a bank, credit union or
microfinance institution in the past one year. This
study also shows that India scores rather poorly on
financial inclusion parameters than the global
average. In India, only 35 per cent of people had
formal accounts versus an average of 41 per cent
in developing economies. India also scored poorly
in respect of credit cards, outstanding mortgage,
health insurance, adult origination of new loans and
mobile banking.
I.70 In the recent years, the Reserve Bank has
taken several initiatives to push financial inclusion
high on the agenda of Indian banking. It required
banks to provide no-frills accounts, tried to improve
the outreach of Indian banking through the business
facilitator and business correspondent (BC) models
and set up the goal for banks to provide access to
formal banking to all 74,414 villages with a
population over 2000. In June 2012, the process
was refined further by advising all banks to prepare
road maps covering all unbanked villages with
population of less than 2000 with banking services.
Yet, the Reserve Bank’s assessment is that financial
inclusion remains a substantially unfinished
agenda. This is also suggested by independent
appraisals through analysis of the banking data,
evaluation studies and outreach activities. Latest
figures indicate that there are over 110,000 BCs
employed, which is not a large number in context
of the under banked villages that exist.
I.71 The Reserve Bank had adopted the ICT-based
agent bank model through BCs for ensuring
door step delivery of financial products and services
since 2006. The list of eligible individuals/entities
who can be engaged as BCs is being enlarged from
time to time. For-profit companies have also been
allowed to be engaged as BCs. The BC model has
not been very effective in addressing financial inclusion needs. The model, by itself, cannot serve
the financial inclusion objective. It cannot substitute
the services and the customer confidence that the
brick and mortar bank branches provide. Also, most
BCs are not adequately trained in the use of
technology, knowledge of bank products and
processes and have not imbibed the customer
service culture. There is a need for mainstreaming
financial inclusion. To improve the access of the
poor to banking, banks need to open branches to
provide low-cost intermediation with simple
structures, minimum infrastructure for operating
small customer transactions and supporting up to
8-10 BCs at a reasonable distance of 2-3 kms. This
will lead to efficiency in cash management,
documentation and redressal of customer
grievances.
I.72 Following the Reserve Bank directive in
November 2005, no-frills accounts have been
accepted by banks as one of the important pillars
of financial inclusion. Such accounts opened with
nil or very low minimum balance have the potential
to effectively combat credit rationing and provide
the much-needed finance to a large section of the
under-privileged population. In order to further
encourage such accounts, the Reserve Bank in
August 2012 asked banks to rechristen these as
‘Basic Savings Bank Deposit Account’, with a view
to remove the stigma attached to earlier name and
to integrate them as part of basic baking services.
It also issued specific guidelines to bring about
uniformity on basic banking services across banks.
It specifically removed altogether the requirement
of any minimum balance and has asked banks to
offer deposit and withdrawal of cash at bank branch
as well as ATMs.
I.73 The number of no-frills accounts by banks
had increased to 103 million by March 2012.
However, over three-fourths of such accounts are
dormant. This raises the question whether the
blanket supply-side thrust to financial inclusion is
workable? For financial inclusion to work, it is
necessary to replace the bank or the service
provider approach with customer-centric approach.
As such, more work is necessary for effective strategy for implementation of the financial
inclusion goals. The medium-term strategy for
banks would need continue with a multi-facet
approach with activities woven around linking of
bank finance with Self Help Groups (SHGs)
through MFIs or otherwise. BCs would need to be
an integral part of the financial inclusion by banks
and banks must ensure fair remuneration and help
develop faith in these agents, but coexist, they
cannot substitute but only complement banking
infrastructure. Furthermore, banks need to actively
leverage and develop delivery models that are
technology driven. In doing so they must choose
technology that can support up-scaling and customisation, as per individual requirements. BCs
and SHGs can play a key role in developing
customer-centric approach.
I.74 The task of financial inclusion is a colossal
one. It cannot be outsourced to other layers even
if they form important element of the strategy in
place. These layers have to be integrated with
mainstream banking. It is in banks’ medium to long
term interest to do so, as financial inclusion may
be a short term pressure on banks profitability, but
over the years could increase the size and scope
of banking in India. It will add to the banks’ revenue
stream making it commercially viable.
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