For the Year July 1, 2012 to June 30, 2013*
Macroeconomic conditions deteriorated during 2012-13, posing several challenges in 2013-14 so far. Growth slowed
further in 2012-13, due to structural constraints and weak external demand. Also, vulnerabilities surfaced with the
widening current account deficit (CAD), high fiscal deficit earlier in the year and deterioration in asset quality.
Reflecting these developments, the Reserve Bank undertook calibrated monetary easing, allowing transmission to
complete from the past two years of monetary tightening. Consequently, headline inflation moderated in the later
part of the year, helped in part by the negative output gap. Concerted efforts in the second half of the year helped
correct fiscal deficit to a significant extent. However, macroeconomic risks have since amplified, as the global interest
rate cycle is reversing following the US Fed’s indications of likely tapering of quantitative easing (QE). Emerging
market economies, particularly those with CAD, have come under pressure due to capital outflows. The Reserve
Bank and the Government have taken several steps to address volatility in the foreign exchange market and narrow
the CAD. However, global risks coupled with domestic structural impediments have dampened prospects of a recovery
in 2013-14 and posed immediate challenges for compressing CAD and staying on the fiscal consolidation path. In
this milieu, it is important to preserve macro-financial stability to rebuild growth on a sustainable basis.
I.1 Growth decelerated further in 2012-13 to a
10-year low of 5.0 per cent. The slowdown also
became more pervasive across sectors, including
services. Growth had averaged 8.8 per cent during
2005-06 to 2010-11, despite a low of 6.7 per cent
in 2008-09 due to the external shock. The
subsequent slowdown was primarily exacerbated
by structural bottlenecks and governance issues,
although high inflation, monetary tightening and
global factors also played a role.
I.2 In terms of industrial performance, mining
output contracted for the second consecutive year,
as structural constraints came to fore with the
clampdown on illegal mining and an inadequate compensatory supply response in the short run
amid unclear regulatory environment. Mining of coal
and iron ore were particularly affected and the
consequent coal shortages spilled over as an input
supply constraint for the power sector, adversely
impacting both its current output and investments.
Manufacturing output nearly stagnated, recording
a dismal 1.0 per cent growth y-o-y during 2012-13,
as structural constraints and governance issues
clogged production activity. Growth also slowed due
to cyclical factors in both external and domestic
demand. Subdued growth in world trade kept export
demand low. Domestic demand deceleration was
partly due to the lagged impact of monetary
tightening during January 2010–October 2011 in response to high inflation. Agricultural growth also
decelerated to below trend, due to the spatially and
temporally deficient monsoon that impacted kharif
production. Two years of industrial slowdown and
dampened demand has slowed down services
sector activity as well.
I.3 The negative output gap that emerged with
growth staying below potential and past monetary
tightening helped moderate headline wholesale
price index (WPI) inflation towards the end of the
year. Headline inflation, which had risen sharply in
H2 of 2009-10 to reach double digits had prompted
Reserve Bank to assume an anti-inflationary
monetary policy stance. As inflation averaged close
to double digits during 2010-11 and 2011-12, the
Reserve Bank persisted with this stance. During
January 2010 and October 2011, monetary policy
was tightened through a cumulative increase in
effective policy rate by 525 basis points (bps) (from
reverse repo rate of 3.25 per cent to repo rate of
8.5 per cent) and an increase in the cash reserve
ratio (CRR) by 100 bps from 5.0 per cent to 6.0 per
cent. Monetary tightening was spread over an
extended period, as policy rates had to be raised
from the low levels that they reached consequent
to the crisis-driven stimulus and inflation expectations
remained elevated.
I.4 Though growth began decelerating in H1 of
2011-12, inflation stayed near double digits,
prompting Reserve Bank to keep monetary policy
in tightening mode. However, with inflation
projections suggesting that it would start receding
in Q4 of 2011-12, the Reserve Bank paused
tightening in its December 2011 mid-Quarter
Review. With signs that inflation was moderating in
line with projections and with demand-side
pressures starting to ebb, the Reserve Bank
prepared grounds for a policy-easing cycle by
imparting more liquidity through aggressive CRR
cuts of 125 bps in Q4 of 2011-12. This was followed
up with 100 bps cuts in the policy rate, another 75
bps reduction in the CRR on a cumulative basis
during 2012-13 and a 100 bps reduction in the SLR besides a liquidity injection of `1.5 trillion through
OMOs. The accentuation of risks to macroeconomic
stability arising from the twin deficits in the form of
wide fiscal and current account deficits and inflation
persistence inhibited the Reserve Bank from taking
a more pro-active growth-supportive stance despite
growth slowing down more than anticipated, mainly
on account of structural constraints and governance
issues. The expected fiscal correction came later
in the year, by which time worries on the CAD front
had mounted and emerged as the biggest macroeconomic
risk.
I.5 The Reserve Bank cut the repo rate by
another 25 bps to 7.25 per cent in early May 2013
in continuation of its growth-supportive monetary
policy stance. However, the Federal Reserve
Chairman’s comments subsequent on May 22,
indicating likely tapering of quantitative easing (QE)
altered global financial conditions in a significant
way. It triggered global bond sell-offs that generated
large capital outflows from emerging markets,
including India, and imparted significant downward
pressures on emerging market currencies across
the world. Considering the global and domestic
macro-financial conditions and the risks to the CAD,
the Reserve Bank paused in its mid-quarter review
on June 17, 2013. Financial market pressures
exacerbated after further indications from the Fed
that it could completely wind down QE by the middle
of 2014 precipitating sudden stop and a reversal of
portfolio investment flows. With continued capital
outflows, mounted concerns over the financing of
the CAD during 2013-14. Amid these strains, the
rupee depreciated by 7.5 per cent against the US
dollar during May 22–July 15 and large volatility
was observed in the foreign exchange market.
There have been significant FII outflows of about
US$ 14.6 billion during May 27 to August 9, 2013
which extended sharp downwards pressure on
exchange rate.
I.6 In response, on July 15, 2013, the Reserve
Bank announced a package of liquidity tightening
measures to contain volatility in the foreign exchange market. It also announced additional
measures on July 23, 2013 and on August 8, 2013.
The measures included increasing the marginal
standing facility (MSF) rate and the bank rate by
200 bps to 10.25 per cent, announcing an auction
of `120 billion in open market sales of government
securities, capping LAF borrowing access for each
individual bank at 0.5 per of its NDTL and
increasing the minimum daily maintenance of CRR
from 70 per cent to 99 per cent of the daily average
requirement on a fortnightly basis. Further, on
review of the earlier measures, the Reserve Bank
on August 8, 2013 announced auction of
Government of India Cash Management Bills
(CMBs). Accordingly, `220 billion of CMBs were
auctioned in the following week.
I.7 The strategy to restrain domestic liquidity
had the immediate impact of stabilising the rupee,
although interest rates in the money and debt
markets rose. During July 15-29, the rupee
appreciated by 1.3 per cent. Against this backdrop,
the Reserve Bank continued to hold policy rates
and its stipulation on reserve requirements in its
First Quarter Review on July 30, 2013. In its forward
guidance it indicated its intention to roll back the
liquidity tightening measures in a calibrated manner
as stability is restored to the foreign exchange
market, so that the monetary policy could revert to
supporting growth with continued vigil on inflation.
Post-policy review, the rupee came under fresh
pressure and it depreciated by 3.0 per cent within
two days till end-July 2013.
I.8 Amidst continuing rupee volatility in August
and easing liquidity conditions during July and early
August 2013 along with forward looking assessment
of liquidity conditions, the Government and Reserve
Bank decided to auction CMBs.
I.9 The intensification of exchange market
volatility has prompted the Reserve Bank to
undertake unconventional measures in order to
restore stability in the currency market so that
macro-financial conditions remain supportive of sustainable growth. It is in this context that the
measures should be seen as part of an integrated
package comprising policies to create a conducive
environment for capital inflows and to discourage
imports of gold. However, complementary action to
push forward structural reforms to reduce the CAD
and accelerate growth, while increasing savings
and investment, will be needed to move towards
internal and external balance.
ASSESSMENT OF 2012-13
I.10 The year 2012-13 was marked by slowing
growth, lingering inflation, large fiscal and current
account gaps and deteriorating asset quality. Thus,
monetary policy was faced with a Hobson’s choice.
With growth decelerating further and staying below
trend for the second consecutive year, ordinarily
the policy response would have been an
accommodative monetary policy. The Reserve
Bank did ease monetary policy, but in a calibrated
manner. There was clearly a demand from industry
and financial markets for a more aggressive
easing. At the same time, there were worries that
consumer price inflation was hurting people and
that the Reserve Bank was not able to subdue
inflation. Persisting inflation was eroding the
competitive efficiency of the economy and lowering
the financial savings of households with its
adverse consequences for the CAD, investment
and long-term growth. The Reserve Bank did
carefully weigh all information and options and,
as the year progressed, it calibrated monetary
policy in line with the evolving macroeconomic
dynamics.
I.11 In assessing the developments of 2012-13
it is important to understand (i) why growth slowed
further in 2012-13, (ii) why inflation, after a modest
decline towards the end of 2011-12, continued to
linger above its growth-neutral threshold, (iii) why
the fiscal deficit widened in H1 of 2012-13 before
the fiscal retrenchment in H2 and (iv) why the CAD
widened and how external sector fragilities
impacted the economy.
Causes for economic slowdown
I.12 Growth slowdowns are typically associated
with cyclical or structural shocks that are often
called real business cycle shocks in economics.
The former are transitory, while the latter are more
persistent because by nature they last until newer,
lasting shocks take growth to a different level of
output in either direction. Cyclical shocks are in the
nature of upswings and downswings in growth or
in terms of booms and busts. Permanent shocks
are generally associated with real business cycle
proponents, such as productivity changes,
demographic changes, wars, natural calamities,
structural deficits and other structural factors.
I.13 Over the past two years, although part of
the slowdown has been driven by cyclical factors,
structural constraints have played a major role in
the slowdown (see Box II.1). Mining activity was
impacted adversely by governance factors. The
slack in manufacturing activity was largely due to
poor investment on the back of structural issues
facing the infrastructure sector. In addition, global
factors played an important role in the current
growth slowdown. Global growth decelerated to 3.1
per cent in 2012, the lowest since the 2009
contraction that followed the global financial crisis.
Likewise, global trade decelerated sharply to 2.5
per cent from 6.0 per cent in the preceding year
and 12.5 per cent a year ago. Consequently,
external demand fell and revival was difficult.
I.14 Growth slowdown to a substantial extent
has been the result of investment downturn.
Investment climate for the private corporate sector
remained weak in 2012-13. The cost of new projects
planned during 2012-13 which was sanctioned
financial assistance by banks/FIs or funded through
ECBs/FCCBs/capital market issuances in the
domestic market, aggregated to `2,634 billion as
against that of `2,509 billion in 2011-12. In addition,
many projects sanctioned in the past had been
cancelled in the recent years. The investment plan
in 2012-13 was led by high value projects in power
and metal & metal products industries.
I.15 Based on the time phasing details of
expenditure on such projects envisaged at the
proposal stage, it is estimated that actual capital
expenditure made during 2012-13 was lower than
that in 2011-12 and available indication, so far,
points that it would further decline in 2013-14.
I.16 Monetary policy encountered difficulties in
supporting revival in the face of the predominant
role of non-monetary factors in the slowdown and
the persistence of high inflation. It is generally
recognised that monetary policy can best impact
growth by providing a reasonable degree of price
stability. Loose monetary policy can have a lasting
influence on inflation and inflation expectations and,
in turn, can cause actual as well as potential growth
to fall. On the other hand, its direct impact on growth
is limited in that it can influence the level of output
in a counter-cyclical way. If there is a cyclical fall in
output to below potential, monetary policy can try
to lift aggregate demand by easing monetary policy.
If the economy gets overheated and operates at a
level above the potential output, it is important to
tighten monetary policy and bring it back to potential
to counter acceleration in inflation. Long-run
changes in growth are mainly driven by technology,
productivity shocks and fiscal policies that affect
thrift and investments. The greater focus of
monetary policy on inflation relative to growth is
also because inflation has distributional
consequences and welfare costs that can hurt the
poor the most. These considerations affected the
Reserve Bank’s mix of growth-inflation trade-offs
in its policies, even as growth decelerated.
Persistence of Inflation
I.17 The year 2012-13 was marked by headline
WPI inflation ruling at a lower level than in the
previous two years. On an average basis, headline
inflation came down to 7.4 per cent from 8.9 per
cent in 2011-12 and 9.6 per cent a year ago.
Headline inflation, after receding in Q4 of 2011-12,
exhibited persistence at that relatively lower level.
This persistence mainly reflected high food and fuel inflation almost throughout the year. So, although
non-food manufacturing inflation receded further
during H2 of 2012-13 due to softer global commodity
prices and a fall in demand-side pressures, the
overall WPI inflation exhibited a fair degree of
persistence. The year saw the negative output gap
helping to moderate inflation, but encountering
resistance amid supply-side constraints.
I.18 Food inflation originated from an unusual
spike in vegetable prices during February–April
2012, a rise in cereal prices later in the year due to
the delayed monsoon and a significant increase in
minimum support prices (MSPs). Fuel inflation
largely reflected the impact of administered price
changes during the year, with some of the
suppressed inflation coming to the fore. A marked
growth slowdown and past monetary tightening
along with softer global commodity prices contributed
to manufactured non-food products inflation
declining sharply in H2 of 2012-13 and further in
Q1 of 2013-14. Consequently, despite the pressures
of food and fuel inflation, headline WPI inflation
remained range bound between 7–8 per cent for
the first 11 months of 2012-13, before it declined
sharply in March 2013 to 5.7 and below 5 per cent
during Q1 of 2013-14. Non-food manufactured
products inflation has declined further in 2013-14
and stood at 2.4 per cent in July 2013.
Fiscal imbalances and the reversal: a story of
two halves
I.19 Fiscal developments during 2012-13 were
split into two halves. The period H1 of 2012-13 was
characterised by a fiscal slippage to a degree that it
could have undermined macro-stability. However, H2
of 2012-13 was marked by an equally remarkable
fiscal retrench, although in the face of a significant
overshooting of subsidies from the budget estimate,
the burden of adjustment fell disproportionately on
plan revenue expenditure and on plan and non-plan
capital expenditure. At a time when private investment
in the economy was slack, the reduction in the
government’s capital expenditure had adverse implications for aggregate investment and growth in
the economy. The importance of fiscal correction
carried out during H2 has to be judged in the context
of the twin deficit risks that the country faced.
I.20 The fiscal correction in the second half of the
year resulted in a significant reduction in the gross
fiscal deficit (GFD) to 4.9 per cent of GDP in 2012-13
from 5.7 per cent in 2011-12. In the process, the
actual fiscal deficit in 2012-13 turned out to be lower
than that envisaged in the Union Budget.
I.21 The containment of the GFD in 2012-13 in
the face of a shortfall in tax and non-tax revenues
was largely brought about by scaling down
expenditure. Total expenditure was lower than the
budget estimates (BE) mainly on account of lower
plan expenditure (79.5 per cent of BE). The share of
capital expenditure in total expenditure declined. In
fact, the capital outlay to GDP ratio was lower in
2012-13 than in 2011-12. While the compositional
shift might have been dictated by the expediency to
reduce the headline deficit, it does raise concerns
about the quality of fiscal consolidation. Over the
medium term, efforts should be to contain revenue
expenditure, raise tax revenue buoyancy and contain
subsidies to enable durable fiscal consolidation.
External sector vulnerabilities come to the fore
in 2012-13
I.22 External sector vulnerabilities came to the
fore in 2012-13, as the CAD widened to a historic
peak of 4.8 per cent of GDP on top of an already
high level of 4.2 per cent in the previous year. The
widening of the CAD was largely the result of high
oil and gold imports and moderation in export growth.
I.23 In order to contain gold imports, import
duties on gold were doubled from 2 per cent to 4
per cent in March 2012, raised further to 6 per cent
in January 2013 and then hiked to 8 per cent in
June 2013. Further, in August 2013, custom duties
on gold, platinum, refined gold bars and silver bars
were hiked by 2 percentage points each, taking the
import duty on gold to 10 per cent. Besides, the
Reserve Bank has been tightening gold imports through a series of regulatory steps. In March 2012,
it issued directions to NBFCs to maintain a Loanto-
Value (LTV) ratio not exceeding 60 per cent for
loans against collateral of gold jewellery. In May
2012, it asked banks to reduce their regulatory
exposure ceiling on a single NBFC that had gold
loans in excess of 50 per cent of their financial
assets. In November 2012, it asked banks to stop
financing NBFCs for purchase of gold in any form,
except by way of working capital finance.
I.24 In 2013, the Reserve Bank restricted the
facility of advances against the security of gold
coins per customer to gold coins weighing up to a
maximum of 50 gms. In June 2013, it extended the
restrictions to all nominated agencies/ premier/ star
trading houses that were permitted to import gold.
Further, it stipulated that all letters of credit (LCs)
could be opened only on a 100 per cent cash
margin basis on imports of gold and would have to
be on a document against payment (DA) basis. In
July 2013, it revised the scheme of gold imports in
consultation with the government, based on the
principle that 20 per cent of the imported quantity
by nominated banks/ agencies had to be retained
in customs bonded warehouses and fresh imports
could only be undertaken after at least 75 per cent
of the gold remaining in the customs bonded
warehouses were exported. With this, the Reserve
Bank withdrew extant instructions with regard to
gold on consignment basis, LC restrictions, etc.
These instructions were further clarified/modified
in August 2013 and import of gold in the form of
coins and medallions was prohibited. Further,
release of gold for domestic use was made
contingent on the full upfront payment.
I.25 Meanwhile, with a view to restraining fiscal
subsidies and to allow price responses to work to
curtail demand for oil and help bring about a CAD
correction, the government hiked the price of diesel
and capped the supply of subsidised LPG cylinders
in September 2012. Later in January 2013, it partially
deregulated diesel prices by allowing a monthly
reset. These measures are expected to help contain oil demand to some degree. However, oil and gas
prices are yet to be fully market-determined and in
the absence of free pricing the reduction in demand
may not be enough to shrink the trade deficit to the
desired extent.
I.26 With a view to moderate foreign currency
outflows, the Reserve Bank undertook certain
measures on August 14, 2013. These included (i)
reduction in limit for overseas direct investment (ODI)
under automatic route from 400 per cent to 100 per
cent (except for Navratna PSUs, ONGC Videsh
Limited and Oil India in overseas unincorporated
entities and incorporated entities, in the oil sector)
(ii) reduction in remittances by resident individuals
under the Liberalised Remittance Scheme (LRS)
from US$ 200,000 to US$ 75,000 per financial year,
and (iii) prohibition on use of LRS for acquisition of
immovable property outside India directly or
indirectly. However, the Reserve Bank would
continue to consider genuine requirements above
the revised limits under approval route. Also, with a
view to augment NRI deposit flows, (i) incremental
FCNR(B) and NRE deposit were exempted from
CRR and SLR counting from the base date of July
26, 2013; these deposits were also excluded from
adjusted net bank credit for computation of priority
sector lending targets; (ii) interest rates on NRE
deposits were deregulated by removing the cap, that
they cannot exceed interest rates on comparable
rupee deposits.
I.27 With slowing growth over the past two years,
external sector sustainability concerns came on the
horizon. During 2012-13, India’s external debt rose
by about US$ 45 billion to US$ 390 billion. Its net
international investment position worsened by US$
57 billion to US$ (-) 307 billion. On a residual
maturity basis, the short-term external debt
constituted 44.2 per cent of total external debt and
59 per cent of foreign exchange reserves at end-
March 2013. Thus, maintaining external sector
sustainability poses an important challenge going
forward.
PROSPECTS FOR 2013-14
I.28 The year 2013-14 has begun with tumultuous
changes. After early signs that growth was picking
up in the US and Japan, the indication by the Fed
that it would unwind part of the monetary stimulus
earlier than anticipated, has led to tightening in
financial conditions. Bond yields firmed up across
the curve and across geographies, and brought
further changes in other asset prices. Currencies
of the Emerging Markets and Developing Economies
(EMDEs) depreciated speedily, not just of the
current account deficit economies but also for some
current account surplus economies. This, in turn,
led to a decline in equity prices as portfolio shifts
occurred from EMDEs to US markets. Global
commodity prices, which had exhibited a softer bias
during February–April 2013, firmed up temporarily.
Political unrest in parts of the Middle East also put
upward pressure on global oil prices.
I.29 These global spillovers affected India, like
many other EMDEs. After the Fed Chairman’s
comments on May 22, until July 15, 2013 foreign
institutional investors (FIIs) on a net basis disinvested
US$ 8.3 billion of their bond portfolio and US$ 2.1
billion of their equity portfolio in cash markets in
India. The resultant net outflows brought the rupee
under immense pressure. Considering the
heightened exchange rate volatility, the Reserve
Bank announced measures to stabilise the rupee
on July 15, 2013 which were later modified in July
23, 2013 (see paragraph I.5).
I.30 The emerging macroeconomic scenario for
the year 2013-14 is challenging amid the wide CAD,
risks to fiscal targets, persistence of high consumer
price inflation, risk of exchange rate depreciation
feeding into inflation, slowing growth and
deteriorating asset quality. As such, macroeconomic
and monetary policies need to be carefully
calibrated to achieve the immediate objective of
maintaining stability without compromising growth.
Growth Outlook for 2013-14
I.31 Recovery is possible and can take shape
later in 2013-14, but is predicated on better governance, the removal of supply constraints and
maintenance of stability. Despite the new risks, as
a baseline the real GDP growth outlook for 2013-14
is better than that in 2012-13, following the growth-supportive
measures taken by the Government of
India and the south-west monsoon that has
performed well so far. The Annual Monetary Policy
Statement for 2013-14 of May 3, 2013 projected
the baseline GDP growth for 2013-14 at 5.7 per
cent conditional upon a normal monsoon, revival
in domestic investment and global growth. While
the risks to the first of these conditions have since
diminished, the risks to the latter have increased.
Weakness in industrial activity has persisted and
global growth has been tepid. Considering these
factors, the First Quarter Review of Monetary Policy
at end-July 2013 scaled down its growth projection
from 5.7 per cent to 5.5 per cent.
I.32 Normal and spatially well-distributed rainfall
so far during the south-west monsoon augurs well
for the agriculture sector and is expected to boost
rural demand for industrial goods and services. Until
August 13, 2013, 85 per cent of the country’s area
had received excess or normal rainfall, with the
remaining 15 per cent falling in Haryana and parts
of the East and North-East region receiving
deficient rainfall. The Reserve Bank’s foodgrain
production weighted index showed that rainfall was
10 per cent above normal in the current monsoon
season till August 13, 2013. Ample rainfall has
resulted in an improvement in the water storage
levels in reservoirs.
I.33 Water storage in 85 major reservoirs till
August 8, 2013 was 66 per cent above the last
year’s level and 55 per cent above the average of
last 10 year’s storage. This would benefit the Kharif
and the Rabi crops, as also hydropower generation.
Crop prospects are also encouraging as the area
sown under kharif crops till August 9, 2013 was 11
per cent higher than last year and 7 per cent higher
than the normal area sown till date. Encouraging
prospects for crop also augurs well for rural
demand. The current slowdown in any case, has impacted economic activity in urban areas more
than in rural areas. As such, the rural economy
could provide some buffer on the back of satisfactory
monsoon.
I.34 Industrial growth has been nearly stagnant
for two years now, with signs that the stagnation
has extended into 2013-14. Corporate performance
continues to weaken as a result of slowing activity
levels in industry and services sectors. Results of
a sample of 1,149 listed non-government and non-financial companies available till August 12, 2013
for Q1 of 2013-14 indicated that sales had
decelerated further. The expenditure on consumption
of raw materials had contracted and at the
aggregate level profits recorded moderate growth.
The operating profit margin (EBITDA to sales ratio)
was maintained at the level observed in the previous
quarter but the net profit margin declined due to
higher interest to sales ratio. However, the
downward spiral could get arrested with some
uptick later in the year as improved rural demand
and better project execution supports activity. The
low inventory levels of finished goods may enable
expansion in output levels if rural consumption
demand improves. If construction activity also
improves as public investment in road, urban
housing projects and execution of mega projects
pick up, it will generate more demand across the
industrial sector.
I.35 However, in attempting to revive demand,
it is important to reduce the current high consumer
price inflation. This is necessary to arrest the
flagging growth rate of private final consumption
expenditure. The positive orientation of the Union
Budget 2013-14 and measures to arrest
macroeconomic deterioration and stabilise the
economy are expected to have some favourable
impact on investment with a lag. The effects of
government efforts to incrementally resolve key
policy impediments to investment, such as land
acquisition, environmental clearances and raw
material shortages, particularly coal, should translate into ground-level execution. These include
actions taken by the Cabinet Committee on
Investments (CCI) since January 2013 that are
aimed at fast-tracking the stalled mega investment
projects. Evidently, it takes a mobilisation time of
around six to eight months between project
approval and actual investment, implying that the
results would be visible towards the end of 2013.
Recent steps to increase in-bound FDI could also
provide a fillip to domestic investments.
I.36 However, recovery has to be earned in this
difficult economic environment through concerted
action. The economy is currently cruising in slow-speed
mode along a rough road. Strategically, it is
necessary to first patch the rough spots by putting
in place a set of complementary policies to address
the structural constraints.
Inflation Outlook for 2013-14
I.37 Although headline inflation had moderated
in Q1 of 2013-14 to an average of 4.7 per cent,
risks on the inflation front are still significant. First,
this is evident in a rebound in inflation to 5.8 per
cent in July 2013. Creeping inflation pressures are
visible arising from rising food and fuel prices, the
latter in large part due to exchange rate depreciation.
Second, while WPI inflation has moderated, CPI
inflation remains close to double digits. Third,
although food inflation came down from its high of
January 2013, it has resurfaced since May 2013.
While moderate MSP increases this year and a
good monsoon give hope that inflation will be
contained, if high food inflation persists into H2 of
2013-14, the risks of generalised inflation could
become large. In this context, there is a need for
close attention to food management and for taking
policy action to address structural factors that
constrain agricultural supply response. Fourth, the
pass-through of the depreciation of the rupee
exchange rate by about 11 per cent in the first four
months of 2013-14 is incomplete and will put
upward pressure as it continues to feed through to
domestic prices. The exchange rate pass-through has declined in recent years. However, increase in
inflation could occur, given the significant
depreciation of the rupee.
I.38 Overall, the inflation outlook appears to be
better than in the previous year. Non-food
manufactured products inflation at 2.4 per cent in
July 2013 remained within comfortable limit. In its
Annual Policy Statement of Monetary Policy on May
3, 2013, the Reserve Bank projected WPI inflation
to be range-bound around 5.5 per cent during 2013-
14, keeping in view the domestic demand-supply
balance, the outlook for global commodity prices
and the forecast of a normal monsoon. The
projected path of inflation suggested some
moderation in the first half of the year on account
of past policy actions, although there could be some
increase in inflation during the second half that
largely reflects base effects. Headline inflation since
then has moved in line with the projected path. As
communicated at the time of the Annual Policy, the
Reserve Bank will endeavour to condition the
evolution of inflation to a level of 5.0 per cent by
March 2014, using all instruments at its command.
Its objective is to contain headline WPI inflation at
around that level in the short term and 3.0 per cent
over the medium term.
I.39 On the demand-supply balance, the supply
may turn out to be slightly weaker than assessed
earlier. Demand deceleration continues, but rural
demand may stay robust in the wake of a likely good
crop on the back of a normal monsoon. The outlook
for global commodity prices largely remains benign,
but risks of price increase on-shore have increased
following the rupee depreciation and firming up of
global crude prices during July 2013. Therefore,
some price pressures may build up in the latter half
of 2013-14. The normal monsoon, however, has
taken a major risk off the horizon, although the
renewed upsurge in food prices in the first four
months of 2013-14 implies that a close vigil is
necessary so that the relative price change does
not affect the general level of prices.
Need to stay focused on controlling twin deficit
risks
I.40 The budget estimates for 2013-14 and the
rolling targets set for 2014-15 and 2015-16 indicate
a continuation of the momentum of fiscal
consolidation, although slight deviations in revenue
and fiscal deficits from the path envisaged by the
Kelkar Committee could persist.
I.41 The planned reduction in the GFD to 4.8
per cent of GDP in 2013-14 (BE) is expected to be
achieved through higher mobilisation of
disinvestment proceeds, tax revenues,
telecommunications receipts and reduction in
expenditure on subsidies. However, as the Budget
relies largely on revenue-led fiscal consolidation,
its success would depend on the revival of
investment climate and growth. The budget
estimates of gross tax revenue were based on
estimated nominal GDP growth of 13.4 per cent.
However, with growth likely to be lower, it may be
difficult to achieve the budgeted tax-GDP ratio of
10.9 per cent even with the budgeted tax buoyancy
of 1.4 per cent during 2013-14. Gross tax revenue
growth during the first quarter of 2013-14 was lower
than a year ago due to deceleration/decline in major
tax revenues. Among the other major items of
government revenue, disinvestment receipts are
budgeted at `400 billion in 2013-14. An additional
amount of `140 billion is expected from disinvestment
of its residual shareholdings in non-government
companies. Given the emerging conditions in the
financial markets, it would be challenging to raise
the budgeted disinvestment proceeds. Against this
backdrop, strategic planning is necessary. The
possibility of larger dividends from cash-rich public
sector undertakings (PSUs) and further stake sales
in PSUs, which are likely to get investor interest
and consequently better price realisation, need to
be explored fully.
I.42 On the expenditure side, both capital and
plan expenditure are budgeted for a sharp rise in 2013-14. The re-prioritisation of expenditure in
favour of capital expenditure indicates an increase
in the capital outlay to GFD ratio to 38.5 per cent
in 2013-14 from 28.1 per cent in 2012-13 (RE).
Although plan expenditure in 2013-14 is budgeted
higher, the budgetary support extended to central
plan outlay during the first two years of the plan
(i.e., 2012-13 and 2013-14) works out to only 27.2
per cent of the total budgetary support envisaged
for the entire five-year period of the Twelfth Plan.
I.43 A positive feature on the non-plan
expenditure front is the envisaged containment of
expenditure on subsidies at 2 per cent of GDP in
2013-14. However, while the phased deregulation
in diesel prices would help to keep the fuel subsidy
under control, the volatility in the exchange rate
may exert upward pressure on fuel and fertiliser
subsidies in 2013-14. The under-recoveries of oil
companies have risen sharply due to exchange rate
depreciation and a rise in global crude oil prices,
combined with lagged adjustment of prices and
vestiges of administered price mechanisms
prevailing in the sector. While the impact of National
Food Security Ordinance on the food subsidies is
manageable for 2013-14, in the years to come it
will add to the fiscal pressures. The key concern is
that it is difficult to contain food subsidies within
budgeted amount even in 2013-14 when the Act
will just begin to get implemented. Over the next
few years the growing subsidies could restrict
investment opportunities, including those in
agricultural sector.
I.44 Regarding finances of the state
governments, while several states have limited their
deficit and debt in recent years within the targets
set by the Thirteenth Finance Commission, finances
of the states participating in the Financial
Restructuring Plan (FRP) would be under pressure
due to additional debt and interest burden linked to
issuance of bonds/special securities by state power
distribution companies (discoms) under the
scheme. It is imperative that the mandatory
conditions and recommended suggestions of the FRP are implemented in the true spirit by the
discoms and state governments if these utilities are
to become financially viable. Going by the magnitude
of financial implications on states’ finances, the
state governments have to ensure that debt
restructuring does not become a perpetual feature,
considering its downside risks to the stability of
state finances.
I.45 Even though CAD is expected to widen
during Q1 of 2013-14 on account of higher trade
deficit, it is likely to moderate thereafter. After sharp
increase in first two months of the current fiscal
year, trade deficit has narrowed considerably in the
months of June and July 2013. Going forward, the
CAD is expected to see correction due to trade
policy measures taken to curb gold imports and
price adjustments effected to moderate consumption
of fuel products. Besides, there may still be scope
for curbing non-essential imports as well to improve
the trade balance. CAD in 2013-14 is expected to
be lower than the historic high of 2012-13.
I.46 Nevertheless, CAD may continue to be
much above the sustainable level, which is
estimated at around 2.5 per cent of GDP,
underscoring the importance of medium-term
correction aimed at improving expor t
competitiveness, discouraging avoidable imports
and to improve more stable capital inflows.
Need to preserve financial stability with
possibilities that financial accelerator may
increase asset quality risks
I.47 Over the current year and the next, utmost
attention is needed to contain financial stability risks
that are rising with the deteriorating asset quality
of banks. Although the average leverage ratio for
the corporate sector remains comfortable, stress
is building up in some sectors, especially
infrastructure, where firms are finding it hard to
raise fresh equity given an already high net debt to
equity ratio. If infrastructure sector issues are not
quickly resolved, it can have a domino effect on the
asset quality of banks.
I.48 Given the current fluid situation with respect
to key asset prices in currency, equity, bond and
commodity markets, the external finance premium
facing a firm could go up and impact access to
finance. These effects could get magnified, because
a change in collateral valuations could emasculate
a firm’s ability to borrow. The conventional interest
rate effects could propagate, with balance sheet
effects being transmitted beyond an individual firm
in an inter-connected world. Therefore, it is
important for firms to use appropriate strategies to
mitigate these risks by hedging them to the extent
possible.
I.49 In the aftermath of the global financial crisis,
when the asset quality of banks in most advanced
and emerging economies was adversely affected,
the bad loans in the books of Indian banks,
particularly public sector banks, appear to be
contained. The ratio of gross Non-Performing
Assets (NPAs) to gross advances for scheduled
commercial banks in India rose marginally
immediately after the crisis, but declined thereafter
to remain flat at around 2.5 per cent during 2008-
11. The asset quality of banks has deteriorated
significantly thereafter, due to the slowdown in the
economy and the emergence of sector-specific
issues amid structural bottlenecks in the economy.
The ratio of gross NPA to gross advances for
scheduled commercial banks increased markedly,
from 2.36 per cent in March 2011 to 3.92 per cent
in June 2013. Public sector banks account for a
disproportionate share of this increase, with the
new private sector banks managing to lower their
NPA ratio in this difficult climate. The amount of
restructured advances has been considerable
during this period. For the system as a whole,
restructured standard assets as a percentage of
gross advances more than doubled, from 2.6 per
cent in December 2010 to 6.1 per cent in June 2013. The slippage ratio, which captures fresh
NPAs, increased from 2.1 per cent in March 2011 to 3.1 per cent in September 2012, but declined
subsequently to 2.8 per cent in March 2013.
I.50 Macro stress tests suggest that under a
severe stress scenario the gross NPA ratio may rise
to 4.4 per cent by March 2014, but even under such
a scenario, the system-level CRAR of SCBs could
decline to 12.2 per cent by March 2014, yet remain
above the regulatory requirement of 9 per cent.
I.51 During the economic downturn, the Reserve
Bank had taken several measures to tackle asset
quality issues. Standard asset provisioning on
commercial real estate (CRE) exposures was
increased and a provision coverage ratio for banks
was introduced. In the aftermath of the crisis,
following the recommendations of the Mahapatra
Committee report, the Reserve Bank has sought
to do away with regulatory forbearance regarding
asset classification on restructuring of loans and
advances (except in cases of change of date of
commencement of commercial operations for
infrastructure and non-infrastructure projects),
generally in line with international prudential
measures. However, while moving in that direction,
it has adopted a more balanced approach, allowing
a two year adjustment window in view of the current
domestic and global macroeconomic situation.
Further, provisioning requirement on standard
restructured assets have also been increased in a
gradual way spread over a period of three years.
The revised restructuring guidelines have also
increased the promoter’s sacrifice and personal
guarantees in all cases. This is expected to mitigate
the moral hazard problems associated with
restructuring.
I.52 Apart from the deterioration in asset quality,
a medium/long-term challenge for the Indian
banking sector is the smooth transition to the Basel
III framework for improved risk assessment and
management. India is one of the first countries to
come out with the final guidelines on Basel III capital
regulations, which are effective from April 1, 2013
in a phased manner to be fully implemented by end-March 2018. In this context, the need for India
to adopt stringent capital requirements stems from
its growing involvement in the global banking
system, both as a market and as a service provider,
and its vulnerability to global contagion. The
Reserve Bank has prescribed a minimum capital
ratio (CRAR) of 9 per cent, which is higher than the
regulatory minimum prescribed by the Basel
Committee on Banking Supervision (BCBS), as
was also the case under Basel II.
I.53 Despite the fact that Indian banks appear
well-capitalised with an overall CRAR at 13.5 per
cent (at end-June 2013), the challenges in
implementing Basel III cannot be underestimated.
First, Basel III would significantly increase capital
requirements for Indian banks. The credit needs to
finance growth could go up over the years and,
accordingly, the capital needs of the banking sector
would be higher. Second, given the strong presence
of public sector banks, the fiscal burden of Basel
III cannot be overruled if majority shareholding by
the government is to be maintained.
I.54 The available broad estimates suggest that
the full implementation of Basel III by end-March
2018 would require common equity of `1.4-1.5
trillion on top of internal accruals, in addition to
`2.65-2.75 trillion in the form of non-equity capital
for public sector banks alone.
I.55 Infusing bank capital would enable banks
to perform better in its core business of lending to
support growth. The banking sector faces a
challenging task in near term to support recovery
in the economy through improved credit off-take,
while at the same time reversing the asset quality
deterioration. They also need to remove obstacles
to financing for financially excluded segment,
especially through more credit to SMEs and
extension of a range of financial services to the
low-income households. Apart from expanding the
reach of financial services, gaining more financial
depth is also necessary to improve savings,
investment and growth in the economy.
Looking Ahead
I.56 Indian economy is currently going through
a difficult period. However, the problems are not
unique to India. Growth has also slowed down in
many other EMDEs. What is important at this stage
is to preserve India’s growth potential by arresting
the downtrend and maintaining stable macroeconomic
conditions. For this, the focus need to be
on implementation of measures aimed at removing
structural constraints so that production and
investment activity could gather momentum. This
is important, because spillovers from global growth
and financial market conditions can only account
for a part of the slowdown. Current slowdown has
been accentuated by structural factors that have
come in the way of smooth adjustment through pure
demand management policies. With consumer price
inflation, fiscal deficit and current account deficit
being amongst the highest in EMDEs, the need to
preserve macroeconomic stability has emerged as
a binding constraint. As such the momentum of
recovery could come from reengineering focus on
unclogging the stalled investment projects, giving
an impetus to investments in key infrastructure
sectors, supporting productivity enhancements by technology enhancements, bringing in more
managerial efficiencies and supporting research
and development.
I.57 Inherently, the Indian economy has several
strengths including its natural endowment and
demographic dividends. Simple institutional reforms
such as better regulation of natural resources,
improved harnessing of water resources, investing
more in skill formation, digitalising land records,
land consolidation, better integration of regional
agricultural markets, freer labour markets and more
competitive domestic markets can go a long way
in improving India’s potential as well as actual
growth. As such, efforts in the direction of
macroeconomic stability and structural reforms can
pave the way for the recovery.
I.58 The Rest of the report covers the Economic
Review in Part I and the functions and operations
of the Reserve Bank in Part II.
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