For the Year July 1, 2010 to June 30, 2011*

PART ONE: THE ECONOMY - REVIEW AND PROSPECTS

I - ASSESSMENT AND PROSPECTS

The Indian economy returned to a high growth path in 2010-11. However, challenges emerged as the year progressed. First, investment activity slowed in the second half of the year as business confidence was impacted by high commodity prices, tight monetary policy, political factors and execution issues. Second, while headline fiscal numbers improved during the year, the improvement was led by cyclical and one-off factors, leaving its sustainability in question. Third, though monetary policy was tightened through the year, inflation remained sticky on the back of new pressures. It also turned broad-based in the later part of the year with cost-push and demand-pull factors feeding into producer prices. This prompted the Reserve Bank to take aggressive policy actions during May-July 2011. Going ahead, global uncertainty, sticky inflation, hardening interest rates and high base, especially for agriculture, could moderate growth in 2011-12. On the other hand, though global commodity prices appear to have plateaued, inflation is likely to be elevated in near term and fall only towards the later part of the year as monetary transmission works through further. For medium-term growth sustainability, it is important to rebalance demand from private and government consumption to private and public investment, while inflation is lowered on an enduring basis through better supply responses. Continued focus on development of infrastructure and agriculture technology through public policy would facilitate improved supply response.

I.1 The Indian economy rebounded strongly in 2010-11 from the moderation induced by global financial crisis. However, several macroeconomic factors posed new challenges in 2010-11. During the preceding year and a half, the Reserve Bank had to carefully calibrate its monetary policy as the global financial crisis and the consequent slowdown in the global growth adversely impacted India’s real and financial economic conditions. Both, fiscal and monetary policies worked in tandem to pull the Indian economy quickly and firmly out of the slowdown.

I.2 Even as growth reverted to its trend, new challenges emerged. First, the headline inflation accelerated from the negative levels in mid-2009 to double digits during March-July of 2010. The whole of 2010-11 was marked by inflation persistence, with headline inflation averaging 9.6 per cent. The Reserve Bank responded to the inflation challenge by raising repo rate seven times during the year by 25 basis points (bps) each. Despite these actions, inflation remained elevated due to both newer supply-side shocks and demand factors. As input costs rose and were passed on substantially amidst strong consumption demand, inflation became generalised since December 2010.

I.3 In response to the generalisation, the Reserve Bank raised its policy rate – the repo rate – more aggressively in 2011-12. It hiked the rate by 50 bps in May, 25 bps in June and again by 50 bps in July. With this, operational policy rate has been raised by 475 bps in less than 17 months since March 2010, when the rate hikes began. Monetary transmission improved considerably in the latter half of 2010-11 after sustained tight liquidity prompted banks to raise deposit and lending rates. It continued into 2011-12, helping avert inflation gathering further momentum amidst high inflation expectations and persistence of pricing power of the producers, reflecting strong demand.

I.4 Second, even as overall GDP growth increased supported by strong private consumption demand, investment slowed down during the second half of 2010-11 and has shown no signs of improvement yet. Considering that investment intentions in the new projects declined significantly in the second half of 2010-11 on a sequential basis, maintaining corporate investment levels in 2011-12 could turn out to be difficult. Corporate fixed investment, as captured by phasing details of the projects sanctioned financial assistance, which showed a seven fold jump during 2003-04 to 2009- 10, also turned flat in 2010-11, with a sharp dip in the second half. Public investment in relation to the size of the economy declined during 2008-09 and 2009- 10. With revenue deficit, despite some improvement during 2010-11 remaining above the levels that prevailed during 2004-05 to 2007-08, fiscal space to support investment in the economy remains limited. This underscores the importance of focusing on quality of fiscal consolidation. Meanwhile, in an uncertain interest rate environment, it remains to be seen how far the momentum in investment can be sustained ahead. As such, in the short run, investment cycle can be elongated by focusing on better execution of pipeline investment and improved governance at all levels, internal and external to a firm.

ASSESSMENT OF 2010-11

I.5 In assessing the macroeconomic performance of 2010-11, some questions are central to the overall assessment as set out below.

Why did inflation persist and was this predictable?

I.6 The year 2010-11 was marked by strong inflation exhibiting persistence on the back of elevated inflation expectations, spike in vegetable prices with unseasonal rains post-monsoon and rising global commodity prices that resulted in significant cost-push and demand-pull pressures since December 2010. Drivers of inflation changed during 2010-11. Food products were the main drivers of price rise during April-July 2010, accounting for about two-fifths of increase in WPI. Their share declined during August- November, when non-food primary products turned out to be the main drivers. However, these price pressures spilled over to manufactured non-food products during December 2010-March 2011, which accounted for 61 per cent of the price rise in this period.

I.7 Inflation became difficult to predict in face of this changing pattern, where new unforeseen price pressures emerged. The declining trend in inflation during first half of 2010-11 was disrupted by sharper-than-expected rise in global commodity prices and structural factors constraining the decline in food prices in spite of normal monsoon. An unforeseen spike in vegetable prices due to unseasonal rains followed the good monsoon. Finally, as inflation spilled over to the manufactured non-food products, producers were able to pass on a large share of the input cost pressures reflecting strong demand.

Was monetary tightening adequate and did it help fight inflation?

I.8 Cumulative monetary tightening by raising operational policy rates by 475 bps since mid-March 2010 has been one of the sharpest around the world. Of this, hikes of 325 bps occurred during 2010-11. The hikes were in smaller but frequent doses as the frequency of scheduled policy decisions was increased to eight from four, enabling a smoother adjustment of the financial markets to monetary policy actions. The magnitude of these rate hikes was small as the nature of inflation was largely supply-driven for the larger part of the year. Also, liquidity conditions were already unusually tight following the unexpectedly large 3G/BWA spectrum auction revenues that resulted in large government cash balances with the Reserve Bank for a major part of 2010-11.

I.9 Policy choices toughened during the second half of the year. Inflation had become generalised towards the later part of the year, even as the headline IIP growth numbers available then on the basis of old index (base: 1993-94) suggested a distinct deceleration. The Reserve Bank assessed that this deceleration was exacerbated by few volatile components. The deceleration was much less if these volatile components were excluded from the growth. Furthermore, related indicators such as credit expansion, corporate profitability, exports and imports, trend in tax collections did not corroborate the slowdown. Monetary policy was tightened further in face of persistence of high inflation. However, the hikes remained small in quantum as headline and core inflation were expected to trend down. Also, uncertain inferences on growth due to data quality prompted a cautious view. The new IIP numbers (base: 2004-05) released subsequently reinforced the RBI view that growth had not decelerated during the second half of 2010-11.

I.10 In face of a series of supply-side shocks, monetary tightening helped to keep some check on the spillover effects and high inflation expectations. However, monetary policy was constrained by the extraordinarily large stimulus given in the wake of global financial crisis. Large surplus liquidity needed to be siphoned out first, before rate hikes could begin to gain traction. Both, the rate and quantum channels of monetary transmission were weak in the first half. Banks started responding to monetary signals in the second half of the year by raising deposit and lending rates, helping restrain inflationary pressures from spiraling up further.

Did the growth rebound of 2010-11 lose steam in the second half?

I.11 It is now clear that the growth did not lose momentum in the second half of 2010-11. IIP growth accelerated to 8.2 per cent in 2010-11 from 5.3 per cent in the previous year. It grew at about the same pace in the second half as in the first half.

I.12 Agricultural growth rebounded in the second half due to record Kharif crop on back of normal monsoon. The consequent rise in farm incomes supported demand conditions and with linkages with industry and services, kept the overall growth momentum. Services remained buoyant, except ‘community, social and personal services’ where policy-induced deceleration was visible as fiscal consolidation resumed.

I.13 Overall growth in 2010-11 is currently estimated at 8.5 per cent and is likely to turn higher after factoring in the new base IIP in the GDP data revisions. The above trend growth in 2010-11 was supported by strong aggregate demand conditions primarily emerging from high private consumption. As a result, the supply-side price pressures spilled over to generalised inflation.

Was the fiscal consolidation in 2010-11 temporary or permanent?

I.14 Fiscal deficit ratios in 2010-11 turned out to be better than envisaged in the Union budget. Centre’s gross fiscal deficit (GFD) was 4.7 per cent of GDP against 5.5 per cent budgeted. Compared with a GFD of 6.4 per cent of GDP in 2009-10, this was a huge swing.

I.15 A qualitative assessment of fiscal correction during 2010-11, however, raises concerns. Not only did the correction in revenue account reflect morethan- anticipated non-tax revenues from spectrum auctions, there has been a spillover of subsidy expenditure from the last quarter of 2010-11 to the current fiscal year. Although the share of capital expenditure in total expenditure increased in 2010- 11 from 2009-10, it was marginally lower than the budget estimates. In particular, capital outlay-GDP ratio fell short of the budgeted ratio in 2010-11 and is still significantly lower than that achieved during precrisis period. Consequently, in outstanding terms, the Central government’s capital outlay (as ratio to GDP) as at end-March 2011 was lower at 12.9 per cent than 13.8 per cent a year ago.

I.16 Improved fiscal position had a large temporary component arising from a business cycle upswing and one-off revenue gains. This resulted in the improvement in headline deficit numbers. Not counting for the revenue proceeds of two main one-off items – spectrum auction and the disinvestment – the GFD/GDP ratio works out to be 6.3 per cent of GDP during 2010-11. Also, revenue buoyancy was supported by a cyclical upswing that led to above trend growth. So the one-off gains and higher growth in nominal GDP of 20 per cent against the budgeted 12.5 per cent contributed largely to lower deficits, while the permanent component of fiscal consolidation was rather weak.

I.17 Clearly, a more enduring fiscal consolidation strategy that focuses on expenditure compression by restraining subsidies as well as revenue enhancement by implementing Direct Taxes Code (DTC) and Goods and Services Tax (GST) needs to be put into place without any further delay.

Why did the CAD improve and is this improvement sustainable?

I.18 The improvement in the current account gap is more sustainable than the fiscal gap. The improvement came about by cyclical upswing in global trade and turnaround in invisibles. The Current Account Deficit (CAD) improved markedly in the second half of 2010-11 on back of a strong pick-up in exports from November 2010. Diversification of trade in terms of composition as well as direction helped in achieving strong export performance. Trade policy supporting exports through schemes such as Focus Market Scheme (FMS), Focus Product Scheme (FPS) and Duty Entitlement Passbook Scheme (DEPB) also helped.

I.19 The CAD improved to 2.6 per cent in 2010-11 from 2.8 per cent in 2009-10. Going forward, there could be some pressure on CAD if the global economy weakens significantly and affects exports. With adequate foreign exchange reserves, India remains capable of handling any pressures emanating from the external sector in the near term. However, from a medium to long term perspective, it is important to improve resilience of external account by pursuing policies that shift the composition of capital flows so as to reduce dependence on its volatile components. Augmenting FDI further could bring about a better balance between different components of capital flows and reduce the possibility of volatile currency movements and any pressure on reserves in the face of contagion risks.

Have financial markets mitigated risks postcrisis?

I.20 Financial markets across the world have witnessed significant deleveraging in the post-crisis period. However, balance sheet risks still remain. Effective market discipline is not getting reestablished. Assurances that multilateral backstops have the capacity to facilitate an orderly deleveraging without triggering further fiscal or bank funding lack credibility. Against this backdrop, it is important to look at whether financial risks have been sufficiently mitigated in India, should another round of contagion occur.

I.21 A strong payment and settlement system architecture with central counterparties and Delivery versus Payment (DvP) is in place in India. While in the post-Lehman crisis, NBFCs and Mutual Funds came under some stress, banks proved to be largely resilient. Since then regulators have taken several measures to strengthen regulation and supervision, increase transparency and reduce settlement risks for derivatives and other financial instruments. Despite these measures there still remain areas of concern.

I.22 The OTC interest rate derivative market in India display a significant degree of concentration, with domination by a few banks. The growth of derivatives as off-balance sheet items of Indian banks is also a source of risk. The absence of a liquid 3- month or 6-month funds market has led to the absence of a term benchmark curve. This is hindering trading in Forward Rate Agreements (FRAs) as also in swaps. However, recent emergence of a deep and liquid Certificates of Deposit (CDs) market with significant secondary market trading could alleviate this issue.

I.23 India continues to promote orderly development of the financial markets. In particular, efforts have been made to develop a vibrant interest rate futures (IRF) market to support long-term debt financing in India. In March 2011, the Reserve Bank permitted IRF trading in 91-day Treasury bills with cash settlement in rupees. Guidelines for 5-year and 2-year IRFs are being finalised in consultation with the Securities and Exchange Board of India (SEBI). Furthermore, the Reserve Bank has decided to extend the period of short sale in central government securities from the existing five days to a maximum period of three months in order to provide a fillip to the IRF market and the term repo market.

Can Indian banks withstand financial market stress?

I.24 A corollary to the above question is whether the financial system can withstand another wave of stress in the global markets. Since the Indian financial system remains bank dominated, banks’ ability to withstand stress is critical to overall financial stability. A series of stress tests conducted by the Reserve Bank in respect of credit, liquidity and interest rate risks showed that banks remained reasonably resilient. However, under extreme shocks, some banks could face moderate liquidity problems and their profitability could be affected.

I.25 Recent trends in asset quality, with deterioration observed in case of some major banks, is a matter of concern. Asset quality of banks needs to be closely watched in the changing interest rate environment as the sticky loan portfolio of small and medium enterprises might rise. Risks of asset quality deterioration in infrastructure sector exists. Such deterioration needs to be averted by quickly resolving the pricing and input supply issues. However, overall trends in non performing assets (NPAs) do not indicate any systemic vulnerability. At a system level, the Gross NPA (GNPA) ratio of scheduled commercial banks increased marginally to 2.52 per cent by end- June 2011 from 2.35 per cent at end-March 2011 but still remains low. Based on unaudited results of these banks, the Capital to Risk (Weighted) Asset Ratio (CRAR) based on Basel II was 13.86 per cent as at end-June 2011. Though this was lower than 14.19 per cent as at end-March 2011, it was well above the minimum requirement.

PROSPECTS FOR 2011-12

I.26 The Indian economy needs to brace up for a difficult year from a macroeconomic perspective. With weak supply response, inflation remains an important macroeconomic challenge. Consumption demand has been strong so far, though private consumption may decelerate ahead responding to monetary transmission from higher interest rates. However, it is important to shore up investment from the point of view of sustaining high growth over the medium term. Both, fiscal and monetary space is limited for any counter-cyclical stimulus if global conditions deteriorate. As such, demand rebalancing from private and government consumption to private and public investment holds the key to meeting the macroeconomic challenges in 2011-12.

I.27 There are risks that the twin deficits – fiscal and current account – could increase if the global economic problems deepen. Global uncertainties have increased markedly since the Standard & Poor’s (S&P’s) downgraded long-term sovereign credit rating of the US to AA+ from AAA on August 5, 2011. This followed a US deficit reduction plan of US$ 2.4 trillion over next 10 years as against earlier proposals for a sharper reduction of about US$4 trillion. Credit Default Swap (CDS) spreads, including those for the sovereigns, have widened since the event resulting in amplification of the debt difficulties in the Euro zone region.

I.28 The S&P action came at a time when there were increasing signs of growth slowing down in the major advanced economies, especially the US. The likely impact of these developments on the Indian economy, going forward, will depend upon the effect it will have on trade, capital flows and global commodity prices.

Growth Outlook for 2011-12

I.29 After above trend growth during 2010-11, growth is expected to decelerate but remain close to the trend of about 8.0 per cent in 2011-12. Growth prospects for the year 2011-12 seem to be relatively subdued compared to the previous year due to a number of unfavourable developments. Global uncertainties have increased. If global financial problems amplify and slows down global growth markedly, it would impart a downward bias to the growth projection indicated in the First Quarter Review of Monetary Policy 2011-12. Currently, global oil and commodity prices even, after some correction, remain high and could adversely impact growth. Persistent inflationary pressures, rising input costs, rise in cost of capital due to monetary tightening and slow project execution are some of the factors that are weighing on growth. While the prospect for the farm sector looks encouraging with the normal South-West monsoon so far, industrial sector growth is likely to decelerate due to above mentioned factors. The growth of the services sector will be driven by the unfolding of the global and domestic economic situation, but is largely expected to keep its momentum.

I.30 At the sectoral level, crop prospects remain good, except in the case of some cereals, pulses and groundnut. The monsoon up to August 17, 2011 was just 1 per cent below the Long Period Average. A rainfall deficiency in Haryana, Orissa and parts of North-East, Maharashtra and Andhra Pradesh may have small adverse impact. However, RBI’s overall foodgrains production weighted rainfall index was 101 till August 17, 2011, compared with 88 in the corresponding period last year. Sowing up to August 12, 2011 was marginally higher than in corresponding period of the previous year. On the whole, the prospects for agriculture at this juncture appear promising, though the growth is likely to turn out to be less than last year on a high base.

I.31 The outlook for the industrial sector in 2011- 12 remains uncertain with the downside risks outweighing the upside risks. The downside risks to the industrial growth in 2011-12 may arise from (i) falling business confidence in face of global uncertainties and political factors, (ii) firm commodity prices amidst inflationary pressures, (iii) tightening of monetary conditions and (iv) weak supply response. Fixed investment growth has slumped to 0.4 per cent in the last quarter of 2010-11. Private consumption may moderate if inflationary pressures persist. The core sector performance is lagging behind the overall economic activity, resulting in infrastructure bottlenecks. The power sector growth in 2011-12, in particular, may moderate if the coal sector continues to underperform, with thermal power accounting for about 70 per cent of total power generation in India.

I.32 On the positive side, the June IIP growth of 8.8 per cent has bucked the trend of industrial growth entering a soft patch. Though the acceleration is driven by capital goods that exhibit volatile output from month to month, it has helped register a 6.8 per cent IIP growth in Q1 of 2011-12. Industrial growth ahead may derive support from domestic demand due to rising income of people from higher salaries and wages. Though demand for some interest ratesensitive sectors has been impacted, overall consumption demand has remained strong in spite of rising prices and interest rates. In spite of high inflation, real demand has not suffered as wage inflation, especially in rural areas has outstripped commodity price inflation.

I.33 There is a very strong structural dimension to service sector growth in India, especially with factors such as low product penetration, favourable demographics and strong demand from rural/semiurban areas shielding services such as transport, communication, finance and insurance from a cyclical slowdown in the industrial sector. The hotel and restaurant segment is expected to register robust growth during 2011-12 driven by domestic demand. The outlook for external demand driven services, however, continues to remain uncertain, given that global growth is weakening again.

I.34 On current reckoning, real GDP growth is expected to moderate to around 8.0 per cent in 2011- 12 from 8.5 per cent in 2010-11. At the same time, it is expected that the robustness of the services sector, which accounts for more than 65 per cent of GDP, would continue to support the growth process. Even so, there are major downside risks to growth during 2011-12 that may arise if (i) global financial conditions worsen, (ii) global recovery weakens further, or (iii) food and non-food commodity price inflation remain high. From the demand side, moderation is expected as investment may remain soft in the near term, while private consumption may decelerate. In face of moderating demand, expenditure-switching from government consumption expenditures to public investments would help.

Inflation Outlook for 2011-12

I.35 Inflation is likely to remain high and moderate only towards the latter part of the year to about 7 per cent by March 2012. With global growth environment deteriorating, global commodity prices, including crude oil, have weakened since the fourth week of July. However, the decline has not been very significant. Should the global recovery weaken ahead, commodity prices may decline further, which should have a salutary impact on domestic inflation.

I.36 Given the fiscal limitations and growing signs of weakness in the US, the Fed has already indicated that it will pursue its near zero rate policy at least till mid-2013. It has also hinted at another dose of quantitative easing. This policy stance may keep the commodity prices elevated. Global commodity prices currently remain far above their level in the previous year. The pass-through of the rise in global commodity prices till April 2011 has been incomplete, especially in the minerals and oil space. As such, the benefit of a moderate fall in global commodity prices on domestic price level would be limited.

I.37 On a year-on-year basis, inflation may remain stubborn in the near term and start falling sometimes in the third quarter of 2011-12. Incomplete passthrough of high global commodity prices and persistence of high inflation expectations amidst continuing food price pressures may keep inflation elevated in near term. If global oil prices stay at current level, further increase in prices of administered oil products will become necessary to contain subsidies. Fertiliser and electricity prices will also require an upward revision in view of sharp rise in input costs.

I.38 The high and persistent inflation over the last two years has brought to the fore the limitation in arresting inflation in absence of adequate supply response. However, monetary policy still has an important role to play in curbing the second round effects of supply-led inflation. In face of nominal rigidities and price stickiness, there are dangers of accepting elevated inflation level as the new normal. Doing so can un-anchor long term inflation expectations, which can then lift inflation further from the present level. This can eventually lead to a hard landing, which may impose large costs of disinflation.

Outlook on the twin deficits for 2011-12

I.39 In the context of weakening global economy and the likelihood of some spillovers to the domestic economy during 2011-12, the twin deficits require close monitoring. If the global crisis deepens and domestic economy slows down beyond what is currently anticipated, the fiscal slippage could turn out to be an issue of concern. It could potentially erode the fiscal consolidation achieved in the previous year. On current assessment, the fiscal deficit in 2011-12 is likely to overshoot the budgeted projections. If the economy slows down beyond what is currently anticipated, the resultant revenue erosion could magnify the slippage. At the same time, the fiscal space to support any counter-cyclical policies is more limited than what existed at the time of the global crisis of 2008.

I.40 On the other hand, in the baseline scenario, the CAD would remain at a sustainable level in 2011- 12. Estimates of sustainable CAD suggest a threshold of 2.7-3.0 per cent of GDP. Prospects for external sector for 2011-12 remain somewhat uncertain due to global uncertainties arising from the financial turmoil following the sovereign rating downgrade of the US, slowing pace of global recovery and the sovereign debt problems in the Euro area. These could impinge on commodity prices and exchange rate movements.

I.41 The continuance of robust performance of exports recorded in 2010-11 and 2011-12 so far faces downside risks. If these problems continue to simmer and do not turn into a full-blown crisis, the impact of growth slowdown in the advanced economies on India could partly be mitigated by continued diversification of exports. India’s exports have diversified notably in composition and destination in recent years. The impact could, nevertheless, turn material in case the slowdown in global growth is sharp and widespread.

I.42 Services exports are also likely to expand due to India’s comparative advantage in software services. As the Indian IT industry is inter-twined with the global economy, with the US and Europe constituting the bulk of Indian software exports, some impact from a slowdown in advanced economies can be expected. National Association of Software and Services Companies (NASSCOM), which serve as the chambers of commerce for the Indian IT and BPO companies, had projected software exports in dollar terms to grow by 16-18 per cent in 2011-12. Several pointers suggest that a growth of broadly similar order could still be attained. These include (i) better-thanexpected dollar revenues by software firms in Q1 of 2011-12, (ii) reasonably good guidance for Q2, (iii) locked-in contracts this year and (iv) good corporate earnings and cash on balance sheet of the US firms in spite of sluggish growth. As such, any downside impact would be marginal in the near term. However, it can become perceptible with a lag if crisis assumes severe proportions impacting global growth prospects beyond current year. For the current year, the prospects are that services exports as well as private transfers are likely to remain stable despite problems in the US, Europe and MENA countries.

I.43 As regards capital flows, the impact is more difficult to gauge. Capital flows could surge or diminish, depending upon the degree of risk aversion among several other factors. Going forward, if global crisis turns deep, capital flows are more likely to moderate as (i) foreign portfolio investors may sell equities in the EMEs, including India to cover up losses elsewhere, (ii) risk aversion may raise the cost of borrowings for the Indian corporate and also impact direct investments, and (iii) domestic bonds could still remain less attractive if a slowdown impacts fiscal position adversely.

I.44 On the other hand, capital flows to India could increase in spells as relative returns in EMEs could now be still higher. Several investors view the valuation in the Indian stock market as attractive on an expected future earnings basis. Interest differentials are likely to remain large and alluring to debt flows. With India’s growth prospects still broadly intact, its attractiveness as an investment destination may increase. In the short run, if commodity prices soften and global crisis remains contained, the resultant benefit it may have in lowering inflation, fiscal and current account deficits could attract fresh investments. Therefore, the possibility of lumpy capital inflows cannot be ruled out. Over the course, capital flows could remain volatile and may depend on how trade and capital flows, as also other macro-economic parameters, respond endogenously to exchange rate movements.

I.45 Overall, the year 2011-12 appears to have begun well from the balance of payments front. Exports in dollar terms have risen 54 per cent yearon- year during April-July 2011, while imports have expanded 40 per cent. As a result the size of the trade deficit in absolute terms during the first four months has remained largely unchanged from that in the corresponding period of the previous year. On the capital flows side, FDI to India in Q1 of 2011-12 has risen more than twice that in the corresponding period of the previous year. The prospects for FDI also appear bright as further policy initiatives are on the anvil. The debt component of the capital inflows could rise with rising interest rate differential. However, the balance of payments during 2011-12, although likely to be manageable, requires constant monitoring due to global uncertainties.

RESERVE BANK’s PERSPECTIVE ON THE MEDIUM-TERM
CHALLENGES FOR THE INDIAN ECONOMY

I.46 While the immediate challenge to sustaining high growth lies in bringing down inflation, growth sustainability over medium-term depends on addressing the structural bottlenecks facing the economy. There are several challenges faced by the Indian economy that are constraining growth. These include those relating to education, health, energy, infrastructure and agriculture sectors, where public policy interventions are needed as markets by themselves may not be able to do enough to remove the constraints. The Reserve Bank does not have a direct role in addressing most of these. However, addressing them is central to raising the potential level of growth in the Indian economy. Some of these are discussed below.

Lowering inflation and inflation expectations to acceptable levels

I.47 What policy interventions can help to lower inflation and inflation expectations to acceptable levels? Monetary policy has an important role to play, but may find it difficult to deliver the objective unless complementary policies are put in place. These include, improved supply response for food, higher storage capacity for grains, cold storage chains to manage supply-side shocks in perishable produce and market-based incentives to augment supply of non-cereal food items. Finally, supply response would also depend on better management of water as also technical and institutional improvements in the farm sector and allied activities. Land consolidation, improving land quality, better seeds, irrigation, harvesting, technologies and supply chain to retail points all can contribute to lowering inflation and the inflation expectations that are formed adaptively.

I.48 Tackling food inflation also needs a strategy to break the inertial element arising from rising real wages leading to increases in the Minimum Support Price (MSP), which in turn lead to higher food inflation that feeds back to higher wages with an element of indexation. Some public policy interventions may be desirable in this regard. Rural wage programmes need to be linked with productivity. If productivity improves, real wages can rise without putting pressure on prices. The inclusion agenda can then be pursued on a sustainable basis without drag on inflation and the fiscal position.

I.49 Transmission of inflation from abroad has also been an important element in keeping inflation high in the recent years. International commodity prices remain a potential threat as global liquidity is still far too large due to monetary policy accommodation by advanced countries. Fuel and food security would need to be given particular attention. There is a need for environmentally sustainable solutions to manage energy security. Free pricing of petroleum products can help, as a large population cannot be subsidised in an import dependent item. Finally, pricing power in the manufacturing sector has macro as well as micro angles. A competition policy has been put in place and industrial organisation structures could be studied along with price information to stamp out anticompetitive practices and collusive behavior. Such behavior also adds to inflationary pressures and needs to be curbed.

Harnessing technology for agriculture productivity enhancements

I.50 India is a knowledge economy with a strong technology base. Yet, it has not fully reaped the dividends from technology. For instance, substantial productivity enhancements are possible on the farm sector through better adoption of technology aided by incentives and institutional improvement. Large scale introduction of Precision Farming Techniques involving GIS and Remote Sensing, combined with local-specific fertigation practices, better cultivars and optimal water management can go a long way to improve farm productivity on a sustainable basis. The decline in availability of land for foodgrain production due to increasing urbanisation and diversion of bio-fuels makes it important that technology is harnessed for improving yields. Better adoption of modern technologies in the area of biotechnology, genomic tools, cost-effective and ecofriendly integrated pest management technologies, seed-supply chains and systems, regionally adapted varieties and hybrids, especially drought-resistant varieties can also help in improving farm output. Focus on better water harvesting, especially in dryland regions, and institutional reforms such as creation of infrastructure and laws for digitising land records in the country through appropriate legal framework would help.

I.51 Importantly, the approach to technology advancement has to be eco-friendly. It should focus on providing favourable soil conditions by managing soil organic matter and enhancing soil biological activity; improving soil and water conservation measures; reducing excessive reliance on hydrocarbon inputs; minimum or zero tillage; rotation groups to manage soil fertility and pests; integrated pest management (IPM); and exploiting complementarities in the use of genetic resources by combining these in farming systems with a high degree of genetic diversity. Resource conservation technologies that improve input use efficiency, and conserve and protect natural resources need to be aggressively promoted.

I.52 Rainfed agriculture continues to play an important role in India, contributing around 55 per cent of the cropped area and 45 per cent of the total agricultural output. Since irrigation potential in India is not fully used, there is scope for significantly increasing agricultural production. Rainfed areas contribute more than 70 per cent of the pulses and oilseeds production as well as a substantial part of horticulture and animal husbandry produce. There is, therefore, a need for a comprehensive irrigation/water management strategy as water is probably going to be the most scarce resource in the twenty-first century.

I.53 Water management is particularly important. Worldwide, ground water is preferred to surface due to easier accessibility in terms of place, time and quantity. This has been the case in India also as seen in the shift from canal irrigation in the 1970s to ground water in the 1990s. Currently, as per the Third Minor Irrigation Census, 2005, 75-80 per cent of the irrigation potential is under groundwater, bulk of which are wells - dugwells, shallow and deep tube-wells - and mainly in private hands. Notwithstanding scarcity, competing uses of water, and the consumptive nature of water use in agriculture, policy for agricultural reforms has to take into account the need to evolve programmes for recharge and management of the groundwater reserves of the country, so that extraction is limited only to what we can annually recharge. Natural and incidental recharge based on factors like rainfall, soil characteristics and geomorphology cannot sustain groundwater given the rate at which it is being consumed. Emphasis on steps like water harvesting, cultivation of high value and low water requiring crops, such as pulses and oilseeds in water scarce areas, using water-saving methods of cultivation like System of Rice Intensification (SRI) methodology for paddy and sugarcane, seawater farming for crops that thrive in salt water in coastal areas and investment in research to promote water-efficient crops could facilitate in achieving long-term sustainability in agricultural production.

I.54 In order to step up agriculture growth from a trend of around 3 per cent per annum to 4 per cent would require a judicious use of technology, institutional reforms including those relating to land, incentives for supply response and better input use. Yields need to be improved further by biochemical elements of technology that embody irrigation, genetic seeds, chemical fertilisers and pesticides. Increased yield potential of new varieties can yield better results on optimal use of biochemicals and consumptive use of water that take into account soil moisture conditions of the land. Optimal input use, taking into account land and climatic conditions, can improve yields significantly. This strategy is essential for improving crop output, as the possibilities of further expansion in area under cultivation is limited.

I.55 The agriculture performance appears to have fallen below its potential, partly because price-factors have been emphasised more in relation to non-price factors. While price incentives may still work for large farmers who have large marketed surplus, non-price factors benefit both small and large farmers and output response is greater than through price incentives. The policies focused at price factors alone have led to distortions. For instance, fertiliser subsidies in the past, have not only distorted the optimal use of fertilisers, but have also led to suboptimal investments in fertiliser production as the subsidy was not pegged to nutrients earlier and benefitted inefficient old plants more than the efficient new plants. As such, there is a rationale for extending the Nutrient Based Subsidy (NBS) scheme in scope. Price incentives in the form of higher MSPs, while necessary to stabilize farm incomes, have its limitation in generating aggregate supply response for agriculture.

Maintaining right balance between consumption and investment

I.56 India is amongst the fast-growing emerging markets that has the right balance between consumption and investment in aggregate demand. It does not face the problems of over-investment or from excessive leveraged consumption. In the highgrowth phase, prior to the global financial crisis, leveraged consumption did increase, but from a rather low base. Investment, on the other hand, rose faster. After the global financial crisis, government consumption rose on the back of large fiscal stimulus. In 2010-11, rebalancing took place away from government consumption to private consumption, but investment declined sharply in the second half of the year. There is now a need to maintain long-term balance between consumption and investment by rebalancing demand from consumption to investment. For this, there is a need to step up savings in the economy.

I.57 From the year 2000-01 onwards, gross domestic savings increased mainly on account of rise in private corporate savings and improved performance of public sector savings even as household sector savings remained almost stable as per cent of GDP. The public sector turned from being a net dis-saver to a savings generating sector largely due to fiscal consolidation under the Fiscal Responsibility and Budget Management (FRBM) Act regime. Private corporate savings improved in line with efficiency and profitability. The Planning Commission at the start of the process for formulating the Twelfth Five Year Plan (2012-17) envisaged a growth of 9.0-9.5 per cent. In the changed scenario, where advanced economies may go through a prolonged scenario of slow growth, this may be difficult target to pursue. In order to achieve even a 9.0 per cent growth, the investment rate of 40.5 per cent would be required if ICOR remains unchanged from 4.5 realised during the Eleventh Plan. The CAD that finances the saving-investment gap has averaged less than 1 per cent of GDP over past two decades. Even assuming a higher a CAD/GDP ratio of 2 per cent, gross domestic saving (GDS) rate need to be raised by about 5 percentage points from 33.7 per cent in 2009-10. This underscores, the importance of augmenting saving as well as bringing about technological and institutional improvements to realize higher growth through higher investments and lower ICOR. Overall investment requirements and the need for continued sustainability on current account, thus underscore the need for attaining the highs of private corporate and public sector savings reached in the recent past and exploring the possibility of invoking an upward shift in household savings which have remained stable for many years.

Facilitating energy security

I.58 Amidst high growth, India faces a large energy deficit that can eventually constrain the growth. Factoring the current and expected trends in supply and demand of energy in India, India’s energy deficit could double by the end of the Twelfth Plan from about 170 million tonnes of oil equivalent during 2010-11. By the end of the Twelfth Plan, India may need to import 40 per cent of its energy requirements. Demand-supply gaps could be particularly large in coal and crude oil. This will put pressure on energy prices and balance of payments.

I.59 India will need to augment its domestic energy production. At the same time, moderation of demand, efficient energy usage and alternative sources of energy will have to form the three pillars for achieving energy security. Price increases would be necessary to incentivise energy conservation, curb demand and support supply response through capacity addition. Also, public policy support for augmentation of domestic hydrocarbons, coal and power output through public and private investments is necessary. The demand-supply gap for crude oil, petroleum products as well as natural gas in India is likely to rise. As the Ninth Round of auctioning exploration blocks under the New Exploration Licensing Policy (NELP IX) has not received adequate response, the strategy will need to be re-worked to create enabling financial and regulatory environment where public and private sectors effectively participate in the exploration.

I.60 India has large coal reserves; coal block auctions could be front-loaded. Pipeline investment in power projects is large, but once the projects go on-stream, their optimal utilisation requires that coal supply issues be resolved. This is a priority that would entail better planning and coordination amongst concerned agencies and stakeholders. It is important to ensure that not only do existing power plants get adequate coal supply, but newer plants are also able to secure input supplies so that they start off in time with a reasonable load factor. As a large amount of bank finance is locked in the infrastructure sector, the viability of new infrastructure projects need to be ensured in order to avoid any restructuring needs.

Facilitating infrastructure finance

I.61 As per the assessment of the Planning Commission, during the Twelfth Plan (2012-17) India may need infrastructure investments of over US$ 1 trillion. This poses a mammoth financing task. The infrastructure gap of India, both in relation to other major countries and its own growing demand has been a key factor affecting the overall productivity of investments. The requirement of high initial capital outlay, that too over longer terms, necessitates measures to address the financing constraint to capacity expansion in infrastructure. The financing issue relates not only to possible resource gap, but also to ensure commercially viable funding that remains so over business cycles.

I.62 Infrastructure investment during the Twelfth Plan will need to be funded by both, public and private sectors. Despite increasing participation of the private sector in bridging the infrastructure gap, public investment still has to play a significant role. Fiscal consolidation and reorientation of expenditure towards capital expenditure is required to meet the target. The banking system, despite the risk of assetliability mismatch while lending long-term for infrastructure projects, has seen high growth in credit to this sector in recent years.

I.63 In the recent past, several measures have been taken to support development of corporate bond market to facilitate long-term finance so that infrastructure investment can pick up. The FII limit on investments in corporate bonds has been raised to US$40 billion. FIIs can now invest in corporate bonds of residual maturity of over five years issued by companies in infrastructure sector up to US$25 billion within the overall limit. Disclosure norms have been simplified and withholding tax on investment in India Infrastructure Development Fund (IDF) bonds has been reduced. Banks, Primary Dealers and investment banks have all been allowed as market makers. In the secondary market, repos in corporate bonds have been allowed and new 91-day IRF product has been launched. CDS are also expected to be take off in near term. Reporting platform on OTC interest rate derivatives is now in place and DvP has been facilitated through transitory pooling of accounts.

I.64 Further measures are, however, needed to improve the flow of resources to infrastructure sector on a commercial basis. These include, rationalisation of stamp duties across States and re-look at tax treatment of Pass Through Certificates (PTC). Partial credit enhancement by banks is an option, but has its own problems. Alternative means of risk mitigation through CDS or bond insurance are being explored. More players are also needed to help corporate bond market acquire depth and vibrancy.

Promoting financial inclusion and inclusive growth

I.65 Long-term growth sustainability critically depends on achieving inclusive growth. In turn, financial inclusion is a necessary condition for achieving this. Inclusion strategy aims at not just the pace of growth, but its pattern with a view to cover all in the growth process. It allows people to contribute to as well as benefit from economic growth. Financial inclusion refers to delivery of financial services at affordable costs to the low income or disadvantaged groups in a fair and transparent manner by mainstream institutional players. To support inclusive growth through financial inclusion, the Reserve Bank of India has been encouraging banks to open no-frill accounts with inbuilt overdraft facility, developing suitable recurring deposits, remittance facilities suited for pattern of cash flows for poor and rural households, small loans for entrepreneurial activity and offering micro insurance facility.

I.66 Availability of finance is the most important factor in promoting a sustainable model for inclusive growth. However, there are several barriers to inclusive growth. Investments in agriculture, infrastructure, human capital formation through education, health and skill formation are critical to inclusive growth. For instance, about one crore people will seek to enter the workforce each year over the next decade, posing challenges for employment and skilling. The demographic dividend will turn out to be a threat if skill formation does not gather pace. Recognising this, a National Policy on Skill Development is now being implemented. Finance is important for supply of all these activities. Inclusive finance is necessary for supporting the demand for these activities, so that these can be paid for.

I.67 Financial inclusion is an important priority of the Reserve Bank as only 30 per cent of the commercial bank branches are in rural areas and only 61 per cent of the country’s population has bank accounts. It is both a national commitment and a policy priority especially when a large section of population lacks access to even the most basic formal financial services. The Reserve Bank has taken the task of financial inclusion in mission mode and has fostered an enabling regulatory and policy environment by liberalising branch licensing, mandating banks to open 25 per cent of new branches in unbanked rural centres, permitting large number of entities including corporates to function as Business Correspondents (BCs) and Business Facilitators (BFs), introducing innovative products and encouraging use of technology for reaching the unbanked.

I.68 The list of medium-term challenges discussed above is not exhaustive. They, however, illustrate that while demand management through counter-cyclical monetary and fiscal policies has a role to play in containing inflation and in stabilising growth around its trend, an increase in the trend growth would require policies that remove structural constraints over the medium term. India remains a country with substantial growth potential, given the natural resources, human capital endowment, demographic dividends, its knowledge base and increasing openness. However, the potential can only be reaped through technology improvements, productivity enhancements, reducing energy deficits, development of infrastructure, stepping up saving and investment, pursuit of inclusive growth and lowering inflation on an enduring basis. It should be possible to target a higher growth under the Twelfth Plan than the current trend. However, to maintain macro-economic stability with faster, more inclusive and sustainable growth, the Plan would need to address the medium-term issues upfront.

* While the Reserve Bank of India’s accounting year is July-June, data on a number of variables are available on a financial year basis, i.e., April-March, and hence, the data are analysed on the basis of the financial year. Where available, the data have been updated beyond March 2011 based on information available till mid-August. For the purpose of analysis and for providing proper perspective on policies, reference to past years as also prospective periods, wherever necessary, has been made in this Report.