II. ECONOMIC REVIEW
Growth rebounded strongly in 2010-11, after the dip in 2008-09 in the wake of the global financial crisis and the
recovery in 2009-10. However, inflation rose and remained stubbornly high throughout 2010-11 as supply-side
shocks got generalised amidst strong aggregate demand. With added risks to growth from inflation above the
threshold level where growth-inflation trade-off can work, the Reserve Bank responded with eleven rate hikes between
March 2010 and July 2011. This lifted effective policy rates by 475 basis points in the current interest rate cycle. As
a result of monetary tightening and deteriorating global economic conditions, some moderation in growth and
significant moderation in inflation from the later part of the year is anticipated going forward. However, risk to
demand compression remains from likely slippage on envisaged fiscal consolidation.
II.1.1 2010-11 marked the completion of the process
of recovery from the adverse impact of the global
financial crisis and the consequent slowdown of the
global economy. Slack in the advanced economies,
with their output gap estimated at 3.4 per cent in 2010,
as also the uncertainty about their future growth,
employment and debt still impinge upon the activity
levels in India. However, growth in India was back to
the earlier high growth path.
II.1.2 Starting in double digits, headline inflation
remained elevated throughout 2010-11. With
vegetable prices spiking following unseasonal rains
after a good monsoon and global commodity prices
firming up in the second half of 2010-11, inflation
expectations started to feed on themselves and costpush
factors from the manufacturing side exerted
pressures on inflation. Inflation turned persistent and
generalised as a result. The stance of monetary policy
continued to be anti-inflationary during the course of
2010-11 and in the year so far to contain inflation and
anchor inflation expectations.
I. THE REAL ECONOMY
Growth rebounds strongly in 2010-11
II.1.3 Real GDP growth at factor cost increased to
8.5 per cent in 2010-11 from 8.0 per cent in 2009-10
(Appendix Tables 1 and 2). At this pace, the real GDP
growth rate increased for the second successive year after the global crisis-induced sharp slowdown in
2008-09.
II.1.4 The main impetus to growth during 2010-11
emanated from agriculture which rebounded to
above-trend growth rate on the back of a normal
monsoon. Reflecting this, the contribution of
the agriculture sector to overall GDP growth
increased sharply in 2010-11 (Chart II.1). Services
sector continued to be the predominant driver of
growth, though its growth was slightly lower than
the average in the pre-crisis high growth phase of
2003-08.
Sustainability of high growth – enabling conditions
II.1.5 Growth is expected to moderate to the trend
level of about 8 per cent in 2011-12. If global
conditions worsen, downside bias to this projection
may arise. This raises concern about sustainability
of the high growth over the medium to long-term.
The Planning Commission in its paper on Issues for
the Approach to the Twelfth Plan (2012-17) proposed
a growth target of 9.0-9.5 per cent. A pre-requisite
for high growth is upfront removal of structural
constraints with close attention on legal and
institutional framework, as also execution and
governance. In the short run, growth will have to
contend with risks from low agricultural productivity,
poor infrastructure, high global commodity prices,
quality of corporate governance and low productivity enhancement in the manufacturing sector.
Furthermore, the substantial increase in oil prices in
2010-11 and 2011-12 so far, has raised concerns
about the near-term growth (Box II.1).
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II.1.6 Calculations suggest that aggregate saving
and investment rates need to be stepped up from 33.7
per cent and 36.5 per cent of GDP in 2009-10, in
order to achieve GDP growth of 9.5 per cent,
envisaged for the Twelfth Five Year Plan. An
investment rate of around 38-39 per cent with an ICOR
of around 4.1 (as was envisaged for the Eleventh Five
Year Plan) would be required. Thus, the investment
rate needs to be stepped up by 2.5-3.0 percentage
points. The gross domestic saving rate needs to be
augmented to 37 per cent or more. This underscores
the importance of at least attaining the high levels of
private corporate and public sector savings reached
in the past. Furthermore, there is a need for stepping up of household savings, which have stagnated in
recent years, largely reflecting the reallocation of
savings between financial and physical assets as well
as the near synchronous movement of changes in
financial assets and financial liabilities (Chart II.2 and
Appendix Table 3).
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II.1.7 Preliminary estimates based on latest
available information show that net financial savings
of the household sector moderated to 9.7 per cent of
GDP at current market prices in 2010-11 from 12.1
per cent in the previous year (Chart II.3 and Appendix
Table 4). The decline in the net financial savings rate
of the household sector reflected the slower growth
in households’ savings in bank deposits and life
insurance fund as well as an absolute decline in
investment in shares and debentures, mainly driven
by redemption of mutual fund units. Even so, there
was a shift in favour of small savings and currency during the year. Households’ financial liabilities,
however, increased reflecting higher borrowings from
commercial banks. Notwithstanding the pick-up in the real GDP growth rate during 2010-11, persistently high
inflation, relatively slower adjustment of bank deposit
rates and the volatility in the Indian equity market impacted by global macroeconomic uncertainties,
affected the level and composition of net financial
savings of the household sector.
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Box II.1
Would Firming Oil Prices Cringe Growth?
The oil price shocks of 1970s were associated with sharp
output losses and large inflationary pressures. In the 2000s,
even larger increases in the price of oil were associated with
much softer impact on these macroeconomic variables. The
1973 oil embargo in the wake of the Arab-Israeli War and
the 1979 oil price surge following the Iranian Revolution saw
the supply of oil falling. In contrast, the 125 per cent rise in
oil prices during 2002-06 was driven primarily by excess
global liquidity and rising demand for oil.
That raises the question whether we need to worry about
the rising oil prices in 2011. Blanchard and Gali (2007) found
that the oil prices are no longer correlated with business
cycle as structural changes have weakened and modified
the transmission mechanism of oil shocks. Further work
suggests that this change is attributable to wage rigidities
and anchored inflation expectations in recent period. Also,
economic agents have viewed the recent episodes of firming
oil prices as temporary and volatile movements.
The impact of oil prices on growth is, however, corroborated
by the IMF’s World Economic Outlook, April 2011. It estimated
that if global oil prices average US$ 150/barrel in 2011, it
would lower real GDP growth in advanced economies by
0.75 per cent, while output loss in emerging and developing
economies could vary from 0.75 per cent in Asia and sub-
Saharan Africa to 0.5 per cent in Latin America. There is,
thus, good reason for not being complacent about the
macroeconomic adjustment that may become necessary if
global oil prices firm up significantly. Bodenstein, et al. (2007)
demonstrated that the impact differs from country to country
and ultimately depends on the oil dependence, the structure
of financial market and risk-sharing, critically hinging on
structural parameters.
Trading environment in the oil markets in 2011 remains
uncertain with hedge funds liquidating and re-building positions
causing volatility in prices. Event risks such as the political
turmoil in the Middle East and North Africa (MENA) region,
the Japanese quake shutting oil refineries and the sovereign
default risks in the Euro zone have time and again reversed
the otherwise firming oil prices on the back of global recovery
broadly staying on track. The price of the Indian basket of
crude rose from an average of US$ 69.8/barrel in 2009-10 to
US$ 85.1/barrel in 2010-11 and further to US$ 118.5/barrel in
April 2011, before declining to US$ 110.6/barrel in May 2011
on expectations of weaker global growth (Chart 1). Oil prices
moderated temporarily in June 2011 on account of the decision
of the International Energy Agency (IEA) members to release
60 million barrels of crude from their strategic reserves to offset
supply disruptions, but edged up again, averaging US$ 112.4/
barrel during July 2011. Following the US sovereign rating
downgrade by S&P, oil prices fell again averaging US$ 106.6/
barrel in the first fortnight of August 2011. Even with this, the
August price of the Indian basket of crude is 25 per cent higher
than its average during 2010-11.
In the case of India, imports accounted for 87.3 per cent of
total domestic oil requirement in 2010-11. Net oil imports (oil
import less oil export) accounted for 65.3 per cent of total
merchandise trade deficit in 2010-11. Though it is difficult to
precisely quantify the impact of oil price on growth, a small
macro model developed to evaluate the impact of oil price
shock on India’s economic growth suggests that the impact
could be somewhat significant. The model comprises seven
structural equations pertaining to consumption, investment,
government consumption expenditure, net exports and prices
of non-oil commodities and two major identities relating to
national income and aggregate wholesale price index (WPI)
comprising prices of oil and non-oil commodities. Results
showed that a 10 percentage point increase in oil price
inflation, if passed through fully, would lead to a reduction in
real GDP growth by about 0.3 percentage point. It would
also raise WPI inflation by 1.0 percentage point through direct
impact, with total impact after subsequent rounds of feed
through estimated at about 2.0 percentage points. These
reflect broad approximations and actual impact may depend
on several factors. With existence of non-linearities, the
adverse impact is greater if oil prices change above the 10
per cent threshold.
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References:
Bodenstein, Martin, Christopher J. Erceg, and Luca Guerrieri
(2007), “Oil Shocks and External Adjustments”, International
Finance Discussion Paper No.897, Board of Governors of
the Federal Reserve Board.
Blanchard, Olivier J. and Jordi Gali (2007), “The
Macroeconomic Effects of Oil Shocks: Why Are the 2000s
so Different from the 1970s?”, NBER Working Paper No.
13368, September.
Petroleum Planning and Analysis Cell, GoI.
Strong rebound in agriculture growth in 2010-11
II.1.8 After two consecutive years of subdued
performance, agriculture turned into a significant
driver of growth in 2010-11. The simultaneous
occurrence of a normal and well-distributed southwest
monsoon and excess north-east monsoon, the
first occasion in the last one decade, enabled both
Kharif and Rabi sowings to be above normal.
Consequently, there was record foodgrain production
in 2010-11 (Appendix Table 5).
II.1.9 The progress of monsoon so far during 2011
has been on the whole satisfactory. The monsoon
arrived on time and by July 9, 2011 had covered the
entire country; a week earlier than scheduled. As on
August 17, 2011, cumulative rainfall since the start of
the monsoon season was normal at 1 per cent below
the Long Period Average (LPA). The India
Meteorological Department (IMD) had revised its initial
forecast of normal monsoon in 2011-12 to slightly
below normal monsoon at 95 per cent of the LPA,
with a model error of ±4 per cent. Spatially, the
monsoon has been reasonably well-distributed, though it has been so far deficient in Haryana, Orissa
and some parts of North East, Maharashtra and
Andhra Pradesh.
II.1.10 Though it is still early to predict the impact of
monsoon on agricultural output, Kharif sowing is
progressing well and till August 12, 2011 was
marginally higher than last year. However, sowing
deficiency is observed in case of coarse cereals,
pulses, groundnut and sunflower. If this stays, supply
management would be needed to keep price
pressures at bay. Overall, the agricultural prospects
remain encouraging, even though growth is likely to
decelerate on a high base.
Technology breakthroughs key to maintaining
demand-supply balances
II.1.11 There are several factors constraining
agriculture supply response thereby impacting
inflation. The foremost relates to low productivity and
monsoon dependence. Presently, productivity levels
remain low and productivity differentials across States
and crops continue to persist. The target growth rate
of 4 per cent for the agriculture sector (Twelfth Five
Year Plan), in relation to the trend growth rate of
around 3 per cent, will require considerable
technological and institutional improvements.
II.1.12 Productivity in Indian agriculture is low
compared with productivity at the world level and
major producers such as China and the US
(Chart II.4). Even the most productive States in the
country fall short of the world standards in terms of
yields of major crops, namely, foodgrains, pulses and
oilseeds. Further, there exists a wide variation in
productivity of these crops across States/regions
(Chart II.5). This is significant given the import
dependence for edible oils and pulses. Increase in
foodgrain productivity can be realised by ensuring soil
conservation, which has been neglected and use of
optimal and locale-specific agricultural practices and
introduction of precision agriculture.
II.1.13 India’s self-sufficiency in food and other agroproducts
can be endangered if technology advancements do not keep pace with growing
demand stemming from rising population and income
levels. Policy interventions are required to support
sustainable growth in crop production and
environmental protection through development of
improved and diversified cultivars, eco-friendly and
cost-effective pest management practices, efficient
seed supply systems, and commercialisation of the
diversified and alternative uses of crop produce. This,
in turn, would improve farm incomes and food security,
while helping to keep food inflation low.
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II.1.14 Notwithstanding the sharp decline in the share
of agriculture in GDP from an average of 53 per cent
in the fifties to 19 per cent in the 2000s, 52 per cent
of the work force continues to be engaged in
agriculture. With just around 44.6 per cent of the gross
cropped area irrigated (as per the latest data available
for 2007-08), the dependence of Indian agriculture on rainfall remains preponderant (Chart II.6). It is in
this backdrop that public policy interventions to step
up investment and productivity enhancements for
augmenting food supplies, assumes importance.
Higher demand for protein-based items calls for urgent
actions
II.1.15 In recent years, the demand for other
agricultural products, particularly, protein-based
products such as meat, eggs, milk and fish, and fruit
and vegetables, have increased substantially. This
can be attributed to rising income levels of a fast
growing economy leading to a change in the dietary
habits of the people. The demand-supply mismatches
in the case of these items resulting from inadequate
supply response to structural changes in demand
pattern have led to rising prices. Steps have been
initiated to address the growing imbalance. The
National Mission for Protein Supplements through livestock development, dairy farming, piggery, goat
rearing and fisheries is expected to help bridge the
gap between increasingly divergent demand and
supply of animal-based proteins. To achieve selfsufficiency
in pulses production, increase productivity
and strengthen market linkages, the Government
launched a scheme for integrated development of
60,000 villages in rain-fed areas.
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II.1.16 Even though the per capita availability of milk
has increased from 194 grams per day in 1994-95 to
258 grams per day in 2008-09, there is a need to
address the structural constraints ailing the sector.
The productivity of Indian bovine compares
unfavourably with the world average mainly due to
gradual genetic deterioration, poor fertility, as well as
poor nutritive value of feed and fodder. To sustain
production of milk, Accelerated Fodder Development
Programme intended to benefit farmers in 25,000
villages has been launched. There is need for
research focused on ecological adaptability of cattle
and developing the disease resistance of cross-bred
species.
Need to focus on food management in times of high
food inflation, production and wastage
II.1.17 In recent years, large food stocks have coexisted
with high food inflation. This may sound paradoxical. However, food inflation in recent period
has come from food items that are outside the ambit
of public distribution system (PDS) and reflect a
demand shift with rising income levels. Food stocks
with public procurement agencies have remained
above the buffer stock norms and food security
reserve requirements and have contributed to
mitigating price pressures (Appendix Table 6).
However, the current storage capacity is inadequate
for the stocks, which reached the vicinity of 66 million
tonnes as on June 1, 2011. Therefore, augmentation
of storage capacity is an important aspect of food
management in India. At the same time, it is
imperative to increase the off-take through the existing
PDS. This would keep a check on price pressure and
also ensure more equitable distribution and food
security. The demand-supply gap leading to price
pressures in case of important food items such as
fruit and vegetables and protein-based products,
continue to persist due to near stagnant supply owing
to lower yield and increase in demand. Hence, it is
also equally important to gradually move away
from the cereal-centric policy towards these
items, with supportive policy framework and
required infrastructure. For effective food security,
better management of food stocks is imperative
(Box II.2).
New base IIP shows that industrial growth accelerated
in 2010-11
II.1.18 The Index of Industrial Production (IIP) data
with the revised base (2004-05=100), released in
June 2011 is better representative of the current
industrial structure. It suggests a sharper dip in
industrial growth in 2008-09 amidst global financial
crisis than was captured by the old base (1993-
94=100). Importantly, it also suggests that industrial
performance recovered much less in 2009-10 than
was thought earlier. The recovery was sustained in
2010-11, with IIP growth accelerating to 8.2 per cent
from 5.3 per cent in the preceding year (Chart II.7 and Appendix Table 7).
II.1.19 The old base IIP data suggested that the
industrial growth decelerated in the second half of
2010-11. Under the new base, IIP growth remained broadly unchanged across the two halves of 2010-
11, recording 8.2 per cent growth in the first half and
8.3 per cent in the second half. The new base has
better coverage and is reflective of the more recent
production structure based on 399 item groups as
against 303 in the old base. The Reserve Bank in
its report on ‘Macroeconomic and Monetary
Developments’ accompanying the Monetary Policy
Statement of May 2011 had indicated that the recent
IIP slowdown was exacerbated by a few volatile items.
The analysis adopting the trimmed mean approach
to compute IIP growth excluding volatile items showed
that the industrial growth had not dropped as much as appeared from the headline numbers. The new
base data confirms the view and shows that the IIP
growth was in fact higher.
Box II.2
Food Management – What Needs to Improve?
The draft National Food Security Bill (NFSB) seeks to give
legal right to every below poverty line (BPL) family in India to
get 35 kgs. of wheat or rice per month at the rate of `3 per kg
for rice and `2 per kg for wheat by way of central allocation
to the States to be distributed through the targeted PDS. In
this backdrop a holistic review of food management would
be helpful.
Food management in India, as it stands now, entails
procurement of foodgrains from farmers at minimum support
prices (MSP), distribution of foodgrains to consumers,
particularly the vulnerable sections of society at affordable
prices and maintenance of buffers for food security and price
stability. It has been reasonably successful in warding off
the threat of famine, though has had limited success
regarding certain other objectives such as price stability,
equitable access and food security.
Procurement and Pricing
Procurement of foodgrains, in particular, wheat and rice, is
an open-ended operation. The Food Corporation of India
(FCI) procures foodgrains at the MSP, which are based on
the recommendations of the Commission for Agricultural
Costs and Prices (CACP). In addition, in recent years, a
number of states have opted for Decentralised Procurement
Scheme introduced in 1997, under which foodgrains are
procured and distributed by the State governments
themselves. Between 2006-07 and 2010-11, MSP of rice and
wheat were hiked at an average annual rate of 14.1 per cent
and 14.6 per cent, respectively. On average, agricultural price
policy has provided a margin of around 20 per cent over
total costs to both rice and wheat farmers (Dev and Rao,
2007). This has ensured sufficient and steady procurement
of foodgrains which can cater to the demand for the PDS
and various welfare schemes of the Government. Price
interventions alone are, however, inadequate for ensuring
better food management and greater focus on non-price
interventions is necessary. Skewed incentives have affected
land use and cropping pattern. Spatially, bulk of the public
procurement remains confined to a few States for want of
access to take-in windows.
The off-take of foodgrains has not kept pace with procurement
despite the Central Issue Price (CIP), the price at which
foodgrains are lifted by States for distribution under various
welfare schemes, being constant since 2002. This has
resulted in stocks of foodgrains building up to a level much
higher than the quarterly buffer norms and food security
reserve requirements. Basu (2010) is of the view that lack of
adequate storage is not the central problem for food
management. He underscored the need to look at the entire
system of food production and procurement, and its release
and distribution.
Production and Food Security
Foodgrain production in India grew at an average rate of 1.6
per cent annually between 1990 and 2010, lower than the
decadal rate of population growth of 1.8 per cent. Resultantly,
per capita net availability of foodgrains per day declined from
510 grams in 1991 to 444 grams in 2009. This is despite the
fact that food stocks have been at their peak in the 2000s.
This may have implications for food security in future.
The NFSB has been approved by the Empowered Group of
Ministers (EGoM) on food security. If the Bill is implemented,
the total requirement of foodgrains will increase. Given the
limitation to expanding the area under crops, increased
supply of foodgrains would thus have to come from increase
in productivity. This has implication for capital expenditure in
agriculture, including that on storage facilities. Further, it could
pose a fiscal challenge through significant increase in food
subsidy bill, estimated at about `92,000 crore by the Expert
Committee (GOI, 2010).
Distribution and Delivery Mechanism
Distribution and delivery have been the most intricate and
challenging aspects of food management in the country. The
existing PDS in India with roughly 0.5 million Fair Price Shops
(FPS) is plagued with deficiencies such as low margins that
create perverse incentives for diversion of foodgrains.
Surveys conducted in the past revealed significant inclusion
and exclusion errors in PDS coverage. The Planning
Commission, in early 2000s, found that the total leakage of
grains meant for BPL population was 58 per cent. Pending
unanimity in approach for identification of beneficiaries,
Aadhaar smart cards could help reduce identification errors
and leakages significantly. Smart cards have the ability to
store and record a large amount of programmed and
authorised biometric information that can be matched to the
actual fingerprint or signature of an individual involved in a
transaction, including eligibility for rations, quantity, price and
time intervals at which he/she could be supplied rations.
These features of the proposed smart card are expected to
immensely help the existing food coupon or food-stamp
system, introduced on a pilot basis in select districts in Andhra
Pradesh, Arunachal Pradesh and Bihar. Greater use of
Information and Communication Technology (ICT) in PDS,
such as GPS tracking of movement of vehicles transporting
PDS commodities, CCTV monitoring of FPS and
computerisation of various operations of PDS could also
improve its efficiency. Other reform measures for food
management which could be considered include allowing
food coupons to be redeemed at approved private food
retailers, thus providing freedom to choose quality of grains
and thereby reducing incentive for adulteration of foodgrains.
An even bolder measure would be direct cash transfer that
offers households the choice of purchase of any mix of grains,
pulses or other household basics up to the value of the
coupon.
References:
Basu, Kaushik (2010), “The Economics of Foodgrain
Management in India”, Department of Economic Affairs
Working Paper, No. 2/2010-DEA.
Dev, S. Mahendra and Chandrasekhara Rao, “Agricultural
Price Policy, Farm Profitability and Food Security.”
Economic and Political Weekly, June, 45:(26 & 27):,174-182.
GOI (2010), Report of the Expert Committee to Examine
the Implications of National Food Security Bill (Chairman:
Dr. C. Rangarajan), Prime Minister’s Economic Advisory
Council.
II.1.20 Further analysis of the IIP growth suggests
some deceleration in mining and electricity in 2010-
11 emanating from poor performance of coal and
consequent lower thermal power generation. The usebased
classification exhibits strong performance of
capital goods and acceleration in growth across all
sectors except consumer durables (Chart II.8 and
Chart II.9). The IIP growth during April-June 2011
shows some deceleration, but this was substantially
on a high base.
II.1.21 Despite the emphasis on manufacturing sector
in India’s planning process, its share in real GDP, as
of 2010-11, was only 15.8 per cent. There is a need
to boost this sector, not only to increase output but
also to gainfully employ a larger number of people.
A number of recent studies have highlighted the
growth of total factor productivity in the organised
manufacturing sector in the past three decades.
There, however, exists wide differentials in productivity
between different States and different industry groups.
Also, there is a large difference in productivity between
the organised and unorganised sub-sectors of
manufacturing. Considering that the latter accounts
for almost four-fifths of total employment in the
manufacturing sector, there is an urgent need to
bridge the gap.
Infrastructure sector registers moderation in growth
amidst capacity concerns
II.1.22 During 2010-11, the eight core infrastructure
industries posted a moderate performance compared
to the previous year (Chart II.10). Infrastructure
industries such as crude oil, natural gas, petroleum
refinery and steel recorded strong growth while
cement production and electricity generation
witnessed moderation in growth. Production of
fertilisers was stagnant and coal output declined. The
core infrastructure sector recorded lower growth of
5.0 per cent during April-June 2011 due to decline in
natural gas and cement production.
II.1.23 The high deficit in power generation is a
constraining factor for growth. Currently atomic energy and solar power are expensive options
compared to coal. Hence, for the time being, rapid
increase in power generation would have to be
through the conventional systems.
II.1.24 The recent slowdown in the production of
crucial infrastructure industries such as coal and
natural gas, given the large growth in demand raise
concerns about sustaining growth. The current level
of natural gas production in the country is inadequate
to meet the industrial demand, particularly of the
power and fertiliser industries. In view of
unfavourable demand-supply balance of
hydrocarbons in India, acquiring oil and gas assets
overseas is one of the important components of
enhancing energy security. Towards this end, the
Government is also encouraging national oil
companies to aggressively pursue equity oil and gas
opportunities overseas. There is also a need to
speed up exploration in the KG basin.
II.1.25 Capacity utilisation, which is an indicator of
demand pressure in the economy, differed across the
various infrastructure industries. During 2010-11,
capacity utilisation in petroleum refining remained
stretched at 109.3 per cent, while that in cement and
thermal power generation eased in line with the
production trend for these two industries. Capacity
addition in power sector during 2010-11 was 12,161
MW, 56.7 per cent of the target for the year. Capacity
constraints in coal, ports and railways raise major
concerns about sustaining growth.
Services sector sustains momentum, albeit with
marginal deceleration
II.1.26 Services sector growth of 9.2 per cent in
2010-11 was marginally lower than that in the
previous year largely due to deceleration in
‘community, social and personal services’ reflecting
fiscal consolidation (Chart II.11). Services dependent
on external demand such as tourist arrivals,
passengers handled at international terminals, export
and import cargo showed acceleration in growth
during 2010-11, indicating improvement in global
economic conditions. Cell phone connections also
registered double digit growth, though lower than the
previous year. Cargo movements in sea ports and
railway freight traffic showed signs of moderation
during 2010-11 on account of capacity constraints
(Chart II.12).
Vulnerabilities that could impede sustained high
growth of services sector remain
II.1.27 Being the largest sector of the Indian
economy, the services sector has significant
implications for growth. It is export-intensive,
employment-oriented and attractive for foreign direct
investors. In view of the above, the sustainability of
the services sector growth is important. One major challenge for its sustainable growth arises from its
dependence on external demand. This increases its
vulnerability to global economic developments, as was
witnessed during the global financial crisis
(Chart II.13). India is facing increased competitiveness
in IT/ITeS and telecommunications of late. The sector
has responded well so far, but in future the wage price
pressures may pose a threat to growth and profitability.
Another area where other countries have gained tremendously is tourism. India has potential but
infrastructure such as road connectivity to tourist
areas is a major challenge. Globally traded services,
viz., financial services, health care, education,
accountancy and other business services, also have
vast potential for growth which is yet to be tapped.
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II.1.28 The Indian Health Care Federation has
prepared a roadmap for making India a world-class
destination for medical tourism. For this, accreditation
of Indian hospitals is paramount as it will help in
ensuring quality standards across a spectrum of
speciality and super-speciality hospitals. In addition,
to encourage medical tourism, there is a need to
provide supportive infrastructure such as improved
air connectivity, streamlining of immigration process
along with developing health support infrastructure.
Private consumption and investment continue to drive
growth
II.1.29 The drivers of growth from the demand side1 revealed the continued predominance of private final
consumption expenditure (PFCE) in driving growth,
followed by gross fixed capital formation (GFCF). On
the other hand, the growth of government final
consumption expenditure (GFCE) moderated sharply
in 2010-11 reflecting the re-emphasis on fiscal
consolidation following the gradual withdrawal of fiscal
stimulus measures that had to be undertaken in the
previous two years to support the economic recovery.
The rebalancing in government expenditure could be
maintained in 2011-12 by staying on the path of fiscal consolidation. External demand improved in line with
the global recovery process, and as a result, the
contribution of net exports turned positive in 2010-11
(Chart II.14).
![15](http://rbi.org.in/scripts/images/7IIER230811_15.gif) |
II.1.30 Even though aggregate expenditure, in real
terms, accelerated in 2010-11 with private
consumption as well as investment expenditure
growing at a brisk pace, some moderation in
expenditure is expected going forward in response
to high inflation and demand-side policy measures.
There was a perceptible slowdown in investment in
the second half of 2010-11. Recovery from the soft
patch, would depend on pick-up in execution of large
infrastructure projects.
Employment situation improved in the recent years
II.1.31 High growth rate along with subdued or
marginal increase in employment generation has
been a pressing concern in the post-reform period.
Available data provides evidence of creation of
additional employment opportunities, though at a
slower pace when compared with the high economic
growth experienced in recent years. According to the
results of latest quinquennial survey by the National
Sample Survey Office (NSSO, 66th round),
employment situation improved in both rural and
urban areas in 2009-10 compared to the previous
round (2004-05). The overall unemployment rate,
measured by current daily status, declined from 8.2
per cent in 2004-05 to 6.6 per cent in 2009-10 and
the decline in unemployment rate was more pronounced for men than for women. The overall work
participation rate (usual status), however, declined to
39.2 per cent in 2009-10 from 42.0 per cent in 2004-
05, largely driven by decline in women work
participation rate.
II.1.32 High industrial growth, with a rate of growth in
real value added in organised manufacturing of about
10 per cent per annum during 2003-09, also was
associated with increase in employment in this sector.
The latest Annual Survey of Industries (ASI) data
reveal that between 2003-04 and 2008-09,
employment in the organised manufacturing sector
increased by 7.5 per cent per annum, as against
decline of 1.5 per cent per annum between 1995-96
and 2003-04. This marks a clear difference from the
previous phases of high growth in manufacturing
output when there was no major contribution to
employment generation.
II.1.33 Labour Bureau has been conducting a series
of quarterly quick employment surveys since
January 2009 to study the impact of the global
economic slowdown on employment in eight major
industries of the Indian economy. As per the latest
data available, employment increased by 9.8 lakh
during 2010-11 with the major share accounted by
the IT/BPO sector.
__________________
1 Despite well known limitations, expenditure side GDP data are being used as proxies for components of aggregate demand.
_________________
II. PRICE SITUATION
High inflation persisted through the year
II.2.1 With growth consolidating around the trend,
inflation emerged as the dominant policy challenge for the Reserve Bank during 2010-11. Inflation
remained high throughout, while the underlying drivers
changed during three distinct phases during the year
(Chart II.15). Price pressures were both external and
domestic, with changing relative roles of supply and
demand side factors. The monetary policy response
of the Reserve Bank was accordingly calibrated
based on assessment of the changing drivers of
inflation and assessment about the role monetary
policy could play in dealing with different sources of
inflation. Monetary policy was, however, continuously
tightened during the course of the year, reflecting
normalisation of crisis time stimulus, to begin with,
but subsequently conditioned by the rising inflationary
pressures. In the absence of anti-inflationary
monetary policy response, the inflation condition
and inflation expectations would have deteriorated
further.
![16](http://rbi.org.in/scripts/images/7IIER230811_16.gif) |
Drivers of inflation shifted over three different phases
II.2.2 The changing inflation dynamics during
2010-11 could be evident from changes in
weighted contributions to increase in WPI over three
distinct phases. During the first period April-July 2010,
the increase in WPI was quite significant (3.4 per cent)
and was largely driven by high food prices. In spite of
good Rabi arrivals, food inflation remained high as
prices of protein-rich items firmed up, perhaps
reflecting continuing demand shifts with rising income
levels. During the second phase between August and
November 2010, the magnitude of price rise was
moderate (2.0 per cent) but primary non-food articles witnessed strong price pressures and became
the major driver of inflation during this phase.
Cotton prices firmed up reflecting global supply
shortages and spiked in September. Mineral prices
also rose. During the third phase between
December 2010 and July 2011, inflationary pressures
rebounded strongly. WPI rose by 7.1 per cent, driven
largely by broad price pressures in the manufactured
products group, indicating generalisation of price
pressures. Price pressures have remained strong
during 2011-12 so far, largely reflecting faster
transmission of input cost pressures to manufactured
product prices and revision in administered fuel prices.
![17](http://rbi.org.in/scripts/images/7IIER230811_17.gif) |
II.2.3 The WPI increased persistently during
2010-11 (Chart II.16). The moderate softening of
inflation (y-o-y) witnessed up to November 2010 was
led by decline in contribution of food inflation to
overall inflation (Chart II.17). During the last quarter
of 2010-11, the contribution of non-food
manufactured products to overall inflation increased,
as higher input costs transmitted to output price
increases, in a robust growth environment. The new
IIP series (base 2004-05) confirmed that industrial
growth did not decelerate in spite of waning base
effects. This is likely to have contributed to build-up
of non-food manufactured products inflation.
Supply shocks and rigidities in the supply chain
sustained the price pressures
II.2.4 The significant role that supply side factors
played in keeping inflation elevated was visible from
the trends in food and fuel inflation during the course of the year. Despite a normal monsoon, inflation in
primary food articles did not moderate on the expected
lines as the contribution to food inflation largely
emanated from the protein-rich items, whose output
is less responsive to monsoon in the short-run
(Chart II.18). The recent NSSO survey results on
consumer expenditure of households in India suggest
that with rising per-capita income, the share of income
spent on food has declined. Within food, however,
the share of protein-rich items has increased in both
urban and rural areas from 2004-05 to 2009-10. This
trend is also reflected in pressures on prices being
largely in non-cereal food-items that have deviated
sharply from the trends in recent years without trend
reversion to mean.
![18](http://rbi.org.in/scripts/images/7IIER230811_18.gif) |
![19](http://rbi.org.in/scripts/images/7IIER230811_19.gif) |
II.2.5 During November-December 2010
unseasonal rains in certain parts of the country led to
significant loss of output of perishable food articles,
especially vegetables, leading to further pressures
on prices. Food inflation moderated from January
2011, reflecting the arrival of fresh crop in the market
as also Government’s measures to ease price
pressures. The Government took fiscal measures
such as removing import duties on rice, wheat, pulses,
edible oils and sugar and reduced import duties on
some other agro-commodities. It also took several
steps to pave way for more sugar imports. In addition,
it took many administrative measures, including
enhancing allocation of wheat and rice to States and
for distribution by NAFED and NCCF through their
outlets, besides more wheat for open market sales
by FCI. The Government also banned export of
non-Basmati rice, edible oils and pulses (except
Kabuli chana). Supply augmenting measures
become crucial to deal with food inflation, in view of
the known limitations of monetary policy in dealing
with such inflation. Demand for food is not very
sensitive to interest rate actions, though these actions
may still be required to prevent generalisation of
inflation.
II.2.6 Fuel inflation was driven by both increases in
administered and freely priced products under the fuel group (Chart II.19). One important development
during the course of the year was the deregulation of
petrol prices in June 2010 along with the upward
revision in administered prices of other petroleum
products. As international crude oil prices increased
significantly during the year, freely priced products
exhibited significant pick-up in inflation during the
second half of the year. Administered price increases,
however, significantly lag behind the trends in
international crude prices indicating the presence of
suppressed inflation. This was partly corrected with
increases in diesel, LPG and kerosene prices in June
2011. Since then, global crude oil prices have softened
somewhat after S&P’s sovereign rating downgrade
of the US, they still remain high. The Indian basket
price for crude oil averaged US$ 106.6 per barrel
during the first fortnight of August 2011. Even at this
level, the under recoveries are estimated at over
`90,000 crore, of which a major portion may have to
be borne by the Government.
II.2.7 Lags in price adjustment of petroleum
products lead to suppressed inflation and build-up of
inflation expectations when discrete price adjustment
is made. These lags impact fiscal deficit and inflation.
There is a need for free pricing of all petroleum
products with better targeting of subsidies in order to
ensure necessary demand adjustment in an import dependant item and also encourage investment in
alternative sources of energy. Any short-term price
stabilisation objective could be attained through a
separate fund created for that purpose with a provision
for annual fiscal transfers from the budget within the
limits of fiscal prudence.
Generalisation of price pressures accelerated,
necessitating sustained anti-inflationary monetary
policy actions
II.2.8 Inflation in non-food manufactured products
remained range-bound between 5.3 to 5.9 per cent
in the first eight months of 2010-11, which was still
higher than the average over the last decade at about
4 per cent. In the last quarter of the year, however,
inflation in this category increased significantly
reaching 8.5 per cent in March 2011, indicating
stronger pass-through of input costs than expected,
as also pricing power of producers amidst strong
private consumption demand that supported
momentum in industrial growth (Chart II.20).
Manufactured food products inflation declined sharply
during the initial period of the year reflecting largely
decline in sugar prices and strong base effects, but
reverted course subsequently.
Global commodity prices hardened during 2010-11,
partly reflecting geo-political developments and
weather related disturbances
II.2.9 International commodity prices moderated
somewhat during the first quarter of 2010-11
as greater uncertainty relating to recovery in
advanced economies impacted commodity markets
(Chart II.21). However, prices rebounded significantly thereafter, both on account of weather related supply
disruptions in a number of primary commodity
producing countries and geo-political tensions in the
Middle East and North Africa (MENA) region. The
increase in global food prices was also significant,
with severe welfare implications for low income
countries. Some softening of global commodity prices,
however, was witnessed during the initial months of
2011-12. The impact of increase in international
commodity prices on domestic inflation has been
different for different commodity groups (Box II.3).
WPI and CPIs exhibited convergence
II.2.10 The year 2010-11 started with significant
divergence between inflation as measured by WPI and CPIs, which in turn became a source of contention
in terms of the relevant measure of inflation used in
India for conduct of policies (Chart II.22). During the
course of the year, however, this gap narrowed
significantly. While the decline in CPI inflation
primarily reflected lower food inflation, the high WPI
inflation reflected increasing generalisation of price
pressures.
Box II.3
Transmission of Global Commodity Price Shocks to Domestic Inflation
With a surfeit of liquidity as a result of very low levels of
interest rates and successive measures of quantitative easing
by global central banks, global commodity prices recovered
faster than the global economy supported by leveraged
trades. This has become a major source of pressure on
headline inflation in India during 2010-11. The significant
reversal in the commodity price cycle was also broad based,
covering food, oil, metals and other commodities. The FAO
food price index increased through 2009 and 2010 to regain
the pre-crisis peak by February 2011. Oil prices crossed US$
100 per barrel mark in the last quarter of 2010-11 and have
remained high thereafter.
The global food price pressures reflect the combined impact
of growing demand and weak supply response. Robust
growth in EMEs and growing population have boosted the
demand for food items. Rising per capita income is changing
food habits resulting in higher demand for protein-rich food
items, such as meat and dairy products. On the supply side,
the availability of arable land is shrinking, due to increasing
urbanization as well as diversion of land for bio-fuels
production. Recent spikes in oil prices have also raised the
input costs for farms, including transportation and fertilizer
costs. Climatic changes and weather related disturbances
are also impacting global food prices. Import barriers and
large farm subsidies in advanced economies are influencing
the supply response through price distortions.
Low energy efficiency and policies on oil subsidies have also
contributed to the demand growth. The pace of urbanisation
in EMEs with emphasis on physical infrastructure has
increased demand-supply imbalances. The demand for
metals and minerals, particularly steel, copper, aluminium,
oil and coal have increased. In the case of oil, the peak oil
hypothesis seems to suggest that global production may be peaking. Progress on alternative sources of energy also lags
behind the demand trends. The recent concerns on nuclear
power post-Japanese earthquake can only worsen the
energy supplies. Financialisation of commodities has added
a new dimension to the commodity price cycle. Geo-political
factors continue to be an important factor behind sudden
and sharp increases in oil prices, as has been the case since
the beginning of 2011.
The actual impact of global commodity shocks on consumer
price inflation in developing countries depends on
government policy measures (Jongwaninch and Park, 2011).
The spillover effects to domestic prices depend on the degree
of import dependence in a commodity, domestic supplydemand
trends, administered price interventions and pricing
power at the wholesale level. The impact ultimately depends
on the weight of respective commodities in the WPI and the
linkages with other commodities that determine the second
round effects (Table-1). The second round effect reflects
response of wages and prices aimed at protecting real wages
and profit margins as input costs rise. The estimates
presented for different commodities in Table-1 reflect the
combined impact, with the direction of causation presumed
from global prices to domestic prices. Given the uncertain
outlook for commodity prices, despite the softening of price
pressures so far in the year, upside risks to India’s inflation
path could persist.
References:
Food and Agricultural Organisation (FAO) (2010), World Food
Outlook, November 2010
Jongwaninch, Juthathip and Donghyun Park (2011), “Inflation
in Developing Asia: Pass-through from Global Food and Oil
Price Shocks’, Asian-Pacific Economic Literature, 25(1):
79-92, May
Table 1: Impact of Global Commodity Price Movements on Domestic Prices |
Item |
2010-11
(Y-o-Y Increase in Per cent, March) |
July 2011 over March 2011
(Increase in Per cent) |
Estimated Elasticity |
Weight in WPI |
International Prices |
Domestic
Prices
(WPI) |
International Prices@ |
Domestic
Prices
(WPI) |
Short- run# |
Long-
run$ |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
Rice |
1.8 |
-1.9 |
2.3 |
8.8 |
1.8 |
0.01 |
-- |
Wheat |
1.1 |
65.7 |
0.2 |
-4.0 |
-1.2 |
0.02 |
-- |
Maize |
0.2 |
82.7 |
25.3 |
3.5 |
7.5 |
0.02 |
-- |
Soyabean Oil |
0.4 |
42.8 |
19.2 |
2.3 |
3.2 |
0.06** |
0.47 |
Sugar |
1.7 |
40.6 |
-7.1 |
7.5 |
-0.2 |
0.05** |
0.66 |
Cotton |
0.7 |
167.6 |
103.0 |
-46.9 |
-31.5 |
0.17** |
0.98 |
Rubber |
0.2 |
63.8 |
44.8 |
-12.8 |
-1.8 |
0.34** |
1.08 |
Coal |
2.1 |
33.6 |
13.3 |
-4.9 |
0.0 |
0.03** |
0.48 |
Petroleum |
9.4 |
37.0 |
6.3 |
-0.7 |
33.4 |
0.07** |
0.55 |
Fertilizers |
2.7 |
28.5 |
9.9 |
29.0 |
5.1 |
0.00 |
-- |
Aluminium |
0.5 |
15.9 |
2.1 |
-1.2 |
0.9 |
0.03** |
0.42 |
Copper |
0.1 |
27.3 |
3.2 |
1.5 |
-2.5 |
0.03** |
0.53 |
Gold |
0.4 |
27.9 |
36.2 |
10.4 |
5.4 |
0.28** |
1.00 |
Silver |
0.0 |
109.6 |
90.3 |
6.0 |
2.4 |
0.41** |
1.00 |
Source: World Bank and Ministry of Commerce and Industry, GOI.
# : Estimated using Partial Adjustment Model
$ : Long-run elasticities are not reported for products where short-run elasticity is not significant.
** : Significant at 1 per cent level of significance. |
Growth-inflation trade-off acquired the centre stage
of policy debate
II.2.11 As inflation persisted at above the comfort
level of the Reserve Bank through the year, a decision
on the difficult choice of sacrificing some growth to
contain inflation became inevitable. Historical
experience does not provide much evidence for any
conventional growth-inflation trade-off in the Indian
case that could support inflation tolerance as a means
to higher growth. In fact, long-term data show that
high inflation has generally been associated with
lower, not higher, economic growth (Chart II.23).
II.2.12 In the debate on growth-inflation trade-off and
the role of monetary policy, the empirical evidence
and theoretical justifications over time have led to a
shift in the mainstream thinking from “inflation
tolerance can grease growth” to “inflation hurts growth
and hence must be contained”. While some still subscribe to the conventional view (influenced by the
Philips curve) that higher inflation tolerance could yield
higher growth, others view that inflation itself is a risk
to growth, especially when inflation is high and
above a threshold. As such, “low and stable inflation”
remains a dominant policy objective for the Reserve
Bank.
![24](http://rbi.org.in/scripts/images/7IIER230811_24.gif) |
II.2.13 If inflation is a risk to the medium-term growth,
it is important to recognise the transmission channels
through which the impact on growth could materialise,
and also the possibility of a threshold level of inflation
beyond which the risks from inflation to growth could
magnify. In the Indian case, three important factors
that contributed to the high growth performance prior
to the global crisis can be expected to be adversely
affected by persistent high inflation. These three
factors have been: (a) growing openness (and the
resultant competition on a global scale), (b) strong
growth in investment demand led by the private sector,
and (c) fiscal consolidation.
II.2.14 High persistent inflation is a risk to external
competitiveness, because of the associated real
appreciation of the exchange rate, which could
weaken growth by impacting export prospects.
Moreover, in an open economy, domestic producers
could find it difficult to pass on higher input costs in the form of higher output prices, because of the
competition from imports resulting in pressures on
earnings and dampening of investment plans. Private
investment is particularly impacted by distortions
through both high inflation and inflation volatility.
Private investors have to spend time and money to
understand and manage the effects of inflation on
their business. Moreover, foreign investors may also
see inflation as a risk factor, which could affect capital
flows.
II.2.15 The fiscal situation may not improve in an
environment of high inflation, despite planned
intention for consolidation. In an environment of rising
inflation government expenditure may continue to
grow at a pace exceeding the rate of inflation but
revenue collections may not keep up with inflation.
This would especially occur when global commodity
prices drive inflation, necessitating much larger
subsidies than may be planned. While delayed fiscal consolidation could dampen growth impulses and also
increase the risk of inflation, a high inflation
environment may in itself become a constraint to faster
fiscal consolidation.
II.2.16 Inflation could also work against growth
through other channels, the most important one being
monetary policy response to inflation and the
associated increase in the interest cost of capital. Fall
in asset prices in response to high inflation which
involve wealth and income effects also may not be
congenial to growth. In pursuing the anti-inflationary
policy, however, it is important for a central bank to
identify the threshold level of inflation, which may be
consistent with the highest sustainable growth path.
Inflation higher than the threshold level would have
to be contained to avoid the welfare loss arising from
both high inflation and lower growth. Estimates on
threshold inflation for India are found to be in a range
of 4-6 per cent (Box II.4). Desirable level of inflation may be even lower than any estimated threshold level
in view of the distributional consequences of inflation
and other macro-economic considerations. In the ageold
policy debate on growth inflation trade-off, the
emphasis has always been on the short-run
stabilisation role for monetary policy. This is because
the natural trend growth of the economy is conditioned
by structural factors.
Box II.4
Growth Inflation Trade-off and Threshold Inflation
The growth-inflation trade-off debate in economics is a long
standing one. The Phillips curve relationship – the empirically
observed negative relation between change in nominal
money wages and rate of unemployment – gained popularity
in the late 1950s and 1960s, but has been long discredited
by economists. The stagflation of the 1970s destroyed faith
in it. Phelps and Friedman helped explain the existence of
stagflation by distinguishing the ‘short-run Phillips curve’, also
called the ‘expectations-augmented Phillips curve’. Even
though short-run Phillips curve shifts up when inflationary
expectations rise, in the long run monetary policy cannot
affect unemployment, which adjusts back to its ‘natural rate’.
So Phillips curve becomes vertical in the long run, as
expected inflation equals actual inflation. The long-run Phillips
curve is known as the Non-Accelerating Inflation Rate of
Unemployment (NAIRU).
In the policy debate on the trade-off, a common distinction is
often made between the short-run Phillips curve and the longrun
NAIRU. At NAIRU, inflation is fully anticipated. If a central
bank uses the trade-off in the short-run and gives an inflation
surprise (which was not anticipated) in its attempt to allow
growth to remain above potential, then the actual inflation
will exceed the expected inflation, and the trade-off
relationship may work in the short-run. But the adaptive
expectation process could soon lead to revision in inflation
expectations, causing an upward shift in the short-run Phillips
curve, at which higher inflation will co-exist with NAIRU. If
expectations are rational, then the trade-off relationship may
not exist even in the short-run.
![25](http://rbi.org.in/scripts/images/7IIER230811_25.gif) |
Following the work of Palley (2003), it is now being realised
that the Phillips curve relationship may be lot more complex,
with the likelihood of the relationship changing from low
inflation to high inflation. In these models, inflation
expectations are a positive function of actual inflation. Phillips
curve is negatively sloped at low levels of inflation, becomes
positively sloped at high levels of inflation and turns vertical
if inflation expectations converge to actual inflation (Chart-
1). Thus, there is a threshold inflation at P*, which could be
country specific and is an important guidepost for monetary
policy in terms of when it could use the short-run trade-off,
and when it has to just focus on containing inflation even at
the cost of sacrificing growth. At inflation lower than P*, relying
on short-run trade-off could make sense. But at inflation rates
above P*, there would not be any exploitable trade-off relationship for policy, and by containing inflation a central
bank could best contribute to sustainable employment and
growth levels in the medium-run (Gokarn, 2011).
Different techniques have been used in the literature to
estimate threshold inflation. Three broad approaches have
been: (1) running a series of spline regression to find
threshold value of inflation which maximises adjusted R2 and
minimises Root Mean Square Error (RMSE), following Sarel
(1996), (2) to estimate the unknown threshold inflation along
with other regression parameters using non-linear least
squares (NLLS) (Khan and Senhadji, 2001) and (3)
estimating threshold using Logistic Smooth Transition
Regression (LSTR) model (Espinoza et.al, 2010). Empirical
estimates for threshold inflation for India using these
alternative techniques are found to be in 4-6 per cent range.
Estimated threshold level, however, need not completely
condition the inflation objective of monetary policy, since even
at the threshold level, the welfare costs of inflation particularly
for the poorer section of the society, have to be contained.
Keeping in view the distributional consequences and the
macro-economic requirements of an open economy to keep
inflation low relative to the rest of the world, the Reserve
Bank’s medium-term inflation objective has been 3 per cent.
The average of the non-food manufactured products inflation
in the last one decade has been about 4 per cent. Anchoring
inflation expectations to check inflation has been an important
element behind monetary policy actions. This has motivated Reserve Bank’s emphasis on containing perceptions of
inflation in the range of 4.0-4.5 per cent. Clear communication
has been made in the policy statements to this effect. The
importance of containing inflation even at the cost of some
marginal sacrifice of growth in the short-run appears to be
consistent with the estimates of growth-inflation trade-off for
India, as also the distributional and other objectives behind
containing inflation.
References
Espinoza, R., Leon, H. and Prasad, A., (2010), “Estimating
the Inflation-Growth Nexus, A Smooth Transition Model”, IMF
Working Paper 10/76.
Gokarn, Subir (2011), “Sustainability of Economic Growth
and Controlling Inflation – The Way Forward”, Address at
FICCI’s National Executive Committee Meeting, Mumbai,
April 5.
Khan, Mohsin S. and Abdelhak S. Senhadji,
(2001),';Threshold Effects in the Relationship Between
Inflation and Growth,'; IMF Staff Papers, vol. 48(1).
Palley, T.I. (2003), “The Backward Bending Phillips Curve
and the Minimum Unemployment Rate of Inflation (MURI):
Wage Adjustment with Opportunistic Firms”, The Manchester
School of Economic and Social Studies, 71(1): 35-50.
Sarel, M (1996), “Non-linear Effects of Inflation on Economic
Growth”, IMF Staff Papers, Vol.43, No.1.
Price statistics improved, with a revised WPI base
and new indices of CPI
II.2.17 Two significant improvements in database on
prices during the year were the revision of WPI base
from 1993-94 to 2004-05 and the introduction of a
new Consumer Price Index for ‘rural’, ‘urban’ and ‘All
India’ from January 2011 (Box II.5). The new series
of WPI marks a major improvement in terms of scope
and coverage of commodities and is also more
representative of the changing underlying economic
structure. It captures the present underlying economic
structure, which is consistent with changes in the
production and consumption patterns. The introduction of new CPIs provides a nationwide price
index which is more comprehensive both in coverage
across regions and commodity groups. The weighting
pattern also reflects more recent consumption pattern
as compared to the existing CPIs. As year-on-year
inflation data based on the new CPI become available
from January 2012, it will be closer to the measure of
inflation that is being commonly used in other
countries for the conduct of monetary policy.
Anti-inflationary thrust of policy sustained in 2010-11
amidst changing dynamics of inflation
II.2.18 The changing dynamics of inflation had a
major element of uncertainty throughout the year,
which added significant complexity to the Reserve
Bank’s forward looking assessment of the inflation
outlook. Significant revisions of provisional data over
successive months also widened the information lags,
particularly the information on the extent of
generalisation of price pressures. High inflation and
repeated supply shocks impacted the inflation
expectations adversely, and the Reserve Bank sustained its anti-inflationary thrust of monetary policy
to anchor inflation expectations and contain demand
induced pressures on inflation. The focus of medium-term inflation management, however, must be to ease
supply constraints in key sectors where demand could
be expected to continue to grow.
Box.II.5
Towards Better Price Statistics
Revision of WPI Base Year
One significant development during 2010-11 relating to
prices data was the revision of base year of WPI from 1993-
94 to 2004-05. The weight of primary articles declined in
the revised WPI, while the weight increased for fuel group
and manufactured products (Table 1). Although the changes
in the weights for manufactured products are not substantial
for the group as a whole, there has been a shift in weights
towards non-food manufactured products. A substantial
increase in the number of new items added/revised reflects
the changes in production pattern during the decade. The
new series has 417 new commodities, of which 406 are
new manufactured products. These include items from
unorganised manufacturing activity. Also the new series has
wider coverage as the price quotations have increased from
1,918 in the old series to 5,482 in the new series.
The average overall inflation rate, according to the new
series and the old series, is about 5.5 per cent for the
overlapping period for which data are available (i.e., 2005-
06 to 2009-10) indicating that there is not much difference in the rate of inflation between the two series. This, however
is marked by differential inflation rates for food and
non-food products in the old and new series. Higher food
inflation (both primary and manufactured) in the new series
is largely offset by the lower inflation in the non-food
manufactured products leading to smaller difference in the
overall inflation.
Introduction of new Consumer Price Index
The Central Statistics Office (CSO), Ministry of Statistics
and Programme Implementation introduced a new series
of Consumer Price Indices (CPI) for all-India and States/
UTs separately for rural, urban and combined. Indices are
being released from the month of January 2011 with 2010
as the base year. The weighting pattern is derived from the
NSSO’s Consumer Expenditure Survey of 2004-05. A
comparison of the new CPI series against the existing series
suggests that while the weight of food group has declined
significantly for both rural and urban groups, the
miscellaneous group, largely including services, has shown
increase in its share (Chart 1).
Table 1: Major Changes in the Weights and Commodities in the Revised WPI Series |
Items |
Weights |
Number of Commodities |
New Series (Base:2004-05) |
Old Series (Base:1993-94) |
New Series (Base:2004-05) |
Old Series (Base:1993-94) |
New Items
added/ revised |
1 |
2 |
3 |
4 |
5 |
6 |
All Commodities |
100.00 |
100.00 |
676 |
435 |
417 |
I. Primary Articles |
20.12 |
22.03 |
102 |
98 |
11 |
Food |
14.34 |
15.40 |
55 |
54 |
1 |
Non-Food and Minerals |
5.78 |
6.63 |
47 |
44 |
10 |
II. Fuel and Power |
14.91 |
14.23 |
19 |
19 |
0 |
III. Manufactured Products |
64.97 |
63.75 |
555 |
318 |
406 |
Food |
9.97 |
11.54 |
57 |
41 |
25 |
Non-Food |
55.00 |
52.21 |
498 |
277 |
381 |
III. MONEY AND CREDIT
II.3.1 During 2010-11, the Reserve Bank’s
monetary policy stance became strongly antiinflationary.
Money growth was moderate during the
year but picked up during the last quarter of 2010-11.
Liquidity remained in deficit mode for a major part of
the year on account of both structural and frictional
factors. The tight liquidity helped in strengthening the
monetary policy transmission, reflected in rise in
deposit and lending rates of the banks during the latter
part of the year. Credit to the commercial sector
increased rapidly during the first quarter of 2010-11,
reflecting mainly the borrowings by telecom companies
to pay for spectrum auctions. Notwithstanding some
deceleration in the second quarter of 2010-11, credit
growth remained strong throughout the year, in line
with the strong growth of the economy.
II.3.2 In 2011-12 till July, as liquidity eased and was
broadly within the desirable level of deficit (one per
cent of NDTL of banks), the pace of injection of
primary liquidity declined leading to a deceleration in
base money growth. Money supply, on the other hand,
remained strong on the back of strong growth in
deposits.
Strong growth in reserve money in 2010-11 reflected
increase in currency demand and large injection of
primary liquidity
II.3.3 Trends in reserve money largely reflect the
impact of the monetary policy changes and liquidity
management operations. There was strong growth
in reserve money during 2010-11 due to large injection
of primary liquidity in response to the tight liquidity
conditions that prevailed since end-May 2010. Even
adjusting for the policy-induced change in the cash
reserve ratio (CRR), reserve money growth in 2010-
11 was higher than that in 2009-10 (Chart II.24 and
Appendix Table 9).
II.3.4 Currency in circulation is the largest
component of reserve money and is primarily determined by demand. There was acceleration in
currency in circulation in 2010-11, due to increased
demand on account of economic growth, high inflation
and low yield on deposits for most part of the year
(Box II.6).
II.3.5 On the sources side, net Reserve Bank credit
to the Centre2 has been the dominant source of
increase in reserve money since 2008-09 (Chart
II.25). This is because government borrowing shot
up significantly in the wake of the global financial crisis
and necessitated active management of liquidity in
the form of unwinding/de-sequestering of market
stabilisation scheme (MSS) balances (in 2008-09 and
2009-10). Besides, there were large scale injections
under liquidity adjustment facility (LAF) and open
market operations (OMO) purchase auctions during
times of liquidity duress in these three years.
Primary liquidity injected mainly in the form of large
scale repo and OMO in 2010-11
II.3.6 The most notable source of increase in net
Reserve Bank credit to the Centre during 2010-11 was LAF operations. This reflected the change in the
mode of the LAF from reverse repo (absorption of
liquidity) to repo (injection of liquidity). The other major
source of injection of liquidity was open market
purchases worth about `67,000 crore conducted
mainly through the auction route. The OMO was
confined to the second half of the year. The Reserve
Bank also unwound the remaining MSS balances
amounting to `2,737 crore by July 2010.
![28](http://rbi.org.in/scripts/images/7IIER230811_28.gif) |
II.3.7 Even though LAF operations and open market
purchases explain almost the entire fiscal variation
in net Reserve Bank credit to the Centre, the most
significant liquidity impacting variable intra-year was
the Centre’s surplus balances with the Reserve Bank,
which is an autonomous determinant of liquidity. From
June 2010, there was a significant increase in
government’s balances with the Reserve Bank
reflecting the higher-than-expected proceeds from
auctions of telecom spectrums. The balance was
further boosted by the quarterly advance tax
collections. The government balances continued to
build up till the end of the third quarter of 2010-11.
The sharp drawdown of government balances during
the fourth quarter improved the liquidity situation.
II.3.8 Overall monetary conditions reflected
significant changes in the autonomous drivers of
liquidity as well as the offsetting discretionary liquidity management operations of the Reserve Bank. During
the third quarter of 2010-11, large liquidity deficit
occurred amidst tight monetary policy stance. The
Reserve Bank undertook liquidity injections through
LAF repos that peaked at nearly two times more than
the level conforming to the comfort zone of the
Reserve Bank. The aggregate outcome of variations
in autonomous and discretionary components of
liquidity match with the changes in banks’ reserves
(Chart II.26). Detailed discussions on liquidity
management operations of the Reserve Bank are
presented in Chapter III.
Slower pace of deposit mobilisation and dip in
multiplier led to low rate of money growth in 2010-11
II.3.9 Broad money (M3) growth decelerated for the
third successive year in 2010-11, though the pace of
deceleration was lower than that of the previous year,
reflecting the resurgence in economic activity
(Appendix Table 10). On the components side, the
deceleration was mainly on account of contraction in
demand deposits. There was a slowdown in the
growth of time deposits initially, which though reversed
trend during the latter part of the year as banks raised
interest rates markedly (Chart II.27). The stronger
transmission of monetary policy led to a substitution
from demand deposits to time deposits during the last
quarter of 2010-11 and in 2011-12 so far. Currency with the public, however, increased at a rapid pace
and accordingly, the share of currency in the
annual increment in M3 also increased in 2010-11
(Chart II.28).
![30](http://rbi.org.in/scripts/images/7IIER230811_30.gif) |
II.3.10 The significant increase in currency with the
public was on account of prevalence of high inflation,
real income growth and low return on deposits for
most part of the year (Box II.6). In 2011-12 so far,
currency demand, however, decelerated due to the increase in opportunity cost of holding cash as interest
rates on time deposits increased.
II.3.11 The strong growth in currency coupled with
the subdued growth in deposits led to an increase in
the currency-deposit ratio in 2010-11. Moreover, the
Reserve Bank increased the CRR in April 2010
leading to an increase in the reserve-deposit ratio.
The increase in these two behavioural ratios led to a
dip in the money multiplier. This explains the rather
subdued growth in broad money despite high growth
in reserve money in 2010-11. Concomitant with the
dip in the money multiplier, there was an increase in
the velocity of money in successive quarters of 2010-
11, reflecting heightened nominal activity (Box II.7).
Share of bank credit to the commercial sector in the
annual increment in M3 increased significantly
II.3.12 On the sources side, net foreign assets
registered an increase in 2010-11 as against a decline
in the previous year. Net domestic assets, however,
remained the dominant source of increase in M3
during the year. The share of bank credit to the
commercial sector in the annual increment in M3
increased significantly reflecting the strong growth in
credit to the commercial sector. This is also
reflected in the strong growth in non-food credit during
the year (Chart II.29). In 2011-12 so far (up to July), even as credit growth is decelerating, it remains
above the Reserve Bank’s indicative trajectory for the
year.
Box II.6
Determinants of Currency Demand – What Caused the Shift in Trend?
The demand for currency is determined by a number of
factors such as income, price level, the opportunity cost of
holding currency, i.e., the interest rate on interest bearing
assets and the availability of alternative instruments of
transactions, eg. credit/debit cards, ATMs, cheque payments,
etc.. Currency is also used as a store of value, particularly in
countries with low inflation or large shadow economies.
Currencies such as the US dollar, euro, yen and pound have
large off-shore demand as medium of international
transactions.
Several factors could explain the growth in currency demand
in India in 2010-11. Inflation remained high, often in double
digits, in respect of commodities such as foodgrain, pulses,
fruits and vegetables, and milk during 2009-10 and 2010-11
– where transactions are expected to be cash-intensive.
Consequently, after a long period of secular decline, the share
of agriculture and allied activities in nominal GDP increased
from 17.6 per cent in 2008-09 to 19.0 per cent in 2010-11.
Second, there was a step-up in real economic activity from
6.8 per cent in 2008-09 to 8.5 per cent in 2010-11. Third, the
interest rate on bank deposits was generally lower than
inflation during 2010-11, implying a negative real rate of return
on deposits.
A study of the decadal trend reveals that even as income
elasticity of currency demand has stayed relatively stable,
price elasticity increased significantly in the decade of 2000s,
which experienced a low and stable inflation for a major
part. In the remaining years, when inflation was relatively
high, currency demand shot up significantly. In theory,
increase in ATM network (increase in number of ATMs as
well as access usage rules such as freer access to ATMs of
other banks) decreases show leather costs. However, crosscountry
evidence suggests that the attractiveness of currency
as a medium of exchange can increase as against card
payments. This is observed in India also (Chart 1). This could
have facilitated the substitutability between currency and
demand deposits in recent years.
![35](http://rbi.org.in/scripts/images/7IIER230811_34.gif) |
During the 2000s, the acceleration in per capita real GDP
growth, commercialisation of agriculture and allied activities and urbanisation, and availability of higher denomination
notes appear to have maintained the increasing growth trend
of the cash economy operating from both the demand and
the supply sides. The social sector expenditure by the
Government, particularly in rural areas (MGNREGS, etc.)
also seems to have boosted demand for cash, particularly
in 2008-09 when the currency to GDP ratio peaked. Also,
currency use, being anonymous, facilitates tax evasion. With
increasing importance of KYC and CBS and reporting of large
value bank transactions for tax purposes in the recent years,
currency demand can potentially rise, reflected in uptrend in
the currency to GDP ratio (Chart 2).
![33](http://rbi.org.in/scripts/images/7IIER230811_33.gif) |
Over the long term, an estimated relationship using VECM,
relating to demand for currency in India for the period 1972-
73 to 2010-11 reveals that a 1 per cent increase in the real
income (GDP) leads to a 1.24 per cent increase in the
demand for currency. The price effect on the demand for
currency is also found to be close to unity. A 1 per cent
increase in the prices (WPI) leads to a 1.05 per cent increase
in the demand for currency. Further, it was found that interest
rate per se is not a significant determinant of currency.
However, in the years when the real return on term deposits
is negative (the average inflation being higher than the
average rate on deposits of one-three year maturity), the
interest rate seems to be a significant determinant of currency
demand.
References:
Amromin, Gene and Sujit Chakravorti (2009), “Whither Loose
Change? The Diminishing Demand for Small Denomination
Currency”, Journal of Money, Credit and Banking, 41(2-3):
315-335, March-April.
Embaye, Abel and Wei-Choun Yu, (2010). “ Tax Evasion and
Currency Ratio: Panel Evidence from Developing Countries”,
Empirical Economics.
Nyberg, Lars (2011), “Will Cash Replace Cards?”. Speech
at Cards & Cash Payments Forum in Stockholm, May,
Sveriges Riksbank.
Box II.7
Short-run Shocks to Money Velocity and the Behaviour of Money Growth
M3 growth, for most part of 2010-11, remained below the
Reserve Bank’s indicative trajectory. This deceleration in
money growth alongside both a robust pick-up in growth as
well as a high inflation environment, would suggest a
corresponding increase in the velocity of money (following
the conventional quantity theory of money equation MV=PY).
In a theoretical framework, the velocity of money is generally
presumed to be stable, if not constant, especially in the short
run. Any breakdown in its stability, particularly due to
significant short run shocks, and the volatility therein could
either amplify or dampen the expected relationship between
money, output and prices (as set out in the conventional
monetary arithmetic above). Also anticipated and
unanticipated shocks to money demand and the resultant
shift in the velocity pattern could add further noise to the
trend in money growth.
In almost every country, velocity of money has exhibited
significant deviations from its respective medium-term
trend post the global crisis, thereby complicating the
analysis of monetary trends vis-à-vis those of output and
prices. The sharp fall in velocity for the US (because of the
financial crisis) despite the massive quantitative easing in
the aftermath of the Great Recession and the ensuing
“velocity crowding out of quantitative easing” highlights that
external developments, especially contagion risk arising from
crises, could add significant instability to domestic money
demand.
In India, the velocity of money, computed as a ratio of the
nominal income to broad money, has declined since the late
1960s. Bordo and Jonung (1987) in their pioneering study
identified a “U” shaped velocity pattern across countries with
distinct phases corresponding to the level of development.
In the initial developing phase of a country, due to the
increasing monetization of the economy, money demand rises (reflected in money supply growth) and velocity falls.
Once the financial system deepens accompanied by financial
and technological innovations, as the country develops,
increasing confidence in the stability of the financial system
lowers the income elasticity of money demand which can be
seen as the rising phase of velocity.
![36](http://rbi.org.in/scripts/images/7IIER230811_35.gif) |
In the Indian context, both annual and quarterly data
correspond to the initial falling phase of velocity which could
be ascribed to the increasing monetization of the economy
(Chart 1). Despite the financial sector reforms and the
enhanced financial deepening, the economic growth of the
last decade has plausibly accelerated the monetisation
process so much that it more than offset the gains from the
financial sophistication. Hence the continued decline in
velocity.
In recent years, however, the rate of decline in velocity had
accelerated. Accentuated liquidity preference and slack credit
demand in the aftermath of the crisis were reflected in sharp
fall in velocity (Chart 2). Subsequently, with the return of
confidence in the financial system and the economy, velocity increased to its normal trend. This increase in velocity
following the fast paced fall witnessed in the past two years,
explains the subdued growth in M3 in 2010-11.
A Vector Error Correcting Model (VECM) estimation of some
determinants of velocity as suggested by theoretical and
empirical literature – output [Y - GDP at factor cost (constant
price)], interest rate (R1 - Annual SBI lending rate; R2 -
Quarterly 91-day T-Bill rate), inflation expectations (WPI),
financial deepening indicator proxied by bank credit to GDP
ratio (CY), and a dummy variable (D1 - Annual; D2 - Quarterly)
capturing the impact of short run disturbances on velocity –
yielded the following results.
Annual Data: |
|
V = 54.38 – 4.03 Y + 0.04 R1+ 1.28 D1 |
(9.81) (1.39) (6.29) |
|
Quarterly Data: |
|
V = 39.52 – 3.19Y + 0.05 R2 + 1.90 WPI + 2.30 CY- 0.18D2 |
|
(5.06) (6.34) (6.96) (2.65) (6.98) |
Money growth trajectory projection involves the conditional
predictability of velocity. Hence, money growth in the absence of reference to velocity trends could at times be misleading,
even in the short run. Empirical estimates suggest that the
conventional determinants of velocity (GDP, interest rate
and financial deepening) as well as the short term
shocks are statistically significant for Indian data. But in times
of major uncertainty velocity could significantly deviate from
its medium trend and weaken any forward-looking
assessment.
Short-run trends in money growth should be seen along with
expected changes in velocity. In the medium run, however,
velocity could be expected to remain anchored to the long
run trend, and hence, money growth in the medium-term is
more likely to be consistent with the inflation and output trends
than in the short-run.
Reference:
Pattanaik, Sitikantha and Subhadhra S (2011), “The Velocity
Crowding-out Impact: Why high money growth is not always
inflationary”, RBI Working Paper, May 2011.
Bordo, Michael D., and Lars Jonung, The Long-Run Behavior
of the Velocity of Circulation: The International Evidence,
Cambridge: Cambridge University Press, 1987.
II.3.13 Disaggregated data suggest that the flow of
credit to industry during 2010-11 remained strong
while that to services and personal loans increased
significantly (Appendix Table 11). Within industry,
even though infrastructure continued to account for
the largest share of industrial credit, the share of other industry groups such as food processing, basic
metal and metal products and engineering in
incremental credit to industry increased (Chart II.30).
During the first quarter of 2011-12, while the
dominant share of incremental industrial credit went
to infrastructure sector, basic metal and metal
products, petroleum and mining and quarrying also
together accounted for one third of the incremental
industrial credit during the quarter.
Growing disparity between credit and deposit growth
added to the strain on liquidity for most of 2010-11
II.3.14 The continued strong growth in credit
juxtaposed with subdued growth in deposits for a large
part of the year was a structural factor that constrained
liquidity in the system. The difference between the
growth rate of credit and deposits peaked in mid-
December 2010, and declined thereafter as credit
growth showed slight moderation and bank deposits
increased following hike in deposit rates reflecting
stronger monetary policy transmission (Chart II.31).
The incremental funding for the commercial sector in
2010-11 was entirely accounted for by banks
II.3.15 Even as bank credit to the commercial sector
recovered strongly during 2010-11, the flow of
resources from non-banks, both domestic and foreign,
declined (Chart II.32). The sharp decline in domestic
non-bank funding was mainly on account of a
decrease in resources raised through private
placements. Subscription to commercial papers by
non-banks also declined. As for the foreign sources,
while external commercial borrowings and short-term
credit from abroad increased, there was a decline in
FDI inflow leading to an overall dip in foreign funding
for the commercial sector. The moderation in non-banking sources of finance subdued the pace of
increase in the total flow of resources to the
commercial sector in 2010-11, notwithstanding the
near 49 per cent increase in resource flow from
banks.
![39](http://rbi.org.in/scripts/images/7IIER230811_38.gif) |
![40](http://rbi.org.in/scripts/images/7IIER230811_39.gif) |
II.3.16 During the first four months of 2011-12, nonbanking
sources, however, accounted for nearly 70
per cent of the funding for the commercial sector. This
was mainly on account of revival of FDI inflow.
II.3.17 Banks’ investments in liquid schemes of debtoriented
mutual funds had grown manifold in the
recent period. The mutual funds, on the other hand,
are large lenders in the over-night money markets
where banks are large borrowers and in certificates
of deposit (CDs) of banks. Such circular flow of funds
can lead to systemic risk in times of stress/liquidity
crunch. Even though SCBs’ investment in instruments
issued by mutual funds declined marginally in
2010-11, it increased by nearly 1.5 times between
end-March 2011 and early May 2011. The Monetary
Policy Statement for 2011-12 imposed limits on total
investment in debt-oriented instruments of mutual
funds by SCBs. Resultantly, the investment in such
schemes moderated from mid-May 2011, with some
reversal seen in July 2011.
_______________________
2 Changes in net Reserve Bank credit to the Centre primarily reflect the combined impact of the Reserve Bank’s liquidity management operations conducted through OMO, operations under the MSS, LAF and Marginal Standing Facility (MSF - introduced in 2011-12) as also the government’s cash management operations. Increase in repo under LAF/OMO purchases/availment of MSF and decline in reverse repo under LAF/MSS balances/government’s surplus balances with Reserve Bank lead to increase in net Reserve Bank credit to the Centre, and vice versa.
______________________
IV. FINANCIAL MARKETS
Sovereign risks come to fore in the international
financial markets
II.4.1 International financial markets witnessed
frequent re-pricing of risks during 2010-11, reflecting
persisting uncertainties. Sovereign risk concerns,
particularly in the Euro Area affected the financial
markets for a greater part of the year, with the
contagion of Greece’s sovereign debt problem
spreading to other economies in the Euro Area,
notably Ireland, Portugal and Spain, despite transient
stability resulting from the significant European rescue
package. As a result, sovereign CDS spreads
widened in the region (Chart II.33 a to d). The multipaced
global recovery led to divergent policy
responses. While advanced economies (AEs) either
maintained or further eased their monetary policy to
stimulate economic growth, a number of EMEs
resorted to monetary tightening in response to
inflationary pressures. During 2010, EMEs attracted greater portfolio flows given the easy availability of
liquidity in AEs, especially after the announcement of
the second round of quantitative easing (QE2) by the
US Fed. These flows, in turn, exerted upward
pressures on EME currencies and asset prices,
prompting some of these economies to take recourse
to macro prudential measures and soft capital
controls.
![41](http://rbi.org.in/scripts/images/7IIER230811_40.gif) |
II.4.2 Towards the end of 2010 and early 2011,
however, there was a rebalancing of global portfolios
on the back of strengthening economic recovery in
AEs, particularly the US, and equity prices in these
economies increased. While credit spread narrowed
down considerably in many AEs, bond yields firmed
up reflecting the post-crisis rise in debt to GDP ratio
as well as incipient signs of inflationary concerns. By
end-February 2011, geopolitical risks in Middle East
and North Africa (MENA) region and the
repercussions on oil prices affected investor
sentiments and sovereign CDS spreads increased in
a few vulnerable economies in the Euro Area. AEs continued to be weighed down by stagnant real estate
markets, high unemployment and weak sovereign
balance sheets. Yield curves in both AEs and EMEs
flattened, particularly since end-March 2011 indicating
economic growth moderation. Global financial
markets have, by and large, been in a corrective mode
since end-April 2011 but risks have been on the rise.
The second half of 2011 could be more volatile in an
environment of widening interest rate differentials
between AEs and EMEs and enhanced financial risks
following downgrade of US sovereign debt and
apprehension of lower growth in AEs. The
developments in the global markets had their spillover
effect on equity and foreign exchange markets in India.
Monetary policy transmission strengthens with
liquidity shifting to a deficit mode
II.4.3 With the Indian economy reverting to its precrisis
growth trajectory during 2010-11, the primary
concern of the Reserve Bank was to anchor
inflationary expectations through policy rate hikes. The effectiveness of the police rate hikes would hinge on
the transmission of the same to the financial markets.
The Working Group on Operating Procedure of
Monetary Policy (Chairman: Shri Deepak Mohanty)
observed that monetary policy transmission is the
strongest in the money market and is more effective
in a deficit liquidity situation than in a surplus liquidity
situation. As part of its calibrated exit from the crisis
driven expansionary monetary policy stance, the
Reserve Bank raised its repo rate by 175 bps and its
reverse repo rate by 225 bps during April 2010 –
March 2011. Liquidity conditions transited from a
surplus mode to a deficit mode during the year,
resulting in an effective policy rate hike of 325 bps.
![42](http://rbi.org.in/scripts/images/7IIER230811_41.gif) |
II.4.4 The money market rates movement during the
year was mainly influenced by the underlying liquidity
conditions and the policy rate changes (Chart II.34).
During the liquidity surplus phase (April-May 2010),
in response to the hike in the repo rate by 25 bps, the
average daily call money rates increased by 32 bps. The certificates of deposit (CD) rates declined. At the
medium to longer end, the yields on 5-year and
10-year G-secs too declined by 21 bps and 38 bps,
respectively.
II.4.5 During the liquidity deficit phase, monetary
transmission strengthened. With a repo rate hike of
150 bps during the period June 2010-March 2011,
the average daily call rate increased by 332 bps and
hovered around the upper bound of the corridor. The
higher call money rates also reflected the skewed SLR
holding across the banks. The rates in the
collateralised segment generally moved in tandem
with the call rate, but mostly remained below it. The
other money market rates also increased. In tune with
the monetary policy stance, the yield curve shifted up
reflecting the hardening of the short to medium-term
rates. The lower than budgeted market borrowing
programme for the second half of 2010-11, increase
in the investment limits of FIIs in government
securities, OMO purchases by the Reserve Bank
during the third quarter of 2010-11, as also the lower
than expected market borrowings announced for the
first half of 2011-12 improved the market sentiment.
These factors, along with a well-anchored medium
to long-term inflation expectations and a moderation
in growth outlook contributed to the flattening of the
yield curve. Accordingly, the rise in the medium term
(5-year) and long-term (10-year) yields was lower than
that of money market rates (Chart II.35). In view of
the flattening of the yield curve at the longer end, the
share of the primary issuances of the longer dated
securities was raised during the year.
II.4.6 The transmission of policy rate hikes to the
credit markets, which remained weak during the first
quarter of 2010-11, strengthened significantly
thereafter following the introduction of the Base Rate
in July 2010 and the prevailing deficit liquidity
conditions turning tight from end-May 2010. Banks
increased deposit rates by 25-500 bps across various
maturities between end-June 2010 and end-March
2011 to accommodate the accelerated growth in
credit. Several banks increased their Base Rates by
25-250 bps between end-July 2010 and end-March 2011. Base Rates ruled in a narrow range reflecting
a greater convergence of rates across banks. The
Base Rate system has improved the transmission
from the policy rate to banks’ lending rates (Please
refer to Box III.1 of Chapter III on monetary policy
transmission after the switch over to the Base Rate).
Monetary transmission strengthens further during
2011-12 so far.
II.4.7 The transmission mechanism strengthened
further during 2011-12 so far. Following a cumulative
increase of 125 bps in the repo rate during April-July
2011, money market rates moved in step with the
policy rate hikes. The issuances of cash management
bills to the tune of `58,000 crore during April-July 2011
to meet temporary mismatches between Government
receipts and expenditure also exerted pressure on
money market rates. The yields on dated Government
securities increased across maturities during 2011-
12 (April-August 12) rising more at the shorter end
than at the longer end, reflecting the impact of policy
rate hikes and larger issuances at the short-end.
Interestingly, the yield on 10-year securities was lower
than the yields at the shorter end, reflecting the
preferred market habitat and the liquidity of the
10-year segment resulting in a kinked yield curve.
II.4.8 In the credit market, banks increased their
deposit and lending rates in response to the increase
in the policy rate by the Reserve Bank. During 2011-
12 (April-August 11), 52 major banks with a credit
share of around 99 per cent raised their Base Rates
by 50-175 bps and 23 major banks accounting for
around 75 per cent of bank deposits raised their
deposit rates in the range of 25-250 bps. The rise in
deposit rates was relatively sharper for maturities up
to 1 year for all categories of banks.
II.4.9 The Indian capital market witnessed some
revival in April 2011, aided by steady FII inflows and
strong global cues. However, relatively better
performance of equity markets in AEs weighed on
market sentiments. The persistence of sovereign debt
problems in the Euro Area and the delay in finalising
a higher public debt ceiling in the US on the global
front, and lower than expected earnings by some of
the major corporates on the domestic front, adversely
affected the markets and the stock markets remained
subdued since May 2011.
II.4.10 Since an excessive liquidity deficit can
destabilise the financial markets and impede credit
flow to the commercial sector, the Reserve Bank drew
a distinction between its monetary stance and its
liquidity management and undertook liquidity
enhancing measures to promote orderliness in the
financial markets (Please see Table III.3.1 of Chapter
III for details of the measures taken by the Reserve
Bank.)
Divergent volume growth across market segments
II.4.11 As the financial market conditions normalised
post global financial crisis, the various segments of
financial markets witnessed further recovery in trading
volumes during 2010-11 (Chart II.36). The
collateralised segment of the overnight money market
accounted for around 85 per cent of the total volume
during 2010-11. The CP market witnessed large
issuances in the immediate post-Base Rate
environment and reached a peak in October 2010
mainly on account of sharp increase in issuances by leasing and finance as well as manufacturing
companies. The issuances of CDs increased sharply
during the second half of the year reflecting banks’
efforts to mobilise more funds to meet the increased
credit demand. The volumes in G-secs market
declined in a rising interest rate environment.
Reduced volatility in financial markets
II.4.12 The volatility1 in the Indian financial markets
was generally lower in 2010-11 than in the previous
year, barring a brief spell of heightened volatility during
May 2010 (Chart II.37). The increased volatility during
May 2010 could be attributed to the transition of the
liquidity situation from surplus to deficit mode for the
money and G-sec markets and to the resurfacing of
sovereign debt concerns in the Euro Area for the
equity and forex markets.
Equity markets remain range bound in absence of
improved earnings visibility
II.4.13 Equity markets remained range-bound during
2010-11 (Chart II.38). Much of the gains during Q2
and Q3 of 2010-11 were offset by a correction during
Q4 of 2010-11. Equity markets, which were
negatively impacted by the sovereign debt crisis in
the Euro Area in May 2010, rallied during July-
December 2010 on the back of large FII investments,
better corporate performances and relatively strong
economic growth. During Q4 of 2010-11, equity
markets were weighed down by concerns over
domestic corporate profitability, weakening
investment climate and global uncertainty. In the
primary market, resource mobilisation through public
issues was higher than a year ago, reflecting mainly
follow-on public offers (FPOs) and rights issues
(Appendix Table 12). Although the number of IPOs
was higher in 2010-11 than a year ago, the individual
issue size was lower. Resources raised by mutual
funds in the equity market, however, turned negative,
reflecting muted participation by retail participants
and corporates. However, the resources raised by
mutual funds in the debt segment increased during
2010-11 over the previous year, reflecting institutional investor preference in a rising interest
rate environment.
![44](http://rbi.org.in/scripts/images/7IIER230811_43.gif) |
Volumes rising in equity and currency derivatives
II.4.14 The presence and role of derivative segments
- OTC and exchange traded - has been increasing
steadily over the years (Box II.8 and Chart II.39). The
volumes of the derivatives segment of the equity
market increased substantially during 2010-11 and
their volumes were considerably higher than those of the cash segment. The increased turnover in the
equity derivatives during 2010-11 was associated with
reduced volatility in the stock price indices.
II.4.15 In the currency futures segment, the volumes
increased sharply in September 2010, with the
commencement of operations by the United Stock
Exchange (USE), which introduced currency futures
in four currency pairs (Appendix Table 13). The daily
trading volumes in currency futures exhibited a
gradual secular uptrend thereafter. The increased volumes in the currency futures market are mainly
attributable to the cash settlement (which obviates
the need for payment of the principal amount),
the speculative interest in the backdrop of
non-requirement of underlying exposure and the
absence of restrictions on cancellation and
re-booking.
Housing prices remain firm and volumes decline
II.4.16 Housing prices continued to remain firm
during 2010-11, barring a brief phase of moderation
in the metros during Q3, despite the hardening of
mortgage rates in response to policy rate hikes as
evidenced by the Reserve Bank’s Quarterly House Price Index (HPI)2 (Chart II.40 a and b). The volume
of transactions, however, exhibited a declining trend
during the second and third quarters of 2010-11 but
revived during the Q4 in most cities. On a y-o-y basis,
out of the seven cities, while housing prices increased in six cities, transactions volumes fell in
five cities. Housing prices and transaction volumes
in Mumbai and Delhi continued to increase on a
y-o-y basis. Quarterly credit deployment in the
housing sector continued to increase during 2010- 11, notwithstanding increase in interest rates and
macro prudential policy measures such as increase
in provisioning requirement for housing loans with
teaser interest rates, increase in risk weights for high
value housing credit and the stipulation of a higher
margin.
![46](http://rbi.org.in/scripts/images/7IIER230811_45.gif) |
![47](http://rbi.org.in/scripts/images/7IIER230811_46.gif) |
Box II.8
Financial Derivatives in India - Current Status
Derivatives instruments in India are regulated by the
Reserve Bank of India, Securities and Exchange Board of
India (SEBI) and Forward Markets Commission (FMC). The
Reserve Bank of India Act, 1934 (as amended in 2006)
empowers the Reserve Bank to regulate OTC derivative
products as long as at least one of the parties in the
transaction is regulated by it; exchange-traded derivatives
are governed by the rules of the respective exchanges and
overseen by the SEBI. Financial institutions in India can
use OTC derivatives for their own balance sheet
management while non-financial firms are only permitted
to hedge their exposures.
OTC derivatives
Over the years, the Reserve Bank introduced various plain
vanilla interest rate and foreign currency derivatives. Certain
products like swaps having explicit/implicit option features
such as caps/ floors/ collars are not permitted. The Reserve
Bank has, however, permitted the use of cross currency
swaps, caps and collars and FRAs for specific purposes.
The Reserve Bank has issued guidelines on credit default
swaps and securitisation to develop the credit derivative
market.
The Reserve Bank issued the guidelines on forward rate
agreements (FRAs) and Interest Rate Swaps (IRS) in 1999
to enable banks, primary dealers and all-India financial
institutions to use these products for their own balance sheet
management and corporates to hedge interest rate risks.
Overnight index swaps (OIS) based on overnight Mumbai
Interbank Offered Rate (MIBOR) benchmark registered
significant growth over the years, although other
benchmarks beyond the overnight have not become popular
possibly due to the absence of a vibrant inter-bank term
money market. Foreign banks dominate the IRS market. It
is mandatory for entities regulated by the Reserve Bank to
report their IRS/FRA trades on the reporting platform
developed by the Clearing Corporation of India (CCIL). CCIL
has been providing non-guaranteed settlement of FRA/IRS
trades since November 2008. Guaranteed settlement in IRS/
FRA segment is expected to be started soon by CCIL. CCIL
has also started providing portfolio compression exercise
in the OTC interest rate swaps aimed at reducing the overall
notional outstandings and the number of outstanding
contracts.
Within the OTC foreign currency derivatives market, the
swap segment is the most active. Rupee-foreign exchange
options allowed in July 2003 is gradually picking up.
Exchange Traded Derivatives
The experience of exchange traded derivatives in India has
been mixed. Equity derivatives like Index futures were
introduced in June 2000, followed by index options in June
2001, and options and futures on individual securities in
July 2001 and November 2001, respectively. Equity
derivatives have grown rapidly since their inception. These
derivative contracts are settled by cash payment and do
not involve physical delivery of the underlying product. FIIs
have an increasing presence in the equity derivatives
markets and currently contribute around 21 per cent of the
market turnover.
Currency futures witnessed substantial increase in volumes
since it was launched in NSE in August 2008 on Rupee-
USD pair. Following the guidelines issued by the Reserve
Bank and the SEBI in January 2010, the NSE and MCX
subsequently launched futures trading in three new currency
pairs, namely, EUR-INR, GBP-INR and JPY-INR in February
2010. Currency options - introduced in the Indian stock
exchanges in October 2010 - saw a significant increase in
volume and open interest.
Trading in Interest Rate Futures (IRF) was re-activated in
August 2009 on a 7 per cent notional coupon bearing 10-
year Government of India security settled through physical
delivery. IRF Trading on 91-day Treasury bills issued by
the Government of India has been permitted by the Reserve
Bank in March 2011 with cash settlement. The May 2011
Annual Policy Statement has proposed the introduction of
IRFs for 2- and 5-year tenors also.
As compared to the exchange traded equity and currency
derivatives segments, the IRF segment remains
dormant in India despite the fact that globally it occupies
70 per cent of the overall derivatives turnover in the stock
exchanges.
Exchange-traded commodity derivatives have been trading
in the commodities exchanges since 2000. Currently, the
22 commodities exchanges operating in the country mostly
trade in futures.
Real exchange rate appreciates reflecting inflation
differential
II.4.17 During 2010-11, while several Asian countries
resorted to capital control, India hardly intervened
through purchase/sale of foreign currency or active
capital account management. The rupee dollar
exchange rate showed two-way movement in the
range of `44.03-47.58 per US dollar (Chart II.41). The
rupee appreciated by 4.0 per cent on an average basis
against the U.S. dollar during the year. Most of
this appreciation occurred during Q2, on the
back of strong equity inflows. On an average basis, the 6-currency real effective exchange rate
(REER) appreciated by 13.1 per cent in 2010-11, the
30-currency REER by 4.5 per cent and the 36-
currency REER by 7.7 per cent. The 6-currency
index showed the maximum appreciation compared
to other indices reflecting higher inflation differential
with these countries (Appendix Table 14).
Financial system remains bank dominated
II.4.18 The Indian financial system is primarily a bankdominated
system. The dominance of banks has
increased further during the post-crisis period, which
essentially reflected an increasing preference for safer
avenues of savings (Box II.9).
Financial markets may imperfectly track banking
indicators
II.4.19 The banking system is usually closely
integrated with the financial market developments owing to its interface with market forces, which can
generate market risks, impact on profitability and
even lead to defaults. Banks in India, however, remained resilient even during the crisis period and
did not face funding and maturity risks to the extent
faced by the global banks (Box II.10). This is, however, not borne out from the CDS spreads
and the stock prices of the banks in India which
largely paralleled the global trends, reflecting
increasing integration with the global financial
markets.
Financing of infrastructure poses challenge ahead
II.4.20 The development of the financial markets and
healthy balance sheets of the financial sector entities
are prerequisites for financial intermediation with a view
to bridging enormous infrastructure deficit (Box II.11).
Box II.9
Trends in Non-Bank Financing - Is the Financial System still Bank Dominant ?
In India, commercial banks account for more than 60 per
cent of the total assets of the financial system (Chart 1).
The other major components of the financial system include,
inter alia, insurance institutions, Non-Banking Financial
Companies (NBFCs), cooperative banks and mutual funds
in a descending order of their assets share.
About 72 per cent of total assets of the banking sector were
held with public sector banks at end-March 2009. Evidently,
the perceived sovereign backing triggered an inflow of
assets into the public sector banks. The dominance of banks
in the financial system is also evident from the flow of
financial resources to the commercial sector (Table 1). The
flow of bank credit to the commercial sector picked up
phenomenally in 2010-11 to 58.2 per cent, registering a
growth of 47.7 per cent.
![50](http://rbi.org.in/scripts/images/7IIER230811_49.gif) |
Table 1: Flow of Financial Resources to the Commercial Sector |
Amount in ` crore |
Item |
2007-08 |
2008-09 |
2009-10 |
2010-11 |
1 |
2 |
3 |
4 |
5 |
A. |
Flow from Banks |
4,44,807 |
4,21,091 |
4,78,614 |
7,11,031 |
|
|
(44.5) |
(48.3) |
(44.8) |
(58.2) |
B. |
Flow from Non-banks (B1+B2) |
5,54,333 |
4,51,399 |
5,88,784 |
5,11,0 06 |
|
|
(55.5) |
(51.7) |
(55.2) |
(41.8) |
B1. |
Domestic Sources |
2,47,926 |
2,58,132 |
3,65,214 |
2,92,084 |
|
|
(24.8) |
(29.6) |
(34.2) |
(23.9) |
B2. |
Foreign Sources |
3,06,407 |
1,93,267 |
2,23,570 |
2,18,922 |
|
|
(30.7) |
(22.2) |
(20.9) |
(17.9) |
C. |
Total Flow of Resources (A+B) |
9,99,140 |
8,72,490 |
10,67,398 |
12,22,037 |
|
|
(100.0) |
(100.0) |
(100.0) |
(100.0) |
Source: RBI.
Note: Figures in brackets indicate percentage share in total resources. |
Box II.10
Impact of Financial Market Developments on Financial Soundness Indicators of the Banking System
While the Indian banking sector has significantly grown in
size in the recent years, its soundness has largely been
maintained even during financial crises. The impact of
sub-prime crisis on banks was almost negligible due to limited
exposure to toxic assets owing to the counter-cyclical
prudential norms prescribed by the Reserve Bank.
The impact of financial market developments on banks is
reflected by the trends in their various soundness
indicators, namely, Return on Asset (RoA), Capital to Risk
Weighted Assets Ratio (CRAR) and Non-Performing Assets
(NPAs). Some of these major soundness indicators of the
banking system showed significant resilience even
during the times of the crisis (Table 1). The Returns on Advances and Investments moved in opposite directions
during phases of rising and falling interest rates. As a result,
banks could earn a stable RoA in a volatile market
environment by making appropriate adjustments to their
portfolios, while ensuring sound asset quality and high levels
of CRAR.
The stable performance and sound health of the Indian
banking system, however, does not preclude important
initiatives that need to be taken in order to further increase
operational efficiency of banks. There is also a need to
strengthen the countercyclical prudential regulatory
framework and step up capital adequacy to meet unforeseen
risks emanating from developments in the financial markets.
Table 1: Size and Soundness of the Indian Banking Sector
|
(in per cent)
|
Year |
Banking
assets to GDP |
RoA |
Return on
Investments |
Return on
Advances |
Gross
NPAs |
CRAR |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
2004-05 |
72.4 |
1.01 |
7.9 |
8.1 |
5.2 |
12.8 |
2005-06 |
75.6 |
1.01 |
7.7 |
8.2 |
3.3 |
12.3 |
2006-07 |
80.6 |
1.05 |
7.2 |
8.9 |
2.5 |
12.3 |
2007-08 |
86.8 |
1.12 |
7.3 |
8.9 |
2.3 |
13.0 |
2008-09 |
93.8 |
1.13 |
7.0 |
9.9 |
2.3 |
13.2 |
2009-10 |
92.0 |
1.05 |
6.6 |
9.3 |
2.4 |
13.6 |
Average |
83.5 |
1.10 |
7.3 |
9.2 |
3.0 |
12.8 |
Standard Deviation |
8.7 |
0.05 |
0.46 |
0.95 |
1.14 |
0.51 |
Source: Reports on Trend and Progress of Banking in India, various issues.
Statistical Tables Relating to Banks in India, various issues. |
Box II.11
Infrastructure Financing
Infrastructure deficit remains a major stumbling block in the
growth process of the Indian economy. It is widely recognised
that poor and inadequate infrastructure is adding to
production costs, affecting productivity of capital and eroding
competitiveness of productive sectors of the economy
(Subbarao, 2009). The Planning Commission has projected
the investment requirement for the infrastructure sector for
the Twelfth Five Year Plan (2012-2017) to be of the order of
`40,99,240 crore (about US$ 1,025 billion), which cannot
be met by the public sector alone due to fiscal constraints.
Gross Capital Formation (GCF) in infrastructure has hovered
around 5 per cent of GDP and is likely to fall short of the 11th Five Year Plan’s (2007-2012) target of raising it to 9 per cent
of GDP by 2012, which is also the level attained in some of
the Asian economies. In India, there has been a significant
increase in the share of bank credit to infrastructure from
2.2 per cent of gross bank credit as at end-March 2001 to
around 13.4 per cent as at end-March 2011. Credit extended
by commercial banks is, however, constrained by the risk of
asset-liability mismatch.
Globally, the corporate bond market plays a significant role
in financing infrastructure development. In India, the
corporate bond market is underdeveloped and the stock of
listed non-public sector debt at 2 per cent of GDP is significantly lower as compared with that of other EMEs, such
as, Malaysia, Korea, and China. In order to develop the
corporate bond market, some of the measures which need
consideration include exemption from withholding tax for FIIs,
rationalisation of stamp duties across states, tax treatment
of pass through certificates, reconciliation of definitional
differences in respect of bonds and debentures,
enhancement of scope of investment by insurance
companies and provident /pension /gratuity funds, permission
to FIIs to invest in to-be-listed bonds, repo lending by
insurance companies and mutual funds, single unified
database to ensure reporting by all entities and partial credit
enhancement by banks.
Securitisation of infrastructure bonds/loans is an important
way of increasing the quantum of debt financing of
infrastructure projects by banks/FIs/NBFCs. The
infrastructure sector has a high potential for bundling of
securities of infrastructure bonds/loans and selling them to
institutional and retail investors based on their perceived
risks. Credit derivatives and credit insurance are also
expected to provide efficient risk transfer mechanisms and,
thus, play a significant role in the corporate bond market
development. In this context, the Reserve Bank has come
out with credit default swap (CDS) guidelines, which will come
into effect from October 24, 2011. CDS would allow corporate
entities including insurers, FIIs and mutual funds (MFs) to
hedge the risk of default in repayment of corporate bonds.
Private equity and venture capital funds may have to be
encouraged to accept higher levels of risk in return for higher
expected returns. Take out financing, which is another
important and innovative way of enhancing the quantum of
banks’/NBFCs’ financing of infrastructure projects and which
also facilitates better asset-liability management, has not
taken off despite efforts by the Reserve Bank and the
government and needs to be pushed further.
Foreign sources are supplementing the domestic finance in
financing infrastructure in recent years. The share of FDI in infrastructure sector as a percentage of total FDI has
increased significantly from around 4 per cent in 2002-03 to
around 16.7 per cent in 2010-11.
Public-Private Partnership (PPP) has been an important
mode of financing infrastructure worldwide. PPPs have
received a somewhat lukewarm response in India except in
the case of telecom, airport and roadways, despite their
potential to attract private investments. A number of factors,
which need to be addressed expeditiously in order to bring
down the time and cost overruns in a significant way, are
responsible for this, e.g., deficiencies in the project appraisal
skills, problems in developing an optimal risk sharing
mechanism, lack of transparency in bidding procedures,
overlapping regulatory jurisdictions and governance related
concerns. PPP projects that are economically essential but
commercially unviable are provided financial assistance in
the form of Viability Gap Funding (VGF) and long tenor loans
through IIFCL (UK), a subsidiary of the India Infrastructure
Finance Company Ltd. (IIFCL). The Reserve Bank has
significantly relaxed prudential norms for infrastructure
projects and has initiated a number of regulatory concessions
for infrastructure finance. Additionally, SEBI has raised the
FII limit for investment in corporate bonds, with residual
maturity of over five years issued by companies in
infrastructure sector, to US$ 25 billion.
References
Deepak Parekh Committee Report (2007), The Report of
the Committee on Infrastructure Financing, Planning
Commission, New Delhi.
Economic Survey, 2010-11.
R H Patil Committee (2005), High Level Expert Committee
on Corporate Bonds and Securitisation, Ministry of Finance,
Government of India, New Delhi.
Subbarao, Duvvuri (2009), ‘Should Banking Be Made Boring?
- An Indian Perspective’, RBI Bulletin, December.
________________________
1 Volatility has been measured by using Generalised Autoregressive Conditional Heteroskedasticity (GARCH) model.
2 The Reserve Bank’s housing price and volume indices are based on data in respect of seven cities collected from the Department of Registration
and Stamps (DRS) of the respective State Governments.
________________________
V. GOVERNMENT FINANCES
Lower combined fiscal deficit reflects improvement in
Central and State finances, but its sustainability
requires further reforms
II.5.1 The combined finances of the Central and
State governments showed distinct improvement in
terms of the key deficit indicators during 2010-11 (RE)
as compared with 2009-10. The combined gross fiscal
deficit (GFD) of Central and State governments as a
ratio of GDP declined markedly to 7.7 per cent in
2010-11 from 9.3 per cent in 2009-10 (Appendix Table
15). The combined revenue deficit (RD) also fell
perceptibly. The lower fiscal deficit ratios are the outcome of both Centre and States returning to the
path of fiscal consolidation. However, these ratios are
still well above 2007-08 levels.
II.5.2 The budgets of the Central and State
governments envisage further fiscal consolidation
during 2011-12 driven by expected moderation in
expenditure growth. The combined GFD and RD as
ratios to GDP are budgeted to decline further in 2011-
12. However, in order to meet these targets, concerted
efforts would be necessary to avoid fiscal slippages
in 2011-12, especially arising from higher expenditure
on subsidies if global commodity and fuel prices
continue at an elevated level.
II.5.3 The sustainability of lower deficits during
2011-12, however, requires substantial new measures
in the arena of fiscal reforms, as the 2010-11
improvement was led by the benefit of cyclical
upswing and one-off gains in revenue. For a
sustainable improvement in fiscal position, further
expenditure compression as well as revenue raising
measures would be necessary.
Centre’s lower deficit ratios reflect one-off
unanticipated revenue and higher nominal GDP
growth
II.5.4 Central government finances had
deteriorated significantly during 2008-09 and 2009-
10 on account of expansionary fiscal policy stance
adopted by the government to address growth
concerns as a fallout of global financial crisis.
However, with economic recovery during 2010-11, the
government reverted to the path of fiscal consolidation
with a partial exit from stimulus measures. Benefiting
from more than anticipated realisation of non-tax
revenue receipts and GDP, the Centre’s key deficit/
GDP ratios turned out to be lower in revised estimates
than were originally budgeted (Chart II.42 a and b).
The revised estimates (RE) for 2010-11 show that
the Central government receipts were better than
budgeted, reflecting buoyancy in domestic economic
activity and the increase in indirect tax rates following
partial fiscal exit. Total expenditure, however,
exceeded the budgeted level. This was on account
of government’s decision to utilise higher than
anticipated receipts from 3G/BWA auctions for financing increased outlays in key priority areas (rural
infrastructure, implementation of Right to Education
Act, plan assistance to States and recapitalisation of
public sector banks). Nonetheless, benefiting from
the better than anticipated GDP outcome, aggregate
expenditure-GDP ratio lay within the budget estimates
for 2010-11.
II.5.5 Provisional data from the Controller General
of Accounts (CGA) confirm the expected improvement
in fiscal position of the Central government in 2010-
11. The estimates of key deficit indicators, turned out
to be lower in the provisional accounts than the revised
estimates on account of higher than anticipated
revenue receipts and reduction in plan expenditure.
Lower fiscal imbalances enabled reduction in
government’s debt-GDP ratio during 2010-11, thereby
containing risks to macroeconomic stability.
II.5.6 However, the fiscal correction is far from over.
Enduring correction through expenditure compression
and better returns on public investments has to be
the cornerstone of an effective fiscal strategy. There
are clear limits to one–off revenue generation
measures over the medium to long run.
II.5.7 Expenditure growth remained higher than
budgeted for 2010-11, thereby maintaining pressures
on aggregate demand. The revised estimates of total
expenditure on subsidies (mainly on food, fertiliser
and petroleum) remained higher than the budget
estimates reflecting the impact of higher international
prices of these commodities. Capital expenditure, both plan and non-plan, remained higher than the
budgeted levels in 2010-11. On the whole,
expenditure growth not only turned out to be higher
than that was budgeted for 2010-11 but also
accelerated as compared with that of 2009-10.
State governments resume fiscal consolidation
II.5.8 State governments also resumed the process
of fiscal consolidation in 2010-11, after suffering a
setback in 2008-09 and 2009-10 (Appendix Table 16).
The revised estimates for 2010-11, based on the
budgets of 28 States, indicate a reduction in key deficit
ratios. This shows State governments’ commitment
towards fiscal consolidation. Going forward, the States
are likely to carry forward the process of fiscal
consolidation in 2011-12 as the revenue account is
expected to turn into surplus after remaining in deficit
during 2009-10 and 2010-11, while the GFD-GDP
ratio is expected to decline further.
II.5.9 A disaggregated analysis shows that the
budgeted improvement in revenue account of States
in 2011-12 is mainly on account of decline in revenue
expenditure while revenue receipts-GDP ratio is
expected to be marginally higher. However, the
moderation in revenue expenditure growth is
attributable to a sharp decline in development
expenditure growth (comprising social and economic
services). In line with the improvement in revenue
account, States’ GFD-GDP ratio is budgeted to be
lower in 2011-12 (BE). Capital outlay as a ratio to
GDP at 2.2 per cent in 2011-12 (BE), however, is yet
to revert to the high levels achieved during 2006-07
to 2008-09. Overall, the States seem to be committed
to bringing their finances on a sustainable path in the
medium-term and the present pace appears to be in
tandem with the path suggested by the Thirteenth
Finance Commission.
Further fiscal consolidation necessary for macrostability
II.5.10 The improvement in government finances till
2007-08 under rule-based fiscal consolidation had
provided cushion to the Centre and States for
undertaking fiscal expansion during 2008-09 and 2009-10 to address the growth slowdown.
Notwithstanding an improvement in fiscal position in
2010-11, the fiscal deficit indicators are yet to reach
the pre-crisis levels. Lowering of these indicators are
necessary for lower inflation and macroeconomic
stability. Going forward, it is imperative for the
government to strengthen the process of fiscal
consolidation. Accordingly, more drastic expenditure
reforms alongwith the envisaged tax reforms – Direct
Taxes Code (DTC) and Goods and Services Tax
(GST) – have to be pursued. Expenditure reforms
have to be directed towards restraining built-in growth
in expenditure and also to bring about structural
changes in its composition (Box II.12).
Expenditure driven fiscal consolidation strategy of the
Centre may be challenging
II.5.11 The fiscal consolidation strategy of the Central
government for 2011-12 is primarily expenditure
driven, reflecting the impact of lower growth in
expenditure on salary, pensions and subsidies. In
particular, all subsidies except interest subsidy are
budgeted to decline in 2011-12 (Chart II.43). There is
an urgent need to implement reforms in the system
of subsidies. Concomitantly, a conservative stance
on revenue projections has been adopted. Although
the Union Budget 2011-12 has opted not to further raise the indirect taxes to the levels prevailing before
the crisis and retained the standard rates of central
excise duty and service tax at 10 per cent, the Central
government announced tax rationalisation measures
which would have differential impact on relative prices
across sectors.
Box II.12
Revenue and Expenditure Reforms – Improving the Fiscal Environment
for Robust and Inclusive Growth
Improving growth, making it inclusive and keeping fiscal deficits
low and sustainable are all desirable objectives of economic
policies. Yet, they are often thought as irreconcilable. These
multiple objectives, however, can best be achieved by adopting
sustainable fiscal policies. Growth and equity objectives both
can be served by keeping the balance between revenues and
expenditures of the government at sustainable levels, which
necessitate both revenue and expenditure reforms.
Revenue reforms in India have been pursued for sometime
now. Multiplicity of rates have been brought down, tax rates
lowered and tax base widened. The standard rates of services
and excise taxes have now converged to a single rate of 10
per cent. Peak customs duty has been reduced from over 300
per cent in the late 1980s to 10 per cent as a part of committed
stance of converging over the medium term to tariff prevailing
in ASEAN countries. Major accomplishments include the
introduction of services tax in 1994 and Value Added Tax (VAT)
by the States during 2004-08.
The present State level VAT structure still has some element
of cascading effect. However, with introduction of GST,
cascading effects of CENVAT and services tax are likely to be
removed with a continuous chain of set-offs. While benefiting
taxpayers, GST is also expected to be a plus sum game for
the Governments. Thirteenth Finance Commission (2009)
estimated that GST could provide gains to India’s GDP
somewhere within a range of 0.9 to 1.7 per cent. Revenue
gains are also likely to be large coming from additional GDP
as well as improved tax compliance. Upscaling of inclusive
growth programmes would then be possible through budgetary
resources.
Direct Taxes Code (DTC) would contribute to enhance GDP
growth, raise tax-GDP ratio and improve allocative efficiency
and equity (both horizontal and vertical) of the direct taxes,
bringing about reduction in administrative and compliance costs
(GOI, 2009). DTC would lead to repeal of the current Income-
Tax and Wealth Tax Acts with the objectives of minimising
exemptions, widening tax base, moderating tax rates and
effective enforcement. The Code also proposes to do away
with profit linked deductions and introduce investment linked
deductions for priority areas.
Both these important pillars of tax reforms have been deferred
for want of political consensus and ironing out the operational
details. The federal structure of our fiscal system entails tax
reforms to be more challenging which require a pragmatic
approach by all stakeholders. However, GST and DTC need
to be rolled out without any further delay. Both, States and
Centre gain from these tax reforms. In addition to tax reforms,
other revenue enhancing measures would be needed.
Improved returns on public investment can help. Better
governance of public utilities, especially at sub-national level
can go a long way in correcting the fiscal imbalances.
Appropriate user charges alongwith plugging of leakages are
needed. The financial positions of State Power Sector utilities
require focused attention.
Revenue reforms alone may not suffice in keeping fiscal
position on a sustainable path. Expenditure cutting holds the
key to fiscal consolidation in India. While modes and speed of fiscal consolidation have differed across countries, expenditure
reforms have formed important component. Barrios, et al.
(2010) find that public expenditure-cuts-based consolidations
tend to be more effective. They send convincing signals
regarding the political will of the fiscal retrenchment as well as
ensure its medium-run viability. Expenditure reforms in many
countries have achieved large fiscal adjustments by reducing
spending on transfers, subsidies and public consumption while
ensuring that allocations for education and health remain
adequate (Hauptmeier et al 2007).
Expenditure reforms in India have been directed towards
restraining built-in growth in expenditure and also bring about
structural changes in its composition. In this regard, various
measures over the years were intended to rationalise
manpower requirements and assessing the feasibility of ongoing
schemes. In order to overcome perpetual committed
expenditure, the New Pension System has been introduced.
The process also involved review of the existing subsidy
systems. For instance, the government is gradually moving
towards nutrient based subsidy (NBS) regime in fertiliser sector.
The government has proposed to move towards direct transfer
of cash subsidy to people living below poverty line in a phased
manner in order to ensure greater efficiency, cost effectiveness
and better delivery for kerosene and fertiliser. With the objective
of rationalising petroleum subsidy, government has
decontrolled the pricing of petrol in June 2010. However, these
measures are not sufficient as oil, fertiliser and food subsidies
are still large. Total subsidies constituted 2.1 per cent of GDP
in 2010-11, which was much higher than 1.3 per cent of GDP
in 2006-07. As such, expenditure reforms need to be pushed
more aggressively. Deregulation of diesel and other fuel prices
assumes importance in this context.
Revenue and expenditure reforms need to be speeded up to
provide fiscal space for achieving the objective of inclusive
growth. The government’s strategy for inclusive growth is to
empower people through legal entitlements in respect of
employment, food security, education and information. Fulfilling
these commitments would require substantial outlays thereby
necessitating a stable, efficient and broad-based tax system
which is conducive to overall business environment.
References:
Barrios, S., S Langedijk, and L R Pench (2010), “EU Fiscal
Consolidation after the Financial Crisis: Lessons from Past
Experiences”, European Economy Economic Paper No.418,
Directorate General for Economic and Financial Affairs,
Brussels.
Empowered Committee of State Finance Ministers (2009): First
Discussion Paper on Goods and Services Tax in India, New
Delhi, November.
GOI (2009), Direct Taxes Code, Discussion Paper, Ministry of
Finance, August.
Hauptmeier, Sebastian, Martin Heipertz and Ludger
Schuknecht (2007), “Expenditure Reform in Industrialised
Countries: A Case Study Approach”, Working Paper Series
No 634, European Central Bank, May.
II.5.12 The moderation in non-plan revenue
expenditure growth is welcome as it creates fiscal
space for undertaking other expenditures. However,
capital expenditure, which is budgeted to be
compressed during 2011-12, raises concerns
regarding the quality of fiscal consolidation.
II.5.13 The government recognises that fiscal
correction for 2010-11 reflected the one-off windfall
benefits of higher than anticipated revenue proceeds
from spectrum auctions, which is unlikely in 2011-12.
The Union Budget for 2011-12 does not take into
account any such one-off sources of revenues and
remains conservative on tax buoyancy.
II.5.14 Going forward, credible fiscal consolidation
strategy will contribute to keeping the debt-GDP ratio
at a sustainable level. In this regard, the reduction in
Centre’s debt-GDP ratio to below 50 per cent in 2010-
11 is a positive development. In terms of the revised
methodology for compilation of debt, which excludes
liabilities not used for financing of GFD and calculates
external debt at current exchange rates, the Centre’s
debt-GDP ratio is budgeted to decline to 44.2 per cent
during 2011-12.
Likely expenditure pressures on subsidies pose
challenge for fiscal consolidation in 2011-12
II.5.15 In spite of the Central government’s
commitment towards fiscal consolidation, the
progress towards this end hinges upon a few factors.
First, the reduction in expenditure growth for 2011-
12 is on account of lower subsidy expenditure, which
is based on the underlying assumption of no major
variation in international fertiliser and petroleum prices
during 2011-12. However, the subsequent
developments indicated an uptrend in international
prices of crude oil which could have significant
implications for subsidy expenditure. Even though domestic prices of diesel, PDS kerosene and LPG
have been partially revised on June 24, 2011, the
projected level of petroleum subsidy is likely to remain
higher than the budgeted level for 2011-12. The
elimination/ reduction of customs/ excise duty on
petrol products would also cause revenue loss and
impact the fiscal balance. Second, in view of several
domestic and international downside risks to
economic growth, moderation in tax revenue
collections cannot be ruled out. A slowdown, however,
may also result in decline in oil prices, which may
help in containing subsidy expenditure.
Pace and nature of fiscal consolidation remains a
concern over the medium term
II.5.16 Over the medium-term, the Central
government envisages gradual corrections in revenue
and fiscal deficits under its rolling targets set out for
2012-13 and 2013-14. Even though, rolling targets
set for fiscal deficit seem achievable, at the current
juncture achieving the revenue targets appear to be
a challenge. There could be a shortfall in achieving
the deficit targets prescribed by the Thirteenth Finance
Commission for the medium-term. An amendment to
the Fiscal Responsibility and Budget Management
(FRBM) Act, 2003 is expected during the course of
2011-12, which would lay down the fiscal roadmap
for the next five years. Fiscal rules defined during the
pre-crisis period are also subject to review in many
advanced and developing economies (Box II.13).
Quality of fiscal adjustment has long term growth
implications
II.5.17 While restraint on revenue expenditure
growth not only ensures that the fiscal consolidation
process is sustainable, it also creates a fiscal space
for undertaking additional capital outlay, which is
essential for infrastructure financing and to provide
an enabling environment for sustained economic
growth. Nonetheless, going forward, there are certain
concerns with regard to fiscal consolidation. First, the
ratio of revenue deficit to gross fiscal deficit, which is
an important benchmark for assessment of the quality
of fiscal consolidation, is expected to remain significantly higher at 74.4 percent in 2011-12 (BE)
than 41.4 per cent in 2007-08. This indicates that a
large portion of borrowings are used to finance the
revenue deficit, thereby reducing the availability of
resources to undertake capital outlays which could
have implications for potential growth. With the
GFD-GDP ratio budgeted to be lower in 2011-12,
higher RD-GFD ratio reflects that fiscal adjustment
envisaged during 2011-12 will be mainly through
compression in capital outlay. Accordingly, the
quality of fiscal adjustment may have long-term
implications for growth as fiscal multiplier is generally
found to be higher in the case of capital expenditure
(Box II.14).
Box II.13
Fiscal Indicators in a Rule-based Framework: Cross-country Survey
In the aftermath of global financial crisis, fiscal rules have
come under strain across a number of countries as they do
not distinguish between economic upturns and downturns.
Fiscal rules constrain budget makers by delineating a
‘numerical target’ on budgetary aggregates over a ‘long
lasting time period’ with a view to guiding fiscal policy (Kopits,
2001). Although countries have not repealed pre-crisis fiscal
rules, many of them have either ignored or adjusted their
rules and even taken discretionary action to cut revenues,
boost expenditures and raise the deficit to address the
economic slowdown. High fiscal deficits and sovereign debt
risks, however, have necessitated countries to re-examine
their fiscal rules so as to anchor their fiscal imbalances even
before their economies stabilised. Effective fiscal rules should
not only aim for numerical targets that have an unambiguous
and stable link with an ultimate objective like public debt
sustainability, but also provide sufficient flexibility to respond
to shocks.
In practice, fiscal policy under the rule-based framework is
anchored to a variety of budgetary aggregates.
Conventionally, overall budget balance is targeted for
moving towards debt-sustainability whereby debt-GDP ratio
converges to a finite level. However, as this indicator
provides a low degree of cyclical flexibility for fiscal policy
to respond to shocks, countries also target structural or
cyclically adjusted balance (CAB), whereby the government
pursues the objective of achieving a nominal budget
balance on average over a full economic cycle. While
primary balance rules also exist, they are less linked to
debt sustainability as they tend to ignore imbalances being
incurred on account of interest payments. Similarly, the
golden rules, which target the overall balance net of capital
expenditures, are also less linked to debt. Countries may
also adopt debt rules (DR) by directly setting an explicit
limit or target for public debt (in absolute or as ratio to GDP)
either in gross terms or in net terms (after adjusting financial
assets). Although DRs are most effective for ensuring
convergence to a debt target, they do not provide sufficient
guidance for fiscal policy in terms of its constituents and
can become misleading at times, when debt level is below
the ceiling but rising.
Alternatively, some countries may set permanent limits or
ceilings on total, primary, or current spending in absolute
terms, growth rates, or in per cent of GDP (expenditure rules:
ER) or they may set floors/ceilings on revenues (to boost tax
collection/limit tax burden) (revenue rules: RR). While ERs
provide flexibility for conduct of fiscal policy through cyclical
and discretionary reductions in revenues during an economic
downturn, they do not normally permit discretionary
expenditure stimulus. On the other hand, RRs do not
constrain government spending. Both these sets of rules are
not directly linked to the control of public debt. Furthermore, RRs do not generally account for the operation of automatic
stabilisers on the revenue side in a downturn (or in an upturn
for revenue ceilings). As automatic stabilisers are stronger
on the revenue side, these rules per se may tend to result in
a procyclical fiscal policy. ERs and RRs, therefore, need to
be accompanied by debt or budget balance rules for ensuring
long term fiscal sustainability.
Historically, the genesis of fiscal rules dates back to the midnineteenth
century. However, recognising inadequacies in
stand-alone rule making, countries (New Zealand in 1994
followed by countries in Latin America, Europe and Asia)
started enacting fiscal responsibility legislations (FRLs) as
a permanent institutional arrangement for promoting fiscal
discipline in a credible, predictable and transparent manner
(Corbacho and Schwartz, 2007). The number of countries
adopting national and/or supranational fiscal rules has gone
up from seven in 1990 to 80 in 2009 (IMF, 2009). Increasingly
many (60 per cent) countries including EMEs (Argentina,
Indonesia and Mexico) have adopted combination of budget
balance and debt targets to improve the effectiveness of their
fiscal rules to ensure debt sustainability. Supranational rules
also have combined budget balance rules with debt rules (in
41 countries), which were accompanied, particularly in the
advanced economies by national rules, such as expenditure
ceilings and specific revenue rules in some countries (e.g.,
tax revenue ceilings in Denmark, and a windfall revenue rule
in France).
Rule-based fiscal frameworks have varied across advanced
and developing economies depending upon their different
needs, institutional capacity, and exposure to global shocks.
Advanced economies have tended to favour flexibility in their
fiscal rules by either adopting cyclically adjusted balances
as target indicators or merely strengthening their fiscal
frameworks without emphasising numerical targets. On the
other hand, the EMEs have preferred combination of balance
budget rules and debt rules for working towards debt
sustainability. While in EMEs fiscal rules were accompanied
by FRLs, advanced countries have generally not adopted
FRLs reflecting strength in the existing legal and institutional
framework (Lienert, 2010).
India embarked on FRL framework with the enactment of
Fiscal Responsibility and Budget Management (FRBM) Act
by the Central government in 2003, followed by the States
subsequently. In order to improve the effectiveness of such
legislations, the FRLs in India have a combination of targets
set for various fiscal indicators such as fiscal deficit, revenue
deficit and debt. Notably, India’s FRL system of targeting
revenue and fiscal balances separately is quite unique
internationally as other countries generally tend to target
overall budgetary balance. By targeting a zero level of
revenue deficit, India’s FRLs recognise the importance of phasing out the use of borrowed resources for current
consumption of the government so as to ensure that
borrowings are used only for capital expenditures for longterm
fiscal sustainability. This is consistent with the UK’s
‘golden rule’ fiscal framework, whereby borrowing is
mandated only for capital expenditure. From Union Budget
2011-12, the Central government has started focusing on
reducing ‘effective revenue deficit’, which excludes capital
grants to States from the headline measure of revenue deficit.
Recognising that fiscal consolidation is conducive to
macroeconomic management, the Central government
intends to introduce an amendment to the FRBM Act, 2003
during the course of 2011-12, which would lay down the fiscal
roadmap for the next five years.
References:
Corbacho, Ana, and Gerd Schwartz, 2007, “Fiscal
Responsibility Laws,” in Promoting Fiscal Discipline, ed. by
Manmohan S. Kumar and Teresa Ter-Minassian
(Washington: International Monetary Fund).
Kopits, G. (2001), “Fiscal Rules: Useful Policy Framework or
Unnecessary Ornament?” IMF Working Paper 01/145.
Lienert, Ian (2010), “Should Advanced Countries Adopt a
Fiscal Responsibility Law?” Fiscal Affairs Department, IMF
Working Paper 10/254.
IMF (2009), “Fiscal Rules—Anchoring Expectations for
Sustainable Public Finances”, Fiscal Affairs Department,
December 16.
States’ own initiatives important for their durable fiscal
consolidation
II.5.18 While laying out the revised fiscal roadmap
in amended FRBM Acts, States need to take
cognisance of changing contours of Centre-State
financial relations. With a sharp decline in loans from
the Centre, particularly since 2004-05, resource
transfers from Centre to States in recent years have
been mainly through current transfers, viz., tax
devolution and grants. While current transfers from
the Centre contributed to around one-third of
correction in revenue account of States during the
pre-crisis period (2003-04 to 2007-08), lower tax
devolution due to cyclical downturn in tax collections
at the Central level during the crisis was compensated
by higher grants.
II.5.19 Keeping in view the cyclicality in tax
collections at the Central level, States need to explore
own non-tax sources of revenues by undertaking
reforms in major sectors, viz., power and irrigation.
Effective mobilisation of own non-tax revenues, which
are expected to be more durable than tax revenues,
would facilitate lower dependence of States on Centre
especially during the period of slowdown. While the
tax base of States is likely to expand with the proposed
implementation of GST, States may have to assess
its revenue implications based on the structure of their
State economies.
II.5.20 The recommended share of States in the form
of tax devolution from the Centre has also been raised
by the Thirteenth Finance Commission (FC). States,
on their part, may have to devolve higher resources
to local governments, for facilitating greater
decentralisation and undertake fiscal consolidation
initiatives so as to benefit from State-specific grants
as recommended by the Thirteenth FC. Going
forward, taking into cognisance these factors, States
need to amend their FRBM Acts to provide revised
fiscal roadmap for medium term.
II.5.21 The Central Government had constituted an
Expert Committee in July 2010 (Chairperson: Smt.
Shyamala Gopinath) for comprehensive review of the
National Small Savings Fund (NSSF). The terms of
reference of the Committee were, inter alia, to
recommend mechanisms to make small saving
schemes market linked and to recommend on the lending arrangement of the net collection of small
savings to Centre and States, and to suggest
alternative investment avenues. The Committee
submitted its report to the Government of India in June
2011 (Box II.15). The recommendations of the
Committee are aimed at aligning the administered
interest rates on small savings instruments with
market related rates on government securities. This would reduce the volatility in small savings collections,
which would facilitate a more efficient cash and debt
management of the Central and State Governments
and a smoother transmission of monetary policy
signals. The recommendations would also empower
the State Governments with greater discretion on
borrowings from NSSF keeping in view their cash
position and improve the viability of NSSF.
Box II.14
Fiscal Multiplier: A Cross-Country Experience
The global financial crisis drew discretionary fiscal stimulus
measures almost as reflex actions across countries mirroring
an underlying belief about efficacy of government spending
or taxation measures for stimulating desired change in
aggregate demand. With widespread adoption of
expansionary fiscal policy during the crisis, a long standing
debate about the size of the fiscal multiplier has resurfaced
both in theory and across countries. ‘Multiplier effect’,
originally propounded by Richard Kahn (1930) and later
popularised by Keynes, measures the efficacy of government
spending or tax measures to bring desired change in
aggregate demand. Fiscal multiplier exceeds unity in simple
Keynesian framework but it is now known that it can vary
considerably with impact varying from even negative values
to large positive values. Interaction with a large number of
macro-economic parameters ultimately determines the size
of the multiplier. If with fiscal expansion, monetary conditions
remain accommodative, fiscal multiplier is generally larger.
While lower level of leakages in spending increases the value
of multiplier, concerns with regard to long term fiscal
sustainability may make it less effective and even negative.
The composition of expenditure plays an important role in
assessing the effect of fiscal stimulus in developing countries.
Furthermore, fiscal multiplier calculated as an impact
multiplier differs from cumulative multiplier or the peak
multiplier. Even though there has been a vast literature on
estimating fiscal multiplier, the empirical work on fiscal
multiplier, providing a broad range of results, has not settled
the theoretical debates.
Typically, in advanced economies, the multipliers are
statistically significant and moderately positive. In contrast,
the effects on output in the medium-term in emerging
economies were found to be consistently negative indicating
that discretionary fiscal measures taken in emerging
economies might have a positive impact in the immediate
period but they appear to be anti-growth in the medium-term
as they become more of a structural nature and thus more
difficult to phase out in later years.
In the wake of occurrence of global crisis, a number of studies
were undertaken to examine the impact of fiscal stimulus
under varying conditions. Ilzetzki et al (2011) have shown that the cumulative impact of government consumption on
output was lower in developing countries as compared with
high-income countries. Fiscal expansions that were expected
to persist indefinitely have smaller multipliers due to stronger
private-sector offsets. In general, during crisis when fiscal
stimulus is designed to address recessionary conditions,
fiscal multipliers are expected to be larger than in the normal
period when monetary and fiscal policies may be working at
cross purposes.
An exercise undertaken for estimating the size of fiscal
multipliers in respect of government final consumption
expenditure (GFCE) and the Central government’s capital
outlay using VAR framework adopting methodology similar
to Espinoza and Senhadji (2011) suggests that fiscal
multipliers in India are low. Based on quarterly data for 1996-
97 to 2009-10, it was found that government consumption
positively impacts GDP growth (both in real and nominal
terms) in the short-term. Government consumption multiplier
peaks within first three quarters (ranging between 0.11 and
0.20 under alternative specifications), after which the impact
is found to peter out. Focusing on impact of Central
government’s investment as reflected in annual capital
outlays (in real terms), the cumulative multiplier works out to
around 1.5 when the multiplier peaks. Thus, cross-country
findings as well as the results for India show that government
consumption leads to crowding out with size of multiplier
being significantly lower than one while investment multiplier,
working over the long-run, has crowding-in impact with its
size more than unity. This calls for improving quality of public
expenditure management by increasingly rationalising
outlays towards investment as the Central and State
governments revert to the rule-based fiscal consolidation
path.
References:
Ilzetzki, Ethan; Enrique G. Mendoza and Carlos A. Végh
(2011), “How Big (Small?) are Fiscal Multipliers?”, IMF
Working Paper No. WP/11/52.
Espinoza, Raphael and Abdelhak Senhadji (2011), “How
Strong are Fiscal Multipliers in the GCC? An Empirical
Investigation”, IMF Working Paper No. WP/11/61.
Box II.15
Recommendations of Committee on the Comprehensive Review of the NSSF
The Committee recommended the following measures on
the rationalisation of savings instruments: (i) an increase in
the rate of interest to 4 per cent p.a. on savings deposits to
align with commercial bank savings deposit rate; (ii)
measures to improve liquidity on recurring and time deposit
schemes; (iii) abolition of maturity bonus on Monthly Income
Scheme; (iv) an increase in the annual investment limit on
PPF to `1 lakh to coincide with the ceiling on Section 80C of
the I.T. Act; (v) withdrawal of Section 80C income tax benefit
for accrued interest on NSC; (vii) discontinuance of Kisan
Vikas Patra (KVP) which is prone to misuse being a bearerlike
instrument; and (viii) introduction of a longer maturity
instrument – 10 year NSC.
The Committee recommended that the secondary market
yields on Central government securities of comparable
maturities should be the benchmarks for the small savings
instruments (other than savings bank deposits). A one-year
reference period - taking the average of the month-end
secondary market yields in the preceding calendar year -
may be adopted; however, the inter-year movement of
interest rate fluctuations would be limited to maximum 100
bps on either direction. A positive spread of 25 bps, vis-à-vis
government securities of similar maturities (as against 50
bps recommended by the earlier Committees) would
contribute to the viability of the NSSF. Exceptions were made
only in case of 10-year NSC and Senior Citizens’ Savings Scheme (SCSS) by recommending a spread of 50 bps and
100 bps, respectively. The date of notification of the rate of
interest on small savings by the Government would be April
1, every year, effective 2012-13.
The Committee recommended a reduction in the mandatory
share for States to 50 per cent from 80 per cent at present.
After the States exercise their options, the balance amount,
if any, could either be taken by the Centre or could be onlent
to other States if they so desire, or could be on-lent for
financing infrastructure to companies which are wholly
owned by Government. With the rule-based improvement
in fiscal situation, lower maturity may not involve refinancing
risk. Accordingly, to broadly align with the maturity profile
of the small savings instruments, the Committee
recommended a shorter tenor of 10 years for investments
by NSSF that would largely address the asset-liability
maturity mismatch of NSSF. The rate of interest on
securities issued to the Central / State Governments would
be equal to the sum of the weighted average interest cost
on the outstanding small savings and the average
administrative cost and would be announced every year
on April 1. The reinvestments may be as per the same terms
as for fresh investments. The negative gap between the
outstanding assets and liabilities of NSSF may be funded
by the Central Government. These measures would
contribute to the viability of NSSF.
VI. THE EXTERNAL SECTOR
Global recovery loses momentum; sovereign balance
sheet risks add to uncertainty
II.6.1 The global economy rebounded in 2010 with
a growth of 5.1 per cent after contracting by 0.5 per
cent in 2009. The growth in emerging market and
developing economies (EMDEs) at 7.4 per cent
outstripped the 3.0 per cent growth in advanced
economies (AEs) in 2010 (Chart II.44a). China, India,
Brazil and the ASEAN-5 grew at a significantly faster
pace than the AEs. However, the United States,
Germany and Japan had larger swings in growth rates
transiting from significant negative to moderately
positive growth.
II.6.2 The recovery was marked by continued
uncertainty about the durability of the growth process.
After recovering strongly in the first half of 2010, the
global economy encountered heightened downside
risks emanating from concerns relating to the possible sovereign debt defaults in Greece, Ireland and
Portugal and the weakening sovereign balance
sheets in Italy and Spain. The global recovery lost
some momentum in the second half of the year in the
AEs, particularly in the US and Japan. Growth in world
industrial production also exhibited signs of
deceleration after attaining peaks in March 2010. The
AEs which faced the prospect of double-dip recession,
nevertheless, performed better than expected.
However, the recent downgrading of the US sovereign
debt by Standard and Poors’ (S&P) adversely affected
the sentiments in the financial markets across the
world, renewing fears of slowdown amidst weakening
global economic recovery. Emerging market
economies (EMEs) led by China and India continued
to grow at a faster rate compared to the AEs.
EMEs face rising inflation led by commodity prices
II.6.3 Inflation accelerated in EMDEs during 2010.
On an average consumer price basis, it rose to 6.1
per cent in 2010 from 5.2 per cent in the preceding year. Both India and China faced considerable
inflationary pressures. As a result, Developing Asia’s
inflation rate nearly doubled to 6.0 per cent in 2010
from 3.1 per cent in 2009. In contrast, consumer price
inflation in AEs rose to 1.6 per cent from 0.1 per cent
over the same period, but was still well below the longrun
average in these countries. The core inflationary
pressures remained subdued in these economies, but
a stark divergence has occurred in recent months with
producer price inflation having risen faster with rising
fuel and non-fuel commodity prices.
![53](http://rbi.org.in/scripts/images/7IIER230811_52.gif) |
II.6.4 Global commodity prices firmed up during
2010, owing to rapid growth in EMDEs, strongerthan-
expected growth of AEs and weather-related
supply shocks. Low global interest rates and large
surplus liquidity in the global economy fuelled global
commodity prices with players taking long positions.
OPEC’s lower-than-expected output response
during 2010 and unrest in the Middle East and North
Africa (MENA) since January 2011 drove up oil
prices. Commodity prices are expected to remain
firm in 2011. If, however, monetary accommodation in AEs is progressively withdrawn, the consequent
rise in interest rates could reduce leveraged
position in commodity markets and deflate
commodity prices. Commodity prices could also
experience a decline if the pace of global recovery
slackens further.
II.6.5 Strong capital inflows induced by the multipaced
global growth and the consequent differential
exit from accommodative monetary policy, coupled
with the near full capacity utilisation have generated
inflationary pressures in many EMEs, including
Brazil, China, India, Indonesia, and Russia. In an
increasingly interdependent globalised world,
options for the pursuit of an independent monetary
policy for EMEs like India can get constrained but
this could be managed through appropriate policies
(Box II.16).
II.6.6 In 2010, the improving demand conditions
helped in the recovery of world trade to its pre-crisis
level. Exports of EMDEs witnessed higher growth
than those of AEs. Exports surged during 2010 and
global trade recovered to exceed the pre-crisis high
of July 2008 for the first time in March 2011
(Chart II.44b). However, the growth in global trade
is expected to moderate due to rising prices of food
and other primary products, and unrest in major oil
exporting countries. Capital flows are likely to remain
strong during 2011, but in view of the recent
developments, they do run the risks of turning
volatile, with possible episodes of sudden reversals
(Chart II.44c).
II.6.7 Fiscal policy continued to support economic
activity in the AEs in 2010 (Chart II.44d and e). Going
forward, there is an urgent need for adopting fiscal
consolidation plans. This need is particularly urgent
in countries with debt sustainability issues in the Euro
area and also in Japan and the US to avoid contagion
spreading from the government balance sheet to the
bank balance sheets and the financial markets.
Unemployment situation has remained stubbornly
high in the AEs throughout 2010 and is improving
slowly in 2011 (Chart II.44f).
Balance of Payments improve in 2010-11
II.6.8 The improvement in India’s balance of
payments (BoP) during 2010-11 primarily reflected
pick-up in exports during the second half of the year.
Coupled with a higher invisibles surplus, it led to a
moderation in the current account deficit (CAD) in
2010-11. While recovery in global growth augured well
for pick-up in exports and invisibles, higher
international commodity prices, particularly crude oil,
impacted the import bill. The improved net capital
inflows helped bridge the higher CAD and foreign
exchange reserves increased modestly. Key external
sector indicators such as CAD, level of external debt
and import cover of foreign exchange reserves
continued to remain comfortable. On the capital
account, the composition of inflows poses some
concern as there was slow down in FDI while the
volatile components such as FII and short-term trade
credits showed some rise that have implications for
external debt sustainability. The bilateral nominal
rupee-dollar exchange rate showed a two-way
movement broadly reflecting demand and supply
conditions in the foreign exchange market.
Trade diversification helps narrow trade deficit
II.6.9 India’s merchandise exports grew robustly
during 2010-11 aided by higher rate of growth in global
income and diversification in direction and
composition of trade. The Government’s export policy
in terms of encouragement of Free Trade Zones, Duty
Exemption Entitlement Scheme, focus market
scheme (FMS) and focus product scheme (FPS)
appeared to have contributed to the diversification of
exports in terms of products from labour intensive
manufactures to higher value-added products in
engineering and petroleum sectors and destinations
across EMDEs which led to moderation in trade deficit
during 2010-11 (Chart II.45). While the share of
engineering and petroleum products increased to
27 per cent and 17 per cent in 2010-11 from 21 per
cent and 11 per cent, respectively, in 2005-06, the
share of labour intensive products declined from 29
per cent to 21 per cent during the same period. The share of developing economies in total exports
improved to 42 per cent in 2010-11 from 38 per cent
in 2005-06, while the share of OECD countries
declined to 33 per cent from 45 per cent during the
same period.
![54](http://rbi.org.in/scripts/images/7IIER230811_53.gif) |
Box II.16
Has Increasing Globalisation Limited the Effectiveness of National Policies in India?
In the wake of the global financial crisis, financial globalisation
has come under scrutiny once again. Critiques of
globalisation have re-emphasised that globalisation does not
bring any additional gains than what can already come from
free trade. In the context of increasing capital flows, it has
been time and again pointed out by the critiques that gains
from trade in goods (widgets) are of first order, while gains
from trade in capital (dollars) are of second order, a’la Jagdish
Bhagwati. Another observation has been that countries that
have benefited most from free-market globalisation are not
those that have embraced it wholeheartedly, but those that
have adopted parts of it selectively. Open markets succeed
only when embedded within social, legal and political
institutions that provide them legitimacy by ensuring that the
benefits of capitalism are broadly shared (Rodrik, 2011).
Contrarian arguments have been equally strong. Kose, et
al.(2009) review a large body of literature to highlight gains
from financial globalisation and the various economic policies
that could help developing economies effectively manage
the process of financial globalisation. They find that policies
promoting sound macroeconomy, financial sector
development, institutional quality and trade openness appear
to help developing countries derive the benefits of financial
integration. However, a more recent concern has been:
if globalisation is leading to a loss of national policy
effectiveness?
The answer is not easy to find. Subbarao (2011) suggests
that there is a need to find ways to maximise the benefits of
globalisation while minimising its costs. While spillovers
occur, we need to deal with them. A typical case has been
QE2, which has both positive and negative externalities. Its
announcement caused a double whammy on the EMEs
through a surge in capital inflows and a rise in commodity
prices, both requiring them to tackle inflationary pressures.
They put EMEs in a policy bind as higher interest rates to
fight inflation could potentially intensify capital inflows further.
QE2, however, also helped shore up US recovery, bringing
back confidence in financial markets and ultimately helping
EMEs through improved trade and capital account flows.
Effectiveness of national economic policies goes down in
such cases, especially if they are uncoordinated.
The impact of globalisation on national economic policy
effectiveness is ultimately an empirical question. Our
theoretical understanding of the channels through which
national economies are linked is also inadequate. Yet, it would
not be correct to say that domestic monetary, fiscal or
exchange rate policy becomes redundant with increased
openness. Trilemma in policy choice is a well known problem
and needs to be managed by adopting less than corner
solutions. In fact, under globalisation national policies can
be more carefully calibrated and fine-tuned to serve national
interests.
For instance, monetary policy takes on new importance under
globalisation due to need to contain spillovers and their
impact on nominal asset returns. The case for price stability
as an optimal monetary rule becomes stronger. Even without
nominal price rigidities, price stability is important because it enhances the risk sharing properties of nominal bonds
(Devereux and Sutherlands, 2008). It is important to
recognise that globalisation represents a shock to relative,
not absolute prices. What happens to the general price level
depends on what monetary policy makers then decide to do.
It has been argued that de facto openness has risen sharply
in India and has implied a loss of monetary policy autonomy
when exchange rate pegging was attempted (Shah and
Patnaik, 2011). It is true that the exchange rate regime has
evolved towards greater flexibility as a conscious policy
choice, but this has been calibrated to the changing structure
and dynamics of the economy without loss of monetary policy
independence. Policies had supported this move over a
period of time, inter alia, by capacity building to withstand
volatility and shocks. It has increasingly allowed exchange
rate to serve as a buffer, depreciating to help the economy
when it was weak and appreciating to reduce excess demand
when it was strong. In the past two years, there has been no
significant foreign exchange market intervention. The small
increase in the Reserve Bank’s foreign exchange reserves
mainly reflects various accruals, interest earnings and
valuation changes. Increased exchange rate flexibility has
also minimised the danger that foreign inflows would be
attracted by “one-way bets” on appreciation, or that domestic
firms would borrow excessively from abroad without hedging
their exposure.
Globalisation is a phenomenon that has now acquired a force
of its own. Policy interventions can best aim at a right policy
mix to reap gains from it while minimising the risks. These
gains dynamically can be significant. It may appear that
growing global interdependence has increased the Indian
economy’s vulnerability to external demand and exchange
rate shocks. However, misaligned exchange rates amidst
balance of payment shocks had a much larger adverse
impact on the Indian economy in the earlier crisis episodes.
After the Indian economy has become integrated globally, a
large shock in the form of a swing of US$100 billion in total
net capital inflows in a single year of peak of global crisis
had been managed without too much impact on exchange
rate, interest rates, external and internal balances.
References:
Devereux, Michael B. and Alan Sutherland (2008), “Financial
Globalisation and Monetary Policy”, Journal of Monetary
Economics, 55(8): 1363-1375, November.
Kose, A. Ayhan, Eswar Prasad, Kenneth Rogoff and Shang-
Jin Wei (2009), “Financial Globalisation and Economic
Policies”, IZA Discussion Paper No. 4037.
Rodrik, Dani (2011), The Globalisation Paradox, WW Norton
& Co.
Shah, Ajay and Ila Patnaik (2011), “India’s Financial
Globalisation”, NIPFP Working Paper, No. 2011-79.
Subbarao, D. (2011), “Policy Discipline and Spillovers in an
Inter-connected Global Economy”, Comments at the SNBIMF
Conference on The International Monetary System,
Zurich, May 10.
II.6.10 Comparing across countries, exports from the
group of EMDEs as a whole rose relative to world
exports. Countries like India, Brazil, China, Indonesia
and Russia witnessed higher growth during 2010
(Chart II.46).
II.6.11 While exports of almost all major groups of
commodities improved significantly during 2010-11,
performance in case of valued added products such as engineering and petroleum sector has been
noteworthy. Engineering products, petroleum
products, gems and jewellery witnessed a
significantly higher growth (Chart II.47). Moreover,
efforts to explore new markets particularly in Africa
and Latin America along with added emphasis on
exports to EMDEs also contributed to the export
performance.
![55](http://rbi.org.in/scripts/images/7IIER230811_54.gif) |
II.6.12 With a view to improving efficiency of export
processes, the Union Budget 2011-12 announced the
following measures: (i) introduction of a system of
self assessment in Customs to enable importers and
exporters to assess their duty liabilities; (ii) simplification
of tax refunds on services used for exports of goods
on the lines of duty drawback schemes; (iii) allowing
tax-free receipt of services wholly consumed within
the SEZs along with simplified refunds procedures;
and (iv) setting up of seven mega leather clusters
and a handicraft mega cluster.
II.6.13 Imports grew at a lower pace than exports
during 2010-11. There was an increase in the share
of industrial inputs in total imports (non-oil imports
net of gold and silver, bulk consumption goods,
manufactured fertilisers and professional
instruments), which was indicative of some qualitative
shift in the pattern of imports. Imports of export related
items recorded a steep rise of about 59 per cent during
the year. The share of gold and silver in total imports
remained almost same as that of the previous year’s
level despite the rise in the price of gold and silver in
the international market.
![56](http://rbi.org.in/scripts/images/7IIER230811_55.gif) |
II.6.14 During 2010-11, as per DGCI&S data, India’s
merchandise exports and imports increased by 42.3
per cent and 22.3 per cent, respectively, as against a
decline of 2.2 per cent and 3.5 per cent during the
previous year. Consequently, trade deficit narrowed
to US $ 98.2 billion (5.7 per cent of GDP) from the
previous year (Appendix Table 17). However, on BoP
basis, trade deficit as a percentage of GDP was higher
at 7.5 per cent.
Invisibles growth robust
II.6.15 During 2010-11, invisibles receipts and
payments exhibited robust growth in contrast to a
decline in receipts during 2009-10. This increase -
driven by services exports and private transfers - was
partly offset by a decline in investment income. The
sharp growth in invisible payments was led by its major
components viz., services and investment income.
As a result, net invisibles recorded a modest increase
over the preceding period. Among the major
components of invisibles, services exports witnessed a turnaround and recorded a growth of 37.8 per cent
to US $ 132 billion. While software services receipts
accounted for 44.7 per cent of total services exports,
performance of business and financial services also
improved significantly during the year.
II.6.16 A noteworthy aspect in respect of services
data was the release of provisional aggregate data
on trade in services for the first time for the month of
April 2011 as a follow up of the implementation of the
recommendations of the Working Group on Balance
of Payments Manual for India (Chairman: Shri Deepak
Mohanty). The aggregate data on trade in services
will be released on a monthly basis after a gap of
about 45 days.
II.6.17 Investment income receipts, which is a major
component of invisibles, declined by about one-third
on account of low interest rates abroad. Private
transfer receipts, a significant and resilient component
of invisibles receipts during the global crisis, increased
marginally during 2010-11. With the turnaround in other segments, the share of private transfer receipts in
current receipts declined during 2010-11 (Chart II.48).
Current account deficit shrinks
II.6.18 On BoP basis, trade deficit widened in
absolute terms to US$ 130 billion (7.5 per cent of
GDP) during 2010-11 from US$ 118 billion (8.6 per
cent of GDP) in the previous year despite higher
growth in exports relative to imports (Appendix Table
18). Net invisibles financed about 66.1 per cent of
trade deficit as compared with 67.6 per cent in the
previous year. As a result, the CAD narrowed to 2.6
per cent of GDP during 2010-11 from 2.8 per cent
during the previous year (Chart II.49). Thus, CAD is within the threshold level of sustainable CAD of 2.7-
3.0 per cent (Box II.17).
Capital account improves though composition of flows
poses concerns
II.6.19 The positive perception of India’s growth
prospects attracted capital inflows during 2010-11
which witnessed an increase of US$ 6.3 billion over
the preceding year. The composition and volatility of
such flows posed some concern. There was the
dominance of volatile flows such as FII investment
and debt creating flows like ECBs and short term
credit, while FDI flows moderated. Net FII inflows
remained almost at the same level as that of the
preceding year; there were, however, occasional
bouts of net outflows when investor sentiments
changed. Net FDI inflows were lower by almost
US$ 11.6 billion, due to significant moderation in gross
FDI inflows to India coupled with higher gross
outflows. The moderation in equity flows coupled with
rising debt flows during 2010-11 poses risks to
sustainability.
II.6.20 Non-resident deposits during 2010-11 stood
higher than the previous year mainly on account of
higher inflows under NRO deposits (Chart II.50).
While debt creating flows exhibit significant sensitivity
to the interest rate differentials, at the aggregate level,
capital flows are only weakly sensitive to the interest
rate differentials (Box II.18). Net external assistance
received by India was higher by US$ 2 billion
benefitting from financial sector loan from the World Bank. Buoyant domestic economic activities,
improvement in international financial markets and
lower cost of funds abroad prompted the Indian
corporates to take recourse to ECBs which more than
quadrupled to US$ 11.9 billion. Short-term trade
credits (STC) also increased. Net capital flows, though
higher, were absorbed by the higher current account
deficit.
Box II.17
India’s Threshold level of Sustainable Current Account Deficit
Conceptually, sustainability refers to the ability of a nation to
finance its CAD on an ongoing basis. Therefore, the level of
current account balance (CAB) that could be financed on a
continuous basis without resulting in any external payment
difficulties is termed as the sustainable level. Generally, the
sustainable level of CAD is measured in terms of net external
liabilities (NEL) relative to the size of the economy. The level
of CAB that stabilises the net external assets/liabilities in
relation to the size of the economy is considered as
sustainable. Apart from NEL/GDP ratio, sustainability could
also be assessed in terms of a range of economic indicators,
viz., debt-GDP ratio, import cover, and debt-servicing ratio.
Sustainability of the CAB could also be seen in terms of
solvency. A nation is considered solvent if the sum of its
discounted current account surpluses in future is more than
the current level of net external liabilities. Solvency and
sustainability are closely related as a continued
unsustainable path of external balance would undermine the
solvency of the nation. Theoretically, it can not a priori
be determined what would be the sustainable level of NEL
ratio. It varies from country to country depending upon a
host of factors including credibility and ability of the nation to
sustain interest of the investors.
The issue of current account sustainability has been raised
in several countries from time to time. As a practical solution,
any historically sustainable level could be assumed to be
sustainable in future as well (IMF, 1999). Milessi-Ferretti and
Razin (1996) point out that though generally a CAD at 5 per
cent of GDP is considered as a red mark, the question
whether CAD is excessive or not can only be answered by
modeling the path of external imbalances. But 5 per cent
clearly is a danger level even for countries which have
unrestricted access to global capital markets. Obstfeld and
Rogoff (2005) showed that the then US CAD of 5.4 per cent
of GDP had a high probability of the collapse of the US dollar.
More recently, concerns have resurfaced over CAD
sustainability of a few Euro zone countries. Gagnon (2011)
warns that current account imbalances are coming back as
a result of interplay of fiscal policy, external financial policy, net foreign assets and oil prices. Sustainable CAD in EMEs
is likely to be far less than AEs.
The sustainable CAD/GDP ratio in India has gone up over a
period of time. One of the early studies by Callen and Cashin
(1999) had estimated it at 1.5-2.5 per cent depending upon
growth rate and cost of external finance. However, with much
larger cross-border capital flows and improved institutional
capability to absorb the same, this has improved. Historically,
in India NEL ratio of about 21 per cent was the highest in
1996-97 and it did not cause any pressure on the economy.
In order to empirically workout the level of CAB that is
consistent with historical sustainable peak level of NEL to
GDP ratio, a model akin to ‘Domar Model of Debt
Sustainability’ could be used. Under this model, larger the
absolute size of the differential between the growth rate and
the interest rate, higher would be the size of CAB that is
consistent with a stable NEL ratio. By this method, CAD of
2.7 to 3.0 per cent is found to be sustainable for India over
the medium term subject to a set of conditions, viz., (i) GDP
growth varies between 7.0 to 9.0 per cent and inflation hovers
around 5.0 per cent; (ii) average interest cost on external
liabilities ranges 2.0 to 3.5 per cent; and (iii) capital flows
range around 4-4.5 per cent of GDP and about 3/5th of the
flows are non-debt creating inflows.
Reference
Callen, Tim and Paul Cashin P (1991), “Assessing External
Sector Sustainability in India”, IMF Working Paper, No.181.
Gagnon, Joseph E. (2011), “Current Account Imbalances
Coming Back”, Peterson Institute of International Economics
Working Paper, WP-11-1, January.
Milesi-Ferretti, Gian Maria and Assaf Razin (1996), “Current
Account Sustainability”, Princeton Studies in International
Finance, No.81, October.
Obstfeld, Maurice and Kenneth Rogoff (2004), “The
Unsustainable US Current Account Position Revisited”,
NBER Working Paper No. 10869.
II.6.21 Country-wise, investments routed through
Mauritius remained the largest component of gross FDI inflows to India during 2010-11 followed by
Singapore and the Netherlands (Appendix Table 19)
(Chart II.51). During 2010-11, FDI was mainly
channeled into the manufacturing, services and
‘construction, real estate and mining’ sectors
(Chart II.52).
II.6.22 The increase of US$ 13.1 billion in foreign
currency assets (FCA) on BoP basis during 2010-11
could primarily be attributed to receipts under external
assistance (US$ 6.1 billion), interest and funding income (US$ 4.1 billion) and net purchases (RBI’s
market intervention) from Authorised Dealers (ADs)
(US $ 1.7 billion). During 2011-12 so far (up to August
12), the Indian rupee depreciated against the major
international currencies, partly reflecting higher
demand from importers (Chart II.53). The exchange
rate of the rupee at the current level appears to be
fairly valued (Box II.19).
Foreign exchange reserves stable, reflecting
flexible rupee
II.6.23 During 2010-11, net capital account
surplus, after financing a larger CAD, resulted in a
net accretion to foreign exchange reserves of
US$ 13.1 billion (excluding valuation effect).
Inclusive of the valuation gains, the foreign exchange reserves increased by US$ 25.8 billion. India’s
foreign exchange reserves stood at US$ 316.6 billion
as on August 12, 2011 (Appendix Table 20). The
two-way movement in Indian rupee vis-à-vis US
dollar and Euro was more pronounced since
February 2007 than the earlier period indicating its
flexibility (Chart II.54).
Box II.18
Interest Rate Sensitivity of Capital Flows to India
Interest rate differential has often been viewed as a major
determinant of capital flows to EMEs, and, at times, monetary
policy measures that may be conditioned by the inflation-growth
objectives could magnify or dampen the volume of capital
inflows into a country. In the aftermath of the recent global
financial crisis, multi-speed recovery and divergent inflationary
trends have led to asymmetric monetary exit between EMEs
and the AEs. An outcome of this process has been return of
excessive capital flows to EMEs, exerting pressure on their
asset prices to inflate and the exchange rates to appreciate.
In India, during the normalisation of monetary policy in 2010-
11 when policy interest rates were successively raised, similar
concerns surfaced, particularly in the first half, even though a
higher CAD and the associated higher financing needs eased
the pressure on the exchange rate. Among the push factors,
near zero policy rates maintained in AEs, their weak growth
prospects and ample global liquidity conditions reflecting
quantitative easing, implied scope for larger inflows to EMEs,
including India, in search of higher return. Stronger recovery
in a stable macroeconomic environment and the general
assessment of India continuing to be one of the fastest growing
economies in the world for a long period of time provided the
necessary pull to capital inflows.
Recent empirical assessment for India using both causality
and cointegration analyses suggests that FDI and FII equity
flows, which together on a net basis accounted for around
three fourth of the total net capital inflows during the 10-year
period from 2000-01 to 2009-10, are not sensitive to interest
rate differentials (Verma and Prakash, 2011). FDI inflows are
essentially long-term in nature and are primarily driven by
growth prospects of the Indian economy and confidence of
international investors in India as an attractive long-term investment destination. Stock market returns have been found
to be a major pull factor for FII flows into the domestic financial
markets. In line with the expectations, debt creating flows, in
particular, ECBs, FCNR(B) and NR(E)RA deposits exhibit
statistically significant sensitivity to interest rate differentials,
even though other determinants of these inflows dominate
significantly the impact of interest rate differential. At the
aggregate level, cumulative gross capital inflows appear to
increase by 0.05 percentage point in response to 1 percentage
point increase in interest rate differential. The weak sensitivity
of capital flows to interest rate changes suggests that the
Reserve Bank’s monetary policy needs to continue its focus
on objectives relating to inflation and growth, instead of diluting
the action based on perception of attracting higher capital
inflows and the resultant challenges for exchange rate and
domestic liquidity. The magnitude and composition of capital
flows could be managed using other instruments, as has been
the case in the past.
References:
Calvo, Guillermo A., Eduardo Fernández-Arias, Carmen
Reinhart, and Ernesto Talvi (2001) “The Growth-Interest Rate
Cycle in the United States and its Consequences for Emerging
Markets,” Inter-American Development Bank Working Paper
No. 458, Washington.
Singh, Bhupal (2009), “Changing Contours of Capital Flows
to India” Economic and Political Weekly, VOL XLIV No. 43
October 24.
Verma, Radheyshyam and Anand Prakash (2011) “Sensitivity
of Capital Flows to Interest Rate Differentials: An Empirical
Assessment for India”, RBI Working Paper, WPS (DEPR): 7/
2011, May.
Management of foreign exchange reserves
II.6.24 The guiding objectives of foreign exchange
reserves management in India are safety, liquidity
and returns in line with the general international
practices in this regard. The level of foreign
exchange reserves has traditionally been the
outcome of the Reserve Bank’s intervention in the
foreign exchange market to contain excessive
exchange rate volatility and valuation changes due to movement in prices of securities and of the US
dollar against other currencies. Moreover, the
reserves which are built up mostly out of the
volatile capital flows do not represent surplus
earnings through trade like in the case of some other
countries and they are required to be held as buffer
during periods of sudden stops and reversal in capital
flows.
Investments under Note Purchase Agreement
with IMF
II.6.25 In order to strengthen the IMF’s lendable
resources, the Reserve Bank had entered into a Note
Purchase Agreement (NPA) with the IMF under which
the Reserve Bank shall purchase IMF Notes for an
amount up to the equivalent of US$10 billion. The
earlier commitment of US$ 10 billion under NPA has been folded into the amended and expanded New
Arrangements to Borrow (NAB) which has been
activated on April 1, 2011. As on June 30, 2011
investments amounting to SDR 750 million (`5367.90
crore) have been made in notes under NAB.
Box II.19
Equilibrium Exchange Rate
With the increasing integration of the world economy,
the role of exchange rate has become important in the
external adjustment process and calls for a credible
assessment of equilibrium exchange rate. The assessment
of equilibrium exchange rate is essentially an empirical
exercise.
From the policy makers perspective in the long-term horizon,
there are three complementary methodologies for exchange
rate arrangements. These are: macroeconomic balance (MB)
approach, a reduced form equilibrium real exchange rate
(ERER) approach and an external sustainability (ES)
approach. Exchange rate assessments are based on the
notion of equilibrium, that is, consistency with external and
internal balance over the medium to long-run. The MB
approach - a pillar of current account and exchange rate
assessments for a number of years - calculates the difference
between the CAB projected over the medium term at
prevailing exchange rates and an estimated equilibrium CAB.
The exchange rate adjustment that would eliminate this
difference over the medium term is obtained using countryspecific
estimated responses of the trade balances to the
real exchange rate. The ERER approach directly estimates
an equilibrium real exchange rate for each country as a
function of medium-term fundamentals such as the net
foreign asset position of the country, the relative productivity
differential between the tradable and non-tradable sectors,
and the terms of trade. Under this approach, the exchange
rate adjustment needed to restore equilibrium over
the medium term is calculated as the difference between
the estimated equilibrium real exchange rate and its
current value. The ES approach, involves calculating the
difference between the actual CAB and the balance that would stabilise the NFA position of the country at some
benchmark level.
With respect to the exchange rate of the Indian Rupee, the
preliminary exercise using the external sustainability
approach, shows that the sustainable level of CAD is for
India is around 3 per cent. As the current level of CAD for
India is around 3 per cent, it could be inferred that the
exchange rate is close to its equilibrium value. The broadbased
36 currency trade weighted real effective exchange
rate, a measure of external competiveness, covering about
85 per cent of India’s total trade is generally hovering around
the base level of 100, which also corroborates the above
empirical exercise. IMF has estimated that the real effective
rupee, based on the MB approach, is slightly undervalued
but on average the rupee is in equilibrium (IMF 2010).
The exchange rate policy in India is not guided by a fixed or
pre-announced target or band; rather, it is determined by
the demand and supply in the foreign exchange market.
However, the objective of exchange rate policy has been to
retain the flexibility to intervene in the foreign exchange
market if the capital inflows are lumpy and volatile or if they
disrupt the macroeconomic situation.
References
Jaewoo Lee, Gian Maria, Milesi-Ferretti, Jonathan Ostry,
Alessandra Prati and Luca Antonio Ricci (2008), ‘Exchange
Rate Assessments: CGER Methodologies’, International
Monetary Fund, Occasional Paper No. 261.
IMF (2010), ‘Current Account and External Sustainability’.
IMF Staff Technical Note for Article IV consultations with India,
November.
External debt rises moderately
II.6.26 India’s external debt stock increased by 17.2
per cent to US$ 306 billion as at end-March 2011
owing to increase in commercial borrowings, shortterm
trade credits, multilateral and bilateral borrowings
as well as the valuation effects due to depreciation of
the US dollar against other major currencies. While
long-term debt increased by US$ 32.2 billion to US$
241 billion, short-term debt (on the basis of original
maturity) increased by US$ 13 billion to US$ 65 billion
(Appendix Table 21). In terms of currency composition, the US dollar denominated debt
accounted for the major portion of total external debt
at end-March 2011 with a share of 59.9 per cent,
followed by Indian Rupee (13.2 per cent), Japanese
yen (11.4 per cent) and SDR (9.7 per cent) with the
balance 5.8 per cent accounted for by the Euro, Pound
Sterling and other currencies. Various debt
sustainability indicators remained at a comfortable
level (Chart II.55).
International investment position weakens
II.6.27 Net International investment position (IIP)
computed as a gap between the economy’s external
financial assets and liabilities, is an indicator of the
country’s strength in terms of sustainability of the
financing of its external sector. The international
assets increased from US$ 381 billion at end-March
2010 to US$ 425 billion at end-March 2011, mainly
on account of increases in direct investment abroad
and reserve assets. The increase in international
liabilities from US$ 539 billion as at end-March 2010
to US$ 643 billion as at end-March 2011 was mainly
on account of an increase in inward direct and portfolio
investments and other investments. As a result, net
liabilities increased by US$ 61 billion.
External sector resilient, but global uncertainties can
impact current and capital account movements
II.6.28 India’s external sector remains resilient even
after weathering the global financial crisis. However,
global uncertainties can have considerable impact on
movements in current and capital account of BoP.
Exports which performed well in 2010-11 may not
sustain high growth momentum if the downside risks
to world growth materialise. However, continued
product diversification and targeting new markets
together with proactive policies pursued by the
Government bode well for harnessing export growth
potential. Services exports are also likely to remain buoyant due to India’s comparative advantage in
software services. As projected by NASSCOM,
software exports could grow robustly by 16-18 per
cent in 2011-12. Rising commodity prices, particularly
oil, and geo-political turmoil, may have implications
for BoP. Private transfers continued to remain
buoyant.
![64](http://rbi.org.in/scripts/images/7IIER230811_63.gif) |
II.6.29 Financing of CAD for 2011-12 may not pose
a problem as it is unlikely to be high. However, the
public debt fragilities in the Euro Zone and the growth
slow down in the US may impact capital flows. The
inward FDI flows are likely to be much larger during
2011-12 taking into account the proposals cleared and
the initial trend available up to June 2011. With regard
to portfolio flows they could be volatile, though India
is likely to remain one of the preferred destinations
due to the differential growth rates. The debt flows
may be supported by interest rate differential.
Therefore, the BoP situation remains manageable,
though it necessitates continuous monitoring due to
the global uncertainties.
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