INDIA’S FINANCIAL SECTOR AN ASSESSMENT

INDIA’S FINANCIAL SECTOR AN ASSESSMENT

Advisory Panel on Financial Stability Assessment and Stress Testing

Committee on Financial Sector Assessment March 2009

This Report was completed in June 2008. However, looking at the global financial developments of late, an attempt has been made to update some relevant portions of the report, particularly Chapter I (Macroeconomic Environment) and Chapter IV (Aspects of Stability and Functioning of Financial Markets).

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List of Acronyms

Terms of Reference and Scheme of Report

The Government of India, in consultation with the Reserve Bank of India constituted the Committee on Financial Sector Assessment (CFSA) in September 2006, with a mandate to undertake a comprehensive assessment of the Indian Financial Sector, focusing upon stability and development. The CFSA was chaired by Dr. Rakesh Mohan, Deputy Governor, Reserve Bank of India. The Co-Chairmen at different points in time were Shri Ashok Jha, Dr. D. Subbarao and Shri Ashok Chawla, Secretary, Economic Affairs, Government of India. The Committee also had other officials from the Government of India as its members.

To assist the Committee in the process of assessment, the CFSA constituted four Advisory Panels respectively for the assessment of Financial Stability Assessment and Stress Testing, Financial Regulation and Supervision, Institutions and Market Structure and Transparency Standards. These Panels were assisted by Technical Groups comprising mainly of officials from relevant organisations to provide technical inputs and data support, as appropriate, to the respective Advisory Panels.

• to conduct an analysis of macro-prudential surveillance and financial stability (including business continuity and disaster recovery) and to assess the impact of potential macroeconomic and institutional factors (both domestic and external) on the soundness (risks and vulnerabilities) and stability of financial systems;
• to analyse relevant data and information and apply techniques and methodologies as relevant to banking, insurance, securities markets and non-banking financial sectors;
• to subject the assessment of stability to stress testing duly taking into account potential impact of macroeconomic and institutional factors and risks on the stability (including business continuity and disaster recovery) indicators, including natural and man-made disasters/catastrophe; and
• based on the assessment, suggest measures for strengthening the financial structure and system and its development in a medium-term perspective.

Technical Group on Financial Stability Assessment and Stress Testing

A Technical Group comprising of officials drawn from the Government and other agencies who are directly associated with respective areas of work, assisted the Advisory Panel in preparing preliminary assessments and background material which served as inputs to the Advisory Panel's work (Please see Annex B for the composition of the Technical Group and terms of reference). Apart from the officials indicated in the Annex B the Panel also benefited from the inputs of the officials indicated in Annex C. IRDA formed its own Technical Group for assessment of aspects of Stability and Performance of the Insurance Sector - Annex D.

Approach and Methodology

Scheme of the Report

The report is divided into seven chapters. Chapter I dwells on the macroeconomic environment in the backdrop of current global economic scenario. To the extent that the overall economic situation impinges upon the functioning of institutions, markets and infrastructure, the analysis in this Chapter focuses on potential areas of vulnerabilities which have a bearing on overall stability for sustained growth. It provides an overview of the institutional and financial market environment, bringing out the importance of various financial institutions in the overall financial system as also the relative importance of various financial market segments.

Chapter II assesses the soundness and performance of financial institutions and discusses the emerging issues confronting the financial institutions at the present juncture. It employs various ratios/trend analyses to gauge the performance of financial institutions and benchmarks them with available international best practices, as appropriate. In addition, drawing upon recent events in global financial markets, the analysis also devises a set of liquidity ratios and evaluates the trends. Institutional coverage includes banking sector (commercial banks/Regional Rural Banks/co­operative banks), broader financial sector (NBFCs, DFIs and HFCs) as also the relevant non-financial sectors (corporate and household). Central to the analyses of Chapter II has been the use of stress tests to ascertain the resilience of the concerned institutions. Taking into account the maturity of the financial system and the present financial health of the relevant institutions, stress tests were appropriately designed to focus on the major risk factors.

Chapter III examines the stability and performance of the insurance sector. Subsequent to its opening up to private participation, there has been a rapid growth in this sector. As a consequence, it was deemed desirable to undertake an initial assessment of the strength and resilience of this sector including a stress test.

Chapter IV examines the stability and functioning of financial markets, including the money market, government securities market, foreign exchange market, equity market and corporate bond market. In addition, it also addresses the stability and developmental issues as germane to the credit market.

Financial infrastructure issues are examined in Chapter V, covering the payment and settlement infrastructure, business continuity and disaster management, the regulatory and supervisory structure, the legal infrastructure, liquidity infrastructure and issues relating to the safety net such as deposit insurance.

Chapter VI focuses on some of the salient developmental issues in the Indian context having a bearing on the equity and efficiency aspects, such as financial inclusion.

Annex A

RESERVE BANK OF INDIA
CENTRAL OFFICE,
SHAHID BHAGAT SINGH ROAD,
MUMBAI – 400 001, INDIA

MEMORANDUM

Constitution of Advisory Panel on Financial Stability Assessment and Stress Testing

A Committee on Financial Sector Assessment (CFSA) has been constituted by the Government of India (GOI) in consultation with the Reserve Bank with the objective of undertaking a self-assessment of financial sector stability and development. One of the analytical components of Financial Sector Assessment would encompass a comprehensive assessment of financial stability and stress testing of the Indian financial sector.

2. In this connection the CFSA has decided to constitute an Advisory Panel on Financial Stability Assessment and Stress Testing comprising the following:

4. The Advisory Panel will have the following terms of reference:

1. to conduct an analysis of macro-prudential surveillance and financial stability (including business continuity and disaster recovery) and to assess the impact of potential macroeconomic and institutional factors (both domestic and external) on the soundness (risks and vulnerabilities) and stability of financial systems;
   
   
2. to analyse relevant data and information and apply techniques and methodologies as relevant to Banking, Insurance, Securities Markets and Non-banking financial sectors;
   
   
3. to subject the assessment of stability to stress testing duly taking into account potential impact of macroeconomic and institutional factors and risks on the stability (including business continuity and disaster recovery) indicators, including natural and man-made disasters/catastrophe; and
   
4. based on the assessment, suggest measures for strengthening the financial structure and system and its development in a medium-term perspective.

5. The Advisory Panel would have the option of co-opting as Special Invitees any other experts as they deem fit.
   
   
6. The secretarial assistance to the Advisory Panel will be provided by the Reserve Bank of India. The Technical Groups on Financial Stability Assessment and Stress Testing constituted by the Reserve Bank and the Insurance Regulatory and Development Authority (IRDA) at the instance of the Committee have already progressed with the technical work with regard to above terms of reference. The technical notes and background material prepared by these groups would inter-alia form the basis for discussion by the Panel and in drafting of the Report.
   
   
7. The Advisory Panel will prepare a detailed Report covering the above aspects and the Government of India/ Reserve Bank of India will have the discretion of making the Report public, after a peer review, as they may deem fit.
   
8. The Advisory Panel is expected to submit its Report in about three months from the date of its first meeting.

(Rakesh Mohan)

Chairman of the Committee on Financial Sector Assessment

Annex B

RESERVE BANK OF INDIA
CENTRAL OFFICE,
SHAHID BHAGAT SINGH ROAD,
MUMBAI – 400 001, INDIA

DEPUTY GOVERNOR

Constitution of Technical Group on Financial Stability Assessment and Stress Testing

The Committee on Financial Sector Assessment (CFSA) will undertake a self-assessment of financial sector stability and development. CFSA has decided to constitute a Technical Group on Financial Stability Assessment and Stress Testing comprising the following:

(i) to contribute to the work related to analysis of macroprudential surveillance and financial stability to monitor the impact of potential macroeconomic and institutional factors (both domestic and external) on the soundness (risks and vulnerabilities) and stability of financial systems based on the direction/guideline provided by the Advisory Panel; and

(ii) to compile relevant data and information and apply techniques and methodologies as relevant to Banking, Insurance, Securities Markets and Non-banking financial sectors; and

(iii) to subject the assessment of stability (including Business Continuity and Disaster recovery) to stress testing duly taking into account potential impact of macroeconomic and institutional factors and risks on the stability (including Business Continuity and Disaster recovery) indicators, including natural and man-made disasters/ catastrophe; and

(iv) based on the assessment, to suggest measures for strengthening the financial structure and system and its development in a medium-term perspective; and

(v) to provide such inputs for discussion to the Advisory Group on Financial Stability Assessment and Stress testing as needed and participate in their deliberations.

Annex C

List of Officials who Assisted the Advisory Panel

Annex D

Annex E

List of Peer Reviewers who Reviewed the Report

This report was completed in June 2008. However, looking at the global financial developments of late, an attempt has been made to update some relevant portions of the report, particularly Chapter I (The Macroeconomic Environment) and Chapter IV (Aspects of Stability and Functioning of Financial Markets).

Chapter I

The Macroeconomic Environment

1.1 Introduction

After a period of robust global growth and favourable economic conditions, global financial markets have entered a turbulent phase because of the subprime crisis which started in mid-2007. Non-performing housing loans, declining global equity prices and the rising cost of default protection on corporate bonds forced some major banks to face significant losses. Alongside, the tightening of banking credit standards in major industrial economies has reinforced worries of an impending credit crunch.

The impact has been compounded by the volatility in international food and oil prices. These effects are expected to impact global economic growth in the current year as well as next.

The adjustment process in the advanced economies is underway and its gradual unfolding has implications for global capital flows, exchange rates and the adjustment of domestic economies. With the growing integration of the Indian economy with global markets, the weight of global factors, along with domestic considerations, has also become important in the formulation of macroeconomic policies and outcomes. There are several positives pointing to sustainable higher growth rate. But, some of the recent global and domestic developments show heightened domestic risks to the short-term outlook of the Indian economy.

Against this background, Chapter I analyses the linkages between macroeconomic performance and financial stability and goes on to summarise the global economic developments. It then provides an overview of the Indian economic scenario including the institutional and financial market environment and identifies certain potential macroeconomic vulnerabilities in the Indian economy at the present juncture.

1.2 Linkages Between Macroeconomic Performance and Financial Stability

Macroeconomic developments and shocks can have an impact on the financial sector. The role of macro-prudential or financial stability analysis has therefore gained importance among central banks, regulatory authorities and international agencies. Various macroeconomic developments such as an increase in inflation due to a spurt in crude oil/commodity prices, a sudden inflow/ outflow of capital, a sharp increase in the fiscal deficit, sudden and sharp increases in interest rate/asset prices can adversely affect financial institutions’ balance sheets and the financial markets. This has implications for financial stability. Macro stress testing has, therefore, assumed significance in recent years.

The linkages between macroeconomic performance and financial stability are schematically presented in Chart 1.1. These shocks can emanate from the real or the financial sector. Such shocks affect the banks’ balance sheets through the conventional channels of credit and market risk. They also affect balance sheets through the financial markets and asset prices. Both effects may amplify the first round balance sheet impact, in particular the liquidity and network effects. Taken together, all of these channels then translate into a final impact on balance sheets, as reflected in aggregate loss distribution. This loss distribution, in turn, can then be mapped back into the impact on the economy.

A stable and resilient financial system is therefore vital for achieving sustained growth with low inflation as it can withstand fluctuations resulting from dynamic changes in economic conditions, as well as sudden and substantial increases in uncertainty.

The resilience of the financial system can be tested by subjecting the system to stress scenarios. Since the early 1990’s, stress-tests at the level of individual institutions have been widely applied by internationally active banks. In addition to applying such stress tests to the portfolios of individual institutions at the micro level, stress-testing is assuming an increasingly important role in the macro-prudential analysis

as well. The main objective of an aggregate stress test is to help public authorities identify those structural vulnerabilities and overall risk exposures that could lead to systemic problems.

For macro stress testing, a distinction is made between the “bottom-up” and “top-down” approaches. Under the former, the response to various shocks in a given scenario is estimated at the portfolio level using highly disaggregated data from individual financial institutions at a point in time. The results of the bottom-up approach can then be aggregated or compared to analyse the sensitivity of the entire sector or group of institutions. This approach has the advantage of making better use of individual portfolio data. However, if individual institutions provide their own estimates, the approach may introduce some inconsistencies about how each institution applies the scenario and produces its numerical estimates.

The top-down approach entails the calculation of the consequences based on a centralised model, normally using aggregated data, for the entire sector as a whole. The advantages of the top-down approach are that these stress tests are relatively easy to implement without burdening the individual institutions. The drawback is that the aggregated data only captures the effects for the sector as a whole, and not the different risk profiles and vulnerabilities of the individual institutions.

An important issue relating to stress testing is the determination of yardsticks to be used when setting the ranges of shock variables. In India, stress testing scenarios often tend to be hypothetical due to the lack of past data on benchmarks. To get a more realistic view, however, there is a need to construct scenarios which are combinations of shock variables. The correlations among such variables would need to be considered when constructing such scenarios.

As in many other countries, macro stress-testing in India is constrained by data availability and absence of a comprehensive macroeconomic model. But, in view of its importance for monetary and financial stability, there is, a need to put in place a macroeconomic stress-testing framework for assessment and surveillance on a regular basis.

The rapid pace of financial innovation of the last few years has brought about a proliferation of new and increasingly sophisticated financial products. It has also, in turn, led to significant institutional changes requiring and creating new and expanded roles in the system. Against this backdrop of increased complexity, financial stability depends on the ability to understand financial markets and to be able to identify, in a timely fashion, the potential consequences of new developments. This requires a great deal of reliance on expertise and judgment, market intelligence and a broad range of financial indicators. Many of these indicators are also measures of financial strength.

1.3 The Global Economy

After four years of continuous strong expansion, global activity has slowed down significantly during 2008. Many advanced economies are experiencing recessionary conditions while growth in emerging market economies is also weakening. The financial crisis that first erupted with the collapse of the US subprime mortgage (Box 1.1) has deepened further and entered a new turbulent phase in September 2008, which has severely affected confidence in global financial institutions and markets. According to the projections released by the International Monetary Fund (IMF) in January 2009 (Table 1.1), global economic activity is estimated to soften from 5.2 per cent in 2007 to 3.4 per cent in 2008 and to 0.5 per cent in 2009 with the downturn led by advanced economies. In advanced economies, output is

Box1.1: The Sub-Prime Crisis

The delinquency rate in the US sub-prime mortgage market began to rise in 2005, but market response to developments began only in mid 2007, when credit spreads suddenly began to widen. The trigger was the revelation of losses by a number of firms and the cascade of rating downgrades for sub-prime mortgage products and some other structured products. By August 2007, growing concerns about counterparty risk and liquidity risk, aided by difficulties in valuing structured products, led to a number of other advanced markets being adversely affected. In particular, there was an effective collapse in the market for Collateralised Debt Obligations (CDOs), which are structured products based, in part, on sub-prime mortgages and a withdrawal from asset-backed commercial paper market, and a sudden drying up of the inter-bank term money market. A high degree of inter-linkages across various markets resulted in swift transmission of the crisis from one segment to other segments.

Two explanations have been advanced for the underlying causes. The first highlights the influences particular to this period. Central to this hypothesis is that the ‘originate and distribute’ model altered incentives, so that it became less likely to produce ‘due diligence’ in making loans. Those at the beginning of the sub-prime chain received fees to originate mortgages and were secure in the knowledge that someone else would buy them. Banks at the centre of the securitisation process focused on the profits associated with these instruments, rather than possible threats to their financial soundness and capacity to sustain liquidity. As a result, the quality of mortgage credit declined in the sub-prime area, and much of this credit seems to have ended up being held in highly leveraged positions. Insofar as structured products are concerned, many were highly rated by the concerned rating agencies. In retrospect, it became clear that the ratings were highly sensitive to even minor changes in assumptions about the underlying fundamentals, as well as correlations among defaults and recovery rates. Many investors also did not take on board the fact that ratings were concerned with only credit risk, and high ratings provided no indication of possible major movements in market prices.

The second explanation focuses on the fact that these problems are a manifestation of the unwinding of credit excesses. A continuous worsening of credit standards over the years, in a period of benign interest rates and robust economic growth, eventually culminated in a moment of recognition and recoil.

In terms of possible policy responses, proponents of the first set of arguments contend that the logic of this position leads to the need for central bank liquidity infusions to get markets back on keel. Looking forward, a better understanding of complex financial products and how credit risk transfer techniques reshape downside risks and the greater role of transparency as a cornerstone of modern financial markets assumes importance. Those who focus on credit excesses would emphasise, in addition to the measures enunciated above, the desirability of easing monetary policy, in response to a significant threat to growth.

The current financial turmoil has several important lessons. First, the appropriate role of the monetary authorities and second, the appropriate structure of regulation and supervision. As regards the first, the evidence indicates that the focus of central banks has gradually been narrowing, relative to the more complex responsibilities they have traditionally shouldered. Secondly, there is an increasing trend towards separation of financial regulation and supervision from monetary policy. A view has emerged that problems of information asymmetry might become aggravated in case prudential regulation and supervision are separated from monetary policy, contributing to less than adequate surveillance.

The role of the central bank apart, the sub-prime crisis has thrown up fresh issues and challenges for regulation; the management of risks posed by securitisation; the role of credit rating agencies; the need for greater transparency in financial markets especially where highly leveraged institutions are concerned; better pricing of risk; the design of incentives in banking; better management and supervision of liquidity risk; and, perhaps, the need for the central bank to bring investment banks as well as non-bank financial entities and other market intermediaries that have the potential to affect the stability of financial system under the ambit of its policy framework and operations.

In the Indian case, the authorities have not favoured the adoption of inflation targeting, owing to several reasons. Secondly, the approach to regulation has been institution and market based, being located within the central bank and other regulators combined with a system of coordinated information sharing and monitoring among them. With joint responsibilities for monetary policy and supervision, this has enabled the authorities to use techniques that are precisely calibrated to emerging issues or problems.

forecast to contract on a full-year basis in 2009, the first such fall in the post-war period. Slowdown has been witnessed in both advanced as well as emerging market economies (EMEs) like Argentina, China, India and Thailand during 2008. All major advanced economies like the

Euro area, Japan, the UK and the US are projected to register decelerated growth rates (at times negative growth rates) in 2008 as compared to those during 2007.

The IMF has projected the US economy to grow by 1.1 per cent in 2008 (2.0 per cent in 2007) and contract by 1.6 per cent in 2009. The US economy has been severely impacted by the direct effects of the financial crisis that originated in its subprime mortgage market, though aggressive policy easing by the Federal Reserve, a timely fiscal stimulus package, and a strong export performance on the back of a weakening US dollar have helped to cushion the impact of the financial crisis till the second quarter of 2008. The US economy may contract during the final quarter of 2008 and the first half of 2009, as export momentum moderates and tight financial conditions lead to more problems. The IMF expects the US economy to stabilise by the end of 2009 and then recover gradually. The key factors that will determine short-term outlook include effectiveness of recent Government initiatives to stabilise financial market conditions, the behaviour of US households in the face of rising stress and the depth of housing cycle. The projections envisage a significant slowdown in growth in the Euro area to 1.0 per cent in 2008 from 2.6 per cent in 2007 mainly on account of tightening credit conditions, falling confidence, housing downturns in several economies and the US slowdown. The economy is expected to contract by 2.0 per cent in 2009. The momentum of recession in Japan is projected to accelerate to -2.6 per cent in 2009 (-0.3 per cent in 2008) on account of slowing exports, expected further weakening of domestic demand and slowing down of private investment.

The emerging and developing economies have not decoupled from this downturn. Growth projection for developing Asia by the IMF is placed at 7.8 per cent for 2008 as against 10.6 per cent in 2007 as domestic demand, particularly investment and net exports have moderated. Countries with strong trade links with the US and Europe are slowing down markedly. Also, countries relying on bank-related or portfolio flows to finance large current account deficits have been adversely affected by strong risk aversion, deleveraging and the consequent shrinkage in external financing. Nevertheless, growth in emerging Asia during 2008 was led by China and India. GDP in China eased to 9.0 per cent for 2008 (projected to grow at 6.7 per cent in 2009) from 13.0 per cent during 2007 partly due to slowing of exports. The IMF projects India's growth rate to moderate from 9.0 per cent in 2007 to 7.3 per cent in 2008. Upon weakening of investment though private consumption and exports, India’s GDP is expected to decelerate further to 5.1 per cent during 2009.

Going forward, financial conditions are likely to remain fragile, constraining global growth prospects. Financial markets are expected to remain under stress throughout 2008 and 2009 though some recovery is expected in 2010. Though the forceful and co­ ordinated policy responses in many countries have contained the risks of a systemic financial meltdown, further strong and complementary policy efforts may be needed to rekindle activity. At the same time fiscal stimulus packages should rely primarily on temporary measures and be formulated within medium-term fiscal frameworks that ensure that the envisaged build-up in fiscal deficits can be reversed as economies recover. There are many reasons to remain concerned about the potential impact on activity of the financial crisis. There are substantial downside risks to the global growth outlook, which relate to two concerns, viz., financial stress could remain very high and credit constraints from deleveraging could be deeper and more protracted than envisaged. This would increase risk of substantial capital flow reversals and disorderly exchange rate depreciation for many emerging market economies. Another downside risk relates to growing risk for deflationary conditions in advanced economies. Additionally, the US housing market deterioration could be deeper and more prolonged than forecast, and the European housing markets could weaken more broadly. Factors that would help in reviving the global economy in late 2009 include expected stabilisation in commodity prices, a turnaround in the US housing sector after finally reaching the bottom and support from continued robust demand in many EMEs despite some cooling of their momentum. Policy makers face the major challenge of stabilising global financial markets, while nursing their economies through a period of slower growth and keeping inflation under control.

Rising inflation, which was a concern for a major part of 2008, has however, eased since September 2008 and is now a declining concern on account of marked decline in food and fuel prices as well as augmentation of downward risks to growth from the intensification of the global financial crisis.

As per the IMF projections, inflation in the advanced economies will decline from 3.5 per cent in 2008 to 0.3 per cent in 2009, before edging up to 0.8 per cent in 2010. For the emerging market and developing economies, the IMF projects the CPI inflation to subside from 9.2 per cent in 2008 to 5.8 per cent 2009, and to 5.0 per cent in 2010.

Global financial markets witnessed generally uncertain conditions since 2008. The turbulence that had erupted in the US sub-prime mortgage market in mid 2007 and gradually deepened towards early 2008, resulted in the inter-bank money markets failing to recover as liquidity demand remained elevated. Spreads between LIBOR rates and overnight index swap rates increased in all three major markets, viz., the US, the UK and the euro area. Central banks continued to work together and also individually to improve liquidity conditions in financial markets. Financial markets deteriorated substantially during the third quarter of 2008 (July-September). Bankruptcy/sell-out/ restructuring became more widespread spreading from mortgage lending institutions to systemically important financial institutions and further to commercial banks. The failure of banks and financial institutions also broadened geographically from the US to many European countries. As a result, funding pressures in the inter-bank money market persisted, equity markets weakened further and counterparty credit risk increased. Central banks continued to take action to enhance the effectiveness of their liquidity facilities. EMEs, which had been relatively resilient in the initial phase of the financial turbulence, witnessed an environment of tightened external funding condition, rising risk and till recently, high inflation led by elevated food and energy prices.

During the last quarter of 2008, short-term interest rates in advanced economies eased considerably, moving broadly in tandem with the policy rates and liquidity conditions. In the US, short-term interest rates continued to decline between October 2008 and December 2008 as a result of reduction in its policy rates and liquidity injections. In the UK, short-term interest rates which increased till September 2008, declined from October 2008 as a consequence of the cuts in the policy rate. Short-term interest rates which increased in the Euro area during the quarter ended September 2008, declined in October 2008 on account of reductions in its refinance rate. In the EMEs, short-term interest rates generally softened in countries such as China, India, Singapore, South Korea, Brazil and Thailand but firmed up in economies like Argentina and Philippines from October 2008.

1.4 India

The impressive performance of the Indian economy in recent years bears testimony to the benefits of the economic reforms undertaken since the early 1990s (Table 1.2). Real GDP growth had averaged 5.2 per cent during 1997-98 to 2002-03. Since 2003-04, there has been a strengthening of the growth momentum. Real GDP growth averaged 8.8 per cent during the five year period ended 2007-08,making it one of the world’s fastest growing economies. This is because of a number of factors, including the restructuring measures taken by Indian industry, the overall reduction in domestic interest rates, improved corporate profitability, a benign investment climate, strong global demand and a commitment to a rule based fiscal policy. In the very recent period, growth in Indian economy has seen some moderation on the back of the global financial meltdown. The recent Business Confidence Index (NCAER, October 2008), has fallen to a five-year low of 119.9 reflecting a dent in optimism because of current financial market volatility (Chart 1.2)¹. The index stood at 154 in January 2008 but has consistently deteriorated since then.

Unlike in East Asia, domestic demand has been the main driver of economic activity in India. The consumption to GDP ratio at nearly two-thirds is one of the highest in Asia. The

¹ The computation of BCI is based on two indicators each for overall economic environment and business performance. These include: (a) overall assessment of the economy over the next six months; (b) prevailing investment climate; (c) financial position of firms over the next six months; and (d) present rate of capacity utilisation. In essence, the index captures the prospective assessment of the business conditions and the economic environment by the business sector.

corporate sector has responded to increased global competition by improving productivity between 2003-04 to 2006-07. This, in turn, has improved corporate profitability and led to a pick-up in investment rates, from 22.8 per cent of GDP in 2001-02 to 35.9 per cent in 2006-07. The Wholesale Price Index (WPI) inflation was contained, averaging 5.1 per cent over 2000-01 to 2007-08, partly reflecting a very limited pass through of higher oil prices, administrative steps to dampen food price pressures and stable inflation expectations in view of pre-emptive policy measures. Higher food prices, however, have contributed to Consumer Price Index (CPI) inflation, which has hovered around 6 per cent. Mid-2008 also saw a significant increase in WPI resulting in a high rate of inflation touching almost 13 per cent in August 2008 which however has maintained a downward trend since September 2008. The administered price of petroleum products, which were revised upwards in June 2008, was the major driver of the high inflation rate. Prices of freely priced petroleum products had also increased and added to the inflationary pressure. There has however, been a very significant reduction in oil prices in recent months. The administered price of petroleum products have been reduced in January 2009.

In response to global hardening of interest rates and increased inflationary pressure till August 2008, the Reserve Bank had gradually raised policy rates. The reverse repo (borrowing) rate had risen to 6 per cent (since July 2006), while the repo (lending) rate had risen to 9 per cent. The Cash Reserve Ratio (CRR) for the banking system also was raised from 5.25 per cent in December 2006 to 9 per cent effective from August 30, 2008. In response to higher credit growth, the Reserve Bank tightened prudential norms, including increasing provisioning requirements and raising risk-weights in select sectors. Indicators on financial soundness, including stress tests of credit and interest rate risks, suggest that banks’ balance sheets and income remain healthy and robust.

However, consequent to the reversal of capital flows which have led to a liquidity shortage in the economy the Reserve Bank has reduced key ratios from October 2008, to facilitate flow of funds in the market. By January 2009 the CRR was reduced to 5.0 per cent, repo rate to 5.5 per cent and reverse repo rate to 4.0 per cent. The banks were also allowed to reduce SLR to 24 per cent (Table 1.3 & Chart 1.3).

Merchandise exports has been growing and becoming increasingly broad-based in terms of destinations and composition, reflecting India’s growing integration into the global economy. A striking feature of export growth has been the rapid growth in services exports, amounting to USD 87.7 billion in 2007-08. Merchandise exports and imports for quarter ended June 2008 stood at USD 43.7 billion and USD 75.2 billion respectively. Export to GDP ratio has more than doubled to 13.5 per cent in 2007-08 compared to less than 6 per cent in 1990-91. The growth in imports has also been rapid, with the import/GDP ratio being 21.2 per cent in 2007-08. Despite the widening trade deficit, the current account deficit has remained modest, due largely to high levels of private transfers, aggregating USD 42.6 billion in 2007-08 averaging 3.2 per cent of GDP during the last four years. India is the leading remittance receiving country in the world with relative stability of such inflows.

Strong capital inflows have been instrumental in financing the current account deficit. Capital flows (net) jumped from an average of around USD 9.4 billion (2 per cent of GDP) during 2000-03 to around USD 51.8 billion (5.3 per cent of GDP) during 2004-08. Capital flows (net) amounted to USD108.0 billion during 2007-08. In a reversal of a previously observed trend, foreign direct investment (FDI) has outpaced foreign portfolio investment (FPI), in 2008-09. FDI and FPI for the quarter ended June 2008 stood at USD 10 billion and USD (-)4 billion respectively. The positive investment climate, progressive liberalisation of the FDI policy regime, along with rising pace of mergers and acquisitions across diverse sectors, has boosted FDI flows. The reversal in trend in respect of portfolio capital inflows in 2008-09. however, has, impacted the capital market and the foreign exchange markets in India significantly.

Foreign exchange reserves rose to USD 309.7 billion at end March 2008. The increase in reserves has mainly been on account of an increase in foreign currency assets from USD 191.9 billion during end March 2007 to USD 299.2 billion as at end March 2008. However, in the past few months, the foreign exchange reserves, have shown a declining trend, mainly reflecting valuation changes and stood at USD 248.6 billion as on January 30, 2009.

The rupee, exhibiting two-way movements against the US dollar during 2007-08 remained in the broad range of Rs.39.26 -43.15 per US dollar (RBI Reference Rate). During 2007-08, the real effective exchange rate of the Indian rupee on 6-currency trade-weight based measure reflected an appreciation of 8.1 per cent on an annual average basis (Chart 1.4). The Reserve Bank intervened in the foreign exchange market to contain exchange rate volatility. Net market purchases by the Reserve Bank amounted to USD 78.2 billion during 2007-08 as against USD 26.8 billion in 2006-07. During 2008-09, the Indian rupee generally depreciated. During this period (till end-January 2009), the rupee moved in the range of Rs.39.89 - 50.52 per US dollar.

While financial markets in India have gained depth, liquidity and resilience on account of various measures initiated there has been increased volatility in the markets in 2008-09 – a fall out of the turbulence in the global financial markets which led to a reversal of capital flows.

The fiscal position of the Government since 2004-05 has been shaped by the rule based fiscal correction process. The Central Government has implemented the Fiscal Responsibility and Budget Management (FRBM) Act. Similar legislations have been enacted in 26 States. The improvement in the fiscal position was reflected in the decline in the key deficit indicators of the Central and State Governments in the budget estimates (BE) till 2007-08. During the fiscal year 2007-08 (April 2007-March 2008), the key deficit indicators of the Central Government, viz. the revenue deficit and gross fiscal deficit, were lower than those in the previous year. The continued increase in revenue receipts at a higher rate in relation to increase in expenditure had led to improvement in all the deficit indicators during 2007-08 compared to the previous year and 2007-08 (BE).

During the latter half of 2008-09, Government announced various fiscal stimulus measures for the Indian economy, in the backdrop of the global financial crisis. The FRBM targets for 2008-09 and for 2009-10 have been relaxed to provide a demand boost to the economy. This has resulted in revenue deficit for 2008-09 increasing from 1.0 per cent of GDP (BE) to 4.4 per cent of GDP (RE). Similarly, fiscal deficit increased from 2.5 per cent of GDP (BE) to 6.0 per cent of GDP (RE). The Government has announced that it will return to FRBM targets once the economy is restored to its recent trend growth path.

1.5 Potential Areas of Macroeconomic Vulnerability

Macroeconomic conditions in India, in general, improved significantly in the recent years with the economy witnessing a robust growth and inflation, but for some spikes in April-September 2008, remaining at a moderate level. The banking system has become quite resilient. The depth and width of the financial markets also improved. The payment and settlement system became robust and a major source of systemic risk was eliminated with the implementation of RTGS. There are, however, some downside risks to macroeconomic prospects.

1.5.1 Sustaining Growth

Sustaining the present rate of high growth, is a big challenge. Many institutions/ organisations have projected different rates of sustainable growth depending on the method and assumptions adopted. The 11th Plan approach paper had projected that India should achieve 9 per cent growth during the Plan period. The IMF has projected India’s growth would be 7.3 per cent for 2008 and 5.1 per cent for 2009.

The Indian economy has never grown at double-digit rates except in 1988-89 which was due to the base effect. Many views have been expressed on the sustainability of India’s current growth. There have been several instances in recent history when economies have grown at more than 9 per cent for many years. Japan grew at an annual average of 10.4 per cent between 1960 and 1970. China has grown at above 8 per cent in 14 out of the 19 years since 1987, and at double-digit rates in recent years. In view of positive features of the Indian economy, the Panel believes that though the growth rate will experience some moderation in the immediate future, a trend of eight per cent plus growth rate is sustainable over the medium-term. This is because;

(a) Growth is led by both investment and consumption demand: The changing composition of demand in recent times indicates support to the production capacity to sustain a higher growth rate. During 2007-08 investment and consumption expenditure contributed 39.0 per cent and 65.5 per cent of GDP respectively.

(b) Upbeat investment climate: The investment climate in the recent years has been very good. After a decline in 2002, investment activity picked up sharply in terms of Industrial Entrepreneurs Memoranda (IEM) submitted to the Secretariat for Industrial Assistance (SIA), Department of Industrial Policy and Promotion. Besides rising capacity utilisation, there has also been a substantial increase in investment proposals. While there has been a decline in the Business Confidence Index in the recent times, the investment climate from the medium and long term perspectives remain intact.

(c) Continued upturn in capital goods production: In the last couple of years, the capital goods sector has been expanding at double-digit rates. This also suggests the continuance of the already upbeat and buoyant investment climate. However, during the current year, so far, the capital goods sector has witnessed moderation which is expected to reverse with the reversal of the current phase in the global economy.

(d) Record rise in sales and profits in corporate sector: Since the last quarter of 2003, the Indian corporate sector has recorded a double-digit growth in sales in tune with the buoyant demand conditions prevailing in the economy. There has also been an improvement in corporate profitability. Gross profit to sales of corporates improved from 10.6 per cent during 1997/98 to 2002/03 to 12.7 per cent during 2003/04 to 2006/07. The ratio of profit- after- tax to sales during the same period also increased from 3.6 per cent to 8 per cent. This has translated into a decline in leverage for the corporate sector: the debt equity ratio declined from 67 per cent to 51.4 per cent during the aforementioned period. High internal accruals and lower levels of leverage have put the corporate sector in a good position to sustain growth through investment. However, there has been a moderation in profit in the recent years.

India’s high growth had been aided by the buoyant performance of both the manufacturing and the services sectors. However, there is moderation in growth during the current year on account of deceleration in manufacturing and electricity sectors. The services sector continues to record high growth during the first half of 2008-09 albeit some moderation. But, the performance of the agricultural sector is a concern.

While there is a clear need and justification for fiscal expansion to counter the current global and domestic economic downturn, India needs to return to its path of fiscal correction once the current crisis is over. Public debt needs to be brought down and fiscal discipline needs to be maintained to sustain the growth. Investment in social and infrastructure sectors need to be scaled up. The capital market has to be further developed and portfolio flows need to be prudently managed. Above all, institutional reforms have to be strengthened.

At the current juncture the deepening of financial crisis has impacted the macroeconomic outlook in advanced economies with second round effects across the rest of the world. Consequently monetary policy action against inflation in advanced and emerging economies alike appears to be getting increasingly circumscribed by the more overarching concerns relating to economy and financial system.

1.5.2 Reversing Slowdown in Agriculture

The performance of the agricultural sector is critical for sustaining economic growth. Although the share of agriculture has declined from over half of GDP in 1950s to less than a fifth of GDP by 2006-07, there has not been a concomitant decline in the share of population dependent on agriculture. Over half of the workforce is still dependent on it. As a result, fluctuations in rainfall are magnified through their impact on rural incomes and consumption, and the correlation between agricultural growth and overall GDP growth, has, in fact, strengthened over the reforms period (Table 1.4).

The slowdown in agriculture has been characterised by stagnation in the production of wheat, sugar and pulses. The actual production of foodgrains, on an average, was only 93 per cent of the targets during 2001-07. In the case of pulses and oilseeds, these ratios were much lower. Coupled with this has been another feature: the declining capital formation in agriculture. Gross capital formation (GCF) in agriculture as a proportion to total capital formation has shown a continuous decline, and the share of agriculture in total GCF has declined from 8.6 per cent in 1999-2000 to 5.8 per cent in 2006-07.

Agriculture in India is largely rain - fed. Around 40 per cent of the net - sown area is under irrigation, which leaves the major agricultural season (June-September) dependent on both the timely arrival and widespread dispersion of the South-West monsoon. The high correlation between agricultural growth and rainfall in India (about 0.7 over the period 2000-2007) illustrates the dependence of agricultural growth on rainfall. In the absence of proper irrigation, large parts of the country cannot take advantage of the second agricultural season (October-December).

In the present context, low growth in the agriculture sector could be a challenge for sustaining economic growth. The agriculture sector has to grow faster than its long-term average growth rate of 2.5 per cent. If it remains in distress, growth can neither be inclusive nor sustainable. The most critical problems are low yields and the inability of the farmers to exploit the advantages of the market. Clearly, the need of the hour is to modernise and diversify the agriculture sector by improving both the forward and backward linkages. These will include better credit delivery, investment in irrigation and rural infrastructure, improved cropping pattern and farming techniques, emphasis on diversification of agricultural activities such as horticulture and livestock and development of food processing industry and cold storage chains across the entire distribution system. The absence of reforms, especially creation of a single market, is also a major issue.

1.5.3 Fiscal Consolidation

Among the other critical challenges is the way forward on fiscal consolidation. High fiscal deficits can crowd out private investment. Depending on how they are financed, fiscal deficits can have an adverse impact through inflation, the interest rate and the exchange rate. Further, revenue and expenditure measures are needed to meet the revenue deficit target under FRBM, which require broadening the tax base, tightening control on state borrowings and improvement in efficiency in expenditure management. In 2008-09, the revenue deficit is budgeted to increase by Rs. 1,88,704 crores² as compared to 2007-08(RE) (Table 1.5). However, given the current pressures on the economy in terms of oil prices volatility, rising input costs, increase in current account deficit, coupled with the declared farm loan waivers, the Panel concluded that it would not be possible to contain the fiscal deficit at the budgetary levels for the year 2008-09. While the interim budget for 2009-10 has shown a stoppage, the Government has stated that it will return to FRBM target after the economy restores to its recent trend growth path.

1.5.4 Meeting the Infrastructure Deficit

Among the concerns the businesses in India face are infrastructure, where there are significant gaps. The Eleventh Plan has estimated that for accelerating the GDP growth at 9 per cent per annum during the Plan period, there is a need for accelerating the current level of investment in infrastructure at 5 per cent of GDP during 2006-07 to 9 per cent during the Plan period. Meeting this huge financing requirement appear to be challenging, given the governance structure, policy uncertainty and lack of stricter entry and exit norms prevalent in the country.

(a) Public-Private Partnerships

An investment of roughly USD 500 billion has been projected for physical infrastructure (comprising roads, power, telecom, railways, airports and ports). Of this, roughly USD 150 billion is to be funded by the private sector. The Government therefore has sought to foster a policy and procedural environment to actively

² 1 crore = 100 lakhs = 10 million = 0.01 billion

encourage public-private partnerships (PPP). It has established the India Infrastructure Finance Company Limited (IIFCL) to provide long tenor debt to infrastructure projects and for launching of a scheme for financial support to PPPs in infrastructure. Steps have also been initiated to use foreign exchange reserves for building infrastructure. IIFCL has set up an offshore Special Purpose Vehicle (SPV) entity called IIFC (UK) Ltd. in London to utilise part of foreign exchange reserves for infrastructure development. Reserve Bank has given “in principle” approval to invest upto USD 5 billion in the securities of the SPV and these would be guaranteed by the Government. Additional efforts such as strong and independent sector regulators will reduce regulatory uncertainties for investors. Developing the domestic bond market will facilitate infrastructure finance. The Government has reported giving in-principle approval to 54 Central sector infrastructure projects at a cost of Rs.67,700 crore and approving 23 projects amounting to Rs.27,900 crore for viability gap funding in 2008-09.

The projections for infrastructure finance need to be viewed with a measure of scepticism. Past record suggests that there is tendency to overstate these requirements – in the1990’s, the requirement of FDI in infrastructure was estimated at USD 150 billion, without which any acceleration in growth was thought difficult. Only a small fraction of this figure materialised but that did not keep the Indian economy from sprinting ahead in recent years.

It is well-recognised that financing of infrastructure projects is a specialised activity and would continue to be of critical importance in the period ahead. All over the world, infrastructure services have generally been provided by the public sector for a large part of the twentieth century as most of these services have a significant component of public goods in them. It is only of late that private financing of infrastructure has made some headway.

This trend is not without its echo in India where financing infrastructure was till recently a Government activity. However, there has been a paradigm shift in infrastructure funding from the Government to the private sector due mainly to budgetary constraints in making available funds to meet the burgeoning financing requirements. In addition, the emphasis on allocation of budgetary resources to social sectors has also engendered this shift. As a result, the emphasis has shifted towards PPPs and increasingly, it is perceived that commercial entities such as banks could play an important role in this respect. Although the argument is not without its merits, there are significant challenges for the banking sector in funding the growing infrastructure need (Box 1.2). The Government has recently announced that IIFCL will refinance 60 per cent of commercial bank loans for PPP projects in critical sector for which it has been authorised to raise Rs.10,000 crore by March 2009 as well as an additional Rs.30,000 crore if required

(b) Funding

The Planning Commission has estimated the total investments in the infrastructure sector to be to the tune of Rs. 20,56,150 crore during the plan period. While the public sector, including the public corporate sector, would continue to play a dominant role in investment for infrastructure, investment by the private sector, which includes PPP projects, is envisaged at 30 per cent of the total investment, i.e. around Rs. 6,20,000 crore. Of the total requirement the debt financing needs for infrastructure investment during the Eleventh Five-Year Plan is estimated to be Rs. 9,88,035 crore at constant prices. In other words, more than Rs. 2,00,000 crore a year on average would be required at current prices. However, the availability of debt financing for infrastructure during the Eleventh Plan is estimated at Rs. 8,25,539 crore which implies that there is a funding gap of Rs. 1,62,496 crore for the debt component. The required investment in infrastructure would, therefore, be possible only if there is a substantial expansion in internal generation and extra-budgetary resources of the public sector, in addition to a significant rise in private investment.

Box 1.2 : Challenges of Banking Sector in Funding Infrastructure Needs

Infrastructure projects are characterised by large capital costs and long gestation periods. The assets of these projects are not readily transferable and the services provided are typically non-tradable in nature. In addition, these projects are also susceptible to various market and other non-measured risks. In addition, the nature of financing of these projects necessitates exhaustive due diligence process on the part of funding agencies to ascertain that the project cash flows are adequate to cover the debt service obligations. Therefore, proper risk assessment and adequate risk mitigation mechanisms comprise a sine qua non of the process. The complexity of the transaction and large funding requirements necessitates an innovative approach towards financial structuring and the use of an array of financial instruments.

In India, such financing was earlier undertaken by specialised term-lending institutions. Commercial banks rarely undertook equity positions in projects. Infrastructure financing requires the commitment of long-term funds, both as equity and long-term debt. In the past, since the infrastructure sector was predominantly catered to by public investment, the need for developing appropriate financing mechanisms was not acute. As a result, the financial sector was biased towards short and medium-term debt.

A key question is whether the Indian financial system is equipped to intermediate the huge financial resources that are required for investment in infrastructure. Commercial bank lending to infrastructure has expanded very rapidly over the last few years and has become by far the largest source. It now faces serious constraints as banks’ balance sheets have a growing concentration of risks which they have not been able to transfer. There are issues of ALM mismatch as the maturity of banks’ assets has become longer term while their liabilities have become shorter. Banks will also reach exposure limits to large developers. Moreover, the tenor of the loans is not very long (about half of the concession period of a typical infrastructure project) with a short re-set period. All this points to the need for more diversified sources of long-term finance for infrastructure, including tapping contractual savings. The key lies in the rapid but orderly growth of the corporate bond market.

Being seized of these concerns, the policymakers have made appropriate relaxations for bank lending to infrastructure projects in regard to their exposure and other related norms. The effect of these measures has been an improvement in the credit flow to infrastructure (comprising power, telecom, roads and ports) from less than 3 per cent in 2001 to nearly 8 per cent in 2007.

Over the longer-term, the development of a secondary debt market assumes importance. Of the two major segments, the government debt and the corporate bond market, while the former has exhibited substantial progress, developments in the latter have been less than satisfactory (Chapter IV). The actions required for this purpose are in several areas including, legal, technological, regulatory, risk management etc. Other possible sources of finance could be long-term fund providers such as pension, provident and insurance funds, that have the advantage of providing a better maturity match for infrastructure financing. In addition, steps could be undertaken to actively promote cash-flow based securitisation, subject to prudential safeguards. By facilitating unbundling, better allocation and management of project risks, this could enlarge the market by attracting new players. This needs to be supplemented with a well-defined regulatory framework. Such a framework must provide for transparency, clarity of obligations between participants in the infrastructure projects and reduce the layering of approvals to bring about a greater degree of certainty in obtaining them within a definite time frame.

This is even more of a challenge given the constraints to growth in each of the sources of debt finance. Commercial bank lending to infrastructure has expanded very rapidly over the last few years and has become by far the largest source. Banks’ balance sheets thus have a growing concentration of risk which they have not been able to transfer. There are asset-liability mismatches because the maturity of banks’ assets has become longer term while their liabilities have become shorter. NBFCs’ lending will also be constrained because their cost of funding is higher. External commercial borrowing, till recently had been reined in due to concerns regarding the monetary expansion effects of capital inflows. The infrastructure sector is particularly hard hit as it has a high domestic expenditure component. And finally, insurance companies are limited by their investment guidelines. Also, the public sector insurance companies tend to be risk- averse, which is manifested in their high investments in government securities and less than mandated in infrastructure and that too mostly in public infrastructure companies.

This points to the urgency for getting additional sources of debt financing for infrastructure investment and private participation/financing. This would require a shift from the bank dominated financing system to a capital-market oriented system for financing infrastructure and housing projects. This calls for pension reforms and allowing pension and insurance companies to invest more in long-term corporate debt. The Panel underscores the need for a deep and liquid corporate bond market for infrastructure finance and for reducing the concentration of risks that are building in the banking system.

1.5.5 Governance Issues

As Table 1.6 demonstrates, governance issues and regulations are among the leading deterrents for doing business in India, leading to a ranking of 120 (out of 178 countries) in the World Bank’s Ease of Doing Business 2008 publication. Starting a business in India is significantly time-consuming. Compared to their counterparts in the OECD countries, India’s entrepreneurs need to follow twice as many procedures, face about thrice the time delay, and close to fifteen times the cost as a proportion of per capita income. In the area of credit availability, India lags behind not because of creditor rights (which are virtually on par with OECD standards), but because of lack of credit information available from public registries and from private bureaus. Pendency is also an issue in this context. The contract enforcement procedure is deficient as the number of procedures that must be followed and the resulting time delays are about more than three times that of OECD countries and the costs of contract enforcement are over twice as high. Closing a business takes 10 years with a recovery rate of around 11 per cent, one of the worst among countries.

1.5.6 Demographic Dividend

It has been argued that as more and more people join the workforce in India, this will entail greater savings, as it did in other countries in East Asia that developed rapidly. By 2025, the proportion of working age population (15-59 years), which was roughly 657 million in 2005 increases to 907 million (Chart 1.5). While this will help in sustaining productivity-led growth, there is a need for rapid job creation in the manufacturing sector, particularly in the hinterland states and coastal areas.

The employment elasticity of growth, however, has not been significant. According to the Economic Survey 2007-08, employment elasticity of output has declined from 0.41 over the period 1983 to 1993-94 to 0.15 over 1993-94 to 1999-2000. However, during 1999-2000 to 2004-05, it has increased to 0.48 (Rangarajan et al, Money and Finance, ICRA Bulletin September 2007), with wide divergences across states. The growth rate of employment in the organised sector has declined over the period 1994-2005 to (–0.31) per cent from 1.2 per cent in the previous ten year period. An overwhelming majority of the labour force continues to work in agriculture. The challenge is to create jobs on a scale needed to successfully absorb excess agricultural labour.

India will have the benefit of having a relatively young population for a considerable period of time in comparison to other emerging and even developed countries (Chart 1.6). But it has to create jobs to take advantage of this. Education and skills are a serious concern. The evidence provides limited room for comfort. Although the gross enrolment ratio (GER), which shows the total enrolment in secondary stage (class IX to XII) as percentage of total population

in the relevant age group, has improved from 19.3 in 1990-91 to 39.9 in 2004-05, in the secondary (class IX to X i.e., 14-16 years) stage, the all-India figure is 51.7; and as many as 9 (out of 18 states covered) are below this average. At the post-secondary stage the GER for (class XI to XII i.e., 16-18 years) is 27.8 at the all-India level and 8 states are below this number. On the supply side, merely 18 per cent of primary schools have four or more teachers. Industry too has a role in better utilising human resources by investing more in training. IT firms have set an example that other sectors might profitably emulate.

1.5.7 Oil Prices

As India is primarily an oil importing country, oil prices are a critical element in the sustainability of the growth and, in some ways the maintenance of financial stability. The increase in crude oil prices in the international markets adversely affects the oil importing countries in terms of output loss, inflationary spirals and adverse balance of payments. The increasing cost of production resulting in adverse terms of trade erodes international competitiveness. It also tends to deteriorate the fiscal balance if the Government absorbs the rise in international oil prices and if the pass-through to domestic consumers is staggered and incomplete. The end result in most of the episodes of oil shock has been a significant loss of output in the short run and general level of welfare in the long run. A recent analysis estimates that a supply-induced doubling of prices would raise inflation rate in emerging Asia by as much as 1.4 percentage points above the baseline (BIS, 2007).

Central banks have to manage the dilemma of the growth-inflation trade-off more acutely during episodes of oil price increase. However, recent history suggests that there has been greater success for central banks in stemming inflationary pressures arising out of oil shocks. This is in contrast to the 1970s and the early 1980s which witnessed severe wage-price spirals and a consequent impact on growth on account of monetary tightening.

Crude Oil Price – Recent Trends

The renewed hardening of international crude prices from an average level of USD 57 per barrel at end 2005 to an average level of USD 73 per barrel by July 2006 resulted in an increase of 6-9 per cent in domestic administered prices of petrol and diesel. Subsequently, in response to easing in international oil prices, domestic petrol and diesel prices were cut twice during November 2006 and February 2007. Thereafter, international crude oil prices rose sharply to reach a historical high of USD 145.3 per barrel by early July 2008, reflecting a tight supply-demand balance, geo-political tensions, supply disruptions in Nigeria, a weakening of the US dollar against major currencies and increased interest from investors and financial market participants-(Chart 1.7). Subsequently, crude oil prices eased, reflecting decline in demand in OECD countries and improved near-term supply prospects in non-OPEC countries. The WTI crude price was hovering at around USD 62 per barrel level at end October 2008. This has declined further in recent times and is around USD 40 per barrel currently.

In India, inflation based on year-on-year variations in the wholesale price index (WPI) increased to 7.7 per cent in 2007-08. A year ago it was 5.9 per cent. There was an increase in the prices of all the three major groups, namely primary articles, fuel and manufactured products. Inflation increased further to 12.9 per cent by August 2, 2008 reflecting pass-through of international crude oil prices to domestic prices (domestic prices of petrol and diesel were raised twice during February and June 2008) as well as elevated levels of prices of iron and steel, basic heavy inorganic chemicals, machinery and machinery tools, oilseeds, sugar, raw cotton and textiles on account of strong demand as well as international commodity price pressures. Subsequently, inflation eased to 10.7 per cent by October 25, 2008 reflecting decline in prices of freely priced petroleum products (in the range of 15-22 per cent) in line with decline in international crude oil prices (by 45 per cent since July 2008) as well as easing in other commodity prices such as oilseeds/edible oils/ oil cakes, raw cotton and cotton textiles following global trends. The inflation, continuing its downward trend, stood at 4.4 per cent as on January 31, 2009 along with the decline in petroleum prices.

1.5.8 Food Prices

Another major concern both domestically and globally has been the sharp rise in food prices. While the global food price index rose on an average by 10.5 per cent in calendar year 2006 and by 15.2 per cent in 2007, it has increased substantially by around 42 per cent in the first half of 2008 compared to the corresponding period of the previous year. According to the Food and Agriculture Organisation (FAO), 37 countries in the world are facing food crisis, 31 of which are in Africa and Asia. This increase in food prices has been on account of various factors such as higher global demand, lower stocks and production and diversion of food grains for bio-fuel production and speculation. The anaemic global growth has resulted in a marked decline in food prices since October 2008, resulting in the easing of inflationary pressures.

However, the increase in food prices in India had during the first half of 2008-09 been only a fraction of that observed in many other countries. In particular, the global prices of wheat and rice almost doubled between January and April 2008, while in India the increase has been far less than a tenth of that. This reflects the long-standing public policy emphasis on food security. Even so, the rise in food prices is a cause for worry. The average annual increase in the Wholesale Price Index (WPI) of food articles was around 7 per cent during 2006 and 2007. It was led by wheat (13 per cent) during 2006, rice (6 per cent) and edible oil (13.1 per cent) and pulses (3.21 per cent)in 2007. However, food price inflation has witnessed increase in 2008. The Wholesale Price Index of food articles up to October 18, 2008 had increased by around 6.5 per cent compared to the 4.6 per cent in the previous year.

As regards prospects for the near future, public policies in regard to food, especially diversion to bio-fuel, cross border trading, subsidies, and replenishment or use of buffer stocks would impact the evolution of prices globally. However, the redeeming feature is that supply response in regard to food grains is possible in a year or two. As per FAO estimates, wheat output is set to achieve a new record in 2008, though against the backdrop of deeply depleted stocks. Global production of rice in 2008 is expected to be only marginally better than the previous year and hence, some depletion of stocks held may be expected. The global output of edible oil is anticipated to fall by about 3 per cent in the current year and, according to FAO, oil seeds and edible oil prices are expected to remain firm.

As regards India, the abatement of global prices, indications of better domestic supplies and addition to buffer stocks, along with the series of measures already taken by the Government on the supply side are expected to yield results in the months to come. Over the medium-term, however, the National Food Security Mission launched about two years ago should yield positive results.

1.5.9 Managing the Impact of Capital Inflows

Foreign investment flows into India, comprising foreign direct investment (FDI) and foreign portfolio investment (FPI), have risen sharply during the 1990s reflecting the policies to attract non-debt creating flows. Foreign investment flows (net) have increased from negligible levels during 1980s to reach USD 45 billion by 2007-08. As a proportion of FDI flows to developing countries, the FDI flows to India have shown a consistent rise from 2.2 per cent in 2000 to 4.3 per cent in 2007. The share of net FPI flows to India as a proportion of total flows to developing countries remained in the range of 9-25 per cent during 2004 and 2007. Both direct and portfolio investment flows maintained the pace during 2007-08. Foreign direct investment flows into India were 52.1 per cent higher during 2007-08 on the back of positive investment climate, improved growth prospects and initiatives aimed at liberalising the FDI policy and simplifying the procedures.

Portfolio equity flows during 2007-08, were led mainly by steady inflows from foreign institutional investors (FIIs) and ADRs/GDRs. The number of FIIs registered with the SEBI increased from 997 by end March 2007 to 1319 by end March 2008 and 1541 by end June, 2008. Inflows on account of Foreign Institutional Investors (FIIs) increased to USD 20.3 billion during 2007-08 from USD 3.2 billion during 2006-07. Capital inflows through the issuances of American depository receipts (ADRs) / global depository receipts (GDRs) were also substantially higher (USD 8.8 billion) as booming stock markets during the period offered corporates the opportunity to issue equities abroad.

Gross inward FDI inflows increased to USD 34.9 billion in 2007-08 from USD 23.0 billion in the previous year. The classification of flows under FDI includes sizeable investments from private equity funds and venture capital funds. On the one hand, figures for FDI do not provide adequate information on technology transfer, and linkages with the parent firms are relatively absent. Private equity and venture capital may bring in capital and, to a lesser extent, improved management. But private equity and venture capital also have lower time horizons than classical firm FDI and hence constitute less stable flows.

In 2008-09 however there has been a reversal of capital flows. In the current financial year, net FII outflows have been to the tune of USD 11.9 billion (up to January 9, 2009). There has also been a concomitant depreciation in USD/Rupee exchange rate and a decline in stock market indices. The Reserve Bank’s intervention to ensure stable conditions in foreign exchange market had resulted in some liquidity shortage which had to be tackled through expansionary monetary and accommodating fiscal initiatives. Management of foreign exchange movements could change course due to any abrupt changes in sentiments or global liquidity conditions. Strategic management of the capital account warrants preparedness for all situations.

The benefits of capital account liberalisation are well known. In India there is a broad consensus that it is desirable but should be gradual, well sequenced and undertaken in conjunction with several other measures at the micro and macro level. While the Panel supports a general policy stance that encourages more capital account flows, liberalisation could be used strategically to help the evolution of the financial markets in alignment with concomitant improvements in macro-economic management. Among the more important of these are fiscal consolidations, further strengthening the banking system, diversifying financial intermediation through both banks and non-banks, and developing as well as regulating financial markets in a sound manner.

1.6 Institutional and Financial Market Environment

The financial system in India comprising financial institutions, markets, instruments and services is characterised by two major segments – a growing organised sector and a traditional informal sector. Financial intermediation in the organised sector is conducted by a large number of financial institutions (banking and non-banking) like commercial banks, cooperative banks, regional rural banks and development banks. Non-banking financial institutions include finance and leasing companies and other institutions like the insurance companies, mutual funds, provident funds, post office banks etc.

The financial sector was heavily regulated till the early 1990s. But since then it has become market-oriented and opened up to private players. The reforms have aimed at enhancing productivity and efficiency of the financial sector, improving the transparency of operations, and ensuring that it is resilient and capable of withstanding stress due to domestic or external shocks. Interest rates have been gradually and mostly liberalised. Financial savings have grown steadily in line with liberalisation of the financial sector, reflecting high domestic savings (34.8 per cent of GDP in 2006-07 as per Economic Survey 2007-08).

The predominance of Government ownership of banks, combined with continued directed credit allocations and administered interest rates in certain segments, while auguring well for financial stability and fulfilment of social targets, could constrain the manoeuvrability of operations. The requirements in the form of SLR and CRR also pre-empt a significant part of resources, besides constraining the free pricing of assets. Competition in the banking sector has nevertheless improved due to the emergence of private players and greater private shareholding in public sector banks. The insurance sector has also been opened up to private competition. The regulatory and supervisory apparatus has been restructured, strengthened and augmented with the formation of new regulatory authorities. The size of the capital market has significantly expanded in recent years in terms of market capitalisation and the number and assets under management of mutual funds. Financial markets, in general have thus acquired greater depth and vibrancy.

1.6.1 Financial Institutions

Table 1.7 presents the broad structure of the Indian financial system in terms of number and assets base of financial institutions. As some

financial assets (equities, bonds) are held by private individuals and non-financial corporates, they have not been made a part of Table 1.7. Post office deposits have also not been included. Therefore the total assets of financial institutions may not fully reflect the total size of the financial system as a whole.

Banks are the most important of the financial intermediaries, accounting for nearly 67 per cent of total assets and commercial banks dominate the sector, comprising around three-fifths of the financial system assets. New private and foreign banks, whose activities were limited until the onset of reforms, represent a rising share of the sector, promoting new financial products with strong technological backup. The share of some other segments, particularly the development finance institutions, has gradually declined as a result of restructuring and rationalisation. Some major institutions have since amalgamated themselves into commercial banks.

A large network of regional rural banks (RRBs) and co-operative banks (rural and urban) serves small borrowers, primarily in rural and semi-urban areas as also smaller towns. RRBs were established under an Act of Parliament to improve credit delivery in rural areas with the Central Government, State Governments and sponsor public sector banks all taking holdings in them. Subsequent to the restructuring process in RRBs, their numbers have dwindled and stood at 90 at end March 2008 down from 196 at end March 1991. Co-operative banks cater to the credit needs of specific communities or groups of people in a region and comprise both rural and urban entities.

Development finance institutions at the national level are mostly government owned and have been the traditional providers of long-term project loans. Accounting for approximately 2.4 per cent of total assets, these institutions raise funds in the capital markets and through retail sales of savings instruments. Over the past few years, these institutions have been gradually rationalised, two of them having been amalgamated into banks. Some others have become NBFCs.

Of the state level institutions, the State Financial Corporations registered under the State Financial Corporations Act, 1951 purvey credit to industries/sectors in different states and account for about 0.2 per cent of total assets³.

Insurance sector has been open to private participation since 2000, though public sector insurance institutions dominate, both in the life as well as non-life segment. The insurance institutions account for roughly 14 per cent of sectoral assets, with the share of private insurance companies, currently 1.7 per cent of financial sector assets, gradually increasing. The share of other institutions of about 0.3 per cent is from the Deposit Insurance and Credit Guarantee Corporation (DICGC), a wholly owned subsidiary of the Reserve Bank providing insurance for depositors of commercial and co­operative banks.

NBFCs provide a wide range of services and account for roughly 9.1 per cent of financial sector assets. Deposit taking NBFCs witnessed a rapid growth in the mid 1990s, but consequent to the introduction of new norms for their registration and functioning, their growth has slowed down. The NBFC (non deposit taking) segment has emerged as the dominant component of the NBFC segment in recent times. While NBFCs offer some bank like services, many of them do not have the benefit of low cost deposit funds. Since regulatory and prudential norms differ between the banking and NBFC sectors and the flexibility and range of activities that NBFCs could undertake, the NBFC structure could have some advantages over banks, resulting in them being used, inter alia, by banks as a delivery vehicle for arbitrage opportunities.

Primary Dealers (PDs) are active players in the government securities market. There are nine PDs accounting for roughly 0.1 per cent of assets.

With the development of the securities market, the activities of the mutual funds are on the rise. As at end March 2008, there were 101 mutual funds accounting for 7.2 per cent of the assets of the financial institutions.

1.6.2 Financial Markets

India’s financial markets were relatively underdeveloped and dormant till the mid 1980s because of tight regulation and administrative restrictions. Financial sector reforms, introduced as part of overall economic reforms in the early 1990s, have brought about a sea change in the functioning of these markets. Reforms have encompassed all segments – money, credit, government securities, foreign exchange, equity and to a lesser extent, the corporate debt market. The emphasis has been on deregulation and liberalisation, strengthening transparency and price discovery, easing of restrictions on flow of transactions, lowering transactions costs and enhancing liquidity.

While deregulation, globalisation and liberalisation have engendered several benefits, they also pose several risks to financial stability. Financial markets are often governed by herd behaviour and excessive competition. In recognition of the possible destabilising factors, India has been following a gradualist approach in liberalising its financial markets with appropriate prudential safeguards being put in place that take into account the impact of reforms across institutions and markets. Excessive fluctuations and volatility in financial markets can mask the underlying value and give rise to confusing signals, hindering efficient price discovery. Accordingly, policy efforts have also aimed at ensuring orderly conditions in financial markets. Enhancing competitive efficiency, while at the same time avoiding instability in the system, has been a continuous challenge in implementing liberalisation measures.

In this context, it is useful to understand the increase in the secondary market activities of various segments of the financial markets in India (Table 1.8). With the transformation of the call money market into a pure inter-bank market, the turnover has declined significantly and money market activity has migrated to other overnight collateralised market segments such as market repo and collateralised borrowing and lending obligations (CBLO). The turnover in the term money market segment, however, continues to remain low.

Measures undertaken to develop the government securities market since the early 1990s have contributed to a significant growth in the market. The continuous improvement in market infrastructure has also resulted in