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