7.1 1998-99 proved to be a year of testing challenges to policy making in the face of a variety of domestic and international uncertainties. A number of policy initiatives were necessary to optimise gains emanating from the structural transformation of the economy as a whole and of the financial sector in particular. On the whole, despite some strains, the economy performed reasonably well with an overall growth of 6.0 per cent. The rate of inflation, on a point to point basis, was 4.8 per cent. The position in respect of the overall balance of payments outcome was also satisfactory with foreign exchange reserves reaching a record level of US $ 32,490 million.

Agriculture

7.2 Agricultural sector posted an impressive growth in 1998-99, but a large part of this outcome reflected the fact that in the preceding year, the growth was negative. Foodgrains production crossed the 200 million tonne mark for the first time in Indian economic history.

7.3 The turnaround in agriculture in 1998-99 should, however, be seen in a longer term perspective. The annual average rate of growth in agricultural production in the 'nineties so far has been low at only 2.6 per cent as compared with 5.2 per cent in the 'eighties. The decade of the 'nineties was also characterised by a larger volatility in year to year fluctuations in output, as measured by coefficient of variation, than the preceding decade. A further source of concern is that success in the sector is confined to a few crops, and that potentially high production areas have lagged behind in enhancing farm output. It also appears that the impact of seed technology in the cereal segment has reached a plateau. The losses of crops waiting to be marketed and the losses due to inappropriate handling and storage of grains are estimated to be large. Though total investment in agriculture has been showing a positive trend, public investment in the agricultural sector has been showing a downward trend. On the positive side, the terms of trade have been generally favourable to agriculture in recent years.

7.4 The buffer stocks of foodgrains stood at a high level of around 33 million tonnes at end-June 1999, higher than the 29 million tonnes a year ago. At these levels, stocks are considerably higher than the stated norms from the point of view of food security. The build-up of buffer stocks has been facilitated by the minimum support price mechanism under which the minimum support prices (MSP) are often set higher than the prices recommended by the Commission on Agricultural Costs and Prices (CACP). Apart from the implication that such price setting has for the persistence of high cereal prices even in years of high production, it adds to the storage and maintenance costs in the presence of limited domestic offtake and limited opening up of agriculture for export. Besides, a very high level of stocks poses problems of safe storage. They also impose high fiscal costs, in the form of high food subsidies. There is, therefore, a need for a review of the actual prices being fixed under the MSP mechanism and for strengthening of the distribution arrangements with a view to alleviating the incidence of poverty to the extent possible. Moreover, storage infrastructure needs to be modernised in order to minimise the losses entailed in the existing stocking facilities.

7.5 Notwithstanding the reasonably good agricultural performance during 1998-99, prices of primary articles (and food articles in particular) increased significantly. At the wholesale market segment, the increase in average prices of cereals, pulses, fruits and vegetables, milk and milk products and eggs, fish and meat was generally higher in 1998-99 than in 1997-98. This phenomenon underscored the need for improving the supply and availability position of not only foodgrains but also other products such as fruits and vegetables, milk and milk products and eggs and fish. This aspect needs to be given full consideration in development policy, since it has implications for nutritional content in food intake and productivity.

7.6 Given the trend rate of growth in population and the need for improving the nutritional levels, there is the imperative of raising agricultural productivity through adoption of technologies suited to Indian climatic and soil conditions and through institutional mechanisms that integrate production, credit, marketing and distribution. Research and development, as much as measures for increased irrigation facilities and systems, improved soil conservation, farm mechanisation and extension services would need to be given top priority in agricultural development. The pro-active role of the State in providing forward momentum to these aspects may have to be strengthened.

Industry

7.7 The performance of the industrial sector in 1998-99, as reflected in the movement of the index of industrial production (IIP), was unsatisfactory, as compared to that in the preceding four years. A number of reasons are believed to have contributed to this outcome, viz., the low demand for certain industrial products partly due to decline in agricultural production in 1997-98, the reduction in the Central plan outlay, the sharp build-up of excess capacity in some industries, the continued deceleration in industrial commodity prices, the subdued capital market conditions and international uncertainties. In addition, import liberalisation and overall slack in aggregate demand imply the need to persevere with restructuring of the Indian industry in response to the challenges being posed by the compulsions to be internationally competitive. The restructuring is largely reflected in the growing number of mergers and acquisitions, the diversification of industrial units, the increase in technical collaborations and greater professionalism in corporate managements. It is expected that this will gain in momentum as competitive pressures in the real sector take place, and as manufacturing units take initiatives to intensify research and development (R&D) efforts. Further improvements in productivity will lead to effective cost reductions and increased profitability. Such a process will receive impetus with strengthening of aggregate demand stemming from sustained improvement in the rate of growth.

7.8 In the first quarter of the current year, there has been some turnaround with the IIP registering an increase of 5.6 per cent as compared with 4.5 per cent in the corresponding period of 1998-99. This outcome is mainly due to the upsurge in manufacturing sector production (6.5 per cent as compared with 4.2 per cent in April-June of 1998). In particular, the capital goods sector has posted impressive gains although the base is still narrow. It should be possible to sustain the present momentum in the remaining months of the year, given the lagged effects of the increase in agricultural income during 1998-99.

Services Sector

7.9 A notable feature of the dynamics of structural transformation of the economy in recent years has been the rising contribution of the services sector which includes substantial value-added and skill-intensive services, such as software, to the overall output in the economy. It is important to note that the growth of the services sector has imparted much of the resilience to the overall growth of the economy, particularly in times of adverse agricultural shocks and industrial slowdown. But more importantly, the sector has emerged as the fastest expanding sector, with implications for productivity, employment, trade and fiscal prospects of the economy. Between 1990-91 and 1998-99, the share of services (inclusive of construction) in real GDP increased from 43.7 per cent to 51.2 per cent. The contribution of growth of the services sector to the overall growth of GDP has also increased significantly from 47.5 per cent in 1990-91 to 49.8 per cent in 1998-99. The bulk of the increase in shares has taken place in trade, communications and banking and insurance segments. There are areas where there has been a spurt of technical progress and also increased competition, mainly induced by economic reforms. On the other hand, there are other areas like construction, hotels and railways where the shares have moved up in fractional terms.

7.10 The recent trends in the services sector point to several implications. First, a relatively high growth of the services sector would be generally suggestive of gains in productivity in agricultural and industrial sectors, induced by technological progress and other innovations, which result in moving employment away from the non-services sector to the services producing sector. It also indicates a shift of real expenditure from manufacturing to value-added services, which is generally associated with the process of economic development. Secondly, while the rising share of the services sector in GDP is an encouraging sign of greater degree of diversification of the Indian economy, a corresponding decline in the share of industry and agriculture implies that the overall productivity gains in the economy will depend increasingly on what happens in the services sector. A large part of the services output continues to be non-tradeable in nature. This alongwith the shift of employment would point to the need for policy initiatives towards introducing greater competition and efficiency in the services sector for ensuring its sustained contribution to high long-term growth. Thirdly, the relative prices of the services sector have been moving at a faster pace than those of the industrial sector. The implicit GDP deflator for services moved up by 2.9 times during 1980-81 to 1992-93 and further by 1.4 times during 1993-94 to 1997-98 as compared to that of 2.6 times and 1.3 times, respectively, for the industrial sector. The contribution of the services sector to the overall inflation rate (measured by variation in GDP deflator), therefore, has been higher than the industrial sector. Finally, the growth of the services sector has long-run fiscal implications to the extent that this constitutes a potential tax-base for the government. Under the present tax regime, the services sector is generally under-taxed as it is not effectively brought under the tax base. A rising share of services in the GDP could result in lower growth of revenue to the government unless the indirect tax system is integrated under a single tax system such as the value added tax.

Aggregate Demand

7.11 The growth scene during 1998-99 was dominated by the performance of the agricultural sector, the deceleration in the industrial activity and the continued deterioration in net external demand. The aggregate demand situation in the economy would need to be seen from the viewpoint of autonomous, exogenous and policy induced components, broadly conforming to private, net external and government demand.

7.12 The overall private sector demand after keeping a steady upward trend up to the middle of 'nineties has decelerated since 1996-97, much of it due to private consumption expenditure. The contraction in the share of private consumption expenditure in GDP has emanated from non-durable consumption which declined from 61.7 per cent of GDP in 1994-95 to 59.7 per cent in 1997-98 whereas the durable consumption has maintained its share in the GDP at around 1.5 per cent during this period. Fixed investment of the private sector in terms of machinery and equipment and construction, has also shown evidence of tapering off; it picked up from 12.9 per cent of GDP in 1994-95 to 16.6 per cent in 1996-97 and then fell to 16.1 per cent in 1997-98. Inventory accumulation which has gone down from 1.5 per cent in 1994-95 to (-)0.2 per cent in 1996-97, increased to 0.4 per cent in 1997-98. The decline in private consumption and investment rates in 1997-98 also coincided with a negative demand shock from the external sector. The net external demand deteriorated from (-)0.3 per cent of GDP in 1994-95 to (-)1.1 per cent in 1996-97 and further to (-)1.3 per cent in 1997-98. The only offsetting factor to the demand deceleration has been the government sector consumption demand, which after falling marginally from 10.3 per cent of GDP in 1994-95 to 10.2 per cent in 1996-97, moved up to 11.1 per cent in 1997-98. The rate of fixed investment demand of the public sector, on the other hand, showed a sharp contraction from 8.6 per cent of GDP in 1994-95 to 6.6 per cent in 1996-97, but moved up to 6.8 per cent in 1997-98. These trends indicate that the government sector demand offset some part of the slack in private and external demand. A part of the increase in fiscal deficit was due to the decline in the tax revenue in response to the slowdown in industrial activity and import growth, and a noticeable expansion of policy induced government expenditure.

Fiscal Policy

7.13 The provisional accounts of gross fiscal deficit (GFD) of the Central Government at Rs.1,12,280 crore in 1998-99 amounted to 6.3 per cent of GDP as against 5.7 per cent in 1997-98 while the consolidated GFD of State Governments (26 States) touched a high of 4.3 per cent as against 2.8 per cent in 1997-98. The combined GFD of both the Centre (provisional accounts) and States after netting inter-Governmental transactions, amounted to 8.9 per cent of GDP in 1998-99, which is significantly higher than 7.1 per cent in 1997-98. The large salary and pension bills that the State Governments had to bear in 1998-99, accounted for about 1.1 per cent of GDP.

7.14 Three characteristics of the 1998-99 fiscal developments need to be noted for their implications for fiscal evolution in future. First, the combined gross fiscal deficit of the Centre and States was one of the highest in the decade. Secondly, the GFD-GDP ratio of State Governments was the highest recorded in the Indian fiscal history so far. Thirdly, the revenue deficit of both the Centre and States has been very high, placing enormous burden on the capital account of the budgets. The revenue deficit in 1998-99 amounted to Rs.1,01,012 crore, up by about 61 per cent over the position in 1997-98. Such a high order of deficit cannot be sustained for long, even if India's real GDP grows at an average of 6.0 -6.5 per cent per annum in the coming years for two main reasons. First, it would require a large mobilisation of revenue receipts which, given the rising share of relatively under-taxed services sector, cannot grow without bringing about sharp changes in tax structure and efficiency in tax collections. Secondly, it would imply a large reliance on market borrowings, placing pressure on market rates of interest and crowding out private initiatives.

7.15 Elimination of revenue deficits is vital for overcoming the growing problems associated with interest payments, wages and salaries and subsidy payments. The Union Budget for 1999-2000 envisaged that this objective should be realised in the medium term period of four years in so far as the Centre is concerned. The State Governments too would need to pursue a similar objective over the medium term. This may not be too difficult to achieve, since the combined GFD of States was placed at 2.3 per cent of GDP as recently as in 1993-94 provided States take action to cover at least part of the expenditure incurred by them through cost recovery.

7.16 Corrective actions to rein in the fiscal deficit are critical to help reduce the debt-GDP ratio and the debt service burden. But in the absence of a strong improvement in the tax to GDP ratio, the only way to maintain or reduce the debt-GDP ratio is to cut down aggregate expenditure. However, it needs to be ensured that expenditure adjustment is not at the expense of capital expenditure which, as a proportion of total expenditure of Central Government, has already declined sharply to 22.6 per cent in 1998-99 from 26.1 per cent in 1991-92. Expenditure adjustment also has to go hand in hand with efforts to raise revenues, improve cash flow management and promote the productivity of expenditures in order to contain Government's reliance on borrowings. The costs of financing through incurrence of debt are not to be seen merely in terms of debt servicing, but in terms of the high interest costs that investors outside the Government will have to bear to gain access to funds and the shift of burden of servicing of debt on to the next generation.

7.17 The weaknesses in state finances need to be attended to on a priority basis in view of the limited manoeuvrability that States have in applying fiscal adjustment measures. In recent years, there has been a tendency on the part of some State Governments to incur contingent liabilities like guarantees. Debt and liability financing of development, when carried beyond sustainable levels, would hinder implementation of serious fiscal reforms which should include, as part of the fiscal agenda, large scale investments in non-tradable infrastructure sectors such as power, roads, and communications and upward revisions in electricity tarrifs and irrigation rates, besides the widening of tax base and tax coverage.

7.18 Against this background, the recommendations of the Eleventh Finance Commission would gain in critical importance. The initiatives taken recently by some States to have Memoranda of Understanding with the Centre for formulating medium term strategies to achieve lasting improvement in their finances augur well for the future of federal finance. Latest indications on Central finances show that tax receipts are rising at a satisfactory rate responding to the turnaround in industrial sector performance. To ensure that the objectives of the Budget are met, it is essential to press on with expenditure reforms and with the movement toward the introduction of zero based budgeting.

Monetary Policy

7.19 The conduct of monetary policy in 1998-99 and in the current year so far in terms of its impact on interest rates and prices needs to be placed against the perspectives obtaining from the evolving macroeconomic situation and economic uncertainties. For purposes of convenience, the issue of monetary policy, liquidity management, interest rates and economic activity may be examined separately from that of monetary growth and inflation dynamics, although it is well known that both the issues are very closely connected.

7.20 Monetary policy has had to facilitate the process of growth and inflation control without losing sight of the need to develop financial markets and to promote financial stability. For promoting these diverse considerations, a liquidity management strategy was put in place through an active use of fixed rate repo operations, refinance window, cash reserve ratio and the techniques of private placement of government securities combined with open market operations. The liquidity management strategy generally succeeded in containing the volatility in call money rate within the informal corridor of interest rates defined by the repo rate (acting as the floor rate) and the general refinance rate (acting as the ceiling rate). The other short-term interest rates viz., the 14-day and 91-day Treasury Bill rates also closely followed the call rate and the liquidity conditions emerging from monetary policy action.

7.21 The liquidity condition during the year and the role of monetary policy in modulating it could be seen from the factors that brought about an autonomous influence on the interest rates and those that contributed to off-setting it. The factors governing the short-term interest rate movements may be viewed in terms of what may be regarded as the autonomous liquidity position (ALP) which emanates from the forces that give rise to some amount of independent movement of the central bank's balance sheet. Specifically, in the Indian context, the ALP could be defined as the sum of net RBI credit to Government (net of repos), RBI's net foreign exchange assets and Government's currency liabilities to the public adjusted for RBI's liabilities to non-bank sectors in the form of currency with the public, 'other' deposits with the RBI and net non-monetary liabilities (NNML). The ALP would broadly indicate a hypothetical liquidity position which would prevail if there are no monetary policy interventions. On the other hand, the net policy position (NPP) from the viewpoint of liquidity would broadly refer to a situation of either net withdrawal from or injection of liquidity by the Reserve Bank to the market through instruments such as net repo operations, refinance to banks and credit to the commercial sector (including primary dealers) and changes in reserve requirements. Chart VII.1 presents the trends in ALP, NPP, call rate and 91-day Treasury Bill rate. It showed that ALP recorded a very subdued growth in 1998-99 compared to that in 1997-98 while there was a steep growth in policy-induced liquidity changes during the major part of the year, except for a brief spell in August 1998 when liquidity conditions were further tightened to stem the volatility in foreign exchange market. The short-term interest rates closely followed the net liquidity position, which tended to move up without exhibiting signs of instability.

7.22 The short-run market stabilisation is important and should be viewed in the context of balancing the objectives of inflation control and growth, while pursuing measures to control short-term market conditions and stem the build-up of adverse exchange rate expectations. As the condition on the inflation front was dominated by an adverse supply shock that was temporary and self-reversing in nature, monetary policy could lean more towards bringing down the medium and long-term interest rates for creating the necessary conditions for industrial recovery.

7.23 The effectiveness of monetary policy to influence the interest rates, particularly the long-term interest rates, depends inter alia on the level of development of financial markets, and their integration. In a well developed financial market, there is a close degree of convergence between the direction of movements of short and long-term interest rates, and the yield spread, which carries important information on the stance of monetary policy and the future economic activity. Monetary policy operations in these markets in most countries are carried out on the basis of a few instruments, normally through one or two short-term reference rates or some special arrangement such as the liquidity adjustment facility. A change in the short-term interest rate, transmitted by the monetary policy is carried through the long-term money and credit markets, depending on the market expectation regarding the persistence of monetary policy stance. In the emerging market economies, where financial markets are still evolving and have to acquire the required degree of depth and maturity, the control of monetary policy over long-term interest rates, through the use of a single monetary policy instrument such as a short-term reference rate or a liquidity adjustment mechanism, may not have a strong impact on inflation and growth.

7.24 Given the large borrowing requirements of Government and the present level of development of financial markets in India, monetary policy has to not only depend on a relatively large set of instruments - both direct and indirect - to exercise sufficient control over short-term market developments, but also focus on such instruments that could be of particular significance for the movement of long-term interest rates. Accordingly, the liquidity management strategy was combined with an active interest rate policy directed at stabilising or reducing the interest rates that influence investment. In order to influence the long-term interest rate, the Reserve Bank made active use of the Bank Rate, which is an important interest rate to transmit the signals of monetary policy. The Bank Rate was revised downward thrice during the year, from 10.5 per cent at end-March 1998 to 8.0 per cent by end-March 1999, leading to reduction in the prime lending rates by major public sector banks from 14.0-14.5 per cent to 12.0-14.0 per cent during this period. This was supplemented by the Reserve Bank's effort to soften the medium and long-term government security rates, either through direct devolvement or private placement, combined with open market operations. As a result of the pursuit of liquidity management with an active interest rate policy, the movements in the short-term and long-term interest rates helped to meet both the short-term market stabilisation objective and the long-term objectives of growth. The fact that this was achieved with an annual year-end M₃ growth of 18.4 per cent (16.2 per cent, excluding the RIB proceeds) revealed that the demand forces were contained within a reasonable level consistent with the prospects for price stability.

7.25 While the short-term interest rates showed a tendency towards hardening, the impact on the long-term interest rates was largely hived off through adjustment in other policy instruments. Consequently, the yield spread between the one-year and 10-year government securities declined, on an average basis, from 2.23 percentage points in 1997-98 to 1.73 percentage points in 1998-99.

7.26 In so far as monetary impact on prices is concerned, the measurement of inflation has become a major issue since in the recent period, the inflation rate as measured by the point-to-point variation in the Wholesale Price Index (WPI) has shown a steady decline, reaching to one of the historical lows of 1.19 per cent as on July 24, 1999. On an averaging of weekly data basis, the inflation rate thus measured during this period has worked out to 5.64 per cent. The long-term inflation rate (for nearly three decades) was about 8.5 per cent a year. Monetary growth, as revealed by the trend in the growth of broad money has, on the other hand, remained close to its long-run rate of about 17 per cent. Thus, the current inflation rate seems to have diverged significantly from its long term trend.

7.27 It is well recognised by now that while monetary factors largely explain the long-run price situation, the divergence of inflation rate in the short-run from its long-run value could arise from several factors including the supply side shocks which temporarily disturb the underlying long-run relationship between monetary growth and inflation. Such a divergence was witnessed in many developed economies over 'seventies and 'eighties, caused by considerable instability in money demand function due to large scale financial innovation.

7.28 In India, historically, inflation has stayed within a moderate range, barring a few years of exceptional price pressure arising out of oil price shocks and severe drought conditions. The decadal mean inflation rate (on average basis) at 9.0 per cent in 'seventies, 8.0 per cent in 'eighties, and 8.8 per cent in 'nineties so far (1990-91 to 1998-99) moved closely around the long term mean inflation rate of 8.5 per cent during the entire period of 1970-71 to 1998-99. This suggested that the year to year fluctuations in the inflation rate eventually revert to the average value and did not significantly alter the average inflation rate for the decade or for the sample as a whole. The trend inflation rate closely followed the trend growth in M₃ which remained within the range of 17 to 18 per cent in each of these decades. A simple correlation analysis of the inflation rate and M₃ growth with one period lag suggested a fairly strong order of positive association between these two variables.

7.29 During 'nineties, the inflation rate (on a point-to-point basis) stayed above 10 per cent in four out of five years between 1990-91 and 1994-95, and thereafter declined to low levels reaching 4.8 per cent in 1998-99 and further to 2 per cent in the first quarter of 1999-2000. Chart VII.2 shows that while M₃ growth closely tracked the movement in inflation up to 1996-97, it deviated in the subsequent period, providing an indication of certain degree of overprediction of inflation rate by the M₃ growth. This deviation has been particularly significant in 1998-99 and during the current financial year up to June 1999.

7.30 The intra-year movement in the inflation rate during 1998-99 revealed a strong seasonal pattern, characterised by two distinct cycles—a steady increase from April to September 1998, followed by a gradual fall from October 1998 to June 1999. This seasonal trend was largely explained by inflation in the primary articles group which, with a weight of 32.3 per cent in the WPI, increased from 7.2 per cent in April 1998 to 16.8 per cent in November 1998, but declined thereafter to 3.3 per cent in June 1999. Much of this trend was led by the exceptional price pressure recorded in a few food articles and food products such as fruits and vegetables (mainly potatoes and onions), pulses, condiments and spices, raw cotton, oilseeds, sugar group and edible oils. The price rise in some of these commodities fluctuated from as much as over 50 per cent to (-)15.0 per cent between November 1998 and June 1999. The declining trend in primary articles inflation has been reinforced by the falling manufactured product inflation which, with a weight of 57.0 per cent, came down from 4.0 per cent in April 1998 to 2.2 per cent in June 1999. Even the fuel group inflation has followed a similar pattern.

7.31 Whether the current inflation phenomenon could be reasonably explained by the monetary growth raises the issue of determining how much of this trend is due to permanent component and how much is in the nature of cyclical correction. As supply shocks played a dominant role in the inflation trend during the major part of 1998-99, a correction seems to have followed in the later months, exhibiting a kind of 'cobweb' response by producers to price signals. The bumper crop recorded in rice, wheat, oilseeds, sugarcane, pulses, and major fruit and vegetables in 1998-99 has led to excess supply conditions in some of these commodities, driving down their prices from the last year. The low primary articles inflation has also been contributing to reduction in the manufactured articles' inflation by bringing down the input cost of industries which are dependent on agricultural raw materials. Apart from supply shocks which have a transitory impact on prices, there has been the other type of 'real shocks' which seem to be at work in keeping the manufacture prices at a low level. For example, increased import competition together with the recent sharp decline in world manufacture prices seems to be contributing to low inflation in manufacturing sector in India through cost saving technological innovation and reduced mark up in domestic industries. Evidence also points towards positive productivity shocks in the post liberalisation period, which would normally contribute to improved price competition of industries in the domestic market (See Box II.2).

7.32 The increasing share of the services sector in GDP and its inadequate reflection in WPI is yet another important source of recent divergence of the inflation rate from the money supply growth. To the extent that the economy is getting increasingly tertiarised, a price index based largely on goods inflation, would tend to deviate from the true level of inflation that can be explained by the overall demand and supply situation.

7.33 The money and inflation relationship also needs to take into account the transmission lag of monetary impulses, which can be both long and variable. Preliminary evidence in the Indian context shows that the full impact of a monetary shock on the inflation rate can take a long time to realise, and the lag could even exceed two years (See Box III.2). Notwithstanding the fair degree of association between money and prices over a long horizon, the evolving transmission mechanisms in the more recent years, which are characterised by financial sector reforms and growing market integration, there would be increasing significance of the interest rate, with implications for the underlying relationship between the growth in money supply and inflation rate.

7.34 In the light of the transformation taking place in the economy, M₃ growth projected in the monetary and credit policy statement of April 1999 should be seen essentially as indicative of the stance of liquidity conditions. It should be utilised along with other indicators such as interest rates, exchange rates, fiscal and external positions, and flow of financial resources for purposes of monetary management. Such a multiple indicator approach, besides being informational, provides flexibility in conducting monetary policy as an essential part of the overall economic policy.

Financial Sector

7.35 Macroeconomic management to be effective requires the support of financial sector reforms, in particular those relating to the banking sector. It is for this reason that financial sector reforms were undertaken right from 1991-92. The reforms will not only promote allocative efficiency but also strengthen the soundness and stability of the financial system. In the process, however, financial entities will face severe challenges of competition in different segments and niches of the market. Financial market participants will have to put in place sound institutional mechanisms and risk management strategies that are backed by modern technologies, policies and delivery processes within a reasonable time frame so as to successfully overcome challenges of competition and improve customer satisfaction.

7.36 Commercial banks in particular have a critical role to play in such financial re-engineering. The performance of public sector banks, notwithstanding the improvement seen in recent years, has come under severe strain reflecting heightened market competition and other developments in the economy. Given the stickiness in the operating costs due largely to high staff costs, and the increasing requirements of provisioning on account of non-performing assets (NPAs), the profitability of banks has come under pressure. To overcome this problem, banks would need to expedite exercises towards consolidation, cost reduction and loan recoveries. The efforts of banks would need to be complemented by effective functioning of Settlement Advisory Committees and Debt Recovery Tribunals.

7.37 The working of the banks would need to be strengthened by undertaking legal reforms which encompass changes in the existing laws and introduction of new enactments. Delays in this area of reforms would be costly, in that it would lead to postponement of decisions by investors, and impede financial market development. Good legal support will enhance the soundness of banks which are presently seized with the problem of recovery of overdues. The establishment of debt recovery tribunals and the flexibility provided to banks to enter into compromise settlements have not as yet made much of an impact on the non-performing assets (NPAs) but would eventually turn out to be helpful, if they are supplemented by strong law enforcement and internal controls at banks.

7.38 From a medium-term point of view and for toning up operational efficiency of the financial system, it is imperative that banks adopt risk management and asset-liability management techniiques, efficiency promoting measures, enhanced transparency practices and prudential regulations consistent with the regulatory and supervisory concerns. These measures will help to improve the quality of lending. In addition, the banks will have to consciously adopt new technologies and modern systems and procedures, as well as network management to bring about improvement in productivity.

7.39 The Reserve Bank has taken a number of initiatives in this regard. Financial supervision has been comprehensive and has been brought close to international standards. The Reserve Bank has helped in the setting up of VSAT network and has worked out plans to modernise clearing and settlement systems. It also intends to adopt real time gross settlement system so that risks in payments are eliminated. These initiatives would need to be supported and strengthened by the Government through provision of adequate communication backbone and other infrastructure facilities.

7.40 As the financial sector grows, competition for improving share in it among different financial entities would intensify. In the process, institutions would get into those functional areas where growth prospects are perceived to be high. It is in this background, the issue of strengthening of development financial institutions (DFIs) and their regulation and supervision gain in importance. In the Indian context, DFIs have been the major providers of long-term and development finance in view of the somewhat underdeveloped state of the capital and debt markets. The Narasimham Committee on banking sector reforms suggested that DFIs should convert ultimately into either commercial banks or non-bank finance companies. The Khan Working Group held the view that DFIs should be allowed to become banks at the earliest. The RBI released a discussion paper on the subject. The feedback on the discussion paper indicated that while universal banking is desirable from the point of view of efficiency of resource use, both banks and DFIs should be cautious in moving towards such a system. Corporates continue to depend on DFIs for project finance. On the other hand, the necessary expertise and infrastructure facilities for extending short term finance lie with commercial banks.

7.41 The functioning of NBFCs has been a major source of concern in recent years. On its part, following legislative directions the Reserve Bank has exercised close oversight on NBFCs together with application of regulations that facilitate the growth of NBFCs on sound lines. It is essential to have a comprehensive and regular monitoring of all the critical areas of NBFCs' operations. NBFCs would need to be encouraged to adopt transparency practices and disclosure standards close to those applicable to commercial banks. This is necessary for giving confidence about the viability of the financial system and to enable NBFCs to play their legitimate role in the financial life of the country.

7.42 At present the regulatory and supervisory functions are performed by a number of agencies - the Reserve Bank of India, the SEBI, the NABARD and Registrars of Cooperative Societies. Within these organizations, these functions are performed in different Departments/Sections/Units. While each organization attempts to coordinate its supervisory concerns and works out the required regulations, a co-ordination of oversight functions among the organizations, through a firmly established institutional arrangement, is vital for avoiding any systemic problems that may develop on account of the existence of interfaces among financial entities.

External Sector

7.43 Several unfavourable external sector developments during 1998-99 were addressed by policy initiatives, which eventually resulted in accretion of foreign currency assets, stability in exchange rate and improvement in foreign investor confidence. With the invisible receipts providing a source of strength, the external current account deficit in relation to GDP turned out to be about 1.0 per cent in 1998-99 as against 1.3 per cent in 1997-98.

7.44 While the outcomes turned out to be favourable, the perspectives on future policy actions need to reflect the concerns emerging from the interface between the domestic and international economies. The decline in exports in 1998-99 on top of the sluggish growth in the preceding two years is a matter that needs to be seriously addressed for two reasons. First, a continuous negative net external demand will require the domestic demand to be maintained at a high level, irrespective of the operation of economic cycles and trend factors. Secondly, it would reflect the lack of competitiveness as well as the absence of adequate economic diversification to cater to the changing tastes and preferences of international economy besides making the balance of payment situation unfavourable. Export policies that encompass technology and communications, marketing, standardisation and after sales services, should figure as an important requirement of the day, since they, along with the current efforts at providing adequate finances at competitive interest rates and maintaining stability in exchange rates, would help push exports in a sustained manner.

7.45 The external policy configurations in recent years have so far helped to contain the external current account deficit at a relatively low level, mainly because of dormant import demand coupled with subdued oil prices, and to enhance international reserves. The successful launch of the Resurgent India Bonds and the good accretion to NRI deposits during 1998-99 showed that international investors responded positively to domestic macroeconomic environment and initiatives in building up financial soundness. It is important to persevere with the current policy of cautious and gradual easing of capital account items and to encourage non-debt creating flows to the extent possible. In this process, it is vital that external forward liabilities and short-term debt are continued to be kept within limits.

7.46 Detailed data dissemination and adoption of transparent practices have become major medium through which the interests of the investor community in India's economic development are maintained. In recent years, India has made enormous progress in this area, making use of the new technologies. An array of additional economic data in some areas (e.g., balance of payment and GDP) has already been introduced and efforts to initiate such processes in other areas are underway.

Prospects

7.47 As we enter the New Millennium, there are clear signs of improved economic prospects with stability reflecting the gains from the adoption of prudent and carefully designed macroeconomic policies in recent years. Going by the latest indications, real GDP growth in 1999-2000 would be between 6.0 and 6.5 per cent. This would be in line with the average growth recorded in the five years between 1994-95 and 1998-99. Monsoon conditions seem to be once again good. Besides, incentive prices for kharif crops have already been announced. If the industrial recovery in the first three months is any indication, industrial production should increase at the rate averaged in the last four years, viz., about 7.0 per cent. The very good output performance of capital goods industries augurs well, since this segment often acts as the main driving force of industrial growth. Services sector has been growing at a trend rate and has shown a tendency to post further gains whenever agricultural and industrial sectors perform well. The rate of inflation during the year is also likely to remain low and much below the long-term trend.

7.48 From the available indications, while fiscal developments in so far as the Central Government is concerned seem to be on course during the current year so far, it is important to ensure that the expectations of the Budget for 1999-2000 are fulfilled and fiscal deficit is not allowed to increase beyond the budgeted figure. Such a fiscal stance will help in keeping the macroeconomic environment favourable for growth with price stability. The improvement in real growth prospects in recent months has enhanced the chances of augmenting revenues, and it is essential that growth in expenditures is also contained within the budgeted limits. Timely corrective action has also to be taken in this regard to reduce chances of further fiscal slippage in state finances. A deterioration in state finances also has implications for Centre's deficit. In this connection, the interest being shown by the State governments in undertaking fiscal reforms is welcome and has to be nurtured.

7.49 Monetary policy has rendered it possible to maintain liquidity conditions in support of financial market and real sector activities, with the result the interest rates have been fairly stable in the current year so far. The stance of policy enunciated in April 1999 has proved to be appropriate. The recent developments in the external sector show that the external current account deficit would once again be well within the sustainable level. Exports seem to have shown some signs of rebound in the first three months of the current year, and while import bill is likely to grow, under the impact of oil price increases, inward remittances continue to be buoyant. Capital flows have also been at a reasonable level to bridge the gap in current account deficit.

7.50 The gains at the turn of the new century need to be strengthened by persevering with structural measures that reduce institutional rigidities and further economic activity. Such a forward-looking approach alone will give the requisite added strength to meet the unexpected situations that may develop at home and abroad.