Summary of the Annual Report of RBI for the year ended June 2003 (Part 1 of 2) - RBI - Reserve Bank of India
Summary of the Annual Report of RBI for the year ended June 2003 (Part 1 of 2)
For the Year July 1, 2002 to June 30, 2003*
Part One : The Economy : Review And Prospects
I - Macroeconomic Policy Environment
Introduction
1.1 Cautious optimism characterised the stance of macroeconomic policies during 2002-03, notwithstanding the continuing slowdown in global economic activity and an environment riddled with several external shocks. The shocks impacting the domestic economy included border tensions, severe drought and the hardening of international crude oil prices towards the year’s close. The drought situation necessitated swift responses in supply management. Food supply was bolstered by a drawdown of foodstocks for a substantial increase in targeted public distribution programmes. Coupled with reduction in issue prices and ease in the access to imports, these strategies were effective in containing potential inflationary pressures. In the event, inflation remained weak for the greater part of the year, edging up only in the last quarter in the wake of the firming up of international prices of crude oil.
1.2 The counter-drought stance was reflected in fiscal policy as spending on food and input subsidies rose even as other expenditures were reined in. Revenue shortfalls on account of the continuing slack in economic activity and the reduction of tax/duty rates resulted in modest slippages in fiscal consolidation. Nevertheless, there was a renewal of the commitment to improve the quality of fiscal adjustment through monitorable reform programmes and appropriate incentive structures, especially at the sub-national level. Simultaneously, debt consolidation was carried forward and continued attention was given to measures designed to bring back buoyancy to the tax-GDP ratio.
1.3 Cuts in key policy rates and the cash reserve ratio (CRR) signaled the fine-tuning of monetary-fiscal coordination for stimulating the revival of aggregate demand. The conduct of monetary policy was dominated by the need to contend with large inflows of foreign exchange. The surplus in the current account of the balance of payments for the second year in succession and sizeable capital inflows engendered a record accretion to foreign exchange reserves. Financial markets with overhang of liquidity experienced a distinct easing of rates which, in turn, impacted on monetary policy, necessitating continuous operations to modulate and balance market conditions. Financial sector reforms were carried forward with the objective of rapid convergence with international best practices. The environment for deepening these reforms improved considerably with the enactment of appropriate changes in the institutional architecture, particularly in respect of the recovery of problem assets. The technological infrastructure for the financial system continued to be upgraded.
1.4 Against this backdrop, growth strategies were put in place to propel the economy towards its full potential over the medium-term with emphasis on the quality of growth. Resumption of industrial activity and a robust export performance in the face of the global downturn set the tone for a strategic trade policy centred around doubling of exports from the current level and thereby raising India’s share in global exports to 1 per cent by 2007. The Union Budget for 2003-04 aims at stepping up revenue mobilisation and persevering with expenditure management with an overall shift in emphasis to qualitative aspects of fiscal reform. The Monetary and Credit Policy for 2003-04 provided a stimulus to aggregate demand through reductions in the Bank Rate and the CRR, even while indicating the need for a continued vigil on the inflation front. Several steps were taken to strengthen financial soundness and the content of regulatory supervision. The resurgence of positive expectations regarding the near-term was greatly facilitated by the passage of landmark reform legislations, setting the stage for intensifying structural reforms.
THE MEDIUM-TERM GROWTH STRATEGY
1.5 The year 2002-03 marked the launch of the Tenth Five Year Plan covering the period 2002-07. The Plan sets an ambitious growth target of 8 per cent per annum over the Plan period and envisages conditions for a further acceleration over the subsequent five-year period (2007-12) so that there is a doubling of per capita income over the decade. The Plan also adopts ‘specific and monitorable’ objectives in terms of crucial facets of human development – poverty, employment, education and demographic stability as well as ecological issues in sustainable development.
1.6 The Tenth Plan strategy accords to public expenditure the principal role in raising aggregate demand until private investment can be crowded in sufficiently so as to sustain the growth momentum. Accordingly, the gross investment rate is expected to be raised to about 28 per cent of GDP (from the current level of 24 per cent), primarily financed by a step-up in domestic saving and supplemented by a modest expansion in the inflow of external saving (to 1.6 per cent of GDP from less than 1 per cent during the Ninth Plan period). Other crucial elements in the Plan strategy are a reduction in the incremental capital-output ratio (ICOR) from 4.5 to 3.6, export volume growth of 12.4 per cent per annum, stabilising the variability of rural incomes and halting the dissaving of the public sector.
1.7 Fiscal correction and diverting more resources to productive purposes are keys to achieving the Plan objectives and ensuring fiscal sustainability. The Tenth Five-Year Plan aims at reduction in deficits at both the Central and State level. To achieve the expected level of fiscal consolidation and the growth target, the Tenth Plan envisages an increase in the Centre’s gross tax revenue to 9.9 per cent of GDP by the terminal year of the Plan (2006-07) from 8.2 per cent in the base year (2001-02). The corresponding ratios for the States’ own tax revenue are 6.6 per cent and 5.9 per cent of GDP, respectively. On the expenditure side, the Tenth Plan visualises higher budget support to the Plan (Plan expenditure) by the Centre – on an average, 4.9 per cent of GDP during the Plan period as against 4.4 per cent in the base year. On the other hand, the non-Plan expenditure is anticipated to decline to 9.9 per cent of GDP in the terminal year of the Plan from 11.3 per cent in the base year. Similarly for States, Plan expenditure is envisaged to increase to 4.2 per cent of GDP and non-Plan expenditure is anticipated to decline to 11.5 per cent of GDP by 2006-07 from their respective levels of 3.8 per cent and 13.3 per cent of GDP during 2001-02. These anticipated trends in the revenue and expenditure are expected to improve Government saving and public investment.
1.8 Critical to the Plan strategy are appropriate changes in policy and institutional settings which take due cognisance of the significant structural changes underway in the economy. Agriculture, construction, ‘other transport’ and ‘other services’ are specific sectors targeted for high growth in view of their potential for employment generation with relatively low capital intensity. Employment generation would be the driving factor in speeding up growth in segments within manufacturing. ‘Agriculture and allied activities’, ‘mining and quarrying’ and construction are likely to receive excess investment to meet the Plan objectives. Existing shortfalls in investment in ‘electricity, gas and water supply’, communication, financial services, public administration and community services are expected to be bridged by a significant improvement in private investment, and by removing fiscal constraints as well as generation of internal resources by the public sector. Balanced regional development, reduction in poverty across States, fiscal sustainability and further intensification of financial sector reforms are other notable elements of the Tenth Plan strategy.
REAL SECTOR POLICIES
Agriculture and Allied Activities
1.9 Mitigating the adverse impact of the drought emerged as an overriding priority in 2002-03 even as initiatives for ongoing institutional and structural reform in the agricultural sector were strengthened further.
1.10 The Central Government allotted 3.8 million metric tonnes of rice and wheat free of cost to the 14 drought affected States for various employment programmes. The Task Force on Drought approved a special package of drought assistance for Rajasthan under which people in the worst affected blocks in the State were provided relief employment for 10 days every month and received 8 kgs of foodgrains per day. Accordingly, Rajasthan was allocated 2.1 million tonnes of wheat free of cost from February to July 2003 for the purpose of providing employment to 6.6 million persons. Fodder of 30,000 tonnes was also allocated free of cost to Rajasthan, and 435 cattle camps were provided financial assistance amounting to about Rs.12 crore. The Task Force on Drought also approved allocation of 1,15,000 tonnes of foodgrains to Maharashtra for three months from February 2003 and 75,000 tonnes of rice to Himachal Pradesh for public distribution at Below Poverty Line (BPL) rates. Fodder and water were freely transported by the railways to the affected areas up to June 30, 2003. Onetime special drought relief prices were announced for various commodities ranging from Rs.20 per quintal for paddy, jowar, copra and sesamum, Rs.15 per quintal for sunflower seed, Rs.10 per quintal for bajra and soyabean and Rs.5 per quintal for various pulses. An increase of Rs.5 per quintal in the Statutory Minimum Price (SMP) was announced for sugarcane farmers in all States.
1.11 As part of drought relief measures, interest on kharif crop loans as well as on agricultural term loans during 2002-03 was deferred. The crop loans were rescheduled into term loans which would be recovered over the next five years in the case of small and marginal farmers and over three years in the case of other farmers. The first year’s deferred liability of interest on kharif loans was waived completely as a one-time measure. The Government announced a grant of an input subsidy to small and marginal farmers amounting to Rs.1,490 crore. In view of the severity of the drought, the agricultural input subsidy was extended to cover all other farmers for both sown and unsown areas up to a ceiling of two hectares. All the 14 affected States received additional amounts of input subsidies, cumulatively in excess of Rs.555 crore, for tackling the drought. The Union Budget for 2003-04 expanded the Antyodaya Anna Yojana from April 2003 to cover an additional 50 lakh families, raising the total coverage to more than a quarter of all BPL families during the current year.
1.12 Futures trading is expected to help farmers and traders to hedge their risks and thereby lessen their dependence on Government procurement. Recently, all commodities were made eligible for futures trading. At present, there are 91 commodities under the purview of Section 15 of the Forward Contracts (Regulation) Act, 1952. Trading in these commodities would be conducted only in recognised exchanges regulated by the Forward Markets Commission. Notwithstanding the introduction of futures trading, Minimum Support Prices (MSPs) for these foodgrains and the procurement mechanism would continue to be in existence. The Food Corporation of India (FCI) was directed to open additional centres for procurement of paddy from non-traditional States like Madhya Pradesh, Bihar and Orissa.
1.13 The Agricultural Insurance Company of India Limited (AIC), which was proposed in the Union Budget, 2002-03, was constituted in December 2002 with the capital participation from General Insurance Corporation of India (GIC), National Insurance Company Limited, New India Assurance Company Limited, Oriental Insurance Company Limited, United India Insurance Company Limited and the NABARD. The National Agricultural Insurance Scheme will be transferred to AIC and would be the core business of the company. The new organisation will, in due course, cover other allied agricultural risks in addition to crop insurance.
Manufacturing and Infrastructure
1.14 In recent years, the objective of industrial policy in India has been to infuse competitive efficiency into Indian industry while promoting its restructuring with a focus on core competencies, organisational change and a growing exposure to the cutting edge of international competitiveness.
1.15 The Competition Act, 2002 was enacted in December 2002 to promote competition through prohibition of anticompetitive practices and abuse of dominance and through regulation of companies beyond a particular size. This Act will replace the Monopolies and Restrictive Trade Practices Act, 1969 (MRTP).
1.16 A moderate rate structure and complete CENVAT chain to promote compliance and encourage modernisation in the textile sector is envisaged in the Union Budget, 2003-04. A special package for the power loom sector is likely to enlarge the Technology Upgradation Fund Scheme to cover the modernisation of the sector. The introduction of the revised Textile Sector Infrastructure Development Scheme is expected to improve working conditions, productivity and to provide insurance cover to weavers. A Centrally Sponsored Scheme ‘Apparel Parks for Exports Scheme’ was launched for setting up of apparel manufacturing units of international standards at potential growth centres. Under this scheme, nine Apparel Parks have been identified. A cluster-based approach to the implementation of schemes/programmes in handlooms, powerlooms, sericulture and other decentralised industries has been adopted.
1.17 The Export Import (EXIM) Policy, 2003-04 exempted domestic sales undertaken by the units located in Special Economic Zones (SEZs) from levy of the 4 per cent special additional customs duty. Special purpose vehicles (SPVs) are proposed to be set up to develop industrial clusters. The SPVs, which have no identifiable revenue stream, will be funded entirely by the Central Government and beneficiaries. The SPVs are expected to create a world class physical infrastructure in industrial clusters with a high growth potential and convert static local efficiency into dynamic competitiveness. Ten industrial clusters would be selected under the Industrial Infrastructure Upgradation Scheme announced in the Exim Policy 2002-07. The cap on the number of investment companies being floated by companies would no longer apply to SPVs set up to route funds into new ventures.
1.18 De-reservation of 51 items for the small scale industries (SSI) sector was effected in May 2002. For technology upgradation and quality improvement in the SSI sector, the scope of the on going ISO 9000 reimbursement scheme was enlarged to include reimbursement of expenses for ISO 14001 Environment Standard with effect from October 28, 2002. The Union Budget for 2003-04 announced de-reservation of 75 items for the SSI sector. The de-reserved items include laboratory chemicals and reagents, plastic, leather and paper products. The Government raised the SSI investment limit on 10 drugs and pharmaceutical items from Rs.1 crore to Rs.5 crore in June 2003. The composite bank loan limit for SSI was raised from Rs.25 lakh to Rs.50 lakh in June 2003 to meet their term loan as well as working capital requirements.
1.19 Noteworthy changes in the policy environment are expected to provide a strong impetus for the development of the physical infrastructure. The Union Budget, 2003-04 envisages innovative funding mechanisms principally in respect of roads, railways, airports and seaports. The objective is to leverage public money through private sector partnership, wherever possible. In February 2003, the Reserve Bank allowed banks to finance promoters’ contribution to equity capital in infrastructure projects. Risk weight for the purpose of reckoning capital adequacy was halved to 50 per cent for core sector funding. This is applicable to banks’ investments in securitised paper pertaining to an infrastructure facility. These measures are expected to give a boost to core sector funding.
1.20 The Electricity Bill, 2003 was approved by Parliament in 2003. The Bill seeks to delicense power generation and to permit captive power plants. It would help to facilitate private sector participation in the transmission sector and would provide open access to the grid sector. In April 2003, the Union Cabinet approved a six level intervention plan for the power sector involving a financial assistance of Rs.40,000 crore to State Electricity Boards (SEBs) in the next five years for power distribution reforms. The intervention strategy would encompass initiatives at the national level, State level, SEB and utility level, distribution circle level, feeder level and the consumer level to focus on accountability, deliverability and performance at all levels. The Ministry of Power, the Reserve Bank and States entered into a tripartite agreement in March 2003 for a one-time settlement plan of dues of Rs.42,000 crore payable by SEBs to central public sector undertakings.
1.21 In the telecommunications sector, the monopoly of Videsh Sanchar Nigam Ltd (VSNL) over long distance telephony ceased with its privatisation in 2002. Policies for opening up of international long-distance telephony, setting up of Universal Service Obligation, permitting a fourth operator in the cellular mobile segment and commissioning of internet backbone were put in place. In the Union Budget, 2003-04 the benefit of tax holiday to the telecom and domestic satellite service companies was extended till March 31, 2004. In June 2003, the Department of Telecommunication notified changes in the licence conditions of the cellular and basic service operators to enable greater consolidation in the telecom sector through merger, de-merger and acquisition.
1.22 In the road sector, private parties were allowed to apply for tenders either singly or through a consortium restricted to four members. The Ministry of Road and Surface Transport has short listed 23 build, operate and transfer (BOT) projects under this new bidding process. Airport handling was opened to foreign direct investment up to 49 per cent.
EXTERNAL SECTOR POLICIES
EXIM Policy (2002-07)
1.23 The ongoing strength and buoyancy in the external sector set the tone for an ambitious trade policy stance with continued emphasis on correction of the anti-export bias in the economy. Buoyed by a robust export performance in 2002-03 in the face of sluggish external demand and the burgeoning international reserves, the modified EXIM Policy for 2002-07 seeks a greater integration of international trade into the development strategy of the Tenth Plan.
1.24 The Policy intends to consolidate and accelerate India’s export growth by capitalising on agricultural and allied products as areas of core competence and focusing on special economic zones (SEZs) and exports of services as engines of growth. Removal of export restrictions, modification of norms for fixing duty entitlement pass book (DEPB) rates, promotion of corporate participation in agri-export zones and export infrastructure are envisaged. Besides, agricultural extension, processing, packing, storage, R&D and other facilities in these zones, and transport assistance for exports of agricultural products are emphasised. The policy also contains a special focus on exports of cottage industries, handicrafts, gems and jewellery through market access initiative schemes, duty free imports and appropriate adjustments in value addition norms.
1.25 In recognition of the importance of SEZs, major steps were taken for simplification and codification of rules, regulations and procedures applicable to the SEZs and Export Oriented Units (EOUs). External Commercial Borrowings (ECBs) for tenure of less than three years are allowed to units in SEZs. Sales from the Domestic Tariff Area (DTA) to SEZs are treated as exports and entitle the DTA suppliers to Drawback/DEPB benefits. Special steps are drawn up to promote exports of gems and jewellery and electronic hardware from the SEZs.
1.26 In view of the growing importance of services, the EXIM policy has accorded a special thrust to these exports. Apart from software, a host of traditional (tourism) and non-traditional (health care, entertainment and professional services) services have been identified for promotion. For these sectors, import of consumables, office and professional equipments, spares and furniture up to 10 per cent of the average foreign exchange earning in the previous three years was allowed. The tourism sector was allowed to avail the benefits under the Export Promotion Credit Guarantee (EPCG) and advance licensing schemes. For entertainment and education services, sector-specific Working Groups are set up for framing action plans to achieve export potential within a specified time schedule.
Trade Policy Measures in the Union Budget for 2003-04
1.27 The Union Budget for 2003-04 contains several measures to facilitate foreign trade, such as, reduction/ rationalisation of customs duties, simplification and modernisation of customs clearance procedures, and strengthening export infrastructure. The peak rate of customs duty has been reduced from 30 per cent to 25 per cent, excluding agriculture and dairy products.
1.28 The report of the Task Force on Indirect Taxes (headed by Dr. Vijay Kelkar) submitted to the Ministry of Finance in December 2002 contained various recommendations relating to Drawbacks, SEZs, EOUs and Advance Licensing Scheme. Some of the recommendations of the Task Force have been accepted and implemented by the Government, subsequent to the Budget announcements. These include acceptance of self-declaration certificate of non-availment of CENVAT credit for grant of drawback, release of an amount equivalent to all industry drawback entitlement in cases of shipments under brand rate of drawback, acceptance of exporters’ declaration regarding the weight of constituent material in case of composite item and payment of interest in cases of delayed sanction of drawback beyond one month.
Policies for External Capital Flows
1.29 Significant easing of payments restrictions were effected in respect of current and capital remittances abroad. Domestic entities were allowed to retain significant proportions of their earnings abroad to meet future foreign exchange requirements. Relaxations were effected in the movement of inward and outward capital flows in the form of foreign direct investment, foreign portfolio investment, NRI deposits and external commercial borrowings. Notable among them were:
Norms on release of foreign exchange for purposes such as medical treatment abroad, private visits abroad, use of payment cards abroad, procurement of books and other items through internet liberalised including use of funds held in Non-Resident Ordinary (NRO) accounts for educational and medical purposes.
Repatriation of proceeds from sale of immovable properties allowed after a minimum of 10 years lock in period and subject to annual limits and existing taxation. Repatriation of assets of foreign nationals and assets of nonresident Indians (NRIs)/persons of Indian origin (PIOs) by way of inheritance/legacy allowed up to a yearly limit.
Up to 100 per cent of export earnings can be credited to Exchange Earners’ Foreign Currency Account (EEFC).
Norms for prepayment of external commercial borrowings (ECBs) simplified.
Foreign institutional investors (FIIs) allowed to hedge the market value of their entire investment in equity.
Rules for issue of ADRs/GDRs simplified to allow sponsoring, listing on overseas exchanges, retention of proceeds abroad and free conversions and repatriability.
Listed Indian companies permitted to invest in companies abroad under conditions; ceiling for mutual funds’ overseas investment raised to US $ 1 billion; banks’ investment abroad enhanced to 50 per cent of Tier I capital; improvement in the automatic route for Indian joint ventures/wholly owned subsidiaries abroad.
- Resident individuals permitted to open domestic foreign currency accounts.
International Finance
Financial Transaction Plan
1.30 From September 2002 India became a member of the IMF’s Financial Transaction Plan (FTP) in view of its strong balance of payments and comfortable reserves. Effective participation in FTP would amount to India becoming a creditor member of the IMF. Depending on the extent of its participation in the FTP, India’s Reserve Tranche Position (RTP) in the Fund would increase on which the IMF would pay remuneration at market related rates. The IMF prepares a quarterly FTP indicating the expected total amount that all creditor countries may have to provide during any quarter. In the quarters September-November 2002 and December 2002-February 2003, planned transfers indicated in the FTPs were SDR 6.6 billion and SDR 6.0 billion. Actual transfers effected by all the creditors taken together were about SDR 1.8 billion and SDR 3.3 billion, respectively. In those two quarters, India was allocated SDR 156 million and SDR 128 million, respectively. Since actual transfers under the FTP were far less than the planned transfers, India was not required to effect any actual transfer during those two quarters. This situation changed in the subsequent quarters. India was allocated SDR 140 million under the FTP for March-May, 2003 quarter out of a total planned transfer of SDR 6.2 billion (by all creditor members) and was requested to effect an actual transfer to the IMF for the first time, amounting to SDR 5 million. For June-August 2003, India was allocated SDR 303 million out of a total planned allocation of 13 billion for all FTP members, and actual transfers effected by India during this period amounted to SDR 200 million.
G-20 Initiatives
1.31 In March 2002, India assumed the leadership of the Group of Twenty (G-20). During India’s leadership, the G-20 Deputies deliberated on a range of issues of common concern to the G-20 members including measures for extending the benefits of globalisation, Sovereign Debt Restructuring Mechanism (SDRM), domestic policy requirements for regeneration of international capital flows, combating financing of terrorism, standards and codes, and enhancing the effectiveness of aid.
FISCAL POLICY
1.32 The stance of fiscal policy set out in the Union Budget for 2003-04 was indicated in a renewal of commitment to five basic objectives ("Panch Priorities"): poverty eradication, infrastructure development, fiscal consolidation, development of agriculture including irrigation and enhancing manufacturing sector efficiency. The process of fiscal consolidation is being carried forward through tax reforms and progressive elimination of budgetary drags, including reform of the additional excise duty and expansion of service tax. Debt restructuring and the cash management as part of expenditure management are envisaged as integral elements of fiscal consolidation.
Expenditure Management and Debt Consolidation
1.33 Cash management has been proposed to be initiated on a pilot basis in some major spending ministries so as to facilitate the release of budgetary allocations in a phased manner to permit convergence with the availability of resources within the year. Improvement in cash flow matching is expected to have salutary effects on expenditure management.
1.34 Debt restructuring would be undertaken on three fronts, viz., prepayment of external debt, buy-back of illiquid high interest rate loans from banks, and allowing State Governments to swap high cost Central Government debt with lower cost new borrowings. With regard to external debt repayment, the Union Budget expressed the intention to continue with the policy of prudently managing external liabilities and proactively liquidating relatively higher cost components of the external debt portfolio. As regards domestic debt, Government would offer to buy back high interest loans from banks on an entirely voluntary basis. The buy back scheme would enable the banks to improve their liquidity position. Furthermore, better NPA management is being encouraged through tax incentives if the banks make profits from the buy back for provisioning. Under the debt-swap scheme between the Central Government and the States, all State loans from Government of India bearing coupons in excess of 13 per cent would be swapped over a three-year period ending in 2004-05. The States are expected to save an estimated Rs.81,000 crore in interest and deferred loan repayments over the residual maturity period of the loans. The scheme would also help restrain the debt build-up in States through the small saving schemes.
Tax Reform
1.35 Tax reforms proposed in the Union Budget emphasise six important aspects: (i) Value Added Tax (VAT) for States; (ii) integration of services into the tax net; (iii) improvements in tax administration through greater application of information technology (IT); (iv) rationalisation of excise duties; (v) reduction in customs duty; and (vi) fiscal consolidation through expenditure reprioritisation and revenue augmentation.
1.36 Under direct taxes, measures taken to provide relief to taxpayers and to improve tax compliance include raising of standard deduction for salaried employees; relief to employees by exempting voluntary retirement scheme (VRS) payments from income tax up to Rs.5 lakh; rebate for education expenses up to Rs.12,000 per child for two children made eligible for rebate under Section 88 of the Income Tax Act; and tax rebate for senior citizens is increased to Rs.20,000, thereby making their income up to Rs.1.53 lakh fully exempt from income tax. For individuals, the surcharge is removed entirely; however, for incomes above Rs.8.5 lakhs, a 10 per cent surcharge on the tax has been imposed. On pension, the effective exemption limit becomes Rs.1.83 lakh per annum. The measures for simplification and rationalisation of tax regime include general deductions for individuals tax payers under section 80L on income from dividends, interest etc. up to Rs.15,000. In order in give a boost to investment, the corporate tax rate is left unchanged and the 5 per cent surcharge has been halved. The tax deductibility of interest on housing loans for construction or purchase of a self-occupied house property has been retained at Rs.1,50,000.
1.37 On the indirect tax front, rationalisation of excise rate structure and reduction of the multiplicity of rates are the main planks of tax reforms. In addition, more services have been put under the tax net and the general service tax rate has been enhanced from 5 per cent to 8 per cent. The peak rate of customs duty has been reduced to 25 per cent. In the case of excise duties, a three-tier excise duty structure - 8 per cent, 16 per cent and 24 per cent - has been implemented except for petroleum and tobacco products, pan masala and items attracting specific duty rates. The excise duty rate of 32 per cent, which applied to tyres, aerated soft drinks, polyester filament yarn, air-conditioners and motor cars has been reduced to 24 per cent.
1.38 With the objectives of minimising the cost of tax collection, encouraging voluntary compliance and to give better treatment to the existing taxpayers so as to encourage those outside the tax net to become taxpaying citizens, the budget announced certain measures to strengthen the tax administration, mainly drawing on the recommendations of the Kelkar Committee. Some of the principal measures announced in the budget are:
- outsourcing of non-core activities of the Income Tax Department;
immediate abolition of present discretion-based system for selection of returns for scrutiny;
- expanding the scope of taxpayer services;
direct crediting of all refunds to the bank account of the taxpayer through electronic clearance system,
reduction in the compliance cost to the taxpayer - the Income Tax Act is being amended to enable electronic filing of returns; abolition of tax-clearance certificates for certain categories; and
simplifying the procedures and methods employed during search and seizure, and during survey by the Income Tax department.
Social Security and Insurance
1.39 At present, primary health care, emergency life saving services, services under National Disease Control Programmes and National Family Welfare Programmes are being provided free of cost to all irrespective of their ability to pay. For a large majority of less advantaged citizens, however, access to good health services is still inadequate. In this regard, attempts are being made for utilisation of funds from Centrally Sponsored Schemes to improve functioning of primary health care institutions and minimise inter-State and inter-district differences.
1.40 A 100 per cent Centrally Sponsored Scheme called National Social Assistance Programme (NSAP) has been in existence since 1995 for providing social assistance benefit to poor households affected by old age, death of primary bread earner and maternity care. The programme has three components, viz., National Old Age Pension Scheme (NOAPS), National Family Benefit Scheme (NFBS) and National Maternity Benefit Scheme (NMBS). A scheme, viz., Annapurna was introduced on April 1, 2000, aimed at providing food security to meet the requirement of those senior citizens who though eligible for pensions under the National Old Age Pension Scheme, are not getting the same. Foodgrains are provided to the beneficiaries at subsidised rates of Rs.2 per kg of wheat and Rs.3 per kg of rice. The scheme is operational in 25 States and 5 Union Territories and more than 6.08 lakh families have been identified and are getting benefits of the scheme.
1.41 Public sector general insurance companies have been encouraged to design a community-based universal health insurance scheme during 2003-04. Under this scheme, a premium equivalent to Re.1 per day (or Rs.365 per year) for an individual, Rs.1.50 per day for a family of five, and Rs.2 per day for a family of seven will provide eligibility to get reimbursement of medical expenses up to Rs.30,000 towards hospitalisation, a cover for death due to accident for Rs.25,000 and compensation due to loss of earning at the rate of Rs.50 per day up to a maximum of 15 days. To make the scheme affordable to BPL families, the Government has decided to contribute Rs.100 per year towards their annual premium. In the first phase, at least an additional 50 lakh BPL families will be covered during 2003-04.
1.42 In order to provide relief to senior citizens and others, the Life Insurance Corporation of India (LIC) has introduced a special pension policy, following the announcement made in the budget, guaranteeing an annual return of 9 per cent in the form of a monthly pension scheme called Varishtha Pension Bima Yojana. Any citizen above the age of 55 years of age is eligible for the scheme which envisages a monthly return in the form of a pension for life. The difference between the actual yield earned by the LIC on the funds invested under the scheme and the assured return of 9 per cent, would be reimbursed to the LIC annually by the Government.
1.43 The 2001-02 budget had announced the restructuring of pensions for new Central Government employees and a scheme for the general public. The Union Budget, 2003-04 announced a new pension scheme, containing a basket of pension choices, which will be applicable to new entrants to Government service, except to the armed forces. The scheme will also be available, on voluntary basis, to all employers for their employees, as well as to the self-employed. The new scheme, when introduced, will be based on defined contributions and the contribution will be shared equally by the employees and the Government in case of Government employees. In case of individuals, who are not Government employees, there will be no contribution by the Government. The new pension scheme will allow transfer of benefits in case of change of employment, and will go into individual pension accounts with Pension Funds. The Ministry of Finance will oversee and supervise the Pension Funds through a new and independent Pension Fund Regulatory and Development Authority.
MONETARY POLICY FRAMEWORK
1.44 The monetary policy framework has undergone changes over the recent period in response to reforms in the financial sector and the growing external orientation of the economy. The endeavour of the policy has been to enhance the allocative efficiency of the financial sector, preserve financial stability and improve the transmission mechanism of monetary policy by moving from direct to indirect instruments. The stance of the monetary policy has been to ensure provision of adequate liquidity to meet credit growth and support investment demand in the economy while continuing a vigil on the movements in the price level, to continue with the present stance on interest rates including preference for softer interest rates and to impart greater flexibility to the interest rate structure in the medium-term.
1.45 Bank Rate changes, combined with CRR and repo rate changes, have emerged as important tools of liquidity and monetary management. The liquidity adjustment facility (LAF) has evolved as an effective mechanism for absorbing and/or injecting liquidity on a day-to-day basis in a more flexible manner and, in the process, providing a corridor for the call money market. In alignment with its accommodative stance in the context of stimulating industrial activity, a policy bias for soft interest rates and a flexible interest rate structure was indicated and in consonance, the CRR was reduced from 5.5 per cent to 5.0 per cent in June 2002, to 4.75 per cent in November 2002 and further to 4.5 per cent in June 2003, augmenting the lendable resources of banks by about Rs.13,500 crore. The Bank Rate and the LAF repo rate were reduced by 25 basis points each in October 2002 followed by a 50 basis point cut in the LAF repo rate on March 3, 2003. Comfortable liquidity conditions engendered by large capital inflows enabled a general reduction in market interest rates with varying sensitivity to policy signals across the maturity spectrum. Lending rates of banks exhibited, however, somewhat sluggish downward movements. The softening of interest rates was enabled by the benign inflation environment.
1.46 Monetary policy formulation for 2003-04 is based on conditional expectations of real GDP growth at about 6.0 per cent, inflation in the range of 5.0 to 5.5 per cent, projected expansion in broad money (M3) at 14.0 per cent and non-food bank credit (including investments in commerical papers, shares/ debentures/ bonds of PSUs and private corporate sector) at 15.5-16.0 per cent. The overall stance of monetary policy for 2003-04 re-affirmed preference for a soft and flexible interest rate environment within a framework of macroeconomic stability and centred on a close monitoring of inflation. In pursuit of its stance, the Reserve Bank would continue to modulate market liquidity to meet the economy’s requirements of bank credit. The stance of monetary policy was indicated through a 25 basis point cut each in the Bank Rate and the CRR. The policy preference in regard to the Bank Rate is to keep it stable in the near-term. Measures were taken to increase the efficacy of LAF operations. This was accompanied by gradual phasing out of sector-specific refinance facility and rationalisation of interest rate structure at which liquidity is available from the Reserve Bank. Strengthening of credit delivery mechanisms continued to be a concurrent priority.
FINANCIAL SECTOR REFORMS
1.47 Strengthening of the financial sector and improving the functioning of the financial markets are the core objectives of financial sector reforms in India. The central plank of financial sector reforms is a set of prudential norms aimed at imparting strength to banks and financial institutions as well as inculcating greater accountability and market discipline. These norms include not only capital adequacy, asset classification and provisioning but also accounting standards, exposure and disclosure norms, investment and risk management as well as asset-liability management guidelines. The approach has been to benchmark the norms against international best practices. Financial sector reforms were carried forward during 2002-03 with the announcement of measures for streamlining banking operations, upgradation of risk management systems, operationalisation of consolidated accounting practices and enactment of a new Act to improve the recovery of non-performing loans.
Prudential Norms
1.48 The Reserve Bank’s approach to the institution of prudential norms has been one of incremental convergence with international standards and best practices. The internationally accepted 90-day norm for recognition of loan impairment would be applicable to commercial banks, co-operative banks and regional rural banks with convergence set for the year ending March 2004. For State Co-operative Banks and District Central Co-operative Banks, the convergence is set for the year ending March 2006. Beginning April 2002, banks began to move over to charging interest at monthly rests in order to achieve smooth convergence. The transition time for a sub-standard asset to be classified as a doubtful asset has been shortened from 18 months to 12 months with effect from March 31, 2005. The consequent additional provisioning is to be phased over a four-year period with a minimum of 20 per cent each year. The Reserve Bank participated in a Quantitative Impact Study (QIS) conducted by the Basel Committee to assess the impact of the new Capital Accord. A broader internal process of preparing banks for the complexity of the new Accord and the costs involved in adherence is also underway. The Reserve Bank forwarded its comments on the Third Consultative Paper of the New Basel Capital Accord to the Basel Committee of Banking Supervision in July 2003. The Reserve Bank has emphasised the need to take into account the structural characteristics of different economies as also preserving the spirit of simplicity and flexibility to ensure universal application of the New Accord. India has also shared the international concern on money laundering and financing of terrorism. "Know Your Customer" procedures have been put in place to prevent the misuse of the financial system.
1.49 In January 2002 banks were advised to build up Investment Fluctuation Reserve (IFR) of a minimum of 5 per cent of the investment portfolio within a period of 5 years. IFR should be computed with reference to investment in two categories, viz., ‘Held for Trading’ and ‘Available for Sale’. It is not necessary for banks to include the investment under ‘Held to Maturity’ category while computing IFR. IFR was treated as Tier II capital up to a maximum of 1.25 per cent of total risk-weighted assets. Effective from March 31, 2003 this ceiling was removed. For capital adequacy purposes, Tier II capital including IFR would be considered up to a maximum of 100 per cent of Tier I capital.
1.50 In adherence to the Core Principles of Banking Supervision, guidelines on country risk management and provisioning thereof were provided to banks to encourage internal assessment of country risk. These guidelines are applicable only in respect of countries where a bank has net funded exposure of two per cent or more of its total assets. Depending on the risk category of the country of exposure, banks were directed to make provisions, with effect from the year ended March 31, 2003, on the net funded country exposures on a graded scale ranging from 0.25 to 100 per cent. Provisions held for country exposures are allowed to be treated on par with the ‘provisions held for standard assets’ for being reckoned for Tier II capital, subject to the ceiling of 1.25 per cent of the risk weighted assets.
1.51 Subordinated debt issued by banks in the nature of unsecured redeemable bonds currently qualify for inclusion in Tier II capital. Banks were able to utilise long-term resources raised from the market through subordinated debt to enable them to realign their portfolios for asset-liability management.
1.52 Several measures were taken to strengthen the financial position of the urban co-operative banking sector by extending the capital adequacy standards to urban co-operative banks (UCBs), prescribing an asset-liability management framework for the scheduled UCBs, enhancing the proportion of holding of Government and other approved securities by UCBs for the purpose of SLR, besides restriction on bank finance against the security of corporate shares and debentures.
1.53 Management and internal control systems are weak areas in the functioning of UCBs. New urban banks are required to have at least two Directors with requisite professional qualifications or adequate experience in banking. This requirement was extended to the existing UCBs as well. It has been proposed to impose a complete ban on advances by UCBs to Directors and their specified relatives and to concerns in which the Directors are interested effective October 1, 2003. UCBs which have fully/ partially computerised their operations are required to introduce an electronic data processing (EDP) audit system and set up audit committee of the Board for overseeing and providing directions to internal audit/inspection machinery of the UCB. The Audit Committees would examine and follow up observations and suggestions made in the Reserve Bank’s inspection report and Statutory Audit reports.
NPA Management
1.54 A broad framework has evolved for the management of NPAs under which a menu of options are provided for debt recovery and restructuring. Banks and financial institutions have the freedom to design and implement their own policies for recovery and write-off incorporating compromise and negotiated settlements The menu of options available to banks included : (a) reschedulement/restructuring done at bank level; (b) reschedulement/ restructuring done through the corporate debt restructuring (CDR) mechanism; (c) resolution/recovery through Lok Adalats civil courts and debt recovery tribunals (DRTs); (d) compromise settlement as per management’s own schemes and the Reserve Bank’s guidelines for public sector banks; (e) sale of assets to reconstruction companies/ securitisation companies and (f) recovery through powers available under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002.
1.55 The quality and performance of advances have a direct bearing on the profitability and viability of banks. While several measures have been undertaken towards preventing the accumulation of non-performing loans, in the absence of creditor rights, the problem has persisted, despite the credit appraisal and disbursement mechanism in place. To address this aspect, the final guidelines and directions on SARFAESI Act issued in April 23, 2003 cover all aspects relating to asset reconstruction and securitisation These include, inter alia, registration, owned funds, permissible business, operational structure for giving effect to the business of securitisation and asset reconstruction, deployment of surplus funds, internal control systems, prudential norms and disclosure requirements for asset reconstruction/securitisation companies. The Act empowers secured creditors to enforce any security interest created in its favour without any intervention of court or tribunal. The secured creditor may require the borrower to discharge the liabilities within a stipulated time frame from the date of notice, failing which the secured creditor is entitled to take possession or management of the secured assets. In addition to the guidelines and mandatory directions, the Reserve Bank also issued guidance notes of recommendatory nature covering aspects including acquisition of assets and issue of security receipts. It is envisaged that banks would be able to sell their non-performing loans (NPLs) to securitisation/reconstruction companies at a considerable discount and the resultant shortfall, if any, in the net book value (total assets of banks less provisions held), would be required to be debited to the profit and loss account. Banks were accordingly advised to build up provisions, significantly above the minimum regulatory requirements for their NPAs, particularly for those assets which they propose to sell to securitisation/reconstruction companies.
1.56 Yet another opportunity was provided to borrowers for compromise settlement of chronic NPLs of public sector banks/ FIs up to Rs.10 crore. Fresh guidelines were issued which provide a simplified, non-discretionary and non-discriminatory mechanism for compromise settlement of chronic NPLs. Public sector banks were directed to uniformly implement these guidelines in order to achieve maximum realisation of dues from the stock of NPLs. The processing under the revised guidelines would have to be completed by December, 2003.
1.57 Banks were advised to consider introduction of a new asset category of "special mention accounts" in between "standard" and "sub-standard" accounts for their own internal monitoring and follow-up for assets with potential weaknesses which deserve close attention for resolution through timely remedial action.
Issues in Regulation and Supervision
1.58 The limitations of traditional supervisory practices in the swiftly changing financial environment has provoked supervisors the world over to continuously refine their approaches in consonance with advances in technology, innovations and globalisation. The Reserve Bank’s move towards risk-based supervision (RBS), which entails the allocation of supervisory resources and focus in accordance with risk profiles, is part of a forward-looking refinement of the supervisory function which will help in aligning supervised institutions with the New Basel Capital Accord when it is adopted. Drawing on assistance from international consultants and a study of the country-specific requirements as well as the cross-country experience, management processes were initiated in 2002-03 for a smooth switchover to RBS. They covered a discussion paper and analysis of responses thereon, risk profiling, preparation of manuals, training and other requirements. RBS was introduced during April-June 2003 for a few select banks on a pilot basis. Based on the experience gained, RBS would be extended to all banks in a phased manner.
1.59 The scheme of prompt corrective action (PCA), developed as a tool with trigger points for prompt supervisory response was put in place in December 2002 initially for a period of one year. The PCA framework includes structured action by the Reserve Bank when banks hit the trigger points (capital adequacy, NPAs, return on assets). It does not, however, preclude other discretionary corrective steps by the Reserve Bank.
1.60 As a step towards consolidated supervision, guidelines were issued to banks on consolidated accounting and quantitative methods for compliance from the year ended March 31, 2003. Initially, consolidated supervision would be mandated for all groups where the controlling entity is a bank. Over time, entities in mixed conglomerates would be brought under its purview. A critical requirement for supervised entities would be the setting up of appropriate management information systems (MIS) to support compliance with the consolidated accounting and reporting requirements.
1.61 The Reserve Bank, in its endeavor to ensure convergence of its supervisory norms and practices with the international best practices and to align standards adopted by Indian banks with the global standards, constituted a Working Group to eliminate/reduce gaps in compliance with the Accounting Standards issued by the Institute of Chartered Accountants of India. Based on the recommendations of the Working Group in respect of certain Accounting Standards where there were gaps in compliance, detailed guidelines were issued to banks.
1.62 To enable the regulated entities to manage their exposure to interest rate risk, scheduled commercial banks (excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs), Primary Dealers and specified All India Financial Institutions were allowed to deal in exchange traded interest rate derivatives. In the first phase, these entities are allowed to transact only in interest rate futures on notional bonds and Treasury Bills for the limited purpose of hedging the risk in their underlying investment portfolio.
1.63 Other supervisory initiatives during the year included development of macro-prudential indicators, managing the transition to risk-based internal audit, and computer and information systems audits for inspection in a computerised environment.
1.64 With a view to strengthening supervision of UCBs, the Reserve Bank introduced a system of off-site surveillance. A new system of grading UCBs based on their level of capital to risk weighted assets ratio (CRAR), level of net non perfroming loans (NPLs), record of losses and compliance with liquidity requirements was introduced. A system of supervisory rating for urban co-operative banks under the CAMELS (Capital, Assets, Management, Earnings, Liquidity and Systems) model is envisaged. In order to bring transparency in their balance sheets effective from the year ending March 31, 2003 all urban cooperative banks with deposits of Rs.100 crore and above are required to disclose in notes to their accounts additional specified information. They should also indicate the position of payment of deposit insurance premium to the Deposit Insurance and Credit Guarantee Corporation (DICGC) in their Directors’ Report.
1.65 Considerable progress has been made in consolidating the existing payment systems and in upgrading technology with a view to establishing an efficient, integrated and secure system functioning in a real-time environment. Major projects under implementation are electronic clearing, centralised funds management, structured financial messaging solutions and the Indian Financial Network (INFINET). Facilities under Electronic Funds Transfer (EFT) have been upgraded and their spatial reach expanded with multiple settlements in a day. Foreign exchange clearing has been initiated through the Clearing Corporation of India Limited (CCIL).
Adequate security features are being incorporated into the EFT. Preparatory work for the real time gross settlement (RTGS) is complete. The live run of RTGS is scheduled towards the end of 2003.
Policies for Financial Markets
1.66 A number of steps were taken during 2002-03 to ensure balanced development of various segments of the financial market with a forward-looking perspective. The Reserve Bank’s endeavour has been to develop a competitive and diversified financial market structure catering to various classes of instruments and participants of varying risk profiles, and with different market segments merging seamlessly into a continuum. A key priority is the development of the technological and institutional infrastructure for efficient financial intermediation.The operationalisation of the CCIL and the negotiated dealing system (NDS), introduction of collateralised borrowing and lending obligation (CBLO), collateralised repo transactions and interest rate options would increase the depth of the financial markets and prepare them for the operationalisation of RTGS.
Money Markets
1.67 A basic objective of money market reforms in the recent years has been to facilitate the introduction of new instruments and their appropriate pricing under orderly market conditions. A crucial prerequisite in this regard is the development of market segments which exclusively deal in specific assets and liabilities as well as participants. Accordingly, the call/notice money market is being transformed into a pure inter-bank market. Systemic stability is being ensured through prudential limits on exposures to the call money market. This was supported during 2002-03 through the rationalisation of standing liquidity support to banks from the Reserve Bank and facilities for exceptional liquidity support.
Government Securities Market
1.68 Initiatives for developing and deepening the government securities market were carried forward alongside a strengthening of regulation and surveillance. An enabling environment for proper investment planning by market participants was fostered by transparent dissemination of prospective issuances of government securities, introduction of new instruments to deal with risks associated with unanticipated market movements, and institution of anonymous screen-based order-driven trading in government securities on the stock exchanges.
Foreign Exchange Market
1.69 Orderly development of the foreign exchange market was pursued in the form of easing of entry restrictions, expanding the freedom of market participants and by creating greater space for the market in general by ongoing liberalisation of international current and capital transactions. Authorised dealers (ADs) in foreign exchange were allowed to offer foreign currency – rupee options and to undertake swaps with residents with unlimited hedging of exchange risk. Forward cover was allowed in respect of a number of capital transactions with greater freedom in the booking of forward contracts.
Capital Market
1.70 Policies for the capital market during 2002-03 were directed towards enhancing market efficiency and achieving better investor protection through greater transparency and improved trading and settlement systems. Important legislative changes with far reaching implications for the functioning of the capital market were initiated by the Government of India. The Securities and Exchange Board of India (SEBI) was vested with search and seizure powers in cases relating to insider trading and market manipulations. The penalties to be imposed by the Adjudicating Officer were enhanced so as to serve as effective deterrents. The Companies (Second Amendment) Act, 2002 was enacted to provide for a new, modern, efficient and time-bound insolvency law for both rehabilitation and winding up of sick companies within a maximum time frame of two years.
1.71 The SEBI introduced compulsory rolling settlement on a T+3 basis effective April 1, 2002. The settlement cycle was further shortened to T+2 basis effective April 1, 2003 with a view to reducing risks in the market and protecting the interest of investors, in line with the international best practices.
1.72 The SEBI accepted the recommendations of the Group on Corporatisation and Demutualisation of Stock Exchanges which recommended, inter alia, a uniform model of corporatisation and demutualisation to be adopted for all stock exchanges. With the issue of the SEBI (Central Listing Authority) Regulations, 2003 and formation of Central Listing Authority (CLA), companies are now required to obtain recommendation from the CLA prior to their listing in stock exchanges.
The existing list of stocks on which derivatives are traded was enlarged. With a view to developing the derivatives market further, interest rate derivatives were introduced on National Stock Exchange (NSE) with effect from June 24, 2003. Initially, the contracts have been introduced on a notional Government Security with a 10 year maturity and a Notional Treasury Bill with a maturity of 91 days or three months which would be cash settled. The SEBI put in place the risk containment measures to be adopted for such derivatives contracts. With a view to obviating the need for manual entry and re-entry of data on trade particulars which is time consuming and prone to errors, the Straight Through Processing (STP) for electronic trade processing with a common messaging standard was introduced. Based on the recommendations of the Bhagwati Committee, the SEBI made certain amendments to the Takeover Regulations which include inter alia removal of automatic exemption for acquisition through preferential allotment, increased frequency in disclosure of shareholding when it crosses 5 per cent, 10 per cent and 14 per cent. In order to enable the retail investors to participate in trading in government securities, the screen-based retail trading in government securities was launched on January 16, 2003. With this initiative, a major segment of the Indian fixed income securities market, which until recently was dominated by the wholesale investors like banks and insurance companies, was made accessible to the retail investors.
Corporate Governance
1.73 As part of the broader set of reforms aimed at improving the functioning of the securities market, the SEBI has initiated several measures to improve information flow from listed companies. It has also been the endeavour of SEBI to improve corporate governance practices for listed companies so as to infuse a sense of discipline and accountability in the Indian corporate sector.
1.74 During 2002-03, the SEBI amended the Listing Agreement to tighten disclosure norms for companies opting to publish audited results for the entire year within three months instead of publishing unaudited results for the last quarter within 30 days. Norms with regard to disclosure by listed companies in respect of loans/advances and investments, disclosure of audit qualifications and actions thereon, were strengthened. A clause was incorporated in the Listing Agreement requiring the companies to furnish statements and reports for the Electronic Data Information Filing and Retrieval (EDIFAR) system maintained by SEBI.
Mutual Funds
1.75 Various measures have been undertaken to improve the operations and governance of mutual funds. These include, inter alia, disclosure of performance of benchmarks, guidelines for valuation of unlisted equity shares, distribution of realisation from non-performing or illiquid assets to old investors after redemptions, emphasis on following the code of conduct and insider trading regulations, uniformity in calculation of sale and repurchase price, increasing the frequency of meeting of trustees, guidelines on risk management norms, increase in the investment limit on foreign securities and mandatory registration of intermediaries engaged in selling and marketing of mutual funds units.
Changes in the Legal Framework
1.76 In the recent period, the progress of financial sector reforms has encountered impediments in the form of the inadequacy of the existing legal infrastructure and its incompatibility with the evolving environment. Changes in financial markets, diffusion of financial innovations and the information technology revolution have sharpened the mismatch between the developments in the financial system and the ambit of regulatory authority of the Reserve Bank. A review of the laws relating to the regulatory responsibilities of the Reserve Bank suggests the way forward in the deepening of reforms in the legal architecture.
1.77 Macroeconomic policy settings for 2003-04 imbibe the positive expectations generated by the strengthening of the fundamentals and the resilience acquired by the economy despite being beset by significant shocks during the year gone by. The prospects for the economy are sanguine with real GDP growth expected to shrug off the loss of momentum and set the stage for a surge to full potential. In the wake of a reasonably good progress of monsoon till July, agricultural output is poised to register a recovery and join industry and services in resumption of trend growth. The smart rebound in exports of merchandise and invisibles in 2002-03 is expected to get entrenched during the year ahead. The experience of the early months of 2003-04 suggests that capital inflows would remain strong. The consequent accretion to international reserves would test the conduct of monetary policy, given its aggressive stance on holding wholesale price inflation. Nevertheless, financial markets would continue to experience ample liquidity conditions and a softening of interest rates. Ongoing fiscal consolidation would be supported by a renewed thrust to intensify and broaden the ambit of structural reforms in pursuit of the goals of the development strategy.
* While the Reserve Bank of India’s accounting year is July-June, data on a number of variables are available on a financial year basis, i.e., April-March, and hence, the data are analysed on the basis of the financial year. Where available, the data have been updated beyond March 2003. For the purpose of analysis and for providing proper perspectives on policies, reference to past years as also prospective periods, wherever necessary, has been made in this Report.
II - The Real Economy
MACROECONOMIC SCENE
2.1 A broad-based revival in industrial activity and a resurgence of growth in the services sector sustained economic activity in 2002-03. Real GDP originating in industry recovered steadily from the first quarter onwards, surging up towards trend levels on the strength of a rebound in manufacturing. The improvement in services sector GDP growth emanated from construction, ‘financing, insurance, real estate and business services’ and ‘community, social and personal services’. While the return of growth momentum in industry and services augured well for the economy, severe drought conditions impacted on the farm sector in several States, producing a contraction in real GDP originating from ‘agriculture and allied activities’. The loss of agricultural output was pronounced from the second quarter onwards, reflecting the full effects of the drought. Moisture stress was of a scale and intensity comparable to the severe drought of 1987 which had resulted in real GDP growth slowing down to 3.8 per cent in 1987-88. Despite the intensity of the supply shock to agriculture, the growth of real GDP at 4.3 per cent in 2002-03 was symptomatic of resilience and a degree of weather-proofing of the economy.
Agriculture
2.2 Indian agriculture experienced one of the worst droughts in 2002-03. A long, dry spell beginning in July 2002, a crucial month for sowing and plant growth, culminated in rainfall during the South-West monsoon season being at only 81 per cent of the Long Period Average (LPA).
2.3 The production of foodgrains and non-foodgrains was adversely affected almost across-the-board with the fall in kharif output sharper than that of rabi. Rice and coarse cereals were particularly affected by drought conditions. Oilseeds production declined mainly on account of dip in the production of groundnut, rapeseed/mustard and soyabean. The index of agricultural production (base: triennium ending 1981-82 = 100) recorded the steepest decline since 1979-80.
2.4 Foodgrain procurement was lower in 2002-03, reflecting the drought conditions. Off-take, on the other hand, was significantly higher, mainly on account of Open Market Sales (OMS) including exports, 'food for work' schemes and other welfare schemes (OWS). Higher off-take through the PDS and OWS was facilitated by lowering of issue prices under Targeted Public Distribution System (TPDS) for Above Poverty Line (APL) families, and by increasing the monthly allocation for APL, Below Poverty Line (BPL) families and Antyodaya families. As part of drought relief measures, the Central Government allocated 8.3 million tonnes of foodgrains to the drought affected States; of this 4.7 million tonnes were lifted during 2002-03.
Industry
2.5 A modest revival in industrial activity which set in by March, 2002 permeated all segments during 2002-03, with manufacturing contributing more than 80 per cent of the overall growth of industrial production. Strengthening signs of resumption of investment demand were evident in a sharp rise in the production and imports of capital goods. The industrial recovery enabled a robust expansion in exports of manufactures in spite of the slack in global demand, and triggered a coincident upswing in non-food credit from the banking system.
2.6 The Index of Industrial Production (IIP) rose through the first half of 2002-03 boosted by rural demand in the wake of the rabi harvest, before levelling off in the second half of the year. The growth of manufacturing peaked in September 2002, driven up by resumption of export demand in a wide range of industries. Leading the upsurge in manufacturing were five industry groups comprising 'beverages, tobacco and related products', 'basic chemicals and chemical products', 'food products', 'transport equipment and parts' and 'basic metal and alloy’ industries. The growth in mining and quarrying reached a high in July 2002. The growth of electricity remained broadly unchanged, despite the persistence of demand-supply gaps.
Use-based Classification
2.7 The demand composition of industrial production reveals that consumer non-durables production rose sharply and accounted for nearly half of the growth in the IIP, followed by basic goods. A positive development in 2002-03 was the significant turnaround in capital goods production after an absolute decline in the preceding year. Intermediate goods shared in this expansion albeit on a more moderate scale. Production in the consumer durables segment declined reflecting weak demand, particularly the slowdown of rural demand. Despite some shortfalls vis-a-vis the targets in key infrastructure industries, there was an overall improvement in production conditions in infrastructure during 2002-03.
Services Sector
2.8 Services regained their role as the principal driver of the Indian economy, accounting for 89.4 per cent of the real GDP growth in 2002-03. The resumption of near-trend growth in services was enabled by a pick up in activity in construction, 'financing, insurance, real estate and business services' and 'community, social and personal services'. This outweighed the deceleration in the growth of 'trade, hotels, transport and communication' services which constitute a little less than half of the services sector.
AGGREGATE DEMAND
2.9 The halting recovery of aggregate demand seems to have restrained a stronger acceleration of sectoral activity in 2002-03. The evolution of real effective demand up to 2001-02 indicates that it is consumption which has held up aggregate demand in the period of slower growth since 1998-99. The upsurge in real consumption expenditures in the recent period was shared between private final consumption expenditure and government final consumption expenditure, the latter including the counter-cyclical component of fiscal policy in the context of the slowdown. On the other hand, the growth of real gross fixed capital formation slowed down in both private and public sectors, reflecting the moderation of planned investment in the presence of idle capacity. Since 1995-98, there has been a precipitous decline in private fixed investment in real terms and considerable volatility in stocks/inventories.
2.10 The gross domestic saving (GDS) rate has been increasing in recent years, buoyed by the rise in both physical and financial saving of the household sector. A major factor contributing to this increase has been a steady improvement in personal disposable income. The improvement in the financial saving of the household sector has been mainly in the form of contractual instruments. A major area of concern is an unprecedented deterioration in the rate of public sector saving from a high of 2 per cent of GDP in 1991-92 to a dissaving which began in 1998-99 and touched (-)2.5 per cent in 2001-02, posing a constraint on growth. The rate of saving of the private corporate sector has decelerated since 1996-97 as a result of declining profitability in the downswing of the business cycle.
2.11 On the basis of the latest available data, financial saving (net) of the household sector, as a percentage of gross domestic product at current market prices, is estimated at 11.1 per cent in 2002-03 as compared with the revised estimate of 10.9 per cent in the previous year. The marginal increase in 2002-03 primarily reflected increases in the rates of contractual saving (life insurance, provident and pension funds) and shares and debentures. In contrast, the rate of household sector saving in the form of deposits is estimated to have shown a marginal deceleration in 2002-03 principally due to non-bank deposits and trade debt (net).
2.12 Despite the easing of the traditional constraints on the availability of domestic and external saving, rates of gross capital formation (GCF) at current prices and gross domestic capital formation (GDCF) (adjusted for errors and omissions) have decelerated.
2.13 The growth prospects for the current financial year hinge around the sustainability of the industrial upturn and a recovery in agricultural performance. The performance of agriculture would continue to depend upon the progress of monsoon, particularly its spatial distribution. Initial expectations support a strong rebound from the absolute decline in output recorded last year. The climate for industrial revival is showing a distinct improvement in an environment of higher overall growth prospects, low and stable inflation, rising international competitiveness and conducive monetary and fiscal policies. The buoyancy of the services sector would be contingent upon the strength of the symbiotic interface with the goods sector and the growth of 'new economy' activities.
2.14 The Tenth Five Year Plan (2002-07) has envisaged an average annual growth of 8 per cent. India's growth experience over the Eighth and Ninth Plan periods demonstrates that this growth target is feasible. The future growth strategy will have to rely on a combination of increased investment and improvement in efficiency. Rapid dismantling of policy constraints, procedural rigidities and price distortions will play a critical role in the drive to a higher growth path. It will also require that the appropriate changes in institutional architecture are put in place. In these efforts, achieving a growth rate of 6.0 per cent in 2003-04 becomes a critical minimum.
III - Money, Credit and Prices
3.1 Monetary conditions closely tracked the evolution of real activity during 2002-03. The growth of non-food bank credit, inclusive of banks’ investments in non-Statutory Liquidity Ratio (non-SLR) instruments, was in consonance with the recovery of industrial output. Credit expansion was facilitated by conditions of ample liquidity in financial markets, engendered by massive capital inflows. Interest rates declined across the spectrum in response to the easy liquidity conditions, and to monetary policy signals for softening that were transmitted through cuts in the Bank Rate, the repo rate and the cash reserve ratio (CRR). The lowering of interest rates was made possible by a benign inflation environment except for a spurt in the last quarter due to the hardening of international oil prices and of some drought related price hike for items such as oilseeds and edible oils. On the other hand, currency and deposit growth slowed down moderately reflecting the adverse impact of the drought on rural incomes and the lowering of deposit rates by banks. Broad money growth reflected these diverse impulses from real activity. Reserve money growth was moderated by the deployment of policy instruments to counter the expansionary effects of large external flows.
RESERVE MONEY
3.2 The behaviour of reserve money in 2002-03 was predominantly influenced by the large inflows from abroad. Excess supply conditions in the foreign exchange market were reflected in continuous purchases of foreign exchange by the Reserve Bank and accretions to the Reserve Bank’s foreign currency assets. The primary liquidity generated by this substantial accretion to the net foreign assets (NFA) was sterilised through active recourse to open market sales and repos under the liquidity adjustment facility (LAF). As a result, the net domestic assets (NDA) of the Reserve Bank declined to barely 2.9 per cent of reserve money at end-March 2003.
3.3 The decline in the NDA to near-zero levels as a proportion to reserve money focuses attention on the limits being approached to full sterilisation and, therefore, on the future conduct of monetary policy in the context of large and sustained capital inflows.
3.4 The Centre’s comfortable liquidity position was reflected in lower recourse to loans and advances from the Reserve Bank during 2002-03.
3.5 Reserve money recorded a higher order of year-on-year expansion during 2003-04 so far (as on August 15, 2003). The growth in reserve money was entirely on account of sustained external flows driving up the NFA of the Reserve Bank. As a result, the NFA-currency ratio reached the level of 131.7 per cent as on August 15, 2003. The increase in NFA was partly offset by a further decline in the Reserve Bank’s net credit to the Centre.
MONETARY SURVEY
3.6 Broad money (M3) slowed down in consonance with real GDP growth during 2002-03, remaining within the indicative projection of the Monetary and Credit Policy announcement of April 2002. Slower growth of currency as well as aggregate deposits restrained monetary expansion, as deposits turned relatively unattractive at the margin in comparison with competing instruments of financial saving. This switch in preference away from bank deposits for alternative avenues of asset formation was also evident in a robust growth of postal deposits which drove up the principal liquidity measure i.e. , L1 relative to M3.
Sources of Money Supply
3.7 The pick-up in domestic credit during 2002-03 was absorbed by the government and the commercial sectors. Scheduled commercial banks’ holding of Government securities was around 39.0 per cent of their net demand and time liabilities (NDTL); at end-March 2003, they were higher by Rs.1,95,974 crore than the statutory minimum requirement of 25.0 per cent required for the maintenance of the SLR. Since the 1990s, government securities have emerged as an attractive avenue for investments by banks, particularly in the context of prudential norms imposed under financial sector reforms.
3.8 Food credit declined in 2002-03 due to a significant fall in procurement operations. This added to liquidity in the system. Non-food credit extended by scheduled commercial banks accelerated to accommodate the revival of industrial activity.
3.9 The increase in non-food credit demand was well distributed across industries. Since 1997-98, the share of non-SLR investments in commercial sector credit has doubled, indicative of a shift in portfolio choice for tradable assets as against traditional loans and advances.
Developments during 2003-04
3.10 Year-on-year broad money (M3) expansion decelerated during 2003-04 (as on August 8, 2003) mainly on account of slowdown in aggregate deposits. Deceleration in time deposits growth continued in response to lower interest rates and the continuing impact of last year’s drought. Among the sources, growth in net bank credit to the Government decelerated. Bank credit to commercial sector slowed down primarily on account of decline in food credit which, in turn, was due to lower procurement and higher off-take. Commercial banks’ non-food credit remained more or less steady in consonance with industrial growth. Non-SLR investments declined mainly on account of a decline in banks’ investments in bonds/debentures.
3.11 The flow of resources from non-banks by way of capital issues, GDRs/ ADRs/FCCBs, CPs and credit from financial institutions (FIs) to the commercial sector continued to be subdued. Credit from FIs shrank for the second consecutive year due to slowdown in their new business while loans extended by them in the past were repaid. Capital issues dwindled under depressed conditions in the primary market and waning of corporates’ interest due mainly to sluggish investment activity.
PRICE SITUATION
3.12 Inflation remained low in India over the first three quarters of 2002-03 in a benign international inflation environment. In the US and the Euro area, inflation was close to two per cent. Output gaps held down inflation in most of the industrial countries. Declining inflation raised the fears of deflation in several countries. The Japanese experience of prolonged decline in prices, bound in a spiral of weak activity and financial stress, is being examined afresh as several Asian countries (China, Hong Kong, Singapore, Taiwan and Thailand) joined Japan in deflation, either intermittently or persistently. Consumer prices are expected to increase by less than two per cent in 2003 in advanced economies and by just under six per cent in developing countries.
3.13 Headline inflation firmed up in June and July 2002 on the back of two rounds of increases in POL prices, and the impact of drought conditions which drove up prices of oilseeds and edible oils in the first half of the year. Inflation started easing in the second half of September 2002 as supply management strategies - step up in off-take, reduction in issue prices below economic cost, enhanced allocation for targeted employment programmes and imports - were put in place.
3.14 Reflecting the global situation, inflation in India firmed up in the last quarter of 2002-03, driven up by the hardening of international oil prices and supply side pressures on items like oil seeds, edible oils and oil cakes.
3.15 Within the overall variation in wholesale price inflation, disaggregated commodity price movements indicate that the inflation record of 2002-03 was dominated by the prices of non-food items; in contrast, it was primary food items which drove inflation in the preceding year.
Consumer Price Inflation
3.16 Consumer price inflation, measured by the annual variation in the average consumer price index for industrial workers (CPI-IW) eased during the year, reflecting lagged adjustments to agricultural supply disturbances.
Outlook
3.17 Upside risks from international oil prices for domestic inflation began to ebb with fortnightly downward revisions in domestic mineral oils (POL) prices beginning April 16, 2003. Point-to-point WPI inflation which had spurted to 6.9 per cent on May 3, 2003 caused by the one-time upward revision in electricity prices and the transporters' strike edged down below 4.0 per cent by August 2, 2003.
3.18 Based on the evolving international environment, the movement of key international prices and the underlying monetary conditions in India, inflation in India is expected to be in the range of 5.0 to 5.5 per cent as projected in the Monetary and Credit Policy for 2003-04.
3.19 Monetary conditions in 2003-04 are expected to be dominated by external capital flows. During 2003-04 so far (up to August 8), the net foreign assets of the banking sector rose by Rs.32,997 crore. The demand for non-food bank credit is likely to be maintained on the rising trajectory which began in early 2002, given the positive investment climate and the anticipation of a recovery in agricultural activity. Notwithstanding the projected expansion of non-food credit (15.5 to 16.0 per cent) and the size of borrowings of the Government sector, capital inflows, the release of resources through the CRR cut in June 2003 and lower order of food credit growth, monetary and liquidity conditions would facilitate a soft and flexible interest rate regime, consistent with the monetary policy stance.
IV - Government Finances
4.1 The slowing of economic activity due to the drought impacted on public finances in 2002-03. In the revised estimates, the combined gross fiscal deficit of the Centre and States overshot its budgeted level by more than one per cent of GDP on account of the shortfall in tax revenue and disinvestment from budget estimates. Furthermore, the imperatives for food supply management in the context of the drought necessitated fiscal support in the form of higher food subsidies, which surged back almost to 1991-92 level as a proportion to GDP. Despite these setbacks, there were distinct gains in expenditure management. The Centre reined in its expenditure by pruning non-plan spending. On the other hand, the States' expenditure exceeded budget estimates, but this was mainly in the form of a spurt in capital expenditure towards debt consolidation. Importantly, States were able to contain the revenue expenditure around the budgeted level. Notwithstanding these modest successes in expenditure containment, the slippages from the budgetary projections underscore the deterioration in the quality of fiscal adjustment.
4.2 The tax-GDP ratio has been losing buoyancy over the 1990s, falling by more than two per cent of GDP by the year 2001-02 from the level attained in the late 1980s. This imparts urgency to reforms in the tax regime in the form of simplification of rules, widening the tax base, reviewing exemptions and improving compliance. The surge in interest payments following reforms in budgetary financing has continued unabated, and it is only in 2002-03 that some moderation in pace has set in. The steady improvement in the primary deficit coupled with fall in capital outlay during the 1990s indicates that the burden of the unrelenting expansion in interest outgoes has devolved on productive elements of fiscal spending. The overarching priority attached to reduction of expenditure to meet deficit targets has accentuated the erosion of capital outlays with serious implications for expanding the productive capacity of the economy in the future. Expenditure on subsidies has remained impervious to fiscal adjustment, while spending on social infrastructure continues to remain low. Large gaps in disinvestment have intensified the fiscal stress. Reflecting these adverse developments, the debt-GDP ratio has been climbing since the second half of the 1990s and is expected to touch 77 per cent of GDP by the end of March 2004. Moreover, the monotonic rise in public debt has eroded the Government sector’s ability to generate savings and to service its internal debt. The "quality" of the fiscal deficit has worsened, with the revenue deficit having increased substantially indicating that a larger share of borrowed fund is pre-empted by consumption expenditure.
CENTRAL GOVERNMENT FINANCES, 2002-03
4.3 Expenditure management strategies put in place by the Centre since the second half of the 1990s have begun to yield room for fiscal manoeuvre, notwithstanding the slippages in terms of deficit indicators in the recent years. Despite additional expenditure on account of drought relief and Plan allocations, cuts in non-Plan expenditure enabled a reduction in overall spending (as per revised estimates vis-à-vis budget estimates) by the Centre in 2002-03. The expenditure on subsidies, however, increased significantly during 2002-03 reflecting the impact of dismantling of the Administered Price Mechanism (APM) for petroleum products as also the increase in food subsidy on account of drought conditions. The gap in revenue receipts visa-vis initial expectations was due to the fall in collections of direct taxes. Non-tax revenue remained broadly unchanged at 3 per cent of GDP in 2002-03, unresponsive to the impulses of fiscal reforms. The disinvestment programme made some progress during 2001-02 with the strategic sale process of some public sector undertakings gaining momentum; nevertheless the actual proceeds were lower than the targeted amount.
STATE GOVERNMENT FINANCES, 2002-03
4.4 The growth of revenue receipts of States during 2002-03 over the previous year was facilitated mainly by a rise in States' own taxes and grants from the Centre. There were shortfalls in the States' own revenue receipts (tax and non tax revenue) as well as in States’ share in Central taxes in the revised estimates visa-vis budget estimates.
4.5 Total expenditure in the revised estimates exceeded budget projections in 2002-03 on account of higher capital expenditure. The increase in capital expenditure was mainly due to increases in the repayment of loans to the Centre and financial institutions reflecting the retirement of high cost debt owed to the Centre under the debt-swap scheme. Capital outlay in the revised estimates for 2002-03, however, fell short of budget estimates. The revised estimates for 2002-03 indicate deviations in all major deficit indicators of State finances, with significant slippages in the revenue deficit as well as the primary deficit. Gross fiscal deficit was also higher in the revised estimate as compared with the budget estimates.
DOMESTIC PUBLIC DEBT
4.6 The widening fiscal gap has led to a steep rise in the outstanding liabilities of the Government. Of the outstanding domestic debt of the Central Government, internal debt alone accounted for 66.4 per cent and 'other liabilities', accounted for 29.9 per cent at the end of March, 2003. The sharp increase in the debt-GDP ratio since the mid-1990s is reflected in burgeoning interest payments, despite a decline in interest rates.
4.7 The high level of gross fiscal deficit has aggravated the debt position of States in recent years. The total outstanding debt of States rose by 17.7 per cent in 2002-03. The debt-GDP ratio of States rose to 28.1 per cent by end-March 2003.
Union Budget, 2003-04
4.8 The Union Budget 2003-04 has accorded high priority to fiscal consolidation. All major deficit indicators are expected to be lower than during 2002-03.
4.9 The budget envisages improvement in the buoyancy of tax receipts. The increase in tax revenue is expected to emanate from Union excise duties, corporation tax, income tax, customs duties and service tax. Of the gross tax collection, the share of States works out to 25.3 per cent. The measures envisaged to increase the tax collections are anchored on broadening the tax base and improving the compliance. Capital receipts are budgeted to show a rise mainly due to sharp increase in projected proceeds from disinvestment.
State Budgets, 2003-04
4.10 The State Budgets for 2003-04 envisage continued efforts towards fiscal consolidation through revenue augmentation and containment of expenditure. The revenue deficit is budgeted to narrow from 2.5 per cent of GDP in 2002-03 to 1.8 per cent in 2003-04 and is expected to enable a decline in the gross fiscal deficit of the States from 4.7 per cent in 2002-03 to 4.0 per cent in 2003-04.
Outlook
4.11 A downward inflexibility in the fiscal deficit and the corrosion of public sector outlays on the social and physical infrastructure are the dominant concerns weighing upon the fiscal stance for 2003-04. There is a gathering urgency to halt the dissaving of the public sector, embodied in the rising preemption of resources through the revenue deficit. Fiscal authorities in States which have already moved in the direction of enacting legislation for fiscal responsibility are required to take a hard option i.e., attacking the earmarking of funds for current consumption expenditures. In the current phase of the business cycle, the priority attached to augmenting revenues in the context of the steady deterioration of the tax-GDP ratio has to be tempered with the need to stimulate investment demand and maintain consumption expenditures. Consequently, the thrust of efforts towards revenue mobilisation would have to be on improvements in tax administration, rationalisation of tax structures, rapidly putting in place the IT-enabled environment widening the tax base by including services in a comprehensive manner in the tax net.
4.12 While expenditure management would be carried forward with renewed vigour, improvements envisaged on the revenue side are expected to halt the retrenchment of capital outlays forced by the process of fiscal consolidation. The composition of public expenditure is expected to change in favour of public investment at the cost of subsidies and transfers. Public investment is envisaged in a twin role of raising the level of aggregate demand, and expanding the productive capacity of the economy, as there is compelling evidence that it is public investment which has made the predominant contribution to building human and capital stock in India and that it has been the major facilitator of private investment. 'Crowding in' properties of public investment are particularly strong in the social and physical infrastructure. Accordingly, health, housing, education, employment, agriculture and export promotion are the guiding themes of the Centre's budget for 2003-04, indicative of a shift in focus to the quality of fiscal policy. This is extended to all aspects of the ongoing consolidation, and in particular, towards ensuring the sustainability of public debt, including through pension reforms and limits on contingent liabilities - the two major risks to the progress of fiscal reforms. Pension reforms would assume priority in the coming years with the availability of a menu of schemes, diversification of risk and independent regulatory oversight. Steps are being taken to identify and provide for the fiscal risk embodied in State Government guarantees with limits imposed to restrain their growth. These structural changes are expected to impart sustainability to public debt over the medium-term.
V - Financial Markets
5.1 Financial markets were flush with liquidity over the greater part of 2002-03, bolstered by sustained capital inflows and a liquidity overhang. There was a general easing of market conditions in terms of turnover and rates, the latter enabled by the accommodative monetary policy stance. In the money markets, key rates ruled close to the repo rate, except for a transient firming in mid-May 2002 and episodic spurts after October 2002. Market sentiment recovered quickly from border tensions in May 2002 and over the rest of the year, there was a modest appreciation of the spot exchange rate against the US dollar and a softening of forward premia. Repeated price rallies in the government securities market pushed down yields and flattened the yield curve, abating temporarily in February 2003 as fears of war in Iraq mounted. Yields on corporate bonds fell more sharply than those on gilts as risk perceptions improved. While bank deposit rates decreased in response to monetary policy impulses, this was not fully reflected in the lending rate reductions in the credit market. Activity in the credit market, however, picked up on the back of an upturn in demand from a range of industries. Equity markets remained subdued during the year, tracking developments in international markets. Uncertainty surrounding the disinvestment strategy and the lack of appetite among foreign institutional investors dampened market sentiment.
MONEY MARKET
5.2 Call/notice money market activity during 2002-03 was dominated by shifts in liquidity conditions. The usual beginning-of-the-year liquidity evinced considerable appetite for LAF repos. As the borrowing programme intensified, drawals of food credit began and border tensions surfaced in May, market liquidity tightened, driving up the average call rate to a high of 7.7 per cent on May 22, 2002. Easing of monetary conditions - reduction of CRR - and redemption inflows drove the call rates below the repo rate by the fourth week of June. The reduction in the repo rate on June 27 started a long phase of stability in the call money market with the call rates trailing just below the repo rate up to October 2002. Call/notice money market conditions remained relatively volatile in the remaining part of the year. The year 2003-04 began with softer call rates during April 2003. The call rates settled at sub-repo levels during May-August 2003 (up to August 13) reflecting ample liquidity conditions.
FOREIGN EXCHANGE MARKET
5.3 Tightness prevailed in the foreign exchange market during the first three months of 2002-03. The spot exchange rate firmed up from the third week of June as rising repatriation of export proceeds eased supply conditions and demand from corporates and importers moderated. Supplies continued to rise in the second quarter from export proceeds, unwinding of long dollar positions by banks and remittance inflows. In terms of monthly averages, the spot exchange rate appreciated by 1.0 per cent between April-September 2002 despite net purchases from the market by the Reserve Bank. The spot rate continued to gain strength as remittances from exporters, non-resident Indians and foreign direct investment continued while demand remained slack during October-November. Falling global crude oil prices and rising levels of foreign exchange reserves improved market sentiment and the spot exchange rate appreciated by 0.7 per cent in the third quarter with purchases by the Reserve Bank arresting further gains. Lingering weakness in the US dollar against major currencies owing to dismal US economic fundamentals contributed to the Rupee's gains. Purchases by the Reserve Bank checked the spot appreciation at 1.1 per cent at end-November 2002 over end-March 2002.
5.4 An increase in foreign investment flows from end-December 2002, despite mounting tensions in the Middle East, kept sentiments in the market upbeat and poised for further gains.
5.5 Soaring global crude oil prices resulting from war fears weighed heavily on market sentiment in the last quarter of the year, despite the significant liberalisation of banks' overseas investment and relaxation of restrictions in the forward market. Robust inflows of exports proceeds and inward remittances, however, continued to provide support to the spot exchange rate. On the basis of monthly averages, the Rupee appreciated against the US dollar by 2.3 per cent in 2002-03.
5.6 Activity in both the merchant and inter-bank segments of the foreign exchange market rose strongly. The inter-bank to merchant turnover ratio, however, declined, indicating the stability of market conditions and the narrowing of interest differentials.
5.7 Excess demand conditions prevailed in both merchant and inter-bank segments of the forward exchange market during the first quarter of 2002-03. One-month and the six-month forward premia hardened in May. As the spot market recovered in June, excess supply conditions characterised the forward market and continued to prevail during the rest of the year. The excess supply conditions in the forward segment necessitated a reversal in the strategy of intervention by the Reserve Bank. Outstanding net forward sales of the Reserve Bank remained negative up to August 2002. Forward premia in all maturities declined steadily reflecting heavy forward sales by exporters and easy liquidity conditions in the domestic money market.
GOVERNMENT SECURITIES MARKET
5.8 Yields declined in the secondary segment of government securities market during 2002-03 for the third year in succession reflecting ample liquidity and persistent expectations of interest rate cuts. Yields across residual maturity exceeding 14 years fell sharply relative to the benchmark 10-year security, flattening the yield curve. The aggregate volume of transactions in Central and State Government dated securities and Treasury Bills (outright as well as repos) rose during the year, although the share of outright transactions decreased.
CREDIT MARKETS
5.9 Easy liquidity conditions and monetary policy impulses for softening induced a reduction in deposit rates across all maturities. Comparable reductions were, however, not fully reflected in the prime lending rates (PLRs). Sub-PLR lending of the banking system (excluding exports, the bulk of which is at sub-PLR rates) constituted over one-third of total lending by December 2002. As many as 40 banks comprising 18 public sector banks (PSBs), 6 foreign banks and 16 private banks reduced their PLRs after the announcement of the mid-term Review of Monetary and Credit Policy in October 2002. The effective lending rates of commercial banks remained high due to wide spreads over the PLR which remained unchanged over 2002-03. The interest rate on home loans came down substantially over the year due to policy initiatives to boost the housing finance market.
EQUITY AND DEBT MARKETS
5.10 The capital market remained depressed during 2002-03. The primary market was subdued mainly due to lack of demand for funds by the corporates. Positive investor response to quality issues in the primary market, however, points to selectivity breaking through a generalised risk aversion. The secondary market was weighed down by a host of adverse domestic developments as well as the sell-offs in international equity markets in the first half of the year. Notwithstanding fall in prices of blue chip scrips, mid-cap scrips, PSU scrips and bank scrips experienced increased buying interest.
5.11 The stock market was affected significantly by some sector specific factors at different points of time during the year. In the first half of the year, the BSE Sensex was pulled down by the Fast Moving Consumer Goods (FMCG) sector, which remained subdued on account of drought fears and the depressed Information Technology (IT) sector, which posted lower than expected quarterly results. The BSE Sensex recovered to some extent during November and December 2002 as a result of the rally in PSU stocks on expectations of disinvestment initiatives. Bank scrips, in particular, witnessed a sharp increase almost throughout 2002-03, with improvement in profitability and relaxations on foreign direct investment (FDI) in private sector banks. The BSE Sensex was pulled down by the subdued FMCG and IT sector again in the last quarter of 2002-03.
5.12 Liquidity conditions in money, gilt and foreign exchange segments are expected to remain comfortable over 2003-04, with developments in the year so far providing early indications of market activity in the near term. In the money market segments, rates are expected to remain soft and clustered around the repo rate. The outlook for the Government securities market continues to be positive. The early signs suggest that the liquidity conditions are expected to remain adequate for supporting the government market borrowing programme as well as the off-take of credit for sustaining industrial recovery. The foreign exchange market is reflecting conditions of excess supply which have dominated the first few months of the year. The behaviour of the exchange rate is likely to depend considerably on the movements of the US dollar vis-a-vis other major currencies. The capital market has been experiencing heightened activity recently. Current valuations are attractive and FIIs’ appetite for Indian paper is getting rekindled. The market is expected to further consolidate these gains in the near future. A sustained recovery in financial market activity is contingent upon the abiding strength of the macroeconomic fundamentals and a stronger and more durable recovery in international markets.
VI - External Sector
6.1 A vibrant and diversified export performance underpinned the growing vigour and resilience of India's external sector in 2002-03 notwithstanding an environment dominated by the weakness of the global recovery, declines in equity markets and geo-political uncertainties. Import demand was driven up by the pace of revival of industrial activity domestically relative to the rest of the world; however, with India emerging as the world's fastest growing exporter after China amongst leading exporting nations, the current account of the balance of payments was in surplus for the second successive year. A rising confidence in the macro-fundamentals created a distinct home bias. Readjustments of net financial claims of banks, corporates and exporters in favour of domestic assets resulted in net capital inflows becoming stronger, in spite of lower debt flows and foreign investment. The positive developments in current and capital account transactions were reflected in a modest appreciation of the exchange rate vis-a-vis the US dollar. There was an unprecedented order of accumulation of foreign exchange reserves, the third largest increase among emerging market economies in the year. At the end of March 2003, the reserves were equivalent of around 14 months of imports or about five years of debt servicing, amply satisfying the so-called 'Guidotti rule' (usable foreign exchange reserves should exceed scheduled amortisation of foreign currency debts, assuming no rollovers, during the following year). The burgeoning reserves enabled a further consolidation of external debt during the year through prepayment of multilateral and commercial debt as well as shifts in the composition and maturity of non-resident deposit liabilities.
6.2 Overall GDP growth in emerging market economies (EMEs), particularly in the Asia Pacific region, remained strong despite adverse external developments. Although private direct investment flows were lower, a moderation in outflows of other private capital flows helped to maintain the volume of net private capital flows to EMEs. These flows are expected to be marginally higher during 2003 on account of some improvement in FDI inflows.
6.3 According to the International Monetary Fund (IMF) projections, global GDP and trade volume growth may show some acceleration in 2003 to 3.2 per cent and 4.3 per cent, respectively. The large and growing global macroeconomic imbalances present the biggest risk to a sustained global recovery.
BALANCE OF PAYMENTS
6.4 India's balance of payments (BoP) improved significantly during 2002-03, with an overall surplus in each quarter. A surge in exports of merchandise and invisibles posted the current account into a surplus, in contrast to the previous year when a small current account surplus appeared due to lack of import demand. Growing openness in terms of the share of tradables in the economy is increasingly being driven by exports. The healthy rise in current receipts has had salutary effects on debt servicing capabilities and on import purchasing power. Banking capital movements supported by stable nonresident deposits brought in higher net capital flows, notwithstanding substantial pre-payments of multilateral debt.
6.5 Export growth during 2002-03 was broad-based, across commodity groups as well as destinations. Various policy initiatives taken by the Government in the recent years for export product and market diversification have helped in improving export competitiveness
6.6 In 2002-03, invisibles shared in the vigorous export expansion, rising to constitute 81 per cent of merchandise exports, i.e., 45 per cent of gross current receipts. India's invisible earnings are dominated by private transfers (comprising mainly workers' remittances), followed by software and other business services. Remittances from Indians employed abroad have traditionally been the principal source of invisible earnings. India is the largest recipient of private transfers in the developing world and these amounted to US $ 14.8 billion in 2002-03. India's share in global flows of private transfers is placed at around 3 per cent. Software exports increased by around 27 per cent to US $ 9.6 billion during 2002-03 which is noteworthy in the context of the continuing 'technology slowdown' in the global economy and shedding of new economy stocks in world equity markets.
6.7 In 2002-03, as in the preceding year, it is the invisible account which emerged as the principal component, completely covering the trade deficit and driving the current account into surplus. The movement of the current account into surplus for the second consecutive year in 2002-03 is part of a broader trend emerging out of the crisis of 1990-91 – a conscious policy choice of a moderate current account deficit as an intermediate target for external sector policies.
6.8 Capital account developments dominated the balance of payments in 2002-03. Net capital flows were higher in 2002-03 than in any single year so far. Official assistance outflows increased in 2002-03 consequent upon the prepayment of multilateral debt - US $ 1.34 billion to Asian Development Bank and US $ 1.68 billion to the World Bank. Prepayments of high cost commercial debt were also put into effect by corporates. Thus, the long and medium term debt component of the capital account contracted in 2002-03, extending a phase of consolidation of external debt that has dominated external sector management since the adjustment to the crisis of 1990-91. Short-term debt flows increased to finance the higher order of POL imports.
6.9 Net inflows under non-resident deposits, another important element in debt flows, underwent compositional changes in 2002-03. There was a sharp increase in balances under the repatriable rupee-denominated external rupee accounts [NR(E)RA] as maturing balances of the discontinued non-repatriable rupee deposits [NR(NR)RD] poured into the repatriable scheme. Taken together, the net inflows into these rupee deposits were broadly stable during the year.
6.10 Key indicators of debt sustainability suggest continuing consolidation and improvement in solvency. The external debt-GDP ratio declined during the year to 20.0 per cent and proportion of short-term debt to total debt increased to 3.9 per cent at end-March 2003 from 2.8 per cent at end-March 2002. At 14.7 per cent, the debt service ratio continued to remain low in 2002-03. The marginal increase in debt service and liability service ratios during 2002-03 was due to pre-payments of official debt in the last quarter.
6.11 Weak stock markets pulled down foreign investment flows, both direct and portfolio, during 2002-03. Amounts raised through GDRs/ADRs were maintained.
International Investment Position
6.12 The International Investment Position (IIP) is a summary record of stocks of external financial assets and liabilities of the country and has a more comprehensive coverage than the external debt statistics which are restricted to only those external liabilities which have a contractual obligation to service. Information available up to March, 2002 indicate a distinct improvement in India's net international investment position over the period 1997-2002 on account of a decline of about US $ 13 billion in net foreign liabilities due to the build up of foreign exchange assets by the Reserve Bank.
FOREIGN EXCHANGE RESERVES
6.13 Overall surpluses have appeared in the balance of payments since 1993-94 (except in 1995-96). This has been reflected in growing accretions to the foreign exchange reserves. The accretion during 2002-03, the highest in any single year, was almost entirely in the form of foreign currency assets with small valuation gains booked under gold holdings. The major sources of accretion to foreign currency assets were the current account surplus and inflows in the form of foreign investment, banking capital and non-resident deposits. Valuation gains due to cross currency movement in exchange rates amounted to US $ 3.8 billion. On August 15, 2003 India held the sixth largest stock of international reserve assets among emerging market economies at US $ 85.4 billion.
6.14 Reserve management encompasses preservation of the long-term value of reserves and the need to minimise risk and volatility in returns consistent with the primary objectives of safety and liquidity. The overall approach to reserve deployment is one of high risk aversion with a preference for stable returns. Sound internal control systems are in place to identify, measure, monitor and control various types of risks encountered in the conduct of reserve management.
6.15 The substantial growth in reserves in the recent period has generated a debate regarding the costs and benefits of holding reserves. The accretion to reserves in the recent period has occurred without increasing the overall level of external debt and instead through higher workers' remittances, quicker repatriation of export proceeds and non-debt inflows. Even after taking into account foreign currency denominated non-resident deposit flows (where the interest rates are linked to LIBOR), the financial cost of additional reserve accretion in India in the recent period is quite low, and is likely to be more than offset by the return on additional reserves.
6.16 India was one of the 20 countries selected for a case study in a recent document published by the International Monetary Fund as a supplement to the IMF's "Guidelines for Foreign Exchange Reserve Management". The IMF has observed that India's management of foreign exchange reserves has generally been in accordance with IMF guidelines and is comparable to the global best practices in this area.
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