September, 2011

India Economic Update

Economic Policy and Poverty Team South Asia Region

The World Bank

India Economic Update1 Overview

September, 2011

A Return to Trend Growth, but a Weakening Outlook After a return to trend growth in fiscal year 2010-11, Indias economic growth is likely to slow to 78 percent in the next two years. The slowdown is a result of uncertainties weighing down investment, tighter macroeconomic policies intended to fight still-high inflation, and the base effect of the strong agricultural rebound in FY2010-11. Slow growth in core OECD countries means domestic drivers for growth will have to be strengthened. This would include progress on important structural reforms, and further measures to achieve fiscal consolidation and reorient government spending toward investment and growth. Even then, risks from the uncertain international environment are high. Policymakers would do well in reviewing crisis preparedness at this time. GDP growth is estimated to have reached 8.5 percent in fiscal year (FY) 2010-11, mainly because of strong agricultural sector performance with 6.6 percent growth. GDP growth slowed to 7.7 percent in Q1 FY2011-12, and inflation remained high at around 9.5 percent, increasingly driven by core inflation (calculated by excluding food and energy prices). Growth was supported by an impressive recovery in exports, which relied on Asia and higher oil prices. Capital flows slowed and foreign institutional investment was hit by the financial turmoil gripping global markets in August 2011. Nevertheless, the rupee remained quite stable against the U.S. dollar with very little RBI intervention, and the RBIs foreign reserves increased to more than $319 billion. Macroeconomic policies were tightened with fiscal consolidation and increases in policy rates. The general government budget deficit for FY2010-11 is estimated at 8.5 percent of GDP, of which 6 percent central government deficit, as compared with 10.1 percent and 6.8 percent deficits in FY2009-10. However, the tax-to-GDP ratio was still lower than before the global financial crisis. Since March 2010, the main policy rate was raised 12 times by a cumulative 350bps, but the growth in monetary aggregates continued to outpace the RBIs targets. The global economic environment has deteriorated significantly. Doubts about sovereign debt sustainability in the US and Europe have led to a significant decline in investor sentiment and consumer confidence. Growth forecasts for the global economy have been revised downwards. However, as its baseline scenario, the World Bank forecasts a relatively benign resolution of the recent turmoil. In India, GDP growth in FY2011-12 and FY2012-13 is forecast to reach 7-8 percent, a slowdown from the trend before the global crisis. With the slow growth expected in core OECD countries, Indias GDP growth will have to rely on domestic growth drivers. The slowdown in investment, capital outflows, and decline in the stock market point to deeper structural problems. Investors are holding back in the face of regulatory uncertainty (environmental clearances, land acquisition laws, tax reforms), banks are highly exposed to power projects facing delays due to the lack of coal and gas feedstock, and mining (especially of iron ore) has been hit by recent scandals in Karnataka and Orissa, putting the future growth of the steel industry in doubt. Major structural reforms aimed at improving the investment climate, in particular progress on current legislative initiatives (land acquisition, tax reform, financial sector reform, FDI in retail) would strengthen domestic growth drivers. Further tightening of macroeconomic policies - fiscal
1

Prepared by Ulrich Bartsch, Monika Sharma, and Maria Mini Jos.

consolidation and higher real interest rates will have a dampening effect on aggregate demand, but will strengthen policy credibility and the prospects for sustainable growth later on. This will also require rationalizing government expenditure by expanding investment and cutting subsidies including for items controlled by state governments (most notably, state electricity boards). Investments in infrastructure could alleviate supply bottlenecks and allow low-inflation growth. Capital inflows are likely to be sufficient to finance the current account deficit. Volatility of portfolio flows remains high and poses risks in both directions: renewed shocks to the global financial system could lead to another flight to safety, while global liquidity remains unusually high and could lead to FII surges in emerging markets. The downside risks to growth are high because of the risks to global growth posed by the precarious situation in Europe. A worst-case international scenario would lead to a collapse of demand for Indias exports, and strong contraction in private sector spending, as was observed after the Lehman collapse in 2008. At that time, higher public sector spending set in at exactly the right time largely because of the implementation of the recommendations of the 6th pay commission. The RBI was able to lower policy rates significantly when inflation fell rapidly in line with international commodity prices. However, in the immediate aftermath of the Lehman collapse, the interbank market froze, and short term liquidity became very expensive. Policymakers would do well to review their preparedness for another global shock and prepare contingency measures.

I.

Recent Economic Developments

GDP and its Components

Real GDP growth recovered, and a strong rebound in agriculture offset a weakening performance in industry and services. GDP growth is estimated to have reached 8.5 percent in fiscal year (FY) 2010-11. Throughout the fiscal year, growth weakened, and the trend continued in the first quarter of FY2011-12. Growth in the fourth quarter of FY2010-11 and first quarter of the current FY2011-12 slowed to 7.8 and 7.7 percent, respectively, as compared with a high of 8.9 percent in the second quarter.2 The agriculture sector performed strongly with 6.6 percent growth on the back of robust production and a favorable base effect. The rebound is largely explained by the weather: a good monsoon in 2010 followed the near-failure of the monsoon in 2009. Food grain production is estimated to have reached 236 million tons in FY2010-11, which is 8 percent higher than in FY2009-10, and sets a new record from the previous peak in FY2008-09. Pulses, wheat, oilseeds and cotton production are estimated to have reached all time highs in FY2010-11. Record production has resulted in record procurement by the Food Corporation of India, and food grain stocks reached 65.6 million tons in June 2011. Industrial sector output growth was somewhat disappointing. Output growth reached 7.9 percent in FY2010-11, marginally lower than the 8.1 percent growth in FY2009-10. Industrial output growth (new IIP series with base year 2004-05) dropped to 7.9 percent in the last quarter, compared with an average of 8.4 percent in the first three quarters of FY2010-11, which was mainly due to a decline in the growth in production of capital goods. It dropped further to 6.8 percent in the first quarter of FY2011-12, the lowest performance since Q3 of FY2009-10, the first quarter of recovery after the global financial crisis.
Agricultural Growth Rebound ed But Industry Disappointed. (y-o-y change, in percent)

16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0%

Agriculture

Services

GDP

Industry

16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0%

70% 60% 50% 40% 30% 20% 10% 0% -10% -20%

07-08 Q1 07-08 Q2 07-08 Q3 07-08 Q4

07-08 Q1 07-08 Q2 07-08 Q3 07-08 Q4 08-09 Q1 08-09 Q2 08-09 Q3 08-09 Q4 09-10 Q1 09-10 Q2 09-10 Q3 09-10 Q4 10-11 Q1 10-11 Q2 10-11 Q3 10-11 Q4 11-12 Q1

Investment and Gov. Consumption Slowed. (Components of GDP, y-o-y change, in percent)
Total Consumption Private Consumption Investment Government Consumption

60%

50%
40%

30%
20%

10%
0%

-10%
08-09 Q1 08-09 Q2 08-09 Q3 08-09 Q4 09-10 Q1 09-10 Q2 09-10 Q3 09-10 Q4 10-11 Q1 10-11 Q2 10-11 Q3 10-11 Q4 11-12 Q1 10-11 Q3 11-12 Q1

Demand Growth Slowed.

16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4%
05-06 Q1

(Components of GDP, y-o-y, change in percent) GDP Excl. Gov. Cons. GDP

05-06 Q3

06-07 Q1

06-07 Q3

07-08 Q1

07-08 Q3

Source: CSO. Note: Expenditure GDP growth not always same as production.

Service sector growth dropped marginally to 9.4 percent in FY2010-11 from 10.1 percent in FY2009-10, the decline was driven by a reduction in growth of community, social and personal services on account of a high base effect of the government wage revision in FY2009-10.

The quarterly growth numbers are frequently and substantially revised. In fact, the latest number is partly the result of a downward revision of growth in Q1FY2010-11, and upward revision of Q1FY2009-10. Without the change in the base, GDP growth for Q1FY2011-12 would have been 7.3 percent.

10-11 Q1

08-09 Q1

08-09 Q3

09-10 Q1

09-10 Q3

The deceleration in capital and intermediate goods production is in line with a deceleration in investment, but the data indicates high volatility. Investment growth slowed to a crawl with gross fixed capital formation growth dropping to 0.4 percent in the last quarter of FY2010-11, but recovering to 7.9 percent in Q1 FY2011-12. Consumption growth also moderated driven by a decline in government consumption, whose growth dropped to 2 percent in Q1 FY2011-12 16.4 percent in H1 FY2010-11 because of the withdrawal of some stimulus measures and also a high base due to wage revisions in FY2009-10. Private consumption growth also slowed to 6.3 percent in FY2011-12 from 9.2 in H1 FY2011-12.

Balance of Payments
Despite a strong recovery in exports, the current account deficit widened slightly. Merchandise exports delivered a stellar performance in FY2010-11 rising 42 percent over the previous year and reaching a level of $254 billion. Export growth reached a high of 79 percent in June 2011 over June 2010. Import growth slowed strongly in Q4 of FY2010-11, and the trade deficit reached the lowest level since the great trade collapse during the global financial crisis. Import growth picked up again in Q1 FY2011-12, however, and the trade deficit widened again to $32 billion, a level similar to what it was in late 2009. While the increase in oil prices played a role, the import growth acceleration was mainly due to a pick-up in non-oil imports, which grew by 38.6 percent in Q1 of FY2011-12. A rise in the invisibles surplus and strong remittances contributed to offset some of the trade deficit. Indias export market is shifting, both in terms of products and destination. Geographically, exports are shifting away from the old OECD (EU and the US) and toward emerging markets in Asia and the Middle East. The share of the EU and the US in Indias exports has fallen to 19 percent in the last six months of 2010, from 29 percent in 2003. In contrast, the share of the main trading partners in Asia (China, Indonesia, India: Exports by Country and by Commodity, 8/2010-1/2011 Pakistan, Sri Lanka, Singapore) has (percentage point contribution to overall growth, 6-month average) increased to almost 20 percent from 13 percent over the same period. At Overall exports 41.7 Overall exports the end of 2010, China had emerged Top 15 26.2 Top 15 China 7.3 as the country contributing most to Non-ferrous Metals 4.8 Petroleum and Crude Products export growth, followed by the EU United Arab Emirates 3.3 Transport Equipment UAE, Indonesia, and the US. When Indonesia 2.1 Manufacturres of Metals United States 1.7 aggregating exports to the 27 EU Processed Minerals Singapore 1.7 Electronic Goods member countries, their combined Iran 1.2 Machinery and Instruments contribution to export growth is Sri Lanka 1.2 Ferro Alloys Belgium 1.0 smaller than Chinas, but ahead of Sugar Pakistan 1.0 Cotton Yarn Fabrics Madeups etc the UAEs. Exports to China Kuwait 0.9 Cotton Raw incl. Waste amounted to $1.5 billion in CY2010, Saudi Arabia 0.9 Plastic and Linoleum Products Italy 0.8 as compared with $2 billion to the Primary and Semi-finished Iron and Steel South Africa 0.8 Other Ores and Minerals US, and $3.4 billion to the EU. Regarding the goods India is exporting, both raw materials and manufactured, more sophisticated products are displacing traditional exports such as leather, gems, and jewelry. In 2010, export growth
Germany East Timor Turkey Austria Bahrain Brazil France 0.7 0.7 0.7 0.7 0.7 0.6 0.6 Drugs, Pharmaceuticals and Fine Dyes Intermediates and Coal Tar Oil Meals Manmade Yarn Fabrics Madeups Rice Basmoti Gems and Jewellery Aluminium other than Products

41.7 32.6 6.2 5.8 4.4 3.1 1.9 1.7 1.6 1.4 1.3 1.2 1.1 0.9 0.8 0.6 0.6 0.5 0.5 0.4 0.4 0.4 0.4

Source: Ministry of Commerce, CEIC.

benefited most from growth in nonIndia's Exports: Top 10 Countries and Commodities 2010 (in millions of U.S. dollars) ferrous metals, petroleum products, transport equipment, and European Union 3,422.9 Petroleum and Crude Products manufactured metals. More than half United Arab Emirates 2,389.7 Gems and Jewellery 1,931.2 Transport Equipment of the export increase is contributed United States 1,508.5 Machinery and Instruments by raw and semi-processed China Singapore 802.0 Drugs, Pharmaceuticals and Fine Chemicals materials. Indias exports of Hong Kong 730.7 Manufacturres of Metals petroleum products are partly driven United Kingdom 557.0 Other Commodities by the governments pricing policy: Netherland 550.3 Readymade Garments, Cotton incl. Accessories 508.9 Non-ferrous Metals Indian retail prices are not sufficient Germany Belgium 425.1 Electronic Goods to cover the full costs (including taxes) of petroleum products, and oil companies are only partially reimbursed for under recoveries. Private companies are barred from receiving subsidies, and therefore export refined products from their refineries in India rather than selling in the domestic market, whereas the public sector companies import the same products to supply the domestic market. Petroleum products accounted for about 6 points of the 42 percent export growth. This can be ascribed in part to an increase in international oil prices (average oil prices for the last six months of 2010 were 9 percent higher than in the second half of 2009), while volumes were also increasing in line with private refining capacity. Petroleum and Crude Products is the most important export category with exports of $3.2 billion in CY2010, while Gems and Jewellery accounted for $2.6 billion. Non-ferrous metals contributed most to export growth, but is ranked 9th in terms of the level of exports in CY2010 with $600 million. Net capital inflows slowed to their lowest quarterly pace since before the global financial crisis. The capital account surplus dropped to $21.5bn in H2 FY2010-11, as compared with $38bn in the first half. FDI inflows slowed to $774 million in Q4 FY2010-11, the lowest quarterly flow since 2002. The overall decline in net capital flows from FDI and FII sources was partially offset by an increase in external commercial borrowings. Inflows recovered somewhat during April-May 2011, but the turmoil on global financial markets following the downgrading of credit ratings for the US led to renewed capital outflows as a flight to safety set in. There are also early indications that Indian firms found it more difficult to borrow abroad following the downgrade.
The Real Exchange Rate Stabilizeded (Jan. 2006 - Jun. 2011, 1993=100)
120 110 100
90 80 70 60

3,194.7 2,599.7 1,293.5 915.1 829.3 689.1 683.2 668.9 579.4 559.8

Jan-06

Jul-06

Jul-07

Jan-08

Jul-08

Jan-09

Jan-10

Jul-10

Apr-07

Apr-09

Apr-10

Jan-11

Jan-07

Jul-09

The Outlook is Perceived to Worsen (Perception Indices)

50 40 30

The rupee has remained relatively stable 20 10 against the U.S. dollar and slightly depreciated 0 against the pound and yen in recent months. -10 Since the beginning of 2011, the REER (36- -20 currency trade based) has depreciated 2 percent. At -30 around 100 (the level it had in 1993), the rupee has stabilized between the recent peak of 110, when Fin. Situation Selling Prices Profit Margin capital inflows led to appreciation in 2007, and the Source: RBI recent trough of 90, when capital outflows resulted from the global financial crisis. The RBI intervened only in September 2011 when the rupee dropped by about 9 percent against the US dollar.

External debt increased and reached $306 billion by end-March 2011. Short-term debt and external commercial borrowing rose by around 24 percent during FY2010-11. However, the official foreign reserves of the RBI remained at a comfortable level. The ratio of short-term external debt to 3

3/2005 6/2005 9/2005 12/2005 3/2006 6/2006 9/2006 12/2006 3/2007 6/2007 9/2007 12/2007 3/2008 6/2008 9/2008 12/2008 3/2009 6/2009 9/2009 12/2009 3/2010 6/2010 9/2010 12/2010 3/2011 6/2011

Apr-11

Apr-06

Apr-08

Oct-06

Oct-07

Oct-08

Oct-09

Oct-10

foreign exchange reserves was 21.3 per cent at end-March 2011, a slight increase from 19 percent at end-March 2010. Foreign exchange reserves at end-July 2011 reached $319 billion, more than one-toone coverage of total external debt. Indias stock markets slumped. Indias stock markets embarked on a steep decline in June 2011, with year-to-date performance of the SENSEX index reaching 17 percent, which is significantly worse than the performance of its peers. Stock market valuations fell to their lowest level since endMay 2010. The decline was to a large extent due to the withdrawal of portfolio investment. Rating agencies maintained their India ratings, but the business outlook is worsening. Both Moodys and Fitch upgraded their local currency ratings in early 2010. While Moodys upgraded its rating from Ba2 to Ba1 with a positive outlook, Fitch revised its rating from negative to stable. Industrial outlook surveys show a worsening of the business climate in Q1 of FY2011-12. Company managers are seeing a decline in the financial situations of companies, while profit margins are Core Inflation Dominates WPI Inflation (y-o-y percentage change) shrinking. The deterioration in conditions is also Core Food Energy supported by Purchasing Managers Indices, which 12.0 sank to their lowest in two years.
10.0

Inflation
Inflation moderated somewhat, but it has remained at an elevated level. Inflation reached 9.2 percent (WPI, y-o-y) in July 2011 continuing its moderation since the recent high of 9.7 percent in April 2011. Food wholesale price increases saw a significant moderation from the peak of 22.6 percent in December 2009 to a low of 6.4 percent in February 2011, but has since risen again to about 8 percent during May-July 2011. However, a 3-month rolling average of seasonally adjusted annualized monthly increases in food prices has moved up significantly over 2011 hitting 15 percent in June, which indicates that the moderation could be short lived. With the moderation in food prices came a moderation in the CPI measures of inflation. From a high of 16.2 percent in January 2010, inflation measured by the CPI for industrial workers has declined steadily to about 9 percent in the quarter to June 2011. Core inflation (calculated by excluding food and energy prices from the wholesale price index) has been the main component of overall inflation since September 2010. It reached a high of 10.3 percent during February-March 2011 and moderated to 9 percent since then. Inflation in non-food manufactures increased from 6.3 percent in April to 7.3 percent in May 2011. The increase is interpreted by the RBI as a reflection of high commodity prices, rising wages and rising output prices as a result of pass-through of high input costs. In addition, the RBIs Order Book, Inventory, and Capacity Utilization Survey in Q4 FY2010-11 was the highest in three years. Capacity utilization 4

8.0 6.0 4.0

2.0 0.0

12/2009

11/2010

10/2010

12/2010

1/2010

2/2010

4/2010

5/2010

7/2010

9/2010

1/2011

3/2011

4/2011

6/2011
Jul-11

Core Inflation has been Trending up, in particular Manufacturing Prices (Components of WPI inflation; y -o-y change in percent, Apr. 2005 - May 2011)
25.0 20.0 25.0 20.0

15.0 10.0
5.0 0.0 -5.0

15.0 10.0
5.0 0.0 -5.0

-10.0
-15.0

-10.0
-15.0

May-09

May-10

Primary Food

Energy

WPI

Core

Processed Food

BRICS Consumer Prices and Commodity Prices (y-o-y percent change)

30 150 130 110 90

25
20

15
10 5 0 -5 -10

May-11

Nov-09

Mar-09

Mar-10

Nov-10

Sep-09

Sep-10

Jan-11

Jan-09

Jan-10

Jul-09

Jul-10

Mar-11

70
50 30

10
-10

-30
-50

Jan-2000 Jun-2000 Nov-2000 Apr-2001 Sep-2001 Feb-2002 Jul-2002 Dec-2002 May-2003 Oct-2003 Mar-2004 Aug-2004 Jan-2005 Jun-2005 Nov-2005 Apr-2006 Sep-2006 Feb-2007 Jul-2007 Dec-2007 May-2008 Oct-2008 Mar-2009 Aug-2009 Jan-2010 Jun-2010 Nov-2010 Apr-2011
India South Africa China Brazil Energy (rhs) Non-energy (rhs)

7/2011

3/2010

6/2010

8/2010

2/2011

5/2011

increased in 17 out of 22 industries between Q3 and Q4. Indias inflation trajectory is similar to that of other emerging markets, but Indias level of inflation is relatively high. Inflation accelerated in the run-up to the global financial crisis, dropped into negative territory as global commodity prices collapsed during the crisis, and accelerated again in early-mid-2010. The trajectory is similar in other emerging markets because of the pass-through in commodity prices. Indias inflation was comparable to that of other EMEs in the 2008 rally. PostLehman, CPI inflation in India did not drop significantly because of the food price boom starting in early 2009, well before the extent of the 2009 Monsoon was known.

Taxes and Subsidies on Petroleum Products Prices for diesel, kerosene, and LPG have been increased in June 2011 and petrol in September 2011 to pass on some of the higher international prices. During FY2010-11, a significant difference existed between the administered prices at the pump and the costs and taxes paid by oil companies. However, with sales tax on fuel an important source of revenue for Indias states, retail prices for gasoline and diesel were higher than import parity prices a usual benchmark to assess subsidization of products while kerosene and LPG were sold well below cost. Taxes paid on gasoline and diesel consumption were actually more than sufficient to cover underpricing of kerosene and LPG, and the government raised some revenue from the sales of fuel products, although the revenue did not reach its statutory potential because of the low administered prices. Fuel Prices, Costs, Taxes, and Subsidies, Estimates for FY2010-11 The table shows costs, taxes, and average retail Gasoline Diesel Kerosene LPG prices for FY2010-11 on a per liter basis. The Rs/litre Rs/litre (Rs/cylinder) difference between retail prices and the sum of Cost 26.6 26.6 24.6 495.7 31.8 11.1 1.5 61.9 costs and taxes is shown as Gross Subsidy, which Taxes 58.4 37.8 26.1 557.6 is commonly termed underrecoveries in India. Total Price Retail 56.5 37.3 11.5 361.5 However, the Net Subsidy is just the difference Gross subsidy 1.9 0.5 14.6 196.0 -29.9 -10.7 13.1 134.1 between retail price and costs and shows the net Net subsidy 2010-11 (Rs billion) Total revenue the government derived from the sales of Total Gross subsidy 29.4 26.5 136.6 162.1 354.6 a liter of the product (a negative sign shows net Total net subsidy -473.8 -628.8 122.6 110.9 -869.1 revenue, a positive sign net subsidy). As shown, Sources: Ministry of Petroleum, PPAC, CSO. the government net tax take was about Rs.30 per Notes: 1. Based on Indian basket of crude oil prices 2. Includes international price, import duty, freight charges, and fixed margins liter of gasoline, Rs.11 per liter of diesel, while it 3. Gross and net subsidy for kerosene and LPG includes the subsidy subsidized kerosene with Rs.13 per liter and LPG provided through the budget. Kerosene at 0.82/litre and LPG at Rs 22.58 per with Rs.134 per cylinder. The last row of the cylinder table show estimated amounts for the fiscal year: the taxes received from sales of gasoline and diesel of about Rs.1,100 billion were higher than the subsidies paid on kerosene and LPG, Rs.334 billion. The government had a net surplus tax intake from sales of petroleum fuels of Rs.870 billion. It should be noted that sales taxes for petroleum products are collected by the public oil companies and transferred to state governments. With low retail prices, oil companies cannot recover their costs and tax transfers from retail sales, and therefore receive compensation for underrecoveries from the central government. This makes underrecoveries a transfer from the center to the states.

Fiscal Developments
Budget implementation in FY2010-11 is estimated to have closed the deficit from the widened fiscal stance of FY2009-10. The central government deficit for FY2010-11 reached 6.0 percent of GDP as compared with 6.8 percent in FY2009-10.3 The budget benefited from higher-than-expected growth in nominal GDP, and tax revenue buoyancy helped to increase the tax-to-GDP ratio by 0.5 percentage points, although it is still significantly lower than in FY2007-08, the year before the global crisis induced slowdown and adoption of stimulus measures. The spending-to-GDP ratio, on the other hand, was reduced by 0.7 percent of GDP.
India: Central Government Budget, 2007/08-2011/12 2007/08 2008/09 2009/10 2010/11 % of GDP Est. Total revenue and grants Net tax revenue Gross Tax Revenue Corporate tax Income tax Excise tax Customs duties Other taxes Less: States' share Less:NCCF expenditure netted from receipt Non tax revenue 1/ Total expenditure and net lending Current expenditure Interest payments Subsidies Defense expenditure Capital expenditure and net lending Gross fiscal deficit (WB defn) Memo items Disinvestment + 3G licenses receipts Gross fiscal deficit (GoI defn) Revenue deficit Primary deficit (WB Defn.) Primary deficit (GOI Defn.) Central government domestic debt 2/ Central government debt (including external debt) /2 GDP (market prices, y-o-y change in percent) 0.8 2.5 1.1 -0.1 -0.9 41.6 45.9 16.1 0.0 6.0 4.5 2.6 2.6 44.4 49.1 12.0 0.4 6.4 5.2 3.5 3.1 44.3 48.1 17.3 0.6 6.0 4.0 2.5 1.9 47.0 50.9 5.9 0.3 4.7 3.1 3.1 1.7 41.0 45.3 13.6 0.4 4.6 3.4 2.1 1.6 40.2 44.2 14.0 10.9 8.8 11.9 3.9 2.1 2.5 2.1 1.4 3.0 0.0 2.1 14.2 11.9 3.4 1.4 1.1 2.3 3.3 9.7 7.9 10.8 3.8 1.9 1.9 1.8 1.4 2.9 0.0 1.7 15.7 14.2 3.4 2.3 1.3 1.5 6.0 8.7 7.0 9.5 3.7 2.0 1.6 1.3 0.9 2.5 0.0 1.8 15.5 13.9 3.3 2.2 1.4 1.6 6.8 Budget 9.3 7.7 10.8 4.3 1.8 1.9 1.7 1.0 3.0 0.0 1.6 15.9 13.8 3.6 1.7 1.3 2.1 6.6 Est. 8.7 7.3 10.1 3.8 1.8 1.8 1.7 1.0 2.8 0.0 1.5 14.8 13.2 3.0 2.1 1.1 1.6 6.0 Budget 8.8 7.4 10.4 4.0 1.9 1.8 1.7 0.9 2.9 0.0 1.4 13.8 12.2 3.0 1.6 1.1 1.6 5.0 2010/11 2011/12

Source: Ministry of Finance. 1/ Excludes revenues from 3G licenses. 2/ Net of Liabilities under MSS and NSSF not used for financing CG deficit

The central government budget for FY2011-12 targets an ambitious consolidation. The deficit is targeted to narrow to 5.0 percent of GDP.4 The budget envisages high revenue buoyancy and a reduction in the ratio of subsidies to GDP of 0.5 percentage points, or a contraction in the nominal spending amount by 12.5 percent. On the revenue side, the budget estimates are based on the projection of 9 percent growth in real GDP and an inflation rate of 4 percent. Gross tax revenue is
3

Under the governments accounting rules the fiscal deficit is estimated to have reached 4.7 percent of GDP in FY2010-11 as compared with 5.4 percent in the earlier estimate. The government counts revenue from disinvestment and the sale of 3G telecom licenses above the line, rather than as a financing item below the line. 4 This will measure 4.6 percent of GDP under the governments accounting rules with disinvestment proceeds of 0.4 percent of GDP counted as revenue.

budgeted to increase by 18.5 percent to a level of 10.4 percent of GDP. However, recent data indicate a decline in net direct tax collections during the first two months of FY2011-12 of 48 percent compared with the same period of FY2009-10, a fall to Rs.13 billion from Rs.25 billion in the same period last fiscal year mainly because of an increase in tax refunds. Gross direct tax collections increased by 37 percent at Rs.50.0 billion as compared to Rs 36.7 billion in same period of the previous year. During April-July of FY2011-12, the fiscal deficit reached 55 percent of the budget estimate (BE) for the year. Gross tax revenues grew by 9.8 percent (budget targets 18 percent), while total expenditures increased by 12.8 percent (budget targets 3.4 percent). First quarter revenue receipts fell by 55 percent as compared to the same period in the previous year, but this is largely caused by the high non-tax revenue on account of 3G telecom license revenue in Q1 FY2010-11. The government tabled the first supplementary demand for grants in the monsoon session of parliament to authorize gross additional expenditure of Rs. 347.2 billion. Of this, the net cash outgo amounts to Rs.90 billion, while the rest will be matched by savings or additional receipts. The bulk of the net cash outgo is aimed at meeting requirements for local area development schemes (Rs.23 billion), the Below Poverty Line (BPL) survey (Rs.23 billion), grants for the Integrated Child Development Scheme (Rs.15 billion) and the National Clean Energy Fund (Rs. 11 billion).

Monetary Developments
Growth in monetary aggregates slowed but still outpaced the RBIs targets. Credit growth moderated to 21.0 per cent in March 2011 and 20.6 percent in June 2011 from 24.1 per cent in December 2010. Credit to agriculture and allied sectors grew by 10.6 percent in FY2010-11 as compared to 23.9 percent in FY2009-10 while credit to services witnessed a sharp rise by 24.0 percent compared to 12.5 percent in FY2009-10. Credit to industry grew by 23.6 percent. Growth was led by infrastructure, metal and metal products, textiles, engineering, food processing and gems and jewellery. The RBI continued to raise policy rates citing inflationary conditions as a major concern. The hike of 50bps in July surprised analysts and was taken as a signal that the RBI was taking a more aggressive stance to fight inflation, and another hike by 25bps in September was therefore less surprising. Since March 2010, the main policy rate the Repo Rate at which banks borrow liquidity from the RBI was raised 12 times by a cumulative 350bps. In addition, the cash reserve ratio (CRR) was raised by 100bps between February and April 2011. Effectively, costs of funds for banks rose by more than the Repo Rate, because banks had excess liquidity parked at the RBI at the (lower) Reverse Repo Rate at the beginning of the tightening cycle, but switched to borrowing at the Repo Rate from RBI in June 2010. Liquidity developments are heavily influenced by government balances with the RBI making liquidity management difficult. With a front loaded program of market borrowings and back loaded spending by the government, its balances with RBI reached a high of Rs.1.5 trillion ($35 billion) in January 2011, which then fell to Rs. -0.5 trillion ($12 billion) in April 2011. Within the month of March 2011, government operations injected Rs. 1.5 trillion of high powered money.

II.

The Global Economic Environment5

During the second quarter of CY2011, GDP growth slowed substantially in most of the major high-income economies. Growth was subdued because of higher oil prices and larger-than-expected effects from the Japanese earthquake and tsunami (industrial production in high-income countries fell by 2.1 percent between February and June 2011). However, in the United States, investment grew strongly, and consumer demand (excluding tsunami impacted auto- and gasoline consumption)
5

Prepared on the basis of inputs from DEC Prospects Group.

expanded at a 1.2 percent annualized rate. By the end of July 2011, activity was rebounding, with industrial production in high-income countries increasing at 7.8 percent (annualized rate). The negative influence of higher oil prices on real-incomes was fading. The protracted negotiations over an extension of the government borrowing ceiling in the US and resurgence of debt sustainability concerns in Europe led to a significant decline in investor sentiment and consumer confidence in August 2011. The political compromises made in the US and in Europe were seen as insufficient. In particular, investors felt that the resolution of the stand-off in the US Congress may not ensure long-run debt sustainability, nor the July 2011 EU decision on a second bailout for Greece, while the EUs provisioning of 440 billion in the European Financial Stability Facility may not fend off speculative attacks on other highly indebted countries (Portugal, Ireland, Italy, Spain). Stock markets reacted with strong downward corrections in most countries, which accelerated after the decision of Standard & Poors to downgrade the credit rating of US government debt. Banking-sector valuations have also declined sharply. European banking stocks have lost 35 percent since January 2011, while U.S. banks dropped 25 percent, contrasted with market-wide losses of 17and 6 percent in Europe and the USA respectively. Following the recent turmoil in equity markets, which started in August 2011, growth forecasts for the global economy, and for high-income countries in particular have been revised downwards. The World Bank expects world GDP growth to reach 2.8 and 3.2 percent in CY2011 and CY2012, respectively, a downward revision of 0.4 percentage points in both years. The US economy is expected to expand by 1.7 percent in the current year, as compared with a forecast of 2.6 percent in the June 2011 Global Economic Prospects. For 2012, growth is forecast at 2.2 percent. The economies of the high-income countries are expected to expand by 1.6 percent on average in CY2011, dragged down by Japan with an economic contraction of 0.8 percent. The baseline forecast of a relatively benign resolution of the recent turmoil is subject to high downside risk. While the European Central Bank and core European country governments would probably have the means to stave off serious problems in a single country, a deepening crisis or speculative attack on several large economies simultaneously could overwhelm current crisis reponse mechanisms. Meanwhile, in some of the core countries the public clearly does not support further bailouts. Growth in developing countries is holding up well. However, GDP growth in developing countries has moderated in Q2 as well, partly reflecting weakened external demand from HICs. Among the 21 developing countries reporting, first quarter GDP grew at a solid 6.3 percent annualized pace, and slowed by 0.5 percentage points into the second quarter of 2011. Reflecting disruptions from the Japanese earthquake/tsunami, developing country industrial production slowed much more sharply, from 13.3 percent in the first quarter (3m/3m, saar) to 1.5 percent in the second. Developing-country equity markets have underperformed high-income bourses, declining 15 percent over the year-to-date versus 10 percent in mature markets. Since the end of July, both markets have dropped by an additional 10 percent or more. Developing country bond yields have remained broadly stable since the beginning of August, although due to falling U.S. Treasury yields developing country spreads have increased by about 90 basis points in the month. International capital flows (gross) to developing countries have dropped sharply. They declined from an average of $50 billion in the second quarter to $24 billion during the first two months of the third quarter. Estimates for August stand 48 percent below the 2005-2010 average for the month. Nevertheless, year-to-date inflows (including August) are some 20 percent higher than in the same period of 2010. Latin America and specifically public-sector corporations have been the largest issuers of international bonds. Inflation in both high-income and developing countries is beginning to wane, receding in two thirds of developing countries. Across developing regions, inflation over May-July 2011 has 8

declined in Latin America and the Caribbean (to 7 percent, saar), South Asia (5.7 percent) and SubSaharan Africa (9 percent), but continues to rise in East Asia and the Pacific (6.3 percent) and in Europe and Central Asia (9.8 percent). Recent data for MENA are not available. Commodity prices are mixed reflecting different demand and supply problems, or the safe haven status of some of them. As the premier safe-haven asset, gold prices surged to a peak of near $1,900/oz in August, compared with $1,500 at end-June. Oil prices peaked in March 2011, with the WBG price reaching $119/bbl, falling to about $100/bbl by endAugust 2011. The loss of Libyan production, plus limited access of North American oil to offcontinent markets, has resulted in a growing wedge between European light-sweet Brent oil and heavier North American oil. The apparent resolution of the Libyan crisis (normally a moderately important producer of light-sweet oil) is expected to lead to a fall in oil prices and the differential between Brent and WTI prices. Prices of key grains increased during July and early August following harvesting delays of wheat in Europe and a drop in projected U.S. maize production due to poor weather. Despite anticipated production gains in 2011/12, grain stocks remain tight (e.g. 2011/12 global maize stocks correspond to 1.6 months of consumption versus a 10-year average of 2.4 months) pointing to the risk of additional price spikes.

III.

Outlook

In India, GDP growth is likely to slow down from the fast pace it had reached during FY201011 and in the years before the global financial crisis. In the next two years, FY2011-12 and FY2012-13, GDP growth is forecast to reach 7-8 percent. The slowdown is expected because of structural problems (see next paragraph), tighter macroeconomic policies, slow growth in the core OECD countries, and a base effect: growth in FY2010-11 was buoyed by the strong rebound in agriculture, while agricultural growth is expected to revert to trend (3 percent) in FY2011-12. Fiscal consolidation and higher interest rates are also likely to have a dampening effect on aggregate demand. The latter impact in particular on some long-term investments and demand for housing and consumer durables. Domestic interest rates could have a stronger effect on domestic investment in the near future, because of the lower availability of external loans in the more uncertain international environment. With the slow growth expected in core OECD countries, Indias GDP growth will have to rely on domestic growth drivers. The slowdown in investment, capital outflows, and decline in the stock market point to deeper structural problems. Investors are holding back in the face of regulatory uncertainty (environmental clearances, land acquisition laws, tax reforms), banks are highly exposed to power projects facing delays due to the lack of coal and gas feedstock, and mining (especially of iron ore) has been hit by recent scandals in Karnataka and Orissa, putting the future growth of the steel industry in doubt. Major structural reforms aimed at improving the investment climate, in particular progress on current legislative initiatives (land acquisition, tax reform, financial sector 9

reform, FDI in retail) would strengthen domestic growth drivers. Indias Planning Commission points the way: To achieve rapid growth, the economy will have to overcome constraints posed by limited energy supplies, increase in water scarcity, shortages in infrastructure, problems of land acquisition for industrial development and infrastructure, and the complex problem of managing the urban transition associated with rapid growth. Greater efforts also need to be made in agriculture, health and education to ensure inclusion of the most excluded and sometimes invisible parts of our population. 6 The stabilization of commodity prices and the economic slowdown are likely to support disinflation. The latest interest rate hike by the RBI has brought the real policy interest rate (calculated with forward looking WPI inflation) into positive territory for the first time since Q4 FY2008-09.7 With higher real interest rates, the slowdown in investment and industrial production witnessed in the first quarter is likely to continue. Lower aggregate demand would result in a reduction of capacity utilization and lower pricing power for corporations. Continuing slowdown in GDP induced by tighter macroeconomic policies would put downward pressure on core inflation. However, inflation is unlikely to show a significant decline in the second quarter of FY2011-12 because of built-up momentum (as indicated by seasonally adjusted monthly data) and continuing pressure from energy price increases (already implemented and more to come) and increases in minimum support prices announced for the upcoming harvest.8 However, it is forecast to decelerate from Q3 of FY2011-12, which would allow the RBI to lower policy rates eventually. Despite moderating domestic demand and relatively level international commodity prices, the current account deficit is likely to expand. While the trade deficit was shrinking at the end of 2010 and beginning of 2011, higher import growth since then is likely to continue. Moreover, as the composition of Indias exports is changing towards higher technology content, increasing import content is likely. The trade deficit could reach around $110 billion in FY2011-12, as compared with $97 billion in FY2010-11. Growing services surpluses and net transfers should be sufficient to at least partially compensate. The current account deficit is therefore likely to reach around 3 percent of GDP in FY2011-12. Capital inflows pose risks in both directions. Under the baseline forecast for the global economic environment of a relatively benign resolution of the recent turmoil, capital inflows could resume and finance the increase in the current account deficit. While FDI held up well during the global crisis, inflows in H2 FY2010-11 have been lower. However, a rebound seems to be underway with significantly higher inflows in April-May 2011. The heightened uncertainty that led to sharp asset price corrections in August 2011 also led to some portfolio outflows. As the most recent episode shows, volatility of portfolio flows could be high because of continuing uncertainty about the health of the global economy. Renewed shocks to the global financial system could quickly change investor perceptions and lead to another flight to safety. The risk of such shocks occurring is high in light of the unsettled debt issues in some European countries. On the other hand, global liquidity remains unusually high with little prospect of monetary policy tightening in major developed countries in
6

Planning Commission (2011), Faster, Sustainable, and more Inclusive Growth, An Approach to the 12 th Five Year Plan, New Delhi. 7 The real interest rate was negative through 2008 up to the onset of the global financial crisis when Indian inflation dropped rapidly in line with global commodity prices and Indian GDP. The medium-term average real interest rate was 1.5-2 percent. 8 Price increases in June 2011 for diesel, LPG, and Kerosene amounted to 9, 14.8, and 19.8 percent, respectively.

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2012. High liquidity could lead to sudden FII surges in emerging markets. The RBI has demonstrated its ability to react quickly to short-term capital flows and its reserves remain sufficient to prevent unwanted volatility of the rupee. The downside risks to growth are high because of the risks to global growth from the precarious situation in Europe. A worst-case international scenario would lead to a collapse of demand for Indias exports, and strong contraction in private sector spending. After the time of the Lehman collapse in 2008, higher public sector spending set in at exactly the right time largely because of the implementation of the recommendations of the 6th pay commission. The RBI was able to lower policy rates significantly when inflation fell rapidly in line with international commodity prices. While a possible renewed crisis would have very different origins from the one in 2008, policymakers would do well to review their preparedness for another global shock and prepare contingency measures. These would involve confidence building measures, such as highlighting in the public the (limited) extent of exposure of Indian banks to global shocks, ensuring adequate liquidity in the banking system (outside of the usual LAF window if needed), and fiscal stimulus.

Fiscal Policy
On the revenue side, a moderation in growth could be outweighed by higher-than-expected inflation in FY2011-12. Nominal GDP growth is likely to exceed the 14 percent assumed for the budget because of higher-than-envisaged inflation. Tax revenue could therefore exceed the target offsetting some expenditure overruns. With upside risks to expenditures, structural changes in the budget are needed to support growth and disinflation. In the budget, expenditures are targeted to rise by only 3.4 percent in FY2011-12. This is to be achieved by a contraction in subsidy outlays by 12.5 percent from Rs.1.64 trillion to Rs.1.43 trillion. While the government announced increases in administered prices for diesel, kerosene, and LPG in June 2011, these were also accompanied by a reduction of import duty.9 The net budget overruns from the fuel subsidies could amount to 0.5 percent of GDP if global oil prices remain at around $110/bl. The impact on food subsidies of the food security bill slated to be introduced in parliament is highly uncertain. While it will lead to somewhat higher outlays in the future, the impact on the current budget may be limited. Nevertheless, without additional policy measures, it will be challenging to reach the consolidation target. Meeting the deficit target is an important element of macroeconomic policy credibility. A fiscal contraction in line with the targets for FY2011-12, would likely constrain aggregate demand and lower inflation expectations, even if accompanied by one-off increases in the prices of subsidized items. In addition, rationalizing expenditure over the medium term by cutting subsidies including for items controlled by state governments (most notably state electricity boards) and expanding investment could alleviate supply bottlenecks and lower prices more directly and sustainably than through a contraction in aggregate demand. Since the beginning of the current fiscal year, most observers of the Indian economy have lowered their expectations. The Government of India based its 2011-12 budget on projections of GDP growth of 9 percent and average WPI inflation of 4 percent. However, different officials have revised their expectations for growth downwards, and for inflation upwards since then. The Chairman of the Prime Ministers Economic Advisory Council expects growth to measure 8.2 percent in FY2011-12, while inflation would drop to around 6.5 percent by end-March 2012. The Finance Minister considers that the Indian economy can live with 6-6.5 percent inflation,

Price increases for diesel, LPG, and Kerosene amounted to 9.0, 14.8, and 19.8 percent, respectively.

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but cautions that it would be a little more this year.10 The Ministry of Finance conceded growth could be 8.5 percent in FY2011-12, while the Planning Commission pegged growth for the year at 8 percent in August. In its First Quarter Review 2011-12, the RBI considers that even as some deceleration is expected in 2011-12, overall growth is likely to stay around trend growth of about 8 per cent in the face of still strong consumption demand. The RBI warns that inflationary pressures, which initially emanated from supply side constraints, spilled over to wages and output prices as demand conditions remained buoyant. Currently, inflationary expectations are further feeding on themselves and warrant a close watch.11 Inflation is projected to stay during Q2 of 2011-12, but moderation is expected thereafter. In light of continuing pass-through of earlier energy price increases and increases in minimum support prices, the RBI believes inflation will fall moderately to 7 percent by March 2012. The National Council of Applied Economic Researchs Quarterly Review of the Economy July 2011 pegs growth at 8.3 and inflation at 7.9 percent average for FY2011-12. Commercial banks are more pessimistic than the government: Citibank and JP Morgan forecast growth to slow to 7.6 percent in the current fiscal, and they also expect further monetary tightening as inflation remains elevated.

10

http://articles.timesofindia.indiatimes.com/2011-06-29/india-business/29716799_1_financial-sector-calmprice-pressures-tame-inflation. 11 Reserve Bank of India (2011), Macroeconomic and Monetary Developments Frist Quarter Review 2011-12, Mumbai.

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India: Selected Economic Indicators, FY2007/08-FY2011/12

2006/07 Real Income and Prices (% change) Real GDP (at factor cost) Agriculture Industry Of which : Manufacturing Services Prices Wholesale Price Index 1/ Consumer Price Index Consumption, Investment and Savings (% of GDP) Consumption Public Private Investment Public Private Gross National Savings Public Private External Sector Total Exports (% change in current US) Goods Services Total Imports (% change in current US) Goods Services Current Account Balance (% of GDP) Foreign Investment (US billion) Direct Investment, net Portfolio Investment, net Foreign Exchange Reserves (excl. Gold) (US billion) (in months of goods and services imports) General Government Finances (% of GDP) Revenue Expenditure Deficit 2/ Total Debt 3/ Domestic External 20.0 25.4 5.4 78.0 73.3 4.7 21.0 26.0 5.0 76.2 72.0 4.2 21.1 29.5 8.4 75.4 70.7 4.7 17.2 27.3 10.1 73.4 69.3 4.1 19.9 28.4 8.5 67.9 64.1 3.8 19.1 26.6 7.5 66.5 62.5 4.0 24.5 22.6 28.0 22.7 21.4 28.5 -1.0 14.8 7.7 7.1 191.9 9.8 26.6 28.9 22.4 31.6 35.1 16.2 -1.3 43.3 15.9 27.4 299.2 11.6 15.0 13.7 17.3 16.6 19.8 1.1 -2.3 5.8 19.8 -14.0 241.4 8.0 -5.8 -3.6 -9.6 0.0 -2.6 15.3 -2.8 51.2 18.8 32.4 254.7 8.5 37.6 37.4 37.8 29.0 26.7 40.4 -2.6 37.4 7.1 30.3 274.3 7.1 20.0 20.0 18.0 20.0 25.0 15.0 -3.0 48.0 27.0 21.0 286.5 6.2 68.0 10.3 57.7 35.7 8.3 26.5 37.0 3.6 33.4 67.3 10.3 57.0 38.1 8.9 27.9 39.8 5.0 34.8 69.4 11.0 58.4 34.5 9.5 24.6 35.4 0.5 34.9 69.7 12.0 57.7 36.5 8.4 25.6 37.0 2.1 34.9 68.7 11.5 57.2 34.8 8.5 26.3 37.5 3.8 33.7 67.5 10.7 56.8 35.9 9.8 26.2 38.5 5.0 33.5 6.6 6.4 4.8 6.2 8.1 9.1 3.9 12.3 9.7 10.5 8.0 9.6 4.2 12.2 14.3 10.1 9.3 5.8 9.7 10.3 10.3 6.8 -0.1 4.4 4.2 10.1 8.0 0.4 8.0 8.8 10.1 8.5 6.6 7.9 8.3 9.4 7.5 3.0 7.5 8.0 8.6 2007/08 2008/09 2009/10 2010/11 Est 2011/12 Proj

Sources: Central Statistical Organization, Reserve Bank of India, and World Bank Staff Estimates.

1/ WPI base year 2004-05 2/World Bank Definition 3/ Net of Liabilties under MSS and NSSF not used for financing CG deficits

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