Country Report India
Economic growth for the current financial year, which runs through March, is expected to be at the lower end of the 5-6% range. A cautious recovery is expected for next year, although much will depend on the speed of reforms. The government has announced several reforms since September last year. While implementation risk is present, investor confidence seems to have responded positively. Moreover, with declining inflation, the central bank has decided to cut its policy rate by 25bps in January and might continue the easing cycle later this year. However, with the national elections scheduled for mid-2014, consensus making in India’s parliament will be even more difficult in the coming year. After the elections, as neither the ruling Congress nor the largest opposition party BJP are expected to win convincingly, it is unlikely that India will get a strong leadership. Fragmented politics with much power for regional parties is therefore expected. Meanwhile, the twin deficit on the fiscal and current account balance is growing.
Economic structure and growth
India is an extremely diverse country with large regional differences, a huge gap between rich and poor, very diverse economic sectors and major challenges. The average income in India was about USD 1,500 in 2012 (USD 3,966 in PPP terms) and, according to the World Bank, more than a third of the population lives on less than USD 1.25 per day, most of whom live in rural areas. The agricultural sector is therefore very important. Although it only produces 18% of GDP, about two thirds of the population depends on this sector for its livelihood. At the other end of the spectrum there is the world class IT sector, which is a major driver of the services sector. The services sector accounts for almost 60% of GDP and employs many of the well-educated Indians, who were able to enjoy high quality education. However, for most Indians this schooling remains out of reach and in general the education system is poor. In table 1, India is put next to Indonesia and the other BRIC countries for an international comparison. It is clear that India lags behind those countries, as it scores the worst on four out of five selected indicators, except for income inequality (Gini index) where it actually performs best.
India’s primary export partners are the United Arab Emirates (UAE), the US, China and Singapore. While this might suggest that India is rather immune to a European crisis, the final destination of many products shipped to UAE and, to lesser extent, China and Singapore really is Europe – mainly by way of entrepot trading in the UAE. Important export products are engineering goods, refined petroleum products and gems and jewelry. To produce these products and for its own consumption, India imports large amounts of crude oil and gold.
Source: UN (Human Development Index), World Bank (other data)
The first two quarters of FY 2012/13  posted rather disappointing economic growth figures, with 5.5% yoy in April-June and 5.3% yoy July-Sept. Estimates for this year’s economic growth range from less than 5% to around 6%. The Reserve Bank of India (RBI, central bank) recently lowered its expectation to 5.5%, down from an expected 6.5% in July 2012. Moreover the Central Statistical Office (CSO) published an advanced growth estimate of 5.0% early February. However, in the past years their estimates have not been really close to the final figure and an upward revision is likely. Still, we expect growth to be on the lower end of the 5-6% band, which would be a broad based slowdown from previous year (6.2% yoy). Private consumption, the mainstay of India’s GDP, is affected by the elevated inflation, tight monetary conditions and a rather weak monsoon. Flagging investor confidence, which suffers from policy inaction, and high interest rates weigh on gross fixed investment. Meanwhile, the government should speed up the efforts of fiscal consolidation – even though this would have a negative effect on growth – but has so far changed little in its spending pattern. As a result, the government consumption is more or less at the same level as last year. Finally, external demand remains subdued, but with slowing imports, the net contribution of external demand to growth is about zero. Going forward, the monthly data do not show a definitive movement in either upward or downward direction, although some signs are positive. The Purchasing Managers Indices (PMI) for both services and manufacturing have been, for example, above the 50-point threshold for several months. A cautious recovery is therefore expected for FY 2013/14. The actual outcome will depend, among others, on pre-election spending packages and the recovery of investor confidence on the back of reforms. More on economic reforms in the next sections.
The financial sector in India is tightly regulated and public sector banks hold three quarters of the assets. The government requires banks to buy government bonds via supervisory regulation. In practice, banks tend to hold even more government bonds than required, as the return is attractive considering the perceived low risk. Moody’s reaffirms the close connection between the banking sector and government as they consider systemic support high in India. The government has expressed commitment to a minimum Tier 1 ratio of 8% for government banks. The combination of slowing economic momentum and higher interest rates is expected to affect asset quality in the Indian banking sector going forward. Fitch expects the gross NPL ratio to be 4.2% at the end of the financial year 2012/13 (i.e. March 2013), up from 2.9% the previous year. Especially infrastructure financing is experiencing difficulties, which accounts for about 14% of the non-food loan portfolio (June 2012). The exposure to infrastructure, mainly the power sector, has been growing rapidly in the past three to four years.
 ^ India’s financial year (FY) runs from April through March.
Political and social situation
The United Progressive Alliance (UPA) coalition won the 2009 elections comfortably. The UPA coalition is dominated by the Indian National Congress (INC) of Prime Minister Singh, but also includes several so-called ‘frenemies’. Despite the landslide victory in 2009, the progress on reforms has been slow. The (public) opposition is strong and even within the coalition consensus is sometimes out of reach. Last summer, Finance Minister Mukherjee stepped down to run for (and become) president. Mr. Chidambaram was appointed as the new Finance Minister, the third time he is on this post. Together with PM Singh, expectations were high that they were able to present reforms that would kick start the slowing economy. Indeed, the government announced a series of bold measures in September and October. Initially, this included the hike of the diesel price, allowing foreign investment in retail, aviation and broadcasting, tax incentives for small investors and lower taxes on overseas borrowing. In the recent months, more measures have been announced.
However, the effects of these reforms are difficult to assess. First, not all measures have been approved by parliament and are just merely plans at this stage. For example, the proposal to raise the ceiling on FDI in the insurance sector from 26% to 49% and open up the pension sector to FDI for the first time (up to 49%) needs parliamentary approval. And this will be difficult. Second, a ‘go’ is not necessarily a ‘go’ in India. For example, the measure to allow a larger foreign participation in multi-brand retail. Less than a week after both houses of India’s parliament were unofficially in support of the government’s planned FDI reforms (it was a decision at the discretion of the government, but to get support for other proposals, the government allowed an unofficial vote), a new delay presented itself. It became known that Wal-Mart had spent some USD 25m on lobbying, which could be deemed illegal in India. The opposition saw its chance to demand an investigation and potentially reverse the measure, which is considered controversial as many small retailers in India fear going out of business. Third, implementation risk is high in India and executing the new measures can take months, if not years. However, despite these setbacks, the reforms do seem to have boosted investor confidence, which will hopefully translate into investment decisions and thereby economic growth.
The reforms have come at a political cost. The Trinamool Congress (TMC), the second largest party in the ruling UPA coalition, left the coalition, as it opposed the reforms. Although without the TMC the UPA does not have a simple majority, it has enough support in the parliament for now, as among others the Samajwadi Party has indicated to support (but not join) the UPA alliance – if only to prevent early elections that could possibly bring the largest opposition party BJP party to power. The risk of early elections has therefore decreased and all eyes are now on the scheduled national elections of mid-2014 and several state elections in 2013. In the run-up to the 2014 elections little progress on reforms is expected as parties will try to win as many concessions for its support base as possible, which does not bode well for the more controversial reforms.
The Congress (INC), the dominant party in the ruling coalition, and BJP, currently the largest opposition party, are the two main contenders in next year’s election, although state parties are expected to be kingmakers. Recent appointments suggest that both major parties are warming up. The Congress party appointed Rahul Gandhi as its vice-president. This was long expected, as he is part of the Nehru-Gandhi dynasty, which supplied the first, third and sixth prime minister since independence, and his mother is the president of the party. It has fuelled speculation that Rahul is lined up to become the next prime minister. The BJP elected Rajnath Singh as its president, the second time he is in this role. Despite the experience that both candidates have (either personally or in the family), they will be up for a challenge. Rahul Gandhi will have to regain support for the Congress after a series of corruption scandals and a flagging economy. The recent reforms might help, although some are quite controversial. Rajnath Singh’s BJP was also involved in several scandals and has so far been unable to cash in on Congress’ weakness. The BJP might decide to put the popular Mr. Modi forward as candidate for the prime minister’s role. As Chief Minister of Gujarat, Modi has made name by boosting the economy of Gujarat, one of India’s states. However, he is also tainted by riots in 2002, which costs more than 1,000 Muslims their lives. Either way, the two leading parties will face stiff competition from regional parties. In fact, the current expectation is that the elections will not bring a strong coalition. There is a substantial chance that the current fractious politics will continue or a hung parliament will emerge, which hampers decision making on the more controversial (but often much needed) reforms.
India’s international relationships are influenced by the long-standing border disputes with Pakistan over the Kashmir region and with China in the northern states, as well as by the difficult relationship with Bangladesh. The relationship with Pakistan was showing some signs of thaw, as the Pakistani media reported that their government had awarded India the most favored nation status, which would help to normalize trade ties. While unconfirmed, this would be a major step in the troublesome peace process between the two countries. But early January, the news of two Indian soldiers killed in Kashmir - one of them was allegedly beheaded by Pakistani soldiers - threatened to derail the fragile peace process. On another front, the relationship with Pakistan (but also with China) could become a bit cooler too. Ahead of the withdrawal of US troops from Afghanistan in 2014, India is trying to increase its influence sphere in Afghanistan at the cost of Pakistan and China. It wants to prevent Islamist militants to find a comfortable base in Afghanistan and that its principal rival China gets too much influence. Globally, India aims to strengthen its position as one of the BRICs. The relationship with the US and EU are currently good.
In the area of economic policy, the past months saw two major developments. First, the government announced a series of reform measures, as extensively discussed above. Second, in December 2012, the twelfth five-year plan FYP 2012-17 was approved (which in effect started in April 2012). India uses the five-year plans to guide its policy decisions in broad lines, although practice learns that daily issues can distract. The title of the FYP is indicative of the goals to be achieved: “Faster, more inclusive and sustainable growth”. The government aims to achieve an average growth rate of 8.2% in the five year period, moving up from the current below 6% level to 9%, which is seen as India’s full growth potential by the government. To achieve this ambitious goal, extra effort is needed. Among others, the government formulates the ambition to invest USD 1 trillion in infrastructure, as infrastructural bottlenecks are said to cost annual GDP growth two to three percentage points. While part of this will have to come from the private sector – which suggests that it might be useful to address issues like red tape and corruption – the government will need to shore up investment too. In the current budget, there is little room for this ambition.
The fiscal deficit target is likely to be missed this year, just as last year. It was set at 5.1% of GDP, but has meanwhile been adjusted to 5.3%, which thus might be missed too. A fiscal deficit closer to 6% of GDP (plus the usual 2-3% of GDP deficit from state budgets) is more likely. The IMF expects the fiscal deficit of India to be 9.5% of GDP for 2012, including state budgets, which is too high for comfort in the long run. This year’s excess is largely due to too optimistic growth expectations (7.5%), a rather late monsoon pushing up social spending and a growing subsidy bill. Fertilizer, diesel, electricity, food and other subsidy schemes amount to about USD 36bn per year and are hard to control. For next year, the IMF has put its estimate for the fiscal deficit on 9.1% of GDP, which would be a slight improvement from this year. The recently announced phasing out of regulated diesel prices would help in this regard, but more is needed in the area of cutting subsidies to really improve the fiscal situation. Also, the introduction of the goods and services tax, which is controversial and thus not expected before the 2014 elections, would help, as it broadens the revenue base.
The new budget will be presented in February and will be closely watched, as this is the last budget before the elections and would normally include large populist spending programs. However, two out of the three major rating agencies have put India on a negative outlook, which would push the bond rating into junk status. This could have repercussions for the popularity of the Congress party and the budget statement is therefore likely to put emphasis on the Direct Benefit Transfer (DBT) and keep additional spending limited. Under the DBT scheme, which was launched on 1 January, the government will directly transfer social benefits and subsidies to the recipient’s bank account. Combined with the Unique Identification (UID) project, the government hopes to reduce corruption and improve targeting of subsidies – the bulk of India’s subsidies never reach the targeted group. While the DBT scheme is only rolled out in 20 of the 640 districts in India and for a few of the subsidies, it is has a huge potential in the long run. And in the short-run, marketed well, it could boost Congress’ stance without boosting government spending.
Public debt of the central government is stable, but rather high at around 50% of GDP. The IMF puts the general government debt (i.e. including states) at 67.6% of GDP for 2012. This is down from the 78.5% of GDP in 2006 and IMF expects public debt of the general government to further decrease in the coming years to around 64% of GDP in 2017. Financing India’s public debt is not expected to be an issue, as the government is able to place most of its bonds with domestic banks as, through regulation, banks have to buy bonds worth 23% of its deposits. However, there are some issues. First, India is on a negative outlook. A downgrade by the rating agencies might not hinder the financing of India’s government deficit too much, as it sources from the domestic banking sector, but it could push financing costs up. A second issue of the rather high public debt level is the crowding out effect. In practice, banks tend to hold a higher percentage of government bonds than regulatory required, which limits the ability to extend credit to the private sector. Finally, the government could face substantial contingent liabilities from the banking sector. About 80% of the banking sector is state owned and NPLs are rising (see section on the banking sector). So far, the government has put up capital for its state banks when needed. It is unclear how much more is needed in the coming years.
Figure 3: Fiscal indicators
Inflation remained stubbornly high in India, but seems to have eased somewhat recently. The wholesale price index (WPI), the general measure of inflation in India, declined from close to 10% in the fall of 2011 to 7.2% in December 2012. While this is a three-year low, it is still rather high, largely due to food inflation, which moved into double digits in December. The depreciation of the rupee over 2012 did not help inflationary pressure either. In the coming months, food prices, the pass-through of diesel price adjustment and possibly changes in other administered prices (such as railway ticket prices) are expected to keep inflation at the current level. With the easing inflation pressure, weaker economic growth and tight liquidity conditions in mind, the Reserve Bank of India (RBI) cut its policy rate and the cash reserve ratio by 25bps to 7.75% and 4.0%, respectively, on 29 January 2013. It was the second policy rate cut in the current easing cycle. The government has and will likely continue to exert pressure on the RBI to cut the policy rates to stimulate the economy. But the RBI is rather independent and will be hesitant to further cut rates without a substantial decrease in inflation, a continued slowdown of the economy or credible fiscal consolidation plans.
Balance of Payments and external position
The current account balance of India tends to show a moderate deficit, but the balance has been deteriorating in the past year. It is forecast to come in at 4.6% of GDP for 2012, which is higher than the usual 2-3% of GDP. For 2013 and 2014, a moderate improvement is expected again to around 3-4% of GDP. The widening deficit on the trade balance – already the main culprit of the deficit on the current account balance – caused the deterioration of the current account balance. The deficit on the trade balance worsened from 9% of GDP in 2011 to 10.5% of GDP in 2012, on the back of weaker external demand. The export value shrunk 3.3% over 2012, while imports grew by 3.9%, despite a weaker economic growth and a depreciation of the rupee. For next year, the export revenues are expected to grow faster again than the import bill, helping the trade balance to improve. The import bill mainly consists out of oil and gold. The recent decision to deregulate diesel prices could therefore in the long run have a positive effect on the trade balance, as higher diesel prices are expected to lead to a lower demand.
India’s external financing requirement, which is expected to be around USD 186bn in 2013, stems from the current account deficit (about 50% of the total amount) and from repayments on short-term loans (about 35%) and on medium/long-term loans (about 20%). Investment financing flows, i.e. foreign direct investment and portfolio inflows, should be able to cover about a quarter of the financing needs. India has a rather closed capital account and investing in India is still bound to many rules. However in the past years, the government has adopted several measures to facilitate investment in India, as it realizes that it requires foreign capital. While the economy in India might be in a slump now, investors still see the potential and companies like Wal-Mart, Tesco and IKEA are willing to invest (although multibrand retail is not completely open yet). The adoption of changes to the insurance and pension sector could attract more foreign companies. Despite the importance of investment financing, the bulk of India’s financing requirement is covered by debt financing. For 2013, India is expected to attract about USD 70bn in short-term debt, which would be close to two thirds of the debt financing. The other third comes from different sources, such as commercial banks loans and international bond issues.
As a result of the regular need for debt financing, India has built up a stock of external debt to the amount of almost USD 300bn (end-2012). In relative terms, this is a rather low 16% of GDP. In 2013, this stock of foreign debt is expected to rise to a little over USD 300bn (14% of GDP). The maturity structure of the India’s external debt is rather long with less than a quarter in short-term debt. Of the medium- and long-term debt about half is owed to private creditors and the other half to public creditors.
The foreign exchange (FX) reserves of India were USD 258bn end-2012 and are expected to rise to around USD 265bn in this year. If this is achieved, the FX reserves would cover more than 80% of the total foreign debt and more than 3.5 times the short-term debt. While this is adequate, the FX cover has decreased, as in 2009 the FX reserves still were larger than the total external debt. This is due to a combination of continuously rising external debt and a small decline in FX reserves in the period 2010-12. FX reserves are now rising again. The import cover has also decreased, also on the back of a growing import bill, but is still expected to be at an acceptable 5 months in 2013. Overall, the external position of India is still adequate.