On January 27, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with India.
India’s growth has slowed markedly, reflecting global developments and domestic supply constraints, while inflation remains stubbornly high. Led by falling infrastructure and corporate investment, the slowdown has generalized to other sectors of the economy. The financial positions of banks and corporates have deteriorated. The combination of persistently-high inflation, sizeable current account and fiscal deficits intensified the global liquidity tightening-induced balance of payment pressures experienced during the summer, which resulted in significant portfolio debt outflows, and pressures on currency, equity and bond markets. Along with improving external conditions, positive policy steps taken by the authorities have improved market sentiment. The current account deficit, after reaching a record high in FY2012/13 (fiscal year ending March), is narrowing fast, and capital inflows have picked up. While recent policy initiatives have reduced vulnerabilities, the policy space remains strictly circumscribed because of high deficits and debt, and elevated inflation.
Growth is projected at 4.6 percent for fiscal year 2013/14, and should pick up to 5.4 percent in 2014/15 (at factor cost). Stronger global growth, improving export competitiveness, a favorable monsoon, and a confidence boost from recent policy actions should deliver a modest growth rebound. However, fiscal restraint and a tighter monetary stance will act as headwinds, slowing the recovery. CPI inflation is expected to remain near double-digits well into next year, driven by high food inflation that feeds quickly into wages and core inflation; entrenched inflation expectations; the pass through from a weaker rupee; and ongoing energy price increases. WPI inflation is forecast to remain above the Reserve Bank of India’s comfort zone, given that supply constraints will ease only gradually. The current account deficit should narrow in fiscal year 2013/14 to about 3.3 percent of GDP, supported by rebounding exports, higher remittances, rapidly-shrinking gold imports, weakening domestic demand, and broadly stable oil prices.
The principal risk facing India is the inward spillover from global financial market volatility. Protracted economic and financial volatility (triggered by advanced economies’ exit from unconventional monetary policies), a lengthy Euro area growth slowdown, and higher oil prices are the main external risks. Slow progress on structural reforms, high inflation, failure to ease supply constraints, and resorting to expansionary fiscal policy are key domestic downside risks. On the upside, going beyond announced reforms or faster-than-envisaged legislative progress would lead to higher growth and reduce economic vulnerabilities.
Executive Directors commended the Indian authorities for their ability to maintain macroeconomic and financial stability amid a challenging macroeconomic landscape. Directors welcomed ongoing efforts, including recent policy initiatives, to reduce external vulnerabilities, rebuild buffers, and revive investment. They noted, however, that growth has slowed markedly and inflation remains persistently high, while spillovers from global financial market volatility continue to pose a significant risk. Against this backdrop, Directors underscored the need to rein in inflation, prudently consolidate the fiscal position, and accelerate structural reforms to address supply bottlenecks and promote sustainable and inclusive growth.
Directors supported the central bank’s policies of rupee flexibility and limited foreign exchange intervention. They welcomed the gradual, cautious move toward further external liberalization. Directors considered that these measures are important tools to deal with capital account pressures, which, if they were to re-emerge, should be complemented by judicious use of reserves, tightening of monetary conditions, and additional fiscal adjustment. Directors encouraged continued efforts to improve the financing of the current account deficit. Measures to facilitate foreign direct investment inflows and deepen domestic capital markets should continue to help reduce external vulnerabilities.
Given entrenched double-digit inflation expectations, Directors recommended that the authorities maintain the monetary policy stance appropriately tight, and stand ready to raise the policy rate further so as to bring down inflation to more sustainable levels. They welcomed recent initiatives to strengthen the monetary policy framework with a clear communication strategy, aimed at enhancing the effectiveness of monetary policy.
Directors commended the government’s commitment to fiscal consolidation and supported its medium-term targets. To this end, they emphasized the need for a comprehensive package of measures, comprising both tax and subsidy reforms, to ensure the quality and sustainability of consolidation. Rationalizing fuel and fertilizer subsidies and introducing the goods and services tax are essential to create fiscal space, while safeguarding priority capital spending and targeted social programs, particularly health and education.
Directors stressed that reviving growth and raising the long-term growth potential require broader structural reforms to improve infrastructure, the business climate, and the pricing and allocation of natural resources. They also saw as key priorities reforms aimed at boosting agricultural productivity and supporting formal job creation, by relaxing labor laws and addressing skills mismatches.
Directors recognized that India’s financial system is well capitalized and supervised, and welcomed progress in implementing the recommendations of the FSAP Update. They welcomed in particular recent measures to enhance supervision and increase bank provisioning. Directors noted nevertheless that deteriorating corporate financial positions and weakening bank balance sheets, especially among public banks, warrant close monitoring. They encouraged the authorities to further strengthen prudential regulation of banks’ asset quality classification and concentration risks, and pay due regard to the inter-linkages between corporate vulnerabilities and banking system health. Steps are also needed to modernize the legal and insolvency framework.