CHAPTER III: Analysis and Outlook
The Indian economy recovered quickly after the global crisis of 2008-09, which reduced the growth rate of real GDP at factor cost to 3.5% in Q4 of 2008-09. Growth improved to 11.2% by Q4 of 2009-10. However, following the crisis in Eurozone and the slow recovery in several other countries, in combination with certain domestic factors, economic growth began to decelerate thereafter and has averaged 5.8% in last five quarters. A decline in the contribution of the industrial sector to overall GDP growth, from 36.9% in Q4 of 2009-10 to 9.8% in Q4 of 2011-12, has been the key factor in this moderation. Besides the slowdown in growth, the economy has been under pressure on account of elevated levels of inflation, a high fiscal deficit and a widening current account deficit.
Moderation in manufacturing growth-expectations and interest costs
While the global economic slowdown has adversely affected export dependent sectors, depressed business sentiment, coupled with high interest rates and moderation in credit growth have led to a deceleration in investment growth, as well as some moderation in consumption demand, resulting in slower overall growth.
The Reserve Bank of India's quarterly Business Expectation Index (BEI)1, after recovering from a low of 96.4 in Q1 of 2008-09 to 126.5 in Q3 of 2010-11, has declined steadily thereafter. The index, however, still remains in the growth terrain (i.e., above 100, which is the threshold that separates contraction from expansion). Nearly half of the companies reported production constraints preventing them from attaining their normal production levels during the quarter July-September 2012. They cited lack of domestic demand, uncertainty of the economic environment, shortage of power, lack of export demand and shortage of working capital finance. Deseasonalized IIP growth has generally mirrored the BEI (Fig 3.1).
Fig 3.1: Business Expectation Index and IIP growth (Deseasonalized annualized QoQ)
3.3 While high interest rates may have been necessary to combat inflation, they have also raised the interest cost for manufacturing industries. Interest as a percentage of operating profits of these companies (non¬government non-financial) increased from 15.2% in Q4 of 2009-10 to 30.3% in Q1 of 2012-13. Investment as measured by new projects in the CMIE Capex declined from 28.5% of GDP to 9.7% of GDP over the same period (Fig 3.2). Of course, a substantial portion of the decline in new projects occurred before interest expenses grew substantially, suggesting that other factors such as the difficulty in acquiring various project clearances or land may also have played a part. The proposal for setting up a National Investment Board (NIB) headed by the Prime Minister for fast tracking projects over Rs.1000 crore is intended to reduce unnecessary delays in granting such clearances, for delays not only slow growth but also render projects unviable, turning them into NPAs for the banking system. 3.4 The decline in investment affected the production of capital goods. Higher growth of imports of capital goods in 2011-12 (para 1.27 of Chapter 1) also contributed to deceleration in growth of domestic production. Based on an analysis of relationship between production and imports of manufactured goods industries, RBI has also observed a negative association between production and imports in case of electrical machinery (which had a negative growth in last 5 quarters) resulting in substitution of domestic output by imports. 3.5 Some sectors have been affected by high interest rates to a greater extent than others. In interest-sensitive sectors like capital goods and consumer durables (Fig 3.3), there seems to be a strong negative correlation between the growth in production and rising repo rates. Here again, though, high interest rates should be seen as only one of the factors affecting growth.
Fig 3.2: Interest cost of Companies and Investment in industrial projects
Cycle of moderation in expectation may have reached its trough
3.6 There are, however, signs that the cycle of moderation of expectation has reached its trough. The confidence building measures announced by Government in September and October, 2012 including liberalization of FDI policy in sectors like multi-brand retail, aviation, power and broadcasting sectors to attract foreign investment, announcing a road map to achieve fiscal consolidation, rationalization of subsidy on diesel, etc. are gradually improving business expectations, though progress on implementing some of the suggested measures, such as the proposed National Investment Board, is needed to consolidate the shift. RBI’s business expectation index, after having declined for seven consecutive quarters, moved up in the Oct-Dec, 2012 quarter. HSBC’s purchasing managers index (PMI), picked up in November, indicating the fastest rate of expansion in November in the last five months. Companies reported an increase in order book volumes and together with depletion of inventories, this could set the stage for higher output growth.
Some early signs of improved availability of investable funds
3.7 The slowdown in investment was also partly due to financing constraints. As indicated in Chapter 1, growth of aggregate deposits moderated considerably, from an average of 17.8% during Apr-Sep, 2011 to 14.2% during Apr-Sep, 2012. Corporate profitability as reflected in corporate internal accruals (profit after tax and depreciation) also declined sharply from 14.3% of sales in Q1 of 2009-10 to 8.2% in Q3 of 2011-12. There has also been a slowdown in national savings, particularly financial savings since 2007-08 (from 26.0% of GDP in 2007-08 to 19.6% of GDP in 2010-11) due to public dis-savings, fall in corporate savings and shift in household savings towards real assets away from financial assets (even if we do not include gold purchases). The components of household savings clearly indicate that there has been a steady decline in the share of pension and provident funds as real interest rates have declined and a decline in investment in shares and debentures, as real estate and gold have become perceived as more attractive alternatives. In addition to increasing customs duty on gold to reduce its demand - and there is a limit to how much this can be done without encouraging smuggling - - measures to offer gold-linked savings as well as bonds linked to real returns are being considered (see later). Finally, corporate profitability also appears to be reversing its declining trend (Fig 3.4) which suggest that availability of domestic funds for investment may see an increase in subsequent quarters. 3.8 Because of the slowdown and high levels of leverage, some industry and infrastructure sectors are experiencing an increase in non- performing assets (NPAs). Overall NPAs of the banking sector increased from 2.36% of total credit advanced in March, 2011 to 3.57% of total credit advanced in September, 2012 (Fig 3.5). While there has been across the board increase in NPAs, the increase is particularly sharp for industry and infrastructure sectors, with NPAs as% to credit advanced increasing from 1.91% in March, 2011 to 3.44% in September, 2012. Sectors, particularly under stress include textiles, chemicals, iron & steel, food processing, construction and telecommunications. The rapid rise in non-performing bank loans suggests once again the need for a single-minded focus by all stakeholders on reducing unnecessary delays to project completion. Moreover, failing projects need to be restructured rapidly and equitably, drawing in new promoters if the old ones cannot bring in better capabilities and new equity, and requiring greater risk capital up front in future financing, including greater promoter equity to buffer bank claims.
Fig 3.4: Corporate Profitability and Gross Fixed Capital Formation
3.9 Headline inflation measured in terms of the Wholesale Price Index (WPI) is still uncomfortably high, albeit at a lower level than what was observed in 2010-12. The frequency distribution of commodities included in the WPI indicates that there has been a sharp reduction in the number of commodities experiencing double digit inflation in the first half of 2012-13 (Table 3.1) along with a corresponding increase in the number and weights of commodities with inflation in the single digits. This distributional shift has not only resulted in the moderation of inflation but suggests more room for adopting commodity focused strategies for containing inflation.
Fig 3.5: Non-Performing Assets of the Banking Sector
Table 3.1: Frequency distribution of WPI- commodities in terms of inflation range
|Frequency Distribution of commodities by inflation range (Number of Commodities)|
|up to 5||492||459||389||394||340||397||449|
|Weights of the Commodities (per cent)|
|up to 5||75.25||63.66||40.50||47.17||39.37||47.86||49.21|
3.10 Policy decisions to contain inflation are expected to be ahead of the curve. This requires understanding the momentum of inflation along with its current level. Besides headline WPI and CPI inflation, RBI has been monitoring non-food manufacturing (NFM) inflation as the key measure of core inflation that will influence its policy stance. The reason for this emphasis is partly because demand conditions, which can be affected by RBI interest rate policy, are better measured by NFM inflation, and NFM inflation is also relatively sticky. The seasonally adjusted annualized rate of inflation (SAAR) indicates the momentum of NFM inflation is currently on a decline.
3.11 Within core inflation, while the inflation for capital goods has continued to remain muted, inflation for consumer durables has been showing signs of easing recently (Fig 3.7). Inflation for consumer durables generally remained above core inflation and its moderation reflects the impact of monetary policy.
WPI food inflation has shown a sharper moderation during the period April 2010 to October 2012, because of its initial high levels. Food inflation however is more structural and its response to monetary policy changes is relatively weak. However, the momentum of food inflation is also pointing towards moderation (Fig 3.8).
Fig 3.6: Momentum of WPI Core Inflation
Fig 3.8: Momentum of food inflation
3.13 Some economists prefer the central bank to target consumer price inflation rather than the NFM inflation, because the former is what the person on the street experiences. Moreover, generalized and persistent CPI inflation could entrench high inflationary expectations amongst the public. Though there have been 3 consumer price indices, before the Central Statistical Office launched the new series of CPI in January, 2010, all of these indices have been for a specific class of consumers. CPI for industrial workers, which is primarily used for wage indexation, however, has been the CPI index preferred by many economists. Inflation during August 2010 to March 2012 appears to follow more or less a similar trend irrespective of whether it is measured in terms of WPI or CPI-IW. A nearly 2-percentage point gap has emerged in recent months between these two measures. Momentum of CPI-IW as measured by its deseasonalized series, however indicates moderation in inflation in recent months, consistent with WPI-core and WPI-food (Fig 3.9).
Why has inflation persisted?
3.14 Inflation in protein foods particularly meat, fish and eggs; milk and milk products; and vegetables and fruits has continued to persist because of changes in dietary habits and supply constraints. Data from National Accounts Statistics indicate that while the share of food in total private final consumption expenditure continued to show a decline, expenditure on protein foods increased from 18.6% of total food expenditure in 1980-81 to 29.6% in 2010-11. An increase in income made this desirable shift in consumption feasible. At the national level, per capita income, adjusted for inflation continued to rise. There was also a significant increase in rural wages. Rural wages in nominal terms went up by an average of over 18% since 2008-09. Inflation-adjusted rural wages also went up by 7.5% during this period. (Fig 3.10) The input costs for producers in both food and non-food segment, as reflected in the prices of feed, fodder and other inputs also increased. An increase in MSP, while necessary to ensure remunerative returns to farmers, raised the floor prices and also contributed to rise in input prices.
Commodities under price pressure and policy initiatives
3.15 As indicated earlier, a few commodities have contributed disproportionately to inflation. In Q2 of 2012-13, 19 commodities (commodity groups) with a weight of 28.5% in WPI contributed 67.8% to total inflation (Table 3.2). Contribution of each of these commodities to inflation in Q2 of 2012-13 exceeded 1.5 times of their weight (with the exception of milk).
Fig 3.10: Index of per capita income, rural wages and CPI-IW
Table 3.2: Contribution to inflation (in%): items to be watched
|Fish (inland+ marine)||1.30||5.47||2.29||2.96||4.12||6.79||5.64||4.67|
|Oil seeds+ edible oil+ oilcake||5.32||2.47||6.27||6.89||5.64||6.26||8.84||11.97|
|Non-Administered Mineral Oil||3.04||6.63||10.92||10.2||13.7 3||13.18||9.01||7.82|
|Cement & Lime||1.39||0.2||0.32||0.08||1.12||1.27||1.37||2.12|
|Gold & gold ornaments||0.36||1.75||2.75||3.15||3.66||4.06||3.6||2.78|
3.16 Two factors contributed to an increase in inflation in cereals. Besides an increase in the minimum support prices (MSP) for wheat and rice, there has been a mismatch between open market availability and demand, particularly for wheat. Food Corporation of India has already announced a programme of open market sales of 65 lakh tonnes of wheat in next three months which is expected to cool the market and dampen expectation of a price rise. The upsurge in the prices of pulses has largely been due to a persistent mismatch in demand and domestic availability. In the long run, containment of inflation in pulses would require an increase in the supply of pulses through improved productivity.
3.17 Prices of vegetables have remained volatile in recent past. Apart from a demand and supply mismatch, inefficient intermediation and loss in the value of vegetables at different stages of their transactions have contributed to both an increase in prices and its volatility. Both the locational differences in prices and the volatility of prices over time could be considerably reduced with improvement in the supply chain mechanism. The existence of a large number of intermediaries between the farmer and the consumers and time delays due to activities such as packing, sorting, transporting and delivery adds to intermediation costs and value losses. Organised marketing and greater private sector participation is critical for improving this state of affairs but it requires reforming the APMC legislation. The Inter Ministerial Group on Inflation (IMGI) had suggested exempting perishables from the purview of APMC, provide freedom to farmers to make direct sales to aggregators and processors, introduce electronic auction platform for all mandis and replacing licenses of APMC market with an open registration backed by bank guarantees to ensure wider choices to growers and to prevent cartelization by traders. Electronic display of prices for short duration vegetable crops could reduce the asymmetry in information flow and provide appropriate marketing signals to producers.
3.18 There have been some developments along these recommended lines. To develop integrated value chains, the government has also been emphasizing the need for exempting vegetables from the levy of market fees. The States of Madhya Pradesh and West Bengal have recently waived the market fee on fruits and vegetables. Such waivers are expected to promote investment in development of backend infrastructure by private sector. The Ministry of Agriculture in collaboration with Forward Markets Commission is facilitating display of spot and futures prices on Price Ticker Boards in around 1700 mandis in different states. Recently, the government has permitted Foreign Direct Investment (FDI) in multi-brand retail trading. This will help consumers and farmers by improving the logistical facilities connecting the two.
3.19 The persistence of high inflation in milk and animal products has partly been due to the regional concentration of production centres, rising input costs which raised the floor price and lower productivity. While in some cases, there has been an increase in availability, typically it has been at a higher cost. Further, due to limited organized marketing (even in case of milk it is around 15% of total milk produced) back end infrastructure such as a seamless cold chain has not been established, reducing quality and increasing wastage. A number of measures have been announced in Union Budget 2012-13 to augment supply and improve storage and warehousing facilities. Government had launched a National Mission for Protein supplements in 2011-12 with allocation of `300 crore. To broaden the scope of production of fish to coastal aquaculture, apart from fresh water aquaculture, the outlay for the mission in 2012-13 is being stepped up to Rs. 500 crore.
3.20 Issues related to sugar industry have been analyzed by the Rangarajan Committee. The Committee has recommended deregulation of sugar industry and dismantling of regulated release mechanism together with the levy obligations. These recommendations are under consideration by the Department of Food and Public Distribution.
3.21 The NFM products except for fertilizers (urea), non-administered petroleum products and edible oils are fully tradeable and none of these products are under administered price regime. Domestic prices for these products are governed both by global commodity prices and the domestic availability of these products. A stable rupee and moderate global prices, both relatively exogenous factors, may be important in keeping the prices of these products stable.
3.22 To summarize, inflation in India stems from a traditional mismatch between demand and supply. The relative magnitude of the imbalance has varied across sectors. For example, demand for consumer durables has remained high till recently, even while the demand for capital goods has remained more muted because of the slowdown in investment.
The inflation picture is further complicated in India because of shifting consumption basket and the supply of proteins and micro-nutrients like fruits and vegetables has not responded quickly. Interest rates are probably an inappropriate tool to shift people’s preferences. This is why it may be reasonable for the RBI to look through the rise in food prices (which is what it does by focusing on NFM inflation, which puts lower emphasis on food prices), while trying to ensure that food inflation does not feed into wages and generalized inflation. Unfortunately, food is a big part of a worker’s consumption basket, and higher food prices do feed into higher wage demands. What can be done? Government efforts to create the conditions for greater protein supply (some of which are described earlier) are important. Tempering wage inflation that is not directly linked to productivity increases may also be worth exploring.
Current Account Deficit (CAD)
3.24 India's current account deficit (CAD) has remained within manageable limits in recent years and has been financed largely by capital flows. During 2011-12 however, the CAD widened to 4.2% of GDP because of the widening trade deficit. This has increased Balance of Payment vulnerability to 'sudden stop' and reversal of capital, especially when sizeable flows comprise of debt, and volatile portfolio investment.
Forecasting inflation in India
Augmented Phillips curve framework lends support that both demand and supply factors are drivers of inflation. Global commodity prices have a strong and quick pass-through and an increase of 10% in global non-fuel commodity prices increases headline WPI inflation by 70-90 basis points in the same quarter, with the long-run impact being double (140-180 basis points). The exchange rate pass-through is 0.06 in the short-run and 0.12 in the long-run, i.e., 10% appreciation (depreciation) of rupee vis-à-vis the US dollar reduces (increases) inflation by 60 basis points in the same quarter, while the long-run pass-through is 120 basis points. A deficiency of 10% in the rainfall in July increases headline inflation by 60 basis points with a lag of three quarters and the long-run impact turns out to be 120 basis points. Minimum support prices have a substantial impact: 10% increase in minimum support prices increase headline WPI inflation by 100 basis points with lag of a quarter, and the long-run impact is 200 basis points. At the same time, minimum support prices are also found to respond to headline WPI inflation with a lag. The finding of demand conditions having a relatively stronger impact on NFMP inflation vis-a-vis headline inflation supports the RBI’s policy focus on NFMP as an indicator of demand pressures in the economy. Second, NFMP inflation is more persistent compared to headline inflation. The relatively sticker nature of NFMP also extends support to NFMP being used as a core measure of inflation or an indicator of underlying inflation pressures.
Muneesh Kapur- Inflation Forecasting: Issues and Challenges in India- Reserve Bank of India, Working Paper series (DEPR):01/2012.
3.25 The priority has therefore been to reduce CAD through improving trade balances. Efforts have been made to promote exports by diversifying the export commodity basket and export destinations. One way to limit imports is to bring prices up to international levels so that users see the full cost. A recent study commissioned by the Ministry of Finance on “Diesel Price and Under Recoveries: Macro-Economic Impacts” by Integrated Research and Action for Development of the Department of Economic Affairs, Ministry of Finance, suggests that diesel price revision will have a positive impact on curbing inflation over the medium term, enhancing GDP growth and reducing the fiscal deficit (Box 3.2).
3.26 Emphasis has continued on further facilitating remittances and encouraging software exports that have been responsible for the surplus on the invisible account. In recent years, this surplus has lowered the impact of widening trade deficit on CAD significantly. The two components together account for nearly two-third of the trade deficit that was more than 10% of GDP in 2011-12. Remittances particularly are known to exhibit resilience when the country is hit by an external shock, as was evident during the global crisis of 2008.
Diesel Price and Under Recoveries: Macro-Economic Impacts
A study on the “Diesel Price and Under Recoveries: Macro-Economic Impacts” by Integrated Research and Action for Development commissioned by the Ministry of Finance, suggests that diesel price revision will have a positive impact on curbing inflation, enhancing GDP growth and reducing the fiscal deficit
Impact on inflation
Any increase in price of diesel will lead to higher prices immediately but lower price rise in longer run as the fiscal deficit is reduced. With no change in policy, average inflation 2011-15 will be 7.13%, while with a one shot 30% increase in diesel price, average inflation rate may come down to 5.68%. Even with a 10% increase in diesel prices, the inflation rate expects to come down to an average of 6.66% during 2011-15.
Impact on GDP:
GDP is affected by diesel price policy also. Under the various scenarios studied, GDP is impacted negatively in the immediate quarters following a price rise of diesel. However as the impact of price rise dissipates and inflation falls (compared to the “no change” scenario), GDP increases faster. GDP growth is projected to average 8.23%, 8.92% and 8.46% during 2011-15 with a business as usual, a one shot 30% increase in diesel prices and a partial 10% increase in prices, respectively.
Demand of Petroleum products
Analysis indicates diesel consumption will reach 2681 crore litres, 2445 crore litres and 2549 crore litres with a business as usual, one shot 30% increase in diesel prices and a partial 10% increase in prices, respectively.
Fig 3.11: Quarterly movement of BOP parameters
3.27 Gold imports have been one of the major factors in deterioration of CAD. Concerned over the sharp rise in the growth of gold loan companies, RBI has been tightening norms for NBFC’s lending against gold and removed in February, 2011 the priority sector tag to such loans that banks used to give to NBFCs for on-lending, thus pushing up the cost of money for such companies. In March, 2012, RBI capped the amount NBFCs can lend against gold at 60%. This was followed by putting banks’ exposure to single gold loan NBFCs from 10% to 7.5% of their capital base. Commercial banks were also asked to set an internal ceiling for overall exposure to gold loan NBFCs. In October RBI barred banks from financing the purchase of gold in any form other than working capital finance.
New gold-backed financial instruments in the form of modified gold deposits and gold accumulation plans, besides gold-linked accounts and pension products linked with the precious metal, are some of the measures being considered to reduce the attraction of a direct investment in bullion and jewellery in the domestic market and check a substantial rise in imports. Gold-backed products will allow investors to gain the benefits of investments in the high-yielding commodity without actually investing in the physical commodity. They will thus provide more choices to investors in the domestic market. Of course, gold-linked instruments will have to be hedged through direct purchases of gold, or in the derivatives markets. Any rollout of gold-linked instruments will have to be monitored carefully to see whether the overall demand for gold actually falls. More generally, however, the demand from the public for financial investments in assets that retain their real value needs to be addressed. Of course, the ideal solution to this problem would be to bring down inflation so that household see good returns from traditional financial instruments.
3.29 Capital flows are driven by both pull (economic fundamentals of recipients) and push (policy stance of source countries) factors and have implications for exchange rate management, overall macroeconomic and financial stability including liquidity conditions. Capital account management needs to emphasize promoting foreign direct investment and reducing dependence on volatile portfolio flows. This would ensure that to the extent current account deficit is bridged through capital surplus, it would be through stable and growth enhancing investment flows. In the prevailing international financial architecture, reserves are the first line of defense against the volatile capital flows. In this context, the decline in reserves as a fraction of GDP, while not an immediate source of concern, needs to be watched closely.
3.30 As has been pointed out earlier, the growth slowdown in the current fiscal and in the previous year owes partly to domestic factors. In an environment where the supply side is constrained, a high fiscal deficit contributes to excess demand. Higher governmen