September, 2011

Economic Policy and Poverty Team

South Asia Region

The World Bank

India Economic Update

Overview

A Return to Trend Growth, but a Weakening Outlook

After a return to trend growth in fiscal year 2010-11, India’s economic growth is likely to slow to 7-8 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 RBI’s 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 RBI’s 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, India’s 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.

India Economic Update1 September, 2011

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 India’s 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.

1

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.

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.

2 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.

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

-4.0%-2.0%0.0%2.0%4.0%6.0%8.0%

10.0%12.0%14.0%16.0%

07

-08

Q1

07

-08

Q2

07

-08

Q3

07

-08

Q4

08

-09

Q1

08

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10

-11

Q1

10

-11

Q2

10

-11

Q3

10

-11

Q4

11

-12

Q1

Agriculture Services GDP Industry

Agricultural Growth Rebound ed But Industry Disappointed.(y-o-y change, in percent)

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

05

-06

Q1

05

-06

Q3

06

-07

Q1

06

-07

Q3

07

-08

Q1

07

-08

Q3

08

-09

Q1

08

-09

Q3

09

-10

Q1

09

-10

Q3

10

-11

Q1

10

-11

Q3

11

-12

Q1

Demand Growth Slowed. (Components of GDP, y-o-y, change in percent)

GDP Excl. Gov. Cons.

GDP

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

-10%

0%

10%

20%

30%

40%

50%

60%

-20%

-10%

0%

10%

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30%

40%

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60%

70%0

7-0

8 Q

1

07

-08

Q2

07

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Q3

07

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Q4

08

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Q1

08

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-10

Q1

09

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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

2

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.

India’s 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 India‟s 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,

Pakistan, Sri Lanka, Singapore) has

increased to almost 20 percent from

13 percent over the same period. At

the end of 2010, China had emerged

as the country contributing most to

export growth, followed by the

UAE, Indonesia, and the US. When

aggregating exports to the 27 EU

member countries, their combined

contribution to export growth is

smaller than China‟s, but ahead of

the UAE‟s. Exports to China

amounted to $1.5 billion in CY2010,

as compared with $2 billion to the

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

India: Exports by Country and by Commodity, 8/2010-1/2011

(percentage point contribution to overall growth, 6-month average)

Overall exports 41.7 Overall exports 41.7Top 15 26.2 Top 15 32.6 China 7.3 Non-ferrous Metals 6.2 EU 4.8 Petroleum and Crude Products 5.8 United Arab Emirates 3.3 Transport Equipment 4.4 Indonesia 2.1 Manufacturres of Metals 3.1 United States 1.7 Processed Minerals 1.9 Singapore 1.7 Electronic Goods 1.7 Iran 1.2 Machinery and Instruments 1.6 Sri Lanka 1.2 Ferro Alloys 1.4 Belgium 1.0 Sugar 1.3 Pakistan 1.0 Cotton Yarn Fabrics Madeups etc 1.2 Kuwait 0.9 Cotton Raw incl. Waste 1.1 Saudi Arabia 0.9 Plastic and Linoleum Products 0.9 Italy 0.8 Primary and Semi-finished Iron and Steel 0.8 South Africa 0.8 Other Ores and Minerals 0.6 Germany 0.7 Drugs, Pharmaceuticals and Fine 0.6 East Timor 0.7 Dyes Intermediates and Coal Tar 0.5 Turkey 0.7 Oil Meals 0.5 Austria 0.7 Manmade Yarn Fabrics Madeups 0.4 Bahrain 0.7 Rice Basmoti 0.4 Brazil 0.6 Gems and Jewellery 0.4

France 0.6 Aluminium other than Products 0.4

Source: Ministry of Commerce, CEIC.

3

benefited most from growth in non-

ferrous metals, petroleum products,

transport equipment, and

manufactured metals. More than half

of the export increase is contributed

by raw and semi-processed

materials. India‟s exports of

petroleum products are partly driven

by the government‟s pricing policy:

Indian retail prices are not sufficient

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 rupee has remained relatively stable

against the U.S. dollar and slightly depreciated

against the pound and yen in recent months. Since the beginning of 2011, the REER (36-

currency trade based) has depreciated 2 percent. At

around 100 (the level it had in 1993), the rupee has

stabilized between the recent peak of 110, when

capital inflows led to appreciation in 2007, and the

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

60

70

80

90

100

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120

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r-11

The Real Exchange Rate Stabilizeded(Jan. 2006 - Jun. 2011, 1993=100)

-30

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The Outlook is Perceived to Worsen(Perception Indices)

Fin. Situation Selling Prices Profit Margin

Source: RBI

India's Exports: Top 10 Countries and Commodities 2010

(in millions of U.S. dollars)

European Union 3,422.9 Petroleum and Crude Products 3,194.7

United Arab Emirates 2,389.7 Gems and Jewellery 2,599.7

United States 1,931.2 Transport Equipment 1,293.5

China 1,508.5 Machinery and Instruments 915.1

Singapore 802.0 Drugs, Pharmaceuticals and Fine Chemicals 829.3

Hong Kong 730.7 Manufacturres of Metals 689.1

United Kingdom 557.0 Other Commodities 683.2

Netherland 550.3 Readymade Garments, Cotton incl. Accessories 668.9

Germany 508.9 Non-ferrous Metals 579.4

Belgium 425.1 Electronic Goods 559.8

4

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-to-

one coverage of total external debt.

India’s stock markets slumped. India‟s 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 end-

May 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

Moody‟s and Fitch upgraded their local currency ratings in early 2010. While Moody‟s 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

shrinking. The deterioration in conditions is also

supported by Purchasing Managers‟ Indices, which

sank to their lowest in two years.

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 RBI‟s Order Book, Inventory, and

Capacity Utilization Survey in Q4 FY2010-11 was

the highest in three years. Capacity utilization

0.0

2.0

4.0

6.0

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10.0

12.0

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Core Food Energy

Core Inflation Dominates WPI Inflation(y-o-y percentage change)

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Jan

-09

Mar

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May

-09

Jul-

09

Sep

-09

No

v-0

9

Jan

-10

Mar

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10

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No

v-1

0

Jan

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Primary Food Energy WPI Core Processed Food

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

-50

-30

-10

10

30

50

70

90

110

130

150

-10

-5

0

5

10

15

20

25

30

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00

Jun

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Ap

r-2

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1

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01

Feb

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02

Jul-

20

02

Dec

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02

May

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03

Oct

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03

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Au

g-2

00

4

Jan

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Jun

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05

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00

5

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00

6

Sep

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06

Feb

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07

Jul-

20

07

Dec

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07

May

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08

Oct

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08

Mar

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Au

g-2

00

9

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No

v-2

01

0

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r-2

01

1

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

India South Africa China Brazil Energy (rhs) Non-energy (rhs)

5

increased in 17 out of 22 industries between Q3 and Q4.

India’s inflation trajectory is similar to that of other emerging markets, but India’s 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. India‟s inflation was comparable to that of other EMEs in the 2008 rally. Post-

Lehman, 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 India‟s 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.

The table shows costs, taxes, and average retail

prices for FY2010-11 on a per liter basis. The

difference between retail prices and the sum of

costs and taxes is shown as Gross Subsidy, which

is commonly termed „underrecoveries‟ in India.

However, the Net Subsidy is just the difference

between retail price and costs and shows the net

revenue the government derived from the sales of

a liter of the product (a negative sign shows net

revenue, a positive sign net subsidy). As shown,

the government net tax take was about Rs.30 per

liter of gasoline, Rs.11 per liter of diesel, while it

subsidized kerosene with Rs.13 per liter and LPG

with Rs.134 per cylinder. The last row of the

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.

Fuel Prices, Costs, Taxes, and Subsidies, Estimates for FY2010-11

Rs/litre Gasoline Diesel Kerosene LPG

(Rs/cylinder)

Cost 26.6 26.6 24.6 495.7

Taxes 31.8 11.1 1.5 61.9

Total 58.4 37.8 26.1 557.6

Retail Price 56.5 37.3 11.5 361.5

Gross subsidy 1.9 0.5 14.6 196.0

Net subsidy -29.9 -10.7 13.1 134.1

2010-11 (Rs billion) Total

Total Gross subsidy 29.4 26.5 136.6 162.1 354.6

Total net subsidy -473.8 -628.8 122.6 110.9 -869.1

Sources: Ministry of Petroleum, PPAC, CSO.

Rs/litre

Notes: 1. Based on Indian basket of crude oil prices

2. Includes international price, import duty, freight charges, and fixed margins

3. Gross and net subsidy for kerosene and LPG includes the subsidy

provided through the budget. Kerosene at 0.82/litre and LPG at Rs 22.58 per

cylinder

6

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.

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 government‟s 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 government‟s accounting rules with disinvestment proceeds of

0.4 percent of GDP counted as revenue.

2007/08 2008/09 2009/10 2010/11 2010/11 2011/12

% of GDP

Est. Budget Est. Budget

Total revenue and grants 10.9 9.7 8.7 9.3 8.7 8.8

Net tax revenue 8.8 7.9 7.0 7.7 7.3 7.4

Gross Tax Revenue 11.9 10.8 9.5 10.8 10.1 10.4

Corporate tax 3.9 3.8 3.7 4.3 3.8 4.0

Income tax 2.1 1.9 2.0 1.8 1.8 1.9

Excise tax 2.5 1.9 1.6 1.9 1.8 1.8

Customs duties 2.1 1.8 1.3 1.7 1.7 1.7

Other taxes 1.4 1.4 0.9 1.0 1.0 0.9

Less: States' share 3.0 2.9 2.5 3.0 2.8 2.9

Less:NCCF expenditure netted from receipt 0.0 0.0 0.0 0.0 0.0 0.0

Non tax revenue 1/ 2.1 1.7 1.8 1.6 1.5 1.4

Total expenditure and net lending 14.2 15.7 15.5 15.9 14.8 13.8

Current expenditure 11.9 14.2 13.9 13.8 13.2 12.2

Interest payments 3.4 3.4 3.3 3.6 3.0 3.0

Subsidies 1.4 2.3 2.2 1.7 2.1 1.6

Defense expenditure 1.1 1.3 1.4 1.3 1.1 1.1

Capital expenditure and net lending 2.3 1.5 1.6 2.1 1.6 1.6

Gross fiscal deficit (WB defn) 3.3 6.0 6.8 6.6 6.0 5.0

Memo items

Disinvestment + 3G licenses receipts 0.8 0.0 0.4 0.6 0.3 0.4

Gross fiscal deficit (GoI defn) 2.5 6.0 6.4 6.0 4.7 4.6

Revenue deficit 1.1 4.5 5.2 4.0 3.1 3.4

Primary deficit (WB Defn.) -0.1 2.6 3.5 2.5 3.1 2.1

Primary deficit (GOI Defn.) -0.9 2.6 3.1 1.9 1.7 1.6

Central government domestic debt 2/ 41.6 44.4 44.3 47.0 41.0 40.2

Central government debt (including external debt) /2 45.9 49.1 48.1 50.9 45.3 44.2

GDP (market prices, y-o-y change in percent) 16.1 12.0 17.3 5.9 13.6 14.0

Source: Ministry of Finance.

1/ Excludes revenues from 3G licenses.

2/ Net of Liabilities under MSS and NSSF not used for financing CG deficit

India: Central Government Budget, 2007/08-2011/12

7

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 RBI’s 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.

8

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 EU‟s 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 & Poor’s 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 17-

and 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

9

declined in Latin America and the Caribbean (to 7

percent, saar), South Asia (5.7 percent) and Sub-

Saharan 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 end-

August 2011. The loss of Libyan production, plus limited access of North American oil to off-

continent 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 FY2010-

11 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, India’s 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

10

reform, FDI in retail) would strengthen domestic growth drivers. India‟s 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 India‟s 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.

11

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

India‟s 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 Minister‟s 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,

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

12

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 Research‟s 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-calm-

price-pressures-tame-inflation. 11

Reserve Bank of India (2011), Macroeconomic and Monetary Developments Frist Quarter Review 2011-12,

Mumbai.

13

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

2006/07 2007/08 2008/09 2009/10 2010/11 2011/12

Est Proj

Real Income and Prices (% change)

Real GDP (at factor cost) 9.6 9.3 6.8 8.0 8.5 7.5

Agriculture 4.2 5.8 -0.1 0.4 6.6 3.0

Industry 12.2 9.7 4.4 8.0 7.9 7.5

Of which : Manufacturing 14.3 10.3 4.2 8.8 8.3 8.0

Services 10.1 10.3 10.1 10.1 9.4 8.6

Prices

Wholesale Price Index 1/ 6.6 4.8 8.1 3.9 9.7 8.0

Consumer Price Index 6.4 6.2 9.1 12.3 10.5 …

Consumption, Investment and Savings (% of GDP)

Consumption 68.0 67.3 69.4 69.7 68.7 67.5

Public 10.3 10.3 11.0 12.0 11.5 10.7

Private 57.7 57.0 58.4 57.7 57.2 56.8

Investment 35.7 38.1 34.5 36.5 34.8 35.9

Public 8.3 8.9 9.5 8.4 8.5 9.8

Private 26.5 27.9 24.6 25.6 26.3 26.2

Gross National Savings 37.0 39.8 35.4 37.0 37.5 38.5

Public 3.6 5.0 0.5 2.1 3.8 5.0

Private 33.4 34.8 34.9 34.9 33.7 33.5

External Sector

Total Exports (% change in current US) 24.5 26.6 15.0 -5.8 37.6 20.0

Goods 22.6 28.9 13.7 -3.6 37.4 20.0

Services 28.0 22.4 17.3 -9.6 37.8 18.0

Total Imports (% change in current US) 22.7 31.6 16.6 0.0 29.0 20.0

Goods 21.4 35.1 19.8 -2.6 26.7 25.0

Services 28.5 16.2 1.1 15.3 40.4 15.0

Current Account Balance (% of GDP) -1.0 -1.3 -2.3 -2.8 -2.6 -3.0

Foreign Investment (US billion) 14.8 43.3 5.8 51.2 37.4 48.0

Direct Investment, net 7.7 15.9 19.8 18.8 7.1 27.0

Portfolio Investment, net 7.1 27.4 -14.0 32.4 30.3 21.0

Foreign Exchange Reserves (excl. Gold) (US billion) 191.9 299.2 241.4 254.7 274.3 286.5

(in months of goods and services imports) 9.8 11.6 8.0 8.5 7.1 6.2

General Government Finances (% of GDP)

Revenue 20.0 21.0 21.1 17.2 19.9 19.1

Expenditure 25.4 26.0 29.5 27.3 28.4 26.6

Deficit 2/ 5.4 5.0 8.4 10.1 8.5 7.5

Total Debt 3/ 78.0 76.2 75.4 73.4 67.9 66.5

Domestic 73.3 72.0 70.7 69.3 64.1 62.5

External 4.7 4.2 4.7 4.1 3.8 4.0

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