India: Macroeconomic Issues

Renu Kohli
Tokyo, May 21st, 2012
Disclaimer for presentations The views expressed in this presentation are the views of the author and do not necessarily reflect the views or policies of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms.

Outline

Current Macroeconomic Issues and Policies Prudential Policies and capital controls How does the current slowdown impact the banking sector? Does all this change the long-term structural growth story? ?

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Economic performance: Brief profile

GDP growth averages 8.3% since 2003-04, from 6% in nineties Well-diversified, evenly balanced, solid moorings: Investment shares rose from 24% to 39% in 6-7 years; Savings jumped from 23.7% to 37%. CAD between 1-2.5% of GDP for most part: Export growth >20% in the five years to 2008; Import growth rapid, averaging 30% during 2003-2008; Oil i imports t at t double d bl this thi pace. Weathered the crisis well as result: Ample policy space allowed appropriate policy responses to combat the shock and rebound swiftly. swiftly But the recovery has not sustained

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Growth has been slowing in 2011-12

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Weak investment driving current slowdown

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Inflation reigns high; recent slowing only from base effects

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Structural basis to inflation; temporary supply shocks

Rising incomes: structural shift in 2004 2004-05; 05; 39% increase in real per capita income between 2004-05 and 2009-10 Consumption shift towards higher intake of proteins Terms of trade shift towards agriculture Fi l laxity Fiscal l i Subsidy and welfare-schemes induced boost to consumption and rural incomes Global price increases in oil, commodities and food

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Supply-side response?

Long term decline in yields, stagnant productivity Falling per capita availability of key items of bulk consumption: pulses, edible oils, etc. Heavy rain dependence, small holdings Lack of public investment: weak rural infrastructure M k i Market imperfections, f i inefficient i ffi i supply l chain h i

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Large fiscal deficits, slow pace of consolidation

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Subsidies dominate spending; low public capex

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Source: IMF Staff Report, 2012

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Revenues growth-dependent; borrowings rising

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Source: IMF Staff Report, 2012

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Monetary responses to check inflation

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Monetary policy framework

Liquidity adjustment facility (LAF) key element in the operating framework of monetary y policy p y Single policy rate - Repo - signals stance; operates within corridor set by Bank rate and reverse repo rate (1%) Objectives: Growth with price stability. Operating targets: overnight call money rate (weighted average); Operating objective: contain this rate around the repo rate within the corridor. Other instruments to manage g persistent p liquidity: q y outright g open p market operations (OMO), cash reserve ratio (CRR) and market stabilisation scheme (MSS)

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How does it work in practice?

Monetary transmission substantially more effective in a deficit rather than a surplus liquidity situation; Most effective at the short-end of the yield curve Magnitude d of liquidity d ideal d for effective monetary transmission [+// 1% of net demand and time liabilities (NDTL) of banks] varies. M Many di distortions t ti impede i d synchronization h i ti

Rate controls on small savings deposits, Statutory appropriation of bank reserves Level of lender competition Asset-liability mismatches at banks

Recent deregulation of savings bank deposit rate

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Monetary policy transmission

Factors affecting liquidity: Government borrowings; intervention; low deposit growth g
India: Yield curve (in percent)

10 10 9 9 8 8 7 ON 3M 1Y 5Y 10Y Apr 2012 Jan 2012 Mar 2012

Nov 2011

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Exchange rate policy: growing flexibility

Intermediate regime: does not target g any y particular p REER level Incorporated reserve accumulation-cum-intervention until 2007-08 2007 08 to manage capital inflows/outflows and avoid excessive appreciation Period of hands-off since 2009: no intervention or reserve accumulation in this period Current intervention to manage outflow and currency pressures

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Wide, unsustainable external deficit

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Poor quality of financing

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Prudential Policies and capital controls

Capital Controls: Current state of liberalization

Capital account still partially liberalized: Post crisis shift on use of capital controls to manage volatile flows intervention; other controls Equity: Unrestricted but 2 exceptions

Restricted to approved FIIs. FIIs can only take equity participation up to 24% of firms capital, but can exceed with Board approval FDI encourage; some sectors barred FIIs participation in government & corporate bond market is capped. Domestic firms can borrow abroad with caps in amount, amount maturity maturity, and cost; beyond this, it is contingent on specific RBI approval. End-use restrictions apply. Banks/non-bank FIs - upto 50% of Tier I capital or US$10 million; short-term portion of funds capped at 20% of unimpaired Tier I capital. GAAP limits apply. Likewise pattern for non-banks financial institutions.

Debt flows restricted:

Price/quantities varied to manage surges and ebb of short-term capital Interest rate wedge prevents arbitrage despite some porosity Reasonable success in navigating the trilemma

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Policy framework on capital flows

Explicitly stated capital account management framework Ample A pl p policy li space p f for r multiple ltipl i instruments, tr t i.e. i quantitative tit ti limits, li it price pri based as well as administrative measures Short term debt: quantitative restrictions; only for trade transactions Original sin, viz. excessive foreign currency borrowings by domestic entities, particularly the sovereign, avoided Prudential regulations to prevent excessive dollarization of balance sheets of financial sector intermediaries, especially banks Cautious approach to liability dollarisation by residents Significant liberalization of permissible avenues for outward investments for domestic entities.

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Macroprudential tools extensively used in India

These have been reasonably effective in preventing buildup of imbalances, e.g. asset price bubbles Key tools: risk weights; provisioning requirements; sector exposure limits; l LTV T ratios, margin requirements and d the h b build ld up of foreign currency liabilities Were especially W i ll used d ahead h d of f the h GFC to restrain i di diversion i of f capital inflows into asset price and credit boom Critical in reconciling domestic macroeconomic objectives with external sector policies and managing the capital account

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To contain asset price inflation: Property prices

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To contain asset price inflation: Stock prices

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Illustration: Recent policy responses to capital outflows

Since Sept. 2011: Intervention in forex market to stabilize and manage expectations Nov 2011: Caps on foreign investments in Nov. sovereign and corporate bonds ($5bn to $15 bn; $5 bn to $20 bn respectively) Dec 2011: Prohibiting exporters from g of forward cancellation and rebooking contracts to check speculation (still remains in place) May 2012: Exporters were asked to liquidate half of their dollar holdings within a fortnight May 2012: Intra-day trading limits for banks fixed at five times the limits on net overnight open positions of banks (to check volatility) Nov 11 & Apr 12: Interest rates on rupee and foreign currency deposits of NRIs Apr 2012: Deregulation interest rate caps on g currency export p credit raised abroad by foreign Indian banks
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Future direction of capital account liberalization: Ke issues Key iss es and nd Road Ro d ahead he d

Broad principles of liberalization:

CA architecture corresponding to real economy; financial stability Macroeconomic framework Policy y liberal barring g some sectors Structural factors need to be addressed Political convergence in some spheres QFIs: Implications; recent developments Risks Short-term vs long-term flows

FDI flows:

Portfolio flows

Investments in debt

Outflows Access to financial markets

NDF Rupee for trade invoicing CDS

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How does the current slowdown impact the banking sector?

Banks impacted by the slowing growth

Causes:

Global crisis shock Weak economic recovery in advanced economies Pre-crisis c s s credit c d boom; b ; aggressive lending by banks Inflation; Monetary tightening Current growth slowdown

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Trend in Growth Rate of Slippages and Gross NPAs vi vi Gross Loans vis--vis Lo ns & Advances Ad n es

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NPAs: Sector shares and growth rates, Sept 2011

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Impact: Profitability has fallen; capital dented

Change in CRAR and Net NPA (End-Dec. 2011 over End-March 2011)

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Credit overhang: NPLs and restructured loans

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Source: UBS Research

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Risks for banks ahead

Rising NPAs have been a big concern in 2011-12 turning public sector banks focus upon p recovery But a slowing economy is rapidly increasing the incidence of bad loans. Material risks will arise in FY13 according to most analysts: NPAs likely to migrate to lower categories (e.g. D2/D3/loss assets); higher incremental provisioning (25-75 bps) Public sector banks, e.g. Union Bank, IOB, SBI, PNB and BoI have added 0.8-1.1% of advances into sub-standard and D1 categories over FY09-11. Fi Firms under d stress, low l probability b bili of f material i l reduction d i in i interest i rates imply a 20% jump in NPAs in FY13 while credit growth is expected average just 16-17%. Net interest margins of public sector banks expected to slide 10 10-15 15 bps in FY13: while interest rates have fallen after 50 bps monetary easing in April, deposit rates still high. Deposit growth<credit growth leaving little room for reduction. with

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Corporate deleveraging still incomplete

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Source: UBS Research

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Does all this change g the longg term structural story?

What is the potential for long-term growth?

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Fundamental, structural drivers of growth

Attractive demographics: Falling dependency ratios, rising labor force

High savings rate: Around 35% of GDP, India is now well above the emerging market average; can support national investment shares approaching Chinas; China s; similar dynamics to those that launched East Asias growth in the 1960s and 1970s. Higher infrastructure investment: Significant need for investments in infrastructure like airports, p ,p ports, , roads, , power, p , and railways y is likely y to provide p investment opportunities. Planned - $1 trilion over 2012-17; some analysts estimate infrastructure investment of US$2.5trn in the next 15 years.
Productivity improvements through small policy changes at existing technology can deliver GDP growth of 8-9% pa for the next 10-20 years Global drivers expanding tradable sector Vibrant private entrepreneurship Transition dynamics: agriculturemanufacturing IT The rural segment:

Consumption: Penetration levels for most products and services, services including finance, are relatively low;, implying room for high-growth investment ideas

Convergence Diffusion and dispersion: top to bottom; centre to periphery Inclusive growth dynamics boost and positive spillovers

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Potential spoilers and risks

Political shortcomings: bureaucratic restrictions and regulation Poor state of infrastructure Education, skills and literacy gaps But often, such constraints can serve as sources of future growth as bottlenecks are gradually removed, e.g. China in the 1980s. Potential areas of macroeconomic concern:

State of national sheet: Fiscal deficits persistent and structural; current account deficit stands out for its vulnerability to short-term, volatile financing. Inflation Reversing the weakening savings-investment rates

Rising energy dependency

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Potential areas of macroeconomic concern

Reviving R i i G Growth h Fiscal consolidation Current account Inflation Reversing the weakening savings-investment rates Meeting the Infrastructure Deficit International oil prices Reaping the demographic dividend Managing capital flows

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Thank You