Current State of the Indian Economy Cautious optimism for the future

February 2013 www.deloitte.com/in

The Big Picture The Indian Economy has experienced its worst slowdown in nearly a decade on the back of global contractionary headwinds, domestic macro-economic imbalances and policy reversals on the fiscal front, 2012 has been a challenging year for the economy. The year started with news that the previous fiscals fourth quarter GDP had dropped to 5.5%. That coupled with low growth, macro-economic issues such as high fiscal deficit, expansionary subsidies and worsening current account balance has added to the slowdown. The 2011-12 Budget had proposed to amend the 1961 income tax law by introducing retrospective tax adjustments and General AntiAvoidance Rules (GAAR). These steps were viewed negatively by foreign investors. Subsequent downgrading of the Indian economic outlook from stable to negative by a major rating agency, led to continued downward pressure on the investment climate. Additionally, as fiscal conditions worsened over the year, export numbers were revised in light of data discrepancies leading to a widening of the current account deficit. In the second half of the fiscal, the Government proactively intervened

with phased reforms to stabilize the economy. Measures were taken to reduce subsidies (oil, fertilizers) which would in turn lower the fiscal deficit. The Government also took concrete actions to attract foreign direct investment (FDI) and strengthen the rupee. However, the impact of these policy reforms remains uncertain in the short term. Concerns continue to exist over the current account deficit scenario, prevailing supply side constraints, inadequate infrastructure investments and long term policy directions. In face of a perceivably weak macroeconomic climate, a well-planned economic revival policy is required to steer the Indian Economy back on the growth path. Even though the long term prospects of the economy look promising, cautious optimism is the tone in the short to medium term. Global Linkages Performances of advanced economies continue to weigh on Indias growth story. The World Economic Forums annual meeting for 2013 was held in Davos, Switzerland in January 2013, bringing together more than 2,000 top business leaders, international political leaders,

Output Growth Rates in % (Current & Expected) 8 7 6 5 4 3 2 1 0 -1 2010

World

Advanced Economies 2011

Euro Area Emerging & Developing Economies 2012 2013

United States

selected intellectuals and journalists to discuss the most pressing issues facing the world. The IMF, in its update of World Economic Outlook, lowered the world GDP growth projections by 0.1% each for 2013 & 2014 as compared to the October 2012 projections. This is on account of downside risks that continue in light of renewed setbacks in the Euro area and continued risks of excessive fiscal consolidation in the United States. In particular, the Euro-zone faced considerable fiscal strain in the face of an austerity driven recession during 2012. The Euro-zone manufacturing activity contracted for a 17th month consecutively in December, according to a key survey of business managers.

Indian exports to Euro-zone, which constitute around 17% of the total exports, appear to be impacted due to the decreasing demand from Euro countries. In the first nine months of 2012-13, a 10% contraction in exports has been observed when compared to that over a similar period in the previous year. Moreover, despite the fact that the US government was able to formulate a solution to mitigate a dreaded fiscal cliff, near term risks continue to persist. This makes the global environment in the coming years more uncertain and exporters might find it more challenging. A note of optimism appears to surface for the Indian service providers with the recently concluded free trade agreement on services and investment between India and ASEAN countries. Furthermore, gradual recovery in Japanese economic conditions along with recent rebound in Chinas manufacturing sector is expected to improve trade conditions in the region.

Economic opportunity is dwindling. While reforms have been initiated, further action to create infrastructure, boost savings and generate growth will be welcome
Current State of the Indian Economy Cautious optimism for the future 3

The Indian environment The current state of the economy makes it necessary for the government to put in place a robust and implementable plan of action for its revival. The economy has experienced a consistent fall in the quarterly GDP growth since the beginning of 2011, alarmingly high levels of twin deficits viz. Current Account Deficit (CAD) and fiscal deficit as well as worrying volatility in the inflow of foreign investments. Though inflationary pressure has receded in the last quarter of 2012, it still remains above the target level of Reserve Bank of India (RBI). This along with other worrying economic indicators has put the Indian economy in a challenging pathway in the short term. Budget 2013 provides an opportunity to regain focus by adhering to the path of fiscal consolidation and take appropriate policy initiatives outlining the timely recovery of the Indian economy. Strengthening fundamentals and boosting growth inducing investments is the foremost consideration at this stage. In order to understand the current state of the economy, we discuss the various aspects of economic performance of the country in 2012, in the following paragraphs.

The fiscal situation The Government has found it difficult to contain expenditure despite proactive reforms to boost the slowing economy. The Government revised its fiscal consolidation roadmap in October 2012. As per the revised roadmap, the fiscal deficit of the central government will be reduced in a calibrated way from the targeted 5.3% of GDP in FY 2012-13 to 3.0% of GDP by FY 2016-17. The revision proved challenging as the actual fiscal deficit fared at 5.9%.
Fiscal Decit as % of GDP 7 6 5 4 3 2 1 0 6.0 6.5 4.9 5.9 5.3
Fisca l Con solid

ation

Targe

4.8

4.2

3.6

3.0

Further, the combined fiscal & revenue deficits had already reached 79% & 85% of budgeted targets by end of December 2012. Major contributors to high levels of deficits this year include lower tax collections due to lower than

expected economic activity (reaching only 63% of annual target in 9 months) and dismal PSUs disinvestment collections (accounting only 27% of annual target in 9 months) as against persistent unplanned government expenditure, which has already reached 72% of target.

Despite these worrying trends, recently announced strong initiatives by the Finance Minister to cut down unplanned expenditure, including subsidies are laudable. An achievement of fiscal surplus of INR 8,227 crores during December 2012 sends a positive signal about Governments

Recently announced initiatives by the Finance Minister to cut down unplanned expenditure including subsidies are laudable
Current State of the Indian Economy Cautious optimism for the future 5

willingness of adhering to its targets. However, policymakers need to make sure that the significant cut backs in public expenditure do not compromise the quality of fiscal adjustment & development prospects in the long run. The real sector Moving on to the other fundamental aspects of the economy, the declining trend in the GDP growth is proving to be another major concern for the government at the moment. After a disappointing growth rate of 5.4% in the first half of 2012-13, the yearly estimates for 2012-13 have been downgraded and it is now expected to grow at only around 5%. The countrys GDP growth at 5.3% in the second quarter is one of its lowest quarterly growth rates in the last decade and annual growth of 5% will be the lowest since 2002-03. The industrial sector, usually sizing more than one fourth of the total GDP, performed significantly below par this year with growth of mere 1% during the first half of 2012-13 as against 4.6% in first half of 2011-12. The

under-performing manufacturing sector, particularly the capital goods industries, poses a real challenge for the country. Though subdued investment activity may play a spoiler, systematic implementation of National Manufacturing Policy as well as rise in external demand will play a critical role in reviving industrial growth. In the agricultural sector, good winter crop sowing prospects are expected to overcome the negative effect of a deficient summer crop output. The yearly output is likely to be better than the 2.1% growth achieved in first half of 2013, though overall the year is expected to close at a lower level compared to earlier years.
GDP Growth Rates (%) 10 8 6 4 2
-

9.5 8.1 7.0

9.6

9.3 6.7

8.4

8.4 6.5 5.2

4.0

A larger concern exists on the services sector which has moderated during 2012. With trade, hotels, transport, storage and communication an important sub-sector in services performing the worst, various indicators of services sector activities such as cargo handling, civil aviation & railway freight etc. suggest further weakening of growth. Additionally, the uncertain global outlook is likely to affect services exports adversely. On the GDP expenditure side, growth in private consumption has moderated during 2012-13 due to high inflation coupled with low income growth. While investments have remained flat on account of issues such as project cost overruns and regulatory delays, gross capital formation has also decreased

in the economy. Sectors such as road transport and highway, power, petroleum, railways, coal etc. continue to suffer due to lack of policy clearances and more importantly funds. It may take a while before the impact of retail sector reforms and policy initiatives to remove infrastructure bottlenecks and induce further investments are felt across the economy. However, there are early signs that the Indian economy may have bottomed out the growth. Overall, besides domestic pressures, with global recovery likely to remain muted in the near future, economic revival in India will be a challenge. All round efforts in removing impediments in business activity and instilling investor confidence will be necessary to revive sectoral growth.

Manufacturing and the mining sector needs urgent revival through implementation of the National Manufacturing Policy and removal of regulatory hurdles

Current State of the Indian Economy Cautious optimism for the future

The external sector The other part of the twin deficit problem relates to the Current Account Deficit. The CAD to GDP ratio reached a highest ever level of 5.4% in Q2 of 2012-13, heightening concerns about the sustainability and financing of trade. At the helm of worsening CAD for the current year is the burgeoning trade deficit. During the period April to December 2012, both exports (US$ 214 billion) and imports (US$ 361 billion) declined. With a sharper drop in exports than imports, the trade deficit has surged to US$ 147 billion in the first 9 months as against US$ 137 billion of last year. Major decline in exports growth is an effect of sluggish global demand and an uncertain macroeconomic environment. In January 2013, the World Economic Outlook has projected the world trade volume to

CAD/ GDP (%)

-0.4 -1.2

-1

-1.3 -2.3 -2.8 -2.7 -4.2

-4.6

grow at 3.2% in 2012 as compared to growth of 12.6% in 2010 and 5.8% in 2011, clearly showing the drop in global demand. On the import side, the decline in non-oil imports is largely off-set by inelastic growth in petroleum, oil and lubricants (POL) imports, contributing almost 35% of total imports. During the month of December 2012, the Government announced export promotion measures like extension of interest subvention schemes,

broadening scope of Focus Market Scheme and Focus Products Scheme etc. However, despite these measures, exports recovery will primarily depend on the level of global economic activity. Furthermore, export diversification policies have not been significantly effective. For example, demand for Indian goods in developing countries such as those in Asia and Africa have dropped recently. Balance of Payment statistics show that capital inflows have improved in 2012-13 and in fact have financed the expanding CAD. While net FDI inflows moderated to US$ 14.7 billion during April-November 2012 (as against US$ 19.6 billion last year), net FII inflows have shown a significant uptrend reaching US$ 11.2 billion in 2012. These robust FII inflows seem to be largely the outcome of improved sentiments about the Indian economy in the second half of the year driven by recent reforms announced by the government in September 2012. These reforms include, inter alia, liberalized FDI norms for the retail, insurance and pension sectors, a roadmap for fiscal consolidation and an increase in FII

limits in the corporate and government debt markets among others. The external debt has witnessed a steep rise in second quarter of 2012-13, reaching US$ 365 billion from US$ 345 billion at the start of the financial year. This is mainly on account of surge in non-resident external rupee denominated deposits due to better returns and surge in External Commercial Borrowings in response to the government incentives. Hence, though adverse CAD conditions have prevailed, the recent spate of reforms have helped the Rupee maintaining its stability against US$ in the last quarter of 2012. Inflation & Monetary conditions For most of the period of 2012-13, the Wholesale Price Inflation (WPI) has remained around the mark of 7.5%. It reached as high as 8% in August 2012 and then revised down to 7.2% by December2012, further moderating to 6.62% in January 2013. Inflation moderation has been faster than expected in the third quarter touching a three year low. However,

Current State of the Indian Economy Cautious optimism for the future

food inflation continues to remain elevated along with fuel & power. Gradual moderation of international commodity prices on account of decrease in crude oil prices and easing of geo-political tensions in the Middle East have helped in moderating domestic inflation. The RBI has recently made a downward revision of the baseline WPI projection for March 2013 to 6.8%, an optimistic projection considering the past trend. While the downward trend in wholesale inflation is a welcome sign, retail inflation remains elevated. Retail inflation surged to 10.6% in December following readings of 9.9%, 9.8% and 9.7% respectively in last three months. Both, food and non-food components of retail inflation index suggest persistent inflationary pressure. We expect that supply side reforms will ease this pressure in the medium term. Following an aggressive 50 basis point rate cut in April 2012, the RBI has been fairly cautious in conducting its monetary policy through 2012-13. The RBI chose to keep the rates unchanged in all its monetary policy announcements till December 2012. RBI did, on the other hand, reduce the cash reserve ratio and the statutory

Ination & Repo Rates (%) 11% 10% Ination 9% 8% 7% 6% 9% 8% 7% 6% 5% 4% Repo rate

Ination

Repo Rate

liquidity ratio in order to maintain adequate liquidity in the economy. However, as GDP growth continued declining and inflationary pressures started to recede in the second half of 2012-13, the RBI consented by reducing the policy repo rate by 25 basis points from 8% to 7.75% in January 2013. This is the first repo rate cut in over 9 months. RBI subsequently also reduced the cash reserve ratio by 25 basis points from 4.25% to 4%. This monetary policy action is expected to result in consequent reduction in the interest rates. However, it remains to be seen if and how much a 25 basis point reduction will encourage banks in passing on a significant benefit to consumers.

10

Outlook The Indian economy is about to experience one of the slowest growth years in nearly a decade. In realization of this, a push for reforms was made in September 2012 bringing a sense of cautious optimism. However, the impact of reforms has remained muted till date. Global economic uncertainties have not helped the case for domestic growth either. A drop in savings and investment has exacerbated the CAD and fiscal deficit scenario. India had achieved an improvement in domestic savings from 26.5% of GDP in 2001-02 to 36.8% in 2007-08 largely due to public savings and good macro-economic prospects. While a considerable portion of savings was eroded due to fiscal stimulus in meeting the financial crisis, a sustainable plan in putting savings back on track never materialized. Consequently, worsening macroeconomic environment particularly high inflation over the past couple of years and a depreciating rupee put a strain on domestic savings resulting in households hedging against this trend by investing in gold or similar products. During this period, corporate savings also fell in light of the wage price spiral and reduced margins due to

Current State of the Indian Economy Cautious optimism for the future

11

high borrowing costs and supply side constraints. With the RBI maintaining high rates, corporate borrowing costs escalated and consequently investments waned. In addition, surplus funds in the public system were utilized to fund the governments high fiscal deficit resulting in a crowding out of private borrowings. Subsequently, investible surplus has virtually declined to its lowest in the past few years. Deep rooted macroeconomic imbalance at this point can be corrected through concrete policy steps to revive growth. Addressing this will be crucial in the forthcoming Budget for 2013-14. The key concern at this point is the fiscal deficit. Sustainable plans need to be considered to further reduce subsidies, widen the tax base, decrease other expenditure and augment revenue through public sector divestments. However, meeting targets may take

time. While the RBI focuses to contain inflation, it is also important for it to consider maintaining adequate liquidity levels by reducing the statutory liquidity ratio and repo rates while controlling the cash reserve ratio. The twin action of fiscal and monetary policies is therefore expected to help raise savings and promote investments in the economy. With increasing investments, growth is expected to follow suit. The efforts of the Finance Minister to initiative strong reforms are laudable. Though the announcements of reforms have helped in lifting investor sentiments, committed implementation of these reforms as well as introduction of further reforms will be required to maintain confidence and show a path to recovery. Budget 2013-14 presents a good opportunity for the Government to start the new fiscal year on a positive note as the stakes slowly rise.

Data in graphical representations are based on reports published by IMF, RBI, Ministry of Finance, CSO and Planning Commission

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