On February 12, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with India.
The Indian economy is on a recovery path, helped by a large terms of trade gain (about 2.5 percent of GDP), positive policy actions, and reduced external vulnerabilities. Since late 2014, a collapse of global oil prices has boosted economic activity in India and underpinned a further improvement in the current account and fiscal positions, and engendered a sharp decline in inflation. A range of supply-side measures (including release of surplus grain buffer stocks) and an appropriate monetary stance have also contributed to the decline in inflation, from an average of about 9.5 percent during 2011–13 to 5.6 percent in December 2015. Due to its further-reduced vulnerabilities and improved growth prospects, India has experienced large foreign direct investment inflows in 2015. As a result, and in conjunction with the continued much-smaller current account deficit (largely due to continued low global commodity prices), international reserves have increased by $46.7 billion since end-March 2014, standing at US$350.4 billion at end-December 2015 (around 8 months of import cover). Nonetheless, persistently high household inflation expectations and large fiscal deficits remain key macroeconomic challenges, resulting in limited policy space to support growth through demand management measures. Furthermore, anemic exports as well as headwinds from weaknesses in India’s corporate financial positions and public bank balance sheets weigh on the economy.
Growth is projected at 7.3 percent for fiscal year FY2015/16, picking up to 7.5 percent in FY2016/17 (at market prices), supported by stronger domestic demand. With the revival of sentiment and picking up of industrial activity, an incipient upturn in private investment is expected to help broaden the recovery. Higher public infrastructure investment and government initiatives to tackle supply-side bottlenecks and repair corporate and public bank balance sheets should also help crowd-in private investment. The Reserve Bank has achieved its inflation target to bring inflation below 6 percent by January 2016. Going forward, near-term headline consumer price inflation dynamics will continue to be underpinned by supply-side factors which, despite the subpar crop outlook, should help achieve the Reserve Bank of India’s inflation goal of around 5 percent for March 2017. Notwithstanding the 125 basis points nominal policy rate cut in 2015, monetary conditions remain consistent with achieving the inflation target of 5 percent by March 2017. Despite the recent export slowdown, continued low global oil prices should help contain the current account deficit at around 1.5 percent of GDP in FY2016/17. The FY2015/16 Union budget deficit target of 3.9 percent of GDP (equivalent to about 4.25 percent of GDP in IMF terms) will likely be achieved.
While the balance of risks has improved, economic risks remain tilted to the downside. On the external side, despite the reduction in imbalances and strengthening of buffers, the impact from intensified global financial market volatility could be disruptive, including from unexpected developments in the course of U.S. monetary policy normalization or China’s growth slowdown. Absent disruptive global financial market volatility, slower growth in China would have only modest adverse spillovers to India, given weak trade linkages. Domestic risks include continued weaknesses in corporate financial positions and public bank asset quality, as well as setbacks in the reform process, which could weigh on growth, accelerate inflation and undermine sentiment. On the upside, further structural reforms could lead to stronger growth, as would a sustained period of low global energy prices.
Executive Board Assessment2
Executive Directors commended the authorities for their appropriate policy actions that—along with favorable terms of trade—have underpinned India’s improved economic performance and reduced external vulnerabilities. They welcomed in particular recent measures aimed at increasing public infrastructure spending, rationalizing subsidies, creating more flexible labor and product markets, and enhancing financial inclusion. Looking forward, Directors noted that global financial market volatility, a potential further deterioration in exports, and strains in bank and corporate balance sheets could weigh on India’s growth prospects. Meanwhile, high fiscal deficits and upside risks to inflation constrain the scope for countercyclical policies.
Against this backdrop, Directors underscored the need for continued vigilance, growth-friendly fiscal consolidation, and sustained reforms to enhance the resilience of the economy and bolster potential growth. Addressing supply constraints and further improving the business environment remain important priorities. Progress in these areas would have a positive impact on poverty reduction.
Directors stressed the importance of preserving external stability. They noted that
India’s international reserves are assessed to be adequate. Directors agreed that, in the event of a surge in global financial market volatility, exchange rate flexibility remains a key shock absorber, complemented by judicious foreign exchange intervention. They encouraged the authorities to sustain the reform momentum to further enhance investor confidence and attract foreign direct investment, while cautiously liberalizing external commercial borrowings by the private sector.
Directors welcomed the adoption of flexible inflation targeting and progress in enhancing monetary policy transmission. Given upside risks to inflation and still high household inflation expectations, Directors agreed that the monetary policy stance should remain appropriately targeted at ensuring durable reduction in inflation toward the medium-term target, supported by clear policy communication, continued fiscal consolidation, and measures to boost food supply. They encouraged the monetary authorities to stand ready to tighten the stance if warranted.
Directors welcomed the recent improvements in the quality and efficiency of public expenditure, as well as revenue-enhancing measures. They called on the authorities to articulate and implement credible measures that would underpin the achievement of the medium-term fiscal deficit targets and increase fiscal space for priority capital spending and social expenditures. Crucial in this regard are further reforms of fertilizer and food subsidies, a well-designed goods and services tax, and improved tax administration.
Directors saw as priorities for the authorities to accelerate reforms to remove supply-side bottlenecks, especially in the agricultural and power sectors; and to facilitate land acquisition. Further reforms are also essential to boost employment in the formal sector, encourage female labor force participation, and enhance labor market flexibility more broadly.
While acknowledging that India’s financial system is generally sound, Directors noted potential risks from weak corporate and bank balance sheets. They supported ongoing efforts to further enhance bank supervision, and encouraged the authorities to continue to strengthen prudential regulation for bank asset quality recognition, augment capital buffers and improve corporate governance at public sector banks, as well as enhance the bankruptcy and insolvency framework. A further deepening of capital markets would also facilitate financial intermediation.
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