world bank_india economic update_sept 2011

8/3/2019 World Bank_India Economic Update_Sept 2011

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September, 2011

Economic Policy and Poverty Team

South Asia Region

The World Bank

India Economic Update


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consolidation and higher real interest rates will have a dampening effect on aggregatedemand, but will strengthen policy credibility and the prospects for sustainable growth later on.This will also require rationalizing government expenditure by expanding investment andcutting subsidies including for items controlled by state governments (most notably, stateelectricity 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 ofportfolio flows remains high and poses risks in both directions: renewed shocks to the globalfinancial system could lead to another flight to safety, while global liquidity remains unusuallyhigh 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 theprecarious situation in Europe. A worst-case international scenario would lead to a collapse ofdemand for Indias exports, and strong contraction in private sector spending, as was observedafter the Lehman collapse in 2008. At that time, higher public sector spending set in at exactlythe right time largely because of the implementation of the recommendations of the 6 th pay

commission. The RBI was able to lower policy rates significantly when inflation fell rapidly inline with international commodity prices. However, in the immediate aftermath of the Lehmancollapse, the interbank market froze, and short term liquidity became very expensive.Policymakers would do well to review their preparedness for another global shock and preparecontingency measures.


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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. GDPgrowth is estimated to have reached 8.5 percent infiscal year (FY) 2010-11. Throughout the fiscalyear, growth weakened, and the trend continued inthe first quarter of FY2011-12. Growth in thefourth quarter of FY2010-11 and first quarter ofthe current FY2011-12 slowed to 7.8 and 7.7percent, respectively, as compared with a high of8.9 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. Therebound is largely explained by the weather: agood monsoon in 2010 followed the near-failure ofthe monsoon in 2009. Food grain production isestimated to have reached 236 million tons inFY2010-11, which is 8 percent higher than inFY2009-10, and sets a new record from theprevious peak in FY2008-09. Pulses, wheat,oilseeds and cotton production are estimated to

have reached all time highs in FY2010-11. Recordproduction has resulted in record procurement bythe Food Corporation of India, and food grainstocks reached 65.6 million tons in June 2011.

Industrial sector output growth was somewhatdisappointing. Output growth reached 7.9 percentin FY2010-11, marginally lower than the 8.1percent growth in FY2009-10. Industrial outputgrowth (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 wasmainly due to a decline in the growth in productionof capital goods. It dropped further to 6.8 percentin the first quarter of FY2011-12, the lowestperformance since Q3 of FY2009-10, the firstquarter 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 personalservices 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 theresult of a downward revision of growth in Q1FY2010-11, and upward revision of Q1FY2009-10. Without thechange 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%

07-08Q1

07-08Q2

07-08Q3

07-08Q4

08-09Q1

08-09Q2

08-09Q3

08-09Q4

09-10Q1

09-10Q2

09-10Q3

09-10Q4

10-11Q1

10-11Q2

10-11Q3

10-11Q4

11-12Q1

Agriculture Services GDP Industry

Agricultural Growth Re bound ed But Industry Disappointed.

(y-o-y change, in percent)

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

05-06Q1

05-06Q3

06-07Q1

06-07Q3

07-08Q1

07-08Q3

08-09Q1

08-09Q3

09-10Q1

09-10Q3

10-11Q1

10-11Q3

11-12Q1

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%

20%

30%

40%

50%

60%

70%

07-08Q1

07-08Q2

07-08Q3

07-08Q4

08-09Q1

08-09Q2

08-09Q3

08-09Q4

09-10Q1

09-10Q2

09-10Q3

09-10Q4

10-11Q1

10-11Q2

10-11Q3

10-11Q4

11-12Q1

Investment and Gov. Consumption Slowed.

(Components of GDP, y-o-y change, in percent)

Total Consumption

Private Consumption

Investment

Government Consumption


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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 grossfixed capital formation growth dropping to 0.4 percent in the last quarter of FY2010-11, butrecovering to 7.9 percent in Q1 FY2011-12. Consumption growth also moderated driven by a declinein government consumption, whose growth dropped to 2 percent in Q1 FY2011-12 16.4 percent in H1FY2010-11 because of the withdrawal of some stimulus measures and also a high base due to wagerevisions in FY2009-10. Private consumption growth also slowed to 6.3 percent in FY2011-12 from9.2 in H1 FY2011-12.

Balance of Payments

Despite a strong recovery in exports, the current account deficit widened slightly. Merchandiseexports delivered a stellar performance in FY2010-11 rising 42 percent over the previous year andreaching a level of $254 billion. Export growth reached a high of 79 percent in June 2011 over June2010. Import growth slowed strongly in Q4 of FY2010-11, and the trade deficit reached the lowestlevel since the great trade collapse during the global financial crisis. Import growth picked up againin 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 pricesplayed a role, the import growth acceleration wasmainly due to a pick-up in non-oil imports, whichgrew by 38.6 percent in Q1 of FY2011-12. A risein the invisibles surplus and strong remittancescontributed to offset some of the trade deficit.

Indias 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 inAsia and the Middle East. The share of the EU and

the US in Indias exports has fallen to 19 percentin the last six months of 2010, from 29 percent in2003. In contrast, the share of the main tradingpartners in Asia (China, Indonesia,Pakistan, Sri Lanka, Singapore) hasincreased to almost 20 percent from13 percent over the same period. Atthe end of 2010, China had emergedas the country contributing most toexport growth, followed by theUAE, Indonesia, and the US. Whenaggregating exports to the 27 EU

member countries, their combinedcontribution to export growth issmaller than Chinas, but ahead ofthe UAEs. Exports to Chinaamounted to $1.5 billion in CY2010,as compared with $2 billion to theUS, 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, andjewelry. 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 6.2EU 4.8 Petroleum and Crude Products 5.8United Arab Emirates 3.3 Transport Equipment 4.4Indonesia 2.1 Manufacturres of Metals 3.1United States 1.7 Processed Minerals 1.9Singapore 1.7

Electronic Goods1.7

Iran 1.2 Machinery and Instruments 1.6Sri Lanka 1.2 Ferro Alloys 1.4Belgium 1.0 Sugar 1.3Pakistan 1.0 Cotton Yarn Fabrics Madeups etc 1.2Kuwait 0.9 Cotton Raw incl. Waste 1.1Saudi Arabia 0.9 Plastic and Linoleum Products 0.9Italy 0.8 Primary and Semi-finished Iron and Steel 0.8South Africa 0.8 Other Ores and Minerals 0.6Germany 0.7 Drugs, Pharmaceuticals and Fine 0.6East Timor 0.7 Dyes Intermediates and Coal Tar 0.5Turkey 0.7 Oil Meals 0.5Austria 0.7 Manmade Yarn Fabrics Madeups 0.4Bahrain 0.7 Rice Basmoti 0.4Brazil 0.6 Gems and Jewellery 0.4

France 0.6 Aluminium other than Products 0.4

Source: Ministry of Commerce, CEIC.


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benefited most from growth in non-ferrous metals, petroleum products,transport equipment, andmanufactured metals. More than halfof the export increase is contributedby raw and semi-processedmaterials. Indias exports ofpetroleum products are partly driven by the governments pricing policy:Indian retail prices are not sufficientto cover the full costs (includingtaxes) 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 fromtheir refineries in India rather than selling in the domestic market, whereas the public sectorcompanies import the same products to supply the domestic market. Petroleum products accounted forabout 6 points of the 42 percent export growth. This can be ascribed in part to an increase ininternational 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 inCY2010, while Gems and Jewellery accounted for $2.6 billion. Non-ferrous metals contributed mostto 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 $774million in Q4 FY2010-11, the lowest quarterlyflow since 2002. The overall decline in net capital

flows from FDI and FII sources was partiallyoffset by an increase in external commercialborrowings. Inflows recovered somewhat duringApril-May 2011, but the turmoil on globalfinancial markets following the downgrading ofcredit ratings for the US led to renewed capitaloutflows as a flight to safety set in. There arealso early indications that Indian firms found itmore difficult to borrow abroad following thedowngrade.

The rupee has remained relatively stable

against the U.S. dollar and slightly depreciatedagainst the pound and yen in recent months.Since the beginning of 2011, the REER (36-currency trade based) has depreciated 2 percent. Ataround 100 (the level it had in 1993), the rupee hasstabilized between the recent peak of 110, whencapital inflows led to appreciation in 2007, and therecent trough of 90, when capital outflows resultedfrom the global financial crisis. The RBI intervened only in September 2011 when the rupee droppedby 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 officialforeign reserves of the RBI remained at a comfortable level. The ratio of short-term external debt to

60

70

80

90

100

110

120

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

Jul-10

Oct-10

Jan-11

Apr-11

The Real Exchange Rate Stabilizeded

(Jan. 2006 - Jun. 2011, 1993=100)

-30

-20

-10

0

10

20

30

40

50

3/2005

6/2005

9/2005

12/2005

3/2006

6/2006

9/2006

12/2006

3/2007

6/2007

9/2007

12/2007

3/2008

6/2008

9/2008

12/2008

3/2009

6/2009

9/2009

12/2009

3/2010

6/2010

9/2010

12/2010

3/2011

6/2011

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 mill ions 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


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foreign exchange reserves was 21.3 per cent at end-March 2011, a slight increase from 19 percent atend-March 2010. Foreign exchange reserves at end-July 2011 reached $319 billion, more than one-to-one coverage of total external debt.

Indias stock markets slumped. Indias stock markets embarked on a steep decline in June 2011,with year-to-date performance of the SENSEX index reaching 17 percent, which is significantlyworse 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. BothMoodys and Fitch upgraded their local currency ratings in early 2010. While Moodys upg raded itsrating 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. Companymanagers are seeing a decline in the financialsituations of companies, while profit margins areshrinking. The deterioration in conditions is alsosupported by Purchasing Managers Indices, whichsank to their lowest in two years.

Inflation

Inflation moderated somewhat, but it has

remained at an elevated level. Inflation reached9.2 percent (WPI, y-o-y) in July 2011 continuing itsmoderation since the recent high of 9.7 percent inApril 2011. Food wholesale price increases saw asignificant moderation from the peak of 22.6percent in December 2009 to a low of 6.4 percent inFebruary 2011, but has since risen again to about 8percent during May-July 2011. However, a 3-monthrolling average of seasonally adjusted annualizedmonthly increases in food prices has moved upsignificantly over 2011 hitting 15 percent in June,which indicates that the moderation could be shortlived. With the moderation in food prices came amoderation in the CPI measures of inflation. From ahigh of 16.2 percent in January 2010, inflationmeasured by the CPI for industrial workers hasdeclined steadily to about 9 percent in the quarter toJune 2011.

Core inflation (calculated by excluding food andenergy prices from the wholesale price index) has

been the main component of overall inflation

since September 2010. It reached a high of 10.3percent during February-March 2011 and moderatedto 9 percent since then. Inflation in non-foodmanufactures increased from 6.3 percent in April to7.3 percent in May 2011. The increase is interpretedby the RBI as a reflection of high commodityprices, rising wages and rising output prices as aresult of pass-through of high input costs. Inaddition, the RBIs Order Book, Inventory, and

Capacity Utilization Survey in Q4 FY2010-11 wasthe highest in three years. Capacity utilization

0.0

2.0

4.0

6.0

8.0

10.0

12.0

12/2009

1/2010

2/2010

3/2010

4/2010

5/2010

6/2010

7/2010

8/2010

9/2010

10/2010

11/2010

12/2010

1/2011

2/2011

3/2011

4/2011

5/2011

6/2011

7/2011

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-09

May-09

Jul-09

Sep-09

Nov-09

Jan-10

Mar-10

May-10

Jul-10

Sep-10

Nov-10

Jan-11

Mar-11

May-11

Jul-11

Primary Food Energy WPI Core Processed Food

Core Inflation has been Trending up, in particular Manufacturing Prices

(Componentsof 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

Jan-2000

Jun-2000

Nov-2000

Apr-2001

Sep-2001

Feb-2002

Jul-2002

Dec-2002

May-2003

Oct-2003

Mar-2004

Aug-2004

Jan-2005

Jun-2005

Nov-2005

Apr-2006

Sep-2006

Feb-2007

Jul-2007

Dec-2007

May-2008

Oct-2008

Mar-2009

Aug-2009

Jan-2010

Jun-2010

Nov-2010

Apr-2011

BRICS Consumer Prices and Commodity Prices

(y-o-y percent change)

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


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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 ofGDP as compared with 6.8 percent in FY2009-10.3 The budget benefited from higher-than-expectedgrowth in nominal GDP, and tax revenue buoyancy helped to increase the tax-to-GDP ratio by 0.5percentage points, although it is still significantly lower than in FY2007-08, the year before the globalcrisis induced slowdown and adoption of stimulus measures. The spending-to-GDP ratio, on the otherhand, was reduced by 0.7 percent of GDP.

The central government budget for FY2011-12 targets an ambitious consolidation. The deficit istargeted to narrow to 5.0 percent of GDP.4 The budget envisages high revenue buoyancy and areduction in the ratio of subsidies to GDP of 0.5 percentage points, or a contraction in the nominalspending amount by 12.5 percent. On the revenue side, the budget estimates are based on theprojection of 9 percent growth in real GDP and an inflation rate of 4 percent. Gross tax revenue is

3Under the governments accounting rules the fiscal deficit is estimated to have reached 4.7 percent of GDP inFY2010-11 as compared with 5.4 percent in the earlier estimate. The government counts revenue fromdisinvestment 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 governments accounting rules with disinvestment proceeds of0.4 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 4.0Income 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 licens es .

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

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


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budgeted to increase by 18.5 percent to a level of 10.4 percent of GDP. However, recent data indicatea decline in net direct tax collections during the first two months of FY2011-12 of 48 percentcompared with the same period of FY2009-10, a fall to Rs.13 billion from Rs.25 billion in the sameperiod last fiscal year mainly because of an increase in tax refunds. Gross direct tax collectionsincreased by 37 percent at Rs.50.0 billion as compared to Rs 36.7 billion in same period of theprevious 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 totalexpenditures increased by 12.8 percent (budget targets 3.4 percent). First quarter revenue receipts fellby 55 percent as compared to the same period in the previous year, but this is largely caused by thehigh non-tax revenue on account of 3G telecom license revenue in Q1 FY2010-11. The governmenttabled the first supplementary demand for grants in the monsoon session of parliament to authorizegross 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 isaimed at meeting requirements for local area development schemes (Rs.23 billion), the Below PovertyLine (BPL) survey (Rs.23 billion), grants for the Integrated Child Development Scheme (Rs.15billion) and the National Clean Energy Fund (Rs. 11 billion).

Monetary Developments

Growth in monetary aggregates slowed but still outpaced the RBIs targets. Credit growthmoderated to 21.0 per cent in March 2011 and 20.6 percent in June 2011 from 24.1 per cent inDecember 2010. Credit to agriculture and allied sectors grew by 10.6 percent in FY2010-11 ascompared to 23.9 percent in FY2009-10 while credit to services witnessed a sharp rise by 24.0 percentcompared to 12.5 percent in FY2009-10. Credit to industry grew by 23.6 percent. Growth was led byinfrastructure, metal and metal products, textiles, engineering, food processing and gems andjewellery.

The RBI continued to raise policy rates citing inflationary conditions as a major concern. Thehike of 50bps in July surprised analysts and was taken as a signal that the RBI was taking a moreaggressive stance to fight inflation, and another hike by 25bps in September was therefore lesssurprising. Since March 2010, the main policy rate the Repo Rate at which banks borrow liquidityfrom the RBIwas 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 bymore than the Repo Rate, because banks had excess liquidity parked at the RBI at the (lower) ReverseRepo Rate at the beginning of the tightening cycle, but switched to borrowing at the Repo Rate fromRBI in June 2010. Liquidity developments are heavily influenced by government balances with theRBI 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 ($35billion) in January 2011, which then fell to Rs. -0.5 trillion ($12 billion) in April 2011. Within themonth of March 2011, government operations injected Rs. 1.5 trillion of high powered money.

II. The Global Economic Environment5During 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-expectedeffects from the Japanese earthquake and tsunami (industrial production in high-income countries fellby 2.1 percent between February and June 2011). However, in the United States, investment grewstrongly, and consumer demand (excluding tsunami impacted auto- and gasoline consumption)

5 Prepared on the basis of inputs from DEC Prospects Group.


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expanded at a 1.2 percent annualized rate. By the end of July 2011, activity was rebounding, withindustrial production in high-income countries increasing at 7.8 percent (annualized rate). Thenegative 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 USand in Europe were seen as insufficient. In particular, investors felt that the resolution of the stand-offin the US Congress may not ensure long-run debt sustainability, nor the July 2011 EU decision on asecond bailout for Greece, while the EUs provisioning of 440 billion in the European FinancialStability 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 & Poors to downgrade the credit rating of US government debt. Banking-sector valuations have also declined sharply. European banking stocks have lost 35 percentsince 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 andCY2012, respectively, a downward revision of 0.4 percentage points in both years. The US economyis expected to expand by 1.7 percent in the current year, as compared with a forecast of 2.6 percent inthe June 2011 Global Economic Prospects. For 2012, growth is forecast at 2.2 percent. The economiesof the high-income countries are expected to expand by 1.6 percent on average in CY2011, draggeddown 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 highdownside 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 orspeculative attack on several large economies simultaneously could overwhelm current crisis reponsemechanisms. Meanwhile, in some of the core countries the public clearly does not support furtherbailouts.

Growth in developing countries is holding up well.However, GDP growth in developing countrieshas moderated in Q2 as well, partly reflecting weakened external demand from HICs. Among the 21developing countries reporting, first quarter GDP grew at a solid 6.3 percent annualized pace, andslowed by 0.5 percentage points into the second quarter of 2011. Reflecting disruptions from theJapanese 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-countryequity 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 anadditional 10 percent or more. Developing country bond yields have remained broadly stable since thebeginning of August, although due to falling U.S. Treasury yields developing country spreads haveincreased by about 90 basis points in the month.

International capital flows (gross) to developing countries have dropped sharply. They declinedfrom an average of $50 billion in the second quarter to $24 billion during the first two months of thethird 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 sameperiod of 2010. Latin America and specifically public-sector corporations have been the largestissuers of international bonds.

Inflation in both high-income and developing countries is beginning to wane, receding in twothirds of developing countries. Across developing regions, inflation over May-July 2011 has


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declined in Latin America and the Caribbean (to 7percent, saar), South Asia (5.7 percent) and Sub-Saharan Africa (9 percent), but continues to rise inEast Asia and the Pacific (6.3 percent) and in Europeand Central Asia (9.8 percent). Recent data forMENA are not available.

Commodity prices are mixed reflecting different

demand and supply problems, or the safe havenstatus of some of them. As the premier safe-havenasset, gold prices surged to a peak of near $1,900/ozin August, compared with $1,500 at end-June. Oilprices peaked in March 2011, with the WBG pricereaching $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 andheavier North American oil. The apparent resolution of the Libyan crisis (normally a moderatelyimportant producer of light-sweet oil) is expected to lead to a fall in oil prices and the differentialbetween Brent and WTI prices. Prices of key grains increased during July and early August followingharvesting delays of wheat in Europe and a drop in projected U.S. maize production due to poorweather. Despite anticipated production gains in 2011/12, grain stocks remain tight (e.g. 2011/12global maize stocks correspond to 1.6 months of consumption versus a 10-year average of 2.4months) pointing to the risk of additional price spikes.

III. OutlookIn 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 andFY2012-13, GDP growth is forecast to reach 7-8percent. The slowdown is expected because ofstructural problems (see next paragraph), tightermacroeconomic policies, slow growth in thecore OECD countries, and a base effect: growthin FY2010-11 was buoyed by the strong reboundin agriculture, while agricultural growth isexpected to revert to trend (3 percent) inFY2011-12. Fiscal consolidation and higherinterest rates are also likely to have a dampeningeffect on aggregate demand. The latter impact in

particular on some long-term investments anddemand for housing and consumer durables.Domestic interest rates could have a strongereffect 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, Indias GDP growth will have to relyon domestic growth drivers. The slowdown in investment, capital outflows, and decline in the stockmarket point to deeper structural problems. Investors are holding back in the face of regulatoryuncertainty (environmental clearances, land acquisition laws, tax reforms), banks are highly exposedto power projects facing delays due to the lack of coal and gas feedstock, and mining (especially ofiron 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, inparticular progress on current legislative initiatives (land acquisition, tax reform, financial sector


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reform, FDI in retail) would strengthen domestic growth drivers. Indias Planning Commission pointsthe way: To achieve rapid growth, the economy will have to overcome constraints posed by limitedenergy supplies, increase in water scarcity, shortages in infrastructure, problems of land acquisitionfor industrial development and infrastructure, andthe complex problem of managing the urbantransition associated with rapid growth. Greaterefforts also need to be made in agriculture, healthand education to ensure inclusion of the mostexcluded and sometimes invisible parts of ourpopulation. 6

The stabilization of commodity prices and the

economic slowdown are likely to support

disinflation. The latest interest rate hike by the RBIhas brought the real policy interest rate (calculatedwith forward looking WPI inflation) into positiveterritory for the first time since Q4 FY2008-09.7With higher real interest rates, the slowdown ininvestment and industrial production witnessed inthe first quarter is likely to continue. Lower aggregate demand would result in a reduction of capacityutilization and lower pricing power for corporations. Continuing slowdown in GDP induced by tightermacroeconomic policies would put downward pressure on core inflation. However, inflation isunlikely to show a significant decline in the second quarter of FY2011-12 because of built-upmomentum (as indicated by seasonally adjusted monthly data) and continuing pressure from energyprice increases (already implemented and more to come) and increases in minimum support pricesannounced 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, thecurrent account deficit is likely to expand.

While the trade deficit was shrinking at the end of 2010and beginning of 2011, higher import growth since then is likely to continue. Moreover, as thecomposition of Indias exports is changing towards higher technology content, increasing importcontent 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 leastpartially compensate. The current account deficit is therefore likely to reach around 3 percent of GDPin FY2011-12.

Capital inflows pose risks in both directions. Under the baseline forecast for the global economicenvironment of a relatively benign resolution of the recent turmoil, capital inflows could resume andfinance 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 assetprice corrections in August 2011 also led to some portfolio outflows. As the most recent episodeshows, volatility of portfolio flows could be high because of continuing uncertainty about the healthof the global economy. Renewed shocks to the global financial system could quickly change investorperceptions and lead to another flight to safety. The risk of such shocks occurring is high in light ofthe unsettled debt issues in some European countries. On the other hand, global liquidity remainsunusually 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 FiveYear Plan, New Delhi.7 The real interest rate was negative through 2008 up to the onset of the global financial crisis when Indianinflation 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.


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2012. High liquidity could lead to sudden FII surges in emerging markets. The RBI has demonstratedits ability to react quickly to short-term capital flows and its reserves remain sufficient to preventunwanted 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

Indias exports, and strong contraction in private sector spending . After the time of the Lehmancollapse in 2008, higher public sector spending set in at exactly the right time largely because of theimplementation of the recommendations of the 6th pay commission. The RBI was able to lower policyrates significantly when inflation fell rapidly in line with international commodity prices. While apossible renewed crisis would have very different origins from the one in 2008, policymakers woulddo 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 thebudget because of higher-than-envisaged inflation. Tax revenue could therefore exceed the targetoffsetting 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 inFY2011-12. This is to be achieved by a contraction in subsidy outlays by 12.5 percent from Rs.1.64trillion to Rs.1.43 trillion. While the government announced increases in administered prices fordiesel, 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 oilprices remain at around $110/bl. The impact on food subsidies of the food security bill slated to beintroduced in parliament is highly uncertain. While it will lead to somewhat higher outlays in thefuture, the impact on the current budget may be limited. Nevertheless, without additional policymeasures, it will be challenging to reach the consolidation target. Meeting the deficit target is animportant element of macroeconomic policy credibility. A fiscal contraction in line with the targetsfor FY2011-12, would likely constrain aggregate demand and lower inflation expectations, even ifaccompanied by one-off increases in the prices of subsidized items. In addition, rationalizingexpenditure over the medium term by cutting subsidies including for items controlled by stategovernments (most notably state electricity boards) and expanding investment could alleviate supplybottlenecks and lower prices more directly and sustainably than through a contraction in aggregatedemand.

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 9percent and average WPI inflation of 4 percent. However, different officials have revised theirexpectations for growth downwards, and for inflation upwards since then. The Chairman ofthe Prime Ministers Economic Advisory Council expects growth to measure 8.2 percent inFY2011-12, while inflation would drop to around 6.5 percent by end-March 2012. TheFinance 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.


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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 growthfor the year at 8 percent in August.

In its First Quarter Review 2011-12, the RBI considers that even as some deceleration isexpected in 2011-12, overall growth is likely to stay around trend growth of about 8 per centin 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 pricesas demand conditions remained buoyant. Currently, inflationary expectations are furtherfeeding on themselves and warrant a close watch.

11 Inflation is projected to stay during Q2 of2011-12, but moderation is expected thereafter. In light of continuing pass-through of earlierenergy price increases and increases in minimum support prices, the RBI believes inflationwill fall moderately to 7 percent by March 2012.

The National Council of Applied Economic Researchs Quarterly Review of the EconomyJuly 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 Morganforecast growth to slow to 7.6 percent in the current fiscal, and they also expect furthermonetary 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.


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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 7.5Agriculture 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

world bank_india economic update_sept 2011

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