H R Khan: Silver linings in the Indian economy
Address by Shri H R Khan, Deputy Governor of the Reserve Bank of India, at the 5th Annual
Banking Conference on "The silver lining of the Indian economy", organized by NMIMS
School of Banking Management, Mumbai, 6 October 2012.
* * *
The speaker acknowledges the contributions of Dr. Mridul Saggar of the Reserve Bank of India.
Dr. Debashis Sanyal, Dean, Dr. Vrinda Kamat, Chairperson - MBA Banking, Faculty and
students of the School of Business Management, NMIMS University, Shri. M G Sanghvi,
Chairman & Managing Director, Syndicate Bank, Shri S K Jain, Executive Director, Bank of
Baroda, distinguished invitees, ladies & gentlemen. It is a great pleasure to be amongst
budding management professionals and corporate leaders of tomorrow. In the period of
gloom and doom for the world in general and India in particular, it is important not to miss the
bloom. I am therefore very happy to be invited to speak on silver linings in the Indian
economy. In bad times the financial markets, the media, the investors and the consumers all
get accustomed to focus on negative news and the positive news gets ignored. Similarly, in
good times, markets and economic agents sometimes run ahead of the realities and
completely discount the negative news and love to accept only the good news. In more
uncertain times, as were recently, sentiments, beliefs and perceptions shift quite fast and do
matter for eventual economic outcomes are characterized by multiple equilibria. These
acquire the characteristics of self-fulfilling prophecy. Yet, in such a period, the economy stays
in the saddle point if we ignore the bloom, simply because animal spirits are weak. So today,
my objective would be to draw your attention to the silver linings that we can see for the
Indian economy in the horizon. I would touch upon the positive streaks on the aspects of
growth, inflation, fiscal and external sector at this juncture, and how these could become the
turning point for the Indian economy provided we carry forward the momentum and convert
intentions into actions.
Recent policy actions start the course correction but momentum needs to be kept
Recent policy measures taken by the government are very significant. They have started the
course correction from a point where the Indian growth story was close to getting seriously
damaged. However, for these measures to succeed it is important to keep up the
momentum. More steps and effective implementation over next 2-3 years are necessary to
fully recoup the lost ground. The economy has been facing serious headwinds as growth had
slowed down to 5.5 per cent or less for the last two quarters over and above the subdued
growth rate of 6.5 per cent for 2011-12, a rate even lower than crisis period low point of
6.7 per cent growth in 2007-08. Our saving and investment rate had also slipped since
2008-09. Gross domestic saving rate averaged 32.7 per cent in three years 2010-11 against
35.0 per cent in the preceding three years due mainly to fall in public sector saving rate. Our
gross domestic investment rate averaged 34.1 per cent against 34.9 per cent for the same
periods as corporate investment rate fell sharply. Preliminary estimates suggest a further
sharp drop in household financial savings in 2011-12 at less than 8.0 per cent of the GDP
from more than 12 per cent two years back. Also, corporate investment is likely to have
declined further. With falling saving and investment, rise in twin deficits and inflation,
potential growth had also dropped by one percentage point or more in the post-global
financial crisis period. As we know, potential growth indicates the rate of growth the economy
can achieve consistent with stable macro-economic conditions. On the other hand, inflation
rose sharply to above comfort levels since December 2009 and averaged 9.5 per cent for
next 24-months before lowering to sub-eight per cent but still proving to be intransigent. It is
staying sticky at over 7 per cent. Centre's fiscal deficit had slipped during 2011-12 to
5.8 per cent against the budgeted 4.6 per cent for the year and 4.9 per cent in 2010-11. With
gross under-recoveries of oil marketing companies working out to over Rs1.8 trillion or
0.8 per cent of GDP due to unrevised prices of diesel, LPG and kerosene, there was little
doubt the centre's GFD/GDP budgeted estimate would then have overshot by a wide margin.
Even after the revision of diesel prices and capping of subsidised LPG cylinders, the budget
imbalances are obvious, underscoring the importance of further fiscal measures to contain
deficit this year.
The current account deficit (CAD) had risen to an all-time high of 4.2 per cent of GDP in
2011-12 and 4.5 per cent of GDP during Q4 of 2011-12. In other words, rising twin deficit,
slowing growth and sticky inflation provided all the ingredients for a possible economic crisis.
Noting this macro-economic deterioration, some international credit rating agencies had
already put India's sovereign rating on a watch list for an impending downgrade that would
have pushed India to a sub-investment grade.
The slew of measures in a span of less than a month should count
Against this background, the policy actions that were announced in September 2012 should
be seen as major initiatives to reverse the course of economic growth path in the country. In
a slew of measures of economic reforms, the government raised diesel prices by ₹5 per litre
and capped subsidised LPG cooking gas cylinders to six a year per household. It permitted
foreign direct investment (FDI) in multi-brand retail up to 51 per cent, in aviation sector up to
49 per cent and in some broadcasting services up to 75 per cent. It also approved sale of its
minority stakes in four public sector firms - Oil India (by 10 per cent), Hindustan Copper
(9.59 per cent), MMTC (9.33 per cent) and Nalco (12.15 per cent) - to raise up to ₹150 billion
- half its disinvestment receipts target for the year. These measures were followed up with
an announcement that withholding tax liability will be reduced to 5 per cent from 20 per cent
for the overseas borrowings /bond issuances for infrastructure sector by Indian firms during
July 2012 and June 2015.
A debt relief package for the state power distribution companies (discoms) has now been
approved. Once implemented efficiently, it can turnaround the investment scenario once
again. This month, a package for the life insurance sector was also worked out. The package
includes easing investment norms for insurers, faster clearance for new products, easing of
procedures, allowing banks to sell products of more than one insurance company and
possibly some tax concessions for the insurance sector. More sector-specific packages could
follow allowing structural bottlenecks to be removed without sacrificing on regulatory
discipline. The Cabinet has also cleared foreign equity cap in insurance sectors at
49 per cent through Insurance Laws (Amendment) Bill, 2008. It also approved certain
amendments to the Pension Fund Regulatory and Development Authority (PFRDA) Bill, 2011
that included foreign investment ceiling in the pension sector at 26 per cent or such
percentage as may be approved for the insurance sector, whichever is higher, may be
incorporated in the present legislation. Besides, it approved several other plans that are
important for the economy, such as the 12th Five Year Plan document for taking it to the
National Development Council (NDC), amendments to the Companies Bill 2011, the Forward
Contracts (Regulation) Amendment Bill, 2010 and the Competition Act, 2002. These moves
show the intent and the policy direction though the ultimate impact would depend on the
political process of law making that follows. There are several unknowns, such as, the timing
of debates and votes, the floor management on the day of the vote and most importantly, the
process by which political differences are narrowed enough to see the results. The
foundation has been laid and one can be confident that the Indian democracy would once
again stand the test of the time.
On our part, we certainly think that the slew of economic reforms measures undertaken by
the government recently would impart a positive momentum to the economy. The Reserve
Bank in its Mid-Quarter Review of Monetary Policy noted the likely positive impact of the
changes in FDI policy on capital flows and over the long run on higher productivity,
particularly in food supply chains. The Reserve Bank had been consistently arguing for need
for supply-side responses to help contain inflation. Earlier in its Annual Report released in
August 2012, it had highlighted the urgent need to step up non-debt creating inflows,
especially in the form of FDI in view of the wide current account deficit (CAD). It had argued
for further improving the FDI inflows in sectors such as insurance, retail, aviation and urban
infrastructure. It had noted that FDI in retail may be particularly helpful in improving supply
chain management through greater investment in backend infrastructure, including cold
storage for farm and poultry products.
Considering that these steps being undertaken paved the way for a more favourable
growth-inflation dynamics, the Reserve Bank moved to address possible liquidity tightening
ahead by a pre-emptive 25 basis point cut in its Cash Reserve Ratio (CRR) at its Mid-term
policy announced on September 17, 2012. CRR is also a potent monetary policy tool and
should help in lowering the cost of credit and augmenting its supply, thus improving credit
flows. The CRR cut was in addition to a 50 basis point policy rate reduction that the Reserve
Bank had effected in April 2012 in anticipation of action for fiscal consolidation and
supply-side initiatives.
Several policy measures have been taken in less than a month. When these measures get
implemented and feed through the system, they would contribute significantly to recovery of
India's growth as well as growth potential. Capital flows have recovered and would go a long
way in restoring confidence for business activity in the country. Growth would start improving
as a result. Whether the recovery will be quick or slow-paced would depend on several
factors, including global conditions, which at the moment are not very conducive in spite of
some positive news on labour and housing markets in the US. What is important is that
recent actions by the Government have reduced the macro-economic risks and structural
impediments.
Part of our recent woes was self-inflicted as inadequate movement on policy and
implementation fronts worsened investment climate that had already suffered due to global
uncertainties and cyclical downturn in the Indian economy. This had added an element of
structural retrogression in the Indian economy. The government has now shown its resolve to
effectively redress this. If steps announced are well-implemented and if we stay on path of
reforms, the economy would turnaround faster than what many expect. But several
challenges remain and not only policy changes but effective implementation holds the key to
success.
The most important challenge would be to further lower the twin deficits by staying on path of
fiscal consolidation, keeping a tab on private consumption demand and using expenditure
switching policies to lower CAD. Monetary policy would for some more time need to focus on
inflation while using available space to support growth to the degree it can. Inflation, if left
unattended to, can play the biggest spoil sport. The rupee has already appreciated
6.8 per cent against US dollar since the onset of this new wave of reforms on September 13,
2012. This may help lower inflation somewhat as exchange rate-pass-through takes place.
However, it is important to understand that exchange rate is neither a first-best solution nor a
sufficient tool for addressing the challenges of structural inflation that we face today.
Ultimately, fiscal policy would need to work towards expediting supply-side responses and
keeping private consumption demand in reasonable control. Monetary policy would need to
be cautious in the interim.
Downward cycle may be bottoming out
After a downturn, there are some signs of green shoots that if nursed with appropriate
policies, including continuous economic reforms, with an eye on macro-financial stability, can
pave the way of recovery for the Indian economy. Falling growth was somewhat arrested in
Q1 of 2012-13. At 5.5 per cent, it was marginally better than in the 5.3 per cent in Q4 of
2011-12. While this is not a material improvement, when juxtaposed with the recent policy
measures there is hope that growth would improve in coming quarters and more so next
year. Rainfall has been deficient by 8 per cent from the long period average in 2012
monsoon season. The deficiency during June and July 2012 has adversely impacted the
Kharif crop. However, good rainfall in August and September have improved the soil
moisture content and reservoir levels and raised the prospects for a good Rabi crop. As we
see subsequent rounds of crop estimates, the deficiency of about 10 per cent in case of food
grains and oilseeds is likely to be reduced, thus providing a further silver lining.
India grew at a rapid pace with an average growth of 8.7 per cent during 2003-04 to
2007-08 essentially because investment boomed, especially in infrastructure such as power,
roads and telecom. In the last three years of this period growth averaged 9.5 per cent before
the Lehman crisis changed the world. India's potential growth was assessed at nearly 8.5 per
cent during this period. India's growth dropped to 6.7 per cent during 2007-08 due mainly to
spill over from global financial crisis. India, however, stood out as an island of calm that
withstood global financial Tsunami. Its growth dropped less than its peers and it staged a
V-shaped recovery clocking 8.4 per cent growth over next two years. However, the euro area
crisis, the rising structural problems and high inflation combined to bring about a precipitous
fall in India's growth. The growth dropped to 6.5 per cent in 2011-12 - lower than the
crisis-affected growth of 6.7 per cent in 2007-08. More importantly, growth has averaged
5.4 per cent over last two quarters.
Is this the new normal? There are strong reasons to believe otherwise. While potential
growth may have fallen, we are clearly running a negative output gap with realised growth
below potential. With current momentum, we can also recoup our lost potential and after a
few years start growing back at 8-8.5 per cent on a sustainable basis. What is important at
this stage is to further improve macro-economic conditions by lowering twin deficits and to
ensure that inflation stays below the threshold at which high growth cannot be sustained.
Growth came down due to exceptional reasons. Firstly, inflation had stayed high for over two
years and there is enough theoretical and empirical evidence to suggest that when inflation
reaches that high and becomes persistent, the costs of deflation in terms of growth sacrifice
turns out to be large. Part of the growth sacrifice occurs for reasons of monetary tightening
that high inflation inevitably brings if complete macro-economic destabilization and possible
hyper-inflation is to be averted. Hyperinflation risk is not something that can be dismissed
lightly. Growth also comes down for reasons beyond monetary tightening. High inflation
erodes consumers' real purchasing power and lowers aggregate demand. It acts as a
regressive tax on poor and erodes their consumption base. Producers also postpone
investment decisions in an era of heightened uncertainty. To contain the high level of inflation
and manage inflationary expectations, monetary policy in India was tightened continuously
since February 2010 and these risks were contained even though inflation still remains
perceptibly higher than the Reserve Bank's comfort. Monetary policy needs to factor in the
growth-inflation dynamics in a forward-looking manner but keep focussing on inflation for
some more time so that inflation persistence is overcome. This would have a positive spin off
for growth to recover. As we have stated in the Mid-Quarter Monetary Policy Review of
September 17, 2012, when the policy initiatives being taken now by the Government
materialize into concrete action, monetary policy will reinforce the positive impact of such
actions while continuing to maintain its focus on inflation management.
Secondly, growth came down because of unfavourable global climate. The euro area crisis
coming on the heels of Lehman crisis is playing on animal spirits. Global trade has
decelerated sharply and is impacting investments. Indian industrial growth is found to be
highly correlated with global industrial growth. As we integrate more and more with the rest of
the world, we have to pay price of globalization even as we reap its benefits. As we have
observed in this context, global developments affect our economy through commerce, capital
flows, confidence, commodity price, contamination, currency rates and credit rating channels.
Global business cycles are, therefore impacting both investment demand and with a lag
impacting consumption demand as incomes fall and appetite for leverage reduces.
Thirdly, growth came down in India because investment climate was vitiated due to
emergence of serious structural bottlenecks related to land, labour, regulatory framework,
linkages or availability of funding, partly due to elevated concerns for asset quality. Part of
the problem occurred in the mining sector, where judicial and executive efforts to improve
governance have created a sort of a hiatus in activity. When a clearer operational regime
comes into play businesses would adjust to more normal functioning based on fair returns.
The other part of the problem was in the power sector where bulk of the 54 GW of new
investments capacities created during the 11th Plan turned into potential bad investments as
coal was in short supply. Mitigation of the problem is hopefully in the offing. If debt
restructuring of discoms is well executed and coal supplies are quickly ensured, the power
sector investments can revive in the 12th Plan. New capacity generation can easily match
and possibly surpass that in the 11th Plan. Power sector can turn out to be a major driver of
growth once again. As per the plans, the SEB losses are being cut by power tariff revisions.
Investment revival is possible
Big steps for reforming power sector are now being taken and can pave the way for revival of
investment. The debt restructuring of discoms is being done in an incentive-compatible
manner and may not encourage moral hazard or regulatory forbearance. The scheme
contains various measures required to be taken by state discoms and state governments for
achieving the financial turnaround of the discoms. The restructuring / reschedulement of loan
are to be accompanied by concrete and measurable action by the discoms / States to
improve the operational performance of the distribution utilities. There may not be an
immediate fiscal impact for the centre, given that its obligations under the scheme are
medium-term in nature, the fiscal impact for the states in the near-term would be the interest
outgo on 50 per cent of outstanding short-term loans which are to be taken over by them in a
phased manner. While, a great deal of ground would still need to be covered for operational
effectiveness of the scheme, it does have the capacity to reverse the falling fortunes of
power sector investments. One hopes that the ticking clock of the potential time bomb of the
power sector can now be defused. It is worth noting that the accumulated losses of the state
power distribution companies (discoms) are estimated to be about ₹1.9 trillion as on
31st March, 2011.
Financial sector can remain robust with efforts to contain newer fragilities
India has stood out amongst its peers with an enviable record on financial stability. India's
gross non-performing assets (NPAs) of scheduled commercial banks as a percentage of
gross advances had declined from 12.7 per cent in 1990-91 to 2.4 per cent in 2010-11. In
case of public sector banks, this ration had dropped from 14.0 to 2.3 per cent over the same
period. However, during the recent economic downturn, there has been a sharp deterioration
in asset quality of the public sector banks (PSBs), as the ratio reversed to 3.2 per cent in
2011-12. While the NPA levels are still low by historical trends or cross-country comparison,
newer fragilities were obvious by the high slippage ratio and a spurt in restructuring loans.
The slippage ratio of the PSBs increased to 5.7 per cent of gross advances by at the end of
2011-12 from 4.2 per cent a year ago. The recovery also slowed down, especially in the
stressed sectors. While some of these changes reflect the NPA cycle that generally tracks
economic cycle, the sectoral bottlenecks also had a role to play in such deterioration.
There has been movement towards resolving the sector-specific issues, especially in power
and aviation. With gradual improvement in economic activity, the stress may be further
reduced across all sectors. This will bring back some of the strength of the bank balance
sheets that had got eroded in recent years. Unlike many other countries, India is a
bank-dominated financial system. Though the role of the financial markets has increased
over the year, the financing pattern of the corporates suggests that banks account for over a
fourth of total sources of funds for the corporates. As such, maintaining health of the banks is
important so that they can nurse recovery by credit expansion with the silver linings already
on the horizon. The ratio of bank credit to GDP in India is around 55 per cent, which is much
below what is prevalent in many advanced economies. Therefore, the challenge for Indian
banks is to facilitate the growth of the real sector through financial products and innovations
subject to adequate safeguards and adoption of sound risk management policies. In the
Indian context, foreign banks can potentially play a significant supplementing role of resource
mobilization to fund higher growth, apart from augmenting competition and efficiency among
the banks. For example, foreign banks still have a lot of leeway available for funding
infrastructure projects vis-à-vis the prescribed exposure limits. Further, given the higher
requirements of lending to the priority sectors under the revised policy framework, foreign
banks can bring in a lot of innovations and better practices and processes to lend to the
critical sectors of the economy like the SMEs and agriculture.
The Reserve Bank has been a conservative central bank that accords very high priority to
financial stability. It is for this reason that the Reserve Bank is focussed on the
implementation of the Basel III norms. It is also training its eyes on curbing increasing
slippage and withdrawing regulatory forbearance that supports it in a phased manner. Some
transitory sops to infrastructure loans in case genuine delays in commencement of
commercial operations are possible but these should be the exceptions rather than the norm.
Maintaining financial discipline is of paramount importance and this would certainly demand
higher accountability and sacrifice by the promoters. On Basel III, the Reserve Bank has
unveiled the broad course that the banks need to follow. With gradual improvements in
market conditions, capital raising options for the banks would steadily improve. It should be
possible for public sector banks (PSBs) to raise about ₹1.5 trillion of equity over the period of
a little over 5-years till the end of 2017-18. The shareholders' value locked in the PSBs need
to be tapped by innovative means. Stronger banks are in fact needed to support credit flows
for higher growth in the Indian economy.
Containment of twin deficits remains a challenge but within our realm
The impact of the recent governmental measures in reducing the fiscal deficit is not likely to
be very large. In effect the reduction in diesel and LPG subsidies would amount to marginal
fiscal correction in the current fiscal year. This underscores the importance of taking both
short term measures for moving closer to the budget targets as well as long term steps to
structurally correct the deficit, thus eventually lowering the fiscal dominance of monetary
policy. Recently, the Kelkar Committee has estimated that GFD/GDP ratio for 2012-13 could
slip by 1 percentage point to 6.1 per cent from the budgeted 5.1 per centif corrective
measures are not taken. It has also made several recommendations on fiscal consolidation
laying down a path to narrow it down to 5.2 per cent in 2012-13, 4.6 per cent in 2013-14 and
3.9 per cent in 2014-15, when the effective revenue deficit can be brought to zero. Improved
tax collection, asset sales, pruning of subsidies and rationalization of planned spending holds
the key to this path. Disinvestments, minority stake sales, higher PSU dividends, hiking urea
prices and widening services tax net are part of the recommended strategy. The bottom line
is that a workable path to fiscal consolidation is available - be it through the Kelkar
Committee or through the rolling targets set following the 13th Finance Commission. What is
important is to get there or at least very close to there through sustained efforts and not
become lax in face of political or electoral cycles. It is expected that the government would
take further aggressive steps to prevent fiscal slippage this year and complete its borrowing
programme broadly in line with what was envisaged and without any undue pressures in the
financial markets. This can make substantial contribution to keeping interest rates low and
reviving the economy. In fact, the recent announcement of the Central Government's
borrowing calendar for the second half of 2012-13, which sticks to the budgeted borrowing
figures reflect Government's resolve for containing the Gross Fiscal Deficit (GFD). It is,
however, imperative that further strong measures forfiscal corrections are implemented in the
rest of the year broadly in line with the Kelkar Committee recommendations. Recent
appreciation of the Rupee has, besides mitigating the risk of imported inflation, would also
greatly aid in containment of GFD by way of reduction in subsidy burden of the Government
arising out of high Rupee cost of imported oil.
The trends in the external sector are also showing signs of some improvement after
considerable stress witnessed last year. The CAD/GDP ratio declined to 3.9 per cent in Q1 of
2012-13 from 4.5 per cent in Q4 of 2011-12. While this is a positive development, it has
come about as imports contracted in face of growth slowdown and some benefits accrued
from exchange rate pass-through from rupee depreciation in 2011-12 and in the first quarter
this year. Macroeconomic and external sector policies would need to still factor in external
sector risks in the coming period, especially as event risks emanating from global
developments remain significant. Therefore, further efforts would be necessary to contain
CAD and bring it in line with its sustainable level of around 2.5 per cent of GDP. The recent
reform measures have brought about major change in global investor perception. These
investors are now willing to continue investing in India's long-term growth story. Another
silver lining is that India's net international investment position (NIIP) that reflects the net
claims of non-residents on India has improved with the decrease in these claims by
US$23.9 billion over the previous quarter to US$220.3 billion as at end-June. While this
largely reflects the valuation changes, augmentation of non-debt creating flows in the new
phase of economic reforms would certainly lower external financing risks, thus providing a
much needed cushion against our external sector pressures.
We need to convert the silver linings to our advantages
I would like to conclude by saying that India in the second half of 2012-13 is shaping as very
different from India in the first half. There are positives emerging across the horizon. This is
reflected in our currency movement that will bring further positive spin offs by lowering
inflation, fiscal deficit and reducing corporate stress. Growth could start improving into the
next year. Battle against inflation is, however, far from over and we need careful calibration
of monetary and non-monetary responses to tame it. Late revival of monsoon and steps
taken/being planned to improve the supply responses should moderate the inflationary
pressure overtime. Stronger fiscal measures on the path envisioned would pave the way for
sustained recovery. We have seen marginal improvement in CAD. This should not, however,
lull us into any complacency as the path to its sustainability requires several adjustments. It
is equally important that correctives now being put in place do not attenuate regulatory
prudence or deflect the focus away from long term sustainability of the external sector by
taking a short term view of the proposed solutions for improving capital flows.
The slew of measures in a short span need to be turned into a habit of well-paced action,
improved execution and governance and credible commitment without backtracking or
reversals. A more gradual-paced reforms earlier enabled us to achieve high growth path. In
the context of steps taken/planned for our reforms, one area where we need to focus
seriously is on communication, both internal and external. This should encompass
convincing our domestic constituency about the experience and benefits of reforms which
have to be carried forward for achieving the goals of inclusive growth by having a strong and
resilient macro-economy. It would also imply meaningful engagement with the international
rating agencies and investor class. There is no reason to believe that these would not work
though there are still many a bridge to cross to translate the intentions to deliverables on the
ground. The silver linings are now visible on the horizon. We need to build upon them and
implement our plans in the right earnest. The door of opportunity is again knocking at us.
These silver linings lifting the dark clouds are, however, not something as part of our destiny
but they are within our reach, if we work hard on them with all sincerity to convert them to our
long term advantages
Thank you all for giving me this opportunity to share some of my thoughts with you.