India - iuj.ac.jp€¦ · Country Report India December 2006 The Economist Intelligence Unit 26 Red...

Country Report

India

December 2006

The Economist Intelligence Unit 26 Red Lion Square London WC1R 4HQ United Kingdom

India at a glance: 2007-08

OVERVIEW The booming economy is likely to enable the Indian National Congress-led United Progressive Alliance (UPA) coalition government not only to remain in power until 2009 but also to relaunch its stalled programme of economic reforms. The government!s greatest opportunity to do this will be in 2007, as much of its agenda in 2008 will be given over to preparations for the next general election, which is scheduled to take place by May 2009. Monetary policy will continue to be tightened in the first half of 2007, but will be eased gradually thereafter. Real GDP growth is forecast to remain strong in fiscal year 2006/07 (April-March) and then to moderate slightly in 2007/08 and 2008/09. Strong domestic demand will lead to a significant widening of the merchandise trade deficit over the forecast period, but surpluses on the services and transfers accounts will limit the current-account deficit to less than 3% of GDP in 2007-08. Inflationary pressures will be difficult to control.

Key changes from last month

Political outlook • Following the state visit of the Chinese premier, Hu Jintao, to India on

November 21st-23rd, relations between the two neighbours are likely to be characterised by a greater degree of pragmatism. Disputes about the border will persist, but it is the trade of goods and services rather than struggles over territory that will preoccupy both countries.

Economic policy outlook • On November 29th the government caved in to political pressure and cut

the prices of petrol and diesel by 4.25% and 3% respectively. This move follows the softening of global oil prices since July, but it is still expected to push up the government!s fuel subsidy bill.

Economic forecast • Following the release of national-accounts data for the second quarter of

2006/07 that showed real GDP at factor cost rising by 9.2% year on year, the Economist Intelligence Unit has revised up its forecast for GDP growth at market prices in 2006/07 to 8.7% (from 8.4% previously).

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India 1

Country Report December 2006 www.eiu.com © The Economist Intelligence Unit Limited 2006

Contents

India

3 Summary

4 Political structure

5 Economic structure 5 Annual indicators 6 Quarterly indicators

7 Outlook for 2007-08 7 Political outlook 8 Economic policy outlook 10 Economic forecast

13 The political scene

18 Economic policy

26 The domestic economy 26 Economic trends 28 Employment, wages and prices 29 Financial indicators 31 Agriculture 32 Manufacturing 33 Infrastructure 34 Financial and other services

36 Foreign trade and payments

List of tables 10 International assumptions summary 10 Gross domestic product by expenditure 12 Forecast summary 22 Central government finances 24 Ease of doing business: India vs China 26 GDP growth by sector 31 Kharif (summer) harvest estimates 36 Merchandise trade 37 Balance of payments, national series 39 International investment position

2 India


List of figures 13 Gross domestic product 13 Consumer price inflation 27 Manufacturing output growth 29 Consumer price inflation 30 Exchange rate, 2006 30 Bombay Stock Exchange Sensex index 35 Telephone subscribers

India 3


India December 2006

Summary

The booming economy should enable the Indian National Congress-led government to undertake further economic reforms in 2007. The opposition Bharatiya Janata Party is in disarray, and the government is likely to remain in power until the next general election in 2009. Strong economic growth is set to continue, powered by the vibrant manufacturing and services sectors, at 8.7% in fiscal year 2006/07 (April-March) and 7.8% in 2007/08. Consumer price inflation is expected to ease from 6.1% in 2006 to 4.8% in 2008. The trade deficit will widen as consumer demand boosts the import bill.

The Congress-led government has proved remarkably stable, but it faces major challenges in terms of wider economic reform, the huge rural-urban income divide and the Maoist insurgency. The US Senate (upper house) approved the Indo-US nuclear deal in November. Campaigning for the state elections in Uttar Pradesh due in March 2007 has begun. A report on the low social and economic status of India�s Muslims spells trouble for the government.

The Reserve Bank of India (the central bank) has raised its overnight lending rate in response to concerns about domestic demand and inflationary pressures. A plan for capital account convertibility is being considered. The bank has acted to slow the investment rush into special economic zones. Fiscal targets for 2006/07 look increasingly ambitious. The ramifications of the Sixth Pay Commission could also the damage fiscal position.

The economy grew by 9.1% year on year in the first half of 2006/07, powered by strong growth in manufacturing and services. Industrial production figures indicate strong domestic consumption of both consumer durables and capital equipment. Wholesale price inflation reached a four-month high of 5.3% in early November. The stockmarket reached a record high in late November. The government estimates that US$320bn is needed to overcome infrastructure problems. Growth in telecommunications is set to continue, given India!s tele-density of only 16%. An emerging skills gap could slow the boom in technology.

India and Japan are set to strengthen their economic ties, and trade negotiations with the Association of South-East Asian Nations (ASEAN) are to resume. The current-account deficit grew to US$6.1bn in April-June. Foreign direct investment inflows could reach US$12bn in 2006/07. Overseas borrowing by Indian firms has risen sharply. Foreign reserves stood at US$163.6bn in mid-November.

Editors: Gerard Walsh (editor); Ravi Bhatia (consulting editor) Editorial closing date: December 4th 2006 All queries: Tel: (44.20) 7576 8000 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

Outlook for 2007-08

The political scene

Economic policy

The domestic economy

Foreign trade and payments

4 India


Political structure

Republic of India

Federal republic, with 29 states and six union territories

The president, currently Abdul Kalam, indirectly elected in 2002 for a five-year term by members of the central and state assemblies

The prime minister presides over a Council of Ministers chosen from elected members of parliament

Bicameral. The Rajya Sabha (the upper house) has 245 members"233 elected by weighted votes of the elected members of parliament and the legislative assemblies of states and union territories, and 12 appointed by the president. The Lok Sabha (the lower house) has 545 members"543 elected from single-member constituencies (79 seats are reserved for scheduled castes and 40 for scheduled tribes) and two representatives of Anglo-Indians appointed by the president

Unicameral or bicameral, with elected members; state governors are appointed by the president

Based on the 1950 constitution and English common law

The United Progressive Alliance (UPA), a coalition led by the Indian National Congress, gained the largest number of seats and formed a minority government, installing Manmohan Singh as prime minister. The UPA requires additional parliamentary backing in order to govern, and is currently supported by the Left Front, a group of left-wing parties dominated by the Communist Party of India (Marxist)

The last Lok Sabha election was completed on May 13th 2004; the next is due by May 2009

Indian National Congress; Bharatiya Janata Party (BJP); Communist Party of India (Marxist), or CPI (M); Samajwadi Party; Rashtriya Janata Dal (RJD); Bahujan Samaj Party (BSP); Dravida Munnetra Kazhagam (DMK); Shiv Sena; Biju Janata Dal (BJD); Communist Party of India; Nationalist Congress Party (NCP); Shiromani Akali Dal; Janata Dal (United)

Prime minister Manmohan Singh (Congress)

Agriculture, consumer affairs, food & public distribution Sharad Pawar (NCP) Commerce & industry Kamal Nath (Congress) Communications & information technology Dayanidhi Maran (DMK) Defence A K Antony (Congress) External affairs Pranab Mukherjee (Congress) Finance Palaniappan Chidambaram (Congress) Home affairs Shivraj Patil (Congress) Human resource development Arjun Singh (Congress) Parliamentary affairs, information & broadcasting Priya Ranjan Dasmunsi (Congress) Petroleum & natural gas Murli Deora (Congress) Power Sushil Kumar Shinde (Congress) Railways Laloo Prasad Yadav (RJD) Urban development Jaipal Reddy (Congress)

Yaga Venugopal Reddy

Official name

Form of state

Head of state

The executive

National legislature

State legislatures

Legal system

National government

National election

Main political organisations

Central bank governor

Key ministers

India 5


Economic structure

Annual indicators

2002a 2003a 2004 a 2005 a 2006b

GDP at market prices (Rs bn)c 24,497.4 27,602.2 31,214.1 35,314.5 39,771.8

GDP (US$ bn) 506.1 595.0 691.6 797.5 875.9

Real GDP growth (%)d 3.6 8.3 8.5 8.5 8.7

Consumer price inflation (av; %) 4.3 3.8 3.8 4.2 6.1

Population (m) 1,034.2 1,049.7 1,065.1 1,080.3 1,095.4

Exports of goods fob (US$ m) 51,153.0 60,895.0 77,939.0 102,213.0 119,396.6

Imports of goods fob (US$ m) -60,723.0 -75,537.0 -105,975.0 -149,414.0 -186,307.1

Current-account balance (US$ m) 7,061.0 8,773.0 781.0 -8,321.0 -15,006.2

Foreign-exchange reserves excl gold (US$ m) 67,666.0 98,938.0 126,593.0 131,924.0 161,794.8

Total external debt (US$ bn) 104.8 112.6 122.7 126.2 b 135.7

Debt-service ratio, paid (%) 14.8 18.6 13.4 13.4 b 7.9

Exchange rate (av) Rs:US$ 48.61 46.58 45.32 44.10 45.30

a Actual. b Economist Intelligence Unit estimates. c Fiscal year beginning April 1st of year indicated; seasonally adjusted; includes statistical discrepancy. d Fiscal year beginning April 1st of year indicated.

Origins of gross domestic product 2005a % of total Components of gross domestic product 2004a % of total

Agriculture 19.0 Private consumption 61.7

Industry 27.4 Government consumption 10.6

Manufacturing 15.9 Fixed investment 24.8

Services 53.6 Stockbuilding 0.3

Statistical discrepancy 0.0 Exports of goods & services 19.1

Imports of goods & services 16.3

Principal exports 2005ab US$ bn Principal imports 2005ab US$ bn

Engineering goods 20.9 Petroleum & petroleum products 26.2

Textiles & clothing 15.6 Capital goods 13.8

Gems & jewellery 15.1 Electronic goods 9.9

Petroleum and crude products 11.2 Gold & silver 8.4

Agriculture & allied products 9.9 Precious & semi-precious stones 6.9

Main destinations of exports 2005 % of total Main origins of imports 2005 % of total

US 19.1 China 7.3

China 9.4 US 6.5

UAE 8.4 Belgium 5.2

UK 4.9 Singapore 4.8

a Fiscal years beginning April 1st of year indicated. b Centre for Monitoring Indian Economy.

6 India


Quarterly indicators 2004 2005 2006 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 QtrGovernment finance (Rs bn) Revenue 942.1 1,359.3 390.7 880.7 970.3 1,334.0 537.3 1,117.5Expenditure 1,312.2 1,708.9 935.8 1,174.0 1,215.2 1,714.1 1,314.7 1,204.7Balance -370.0 -349.6 -545.2 -293.3 -244.9 -380.1 -777.4 -87.2Output GDP at constant 1998/99 prices (Rs bn)a 6,455.7 6,462.2 6,024.8 5,926.5 6,938.6 7,063.5 6,560.6 n/aGDP at constant 1998/99 prices (% change,

year on year) 7.0 8.6 8.5 8.4 7.5 9.3 8.9 n/aIndustrial production index (1993/94=100) 208.9 219.8 210.5 212.8 223.7 239.0 232.5 236.9Prices Consumer prices, industrial workers (2001=100) 113.2 113.5 114.1 116.6 118.9 119.0 121.3 124.3Consumer prices (% change, year on year) 4.2 4.2 4.0 3.7 5.0 4.9 6.3 6.6Wholesale prices (1993/94=100) General index 189.3 189.0 192.3 195.7 197.7 196.5 201.1 205.3Fuel 287.0 289.2 294.7 307.1 312.0 313.5 320.6 327.4Manufactured goods 167.4 168.2 170.6 171.3 172.3 171.5 174.7 177.7Financial indicators Exchange rate Rs:US$ (av) 44.96 43.71 43.60 43.69 45.40 44.40 45.47 46.37Exchange rate Rs:US$ (end-period) 43.58 43.76 43.52 43.99 45.07 44.69 45.09 45.96Bank rate (end-period; %) 6.00 6.00 6.00 6.00 6.00 6.00 6.00 6.00Lending rate (av; %) 10.75 10.75 10.75 10.75 10.75 10.75 11.08 n/aM1 (end-period; Rs bn) 6,067.7 6,139.2 6,437.8 6,786.9 7,213.2 7,718.3 7,708.2 n/aM1 (% change, year on year) 20.7 11.6 16.9 21.4 18.9 25.7 19.7 n/aM2 (end-period; Rs bn) 20,595 21,024 22,101 22,330 23,808 25,504 26,239 n/aM2 (% change, year on year) 16.7 12.7 14.1 13.1 15.6 21.3 18.7 n/aBSE Sensex (end-period; 1978/79=100) 6,603 6,493 7,194 8,634 9,398 11,280 10,609 12,454BSE Sensex (% change, year on year) 13.1 16.1 50.0 54.6 42.3 73.7 47.5 44.2

Sectoral trends Crude oil production (m barrels/day) 0.81 0.80 0.80 0.73 0.75 0.78 0.79 0.78Production index (1993/94=100) Manufacturing 219.2 231.5 220.6 225.6 236.9 253.7 245.3 253.1Mining 157.2 165.3 152.9 141.3 156.0 169.5 158.0 146.0Electricity 181.5 184.8 190.8 186.2 190.3 196.2 200.9 200.7

Foreign trade (US$ m) Exports fob 20,502 21,296 24,721 25,364 25,081 27,588 30,049 31,919Imports cif -27,475 -30,450 -36,808 -37,226 -35,004 -39,509 -41,471 -44,633Trade balance -6,973 -9,154 -12,087 -11,862 -9,923 -11,921 -11,422 -12,714Balance of payments (US$ m)b Merchandise trade balance fob-fob -11,767 -7,128 -13,604 -14,632 -11,837 -11,481 -18,484 n/aServices balance 3,463 6,117 5,372 6,139 4,432 6,322 7,575 n/aIncome balance -1,523 -1,188 -827 -1,542 -2,857 -373 -925 n/aNet transfer payments 4,073 6,305 5,503 4,990 6,436 7,347 5,735 n/aCurrent-account balance -5,754 4,106 -3,556 -5,045 -3,826 1,815 -6,099 n/aForeign reserves excl gold (end-period) 126,593 137,008 133,787 138,348 131,924 145,854 156,732 159,103

a At factor cost. b Reserve Bank of India.

Sources: Centre for Monitoring Indian Economy, Monthly Review of the Indian Economy; IMF, International Financial Statistics; International Energy Agency, Monthly Oil Market Report;

Financial Times; Reserve Bank of India.

India 7


Outlook for 2007-08

Political outlook

The booming economy is likely to empower the Indian National Congress-led United Progressive Alliance (UPA) coalition government to undertake further economic reforms in 2007, but its freedom of movement will continue to be constrained by the demands of its political allies. Although the mainly communist Left Front parties, which support the government but are not part of it, may dislike compromise on economic policy, they are enjoying the political clout that they currently possess and fear the potential return to power of the Hindu-nationalist Bharatiya Janata Party (BJP). This should allow Congress, which is now halfway through its five-year term of office, not only to remain in power until 2009 but also to relaunch its stalled programme of economic reforms. The government!s greatest opportunity to do this will be in 2007, as much of its agenda in 2008 will be given over to preparations for the next general election, which is scheduled to take place by May 2009.

State elections will be held in February 2007 in Punjab, Manipur, Uttaranchal and Uttar Pradesh, none of which is a Left Front stronghold. This could work to Congress!s advantage if it manages to make electoral gains, especially in Uttar Pradesh, India!s most populous state, where it could act as a spoiler in the battle between two regional parties, the Samajwadi Party (SP) and the Bahujan Samaj Party (BSP). In the last state election in Uttar Pradesh in 2002 the SP won 143 seats, the BSP 98, the BJP 88 and Congress 25. Congress is aiming to improve on its previous poor performance in the state by boosting the morale of its cadres, emphasising the UPA!s job-guarantee programme and capitalising on the popularity of the Congress and UPA leader, Sonia Gandhi.

The current chief minister of Uttar Pradesh is Mulayam Singh Yadav of the SP, which is in coalition with other caste-based parties and receives vital support from Congress at the state level. At the federal level the SP provides support to Mr Singh�s minority government from outside the ruling coalition. Despite this, there is deep-seated antagonism between the two parties. The state elections will be a litmus test for the political strength of Congress, and could shed light on the future of dynastic politics in India. Rahul Gandhi, Mrs Gandhi!s son, is widely expected to play a more high-profile role within the party. The state election could provide an indication of his intentions for the near future, although Mrs Gandhi has so far denied that her son will take on an enlarged role any time soon.

Meanwhile, the opposition BJP remains in disarray. The party!s internal politics is currently dominated by the issue of whether it should promote its core ideology (the view that India and Hinduism are intertwined and cannot be divorced from each other), thereby cementing the support of its main constituency, or whether it should instead aim to appeal to a wider spectrum of voters, competing with Congress for the secular vote.

The result of the next general election is likely to be another fractured mandate, and will depend on pre- and post-poll alliances. The BJP may benefit from an

Domestic politics

8 India


anti-incumbency vote, but neither the BJP nor Congress, nor the other "national" party, the Communist Party of India (Marxist), is likely to win a majority on its own. Government will thus continue to be conducted on a coalition basis. There are three potential groupings that could win power at the next election: a BJP-led or Congress-led coalition, or an alliance of left-wing and regional parties. Each combination, however, would contain a number of contradictions, ranging from personality clashes to divergent approaches to economic policy. The only possible scenario under which the Left Front might decide to force an early election is if it believed that a "third front", comprising left-wing and regional parties, could win power.

India!s relations with the US will continue to improve during the forecast period, and the country is likely to emerge as a vital US military and economic ally in coming years. A nuclear co-operation deal between the two countries was ratified by the Senate (the upper house of the US legislature) on November 17th, and now has only to be signed into law by the US president, George W Bush. This will alter the US!s long-held rigid stance on nuclear non-proliferation to India!s benefit. India has yet to gain approval from the Nuclear Suppliers Group (a multilateral anti-proliferation body) and to negotiate a safeguard agreement with the International Atomic Energy Agency, the UN nuclear watchdog, before trade in civilian nuclear material can begin. But India is steadily moving towards a massive expansion of its nuclear power sector, with plans to spend as much as US$40bn over the next 16 years on nuclear reactors from US and other companies.

India�s relations with China, historically troubled by territorial disputes, now increasingly influenced by trade and investment flows, have taken a small step forwards with the visit of the Chinese premier, Hu Jintao, to India in November. Relations between the two neighbours are likely to be characterised by a greater degree of pragmatism in the future, as their rapidly growing economies have made economic co-operation an attractive strategy for both. The border disagreements will persist, but it is the trade of goods and services rather than struggles over territory that will preoccupy both countries.

The peace process between India and Pakistan came to an abrupt halt after a major terrorist attack in Mumbai on July 11th. The Indian police have blamed Pakistan!s Inter-Services Intelligence agency and Lashkar-e-Taiba, a Pakistani-based group fighting against India!s presence in Kashmir, for the attacks, but peace talks between the two countries nevertheless resumed in mid-November. Relations are forecast to remain relatively constructive, and armed exchanges are likely to remain confined to border areas.

Economic policy outlook

A renewed effort to liberalise the economy in 2007 will be limited by the practicalities of coalition politics (particularly demands by the government!s Left Front allies) and by Congress!s focus on the rural sector. Despite the constraints faced by the ruling coalition, some bold measures are being considered. Mr Singh is particularly keen to push through labour market

International relations

Policy trends

India 9


reforms, liberalisation of the financial sector and capital account convertibility. Despite a difficult environment characterised by high international oil prices, volatile portfolio flows and inflationary pressures, the Reserve Bank of India (RBI, the central bank) will ensure that macroeconomic stability is maintained in 2007-08. The RBI is likely to tighten monetary policy a little further to damp down inflation, and will ensure that the exchange rate is managed so as to preserve India!s export-competitiveness, thereby providing a favourable environment for the private sector.

India!s consolidated fiscal deficit (comprising the combined deficits of the states and the central government) is currently equal to around 7.7% of GDP, with the level of public debt standing at around 52% of GDP. The policies required to reduce the fiscal deficit are politically difficult to implement, owing to the extensive social spending agenda of the centre-left government. A worrying debate is under way within government circles, with the Planning Commission (the government!s main planning and project-financing arm) arguing that fiscal targets should be subordinated to the country!s vast social spending needs. In addition, measures such as reducing subsidies, widening the tax net, cutting government employment and closing or privatising loss-making public-sector enterprises are all opposed by either the Left Front or powerful interest groups. The states are largely complacent about fiscal discipline, being aware that annual transfers to them from the centre are enshrined in India!s constitution and are thus largely guaranteed.

Nevertheless, strong economic growth helped to bring the federal budget deficit down to 4.1% of GDP in fiscal year 2005/06 (April-March). In 2006/07 the government has targeted a federal deficit of 3.8% of GDP, based on revenue assumptions that are looking increasingly ambitious. On balance, the Economist Intelligence Unit expects the budget deficit to overshoot the govern-ment!s target, to stand at 4.1% of GDP again in 2006/07. Despite further strong economic growth, the deficit is expected to average 4.2% of GDP in 2007/08-2008/09, reflecting political pressure to boost government spending in the run-up to the next general election.

The RBI will continue to tighten monetary policy in the first half of 2007, after which monetary conditions are forecast to ease gradually. On October 31st 2006 the RBI increased the repurchase (repo) rate"the interest rate at which it lends funds overnight to commercial banks"by 25 basis points to 7.25%, marking the seventh increase since the current tightening cycle began in October 2004. The central bank is anxious to prevent overheating, and should be able to keep wholesale price inflation within its 5-5.5% target range for the rest of 2006/07. However, consumer price inflation, which is not targeted by the central bank, will continue to be higher than wholesale price inflation during 2007. The RBI!s next move will probably be a 25-basis-point increase, to 6.25%, in the reverse repo rate"the interest rate that it uses to absorb funds from the banking system. This could happen before the central bank!s next official policy announcement on January 30th 2007.

Fiscal policy

Monetary policy

10 India


Economic forecast

International assumptions summary (% unless otherwise indicated)

2005 2006 2007 2008

GDP growth World 5.0 5.4 4.7 4.9

US 3.2 3.2 2.0 2.8

China 10.2 10.5 9.6 9.3

EU25 1.8 3.0 2.3 2.3

Exchange rates US$ effective (1990=100) 84.9 84.7 79.2 77.9

¥:US$ 110.1 116.2 105.0 97.5

US$:� 1.24 1.25 1.36 1.34

Financial indicators US$ 3-month commercial paper rate 3.38 5.05 4.92 5.04

¥ 2-month private bill rate 0.00 0.23 1.13 2.00

Commodity prices Oil (Brent; US$/b) 54.7 65.8 65.0 63.3

Gold (US$/troy oz) 445.0 604.3 673.8 650.0

Food, feedstuffs & beverages (% change in US$ terms) -0.5 13.3 -0.2 1.5

Industrial raw materials (% change in US$ terms) 10.2 51.1 1.5 -14.7

Note. Regional GDP growth rates weighted using purchasing power parity exchange rates.

Annual real GDP growth in the US, a vital market for India!s software and services exports, will slow to an average of 2.4% per year in 2007-08. A relatively low level of trade integration with the rest of the world protects the Indian economy from external demand shocks, and economic growth in India will be robust in 2007-08. However, high oil prices could threaten the economy. International oil prices (dated Brent Blend) are projected to average US$65/barrel in 2007 and then to fall to US$63.3/b in 2008, but there are a number of significant risks to this forecast that could lead to higher prices. On the demand side, global demand for oil could rise faster than currently forecast, especially in China, India and other emerging markets, while on the supply side there is the possibility of disruption in, for example, Iran or Saudi Arabia.

Gross domestic product by expenditure (Rs bn at constant 1999 prices where series are indicated; otherwise % change year on year; fiscal years beginning April 1st)

2005a 2006 a 2007b 2008b

Private consumption 17,004.2 18,552.1 19,901.5 21,261.4

6.6 9.1 7.3 6.8

Public consumption 3,091.0 3,307.3 3,538.8 3,768.9

8.0 7.0 7.0 6.5

Gross fixed investment 6,878.9 7,532.4 8,210.3 8,990.3

10.0 9.5 9.0 9.5

Final domestic demand 26,974.1 29,391.9 31,650.7 34,020.6

7.2 8.7 7.5 7.5

Stockbuilding 200.0 150.0 100.0 100.0

-0.3c -0.2 c -0.2c 0.0c

Total domestic demand 27,174.1 29,541.9 31,750.7 34,120.6

25.1 25.9 26.6 26.5

Economic growth

International assumptions

India 11


Gross domestic product by expenditure (Rs bn at constant 1999 prices where series are indicated; otherwise % change year on year; fiscal years beginning April 1st)

Exports of goods & services 6,239.7 7,441.5 8,530.8 9,693.0

22.1 19.3 14.6 13.6

Imports of goods & services 6,189.1 7,090.7 7,988.0 8,983.3

19.0 14.6 12.7 12.5

Foreign balanced 50.6 350.8 542.9 709.6

-1.2c 0.2 c 2.4c 2.3c

GDPd 28,342.7e 30,812.7 33,213.6 35,750.2

8.5e 8.7 7.8 7.6

a Economist Intelligence Unit estimates. b Economist Intelligence Unit forecasts. c Contribution to real GDP growth (as a percentage of real GDP in previous year). d Seasonally adjusted. e Actual.

India!s economic boom is set to continue. The latest data published by the Central Statistical Organisation, for the second quarter of 2006/07, indicate that real GDP grew by 9.2% year on year in July-September, following spectacular first-quarter growth of 8.9%. Real GDP growth (at market prices) in 2005/06 stood at 8.5%"the second-fastest rate of growth among the world!s 20 largest economies. Above-trend rates of growth in manufacturing and services should ensure that annual GDP growth peaks at 8.7% in 2006/07, before slowing moderately to 7.8% in 2007/08 and 7.6% in 2008/09. The main risks to this outlook are a poor monsoon in either 2007 or 2008, a rebound in global oil prices, a domestic stockmarket or asset-price crash, or an unexpectedly sharp economic downturn in the US.

The current economic boom should ensure that private consumption growth remains strong. Private consumption is forecast to increase by an annual average of 7.7% in 2006/07-2008/09. Private investment will be boosted by the boom in manufacturing and services. Capital inflows will keep liquidity high, and local companies will continue to reinvest profits. Government con-sumption is expected to grow by an annual average of around 6.8% in 2006/07-2008/09, reflecting the government!s generous spending plans. Growth in exports of goods and services will be supported by the strong performance of the information technology (IT) sector. Import growth will also continue at a rapid pace, driven by domestic demand growth, which will continue to suck in oil, intermediate inputs and raw materials as well as consumer goods.

In its latest review of macroeconomic and monetary developments, published at the end of October, the RBI explicitly mentioned for the first time that the economy was at risk of overheating. Consumer prices rose by 7.3% year on year in October, while in early November wholesale price inflation reached a four-month high of 5.3% year on year. Buoyant domestic demand will continue to fuel inflationary pressures. India is also facing rapid house price inflation, and the monetary measures that have been taken to date will not have their desired effect until 2007-08. As a consequence, although consumer price inflation is still forecast to slow in 2007-08, we have revised up our forecast for inflation to 6.1% (from 5.1% previously) in 2007 and 4.8% (4.4% previously) in 2008, following an estimated outturn of 6.1% (5.9% previously) in 2006.

Inflation

12 India


The rupee has been appreciating modestly against the US dollar since the beginning of September, and by early December had regained the losses that it experienced in the first half of the year. In early December the rupee was trading at Rs44.4:US$1, compared with its 2006 high of Rs44:US$1, reached in late January. We expect India to remain an attractive destination for foreign investment in the forecast period. In addition, Indian exports will grow strongly, supporting the rupee. However, the current account will stay in deficit, owing to the boom in imports. On balance, the rupee is forecast to depreciate gently from an estimated average of Rs45.3:US$1 in 2006 to Rs46:US$1 in 2007 and Rs46.5:US$1 in 2008.

India!s import boom has widened the current-account deficit to an estimated US$15bn (equal to 1.7% of GDP) in 2006. Firm domestic industrial activity (which will boost imports) and a gradual liberalisation of India!s trade regime will ensure that the deficit widens further during the forecast period, to US$26.5bn (2.7% of GDP) in 2007 and US$32bn (2.9% of GDP) in 2008. Merchandise exports will perform well, but buoyant consumer demand will also fuel rapid growth in goods imports. The net result will be a substantial widening of the trade deficit from an estimated US$66.9bn in 2006 to US$94.4bn in 2008. However, services exports will continue to grow strongly as IT and business-process outsourcing lure Western companies to India. Net current transfers will stay positive, driven by growth in remittances from Indian workers overseas.

Forecast summary (% unless otherwise indicated)

2005 a 2006 b 2007c 2008c

Real GDP growthd 8.5 8.7 7.8 7.6

Industrial production growthd 7.9 10.2 8.1 8.5

Unemployment rate (av) 8.1 b 7.6 7.2 6.8

Consumer price inflation (av) 4.2 6.1 6.1 4.8

Consumer price inflation (year-end) 5.6 6.6 5.4 4.8

Short-term interbank rate 10.8 11.2 11.8 10.8

Government balance (% of GDP)d -4.1 -4.1 -4.3 -4.1

Exports of goods fob (US$ bn) 102.2 119.4 139.3 160.6

Imports of goods fob (US$ bn) -149.4 -186.3 -223.2 -255.0

Current-account balance (US$ bn) -8.3 -15.0 -26.5 -32.0

Current-account balance (% of GDP) -1.0 -1.7 -2.7 -2.9

Total foreign debt (year-end; US$ bn) 126.2 b 135.7 147.9 156.8

Exchange rate Rs:US$ (av) 44.10 45.30 46.00 46.50

Exchange rate Rs:¥100 (av) 40.06 38.99 43.81 47.69

Exchange rate Rs:� (av) 54.89 56.75 62.45 62.19

Exchange rate Rs:SDR (av) 65.17 66.61 71.17 72.25

a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts. d Fiscal year beginning April 1st of year indicated.

Exchange rates

External sector

India 13


India (a) Asia excl Japan

Gross domestic product(% change, year on year)

India Asia excl Japan

Consumer price inflation(av; %)

(a) Fiscal years beginning April 1st.

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

20

02

03

04

05

06

07

08

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

20

02

03

04

05

06

07

08

The political scene

The United Progressive Alliance (UPA) government, led by the Indian National Congress, reached the mid-point of its five-year term in early November. The minority coalition government, which relies on support from the Left Front, a group of left-wing parties dominated by the Communist Party of India (Marxist), has proved more stable than most observers had expected and faces no immediate threats to its stability. The UPA government, led by the prime minister, Manmohan Singh, is one of the few since India�s independence to have survived for so long without encountering a crisis. However, the government faces serious challenges.

First, reforms with significance for the wider economy, including cutting waste-ful subsidies, privatising state-run enterprises, loosening tight labour market regulations and liberalising the retail sector, have been thwarted by the Left Front. More generally, economic reforms that require legislative approval have not materialised as a result.

Second, the huge divide between rural and urban India persists. The problem has been exacerbated by greater integration into the global economy that has brought higher incomes and better opportunities for the urban middle classes but few changes to the lives of the rural poor. The UPA government has increased expenditure directed towards rural dwellers, but given the size of the challenges any government in India is unlikely to be thought to be doing enough. Hundreds of distressed farmers have committed suicide in recent months. This has so far not posed a serious threat to government stability, largely because the main opposition Bharatiya Janata Party (BJP) remains in disarray. It has failed to capitalise on the issue of rural distress, owing both to its current political weakness and to its own questionable track record on addressing economic inequalities.

Third, large tracts of Indian territory are effectively not under the control of the government, but instead are dominated by a rapidly growing Maoist insurgency. The prime minister has identified this as the biggest threat to India�s security, but so far it has had a limited impact on politics at the centre.

The government is stable, but serious challenges remain

14 India


According to the South Asia Terrorism Portal (SATP), an organisation based in the capital, Delhi, that tracks terrorism in South Asia, the Maoist threat has overtaken all other insurgencies in India in terms of its geographical reach. The SATP notes that at least 165 districts in 14 of India�s states, out of a national total of 602 districts, were affected by Maoist activity and violence by end-2005. Another insurgency, in the north-eastern state of Assam, claimed several lives in November following the breakdown of peace talks between the government and the United Liberation Front of Assam (ULFA). ULFA�s fight for a separate homeland for Assamese people looks set to continue.

The government has so far been lucky in one respect: there has been no major outbreak of sectarian violence during its time in office. This has frequently been a potential source of instability in India, and the Gujarat riots of 2002 played an important role in the downfall of the BJP government in the May 2004 general election. But incidents in recent months suggest that this might be about to change. Home-grown Islamic extremism is a serious problem, but one that the government still vehemently denies. The government has not changed its view that the source of Islamic extremism lies outside India, namely in Pakistan. In the wake of the Mumbai bombings on July 11th the Indian authorities also suggested that the perpetrators might have used Bangladesh as a platform to carry out the attacks, but there is no conclusive evidence for this yet.

Focus on these challenges has been deflected to an extent by India�s fast economic growth and its accelerating integration into the global economy. In the last quarter for which data are available (July-September) the economy grew by 9.2% year on year (in real terms at factor cost)"the 13th consecutive quarter of growth above 7%. Merchandise trade flows have increased sharply, rising from US$100bn in 2001 to over US$300bn in 2006, while foreign investors have poured more than US$20bn into India�s capital markets since the UPA government came to power in 2004. Outward investment, until recently small or non-existent, has picked up dramatically. In the first three quarters of 2006 Indian companies made over 100 overseas acquisitions worth US$7.2bn"treble the 2004 figure. Although the UPA government can hardly claim full credit for these developments, it has certainly deflected attention from the minority government�s inability to push through reform. Under normal circumstances this weakness would almost certainly have led to the breakdown of an inherently unstable coalition.

India�s growing importance as an economic and political power has furthered the perception that the country is moving in the right direction. But there continues to be an almost complete disconnect between the rapid pace of growth of the private sector and the slower rate at which India liberalises its economy. The government�s target for economic growth during the Twelfth Plan (2007-12) is 9% a year, which critics claim is too high. Others point out that Mr Singh, as an economist, would not have agreed to an unattainable target. The evidence appears to support such an ambitious target. A respected economist, Surjit S Bhalla, argues in a paper to be published shortly by the Institute of International Economics, �The Middle Class Kingdoms of India and China�, that India�s investment to GDP ratio may have shot up in fiscal year 2006/07 (April-March) to levels that would be able to sustain such rapid

Fast growth deflects attention from the slow pace of reform

India 15


growth. The implications of this, if true, would be enormous. At 1980 growth rates incomes in India would have doubled every 50 years on average, making Indians twice as well off as their grandparents. By contrast, at a growth rate of 8% a year incomes double in less than a decade, making the country!s inhabitants 32 times as well off as their grandparents.

In October Mr Singh appointed Pranab Mukherjee, the number-two in the Congress party and until then defence minister, as minister for external affairs. For over a year the prime minister had also acted as foreign minister following the resignation of Natwar Singh in 2005 over his alleged role in the Iraq oil-for-food scandal. Mr Singh!s double act was strongly criticised by the opposition, but it also coincided, not by accident in view of some observers, with a period in which India laid the groundwork for a fundamental change in its relations with the US. Mr Mukherjee, a veteran Congress politician, who held the external affairs post more than 20 years ago under the premiership of Narasimha Rao, is reported to have been reluctant to take on the role. However, he was apparently the only candidate acceptable to both the prime minister and the Congress and UPA leader, Sonia Gandhi, the two people who wield the most power in India�s administration.

Mr Mukerjee takes charge of foreign affairs at a crucial time in Indian diplomacy. Relations with Pakistan have suffered since the Mumbai bombings in July. Indian police have made claims, so far unsubstantiated, that they have evidence that the attacks were the work of Pakistan!s Inter-Services Intelligence agency. The final shape of the US-India nuclear deal, the cornerstone of the administration�s foreign policy, is still uncertain. Yet Mr Mukerjee is perceived to be the right man to tackle both challenges. He is also likely to work on improving relations with India�s neighbours in the region, and on tackling the repercussions of the wars in Sri Lanka and Afghanistan as well as political instability in Nepal and Bangladesh.

Mr Mukerjee�s successor as defence minister is A K Antony, a former chief minister of the southern state of Kerala. Mr Antony is respected across party-lines, and has the reputation of being a �clean� politician. Other appointments in the October cabinet reshuffle included a film star-turned-politician, M H Amabaresh, who was made a junior minister for information and broadcasting. Mr Amabaresh represents the powerful Vokkalinga community in his native Karnataka state, which is currently ruled by the BJP in coalition with the Janata Dal (Secular) party. Another junior position, minister of state for water resources, went to Jai Prakash Yadav of Rashtriya Janata Dal, a Congress ally. Following the reshuffle, further opportunities to enter cabinet are unlikely to arise before the state elections in Punjab, Manipur, Uttaranchal and Uttar Pradesh in March 2007.

A report on the social, economic and educational status of India�s Muslims, released on November 17th, is likely to dominate the winter session of parlia-ment that began on November 22nd, as well as broader political debate. The findings of the report prepared by a panel headed by a former High Court chief justice, Rajindar Sachar, are alarming. The comprehensive study is the first in many years, and concludes that the Muslim community is �relatively poor,

The low status of India's Muslims spells trouble

The defence minister moves to external affairs

16 India


more illiterate, has lower access to education, lower representation in public- and private-sector jobs and lower availability of bank credit for self-employment� compared with the population generally. The UPA government had asked for the report to be prepared in March 2005, and the results will put pressure on the government to take action. According to the prime minister, the evidence provided in the report will allow the government to formulate policies to address the socio-economic backwardness of the Muslim community, with the aim �to strengthen our pluralistic ethos and build an inclusive society.�

The challenge is huge. The inequalities between India�s two main religious groups, Hindus and Muslims, in terms of social indicators are wide and long-standing. The fear is that these inequalities could fuel communal violence. The opposition has already made it clear that it will not tolerate any attempt on the part of Congress to �de-Hinduise� the country. The BJP is likely to try to exploit the issue and move closer to its core Hindutva (Hindu-nationalist) ideology. Such a step would probably mobilise its core voters, but would fail to appeal to the wider electorate whose support if needs in order to win elections. The timing of the report, only a few months ahead of crucial state election in Uttar Pradesh, is awkward for the government. If the government fails to act on the committee�s recommendations, such as special support programmes for the disadvantaged community, it could loose support in Uttar Pradesh to the Samajwadi Party, which currently runs a minority government in the state.

In October the government deferred the hanging of a Kashmiri Muslim, Mohammad Afzal, for his role in the attacks on the Indian parliament in 2001 that killed 14 people. India blamed the attacks"which brought India and Pakistan to the brink of war"on Jaish-e-Mohammed, a militant group based in the Indian state of Jammu and Kashmir that is fighting to end India!s rule in Kashmir. The case has raised questions regarding the investigation and legal process, as well as prompting debate about capital punishment in India. Mr Afzal�s hanging could have tremendous political repercussions. A mercy plea filed with the president, Abdul Kalam, has led the hanging to be deferred. In such cases the cabinet usually makes a recommendation to the president, who has the final say. The case puts the government in an awkward position. On the one hand, it is under pressure from the opposition and other quarters to be tough on terrorism. On the other, the ambiguity of the evidence, the severity of the punishment and the possible consequences for both communal harmony and the Kashmir question weigh against the hanging. India has not officially abolished capital punishment, but continues to apply the death penalty only in rare cases.

Dramatic developments are afoot on India�s 4,100-km border with Bangladesh. Construction of a steel fence along the border is scheduled to be completed in 2007 at a cost to India of over US$1bn. This little-publicised barrier will seal much of the world�s fifth-longest land border. The suspicion that militants based in Bangladesh were behind the Mumbai bombings in July has strengthened India�s resolve to speed up construction of the fence. India claims the barrier will address a number of security concerns regarding its poorer

India pursues a radical approach to border security

A death penalty that has divided India is deferred

India 17


neighbour: that Bangladesh is a haven for insurgent groups fighting Indian rule in the north-east; that Bangladesh is turning away from its secular, tolerant traditions towards Islamist extremism, and exporting terrorists in the process; and that illegal Bangladeshi migrants are changing the ethnic and religious character of Indian border areas. The fence is unlikely to alter the economics of migration along the border, however. Population pressure is so intense in Bangladesh (the country has an average population density three times that of India) and tickets out of rural misery so rare that the fence is unlikely to prove a major impediment to migration.

The fence in fact has more to do with a separate issue: India�s desire to define its fuzzy borders with its neighbours. Both countries have pledged to resolve all issues relating to the implementation of the Land Boundary Agreement of 1974, including demarcation of 6.5 km of the boundary and the exchange of disputed enclaves. In late October the Indian Border Security Force stepped up security along the border, as political turmoil erupted in Bangladesh when a caretaker government took over from the coalition between the Bangladesh Nationalist Party and its Islamic allies in preparation for a general election. For the time being, struggles over territory and terrorism, rather than trade in goods and services, will determine relations between India and Bangladesh.

The Indo-US nuclear deal that was signed in July 2005"and was seen to epitomise the new strategic relationship between the US and India"ran into problems in the wake of North Korea�s nuclear test in early October. The test has helped to strengthen the non-proliferation lobby, and the Indo-US nuclear deal could still lose momentum, particularly if new obstacles arise. The deal was perceived as the cornerstone of the Congress-led government�s new foreign policy towards the US. It would also overturn a three-decade ban on Indian access to nuclear equipment and fuel, both of which India needs urgently to meet its rapidly rising energy needs. In mid-November the US Senate (upper house) passed the controversial deal with an overwhelming majority. However, India has yet to gain approval from the Nuclear Suppliers Group (a multilateral anti-proliferation body) and to negotiate a safeguard agreement with the UN!s nuclear watchdog, the International Atomic Energy Agency, before trade in civilian nuclear materials can begin.

India and China have agreed to build on areas of common interest and avoid confrontation in areas of potential conflict. The state visit in late November by the Chinese premier, Hu Jintao, the first Chinese head of state to visit India in ten years, was uneventful, and the 13 agreements reached during the trip were marked by pragmatism. Probably the most important is the pledge to double trade to US$40bn by 2010, which is not particularly ambitious given how quickly trade between the two countries has grown in recent years. The agreement means different things to the two countries: China is seeking to improve market access for its manufactured goods, whereas India wants improved conditions to enable its booming information technology and services industry to invest in China. There was no progress on a free-trade agreement, border disputes, tension over Tibet or relations with Pakistan and the US.

Pragmatism defines new Indo-Chinese relations

The Indo-US nuclear deal edges closer to fruition

18 India


But relations between the two Asian rivals have come along ways since the Indo-Chinese border war in 1962. Even 30 years later, in 1992, China carried out test detonations of several nuclear weapons while the Indian president, R Venkataraman, was on a state visit to China. The episode illustrated that, for China, India had long been a second-tier power. But India is now a near-equal in terms of nuclear arms, and the two countries! large economies have made co-operation the most attractive strategy for both. The joint statement closing Mr Hu!s visit declared that the countries were not rivals or competitors but partners for mutual benefit. This is evidently not true, as India and China compete for natural resources and their companies compete for international business. But the purpose of Mr Hu�s trust-building mission was to signal that China was ready to work with India. The two sides agreed to co-operate in the field of civil nuclear energy. The Chinese leadership also defused Indian fears that China might divert rivers on the Tibetan plateau that would have cut off crucial water supplies to India.

Territorial disputes are still at the heart of bilateral difficulties, although some progress has been made. In 2005 India recognised Tibet as part of China. In return the Chinese gave up their long-standing territorial claim to the Indian state of Sikkim. China still claims India�s most north-easterly state, Arunachal Pradesh, as its own. India meanwhile claims Aksai Chin, a region located at the meeting point of China, Pakistan and India and administered by China. But in China�s eyes� the gravest threat posed by India relates to Tibet, which could gravitate towards India in the event of internal disarray in China. India harbours the former leader of Tibet, the Dalai Lama, and about 100,000 Tibetans. For India, Mr Hu�s subsequent visit to Pakistan immediately following his trip to India served as a reminder that China continues to pursue a balance-of-power approach in the region. Pakistan will remain China�s largest aid beneficiary and a recipient of Chinese missile and nuclear technology. India dislikes China�s continued support of Pakistan in these areas, just as the Chinese are suspicious of India�s closer relationship with the US.

Economic policy

On October 31st the Reserve Bank of India (RBI, the central bank) increased its repurchase (repo) rate, the interest rate at which it lends funds to banks overnight, by 25 basis points to 7.25%. This was the fourth rise this year, and indicates the RBI�s concern about rising inflation and domestic demand pressures. Several years of cheap money have fuelled asset price inflation, greater consumption and higher levels of personal debt. The reverse repo rate (the rate at which the RBI borrows from commercial banks), the bank rate and the cash reserve ratio were left unchanged. The RBI now expects that liquidity in the banking sector will be tight and that commercial banks are more likely to borrow from the RBI than to lend to it in the near future. Interest rates are at a four-year high, but will have to rise further to contain the inflationary pressures present in the economy.

According to the RBI�s mid-term review of its annual policy statement for fiscal year 2006/07 (April-March), released on October 31st, there is no clear evidence

The RBI raises interest rates in response to inflation concerns

India 19


that the Indian economy is overheating. The RBI said that it would continue to monitor closely domestic demand, which has been fuelled by a rapid rise in consumer and government spending. The bank said that domestic demand pressures from both government and consumers would remain of concern to it, particularly as India�s plan to spend a total of over US$300bn by 2012 on upgrading infrastructure, the economy�s main supply-side constraint, would keep upward pressure on public spending in the medium term. Of less concern to the RBI are �transient� supply constraints in primary commodities, and bottlenecks caused by rising demand for oil, steel, coal and cement.

The latest rise in the repo rate was also aimed at curbing rapid credit expansion in the housing and retail sectors. Although commercial banks will now pass on the rate rise to consumers, growth in commercial bank lending to consumers is likely to continue at the near-record pace of 30% a year. The RBI has also admitted that growth in monetary and credit aggregates in 2006/07 will be higher than initially thought. The central bank revised up its GDP growth forecast for 2006/07 from 7.5% to 8% in its mid-term review, and the interest-rate rise is unlikely to dampen this pace of growth. However, the bank!s hawkish policy statement in the review and expectations of rising borrowing costs should go some way towards containing inflationary expectations. The RBI expects wholesale price inflation to remain at 5-5.5% in 2006/07.

The panel examining progress towards full capital account convertibility has presented a five-year plan. The rupee is currently convertible for the purposes of trade, but restrictions on capital outflows and inflows remain in place. The committee, chaired by a former central bank deputy governor, S S Tarapore, has proposed a three-phase implementation of measures towards fuller capital account convertibility in 2006-07 (phase I), 2007-09 (phase II) and 2009-11 (phase III). The report was released in September, and is now being studied by the RBI. The proposed phased implementation of convertibility has disappointed those who had hoped that India would liberalise its capital account fully in the near future.

The Tarapore committee's recommendations for capital account liberalisation

• The ceiling for external commercial borrowing (ECB) to be raised in three phases. In the first phase (2006-07) borrowers eligible for ECB to be able to access an additional US$250m with an average maturity of more than ten years with approval from the Reserve Bank of India (RBI, the central bank).

• The investment limit for foreign institutional investors (FIIs) in government bonds to be raised in three phases to 6%, 8% and 10% of total gross issuance by central and state governments in one year.

• The investment limit for FIIs in corporate bonds to be increased to 15% of new issuance in phase II and 25% in phase III.

• A ban on participatory notes for FIIs. • Limits for borrowing overseas by banks to be linked to paid-up capital and free

reserves, and raised to 50% in phase I, 75% in phase II and 100% in phase III. • Limits for corporate investments abroad to be raised to 400% of net worth, from

200% at present.

A plan for full capital account convertibility is presented

20 India


• Limits on individual remittances abroad to be raised to US$50,000 in phase I, US$100,000 in phase II and US$200,000 in phase III.

• The overall ceilings on mutual funds� overseas investments to be raised to US$3bn in phase I, US$4bn in phase II and US$5bn in phase III.

• Foreign institutions and companies to be allowed to raise rupee bonds, subject to a ceiling.

• Non-residents (other than non-resident Indians) to be allowed access to foreign-currency non-resident bank and non-resident (external) rupee account deposits.

• All individual non-residents and non-resident companies to be allowed to invest in the Indian stockmarket through entities registered with the Security and Exchange Board of India.

• A monitoring band of 5% around the rupee�s real effective exchange rate.

The report has been criticised by some as a �guide to manufacturing a financial crisis� rather than a road map towards rupee convertibility. Two recom-mendations have drawn particularly heavy criticism, from some of the committee!s members among others. The first is the recommendation of a 5% monitoring band around the rupee�s real effective exchange rate (REER) that the RBI would defend by intervention in the currency market as and when the REER moved outside the band. One of the dissenters on the panel, a prominent economist, Surjit S Bhalla, warned that fixing the exchange rate in this way would be a gift to speculators. The recommendation goes against the economic theory that a country cannot have an open capital account, an independent monetary policy and a fixed exchange rate"the so-called impossible trinity. In its report, the panel appears to be suggesting that the "trinity" need not apply in practice if prudent policies are in place. Whatever the merits of the argument, as India�s capital account opens up, holding on to a semi-fixed exchange rate has a price: the abandonment of an independent monetary policy. Critics argue that relinquishing the ability to influence the business cycle by setting domestic interest rates, particularly given the importance of domestic demand, would not be a wise move.

The second of the committee!s recommendations that has proved controversial is the proposed ban on participatory notes (PNs), which are derivative instruments through which foreign investors trade in Indian shares. PNs account for nearly one-half of the foreign investment in the stockmarket, mainly through hedge funds. The recommendation appeases regulators, who are suspicious of these investments because the original investor remains anonymous. But the concern is that cutting off this source of funds could lead to a stockmarket crash. The RBI is unlikely to accept such a measure, but will probably examine ways of gradually allowing individual foreigners and hedge funds to buy Indian shares directly, thereby limiting the role of the controversial PNs.

Whichever path India eventually chooses towards fuller capital account convertibility, there are benefits of doing so beyond India�s need to supplement domestic savings and finance its rapid economic growth. This is the thinking behind a recent IMF paper, Financial Globalisation: A Reappraisal, which concludes that the more important benefits of capital account convertibility for countries such as India and China are the indirect or collateral benefits: the

India 21


discipline imposed on economies by unfettered capital flows contributes to a healthier banking sector, stronger capital markets and improved macro-economic policymaking. By freeing the rupee from capital controls, India could give itself the opportunity to turn Mumbai into an Asian financial centre. However, as long as India�s fiscal situation remains as weak as it is at present, a move towards fewer capital controls seems premature, particularly given the prospect of capital flight. Dismantling India�s strict capital controls is attractive and probably inevitable in the long run, but, as in other areas of Indian politics, gradualism is the order of the day.

The investment rush into India�s special economic zones (SEZs) has prompted the RBI to raise the cost of lending to them. The fear is that there may be overinvestment in SEZs, which are business locations for which the govern-ment offers tax incentives and in which India�s stifling labour laws do not apply. On September 20th the RBI stated that, with immediate effect, the exposure of commercial banks to entities for the purpose of setting up SEZs or for acquisition of units in SEZs would be treated as exposure to the commercial real-estate sector. Under current regulations, lending to infrastructure projects carries a risk weight of 100%, while lending to real-estate projects has a risk-weight of 150%. The RBI�s decision to treat SEZs as commercial real-estate projects also implies that they will not enjoy the benefits provided to infrastructure projects.

The RBI�s decision will help to limit the exposure of commercial banks to SEZs, but will also lead to increased borrowing costs for these projects as banks make higher provisions for such lending. However, considerations beyond bank exposure appear to have motivated the RBI. In its annual report, released in August, the central bank had already raised the concern that the SEZ scheme could foster uneven economic development across the country. But the real reason for the RBI�s move could be its fear that some SEZs are nothing but huge land swindles, a charge that the Ministry of Commerce has denied. As of November 23rd the federal government had sanctioned 164 SEZ proposals. These will require 26,800 ha of land. About 266 further proposals, requiring 75,000 ha of land, are under consideration. However, around one-half of the proposed SEZs cover an area of less than 1 sq km, and, according to research by Morgan Stanley, an investment bank, many of them are not commercially viable. This has only added to the suspicion that some smaller SEZs, rather than advancing India�s export-competitiveness, are merely cases of land-grabbing. A better solution, in Morgan Stanley�s view, would be to establish large SEZs in key states.

A wider debate is now taking place on whether the government�s plan of putting economic development on a fast track through SEZs is the right approach. The commerce minister, Kamal Nath, is under pressure to rethink the government!s SEZ strategy. Supporters think that the Chinese-style zones, which allow export-oriented businesses to operate free from tariffs and India�s notoriously rigid labour laws, should be central to developing the country!s comparatively small manufacturing sector. The Ministry of Commerce, for its part, argues that SEZs will return Rs1trn (US$22.3bn) in investment and will

The central bank makes lending to SEZs costlier

Debate about the role of SEZs in the economy intensifies

22 India


create 500,000 jobs over the next few years. However, the charge is gaining credence that as a development strategy the SEZ scheme will work only in the case of very large SEZs, as in China.

The Ministry of Finance is also concerned about the estimated loss of Rs900bn (US$20bn) in tax revenue as a result of tax concessions extended to SEZs. The government has come in for criticism for being too generous with such incentives. Under the 2005 SEZ legislation and guidelines released earlier this year, SEZ developers earn tax-free profits for ten years, while tenants enjoy a five-year tax holiday. The chief economist of the IMF, Rajan Raghuram, highlighted the consequences of these tax incentives for India�s weak fiscal position, when he described the current SEZ scheme as yet another give-away that the government could not afford. A further problem is that the subsidies granted could trigger retaliatory measures under World Trade Organisation rules. Meanwhile, the mainly communist Left Front parties, which support the Indian National Congress-led government in parliament, want more com-pensation for farmers who give up their land, and the Congress leader, Sonia Gandhi, has also said that farmers� interests have to be safeguarded.

The government claimed in October that it would meet its fiscal targets in 2006/07. However, data for the first five months of the fiscal year released by the Controller General of Accounts suggest that the government!s targets of a fiscal deficit of 3.8% of GDP and a revenue deficit of 2.1% might be ambitious. The federal government�s revenue deficit (the difference between unproductive revenue spending and revenue receipts) reached 93.7% of the full-year budget target in April-August, compared with 72.3% in the corresponding period of 2005/06. The fiscal deficit for the first five months of 2006/07 stands at an estimated 61% of the budget target, up from 51.3% a year earlier. The finance ministry attributes the trend to increased distribution of taxes to the states and grants from the centre to the states"estimated at Rs117.3bn during April-August"and to the front-loading of expenditure.

Central government finances (Rs bn; fiscal years Apr-Mar)

Budget estimate 2005/06 2006/07 2006/07 Apr-Aug Apr-Aug % changeTotal receipts 5,640 1,708 2,004 17.4 Revenue receipts 4,035 812 1,066 31.3 Tax 3,272 585 814 39.3 Non-tax 763 227 251 10.7 Capital receipts 1,605 896 939 4.8Total expenditure 5,640 1,708 2,004 17.4 Non-plan 3,913 1,235 1,465 18.7 Plan 1,727 473 539 13.9Revenue deficit 847 744 794 6.8Fiscal deficit 1,487 863 907 5.0

Source: Ministry of Finance.

Whatever the dynamics behind the figures, fiscal consolidation does not seem to be one of the government�s priorities. It is doubtful that the government will now achieve the targets set in the Fiscal Responsibility and Budget Management

The fiscal targets for 2006/07 look increasingly ambitious

India 23


Act, which obliges the government to eliminate its revenue deficit and reduce its fiscal deficit to 3% of GDP by 2009. Even if it were to hit these targets, the government would still not be in a position to reduce its debt stock. The upward pressure that India�s public debt exerts on interest rates is unlikely to diminish, and interest rates are set to rise for cyclical reasons. Interest costs now account for one-third of government revenue and one-fifth of expenditure. A new study by Morgan Stanley confirms the Economist Intelligence Unit�s long-standing view that India�s poor public finances are the main obstacle to achieving annual GDP growth of 8-10% on a sustainable basis. Morgan Stanley maintains that the current loose fiscal stance has helped to speed up economic growth. However, while high capital inflows have so far limited the upward pressure on real domestic interest rates, they will not do so forever, and the government will need at some point to adopt a more austere fiscal stance.

If the past is any guide, the Sixth Pay Commission, which is due to make its recommendations in 2007, will have a significant impact on the economy. The commission�s job is to set pay rates for government employees, but its decisions have a wide-ranging impact, particularly at the state level. Over three years in the late 1990s the Fifth Pay Commission raised the salaries of government employees by an annual average of 19% a year, while pensions rose by an average of 32% a year for three consecutive years. As a result, the value added in the public administration and defence category within the national accounts rose by 14.5%, 10.3% and 13.2% a year in real terms in 1997/98, 1998/99 and 1999/2000 respectively, up from an average of less than 4% a year in the previous five years. The pay rise recommended by the Fifth Pay Commission contributed to a sharp deterioration in India�s fiscal position.

India�s largest credit-rating agency, Crisil, believes that the recommendations of the Sixth Pay Commission could lead to a similar fiscal deterioration between 2009/10 and 2011/12. Crisil estimates that the aggregate increase in salary and pension expenditure for state governments (which generally follow pay rises at the federal level) over the three years would be a staggering US$38bn. By the end of this period the aggregate primary deficits of 21 large Indian states would have risen to an estimated 3.1% of aggregate state GDP. This is three times the level targeted by the Twelfth Finance Commission (TFC, the body appointed to make recommendations on central and state government finance), and higher than the figure of 2.6% of aggregate state GDP at the end of the period of fiscal deterioration in 1999/2000. The estimates assume that state governments will implement the recommendations of the TFC with effect from April 2009, and that the scale of the pay rises will be in line with the Fifth Pay Commission. Crisil cautions that the introduction of higher government wages without identifying new revenue sources to compensate for these expenditure increases could further undermine the fiscal position of India�s states, which already account for around one-half of the country�s total deficit.

India�s business environment is now the best in South Asia. This is according to the latest edition of Doing Business, an annual report produced by the World Bank, which provides a global ranking of 175 economies based on the ease of doing business and the progress of reforms. However, India is ranked 134th in

The Sixth Pay Commission will damage the fiscal outlook

India�s business environment ranks 134 in the world

24 India


the world, 41 places behind China, which is reforming at a faster pace. In terms of reform, India has taken over the top spot in South Asian from Pakistan, with the implementation of a number of reforms. In the past year India has simplified business registration, cutting the time required to set up a business from 71 to 25 days. Tax payment has been simplified, and the corporate income tax rate has been reduced from 36.6% to 33.7%. In addition, a Supreme Court decision to simplify the rules governing loan collateral has helped to ease access to credit, import and export times have fallen following the introduction of new risk-management procedures in customs, and investor protection has improved following reforms to stock-exchange rules. Nevertheless, compared with progress in China the speed of reform in India has been slow.

In the global rankings India surpasses China on measures such as investor protection, obtaining credit and starting a business, but lags behind on registering property, openness to trade and the ease of employing workers. According to the report, there are only two countries in the world, Bangladesh and Timor-Leste, where it is more difficult to enforce a contract. It is important to bear in mind, however, that the report deals in averages, and that huge differences exist between the various Indian states.

Ease of doing business: India vs China India China

2006 rank

2005 rank

Change in rank

2006 rank

2005 rank

Change in rank

Overall ranking 134 138 4 93 108 15Protecting investors 33 33 0 83 114 31

Getting credit 65 96 31 101 117 16Starting a business 88 102 14 128 141 13

Registering property 110 108 -2 21 21 0Employing workers 112 113 1 78 77 -1Closing a business 133 128 -5 75 69 -6

Trading across borders 139 139 0 38 35 -3Dealing with licences 155 154 -1 153 151 -2

Paying taxes 158 159 1 168 169 1Enforcing contracts 173 173 0 63 59 -4

Note. The survey ranks 175 economies on their ease of doing business, from 1 to 175, with first place being the best.

Source: World Bank, Doing Business in 2007.

The government has made the employment of children under the age of 14 as domestic servants a criminal offence. The amendment to India�s Child Labour Act, which was passed in 1986, came into effect on October 12th 2006, although it is unclear how the ban will be enforced or whether it will make any difference in practice. According to the government, there are 13m child workers in India, but non-governmental organisations put the figure closer to 40m. It is not known how many children work in households, but child labour is common, particularly in India�s middle-class households. The measure has been criticised for not addressing the causes of the problem (child poverty and limited educational opportunities for children) and for not going far enough (children over 14 years of age are not protected by the law). The ban also provides an opportunity for bribes to those responsible for enforcing the new

The government bans child labour in domestic service

India 25


law in exchange for turning a blind eye to violations. The government plans to make it mandatory for its employees to confirm their compliance with the new law each year. Despite the law�s shortcomings it is an important step, making child labour, often viewed as acceptable in a country where one-third of the population lives on less than US$1 a day, illegal.

India and Mauritius are reported to be reviewing their double-taxation avoidance treaty in an effort to stop tax fraud by companies that register in Mauritius to escape the tax net. Under the current treaty, a company resident in Mauritius selling shares in an Indian company does not pay tax in India. As there is no capital-gains tax in Mauritius, the gain escapes taxation altogether. Consequently the tax haven has become the largest foreign direct investor in India, although the funds rarely originate in Mauritius. India now wants to restrict the tax benefits to companies that have invested beyond a certain threshold in Mauritius and have had a presence in the country for a considerable time.

Meanwhile, a proposed preferential trade agreement (PTA) with the island nation is due to be signed when the president of Mauritius, Anerood Jugnauth, visits India in December. The agreement covers tariff concessions on around 200 export items from India and 80 export items from Mauritius to India. Indian exports to Mauritius were worth Rs6.9bn in 2004, while Mauritian exports to India touched Rs500m (US$11m). Under the agreement tariffs will be reduced or eliminated, depending on the product, over a four-year period. In parallel talks, the two countries are also negotiating a comprehensive economic co-operation and partnership agreement. Mauritius has agreed to provide concessions to Indian investments in key sectors such as education, tourism, information technology and biotechnology.

One of the most daunting challenges for the government is to deal with the economic inequalities"between both people and states"that have been heightened rather than diminished by fast economic growth. A report by the National Sample Survey Organisation reveals that India�s rapid economic growth has failed to reduce poverty as fast as observers and policymakers had hoped. The number of people living below the poverty line declined from 26.1% of the total population in 1999/2000 to 22.2% in 2004/05. However, given rapid population growth, the absolute number of people in poverty has not fallen. (For the purposes of the study, people consuming less than 2,100 calories of food per day in urban areas and 2,400 calories per day in rural areas are classed as living below the poverty line).

The report indicates that poverty has declined most sharply in India�s poorer states. Poverty in India has fallen more rapidly in rural than in urban areas, although migration to the cities may overstate both the reduction in poverty in rural areas and poverty�s persistence in Indian cities. Migration from states such as Bihar, Uttar Pradesh and Jharkhand to relatively prosperous states such as Haryana, Maharashtra, Delhi and Goa is partly responsible for a decrease in the number of people living below the poverty line in the former states.

India and Mauritius review their tax treaty

Fast economic growth fails to dent poverty across India

26 India


The government is under pressure to address unequal economic development between states, particularly in view of growing problems with internal security. In Orissa, for example, nearly 40% of the population lives below the poverty line, and in some areas of this mineral-rich state the government has lost control to Maoist insurgents. The government�s concern is that, despite ploughing funds into public work programmes and the rural sector, poverty in India is too intractable for this to make a difference.

The domestic economy

Economic trends

Year-on-year GDP growth has been above 8% in six of the past seven quarters, and in the first half of fiscal year 2006/07 (April-March) it reached 9.1%, the fastest pace since economic liberalisation began in 1991. GDP growth at factor cost accelerated to 9.2% year on year in the second quarter (July-September) of 2006/07, from 8.9% in the three months to June. This was led by an 11.9% expansion in manufacturing, the fastest pace of growth since the current series began in 1997. Output of trade, hotels, transport and communication rose to a two-and-a-half-year high of 13.9%. The construction and utilities sectors also reported stronger growth, at 9.8% and 7.7% respectively, in the second quarter of 2006/07, compared with 9.5% and 5.4% in the first. By contrast, agricultural output rose by 1.7%, the slowest pace in 18 months.

GDP growth by sector (1999/2000 prices; % change year on year unless otherwise indicated)

2005/06 2006 (% of GDP) Apr-Jun Jul-SepAgriculture, forestry & fishing 19.0 3.4 1.7Mining & quarrying 2.6 3.4 3.1

Construction 6.8 9.5 9.8Electricity, gas & water supply 2.1 5.4 7.7Manufacturing 15.9 11.3 11.9

Trade, hotels, transport & communications 24.9 13.2 13.9Finance, insurance, real estate & business services 14.5 8.9 9.5

Community, social & personal services 14.3 7.4 6.9GDP at factor cost 100.0 8.9 9.2

Source: Central Statistical Office.

The latest national-accounts data have fuelled the debate over the sustainability of such rapid economic growth. India�s finance minister, Palaniappan Chidambaram, believes that there has been a �step change� in the economy. However, critics allege that the country�s current pace of economic growth is a case of irrational exuberance that is cyclical in nature and is driven by a consumption boom that relies on easy money. They also say that the jump in economic growth, from an average of 6% a year in the 1990s, hides the economy�s structural deficiencies and the inequalities that this rapid economic expansion creates. The fear is that the longer the good times last the less the

Economic growth races ahead in the first half of 2006/07

India 27


government will do to carry out further necessary reforms, including freeing the labour market from excessive regulation and reforming the public sector.

The acceleration of economic growth in India recently has also generated upbeat assessments that Asia!s second-largest emerging market is finally becoming as dynamic as China, but has also brought warnings that the economy is overheating. However, there are crucial differences from the picture in China. In India inflation has nearly doubled in the past 12 months, the equity and housing markets look overbought and the current account has moved sharply into deficit. Besides interest-rate increases by the Reserve Bank of India (RBI, the central bank), little is being done by the government to orchestrate a soft landing.

The latest industrial production data confirm that rising economic activity has been driven by strong domestic consumption and capital investment. Industrial production accelerated to 10.9% year-on-year in April-September, the fastest growth since 1995/96. The output of consumer durables (which accounts for a 5.4% share of the industrial production index) rose by over 15.9% year on year in April-September, while output of non-durable consumer goods (which make up a 23.3% share of the index) increased by 10.1%. The industrial production figures reveal that investment remains strong. The output of capital goods (with a 9.3% share of the index) rose by 15.2% year on year in April-September. In the same period basic goods output (a 35.6% share of the index) rose by 8.8% year on year and intermediate goods (a 26.5% share) by 10.8%.

Manufacturing output growth(% change, year on year; real terms)

Source: Economist Intelligence Unit.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

Q3Q2Q106

Q4Q3Q2Q105

Q4Q3Q2Q104

Q4Q3Q2Q103

Q4Q3Q2Q102

Q4Q3Q2Q101

Q4Q3Q2Q12000

India�s annual industrial output growth accelerated to 11.4% year on year in September from 9.9% in August, as manufacturing production picked up by 12% following an 11.2% gain a month earlier. Most of the sectors tracked by the industrial production index turned in a stronger performance in September; the beverages and tobacco sector and the basic metals and alloys sector reported the joint strongest rate of growth, at 19.8% year on year. This was followed by a 19.6% increase in output of wood and wood products. Textiles production lost some momentum, expanding by only 5.6% after 11.2% growth in August. Output growth for machinery and equipment slowed to 11.6%, from 20.3% a month earlier, while production in other manufacturing fell by 10.9%"the first such decline in three years.

Strong consumption underpins healthy industrial output

28 India


Employment, wages and prices

The National Sample Survey Organisation (NSSO) published its seventh survey of the employment situation in India on September 29th. The survey is released every five years, and provides information on the dynamics of India�s huge labour market, with information on households and population, labour force, workforce, unemployment, underemployment and labour mobility in 2004/05. The estimates are based on a survey sample of about 125,000 households in 8,000 villages and 4,600 urban residential areas across India. The results provide support for the contention that India�s demographic dividend will not materialise unless there is large-scale investment to raise the quality and quantity of education across the country. In addition, female participation in the workforce needs to rise if the country is to capitalise on the demographic changes taking place. Unlike the case with men, tickets out of rural misery for women are rare. The proportion of male workers engaged in agricultural activities declined gradually from 81% in 1977/78 to 67% in 2004/05. By contrast, the proportion of women doing agricultural work dropped by only 5 percentage points, from 88% to 83%, during the same period. The poor quality of education and limited access to it remain the main stumbling blocks. In over one-quarter of rural households (compared with 8% of urban ones) not a single household member can read or write even a simple message. Literacy rates are still very low, at 64% for men and 45% for women, in rural areas. Urban literacy rates are higher, but still fall short of the average literacy rate for the whole population in China.

Yet the survey indicates that some progress has been made. In the period 1999/2000-2004/05 labour force participation rates in rural India increased by nearly 2% for men and about 3% for women. In urban areas labour force participation increased by about 3% for both sexes, although it remains low. About 56% of men and 33% of women in rural areas belonged to the labour force (comprising employed and unemployed persons), compared with 57% and 18%, respectively, in urban areas. In 2004/05 the unemployment rate, measured as the number of unemployed per 1,000 persons in the labour force, stood at 17 in rural and 45 in urban areas. The unemployment rate for women was higher than that for men, and highest among urban women. A further problem is underemployment. About 42% of the population was found to be �usually employed", but the reality is that even this portion of the labour force looks for additional work. The challenge of integrating millions of new entrants into the labour force every year is huge. The prime minister, Manmohan Singh, announced in October that the government�s aim was to create 70m jobs in the next five years. These jobs will largely have to be generated by the state, as even India�s recent stellar economic growth is insufficient for such mammoth job-creation. z

Wholesale price inflation has been rising since it dipped below the 4% mark in April. In the first quarter of 2006/07, inflation measured by the wholesale price index rose as a result of record-high international oil prices and shortages of some agricultural products, such as wheat and pulses. In early November wholesale price inflation was at a four-month high of 5.3% year on year, the

A labour survey indicates the need for expanded education

The inflation rate rises, despite easing oil prices

India 29


mid-point of the central bank!s 5-5.5% target range for inflation. The upward trend is largely a function of higher food prices, which are expected to fall after the kharif (summer) harvest season is over. Consumer price inflation has meanwhile been running at a much faster rate than wholesale price inflation, reaching 7.3% year on year in October.

On November 29th the government caved in to political pressure and cut the prices of petrol and diesel by 4.25% and 3% respectively. This move partially reverses the price increases of 9.2% for petrol and 6.6% for diesel in June, implemented to help stem losses at state-owned oil companies. The government has been under pressure from Sonia Gandhi, the president of the main government party, the Indian National Congress, to cut prices since global oil prices have fallen by US$15-20/barrel from their July peak. The cut in domestic oil prices will push up the government!s bill for fuel subsidies, as it compensates oil companies for their losses from selling petrol below the market price by issuing them with bonds.

Consumer price inflation(% change, year on year; industrial workers)

Source: Economist Intelligence Unit.

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

OctSepAugJulJunMayAprMarFebJan06

DecNovOctSepAugJulJunMayAprMarFebJan2005

Financial indicators

Since falling to a three-year low of Rs46.8:US$1 on July 24th the rupee has strengthened against the US dollar. At the end of November the currency stood at Rs44.6:US$1. The recent appreciation has been underpinned by strong GDP data and a generally bright outlook for the Indian economy, as well as by large capital inflows. Interest-rate increases by the RBI have led to a narrowing in the interest-rate differential with the US and European economies. Owing to the fact that the inflation differential between India and the US looks unlikely to widen markedly and oil prices have weakened, the rupee looks set to be more stable against the US dollar. There is also speculation that the appreciation of the Chinese renminbi may have given the Indian authorities room to let the rupee rise without the immediate threat of a loss in export-competitiveness in relation to China.

The rupee has strengthened against the US dollar

30 India


44.0

44.5

45.0

45.5

46.0

46.5

47.0

47.5Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Exchange rate, 2006

(Rs:US$; inverted scale)

Source: Bloomberg.

India�s stockmarket has recovered well from the sharp falls in May that took the market down from nearly 13,000 to below 9,000 in June. In the past few months the main stockmarket index, the 30-share sensitive index (Sensex) of the Mumbai stock exchange, has recouped all of the losses that it incurred in May and June. By the end of November the Sensex had passed 13,700. The buoyant market has been underpinned by healthy second-quarter corporate earnings (particularly in the services sector) and strong economic growth. Foreign institutional investors have been keen to take advantage of strong growth in the economy and corporate earnings, while local and retail investors have been more wary following the stockmarket falls in May-June.

6,000

7,000

8,000

9,000

10,000

11,000

12,000

13,000

14,000

15,000

Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov

Bombay Stock Exchange Sensex index

Source: Bloomberg.

2005 06

The best-performing sectors over the past year have been capital goods, oil and gas, and information technology (IT). By contrast, manufacturing and pharma-ceutical stocks have performed less well since the May falls, having helped to boost the markets in the months leading up to May. Although corporate earnings are healthy and the performance of India�s economy and exports remains robust, both domestic and external factors could harm sentiment in the months to come. Monetary conditions have tightened slightly following the RBI�s interest-rate rises, while currency movements, particularly in the renminbi

The stockmarket reaches a record high

India 31


and the US dollar, could hurt India�s exports. Slower world economic growth would also hit exporters and cut into profits.

Agriculture

Growth in the farm sector is unlikely to match last year�s performance. Government estimates in September indicate that the foodgrain output of the kharif season declined by 3.8% year on year. Farmers had put 2% less area under foodgrain cultivation as of September 8th owing to insufficient rainfall, while excess rain in some states caused crop damage. The Ministry of Agriculture expects oilseed output to be most badly affected, estimating a 22.6% decline compared with last year�s summer crop. The summer crop accounts for about 55% of full-year production, and it will take a good winter crop for the sector to outperform even its meagre long-term annual average growth rate of about 2%.

Kharif (summer) harvest estimates (m tonnes unless otherwise indicated)

2005/06 2006/07 a % change

Foodgrains 105.0 101.0 -3.8

Rice 78.0 76.0 -2.6

Coarse cereals 27.0 25.0 -7.4

Pulses 4.7 5.0 6.4

Oilseeds 16.8 13.0 -22.6

Sugarcane 278.4 283.0 1.7

Cotton (m bales) 19.6 18.0 -8.2

a First advance estimates by the Ministry of Agriculture.

Source: Press Information Bureau.

Rice production is expected to total 89m tonnes in 2006/07, slightly below last year�s near-record output of 91m tonnes. Government estimates put this year�s kharif rice output at 76m tonnes, 2.6% below last year�s level. The lower estimate again reflects an uneven distribution of rainfall in some of the major rice-growing states, such as Uttar Pradesh, Bihar and Assam, as well as flooding in some states. The decline in kharif rice production could be partially offset by higher production in the rabi (winter season) crop following improvements in irrigation. Government rice stocks on September 1st stood at 7.6m tonnes, compared with 6.4m tonnes a year ago. Wheat output fell to 69.4m tonnes in 2005/06, forcing the country to resort to wheat imports after a six-year gap. So far India has imported 5.5m tonnes of wheat to bolster stocks, but a further 2m tonnes may be needed by March 2007, according to the US Department of Agriculture. India could thus overtake Egypt as the world�s largest wheat importer this year.

The government is preparing a financial aid plan for indebted farmers in the southern states of Andhra Pradesh, Karnataka and Kerala. The latest govern-ment figures show that more than 17,100 Indian farmers committed suicide in 2003. Little has changed since then. Farm lobby groups fear the number could rise further this year, as the cost of seeds and pesticides has been rising and improvements in rural life have been limited. The aid plan includes interest

The summer harvest is down by nearly 4%

Aid for farmers is planned as rural suicides rise

32 India


waivers on overdue loans, the rescheduling of loans and greater credit flow. A similar package worth Rs37.5bn (US$816m) has been announced for six districts in the western state of Maharashtra that have been badly affected by suicides. It is vital for the government to be seen to be taking seriously the concerns of the 230m farmers in India, who have been largely bypassed by rapid urban-led economic growth. The recent rise in farmers� suicides is indicative of the wider crisis in the sector that has arisen from low productivity, chronic public under-investment, poor maintenance of irrigation systems and road connectivity, and a failure to diversify from wheat and rice into other crops. For India�s policymakers and politicians probably the biggest challenge is to halt the trend of a widening gap between the agricultural and non-agricultural sectors.

Manufacturing

In October Tata Steel, India�s second-largest steelmaker, offered to buy an Anglo-Dutch steel firm, Corus, for 455p (US$2.32) per share, valuing the company at £4.3bn (US$8.1bn), the largest ever acquisition by a private Indian company. Tata!s takeover of its much larger rival would make the combined entity the fifth-largest steelmaker in the world. However, in late November the deal was complicated by a counter-offer for Corus from a Brazilian company, Companhia Siderúrgica Nacional (CSN), at a slightly higher price of US$8.3bn, or 475p per share. The offer, made ahead of a meeting of Corus!s shareholders on December 4th, is conditional on further due diligence, financing and approval by the Corus board.

If Tata were to succeed in acquiring Corus, it would represent a further step towards consolidation in the global steel industry, following the takeover by Mittal Steel of its European rival, Arcelor, for US$34bn earlier this year. For both India and the Tata Group, this is not just another corporate takeover but a step-change in the size of overseas acquisitions. Until recently Tata!s largest overseas purchase was that of Glaceau, a US manufacturer of specialist bottled waters, through Tata Tea, for US$677m in August this year. Analysts believe that Indian companies will increasingly buy overseas assets in order to integrate their supply chains and gain access to new customers.

If it succeeds in buying Corus, with an estimated annual turnover of US$40bn the Tata Group would become India�s largest multinational company, ahead of the Reliance Group, which has a turnover of US$24bn. In the first ten months of 2006 Indian companies have announced 130 overseas acquisitions worth an estimated US$19bn. Even if some of these investments do not materialise, foreign direct investment (FDI) outflows are likely to outpace inflows, which came to around US$4bn in January-July. At the same time, India�s overseas commercial borrowing is set to rise further"Tata is believed to require debt of around US$6bn to finance its expansion.

Tata�s acquisition of Corus is threatened by a counter-bid

India 33


Infrastructure

India�s weak infrastructure is widely seen as one of the main obstacles preventing the economy from achieving higher rates of growth. The amount of investment needed to remove this supply-side constraint is difficult to determine. The government estimates that US$320bn is needed to upgrade roads, airports, railways and power infrastructure in the next four or five years in order to overcome India�s infrastructure bottlenecks. This would raise the share of infrastructure in GDP from 4.5% to 8%. Implementation is also a major problem. A status report on infrastructure projects published by the Ministry of Statistics and Programme Implementation in September reveals that 216 out of a total of 742 projects are experiencing large cost overruns, estimated at Rs509bn (US$11.3bn) above an original approved aggregate cost of Rs771bn. Some 269 projects were also experiencing delays as a result of slow progress in work (152 projects), funding problems (40 projects), land acquisition problems (35 projects) and law-and-order problems (ten projects).

Given market imperfections and the central role that the state plays in upgrading India�s infrastructure, investment will not always be made in the projects where it is needed most. Even in aviation, a sector that is no longer dominated by the state, there are signs that rapid growth presents risks that are difficult to control in the absence of a strong regulatory framework. The government has now imposed a temporary ban on the issue of licences for airlines in response to the large losses reported by some airlines currently operating. At the same time, the government has decided to allow new airports to be established within 150 km of the capital, Delhi, Mumbai, Kolkata (Calcutta) and Chennai (Madras) in an attempt to boost the country�s airport infrastructure.

The government agreed in September to establish a special-purpose vehicle (SPV) to build a rail freight corridor linking the country�s four metropolitan cities, Delhi, Mumbai, Chennai and Kolkata. POSCO, a Korean steelmaker with major interests in India�s natural-resource sector, has offered to take a 10% equity stake in the project, as the rail project would connect its proposed steel plant with Orissa�s Paradeep port. The steelmaker�s investment in Orissa, at US$12bn, is the largest FDI project in India. Orissa, a mineral-rich state, is currently attracting considerable investment interest. In September the state government signed 15 memorandums of understanding on proposed power projects with a total generation capacity of 15,920 mw, which will require estimated total investment of Rs650bn.

The government has decided to float an SPV to implement phases five and six of the National Highway Development Programme, as a subsidiary of the National Highways Authority of India (NHAI). Meanwhile, it has emerged that the Ministry of Finance is opposing the NHAI�s demand for autonomy in appraising road projects through the public-private partnership (PPP) route. The finance ministry has also rejected the NHAI�s claim that the slow imple-mentation of the national highway construction programme has been partly owing to the slowness in the process of approving project proposals demonstrated by the ministry!s PPP advisory committee.

Delays and cost overruns blight infrastructure projects

The government explores new methods of financing

34 India


In mid-October it emerged that the government was planning to sell 10% stakes in each of four state power companies, Power Finance, National Hydroelectric Power, Rural Electrification and Power Grid, in initial public offerings. India�s power secretary, R V Shahi, stated that the proposal needed cabinet approval, and that this would take a few months. It is not clear how much money the sale will raise or whether the mainly communist Left Front group of parties that supports the current ruling coalition in parliament will allow the government to go ahead with the plan. The Left Front fears that power prices would rise and that jobs would be put at risk as a result of the partial privatisations. Other critics have said that the move is too insignificant to solve India�s power problem. They believe that power-generating capacity has to rise almost four-fold, from 130,000 mw to 500,000 mw, to make double-digit economic growth possible. However, the proposal has been greeted by some as real progress in a sector that has changed little since the early 1990s.

Financial and other services

In its mid-term review, released on October 30th, the central bank proposed a series of wide-ranging reforms aimed at making India�s banking sector more efficient. The proposals have been well received, as they are designed both to improve the operating environment for banks and to make life easier for customers. Some of the proposals will require further discussion, but this should not prove contentious. In contrast to many other areas of economic policymaking in India, in this instance there are no powerful interest groups that are adversely affected by the measures.

Figures released at end-October indicate the rapid expansion in India�s telecommunications sector. In the first seven months of 2006/07 there was a net addition of 36.5m wireless and fixed-line subscribers, more than twice the 17.8m subscribers added in the same period of 2006/07. At end-October 2006 total fixed-line subscribers stood at 40.6m, while total wireless subscribers were stood at 136.2m. Demand remains strong, with waiting lists for mobile connections. The expansion appears set to continue, given that teledensity in India is still only at 16%.

There are, however, potential difficulties along the way as the government attempts to wield some control over the fast-moving sector. Following the government�s decision a year ago to raise FDI limits in the telecoms sector from 49% to 74%, investment proposals were initially slow to emerge. The problem appears to lie in the security restrictions accompanying the FDI guidelines that relate to remote access, transfer of network information outside India and international transit routing of Indian traffic. The National Association of Software and Service Companies (Nasscom) has supported the view of large foreign telecoms operators that such restrictions are unprecedented. This forms part of a wider domestic debate about the security-related risks associated with a liberalised FDI regime. India�s National Security Council (NSC) says that sensitive sectors for FDI include sea ports, airports, aviation, telecoms, oil-refining, gas pipelines, shipping, roads and defence. The NSC is particularly

The government plans IPOs for four power companies

Rapid growth in telecoms continues

The RBI proposes financial market reforms

India 35


wary of direct investment in these sectors by companies from China, Hong Kong, Macau, Taiwan, Pakistan, Bangladesh, Afghanistan and North Korea, claiming that such FDI could threaten India�s security interests.

By November a number of foreign firms had announced plans to expand into India�s telecoms market under the revised FDI rules. A UK telecoms company, BT, is set to offer national and international long-distance services in India, and is looking to expand into eight telecoms-related sectors through a joint venture with India�s Jubilant Enpro. The company also intends to set up a large research and development centre in the country with an initial investment of US$10m. Announcing BT�s expansion plans in November, the managing director of BT India, C S Rao, estimated the market for voice and date services on virtual private networks (VPNs) and international conferencing, voice and multimedia services for corporate customers to be worth more that US$1bn a year. The corporate market is growing rapidly as Indian firms expand overseas and foreign firms enter the country. The US-based AT&T was the first to announce expansion under the revised FDI rules, and in late November Australia�s largest telecoms operator, Telstra, also announced its intention to enter the inter-national long-distance segment of the market pending clarification of FDI restrictions.

Progress towards telephony for all in India is generating great demand for telecoms equipment. According to a report by In-Stat, a research firm, the Indian market for telecoms equipment is likely to be the fastest-growing in Asia in the years to 2010. Domestic demand for telecoms equipment is forecast to be worth an estimated US$10bn a year by 2010, and the market is expected to grow by around 10% a year during the next few years. As the demands of the telecoms market evolve, Indian equipment manufacturers are responding. Having pre-viously specialised in the fixed-line segment of the market, they are now switching in response to faster growth in the wireless sector.

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

1996 97 98 99 2000 01 02 03 04 05 06

Fixed-line subscribers

Mobile subscribers

Telephone subscribers

('000)

Source: Pyramid Research.

The IT sector has helped to foster some of the recent dynamism in the Indian economy. However, the demand for skilled, competent graduates, and for engineers in particular, has risen to such an extent that shortages are beginning to emerge. Moreover, competence has now become an issue, as some graduates

The skills gap could slow the boom in technology

36 India


lack the technical skills, fluency in English or work experience required by the companies expanding in this area. A recent study commissioned by Nasscom concluded that 75% of India�s engineering graduates were deficient in terms of technical skills, English-language fluency or teamwork ability. An earlier report by McKinsey Global Institute, an independent economics think-tank, found that only one in four of the country!s engineering graduates was suitable for employment by multinational companies or their Indian outsourcing partners. India currently produces more university graduates (some 2.5m) and engineers (around 400,000) every year than any other English-speaking country, but there are now concerns that in the future there will be fewer skilled people to fill the demand for higher-quality workers in the expanding IT services sector. The emerging skills and education gap could threaten further rapid growth in this and other sectors if greater efforts are not made to improve the quality of education provision at India�s institutes of higher education.

Foreign trade and payments

India!s merchandise exports rose by 21.9% year on year to US$10.3bn in September. In the first half of fiscal year 2006/07 (April-March) total exports grew by 22.9% year on year to US$59.3bn. The government�s export target of US$125bn for the full fiscal year now seems within reach. The data reveal that Indian exports have surged not only in the country!s major traditional export markets, the US and Europe, but also in Asia and Africa. The value of India�s exports is still tiny compared with China!s, however"the latter!s merchandise exports are worth nearly ten times India�s.

Merchandise trade (Apr-Sep; US$ bn unless otherwise indicated)

2005/06 2006/07 % changeExports 48,289 59,363 22.9Imports 70,552 83,964 19.0

Trade balance -22,263 -24,601 10.5

Source: Department of Commerce, Economic Division.

India�s trade deficit widened to US$24.6bn in the first half of 2006/07, compared with US$22.3bn in the same period of 2005/06, as a higher import bill for crude oil pushed up total imports. Total imports rose by 19% year on year in the first half of 2006/07 to US$84bn, and by 24.5% year on year to US$15.6bn in September alone. India�s trade deficit is likely to have peaked now that crude oil prices have eased. (The country imports more than three-quarters of its oil requirement). In September oil imports accounted for about one-third of total imports and rose by 25.8% year on year to US$5.1bn, while non-oil imports rose by 24.3% year on year to US$10.5bn. But oil imports during the first half rose by 36.8% year on year to US$28.7bn, much faster than non-oil imports, which rose by 11% year on year to US$55.3bn.

The pace of integration of India�s economy with the rest of the world has picked up in recent years, although the level of trade integration still remains low compared with other large emerging economies. The responsiveness of

The trade deficit widens owing to costly oil imports

India�s integration into the world economy has deepened

India 37


Indian exports to the GDP growth of its main trading partners has increased. In the past four years the economies of the top seven destinations for Indian exports grew by 4.5% on average, while Indian exports to those countries increased by 62%, according to Assocham, an industry lobby group. India�s exports have picked up by roughly 14% for every percentage point of GDP growth in the country!s trading partners.

The study�s sample years though are hardly representative, as they cover four years of a business cycle upturn. Nevertheless, the report suggests that the traditional view that the Indian economy is largely shielded from the inter-national business cycle because of the country!s limited trade integration is becoming increasingly untenable. Growing trade integration has important consequences, not only for exports, but also for economic management. Interest rates in the rest of the world will become more important in setting domestic rates. Similarly, swings in economic activity in the region or the world are now likely to have a larger impact, mainly through trade.

India and Japan are likely to start negotiations in early 2007 on a com-prehensive economic co-operation agreement (CECA) to boost trade and investment ties. The minister for commerce and industry, Kamal Nath, has said that substantial progress has been made in preparing a road map for a CECA between the two counties, which together account for 60% of Asia�s economic output. Mr Nath said that there was a need to diversify the trade basket and to look at new areas of investment. Japan�s ambassador to India, Y Enoki, indicated that negotiations between the two countries could start in January 2007 and be concluded within two years.

Balance of payments, national series (US$ m unless otherwise indicated)

2004/05 2005/06% change,

year on year 2006/07 Apr-Jun

% change,year on year

Merchandise exports fob 85,206 104,780 23.0 28,245 17.0Merchandise imports cif 118,908 156,334 31.5 46,729 23.8

Trade balance -33,702 -51,554 53.0 -18,484 35.9Invisibles inflows 69,533 91,481 31.6 24,138 22.6Invisibles outflows 38,301 50,539 32.0 11,753 21.9

Invisibles balance 31,232 40,942 31.1 12,385 23.3Current-account balance -2,470 -10,612 � -6,099 �

Foreign investment 13,000 18,222 40.2 1,200 -44.7Loans 10,909 4,737 -56.6 4,000 247.2

Banking capital 3,874 1,373 -64.6 5,079 549.5Rupee debt service -417 -572 37.2 -67 -52.8Other capital 656 933 42.2 1,651 254.3

Net errors & omissions 607 971 60.0 614 63.7Capital account balance 28,022 24,693 � 11,863 �

Overall balance 26,159 15,052 � 6,378 �Change in reserves (- indicates increase) -26,159 -15,052 � -6,378 �

Source: Reserve Bank of India.

India and Japan are set to improve their economic ties

38 India


India and the Association of South-East Asian Nations (ASEAN) have agreed to resume the negotiation of a free-trade agreement (FTA), following India�s offer to reduce the list of negative items (which originally contained 1,440 items) from 850 to 560 and to reduce import duty on some highly sensitive products, such as refined palm oil (on which duty would fall from 90% to 60%), crude palm oil (from 80% to 50%), black tea (from 100% to 50%) and pepper (from 70% to 50%). India is also negotiating an FTA with the European Free-Trade Association (EFTA, an association of non-EU member countries comprising Switzerland, Liechtenstein, Iceland and Norway) and a bilateral investment promotion agreement with China, and has supported a Japanese proposal for a pan-Asian trade bloc including ASEAN, China, Japan, South Korea, India, Australia and New Zealand. The government is contemplating suspending all trade concessions under the South Asian Free-Trade Area (SAFTA) pact until Pakistan starts to abide by the market access commitments contained in the agreement.

India�s current-account deficit nearly doubled to US$6.1bn in the first quarter of 2006/07, as strong domestic demand sucked in industrial inputs and high oil prices drove up the country�s import bill. Merchandise imports on a balance-of-payments basis rose by 23.8% year on year to US$46.7bn, on top of a massive 64.5% expansion in the first quarter of 2005/06. Meanwhile, exports grew by 17% to US$28.2bn, compared with 35.4% growth in the year-earlier period.

India!s booming economy attracted US$2.9bn in foreign direct investment (FDI) in the first four months of 2006/07, a 93% year-on-year increase on the US$1.5bn FDI inflow in the same period of 2005/06. Mr Nath estimates that India will receive US$12bn in the current fiscal year, compared with US$8.3bn last year. This increase is important for a number of reasons. First, it would put FDI as a percentage of GDP well above the 1% mark at 1.5%, indicating India!s growing comparative advantage. Second, the rise has been achieved without a fundamental change in the government�s FDI policy, suggesting that FDI inflows could rise again sharply once other sectors, especially retail and banking, are liberalised. Third, higher FDI inflows indicate that investors are increasingly involved in India�s rapid economic growth via the FDI route, and not only via portfolio investment as in the past. This trend, if continued, will help to stabilise India�s balance-of-payments position. In July FDI inflows increased by a record 259% to US$1.2bn compared with US$324m in the same month a year earlier (the total does not include reinvested earnings). According to Mr Nath, India has received a total of US$50.1bn in FDI since 1991, and nearly one-third of this (US$16bn) has flowed into the country since the current Indian National Congress-led government came to power in May 2004.

Indian companies are increasingly borrowing overseas. External commercial borrowing by Indian companies almost doubled to US$4.4bn in the first quarter of 2006/07. The trend is set to continue as Indian companies expand their businesses at home and buy assets overseas. In mid-October, for instance, it emerged that Reliance Petroleum, one of India�s largest companies, plans to borrow US$2bn overseas to help finance the US$6.1bn construction of the

FDI inflows are set to reach US$12bn in 2006/07

Overseas borrowing by Indian companies rises sharply

Trade negotiations with ASEAN are set to continue

The current-account deficit widens

India 39


world�s largest refinery in the state of Gujarat. Indian companies borrowed US$12.8bn in 2005, up from US$4.5bn the previous year.

India�s sizeable reserve assets, which stood at US$163.6bn in mid-November, are often interpreted as a sign of its growing financial strength. But assets are only one side of the coin, and without knowing the liabilities that a country has the reserve position is fairly meaningless. The international investment position looks at both an economy�s financial claims on, and its obligations to, the rest of the world at a particular point in time.

International investment position (US$ bn; end-Mar)

2003 2004 2005 2006Assets 95.6 137.8 168.9 183.1 Direct investment abroad 5.8 7.8 10.1 12.1 Portfolio investment 0.8 0.8 0.8 1.3 Other investment 12.9 16.3 16.5 18.2 Reserve assets 76.1 113.0 141.5 151.6Liabilities 156.1 183.1 209.2 229.2 Direct investment abroad 31.2 38.2 43.6 50.3 Portfolio investment 32.4 43.7 55.3 63.4 Other investment 92.4 101.3 110.3 115.6Net international investment position -60.5 -45.3 -40.3 -46.1

Source: Reserve Bank of India.

At end-March 2006 India�s stock of foreign assets stood at US$183bn and its foreign liabilities amounted to US$229bn, according to data released by the Reserve Bank of India (the central bank) at end-September. Indian residents therefore had an overall net liability of US$46bn to non-residents. The net position had deteriorated year on year by US$6bn, as India�s current-account deficit almost doubled to US$10.6bn in 2005/06. However, compared with three years ago the net investment position had improved by more than US$14bn.

Reserve assets remain the dominant component of India!s external assets, but FDI and other investment have become more important. Around 7% of external assets are in the form of direct and portfolio investments. More than 50% of India�s external liabilities"namely trade credit, loans, currency and deposits, and other liabilities"fall into the category of "other investment". However, the share of this component in total liabilities declined from 59.2% at end-March 2003 to 50.4% at end-March 2006. Meanwhile, India!s reserve assets as of end-March 2006 exceeded external debt (US$125bn) by around US$26bn.

The international investment position has improved

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