ICRA Rating Feature

Outlook for the Indian Economy: Growth expected to remain moderate in 2012-13 unless substantive policy measures are undertaken to boost investment sentiments

Contacts: Anjan Ghosh aghosh@icraindia.com +91-22-30470006 Aditi Nayar aditin@icraindia.com +91-124-4545385

Various domestic and global factors contributed towards a moderation of Indian economic growth to 6.9% in April-December 2011 from 8.4% in 200910 and 2010-11. In this note, we discuss the major factors that dampened growth in 2011-12; the outlook for the next fiscal year; and what we believe are some of the measures that Government of India (GoI) may introduce to revive economic growth in the near-to-medium term.

Slowdown in economic growth in 2011-12

Advance estimates released by the Central Statistics Office (CSO) place GDP growth for 2011-12 at 6.9%, only marginally higher than the 6.7% growth seen in 2008-09, the year of the global economic crisis. Worst affected is clearly investment, which underwent a mild 0.2% contraction in April-December 2011 in year-on-year terms, relative to a growth of 8.9% in the same months of 2010-11, reflecting a dampening of business sentiments and the pace of execution of various projects. Uncertainty about demand conditions given the global outlook and its likely contagion effect; regulatory issues including environmental clearances and land acquisition; as well as sector specific factors like availability of coal and iron ore have impacted investments. Other contributory factors included an increase in interest rates to dampen high inflation and a slowdown in decision-making in various crucial areas like allocation of coal blocks. At the same time, while fisc al policy remains expansionary, higher outgo toward items of non-plan revenue expenditure such as subsidies, limited the fiscal space available for boosting infrastructure spending by the public sector. Investment growth is likely to remain sluggish in 2012-13 as well, unless policy issues are addressed and there is a substantial pick up in the pace of implementation of big ticket economic reforms.

March 2012

Interest rate cycle has peaked with moderation in headline inflation, even though concerns pertaining to commodity prices remain
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The balance of growth-inflation indicators and the guidance provided by the Reserve Bank of India (RBI) in the Third Quarter Review of Monetary Policy suggest that the interest rate cycle has peaked. After remaining between 710% since December 2009, headline inflation related to the wholesale price index (WPI) dipped to 6.6% in January 2012, and is expected to print between 6.6% and 7.0% in March 2012, in line with the baseline projection made by the RBI. Accordingly, ICRA expects that the RBI may embark on monetary easing in April 2012.

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Outlook for the Indian Economy

However, headline inflation is unlikely to moderate substantially in H1, 2012-13 on account of the anticipated revision of domestic prices of various fuel items, electricity and coal. At the same time, the price of crude oil has risen sharply in the recent months, and the possibility of further spikes cannot be ruled out in case the ongoing geo-political tensions escalate. This would fuel inflationary pressures considerably, widen Indias current account deficit and may prompt a depreciation of the Indian rupee. Moreover, higher crude oil prices would necessitate an expansion of fuel subsidies, in the absence of adequate increases in the retail prices of various fuels. Even otherwise, further liquidity measures undertaken by various Central Banks around the world to prop up domestic growth may boost global commodity prices, which would stoke inflationary pressures in India. Accordingly, the extent of reduction in the Repo Rate that the RBI would undertake may be limited. Depending on the evolving scenario for commodity prices, particularly crude oil, and the associated impact of the latter on both domestic fuel prices and the exchange rate of the Indian rupee, ICRA expects the Central Bank to reduce the Repo Rate by 50-100 basis points (bps) in 2012-13.

GDP growth unlikely to improve sharply in 2012-13

While transmission of monetary easing to interest rates would take place with a lag, declining cost of domestic funds would boost consumption sentiments and the growth of rate-sensitive sectors such as construction. Growth of private consumption, which accounts for around 60% of GDP at market prices, is expected to improve to an extent from around 5.1% in April-December 2011 in year-on-year (y-o-y) terms to around 6.5-7.0% in 2012-13, following the easing in headline inflation and the anticipated decline in interest rates. In addition to the impact of monetary easing, the growth performance of the manufacturing and mining sectors is likely to display some improvement given the base effect. Service sector growth, which has remained healthy despite the slowdown in industrial growth in H1, 2011-12, is expected to support overall economic growth in 2012-13. However, given the healthy estimated output of a number of major agricultural commodities in 2011-12, agricultural growth is expected to remain low in 2012-13, even if the monsoon conditions are normal. Also, investment growth is expected to remain sluggish in H1, 201213, given the slowdown in concrete announcements of fresh projects and capacity enhancement in the recent months as well as the likely delay in commissioning of certain projects, particularly in the power sector. At present, the Indian rupee is around 12% cheaper relative to the US dollar as compared to the levels in August 2011, providing exporters with a competitive advantage. Despite the diversification of exports to newer geographies, the growth of Indian exports is likely to be subdued in the coming fiscal year. This is related to the bleak outlook for the Advanced Economies, several of which are likely to display low growth in 2012-13 following the fiscal tightening to be undertaken to reduce the mounting sovereign debt levels. Furthermore, developments in the Advanced Economies would determine global liquidity conditions, risk aversion and business confidence, all of which may critically impact the level of financial flows into India as well as the level of the Indian rupee relative to other major currencies, both of which have undergone considerable volatility over the course of 2011-12. While several uncertainties persist, in the baseline scenario factoring in a normal monsoon, average inflation of around 6.0-6.5% in 2012-13, monetary easing of around 100 bps over the course of 2012-13 and some resolution to the European sovereign debt crisis without a major credit event, ICRA presently expects GDP growth to remain around 6.9-7.0% in 2012-13. However, this forecast may be revised over the course of the year, factoring in the evolving domestic and global scenario.

Budgetary outlays, policy and regulatory measures to boost growth

GoIs fiscal deficit is likely to substantially overshoot the budgeted target of 4.6% of GDP in 2011-12 and the forthcoming Union Budget for 2012-13 is expected to focus on fiscal consolidation (refer ICRAs publication Union Budget, 2012-13: Credible roadmap for fiscal consolidation awaited published in March 2012 ). Accordingly, there is limited headroom to provide a direct stimulus to growth through tax cuts or substantially higher spending in the event of a deeper -than-expected domestic slowdown or an external crisis. However, we believe that it is critically important to undertake various measures to revive business confidence and jumpstart the investment cycle; it is of course likely that many of these policy measures need not be limited to the Budget alone. Budgetary support to infrastructure: The Union Budget for 2012-13 needs to restrain growth of revenue expenditure to create space for infrastructure spending. Higher capital spending by the Central and State Governments would boost economic activity and also partially insulate the domestic economy from any externally driven economic slowdown in the coming year. Over the medium term, infrastructure creation would ease structural bottlenecks and enhance the potential rate of growth of the Indian economy. ICRA Rating Services Page 2

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Outlook for the Indian Economy

In this respect, a few high-impact initiatives could include speeding up the implementation of major infrastructure projects such as the dedicated freight corridor (DFC) and the Delhi Mumbai Industrial Corridor (DMIC). However, such measures would also need to be supported by policy changes, some of which are in the domain of the State Governments that are discussed subsequently. The current fiscal situation constrains GoIs ability to sharply step up capital spending. Hence direct sops may be introduced by GoI to invite private investments, such as accelerated depreciation and incentives for research & development expenditure. Removal of policy hurdles and sector specific reforms: A plethora of regulatory issues and policy hurdles contributed towards the slowdown in both announcement as well as implementation of fresh projects in 2011-12. Although admittedly, resolving some of these issues lies in the domain of the State Governments, there are several steps that the Central Government could initiate to ease such barriers . Moreover, ensuring consensus with various stakeholders and political groups prior to announcement of policies would go a long way in creating a stable policy environment. A key issue facing industry and infrastructure projects in recent times has been the acquisition of land. An early passage of the Land Acquisition and Resettlement and Rehabilitation Bill would create regulatory clarity and enable a re-assessment of project viability. Setting aside concerns related to pricing and rehabilitation of displaced people, the availability of contiguous tracts of land itself has emerged as a key constraint. Going forward, as GoI aims to undertake mega projects such as the DMIC and encourage growth in the manufacturing sector under the National Manufacturing Policy, the identification of clear land banks of relatively infertile land in each State, simplification of procedures and transparent norms for acquisition would create an environment conducive to growth and job creation. Going forward, ICRA expects availability of land to be one of the major factors influencing the growth trajectory of States. Additionally, inter-ministerial consensus towards fast-tracking of and environmental clearances for various projects by the Central and State Governments has emerged as a key constraint in recent times. This has been most acutely felt in the mining sector, both for coal and iron ore. An early passage of the Mines and Minerals (Development and Regulation) Bill, addressing the concerns of various stakeholders, may help ease supply bottlenecks in this sector, through granting of new leases, encouraging private sector participation etc. This would also have a second-order effect on those industries that have forward linkages with the mining sector, such as power, iron & steel etc. Moreover, a sectoral approach could be taken to solve sector-wide issues, in sectors such as coal, power, ports and fertilisers. A beginning has already been made with Coal India Limited (CIL) having been mandated to sign Fuel Supply Agreements guaranteeing supplies at 80% plant load factor (PLF) levels for all projects of independent power producers (IPPs) that are to be commissioned by 2015, subject to certain conditions being fulfilled. However, CILs ability to scale up production to meet the commitments is in serious doubt, and resolving the contentious environmental issues associated with development of new mines, as well as allocation of new coal blocks, would be critical. Additionally, coordination between CIL and the Indian Railways to develop infrastructure and improve the availability of rakes would enhance the volume and speed of evacuation of coal from pit heads. Furthermore, a reduction in the import duty on noncoking coal as well as clarity on existing policies including competitive bidding for coal block allocation and use of surplus coal from captive mines for other projects are awaited. We must, however, reiterate that many of the related policy measures in this regard need not necessarily come under the purview of the Union Budget Policy environment conducive to attract greater FDI: Attracting larger foreign direct investment (FDI) into various sectors in India has also assumed great importance, not only for the beneficial impact in terms of productivity gains, but also to finance the widening current account deficit (CAD). As witnessed to an extent in the recent quarters, India remains vulnerable to sudden outflows of foreign institutional investors (FII) funds as well as drying up of inflows of external commercial borrowings, the magnitude of which are heavily influenced by global trends for risk aversion and liquidity conditions. Facilitating fund flow to infrastructure sector: Apart from policy measures designed to jump start investments, facilitating fund flow for infrastructure projects has also assumed critical importance. GoI has taken several steps in this regard, including the functioning of the Infrastructure Debt Funds and the credit enhancement scheme from the India Infrastructure Finance Company Limited (IIFCL). However, some tricky issues related to withholding tax for FII debt investment and further rationalisation of stamp duty need to be addressed. The Union Budget for 2012-13 could enhance the exemption limits for income tax in order ICRA Rating Services Page 3

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Outlook for the Indian Economy

to channelize greater funds to infrastructure bonds, especially in the light of the success of infrastructure bonds during the year The Union Budget for 2012-13 also needs to provide adequate funds for recapitalization of Public Sector Banks, to ensure flow of adequate credit to the productive sectors of the economy. Reforms related to agriculture: WPI inflation related to food items (primary and manufactured) consistently outpaced annual headline inflation between 2005-06 and 2010-11. Policy measures aimed at reducing structural demand-supply imbalances for protein-rich items and imported items (particularly pulses and oilseeds), reducing wastage and improving systems to minimise short-term demand-supply spikes for perishable items would dampen inflationary pressures. Policy direction from GoI to incentivise higher production of items such as milk, pulses and oilseeds would be key. For instance, the National Food Security Mission for pulses could be extended to a larger number of districts, with an appropriate enhancement in budgetary support. Extending state procurement of foodgrains to additional districts, improving storage facilities of Food Corporation of India and reform of the Public Distribution System would all go a long way in reducing wastage. Greater impetus for the creation of infrastructure, including substantial investments in cold storages etc. and development of the retail chain would reduce wastage of farm produce, ease the supply constraints for perishable items and help avoid inflationary spikes such as those seen in December 2010-January 2011. The Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS), a flagship scheme of GoI, assures 100 days of work in each financial year to adults belonging to rural households , at specified inflation-indexed wages in each State. This has created a floor for wages and boosted the wage rate, particularly for unskilled labour, and thereby raised the cost of production in various sectors. While systematic data is not available, anecdotal evidence suggests that the introduction of this scheme has dampened the supply of migrant labour for non-agricultural and agricultural work, constricting the availability of agricultural workers during key periods such as sowing and harvesting. To the extent that the response to rising wages in various sectors (such as medium and large agriculture and construction) is higher mechanisation, some loss of jobs may occur. Recalibrating the MGNREGS Scheme, with one alternative to offer work during the agricultural lean season, may provide a balanced approach to job creation. Additionally, a moderate pace of growth of agricultural wages would help contain the rise of Minimum Support Prices of various commodities, thereby restraining the growth of food subsidies.

Reiterate commitment to and display convergence towards the Goods and Services Tax (GST) and the Direct Tax Code (DTC): GoI should reiterate its commitment to undertake these major tax reforms within a definite timeframe, which can potentially have a significant impact on investor sentiment. Resolution of a number of issues contributing to the delay in the introduction of the GST requires the building of consensus with the State Governments. Nevertheless, GoI could announce a further reduction in Central Sales Tax (CST) from the present 2% to 1% or abolish it altogether, as required for the transition to GST. However, GoI should specify upfront whether it would provide compensation to the State Governments and the formula for calculating the same, in order to avoid subsequent disputes. Moreover, GoI could place the draft GST law in the public domain. Additionally, the Union Budget for 2012-13 should introduce a negative list of services for the imposition of service tax, which would significantly widen the base for service tax and augment indirect tax revenues.

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ICRA Rating Feature

Outlook for the Indian Economy

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