State of the Economy: Current and future prospects

February 2011 www.deloitte.com/in

The Big Picture The Indian economy continues to stride ahead with robust and broad based real GDP growth for the current fiscal estimated to be at 8.6% and predictions for a 9% average growth over the next few years. Backed by a rise in the domestic saving and investment rates, a revival of growth in agriculture and resilience in the manufacturing and services sector, India has displayed a great recovery post the global slowdown and is also armed for a promising medium and longer term future. But one cannot ignore the possible challenges that lies ahead a persistent inflationary environment, a burgeoning current account deficit, continued uncertainties in the global economy and scams and corruption scandals erupting on the domestic front with rapid succession. Balancing the Economys Scorecard The government has delivered on the Herculean task of elevating the GDP growth rate from 8% (FY 2010) to 8.6 % (FY 2011), while bringing down the fiscal deficit to 4.8% of GDP and strengthening the domestic consumption base.
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A better than expected monsoons resulted in the agricultural sector growing at 5.4% from an annual growth of merely 0.4% last fiscal. Growth in private consumption expenditure, after remaining subdued over several quarters, exhibited significant acceleration in the first half of 2010-11. This fiscal has witnessed strong performance by some of the sectors led by telecom, automotive and IT & ITeS and a revival in several sectors of the industry like cotton and jute textiles, leather, food products and metal products. Domestic capital markets performed well in 2010 with primary markets financing record levels, including the largest-ever initial public offering (IPO) (for Coal India). The number of M&As were 222 in the first nine months of the current fiscal compared to 149 in the same period last fiscal a trend that provides clear evidence of the consolidation of the Indian industry and aggressive working on global expansion. How deep rooted is this growth story? Perhaps the biggest change that will help deliver higher growth rates in the future is the revival of the savings and investments rates in

Rising domestic savings and investments have been the key drivers of growth this fiscal. However, controling inflation without compromising on fiscal consolidation is essential for sustainable growth in the medium and long term
the economy. A number of ongoing initiatives are noteworthy the government has embarked on a program of skill development that plans to train an additional 500 million workers by 2022 so that the nation can take advantage of the demographic dividend. Reforms in the banking sector along with a focus on infrastructure development bode well for the future growth prospects of the country. However, in an increasingly interconnected and uncertain world, Indias future in the coming year(s) will be determined based on the interplay of a number of factors. A glaring trend observed this fiscal is the emergence of inflationary conditions which may become structural in nature. The rise in demand, coupled with strong supply bottlenecks, is a catalyst for inflation, which is one of the growing concerns today. With rising inflation, the focus is inevitably shifted to the fiscal deficit. Although, we have contrived to meet the targeted fiscal deficit this year, the coming year(s) foresees a significant rise in expenditure. There will be no bonanza from 3G auction and broadband wireless access sale! Unless the issues of inflation and rising deficit are addressed in conjunction, the need for the government to borrow from the market to finance the deficit may crowd out private investment at the cost of slowing down growth. The public debt to GDP ratio although lower from last fiscal, still stands at an aggravated 76%. Steady inflow of capital, through short term and sustainable long-term sources is the need of the day owing to the alarmingly high levels of current account deficit (CAD) that we have come to see. Moreover, the vulnerability of the capital markets to vicissitudes in the flow of FII may lower Indias attractiveness as an investment option if, when the rest of the world revives, other investment options become more attractive.
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Economic Growth: The Fine Print The high economic growth (estimated to be 8.6% for FY 2010-11 and 9% for the next few years) is backed by strong domestic demand, rise in private consumption, investment & trade and improvement in agricultural performance. However, high growth rates in the future is based on an assumption that investment will remain at current levels (of 36.5% of GDP) with the productivity of capital (ICOR) at 4.1. These assumptions can fall through unless enough is done to improve the productivity in all the three sub-sectors of the economy namely agriculture, industry (with particular focus on manufacturing) and services. Therefore, we need to usher in a second Green Revolution in agriculture, invest enough in R&D for manufacturing and embark on an aggressive skill development program to retain the productivity of the services sector. External factors (e.g. international price of crude oil, geopolitical stability, sovereign debt issues and the impact of the monetary & fiscal policies in key global economies) have a strong bearing in reaffirming the India growth story. Policy makers should take these domestic and international challenges into account

and frame policies that will create a strong enabling infrastructure that will be geared to cater to the impact arising from these negative factors. Unless that is done, the promise of a persistent and high growth trajectory will remain unfulfilled. Fiscal Deficit: Is it Sustainable? The Centre's gross fiscal deficit in 2010-11 is at 4.8% of GDP. That, combined with States' deficit of 2.5% & quasi-fiscal deficit of 2.8% of GDP in the form of off-Budget items makes the real combined fiscal deficit at 10% of GDP, which remains unacceptably high.

Trends in Consolidated Fiscal Decit

14.0 Fiscal decit as a % of GDP 12.0 10.0 8.0 6.0 4.0 2.0 0.0 2005-06 Central State 2006-07 1.1 2.4 4.0 1.2 1.8 3.3 2.8 2.4 3.5 1.5 2.5 2007-08 2008-09 6.0 6.3 3.3 2.8 2.8 2.5 4.8

2009-10 2010-11 (BE)

Off-balance sheet items

Source: Economic Survey of India,2010 -11

 A large portion of the central deficit this fiscal has been financed by the one-time proceeds from the 3G auction and the BWA sale. These two components contributed nearly `106,000 crore of the entire revenue basket. High buoyancy in the direct and indirect tax collections (Centre & State), increased sales tax collections (State), coupled with the decontrol of petroleum prices have provided additional cushion.

However, sustainability of the fiscal deficit in the future depends on prudent and calculated spending on social sector health and education schemes, while also minimizing the food and fertilizer bill, containing the expenditure on big ticket items such as interest payments and major subsidies which form 25.9% and 11.4% of the total revenue expenditure respectively and possibility of broadening the tax base by introducing the GST.

Although, the fiscal deficit targets have been set at 4.8% and 4.1% of GDP for the years 2011-12 and 2012-12 respectively, the roadmap for how these targets are going to be achieved are nebulous. The extent of borrowings required to finance the deficit continue to grow and remains a big question mark!

State of the Economy: Current and future prospects

Inflation: Although high, can be managed through prudent policies Recent trend in the rates of inflation (with WPI at 9.4% and CPI-IW at 11.0%) are worrying, particularly since it seems to be getting more generalized. Supply side constraints are no longer the only factor contributing to the high inflationary pressures this fiscal. Changes in demand patterns have also had a role to play. Ineffective distribution, hoarding and misuse of subsidies still plague the system. However, this seems to be a temporary phenomenon and measures such as containing wastage of subsidies, ensuring greater monitoring and eliminating price fixing by cartels at the wholesale level, improvements in the infrastructure for storage and distribution and the possible introduction of multi-brand retail through relaxation of FDI norms in this sector will help bring down inflation to more tolerable levels. Capital Inflows & Current Account Deficit The composition of capital flows changed considerably, with large increase in portfolio flows and lower FDI inflows. FII inflows have displayed great volatility, which has led to fluctuations in the equity market, as well as in the exchange rate.

The high current account deficit (CAD) currently at 3.7% of GDP is also a cause for concern. The steady appreciation of the rupee in the last 18-20 months has had an adverse impact on our balance of payments, as also on the tradable industrial and services sectors. The twin challenges are to continue along the path of gradual financial reform and to modernize regulations and institutions to ensure its continued safety and stability. The recent outflow (in the past few weeks) of both FII and FDI should possibly lead us to look deeper behind the euphoric coverage on market outlook. There is a possibility of capital moving out of India due to negative perceptions on the domestic front (various scams, high inflationary levels, etc.) or global events like the European debt crisis or even positive economic developments in the US. A foreseeable increase in the world crude prices may be unfavourable to the import side, but this can be offset to a considerable extent through the increased availability and tapping of domestic sources, such as the Rajasthan oil fields. The sustainability of the CAD targets would depend on the volume of capital inflows (equity capital or any form of long-term sustainable debt).

The macro-economic indicators have pointed out that India has shone during the period following the crisis. That said, we still have the problem of the twin deficits current account and fiscal to tackle. The stickiness of inflation and the waning of capital inflows pose formidable challenges in the path of otherwise healthy growth of the nation, whose GDP growth rate stands far above the global average.

State of the Economy: Current and future prospects

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