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Economic Survey 2006-2007

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Macroeconomic Overview


Vigorous growth with strong macroeconomic fundamentals has characterized developments in the Indian economy in 2006-07 so far. However, there are some genuine concerns on the inflation front. Growth of 9.0 per cent and 9.2 per cent in 2005-06 and 2006-07, respectively, by most accounts, surpassed expectations (Table 1.1). While the up-and-down pattern in agriculture continued with growth estimated at 6.0 per cent and 2.7 per cent in the two recent years, and services maintained its vigorous growth performance, there were distinct signs of sustained improvements on the industrial front (Table 1.2). Entrenchment of the higher growth trends, particularly in manufacturing, has boosted sentiments, both within the country and abroad. The overall macroeconomic fundamentals are robust, particularly with tangible progress towards fiscal consolidation and a strong balance of payments position. With an upsurge in investment, the outlook is distinctly upbeat.

1.2 The advance estimates (AE) of gross domestic product (GDP) for 2006-07, released by the Central Statistical Organisation (CSO) on February 7, 2007, places the growth of GDP at factor cost at constant (1999-2000) prices in the current year at 9.2 per cent. Growth in 2005-06, initially estimated by the CSO at the AE stage at 8.1 per cent in February 2006, was revised upwards to 8.4 per cent at the revised estimate stage in May 2006 and further to 9.0 per cent in the quick estimates released by the CSO on January 31, 2007.

1.3 The ratcheting up of growth observed in recent years is reflected in the Eleventh Five Year Plan target of an average annual growth of 9 per cent relative to 8 per cent targeted by the Tenth Plan (2002-03 to 2006-07). The shortfall in the annual average growth of 7.6 per cent from the target of 8 per cent in the five years of the Tenth Plan is attributable to the disappointing 3.8 per cent growth in the first year of the Plan and its subsequent surge to 8.6 per cent, on average, in the last four years.

1.4 Services contributed as much as 68.6 per cent of the overall average growth in GDP in the last five years between 2002-03 and 2006-07. Practically, the entire residual contribution came from industry. As a result, in 2006-07, while the share of agriculture in GDP declined to 18.5 per cent, the share of industry and services improved to 26.4 per cent and 55.1 per cent, respectively.

1.5 The lower contribution of industry to GDP growth relative to services in recent years is partly because of its lower share in GDP, and does not adequately capture the signs of industrial resurgence. First, growth of industrial sector, from a low of 2.7 per cent in 2001-02, revived to 7.1 per cent and 7.4 per cent in 2002-03 and 2003-04, respectively, and after accelerating to over 9.5 per cent in the next two years, touched 10.0 per cent in 2006-07. Second, growth of industry, as a proportion of the corresponding growth in services, which was 78.9 per cent on an average between 1991-92 and 1999-2000, improved to 88.7 per cent in the last seven years. Third, within industry, the growth impulses in the sector seem to have spread to manufacturing. Industrial growth would have been even higher, had it not been for a relatively disappointing performance of the other two sub-sectors, namely, mining and quarrying; and electricity, gas and water supply. Fourth, since 1951-52, industry has never consistently grown at over seven per cent per year for more than three years in a row before 2004-05. Fifth, year-on-year, manufacturing, according to the monthly Index of Industrial Production (IIP) available until December 2006, has been growing at double digit rates every month since March 2006, with the solitary exception of the festive month of October.

1.6 A notable feature of the current growth phase is the sharp rise in the rate of investment in the economy. Investment, in general being a forward looking variable, reflects a high degree of business optimism. The revival in gross domestic capital formation (GDCF) that commenced in 2002-03 has been followed by a sharp rise in the rate of investment in the economy for four consecutive years. The earlier estimates of GDCF for 2004-05 of 30.1 per cent, released by CSO in their advance estimates, now stand upgraded to 31.5 percent in the quick estimates. The rate of GDCF for 2005-06 as per the quick estimates released by CSO is 33.8 per cent. This sharp increase in the investment rate has sustained the industrial performance and reinforces the outlook for growth.

1.7 Services sector growth has continued to be broad-based. Among the three sub-sectors of services, ‘trade, hotels, transport and communication services’ has continued to boost the sector by growing at double-digit rates for the fourth successive year (Table 1.2). Impressive progress in information technology (IT) and IT-enabled services, both rail and road traffic, and fast addition to existing stock of telephone connections, particularly mobiles, played a key role in such growth. Growth in financial services (comprising banking, insurance, real estate and business services), after dipping to 5.6 percent in 2003-04 bounced back to 8.7 percent in 2004-05 and 10.9 per cent in 2005-06. The momentum has been maintained with a growth of 11.1 per cent in 2006-07.

1.8 After an annual average of 3.0 per cent in the first five years of the new millennium starting 2001-02, growth of agriculture at only 2.7 per cent in 2006-07, on a base of 6.0 per cent growth in the previous year, is a cause of concern. Low investment, imbalance in fertilizer use, low seeds replacement rate, a distorted incentive system and low post-harvest value addition continued to be a drag on the sector’s performance. Given its low share, a mechanical calculation of the adverse impact of low growth in agriculture on overall GDP can be misleading. With more than half the population directly depending on this sector, low agricultural growth has serious implications for the ‘inclusiveness’ of growth. Furthermore, poor agricultural performance, as the current year has demonstrated, can complicate maintenance of price stability with supply-side problems in essential commodities of day-to-day consumption. The recent spurt of activity in food processing and integration of the supply chain from the farm gate to the consumer’s plate has the potential of redressing some of the root causes such as low investment, poor quality seeds, and little post-harvest processing.

1.9 With a shortfall in domestic production vis-à-vis domestic demand and hardening of international prices, prices of primary commodities, mainly food, have been on the rise in 2006-07 so far. Wheat, pulses, edible oils, fruits and vegetables, and condiments and spices have been the major contributors to the higher inflation rate of primary articles. As much as 39.4 per cent of the overall inflation in WPI on February 3, 2007 came from the primary group of commodities. Within the primary group, the mineral subgroup recorded the highest year-on-year inflation at 18.2 per cent, followed by food articles at 12.2 per cent and non-food articles at 12.0 per cent. Food articles have a high weight of 15.4 per cent in the WPI basket. Including manufactured products such as sugar and edible oils, food articles contributed as much as 27.2 per cent to overall inflation of 6.7 per cent on February 3, 2007.

1.10 Starting with a rate of 3.98 per cent, the inflation rate in 2006-07 has been on a general upward trend with intermittent decreases. However, average inflation in the 52 weeks ending on February 3, 2007 remained at 5 per cent. A spurt in inflation like in the current year has been observed in the recent past in 1997-98, 2000-01, 2003-04 and 2004-05.

1.11 The international annual average price of the Indian basket of crude (about 60 per cent of Oman/Dubai and 40 per cent of Brent), after remaining more or less stable in 2002-04 at around US$27-28 per barrel, increased by over 40 per cent annually in the next two years to reach US$75.2 per barrel on August 8, 2006. To stop the hemorrhaging of public sector oil companies’ finances, there was an unavoidable upward revision of retail selling prices of petro-products on June 6, 2006. The pass-through to consumers was restricted to just 12.5 per cent in a three-way burden sharing arrangement among consumers, Government and oil marketing companies. With the softening of international petroleum prices, domestic prices of petrol (motor spirit) and high-speed diesel were reduced by Rs. 2 and Re.1, respectively with effect from November 30, 2006, and again by the same amounts with effect from February 16, 2007.

1.12 Government closely monitored prices every week and initiated measures to enhance domestic availability of wheat, pulses, sugar and edible oils by a combination of enhanced imports, export restrictions and fiscal concessions. In wheat, State Trading Corporation, the parastatal, tendered overseas for 55 lakh tonnes of wheat; private trade was permitted to import wheat at zero duty from September 9, 2006; and exports were banned from February 9, 2007. The minimum support price (MSP) of wheat was raised by Rs. 50 per quintal and announced well in advance of the sowing season to bring additional acreage under wheat. In pulses, imports were allowed at zero duty from June 8, 2006; export was banned from June 22, 2006; and National Agricultural Cooperative Marketing Federation (NAFED) purchased urad and moong overseas. Regulation of commodity futures markets was strengthened for wheat, sugar and pulses; and as a matter of abundant precaution, futures trading was banned in urad and tur from January 24, 2007. Duty on palm group of oils, which meets more than a half of the domestic demand-supply shortfall in edible oils, was reduced by 20-22.5 percentage points in a phased sequence, first in August 2006 and later in January 2007. Further, tariff values of these oils for import duty assessment were frozen. On January 22, 2007, further duty cuts were announced for portland cement, various metals and machinery items. With a firming up of international prices, the impact of duty-free import of wheat and pulses in rolling the domestic prices back was limited. But such imports improved domestic market discipline.

1.13 Inflation, with its roots in supply-side factors, was accompanied by buoyant growth of money and credit in 2005-06 and 2006-07 so far. While GDP growth accelerated from 7.5 per cent to 9.0 per cent between 2004-05 and 2005-06, the corresponding acceleration in growth of broad money (M3) was from 12.3 per cent to 17.0 per cent. Year-on-year, M3 grew by 21.1 per cent on January 19, 2007. The industrial resurgence and upswing in investment was reflected in, and sustained by, growth of gross bank credit (as per data covering 90 per cent of credit by scheduled commercial banks), for example, to industry (medium and large) at 31.6 per cent and for housing loans at 38.0 per cent in 2005-06. It was also observed in year-on-year growth of gross bank credit at 32.0 per cent in September 2006, albeit marginally down from 37.1 per cent in 2005-06. Reconciling the twin needs of facilitating credit for growth on the one hand and containing liquidity to tame inflation on the other remained a challenge. RBI put a restraint on the rapid growth of personal loans, capital market exposures, residential housing beyond Rs. 20 lakh and commercial real estate loans by more than doubling the provisioning requirements for standard advances under these categories from 0.40 per cent to 1.0 per cent in April 2006. Simultaneously, it increased the risk weight on exposures to commercial real estate from 125 per cent to 150 per cent.

1.14 Liquidity conditions remained fairly comfortable up to early September 2006 with the unwinding of the Central Government surplus balances with the RBI and continued intervention in the foreign exchange market to maintain orderly conditions. During 2006-07, up to September 8, 2006, RBI had not received any bid for repo under Liquidity Adjustment Facility (LAF) and the continuous flow of funds under reverse-repo indicated a comfortable liquidity position. In 2005-06, the reverse repo rate had been raised by 25 basis points each time on April 29 and October 26, 2005, and on January 24, 2006 to reach 5.50 per cent. In 2006-07, it was raised again by 25 basis points each time on June 9 and July 25, 2006. There was some tightness with the onset of the festival season and due to high credit expansion and outflows on account of advance tax payment. From mid-September through October, 2006, while RBI had to provide accommodation to some banks through repo facility, with reverse repo operations simultaneously, in net terms, RBI absorbed liquidity from the system.

1.15 With year-on-year inflation stubbornly above 5 per cent from early-August 2006, on October 31, 2006, the RBI announced more measures to stem inflationary expectations and also to contain the credit off-take at the desired growth rate of 20.0 per cent. Unlike the previous four times, when both the repo and the reverse repo rates were raised by the same 25 basis points, thereby keeping their spread constant at 100 basis points, on October 31, 2006, only the repo rate was raised by 25 basis points. With a repeat of this policy move on January 31, 2007, the repo rate reached 7.50 per cent with a spread of 150 basis points over the reverse repo rate. Since deposits are growing at a lower rate than credit, the higher repo rate signaled to the banks the higher price of accommodation they would have to pay in case of credit overextension.

1.16 The cash reserve ratio (CRR) was hiked by 25 basis points each time on December 23, 2006 (5.25 per cent) and January 6, 2007 (5.50 per cent). While a further increase of CRR of 25 basis points was effected on February 17, another similar increase of 25 basis points will follow on March 3, 2007.

1.17 Sustained faster growth of M3 relative to that of reserve money (M0) observed in recent years continued in 2005-06 and 2006-07 so far with the money multiplier () steadily increasing from 4.43 at end-March 2002 to 4.60 at end-March 2005, 4.76 at end-March 2006 and further to 4.79 on January 19, 2007. The increase in money-multiplier coincided with fast growth of M0 at 17.2 per cent during 2005-06 and year-on-year at 20.0 per cent on January 19, 2007 and resulted in the rapid growth of M3.

1.18 Driving the fast growth of reserve money was net foreign assets (NFA) of the RBI. Even with the redemption of the India Millennium Deposits, NFA of the RBI grew by Rs. 60,193 crore and contributed 12.3 percentage points to the 17.2 per cent growth in M0 during 2005-06. The corresponding growth of NFA between end-March 2006 and January 19, 2007 was Rs. 114,338 crore. Liquidity in the system continued to be addressed by Market Stabilisation Scheme (MSS) operations. Outstanding balance under MSS, after increasing from Rs. 29,062 crore (1.0 per cent of M3) on March 31, 2006 to a high of Rs. 42,364 crore (1.5 per cent of M3) on August 25, 2006, started declining thereafter to reach Rs. 40,491 crore (1.3 per cent of M3) on January 19, 2007.

1.19 The change in the liquidity and inflation environment is reflected in the continuous hardening of interest rates in 2005-06 and in 2006-07 so far. With the high demand for credit not adequately matched by deposit growth, there was steady increase in the credit-deposit ratio and hardening of int up by 84 basis points during 2005-06 to 7.53 per cent at end-March 2006, hardened further to 8.08 erest rates. For example, the yield on 10-year residual maturity Government securities, which had goneper cent on February 14, 2007. Movements in the call money rates also reveal a similar picture. The hardening of rates was more pronounced at the shorter end of the yield curve, suggesting concerns about inflation only in the short run.

1.20 The rapid growth in NFA of the RBI was a reflection of the buoyant flows of foreign exchange reserves through the balance of payments. Reserve accretion through the balance of payments was US$15.1 billion in 2005-06 and US$8.6 billion in the first six months of 2006-07. While the appreciation of the US dollar vis-à-vis other major currencies resulted in a valuation loss of US$5.0 billion in 2005-06, in the first half of the current year, the weakening US dollar resulted in valuation gain of a similar amount. Inclusive of gold, IMF reserve tranche position and valuation changes, foreign exchange reserves grew from US$141.5 at end-March 2005 to US$151.6 billion at end-March 2006, and to US$165.3 at end-September, 2006. Such reserves were US$185.1 billion on February 9, 2007.

1.21 In the balance of payments, in 2005-06 and in the first half of 2006-07, capital flows more than made up for the current account deficits of US$9.2 billion and US$11.7 billion, respectively, and resulted in reserve accretion. The current account deficit reflected the large and growing trade deficit in the last two years. Exports grew fast, but imports grew even faster, reflecting in part the ongoing investment boom and the high international petroleum price. In 2005-06, imports (in US dollar terms and customs basis) had grown by 33.8 per cent. In the first nine months of the current year, imports grew by 36.3 per cent. While petroleum imports continued to grow rapidly, non-oil import growth decelerated to a moderate 18.7 per cent in the first nine months of the current year, primarily because of high bullion prices leading to a decline in import of gold and silver in the first few months of the year. The non-POL trade balance, after remaining in surplus till 2003-04, has turned negative since 2004-05.

1.22 India’s exports (in US dollar terms and customs basis) have been growing at a high rate of more than 20 per cent since 2002-03. During 2005-06, with growth of 23.4 per cent, India’s exports crossed the US$100 billion mark. During 2006-07, after a slow start, exports gained momentum to grow by an estimated 36.3 per cent in the first nine months to reach US$89.5 billion. Buoyancy of exports was driven by the resurgence in the manufacturing sector and sustained demand from major trading partners.

1.23 Overall, the external environment remained supportive with the invisible account remaining strong and stable capital flows seamlessly financing the moderate levels of current account deficit caused primarily by the rise in international oil prices. The trend in invisibles (net), comprising of non-factor services (like travel, transportation, software services and business services), investment income, and transfers, compensating to a large extent the trade deficit continued in 2005-06 and through the first half of 2006-07, and resulted in a moderate current account deficit of 1.1 per cent of GDP in 2005-06.

1.24 As a proportion of GDP, invisibles (receipts) at 11.5 per cent of GDP in 2005-06 exhibited steady growth from a modest level of 2.4 per cent of GDP in 1990-91. The most recent two years have shown acceleration, particularly in software and business services. Simultaneously, invisible payments at 6.2 per cent of GDP in 2005-06 have grown, albeit at lower levels and somewhat unevenly, again with acceleration being noticed in the last two years. Under receipts, tourism earnings are estimated to have crossed the US$6.6 billion in 2006. The UN World Tourism Organisation, in January 2007, has noted the ‘emergence’ of South Asia as a tourist destination, with remarkable growth of 10 per cent in tourist arrivals in 2006 which was more than double the global growth. Furthermore, it noted that growth of toursim in South Asia was ‘boosted by India, the destination responsible for half the arrivals to the sub-region.’

1.25 Capital flows into India remained strong. The composition of flows, however, fluctuated from year to year. In the three-year period, 2002-05, there were large ‘other flows’ (delayed export receipts and others) accounting for a sizeable proportion of net capital flows. After being outflows in the previous two years, external assistance and external commercial borrowing (ECBs) — two major debt-creating flows — picked up in 2004-05. These debt flows, as a proportion of total capital flows, were 25 per cent in 2004-05 and 18 per cent in 2005-06. Foreign investment, as a proportion of capital flows, has remained in the range of 39.1 per cent to 79.3 per cent in the last four years ending in 2005-06. There was strong growth in foreign direct investment (FDI) flows (net), with three-quarters of such flows in the form of equity. The growth rate was 27.4 per cent in 2005-06 followed by 98.4 per cent in April-September 2006. This was even after gross outflows under FDI with domestic corporate entities seeking a global presence to harness scale, technology and market access advantages through acquisitions overseas. FII flows, the dominant variety of portfolio flows, after remaining buoyant until 2005-06, turned into net outflows in the first half of 2006-07. FII flows are reported to have turned positive again in the second half of the current year.

1.26 The buoyancy of foreign investment flows through the balance of payments, in part, reflected the bullish sentiments in the domestic capital markets. The BSE Sensex, the bell-weather stock-index of the Bombay Stock Exchange (BSE), rallied from a low of 8,929 on June 14, 2006 to an all-time intra-day high of 14,724 on February 9, 2007. The rally from the 13,000 mark to the 14,000 mark in only 26 trading sessions was the fastest ever climb of 1,000 points. India with a market capitalization of 91.5 per cent of GDP on January 12, 2007 compared favourably not only with emerging market economies but also with Japan (96 per cent) and South Korea (94.1 per cent). The strength of the market micro-structure from large retail participation continued.

1.27 The positive sentiments were manifest also in most indicators such as resource mobilized through the primary market. Aggregate mobilization, especially through private placements and Initial Public Offerings (IPOs), grew by 30.5 per cent to Rs. 161,769 crore in calendar year 2006, with about 6 IPOs every month, on average. Net mobilisation of resources by mutual funds increased by more than four-fold from Rs. 25,454 crore in 2005 to Rs. 1,04,950 crore in 2006. The sharp rise in mobilisation by mutual funds was due to buoyant inflows under both income/debt oriented schemes and growth/equity oriented schemes. The negative inflows in 2004 turned positive for the public sector mutual funds in 2005 and accelerated in 2006. Other indicators of market sentiments, such as equity returns and price/earnings ratio also continued to be strong and supportive of growth.

1.28 The upbeat mood of the capital markets, reflecting the improved growth prospects of the economy, was partly also a result of steady progress made on the infrastructure front. Overall index of six core industries — electricity, coal, steel, crude oil, petroleum refinery products, and cement, with a weight of 27 per cent in IIP — registered a growth of 8.3 per cent in April-December 2006 compared to 5.5 per cent in April-December 2005. On the transport and communications front, railways maintained its nearly double-digit growth in the first nine months of the current year. There was, however, a growth deceleration in cargo handled at major maritime ports (both exports and imports) and airports (exports). The news of gas discoveries in the Krishna Godavari (KG) basin under New Exploration and Licensing Policy (NELP) in recent months was an encouraging development in the country’s pursuit of reduced import-dependence in hydrocarbons.

1.29 Investment requirements for infrastructure during the Eleventh Five Year plan are estimated to be around US$ 320 billion. While nearly 60 per cent of these resources would come from the public sector, the balance would need to come either from the private sector and/or through public-private partnership (PPP). The potential benefits expected from PPP are: cost-effectiveness, higher productivity, accelerated delivery, clear customer focus, enhanced social service, and recovery of user charges. Further, the additionality of resources that PPP would bring, along with the ‘value for money’, continues to remain critical. Based on the number of projects that have been approved or are under consideration, it is estimated that a leveraging of nearly six times could be achieved through this route.

1.30 The ability of Government and the public sector to invest additional resources for developing the much-needed infrastructure critically depends on the creation of fiscal space. The notification of the Fiscal Responsibility and Budget Management Act (FRBMA) 2003, with effect from July 5, 2004, the culmination of the policy resolve to place the process of fiscal consolidation in an institutional framework, has yielded rich dividends in terms of creating such fiscal space. The fiscal deficit declined to 4.1 per cent of GDP in 2005-06 and was budgeted at 3.8 per cent of GDP in 2006-07. With the implementation of the award of the Twelfth Finance Commission (TFC), which was calibrated to restructure public finances of both the Centre and States, the process gained momentum. In the current year, as a proportion of GDP, the budgeted fiscal deficit of the States has declined to less than the mandated 3 per cent two years ahead of schedule, and only a marginal revenue deficit remains to be eliminated. The decline in the deficit indicators of the Centre has been relatively slower with demands on its resources, inter alia, on account of the implementation of the TFC award and a ‘pause’ in fiscal consolidation in 2005-06. The resumption of the fiscal consolidation process in 2006-07, without compromising the National Common Minimum Programme (NCMP) objectives, indicates the commitment towards meeting the FRBMA targets.

1.31 The fiscal consolidation process underway in India, unlike the expenditure compression strategy in most other countries, has been essentially revenue-led and has involved reprioritisation of expenditure with a focus on outcomes. The tax-GDP ratio of the Centre has steadily risen from 8.8 per cent in 2002-03 to 10.3 per cent in 2005-06 and was budgeted at 11.2 per cent in 2006-07. After growing by 20.3 per cent and 22.7 per cent, respectively in 2005-06, corporate income tax and personal income tax have grown by 55.2 per cent and 30.3 per cent, respectively in April-December 2006 over April-December 2005. Buoyant growth in direct taxes revenue has helped take its share in total revenue to 47.6 per cent in 2006-07 (BE). In the reduction of revenue and fiscal deficits, buoyant revenue growth has been complemented by a discernible shift in the composition of expenditure. While as a proportion of GDP, total expenditure of the Centre declined from 16.8 per cent in 2002-03 to 14.1 per cent in 2005-06, gross budgetary support to the Plan increased on a like-to-like basis from Rs. 111,470 crore to (including disintermediated loans to States) to Rs.172,500 crore. The balance from current revenues, which had remained negative till 2003-04, turned positive in 2004-05 and has strengthened to Rs. 22,332 crore in 2005-06. With non-Plan expenditure as a proportion of total expenditure declining from 73.0 per cent in 2002-03 to 69.4 per cent in 2006-07 (BE), there have been distinct signs of reprioritisation of expenditure. With lower levels of borrowings of Government, the public sector draft on private savings has come down.

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