(MENAFN - Arab Times) On Monday, India's Finance minister P Chidambaram drew up a five-year road map to seek to put its finances in order, aiming to narrow its budget deficit to 5.3% of GDP for the current fiscal year and to bring it down to 3% by 2017.
The fiscal deficit was 5.8% in 2011-2012. The road map, although lacking in details, demonstrates the government's intent to walk the talk on budgetary discipline amidst hopes that the roadmap will serve as a cue for the Reserve Bank of India (RBI) to cut policy interest rates. Mr. Chidambaram's plan draws from the recommendations that a committee headed by former finance secretary Vijay Kelkar had laid out in a recent report which called for reform initiatives, a heavy cut in subsidies and controls on government expenditure.
High subsidies have widened the government's fiscal deficit " shorthand for the amount of money that it borrows to fund its expenses " limiting its elbow room to spend on investing in infrastructure and development schemes to spin jobs and multiply income. Chidambaram said efforts will be made to avoid "parking or idling of funds" while ensuring that essential expenditure was not hurt. Mr. Chidambaram said the government has initiated a process to provide cash subsides directly to consumers, instead of paying companies such as refiners and fertilizer producers to keep prices low. The government is also confident of meeting its target of raising INR300.0bln (USD5.56 bln) by selling stakes in several companies in the current fiscal year through March 2013. Experts said the roadmap was good in intent, but lacked detail. As with other reform measures announced since mid-September 2012, which included increasing the price of diesel and allowing more foreign investment in sectors including retail, aviation and broadcast, we believe implementation remains key and view the announcement as a statement of intent.
In late July 2012, the RBI slashed its growth forecast for the current fiscal year through March 2013 to 6.5% from 7.3%. It now says even this lowered projection may not be achieved. Economists already have forecast much weaker growth-possibly as low as 5.0%-this fiscal year because of high interest rates, slow economic reforms and the effects of global economic uncertainties. But despite the slowdown, the RBI has been reluctant to cut rates because inflation has remained sticky, last accelerating to 7.8% y-o-y in September 2012, the highest in 10 months (more on this below). The RBI held its policy rate steady at the last three reviews after cutting it by half a percentage point in April 2012.
The RBI has said the government must have a credible fiscal consolidation plan before it could consider a rate cut. The RBI said Monday it needs to remain cautious for some more time because inflation risks are still high, but it acknowledged that economic growth has slowed sharply and that it could slip below the central bank's forecast for the year. The central bank is widely expected to hold interest rates steady to keep a check on inflation despite the economy slowing to its weakest pace in nearly a decade. However, we believe there is a possibility the central bank could cut its policy rate to back recent government steps to improve its finances, such as raising the price of subsidized diesel.
Recent Developments in India
Following its recent decision in increasing diesel prices designed to cut a budget deficit swollen by energy subsidies, as well as counter the threat of becoming the first of the BRICs economies to be downgraded to junk, India's central bank unexpectedly reduced the amount of deposits lenders must set aside as reserves, supporting the government's push to revive growth even as it kept interest rates unchanged to damp elevated inflation.
On 17 September 2012, Governor Duvvuri Subbarao cut the cash reserve ratio to 4.5% from 4.75%, effective 22 September 2012, adding about INR170.0bln (USD3.12bln) to the banking system. The central bank kept the benchmark repurchase rate at 8.0%, leaving it unchanged for a third meeting as expected.
According to the Reserve Bank of India (RBI), the "primary focus" remains the containment of price pressures. Currently, inflation and India's fiscal and current-account shortfalls constrain a stronger monetary policy response to growth risks. The government's recent actions have paved the way for a more favourable growth-inflation dynamic, the central bank said. Several challenges remain, one of which is persistent inflation. But, as policy actions to stimulate growth materialize, monetary policy will reinforce the positive impact of these actions while maintaining its focus on inflation management. RBI's decision comes after Asian nations such as the Philippines, Indonesia, Malaysia and South Korea held rates last month.
Current Economic Scenario and Budget Deficit
After years of high growth, India is now running into more turbulent weather. GDP eased significantly to 5.3% y-o-y in 1Q12 (April-June 2012) from 6.1% y-o-y in 4Q11, weighed down by a contraction in the manufacturing sector, marking the slowest quarterly expansion in nine years. Breakdown showed that India's manufacturing sector (which contributes roughly 15.7% of total GDP) declined -0.3% y-o-y in 1Q12 from 0.6% y-o-y in 4Q11 as high raw material costs, public-policy ambivalence, tight monetary conditions and global uncertainty took their toll on the manufacturing sector.
Meanwhile, India's manufacturing activity held steady in September 2012 as an increase in factory output, export orders and purchases was offset by a deceleration in employment. The seasonally adjusted measure, prepared by Markit, came in at 52.8, unchanged from the level in August 2012, but higher than the 50-point level that separates expansion from contraction. A figure above 50 indicates expansion, igniting some hope that the country's manufacturing sector has stabilised.
In a turn of events, India's industrial output grew at a modest 2.7% y-o-y in August 2012 beating consensus expectation of a 1.1% growth. The still-weak industrial production momentum confirms industrial activity remains subdued and overall economic momentum muted. The data, released by the Central Statistics Office on 12 October 2012, showed capital goods output, seen as a key indicator of future investment, slumped 1.7% (July 2012: -5.0%) The data was more evidence that the problems afflicting Asia's third largest economy are far from over. GDP has grown 5.5% or less in the last two quarters, a far cry from the 7.0%-8.0%growth seen in the preceding period.
Standard & Poor's and Fitch Ratings this year cut the India's sovereign credit outlook to negative, a step closer to non-investment grade rating, citing widening budget deficit.
The high cost of imported fuel is partly blamed for the ballooning of India's current-account deficit (the gap between exports and goods and services imports) to its widest level in eight years. Currently, India plans to trim its subsidy bill for food, fuel and fertilizer by 12.0% to INR1.9tln, or 2.0% of GDP, this financial year.
On 14 September 2012, the Indian government announced a slew of long over-due measures to boost investment and prop up the rupee. These included allowing foreign direct investment (FDI) in broadcast, multi-brand retail and aviation, together with partial privatization of four state-run industries. The central bank said the government's recent actions had paved the way for more favourable economic conditions by initiating a shift in expenditure away from consumption by reducing fuel subsidies and toward investment, including through foreign direct investment. However, we foresee a lag in implementation, as the Indian government has a history of flip-flopping on policies in the face of political pressure. In December 2011, for example, the government unveiled plans for FDI in multiband retailing, only to back away from it days later.
The Current Inflation Background
On the inflation front, it has quickened lately, a climb that may be exacerbated by the first increase in diesel prices in 14 months and a rise in commodities as the U.S. steps up monetary easing. India boosted the subsidised fuel's tariff on 14 September 2012 to pare its fiscal deficit.
The decision by the government of Manmohan Singh trails intense pressure to plug one of the biggest drains on the treasury, arising from the projected USD34.0bln annual cost of fuel subsidies at a time of high world oil prices. It will also help refiners cut revenue losses by about INR203.0bln (USD3.7bln). The long-awaited move was greeted with elation by investors and raised expectations of more reforms to reverse an investment slump and resuscitate a sluggish economy.
To recap, a cabinet committee increased diesel prices by 5 rupees per litre effective Friday, 14 September 2012. That translates as a 14.0% rise, including taxes, with diesel at the pump now costing roughly INR47 per litre. The hike is the first in 15 months (first increase was on 25 June 2011). Meanwhile, gasoline and kerosene were left unchanged, however the committee decided to limit the number of subsidized cooking gas cylinders per household to six per year, a move seen as hitting the poor hard. Any LPG cylinders bought over this ceiling will be at market rates, which could almost double the price.
Consequently, following the price hike, Indian inflation accelerated to the highest level in 10 months in September 2012, limiting the central bank's ability to cut rates to help support the slowing economy. The wholesale price index rose 7.81% y-o-y in September 2012 (August 2012: 7.55% y-o-y) due to a rise in fuel prices. Fuel prices shot up 4.0% m-o-m in September 2012 after rising 3.1% in August 2012. The government also sharply revised up July 2012's inflation print to 7.52% from 6.87% reported earlier. The inflation results complicate the RBI's task. It will have to decide between cutting rates and risk stoking inflation or keeping rates steady to hold prices down even though that may push Asia's third-largest economy deeper into a slowdown. The RBI has been struggling to control inflation for some years now. It raised interest rates 13 times in 2010 and 2011, but upward price pressures remain due to an inefficient farm supply chain and the government's loose fiscal stance, which dilutes monetary policy efforts. Moving forward, we believe headline WPI inflation will continue to remain high in the range of 7.0%-8.0% y-o-y in 2012 as commodity and food prices will remain elevated.
The sharp deceleration in 1Q12 GDP growth has clearly induced concerns pertaining to easing growth rate in 2012. Our assessment of leading indicators of several sectors points at further possible deceleration in growth momentum. Hence, we are revising downwards our 2012 growth projection for India to 6.5%-7.0% y-o-y from earlier forecast of 7.5% y-o-y. Nevertheless, we are still optimistic about India's strong domestic demand will cushion the negative impact from external conditions, especially the services sector. The private consumption remains the major contributor for economic growth at 60.0% of India's GDP.