Part One

In this section we will review the Macroeconomic and Monetary developments, for the financial year 2006 – 2007

Part Two

Assessment of the performance of the Indian economy and the probable risks.

Part One

Review of the Macroeconomic and Monetary developments

for the financial year 2006 – 2007

Past at a Glance

Sometimes India is described as a re-emerging economy. Since in the 18^th century, this geographical area had accounted for about a quarter of world output – but that is part of history. The economy of independent India which is of contemporary interest had to be built upon the overhang issues of second World War, the trauma of partition, the integration of princely states numbering over 500 and a low level of GDP. We have witnessed one serious balance of payments crisis triggered largely by the Gulf war in the early 1990s. Credible macroeconomic structural and stabilization programme was undertaken in the wake of the crisis. The Indian economy in later years, could successfully avoid any adverse contagion impact of shocks from the East Asian crisis, sanction like situation in post-Pokhran scenario, and border conflict during May-June 1999.

The average saving rate in India was 10 per cent in the 1950s, which rose to 17.5 per cent in the 1970s and further to 23.4 per cent in the 1990s. The saving rate was 32.4 per cent in 2005-06. The strengthening of economic activity in the recent years has been supported by persistent increase in gross domestic investment rates from 22.9 per cent of GDP in 2001-02 to 33.8 per cent in 2005-06. It may also be noted that over 95 per cent of investment in the country during this period was financed by the domestic savings.

On the price stability front, India's performance has been fairly good. Since independence, the inflation rate, in terms of the wholesale price index (WPI), on an average basis, was above 15 per cent in only five out of fifty years. In thirty-six out of fifty years, inflation was in single digit and on most occasions high inflation was due to shocks – food or oil.

The inflation rate accelerated steadily from an annual average of 1.7 per cent during the 1950s to 6.4 percent during the 1960s and further to 9.0 per cent in the 1970s before easing marginally to 8.0 per cent in the 1980s. However, the inflation rate declined from an average of 11.0 per cent during 1990-95 to 5.3 per cent during the second half of the 1990s (1995-2000) and further to 4.9 per cent during 2003-07.

The average current account deficit since 1950-51 has been around one per cent of the GDP. During this period, except for 11 years when there was marginal surplus in the current account, we had modest deficit during the rest of the years. In the aftermath of the balance of payment crisis in the early 1990s, several stabilization and structural reform measures were undertaken.

In recent period, there has been considerable improvement in the fiscal position. The average gross fiscal deficit of the central government as per cent to GDP during the decade of 1980s was 6.8 per cent as against 3.8 per cent in the 1970s. The Government of India is pursuing the path of rule-based fiscal consolidation from the year 2004-05 under the Fiscal Responsibility and Budget Management Act, 2003 whereunder time-specific targets have been mandated. The underlying purpose of the targets is to reduce the ratio of gross fiscal deficit (GFD) to gross domestic product (GDP) to three per cent by 2008-09. Furthermore, the revenue deficit (RD) to GDP ratio has been targeted to touch 0.0 per cent by 2008-09 so that borrowed resources can be used to meet only capital expenditures. The progress of targeted fiscal consolidation has been satisfactory so far and GFD/GDP and RD/GDP ratios are budgeted to reduce to 3.3 per cent and 1.5 per cent, respectively, in 2007-08. The objective is to meet the targets under the Fiscal Responsibility Act by 2008-09.

Overall from an annual average growth rate of 3.5 per cent during 1950 to 1980, the growth rate of the Indian economy accelerated to around 6.0 per cent in the 1980s and 1990s. In the last four years (2003-04 to 2006-07), the Indian economy grew by 8.6 per cent. In 2005-06 and 2006-07, it had grown at a higher rate of 9.0 and 9.4 per cent, respectively. There is, thus, tangible evidence of self-accelerating growth. This robust macroeconomic performance, in the face of recent oil as well as food shocks, demonstrates the vibrance and resilience of the

Now we will review sector wise growth and several macroeconomic and monetary developments that took place in the financial year 2006 – 2007 in Indian Economy.

Real gross domestic product (GDP) growth for 2006-07 was placed at 9.2 per cent in the advance estimates of the Central Statistical Organisation (CSO) released in February 2007, over and above 9.0 per cent in 2005-06. These estimates have vindicated the overall optimism building around the performance of the Indian economy which was also reflected in successive upward revisions in growth projections by various agencies during the course of 2006-07.

.Real GDP originating from agriculture and allied activities is estimated to have registered a growth of 2.7 per cent in 2006-07, closer to the trend growth but lower than 6.0 per cent in the previous year. According to the estimates of the Ministry of Agriculture released in April 2007, total foodgrains production is expected to have increased marginally to 211.8 million tonnes in 2006-07 from 208.6 million tonnes in 2005-06. Among the commercial crops, production of sugarcane is estimated to have increased by 14.9 per cent in 2006-07, making India one of the top producers of sugar in the world, along with Brazil.

Industrial activity expanded strongly, with real GDP originating in industry estimated to have risen by 10.2 per cent in 2006-07 as compared with 8.0 per cent in the previous year. The index of industrial production (IIP) recorded an increase of 11.1 per cent during April-February 2006-07 vis-à-vis 8.1 per cent a year ago. Among all constituent sub-sectors , manufacturing, the prime mover, recorded a growth of 12.1 per cent as compared with 9.1 per cent a year ago.

The production of consumer and capital goods increased by 9.5 per cent and 17.8 per cent, respectively, during April-February 2006-07 over and above the increase of 12.0 per cent and 16.3 per cent a year ago.

Corporate sector performance continued to remain buoyant, supported by favourable domestic and export demand conditions during 2006-07. During April-December 2006, sales and net profits of selected non-financial private companies increased by 28.9 per cent and 48.7 per cent, respectively, as against 16.1 per cent and 36.8 per cent in the corresponding period of the preceding year. Profitability ratios were 1.5 to 2.0 percentage points higher than a year ago, reflecting both sales growth and operational efficiency gains. Strong capacity enhancement was also reflected in the increase of 16.7 per cent in depreciation provision. While the momentum of economic activity and the turnaround in the interest rate cycle resulted in an increase of 17.7 per cent in interest payments in contrast to the decline recorded in the preceding two years, higher growth in sales and gross profits in relation to interest payments ensured a lower interest burden (i.e., interest payments relative to gross profits) and interest cost to sales at 12.9 per cent and
2.1 per cent, respectively, as against 16.4 per cent and 2.3 per cent in April-December 2005. Rsults for the fourth quarter of 2006-07 indicate that the underlying strength of corporate performance as reflected in sales and earnings growth has been sustained.

Real GDP originating in the services sector increased by 11.0 per cent during 2006-07 as against 10.3 per cent a year ago. The growth of trade, hotels and restaurants, transport, storage and communication accelerated to 13.0 per cent in 2006-07 from 10.4 per cent in 2005-06. The construction sector registered a lower growth of 9.4 per cent as compared with 14.2 per cent in the previous year. The growth in activity in financing, insurance, real estate and business services, and community, social and personal services at 11.1 per cent and 7.8 per cent, respectively, were comparable to 10.9 per cent and 7.7 per cent in 2005-06.

Provisional information on the sectoral pattern of bank credit available up to December 2006 indicates some evening out of the skew towards the retail and services sector that dominated the deployment of gross bank credit since 2003-04. While on a year-on-year basis, personal loans continued to record the highest growth among major sectors, credit off-take was the highest in respect of the industrial sector in 2006-07. Personal loans recorded a growth of 34.9 per cent by December 2006 followed by services (32.4 per cent), agriculture (31.2 per cent) and industry (27.8 per cent). Housing loans increased by 30.3 per cent while real estate loans rose by 66.7 per cent by December 2006.

Aggregate deposits of SCBs increased by 23.0 per cent (Rs.4,85,210 crore) during 2006-07 as against 18.1 per cent (Rs.3,23,913 crore) in the previous year. Demand deposit growth slowed to 16.0 per cent from 27.5 per cent in 2005-06 but time deposit growth of 24.5 per cent was notably high vis-à-vis 16.4 per cent in the previous year. Several features distinguish deposit growth during 2006-07. First, there was a clear shift from postal savings to time deposits of banks due to favourable interest rate differentials. Second, the tax incentive available on small savings and equity-linked investments was extended to long-term bank deposits. Third, banks aggressively mobilised deposits in order to rebalance their portfolios consistent with emerging needs. Fourth, supported by continued high profitability, cash-rich private and public companies parked their surplus funds with banks. Fifth, non-resident deposits registered a higher growth during 2006-07 than in the previous year.

Inflation, measured by variations in the wholesale price index (WPI) on a year-on-year basis, increased from 4.1 per cent at end-March 2006 to an intra-year peak of 6.7 per cent in end-January 2007 and remained firm in the range of 6.1-6.6 per cent in the succeeding weeks before moderating to 5.7 per cent on March 31, 2007. As on July 6^th inflation stood at 4.11 per cent

as against 3.8 per cent a year ago. On an average basis, annual inflation increased from 4.4 per cent in 2005-06 to 5.4 per cent in 2006-07.

Balance of payments data released at the end of March 2007 indicate sustained strength and vibrancy in the external sector over the first nine months of 2006-07, reflecting the robust macroeconomic fundamentals. While merchandise export growth remained strong as in the past few years, it decelerated in US dollar terms to 22.5 per cent in April-December 2006 from 29.5 per cent in the corresponding period of 2005-06. The loss of momentum was mainly due to lower growth in exports of chemicals and related products, textile and related products, leather and manufactures and a decline in exports of handicrafts and gems and jewellery.

Net accretion to foreign exchange reserves, excluding valuation changes, amounted to US $ 16.2 billion during April-December 2006 as against US $ 1.8 billion in April-December 2005. Valuation gains, reflecting the appreciation of major currencies against the US dollar, accounted for US $ 9.4 billion of the total accretion to the reserves during April-December 2006 as against a valuation loss of US $ 6.1 billion in the corresponding period of 2005-06.

Overall Assessment

The distinguishing feature of India’s macroeconomic performance in 2006-07 has been the strong acceleration of growth. Industry and services, comprising 82 per cent of the economy, registered double-digit growth. The step-up in the overall growth momentum, setbacks to agriculture notwithstanding, occurred inter alia in an environment of building international interest, and rising business and consumer confidence domestically, in the strength and dynamism of the economy

While there seems to be evidence of structural changes taking place in the economy, there are indications that the upsurge of demand pressures in 2006-07 may contain a cyclical component.

First, as regards structural changes, the recent growth momentum is driven by a step-up in the investment rate, which, in turn, is supported by a sizeable increase in the rate of gross domestic saving. Second, India’s linkages with the global economy are getting stronger, underpinned by the growing openness of the economy. The ratio of merchandise exports to GDP has been rising since the 1990s reflecting growing international competitiveness. This has been supported by buoyancy in export of software and business services, indicative of the knowledge advantage and the sophistication setting into the domestic services sector. Third, there are indications of some improvement in capital use,a turnaround in total factor productivity in manufacturing since 2002-03, restructuring during the period 1996-2003, and a steady improvement in productivity growth in the services sector.

At the same time, it is important to take note of various cyclical factors underlying the recent growth experience.

It is important to assess the optimism generated by India’s recent macroeconomic performance against the evolving configuration of risks which are likely to shape the outlook.

First, the buoyant growth in industry and services has been somewhat marred by the setback to agriculture which has suffered substantial deceleration and instability. It is now widely recognised that the performance of agriculture is critical not only for output and employment but also, particularly for price stability. There has been a virtual stagnation in the output of major food crops.

Second, in the domestic economy, there are indications that supply constraints are impacting the growth momentum. Alongside shortfalls in agricultural performance, large gaps have emerged in the physical infrastructure. In fact, infrastructural bottlenecks are emerging as the single most important constraint on the Indian economy.

Third, a significant worrisome feature of domestic developments in 2006-07 is the firming up of inflation through the year. Currently ruling above indicative projections in terms of wholesale prices and at unconscionable levels in terms of consumer prices, inflation represents the key downside risk to the evolving macroeconomic outlook. It is important to undertake a careful assessment of the manner in which inflation is evolving.

Fourth , Global real GDP growth, both at market exchange rates and on a purchasing power parity basis, is expected to decelerate by about 50 basis points relative to the preceding year. In the mature economies, continuing weaknesses in housing markets and volatility in equity markets remain concerns in the context of the growth outlook. In the emerging economies, there are heightened concerns about the sustainability of capital flows, commodity prices and global liquidity, with potential adverse consequences for otherwise firm growth prospects.

Fifth, Volatility in international financial markets has increased in recent months with deterioration in the sub-prime segment of the US mortgage market in early 2007, concerns on systemic implications of hedge fund failures and the wide diffusion of risks through derivative markets. There are also worries that a sharp reversal of carry trades could precipitate liquidity stress and affect near-term prospects of emerging market economies, should there occur a generalised search for safe haven.

To sum up the assessment, global growth is strong but expected to moderate in 2007 relative to 2006. Inflationary pressures are evident along with elevated levels of commoditty and asset prices and the withdrawal of monetary accommodation is likely to persist. In the global financial markets, current indications suggest that the risks, including geopolitical risks, remain under-priced and diffused. On the domestic front, there is evidence of some cyclical elements though a significant structural change is taking place in the Indian economy. There is a gathering confidence that the economy is possibly poised on the threshold of a step-up in the growth trajectory. However, demand pressures appear to have intensified alongside robust growth and there are increased supply side pressures in evidence.