The report notes that current developments are challenging India’s strong growth performance of recent years. Emerging capacity constraints, continued rapid expansion in credit, and an increase in global commodity prices have combined to trigger a spike in domestic inflation.
The report warns that global commodity prices and domestic demand growth supported by price subsidies will continue to place upward pressure on prices. Further, the government’s attempts to rein in inflation through monetary policy tightening combined with ad hoc interventions, including reduction in customs duties and bans on export of essential commodities, are having limited impact. Real interest rates have actually fallen and the projections for the inflation rate, based on the wholesale price index, have been adjusted upward to 11.5% in FY2008 and 7.5% in FY2009.
"The Indian economy is now at a critical juncture where policies to contain inflation and ensure macroeconomic stabilization have taken center stage," says Ifzal Ali, Chief Economist of the Manila-based multilateral development bank.
GDP growth at 7.9% in the first quarter of FY2008 (April-June), saw the slowest expansion in three and a half years. The slowdown was broad-based. The most pronounced slide was in industry, dragged down by a halving in the manufacturing growth rate.
Higher interest rates and a weakening global and domestic outlook have caused companies to scale back investment. Growth in investment will continue to be limited by faltering business confidence, fewer options for foreign financing owing to a drop in risk appetite by foreign financial institutions, growing difficulties in securing domestic bank financing, and the need to maintain tight monetary conditions and high interest rates to bring down inflation.
The trade and current account deficits have grown wider in recent years, reflecting the impact of escalating oil prices and the expansion in non-oil imports, led by rapid growth in consumer and investment demand.
Net capital inflows are on a much lower track than a year ago as foreign exchange reserves have fallen by $13 billion in the first five months of FY2008 (through end-August). Nevertheless, the accumulated reserves of over 20% of the fiscal year’s estimated GDP provide a very generous cushion against external vulnerabilities.
The report notes that the escalation in oil, fertilizer, and food subsidies, as well as other off-budget liabilities has created large fiscal imbalances.
"Cutting the subsidies is a daunting task, but maintaining them would imperil any return to the high-growth path of recent years," says Mr. Ali.
The report says that India faces a serious dilemma in macroeconomic stabilization. On the one hand, further monetary tightening could threaten growth objectives. On the other hand, financing the current level of subsidies will increase the pressure for rapid credit expansion which, unless checked, will lead to higher inflation. Additional tightening in policy, raising both nominal and real interest rates, will be likely required.
"Dealing with rising prices and a worsening fiscal situation, as well as the need to adopt structural reforms to fulfill the country’s enormous economic potential present a difficult task for the country’s economic managers," says Mr. Ali.
