IMF cautions India against domestic, external headwinds to growth

Even as the government is looking to revive domestic economy, the International Monetary Fund (IMF) has cautioned it against companies’ weak balance sheets, government-run banks’ deteriorating asset quality, and external shocks — all of which might impede the recovery.

In its country report on India, under Article IV of its agreement, IMF also advises the government to look at the quality of fiscal consolidation by augmenting tax collections and reducing subsidies, instead of lowering capital expenditure. Though the report was prepared on February 13 — before the Union Budget for 2015-16 was presented on February 28 — it says the target of narrowing the Centre’s fiscal deficit to three per cent of gross domestic product (GDP) by 2016-17 could be challenging. The Budget deferred the timeline for this target by a year.

At a time when there are talks that India might clock up to 8.5 per cent economic growth rate next financial year, compared with the projected 7.4 per cent this year, thanks to new GDP data, IMF’s projections seem to temper some of the exuberance. Its estimates are based on GDP at factor cost (excluding indirect taxes), a parameter not used in official projections any more.

The international body has projected India’s economy to annually grow at the rate of 6.3 per cent to 6.7 per cent in the next five years. That is lower than the average annual GDP expansion of eight per cent seen in the five years preceding the global economic slowdown of 2008.

By the revised methodology for calculating GDP, and taking 2011-12 as the new base year (against the earlier 2004-05), IMF projects India’s economy to grow 7.2 per cent in 2014-15 and 7.5 per cent in 2015-16. Both rates are lower than the government estimates — 7.4 per cent projected for 2014-15 in the advance estimates and 8.1-8.5 per cent pegged for 2015-16 by the Economic Survey.

IMF attributes the slower projected growth rate to the presence of supply-side bottlenecks and structural challenges. It assumes no substantial legislative changes while making these projections. Some, however, see this as a little unreasonable, given that several reform Bills are under consideration in Parliament.

The report also has a word of praise for the Narendra Modi-led central government. It says the new government, coming to power on expectations of economic reforms, has initiated these. Diesel price deregulation, raising of natural gas prices, labour market reforms and those related to coal are some such initiatives.

But IMF warns that “much remains to be done to raise potential growth, in areas of reforming factor and product markets, many of which are on the concurrent list, and thus will require consensus building to implement”.

The Fund says credit growth is anaemic at present, reflecting weakened balance sheets of public-sector banks (PSBs) and lower demand for bank credit among companies. These are headwinds to growth.

It says any further deterioration in PSBs’ asset quality could constrain their credit supply. It attributes asset-quality issues to weak economic growth in the past and delays in implementation of infrastructure projects. IMF pins its hopes on capital markets (both corporate bonds and equities) to help contribute to financing growth.

It also points to corporate vulnerabilities, saying the share of loss-making companies and those with a leverage ratio above two in total debt increased respectively to 22.9 per cent and 31.4 per cent during 2013-14, though the share of firms with interest coverage ratio below one fell by 2.5 percentage points to 13.8 per cent.

Quoting the Reserve Bank of India’s annual report for 2013-14, it says infrastructure, textiles, engineering, metals & products, chemicals, and mining accounted for 36 per cent of bad assets as of March 2014, subject to greater stress. It also points to unhedged funds of companies.

India’s representative at IMF, Rakesh Mohan, says in a statement on IMF report that though the macroeconomic situation is improving, some challenges to putting the economy back on a sustainable high-growth path remain.

He, along with senior advisor Janak Raj, says investment activity remains weak as some segments of the corporate sector are overleveraged and its related impact shows on banks’ balance sheets.

“A full-blown recovery of the private sector is thus being restrained. Fiscal consolidation could also have some impact on the speed of economic activity. Our authorities are, therefore, trying to strike a fine balance between supporting the recovery and pursuing a prudent fiscal policy,” the statement says.

Though India’s external vulnerabilities have moderated since September 2013, due to effective policy actions and strengthened external buffers, risks remain, says IMF.

The Fund adds the spillover of a volatility in the global financial market, including from unexpected developments in the course of US monetary policy normalisation, could be very disruptive for India.

The warning assumes importance against the backdrop of the US reporting robust job data for February, sparking off talks of a withdrawal of its bond-purchase programme.

In their interactions with IMF, Indian authorities, however, said fundamentals of India’s economy were stronger, reserves were higher, and markets seemed to be distinguishing India from other major emerging-market economies. But they also recognised risks, including those from lower global growth and higher oil prices stemming from geopolitical events.

In the event of external volatility, IMF recommends exchange-rate flexibility as a key shock absorber; it will allow an orderly depreciation of the rupee, with judicious forex intervention in both spot and forward markets, and through liquidity provision through swaps.

Though inflation has dropped substantially, IMF advises RBI to continue maintaining a tight monetary stance, as supply-side issues of inflation are yet to be sorted out. RBI, though, has cut the key repo rate twice recently.

The Fund prescribes a tight monetary stance in the event of volatility in external fund flows as well, to make it costlier to short the rupee, to temporarily bolster the capital account position, and to contain the inflationary impact of an exchange-rate depreciation.

The report also talks of the monetary policy framework and inflation targeting. An agreement for this, though, has already been signed between the finance ministry and RBI; the constitution of this monetary policy  committee remains to be worked out.

IMF says the target of keeping  inflation in the band of four per cent (plus/minus two per cent) requires ramping up of food supply, in line with a strong consumption demand, especially given that food items have a high weight on the consumer price index.