Macroeconomic Overview 

The performance of the Indian economy in 2004-05 so far has exceeded expectations formed at the beginning of the year. Buoyed by a rebound in the agriculture and allied sector, and strongly helped by improved performance in industry and services, the economy had registered a growth rate of 8.5 per cent in 2003-04, the highest ever except in 1975-76 and 1988-89. Normally, strong growth is expected after anaemic growth, and vice versa. Following the ëbumperí growth in 2003-04, initial growth projections for 2004-05 were placed in the range of 6.2 per cent to 7.4 per cent. Modest expectations were further pared down to around 6.1 per cent when rainfall, after remaining normal in June, 2004, became deficient in the crucial sowing month of July and the shortfall in the south-west monsoon turned out to be 13 per cent. Deterioration in the benign world inflation environment, particularly of petroleum, coal and steel, led to further apprehensions about growth and inflation.

1.2  In the event, according to the advance estimate of the Central Statistical Organisation (CSO) released on February 7, 2005 , the economy is likely to grow by 6.9 per cent in 2004-05. Year-on-year WPI-based inflation was 5 per cent on February 5, 2005 (Table 1.1). The economy has managed to maintain the growth momentum in spite of a deficient south-west monsoon, hardening international prices of oil and steel and, last but not the least, its first recorded experience of tsunami which caused extensive damage to life and property in Andaman & Nicobar islands, and 2,260 kms of coastline in Tamil Nadu, Kerala, Andhra Pradesh and Pondicherry.

1.3  After a drought-induced decline of 7.0 per cent in 2002-03, the growth rate in the agriculture and allied sector bounced back to 9.6 per cent in 2003-04. While industry maintained the higher growth of 6.6 per cent observed in 2002-03, the services sector improved its performance significantly from 7.9 per cent in 2002-03 to 9.1 per cent in 2003-04. Growth in the industry and services sectors in 2003-04 was broad-based with manufacturing, public utilities, the trade, hotels, transport and communication group, and community, social and personal services recording higher growth than that in the previous year.

1.4  The year 2004-05 began on a promising note with buoyant industrial growth, early onset of monsoon and forecast of a normal rainfall. But, in the event, the kharif (summer) crop suffered from a shortfall in the south-west monsoon, particularly in July. While the short-fall in kharif foodgrains output is likely to be partly offset by the prospects of a good rabi crop, overall foodgrains production in 2004-05 is estimated to decline by about 3 per cent (Figure 1.1). Yet, with a comfortable buffer of foodgrain stocks, pressure on food manage-ment is minimal. Furthermore, with buoyant performance of non-foodgrains agriculture (e.g. cotton, fruits and vegetables, and dairy), the agriculture and allied sector is expected to grow by 1.1 per cent in the current year (Table 1.2). Not only has the share of foodgrains in agriculture declined, but the share of agriculture in GDP has also gone down by as much as 3.5 percentage points since 2001-02.

1.5  Despite this setback in the kharif crop, the outlook for 2004-05 remains robust because of the persistence of the overall growth momentum observed in 2003-04 through the current year. With distinct signs of continuation of global recovery and world output growth estimated at 5.0 per cent in 2004, the highest in nearly three decades, the Indian economy is expected to do well in 2004-05.

1.6  GDP grew by 7.4 per cent in the first quarter and 6.6 per cent in the second quarter of the current year, compared with 5.3 per cent and 8.6 per cent in the corresponding quarters of the previous year. The deceleration of growth in the second quarter is on account of a negative growth of 0.8 per cent in agriculture and allied sector, a lower growth of 8.2 per cent in the services sector compared with 9.5 per cent in the first quarter, and a fall in the growth of community, social and personal services. The growth in industry accelerated from 6.9 per cent in the first quarter to 8.1 per cent in the second quarter. Within industry, growth in manufacturing accelerated from 8.0 per cent in the first quarter to 9.3 per cent in the second quarter, the highest in any quarter since 1997-98, when CSO started compiling quarterly estimates. Despite a lower growth in the second quarter, the overall growth in the first half of the current year at 7.0 per cent is marginally higher than the growth of 6.9 per cent achieved in the same period last year.

1.7  There was a sudden bout of inflation in the first half of 2004-05, caused by a combination of factors, some exogenous, like the sharp rise in global petroleum prices, deficient rainfall-induced inflationary expectations and monetary overhang from accretion of foreign exchange reserves. The year 2004-05, after starting with a point-to-point, annual inflation rate of 4.5 per cent on April 3, 2004 witnessed a peak level of inflation at 8.7 per cent on August 28, 2004 , the highest in the last four years. However, as a result of the quick monetary and fiscal measures taken by the Reserve Bank of India (RBI) and Government, coupled with a slight easing of global petroleum prices, inflation has been on a declining trend and stood at 5 per cent on February 5, 2005 compared to 6.1 per cent a year ago.

1.8  The 52-week average inflation rate at 6.4 per cent on February 5, 2005 was, however, higher than the 5.5 per cent registered last year. In the current year up to February 5, 2005 , both manufactured products and primary articles recorded lower year-on-year inflation rates at 4.5 per cent and 1.6 per cent, respectively, compared to 6.7 per cent and 3.4 per cent, respectively, last year. But there was acceleration in the inflation rate of the fuel, power, light and lubricant group from 7.6 per cent last year to 10.0 per cent this year due to a hardening of international prices of oil and minerals. The major groups witnessing high year-on-year inflation as on February 5, 2005 include minerals (135.5 per cent), coal (16.2 per cent), petroleum, oil and lubricants (POL) (14.6 per cent), sugar group (21.4 per cent), and basic metals and products (16.0 per cent). The contribution of these items with a combined weight of 21.5 per cent in the WPI was 88 per cent to the current inflation, compared to 52 per cent a year ago. The hardening of international prices of these commodities (except sugar) due to a surge in global demand shows that a major part of inflation is due to external factors.

1.9  Year-on-year inflation as measured by the Consumer Price Index (CPI) for industrial workers declined significantly from 5.1 per cent in April 2003 to 3.5 per cent in March 2004 and further to 2.2 per cent in April 2004. Thereafter, the CPI inflation rate started registering an increasing trend reaching 4.8 per cent in September 2004, as WPI inflation pushed up the consumer prices also. Partly in response to policy measures, and the subsequent easing of external pressure of oil imports, CPI declined to 4.6 per cent in October 2004 and further to 3.8 per cent in December 2004. The CPI inflation, which is considered a more appropriate indicator of general inflation, is also substantially lower than the average WPI inflation at 6.7 per cent in December 2004.

1.10  The lower inflation exhibited by the CPI than by the WPI was mainly because of the food group of commodities having lower than overall inflation and higher weight in CPI than in WPI. Thirty essential commodities for households, with a weight of 17.63 per cent in WPI, registered a 12-month point-to-point inflation of 4.5 per cent on February 5, 2005 , compared to 4.9 per cent a year ago, and accounted for 15.6 per cent of the overall inflation compared to 14.0 per cent a year ago. Out of the 30 items, 11 items registered declines in absolute prices over last year, while year-on-year inflation was less than five per cent for 8 items as on February 5, 2005. There was double-digit inflation for potato, tea, sugar, salt, bajra, gur, and coking coal, partly because absolute prices of these items (except sugar, gur and coking coal) had witnessed a decline in the previous year. Furthermore, food group inflation is lower in CPI than in WPI, suggesting that food prices in the wholesale market increased faster than in the retail markets.

1.11  In the second quarter of 2004-05, Government stepped in to keep inflation under check by reducing excise and customs duties on selected petroleum products; reducing customs duties on non-alloy steel; exempting melting scrap of iron and steel from customs duty; and reducing tariff values of many vegetable oils. The RBI hiked the Cash Reserve Ratio (CRR) in two stages, effective from September 18, 2004 , and October 2, 2004 , respectively, and the reverse-repo rate was hiked effective from October 27, 2004 , to check liquidity overhang in the system. These measures, coupled with the subsequent fall in international crude prices, helped to rein in inflation.

1.12  For the last two financial years, with widening fiscal and current account deficits in the United States (US), the rupee had been strengthening against the US dollar. This trend saw a brief spell of reversal during MayñAugust 2004. With other major convertible currencies strengthening more than the rupee (vis-ý-vis the US dollar), the rupee weakened against major non-dollar currencies. The rising expectations of higher US interest rates and buoyant growth contributed to moderate appreciation of the US dollar. This in turn led to the depreciation of the rupee against the dollar from May 2004. After April 2004, the rupee also depreciated against other major non-dollar global currencies (Euro, Pound Sterling and Yen) until August, 2004. May-July, 2004 also witnessed net portfolio outflows.

1.13  The exchange rate of the rupee has exhibited appropriate flexibility in response to market conditions in 2004-05. Furthermore, the international currency markets also saw large changes in cross-currency rates. Thus, particularly with resumption of capital inflows, the depreciating trend of the rupee vis-ý-vis the US dollar and other non-dollar major currencies was reversed from September and August, 2004, respectively. With the Euro strengthening sharply against the US dollar, the rupee began weakening again from October 2004 against the major non-dollar currencies. In January 2005, in nominal terms, the rupee appreciated against all major currencies.

1.14  In real effective terms, the rupee appreciated in June, August and September, 2004. Despite strengthening nominally against the US dollar from September 2004 due mainly to renewed foreign institutional investorsí (FII) inflows and US dollarís weakness against global currencies, the rupee started depreciating in real effective terms due to a softening of domestic inflation and a sharp fall against non-dollar currencies. This trend continued until end-2004.

1.15  The rising trend in Indiaís foreign exchange reserves continued with such reserves (including gold, SDRs and reserve position in IMF) reaching an estimated level of US$128.91 billion on February 4, 2005 in excess of Indiaís total external debt of US$114 billion at end-September, 2004. However, the accretion to reserves so far in this year at just over US$15.9 billion is small compared to that of more than US$31 billion during the corresponding period of the previous year, and an unprecedented US$36.9 billion in the full year 2003-04. The slowdown in reserves growth ñ not entirely an unwelcome development ñ is due to three main reasons. First is the emergence of a current account deficit during the first half of the year compared to a surplus in the corresponding period last year. Second, with adjustment of interest rates on such deposits, non-resident Indiansí (NRI) deposits went down. Third, relative to 2003-04, when there were large valuation gains with the weakening of the US dollar, such gains during the current year are difficult to predict.

1.16  The current account balance, after being in surplus for the three previous years in succession, turned into a deficit in the first half of the current year (AprilñSeptember 2004-05). The surplus in the current account in the first quarter of the current year was not only reversed but more than offset by the deficit in the second quarter, resulting in an overall current account deficit of US$3.2 billion in the first half of 2004-05. The current account development can be attributed to two main reasons. First, there was a large merchandise trade deficit with a rise not only in the POL import bill because of high prices but also in non-bullion, non-POL imports, which overwhelmed the growth of exports in US dollar terms at over 23 per cent. Second, there was a relatively moderate growth of 23 per cent in net invisibles surplus in the first half of the current year as compared to 35 per cent in the corresponding previous period. While workersí remittances declined marginally, net non-factor services registered a robust year-on-year growth of 174 per cent, and software services exports remained buoyant with 28.7 per cent growth in the first half of 2004-05. Movements in the external merchandise trade account in the first ten months of the current year hold pointers to three emerging trends.

1.17  First, the buoyancy of merchandise export growth (25.6 per cent), in US dollar terms, after a continuous rise of more than 20 per cent in each of the previous two years, reflects a sustained rise in volume of exports with revival of growth in the manufacturing sector and increased export competitiveness. Commodity-wise export growth continued to be broad-based with the manufacturing sector in the lead. The main drivers of this high growth were the five major sectors of engineering goods, gems & jewellery, textiles, chemicals and related products, and petroleum products. However, despite the buoyancy of exports, among the top exporting countries of the world, India ranked 31st in 2003, down from 30th in the previous year. Government has fixed an ambitious target of US$150 billion for exports by the year 2008-09 to double India ís share in world exports to 1.5 per cent.

1.18  Second, the estimated strong growth in non-POL, non-bullion merchandise imports by 33.7 per cent in April-January 2004-05 reflects buoyant domestic demand including for investment, a mildly strengthening rupee in real terms, and greater import liberalization.

1.19  Third, the emergence of the ASEAN + 3 (China, Japan and Korea) countries as Indiaís dominant trading partners accounting for 19.9 per cent of Indiaís total merchandise trade, followed by the EU and North America with shares of 19.0 per cent and 12.9 per cent in 2003-04, respectively, points to a broadening of the trade horizons and a ëlook-eastí emphasis. To broaden its trade horizons further, besides active participation in WTO negotiations, India also engaged itself in a number of bilateral trade agreements.

1.20  The capital account surplus in April-September 2004 was also down by around US$1.5 billion from April-September 2003. Buoyant foreign investment inflows along with robust inflows of commercial borrowings sustained the capital account. The balance of payments surplus was around US$7 billion in the first half of 2004-05, roughly half of what it was in April-September 2003.

1.21  In 2003-04, capital account surplus doubled to over US$20 billion. There was a rise of 255 per cent in net foreign investment flows, mainly of the portfolio variety driven by the heavily bullish sentiments in the Indian stock markets. NRI deposits increased by US$3.6 billion in 2003-04, compared to the previous yearís increase of US$3.0 billion. The capital account remained in surplus during the first half of the current year, but at a reduced level compared to April-September 2003, reflecting a sharp fall in portfolio and banking capital inflows. Portfolio flows declined by about US$3 billion from the corresponding period of the previous year to US$512 million. With a decline in the premium on their interest rates, NRI depositsñthe dominant component of banking capitalódeclined by US$1.2 billion in April-September 2004, compared to an increase of US$2.2 billion in the corresponding period of the previous year. With a more liberalized regime and an improvement in the countryís foreign currency ratings, there was a large increase of about US$2 billion in external commercial borrowings (ECB) in the first half of 2004-05 over the corresponding period of the previous year; but this increase was not sufficient to offset the decline in portfolio flows and banking capital.

1.22  The decline in net portfolio flows in the first half of the current year was particularly pronounced in the first quarter with volatility in the Indian stock market in mid-2004, and reassessment of risk-return payoffs by FIIs in the wake of a rise in US interest rates. Recent data indicate that with resumption of bullish trends in the Indian stock market from July 2004, portfolio inflows have gathered momentum. Similarly, the upward revision of interest rate ceilings on NRI deposits from November 2004 appears to have contributed to a reversal of the declining trend in such deposits in the first half.

1.23  Improvement in Indiaís external debt position continued in 2003-04. Apart from continuing with its extant prudent external debt policy, some initiatives such as prepayment of costly external debt and rationalization of interest rates as well as structure of NRI deposits contributed to an improvement in the debt-sustainability indicators during 2003-04. For example, external debt as a proportion of GDP went down from 20.2 per cent at end-March 2003 to 17.8 per cent at end-March 2004. Similarly, the share of short-term debt in total external debt declined from 4.8 per cent at end-March 2003 to 4.3 per cent at end-March 2004. In the first half of the current year, such indicators have shown a marginal deterioration, but within prudent limits, and for legitimate reasons such as an increase in short-term trade-credit reflecting larger import demand.

1.24  Compared to its stock at the beginning of the year, the growth in reserve money, which had accelerated from 9.2 per cent during 2002-03 to a high of 18.3 per cent during 2003-04, declined to 6.4 per cent in the current year up to January 28, 2005 . The corresponding growth in reserve money a year ago was 7.8 per cent. The lower growth of reserve money in the current year was on account of lower growth of 15.9 per cent in net foreign exchange assets (NFA) of the RBI compared with 32.8 per cent in the corresponding period last year. The sharp decline in net RBI credit to Government observed in 2003-04 (62.8 per cent in the full year) continued in the current year with a further fall of 69.9 per cent upto January 28, 2005, and resulted in NFA constituting 120.9 per cent of reserve money as of that date. Despite a lower growth of reserve money in the current year, liquidity management remained a major concern. This was because, after a sharp increase in reserve money in the previous year, there was a liquidity overhang of over Rs.81,000 crore in the form of outstanding reverse repos under the Liquidity Adjustment Facility (LAF), Government surplus balances and excess reserves of banks from the previous year. This overhang posed a nascent problem in liquidity management. The Government raised the limit under MSS from Rs.60,000 crore to Rs. 80,000 crore on August 26, 2004 , after the threshold limit of Rs.50,000 crore was crossed. Measures taken by the RBI include discontinuation of the auction of 7-day and 14-day reverse repo and its substitution by an overnight fixed rate reverse repo, and raising the cash reserve ratio by 50 basis points to  5 per cent.

1.25  Compared to its stock at the beginning of the year, broad money (M₃