FRBSF Economic Letter
2006-16; July 7, 2006
A Monetary Policymaker's Passage to India
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Each year, the President of the San Francisco Fed joins
the Federal Reserve Board Governor responsible for liaison
with Asia
on a "fact-finding" trip to the region. These trips
advance the Bank's broad objectives of serving as a repository
of expertise on economic, banking, and financial issues relating
to the Pacific Basin and of building ties with policymakers and
economic officials there. The knowledge gained and the contacts
developed are critical in understanding trends affecting the
District, in carrying out responsibilities in banking supervision,
and in ensuring that policymakers have the understanding of global
economic trends necessary to conduct policy and promote the stability
of global financial markets. This Economic Letter summarizes
President Yellen's report on her trip to India in November 2005.
An overview of India's economy
India's economy is booming. Since 1991, economic growth has
averaged about 6%, and in the last two or three years it has
grown even
faster—around 8%—making India, along with China, among the
fastest growing countries in the world. Per capita GNP is still
very low but has been rising impressively.
The service sector in India accounts for more than 50% of total
output—an unusually large share for a developing country—and
its growth has been consistently strong. In the industrial
sector, growth has been more variable, but it has picked up noticeably
in the past two years. The agricultural sector is a major concern
to Indian policymakers. It accounts for roughly 20% of India's
output and employs 60% of the population. In recent years,
farm
income growth has slowed due to weak productivity growth. This
sector has also been held back by inadequate roads and storage
facilities. Clearly, improving performance in agriculture is
a key to increasing the welfare of the bulk of India's people,
who are not fully sharing in the country's overall growth.
India's business climate is improving, and one concrete sign
is that foreign capital is finally flowing in—though not at
anything like the scale into China—after a long history of
hostility to foreign involvement in the economy.
The single most important reason for stronger growth is economic
liberalization. The process dates back to the mid-1980s, following
many years of being a highly closed, highly regulated economy
based on self-sufficiency and modeled on Soviet-style central
planning. In 1991, further reforms were undertaken in the wake
of a balance of payments crisis related to massive fiscal deficits.
The government began to liberalize inward capital controls,
institute banking reforms, and lift trade barriers, further spurring
growth.
This reform process is continuing.
Our perception is that the broad path of reform is firmly established,
though the pace or details may vary with changes in government.
In the elections of May 2004, the Bharatiya Janata Party—which
was pro-reform—was replaced by a coalition led by the Congress
Party. While this coalition has slowed the pace of liberalization,
promising to focus on poverty alleviation and rural reforms,
it is not backsliding, and several of the government officials
we talked with seemed to be aware of the need for more progress
in privatizing state enterprises and otherwise encouraging
private markets.
The most visible example of the success of India's economy
and of unfettered market processes is the IT (information technology)
sector. India's advantages as an IT center include its abundance
of English-language speakers, strong technical education system,
and professional talent with programming and managerial experience.
Government policies have also played a key role, as the service
sector generally is less heavily regulated, less taxed, and
less
dependent on physical infrastructure. Many of the IT sector
representatives we met expressed confidence that this sector
will continue to
attract the business of U.S. companies looking for opportunities
to outsource some of their activities.
The direct importance of IT services for India's overall growth
is easily exaggerated—currently, the sector accounts for approximately
3% of GDP and employs less than 1% of the workforce. But its
success has had a very significant positive demonstration effect.
In particular, it has created pressure for reform in other
sectors, as Indian businesspeople have become more aware of profit
opportunities
to be exploited both at home and abroad. This is a fundamental
change from earlier periods when Indian producers sought government
protection from domestic and import competition. The success
of this sector has strengthened the conviction that Indian
industries can excel at competing in world markets and has generated
a palpable
increase in confidence about the economy's future.
Restraints on growth
Though liberalization has progressed, many regulations still
discourage and distort growth, and much reform remains to be
implemented. For example, despite declines in import tariffs,
India remains a relatively closed economy. Its ratio of exports
plus imports to GDP is between 25% and 30%, well below the
levels of other countries in Asia. In addition, although approval
for
foreign direct investment is easier, such investment is still
wholly prohibited in some sectors, such as retailing, agriculture,
and railroads.
While liberalization has been critical to India's economic
growth, two other factors also have played a role in recent years—stimulative
fiscal policy and stimulative monetary policy. Both are a matter
of some macroeconomic concern. In the case of fiscal policy,
government deficits are huge. Combined central and state fiscal
deficits have been around 8-9% of GDP in recent years. The
fiscal
situation has constrained public infrastructure investment
and crowded out private investment. The deficit also undermines
reforms
in other areas, such as the financial sector, because the government
is always concerned about finding buyers for the debt. Complicating
matters is the concern about how the new government will finance
its social programs, such as a guarantee of limited employment
to a member of every household.
In the case of monetary policy, inflation has now risen to
around 4%. Demand is being fed in part by rapid growth in consumer
spending
fueled by consumer credit. Higher oil prices are also a factor.
To address the inflation problem, the Reserve Bank of India
raised the short-term policy rate in 2005.
Higher oil prices are a concern to India above and beyond their
inflationary impact. Since India is a major oil importer, higher
oil prices are a hit to real income, and the burden tends to
fall disproportionately on India's poor. To shield Indian households,
only a fraction of the price hikes for fuel have been passed
on to consumers. The difference has been absorbed by oil marketing
companies, most state-owned, which has necessitated government
subsidies. The subsidies create a further burden for government
finances.
In the view of most private and public sector representatives
with whom we spoke, the number one barrier to sustainable growth
at the recent accelerated pace in India is infrastructure,
particularly transportation and power. The government has made
some progress
in improving airports, seaport facilities, and roadways. In
fact, The New York Times (2005) did a four-part article on the
construction
of a major highway around India, dubbed "The Golden Quadrilateral." Nonetheless,
problems remain. The power sector faces even more severe problems
related to inadequate capacity and substantial distribution losses,
estimated to be as high as 40%. The government's ability to undertake
needed investments to improve the country's infrastructure is
limited by fiscal problems, as I mentioned. As a result, there
is increasing focus on greater private sector involvement through
public-private partnerships in the development and management
of ports and power generation facilities.
Another factor restraining growth in India is a system of labor
market regulations that restricts flexibility in firing as
well as restrictive business regulations more generally. In the
view
of the experts from the multilateral institutions and the Indian
business leaders with whom we met, these regulations are a
barrier to significant expansion of India's manufacturing sector,
which
is necessary to create more jobs in the economy for less-skilled
workers. According to World Bank measures (2006), India's degree
of labor market flexibility and general business climate rank
very low in comparison to many other developing countries,
including China. India's textile industry, which employs 30 million
people,
has been one of the more highly regulated sectors and is still
dominated by many small businesses. As a result, this industry,
unlike China's, was not well positioned to gear up in response
to the end of the multi-fiber quotas on exports to industrial
countries. Although Indian companies have found ways around
the labor laws by outsourcing production to the unorganized sector,
greater labor flexibility is important to the ability of the
economy to achieve scale economies and generate more jobs.
India's banking sector
As noted, the health of the banking sector and the state of
bank supervision and regulation were a focus of our trip, which
is
natural, given our Bank's responsibilities in assessing the
quality of home country supervision of foreign banks operating
in the
United States. Prior to 1991, the banking system in India was
characterized by weak asset quality, low profitability, and
limited transparency due to directed lending and regulatory forbearance.
However, things have improved considerably. Nonperforming loan
levels have been falling in India and are now in the 4-5% range,
and bank capital is adequate.
Two concerns relating to the health of the banking sector have,
however, attracted concern. First, there is concern that aggressive
retail loan growth may lead to future asset quality problems.
I noted earlier that India is experiencing a credit boom, and
it is possible that lending standards may be declining, which
could lead to higher nonperforming loans in the future.
A second concern relates to the banking system's high level
of exposure to long-term government bonds. Although government
bonds
have fallen to less than 30% of the banking system's assets—from
nearly 40%—this level remains high and entails risks as interest
rates continue to rise.
An important feature of India's banking system is that, as
in China, state ownership of banks is high. Overall, state-owned
entities account for close to three-fourths of total financial
system assets.
Indian private banks are flourishing. They have adopted relatively
stronger risk-management processes, using technology effectively
and developing new financial products. The most successful
of these banks are ICICI and HDFC, which continue to increase
market
share and compete successfully with both state-owned and foreign
banks.
Foreign banks would like to expand in India, but ownership
remains restricted. To date, there are roughly 30 foreign banks
operating
in India, but they represent only 7% of total assets. The Reserve
Bank of India understands the benefits that an increased foreign
banking presence can bring to the financial sector, but it
is committed to giving Indian banks a cushion of time to prepare
for increased competition. Reforms to foreign ownership policy
were announced earlier this year but they do not materially
change
the way foreign banks can operate until 2009.
Conclusion
On a fact-finding trip to India, it would be impossible, and,
indeed, a huge waste, to ignore what glimpses of Indian life
and culture one might get. Though we visited only three cities,
we were struck by the dizzying beauty and the dizzying disparities
that India has long been known for. We were lucky enough
to see the serene magnificence of the Taj Mahal. Another manmade
wonder—more
of the 21st century than of the 17th—was a technology campus,
for all the world like any such facility you might see in
Silicon
Valley. But en route to both, we saw other faces of India—shanties,
roads clogged not just with cars, but with pedestrians, peddlers,
pushcarts, cows, goats, even a caravan of camels. Scenes
like these are not only unforgettable, they are also emblematic
of the challenges the country faces. Our visit raises my
hopes that
India will remain on the path of liberalization, with the
ultimate
goal of improving the economic well-being of its people. Janet L. Yellen
President and Chief Executive Officer
References
World Bank. 2006. Doing Business in 2006: Creating Jobs. Washington,
DC.
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
Board of Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
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