Directors commended the Reserve Bank of India’s (RBI) efforts to tighten monetary conditions. Noting that short-term real interest rates remain below historic norms and financing conditions have hardened only marginally, most Directors recommended further steps to bring the real repo rate clearly into positive territory. They welcomed the RBI’s moves to increase the frequency of policy reviews and publish more guidance on future actions. Most Directors considered that continuing to improve the CPI, including a new national CPI to be introduced in the future, and utilizing information from it in policymaking could increase the impact of monetary policy on inflation expectations. Directors also highlighted the role of structural reforms in containing food price inflation.

Directors welcomed the authorities’ commitment to fiscal consolidation, including their plans to streamline spending. The envisaged Goods and Services Tax and the new Direct Tax Code should increase tax efficiency. Given buoyant economic growth, and since future deficit targets could be more difficult to reach, most Directors saw merit in a further strengthening of the consolidation effort. Saving this year’s over performance in revenue and one-off receipts could help reconstitute fiscal space. More substantial current spending adjustment, mainly by further cutting subsidies and improving the targeting of spending, would help achieve social goals along with medium-term fiscal consolidation. A few Directors favored an appropriate balance between pacing the consolidation and sustaining growth by addressing the exigencies of infrastructure investment and social spending.

Directors observed that low yields in advanced economies and India’s favorable growth differentials could raise capital inflows above its absorptive capacity. While exchange rate flexibility would remain the first line of defense, reserve accumulation and macroprudential measures could be employed if strong inflows continue. Absorptive capacity could also be improved by deepening financial markets or by liberalizing foreign direct investment (FDI), consistent with India’s gradual approach to capital account liberalization.

Directors supported the authorities’ focus on strengthening financial stability, including efforts to strengthen macroprudential regulations to cool the residential real estate market and to ensure a regulatory level playing field across the financial industry. While India’s banking system is resilient and well capitalized, Directors noted that monitoring asset quality will remain important, particularly as prudential norms for infrastructure are eased. They commended the introduction of the RBI’s Financial Stability Report, the announced review of financial laws, and the creation of the Financial Stability and Development Council, and looked forward to the forthcoming Financial Sector Assessment Program.

Directors welcomed the emphasis on investment in infrastructure and human capital.

They supported the measures taken to increase the availability of long-term finance for infrastructure, especially moves to develop the corporate bond market, while noting that in the short run foreign savings also would be needed. Directors supported the authorities’ reform efforts in areas such as land acquisition and government clearances, while also stressing the importance of strong accountability and transparency over large infrastructure projects.

Background

India’s growth is among the highest in the world. Since mid-2009 the pace of India’s recovery—led by domestic demand, especially infrastructure investment—has been strong. Monetary and fiscal policies remain accommodative: real interest rates are low and although there has been some fiscal consolidation, the fiscal deficit remains high. With little slack in the economy, the ongoing exit from the policy stimulus introduced during the crisis, and structural factors affecting food prices, inflation measures are in the 8½ to 10½ percent range. Financial conditions are comfortable, and capital inflows have been strong.

India’s economy is projected to grow by 8¾ percent in real terms in 2010/11, moderating to about 8 percent the following year. Following last year’s drought, this year’s growth is already benefiting from the rebound in agriculture and the pickup in private consumption as employment prospects have improved and disposable incomes continue to rise. Infrastructure is expected to remain an important growth driver and corporate investment is likely to accelerate, aided by conducive financing conditions and robust demand growth. India’s medium-term growth prospects remain strong. The economy is expected to continue to expand rapidly, supported by high investment and productivity gains.

Risks to growth are broadly balanced, with downside risks relating mainly to the global economy. Surging capital inflows could further spur investment, but could complicate macroeconomic management. Sustaining rapid growth over the medium term will depend on sustaining reforms to facilitate infrastructure investment—such as deepening the corporate bond market and lowering the cost of doing business—and improving social indicators while carrying out fiscal consolidation. Improving social outcomes and infrastructure are two key pillars of the government’s strategy to achieve rapid and inclusive growth.