Annual Report

7.1 During 1999-2000, despite a number of difficult domestic and international developments, such as the Kargil conflict and the sharp increase in oil prices, the Indian economy posted a reasonably high rate of growth with relative price stability. Real GDP growth was 6.4 per cent, the annual rate of inflation, on a point-to-point basis, was 6.5 per cent (or 3.8 per cent excluding the impact of rise in administered oil prices) and the accretion to foreign exchange reserves was about US $ 5,546 million. The external current account deficit was below 1 per cent of GDP.

7.2 It is useful at the threshold of the twenty-first century to take stock of the macroeconomic developments since the 1991 crisis. The average real growth rate of the economy at 6.4 per cent during 1992-93 to 1999-2000 was higher than 5.9 per cent during the 1980s and 6.0 per cent during the second half of the 1980s. On a point-to-point basis, the rise in the wholesale price index averaged 7.6 per cent, remaining at the level recorded in the 1980s. However, in the second half of the 1990s (i.e., since 1995-96), the average headline inflation rate came down significantly to 5.2 per cent. The ratio of the gross fiscal deficit (GFD) of the Centre to GDP averaged about 5.8 per cent in the post-1991 period as against 8.2 per cent in the second half of the 1980s on a comparable basis. The external current account deficit averaged 1 per cent of GDP on almost a sustained basis in the recent period. The key indicators of external debt sustainability improved continuously throughout the post-1991 period. Reserve accretions occurred in every successive year, except in 1995-96, to take the level of foreign exchange reserves to over 8 months of import cover by 1999-2000. The new impulses of growth have emerged from the private (including household) sector with private capital formation moving up, financed primarily by private saving.

7.3 There are, however, many concerns. The fiscal position has not been strong enough to share the burden of macro-economic adjustment. The variability in both output growth and the inflation rate continues to exist. Moreover, the task of sustaining 'quality' growth over the medium to long term is not complete; it requires that challenges associated with social sector improvement and productivity growth are addressed with appropriate structural reforms in a wide range of areas of activity including the labour markets. The first quarter of fiscal 2000-01 has also been characterised by several unfavourable developments including pressures in the foreign exchange market and an increase in the overall rate of inflation largely due to an increase in administered oil prices.

7.4 The sectoral growth profile in the two periods, viz., the post-1991 period and the second half of the 1980s, throws up some interesting insights for future policy direction. In the recent period, the services sector recorded an annual average growth of 7.7 per cent as against 7.2 per cent in the earlier period. Agriculture and allied activities which registered an annual average growth of 3.4 per cent in the second half of the 1980s improved their performance to a rate of 3.8 per cent in the post-1991 period. The average growth of the industrial sector, on the other hand, was lower at 7.3 per cent during the 1990s as compared with 8.0 per cent during the 1980s. However, manufacturing growth was more or less even during the two periods. The average growth rates of mining and quarrying and electricity, gas and water supply, on the other hand, were sharply lower in the years since 1992-93. Among the services, the main impetus has emerged from trade, transport and communication and financing, insurance, real estate and business services (which includes software). Besides, the growth rates of construction and community, social and personal services have moved up during the recent period compared to the position in the second half of the 1980s.

7.5 The real GDP growth of the Indian economy is widely believed to be hovering around its 'filtered' trend rate¹, but the economy has still to 'catch up' to achieve an average growth of 7-8 per cent per annum or the potential growth as determined by the production possibility frontier. Such an outcome would be rendered possible if the requisite real investment growth occurs along with technology improvements and efficiency gains.

7.6 According to available data on Net State Domestic Product (NSDP), which is subject to some limitations, there was a decline in the coefficient of variation of the growth rates of NSDP at constant prices of the various States from 293.2 per cent in 1991-92 to 77.5 per cent in 1995-96. This does not fully reflect the continuing deterioration in the economic position of several States in relation to others. Looking at growth in individual States, there is some evidence of widening of the gap between the better-off States and other States. To reduce these disparities, the economies of the backward regions need to grow faster, by adopting pro-active policies including those that help to promote literacy and develop infrastructure. In this context, the role of the rural infrastructure development fund (RIDF) is important. The RIDF, which was set up from the contributions by the scheduled commercial banks to the extent of the shortfall in their priority sector lending targets, has provided funds in five tranches to State Governments to enable them to complete various types of infrastructure projects pertaining to irrigation, flood protection, rural roads, bridges, etc. As against a total corpus of Rs.18,000 crore for the RIDF, the cumulative sanctions and disbursements amounted to Rs.14,386 crore and Rs.6,269 crore, respectively, till end-June 2000. The state-wise performance in respect of disbursements has, however, been uneven. The low level of disbursements was due to the difficulties faced in identifying projects by some State governments, the lack of budgetary support and delays in finalisation of projects, especially those involving land acquisition and tendering procedures.

7.7 Growth of all crops has decelerated to 2.6 per cent in the 1990s (1992-2000) from 4.3 per cent in the second half of the 1980s, notwithstanding normal monsoons and improvements in private capital formation in agriculture, in net irrigated area and in fertiliser consumption. The variability in the inflation rates in recent years is found to originate mainly from the variability of supplies of some farm-related products such as fruits and vegetables, milk and milk products and eggs, fish and meat, which have significant weights in the WPI. A simulated exercise shows that if prices of these commodities increase at an annual rate of 2.5 percentage points (i.e., 100 basis points above the trend growth in population) and assuming the increases in the prices of mineral oils and fertilisers to be in line with the international prices, the headline inflation rate would be about 4.0 per cent a year. This would imply that barring calamities such as the severe cyclones in Orissa, supplies relating to food articles would need to be maintained on a sustained basis through measures that help to reduce vulnerability to the vagaries of weather, ensure efficient land-use with reference to the cropping pattern, diversify agricultural activities with emphasis on value-added farm products, promote the development of irrigation and water resources, and make appropriate use of water and other inputs such as fertilisers, seeds, power, pesticides, including new farm technologies. Such measures are in the area of policy implementation at the state level where administrative arrangements would need to be backed up by well-tuned intelligence gathering and exercises about behavioural responses of farmers and other participants to policy initiatives.

7.8 One of the current developments of concern relates to the mounting stock levels of foodgrains. This problem has emerged from the high procurement in response to the regular hikes in Minimum Support Prices (MSP) of foodgrains unaccompanied by a commensurate rise in the off-take. The rice and wheat procurement-production ratio increased, as a result, from 16.3 per cent in 1989-90 to 18.9 per cent in 1999-2000. The off-take of foodgrains has been low in most years of the 1990s, partly due to limited open market absorption, and partly due to low quantities utilised by the public distribution agencies. In the case of the former, while market prices as well as factors such as quality are important considerations, low public distribution has much to do with the issue price levels, the quantity of the products offered and the inadequate institutional arrangements for quick delivery at areas of need and for linking delivery with work-oriented tasks (like the Food for Work programme). The buffer stocks have generally ruled above the norms in recent years resulting in a high burden of food subsidy on public finances. Better targeting of subsidies through such schemes as food stamp issuance, and a freeze on MSP with appropriate issue prices could help reduce stocks over time. At this juncture, it appears that enhanced exports of foodgrains to reduce the stock levels are also difficult, given the relatively low international prices of grains. It may become necessary to explore such methods of indirect interventions such as options and futures in the realm of agricultural marketing by first establishing a nation-wide multi-commodity exchange. Further, the problems pertaining to skewed availment/distribution of foodgrains under the public distribution scheme would need to be resolved quickly with elimination of inter-State restrictions in the movements of agricultural products.

7.9 The industrial performance has been generally uneven in the post-1992 period. Industrial output growth, as per the national accounts statistics, after showing an upward movement for three consecutive years (1993-94 to 1995-96), exhibited a moderate growth of over 6 per cent in 1996-97 and slackened in 1997-98 and 1998-99. There was some industrial recovery in 1999-2000, made possible by a combination of factors. Improved demand was propelled to an extent by increased exports, easy credit availability, low inflationary expectations and improved business confidence. The recovery was reflected largely in the increase in the output of the consumer goods sector, followed by that in basic goods and intermediate goods. The capital goods sector has suffered a significant slowdown, due to an inadequate pick up in domestic investment demand partly because of the past build up of excess capacities. The slowdown in capital goods production is also due to sharp cutbacks in project investments and the increase in cost overruns (from 51.6 per cent during March 1999 to 56.8 per cent in March 2000) on account of delays in the completion of projects in the public sector. It is important to recognise that consumption-led recovery would not help to sustain high industrial growth since infrastructure bottlenecks are substantial, with the demand for infrastructure services outpacing their supply.

7.10 In recent years, there has been considerable amount of industrial restructuring, led to a large extent by mergers and acquisitions (M&As). Most of the M&As were in consumer goods industries, where exploitation of both economies of scale and scope is likely to give material gains in a relatively short period of time. However, M&As by themselves may not necessarily lead to improvement in competitiveness. A competitive industrial structure is particularly important in 'new' economy industries where concentration of economic power or restrictive practices could jeopardise innovativeness, flexibility and cost minimisation. Once barriers to entry and exit are removed, the possibility of cost competitiveness and improving resource allocation will enhance. However, future policy initiatives for promoting fair competition need to be carefully designed since infromation technology (IT) makes it possible for information flows to be large and quick and helps market participants to devise business strategies that give them advantage over others in the industry.

7.11 The fiscal imbalance of the Central Government and State Governments, as reflected in the combined GFD touched a high level of 9.9 per cent of GDP in 1999-2000. The slippage between the revised and the budget estimates was high at 2.5 percentage points of GDP. While the high level of government sector deficit is attributable to some unavoidable expenditure commitments as well as unanticipated shocks, any further erosion of the fiscal position could turn out to be unsustainable, since the financial saving rate of the household sector is only moderately higher than the ratio of overall fiscal deficit to GDP.

7.12 The need for a turnaround in the fiscal position is well recognised, but it requires a multi-pronged effort at improving revenue buoyancy in particular tax collections, effecting necessary expenditure reductions and raising proceeds from divestment of selected public enterprises. Expenditure management also holds the key to achieving overall fiscal prudence. The combined Government sector expenditure/GDP ratio at 28.7 per cent in 1999-2000, though lower than 30.6 per cent in 1990-91, reflects nonetheless the large size of the Government. About 52 per cent of the aggregate expenditure of the Central Government is committed towards interest payments, defence and statutory grants to States while non-obligatory expenditures such as subsidies and wages and salaries have been high and have tended to move up. Defence expenditures and statutory grants are exogenously given but in respect of others, strong policy actions would need to be put in place. The interest burden could over time be reduced by containing fiscal deficits and by plugging leakages and misappropriations while subsidies could be oriented to operate as 'social safety nets'. The expenditures of Government on wages and salaries and pensions seem to be the most important area where reforms have to be focussed. For instance, the expenditure of the Central Government towards wages and salaries has grown at an annual average rate of 14.8 per cent to Rs.32,433 crore in 1999-2000 from Rs.11,069 crore in 1991-92, which is higher than the 12.5 per cent growth in the overall expenditure of the Central Government. Unless the size of the government is pruned, the wage bill would pose a significant burden on fiscal management. Moreover, there is an urgent need to ensure that solvency of public finances in respect of pensions and other unfunded liabilities is attained.

7.13 The slow-down in revenue collections is reflected in the deterioration in the tax-GDP ratio of the government sector (Centre and States) from 16.4 per cent in 1985-86 to 14.1 per cent in 1999-2000. The structural shift in the composition of GDP seems to have constrained growth in tax receipts. While the agricultural sector has remained out of the tax net, the fast growing services sector has not been adequately taxed. With the manufacturing sector being subjected increasingly to business cycles in recent years, the problem of maintaining the tax-GDP ratio at a reasonable level has become difficult. The wide ranging tax exemptions and concessions extended to various sectors of the economy need to be rationalised after a thorough examination of the effectiveness of such concessions in promoting intended aims or in augmenting the growth of the particular sectors for which they have been extended. Moreover, there is a need for further reform and reorientation of levies such as stamp duties, registration fees, etc. These fees and duties need to be made 'tax payer-friendly'. It should be ensured that they do not impede the volume of transactions and reduce, in the process, the total revenue from these sources.

7.14 While the Government has taken initiatives to strengthen tax administration and reforms including the harmonisation of sales tax rates across States as a prelude to the introduction of VAT, there are some emerging problems arising from the technological development in domestic and international trade that need to be addressed. The rapid pace of globalisation and fast moving e-commerce the world over has increased the 'mobility' of the tax base. It is by now well recognised that in the near future the scope of e-commerce would widen, and the absence of a proper mechanism to tax the trade based on e-commerce may prove to be a potential source of leakage of the tax revenue of the Government. The Government would have to work in concert with other countries, which are also wrestling with this problem, to find a feasible solution. Simultaneously, the Government needs to upgrade its technological infrastructure and systems and procedures so that action in this area could be undertaken expeditiously.

7.15 In the absence of enough corrective actions, the elbow room available for public spending for creation of capital assets and social capital has become limited. In the event of a fall in public capital formation, there would be constraints on the creation of new or additional capacities. Besides, the private sector investments which depend on public sector project demands may not fructify or lose momentum.

7.16 The restructuring of public sector enterprises is yet another area of critical importance from the point of view of moving towards fiscal consolidation. In the last two budgets, the Government has announced several policy initiatives relating to closing down of non-viable public sector undertakings (PSUs), restructuring of potentially viable PSUs and marking down government equity in non-strategic PSUs. The actual realisation of disinvestment proceeds has so far fallen short of the budget targets. The disinvestment process necessarily has to take into account the prevailing or the likely capital market conditions and investor preferences. It would be useful to build different scenarios assuming different degrees of success of the disinvestment process and propose corrective strategies under each scenario for realising the determined final fiscal outcome.

7.17 The fiscal position with regard to State finances, characterised as it is by expenditure overruns due to committed expenses like wages and salaries, pensions and growing debt service obligations cannot be easily corrected in the medium term without the support of a well designed strategy. The State level PSUs, like the State Electricity Boards (SEBs) and the State Road Transport Corporations (SRTCs), have been reporting net losses and have been absorbing scarce funds through budgetary support. Restructuring the PSUs, increasing the user charges and providing greater managerial autonomy are some of the measures that are often advocated as the requisite solutions to the problem on hand. In this context, a fiscal issue of relevance is the growth in the implicit or contingent liabilities in the form of guarantees for accessing finances to meet the needs of PSUs, especially those in the area of infrastructure, besides the explicit liabilities. These off-balance sheet exposures are often costly, and could pose risks of default if the institutions supported by funds do not improve their performance. It is vital that limits are placed on the quantum and value of guarantees that could be given by State Governments and adhered to in the framework of a law.

7.18 With the fiscal deficits persisting, the debt/GDP ratio of the combined Government sector increased from 59.6 per cent as at end-March 1991 to 60.7 per cent as at end-March 2000. The relatively high interest rates on borrowings owing to persistence of fiscal deficits has led to growth in the interest burden (interest payments-revenue receipts ratio) of the combined Governments from 23.6 per cent in 1990-91 to 32.2 per cent in 1999-2000. However, the interest burden has risen more sharply for the Central Government from 39.1 per cent to 50.9 per cent of revenue receipts during the same period. The high stock of debt fuels expectations about the uncertainties of future budgetary policies and adds higher risk premium, thereby leading to volatility in the financial markets and constraining downward movement in long-term interest rates. With the Central and State governments meeting their repayment obligations through fresh borrowings, the bunching of repayments has also brought pressure on the market by increasing gross borrowings with adverse implications for interest rate evolution. While the debt management operations during 1999-2000 attempted to extend the maturity profile without having adverse effects on interest cost, the high overhang of debt acts as a severe constraint for continuance of such a policy stance in the coming years. Moreover, the adverse effect of a high debt ratio has been the reduced allocation of funds for social and other productive expenditures of the Government in order to accommodate the ballooning interest commitments. It is imperative, therefore, to limit public debt accretion together with contingent liabilities over the medium-term and thereby to lend credibility to the fiscal stance.

7.19 It is in the context of sustainability and the need for fiscal adjustment in the medium term that a strong institutional mechanism embodied in the form of Fiscal Responsibility Legislation (FRL), as announced in the last Budget, would be necessary at the level of the Central Government. The FRL at the Central Government will help in attaining sustainability, but for it to be credible it should include stringent requirements for fiscal transparency, backed by strong enforcement mechanisms. The legislation should explicitly focus on the elimination of dissavings of the public sector, placing statutory limits on borrowings and stabilisation of the debt/GDP ratio at a sustainable level. State Governments too should also be encouraged to balance their revenue accounts by introducing FRL on the lines envisaged in respect of the Central Government.

7.20 The current account deficit has averaged about 1 per cent of GDP over the years since 1992-93. While commodity exports have generally grown over the years, there has been variability in export performance. On the other hand, competitiveness in services has strengthened during this period. Invisible earnings in the form of remittances from expatriate Indians and software exports have emerged as a major source of support to the balance of payments. As a result, current receipts have gone up, and formed over 90 per cent of current payments in 1999-2000.

7.21 Capital flows have been fairly strong since 1993-94 with brief interruptions, particularly in 1995-96. In the absence of a significant expansion in the external financing requirement, larger capital flows have helped to build foreign exchange reserves from a level of 2.5 months of imports as at end-March 1991 to 8.2 months as at end-March 2000. There has also been a progressive reorganisation and consolidation of external debt. The debt-GDP ratio has declined from over 41 per cent in 1991-92 to around 22 per cent in 1999-2000. Over the same period, the debt service ratio has fallen from 35 per cent to 16 per cent. The strategy for management of external debt to contain short-term and volatile elements within prudent limits was pursued.

7.22 While the external position has remained fairly comfortable over the last eight years, the growing openness of the economy and the need for accelerating growth in the medium term bring to the fore some areas of concern which require particular attention.

7.23 It is generally accepted that earnings on account of exports of goods and services are the mainstay of the balance of payments. In the 1990s, the ratio of current receipts to GDP has moved up to around 15 per cent, mainly on account of buoyant invisible earnings. The ratio of merchandise exports to GDP has, however, stagnated at 8-9 per cent with a downward drift in the two years of 1997-98 and 1998-99. A sharp decline in global inflation vis-a-vis inflation in India has had unfavourable effects on India's export competitiveness. Sluggishness in external demand was also precipitated by the recent financial crises in some parts of the world. Besides, vigorous export strategies by competitor countries, low-to-intermediate technological content of Indian exports and specific product level deficiencies are the other factors that constrained the improvement in the exports to GDP ratio.

7.24 Stepping up exports on a sustained basis holds the key to a healthy balance of payments position, in the context of India's growing global financial integration with accompanying uncertainties in capital movements. It is, therefore, necessary to create a conducive export environment by effecting enduring improvements in productivity at the specific export industry level. Such an action is particularly required in knowledge intensive and sunrise export categories. Besides, it is useful to utilise the medium of e-commerce for providing trade as also foreign investment, with sufficient monitoring and regulatory safeguards. The creation of a scheme for granting assistance to States for development of export related infrastructure is also a step in the right direction. Policies for foreign direct investment (FDI) need to emphasise the intrinsic link between FDI and exports by allowing for a greater role for foreign enterprise in infrastructure development. India's exports are reported to be suffering from a technological lag and are concentrated in lower segments of the product life cycle. As a consequence, India has not been able to exploit the shifting patterns of external demand in comparison with the export-led economies of Asia. Here again, FDI could play a major role in transferring closely held technologies and in diffusing innovations, both horizontally and vertically. In market-based exchange and payments systems, aggressive marketing strategies, brand promotion and improvement in the quality perception of goods overseas would provide the cutting edge of non-price competitiveness. This is where attention needs to be paid in full measure. There is an urgent need to diversify the external market structure of India's exports through appropriate marketing plans. The geographical pattern of exports has remained virtually unchanged since the 1970s. The South-East Asian economies and China have shown the vigour and resilience that exports can acquire when they are widely diversified in their destination patterns. In addition, exim policies should carry forward the efforts to reduce the anti-export bias in the trade regime, particularly in scaling down tariffs to international levels and in improving the access of domestic producers to imported inputs.

7.25 Structural changes underway in the economy would impact upon patterns of import demand and alter the responsiveness of imports to the domestic activity and relative prices. In so far as POL imports are concerned, the international price shocks in 1999-2000 were weathered mainly because of low non-oil import demand coinciding with the pick up in exports and net invisible receipts. The share of POL imports in total imports, however, has to be closely watched since India is vulnerable to oil price shocks. From the experience of the past oil shocks, it is necessary to contain this share at no more than one-fifth of total imports, so as to insulate the economy from cost push inflationary pressures emanating from oil price hikes. Nevertheless, with domestic consumption growing in line with the real growth rate of the economy, there is a widening gap between demand and supply. Intensive efforts for oil exploration together with augmentation of indigenous refinery capacity would save foreign exchange payments for relatively costlier imports of petroleum products. In these areas of policy, foreign direct investment by large oil companies could have a potentially critical role of providing benefits from exploitation of world-wide economies of scale and leading domain technologies.

7.26 The category of non-oil non-gold imports has remained subdued through the later half of the 1990s, essentially reflecting the structural shifts in the production pattern. The burgeoning growth of the services sector, with the consequential fall in the comparative share of commodity producing sectors in the national output, and the ongoing industrial restructuring to exploit economies of scale are some of the factors which have been at work in recent years, significantly altering the pattern of import demand. These factors also imply that there will be a shift in the composition of industrial output towards consumer goods and to an extent, basic and intermediate goods. Over the medium term, sustaining a growth rate in the range of 7 to 8 per cent would, however, require substantial increase in capital deepening and this may lead to higher imports of capital goods. Current receipts, therefore, will have to go up to meet the anticipated growth in import payments, if the reserves position has to be maintained.

7.27 The capital account of the balance of payments has been undergoing a progressive liberalisation. In respect of some components of the capital flows such as FDI, portfolio flows, banking flows and overseas investment by Indian corporate entities, liberalisation has preceded current account convertibility. Proactive changes in the policy regime have facilitated the sequential opening up of the capital account. The FEMA, which replaced the FERA in June 2000, reflects a shift in policy emphasis: from conservation to management of foreign exchange consistent with the orderly evolution of trade and payments and the foreign exchange markets; from a 'citizenship' basis to a 'residency' basis in the conduct of foreign exchange transactions; and from criminal procedures of enforcement to civil procedures - all under a transparent framework that promotes accountability. The FEMA contains various provisions in regard to capital account transactions which will facilitate better management of capital flows.

7.28 The capital account has undergone substantial, largely policy induced, changes in size and composition, with equity flows occupying an equiproportional share with debt flows over the 1990s. This has had beneficial effects in terms of transfer of technology, financial market reforms and consolidation of the country's exposure to external debt. The FDI has, over the 1990s, been viewed as the 'preferred' source in the hierarchy of capital flows to developing countries. The policies for FDI have, therefore, been progressively simplified. The emphasis is on dismantling of regulatory entry barriers. Investment proposals are being shifted to the automatic route. Further action is required for infrastructure upgradation with support from FDI itself, better exit policies, legal reforms which bring about consistency in laws within the country and in line with international standards, and decentralisation of the implementation process with accompanying State level reforms for quick and easy access to land, public utilities, raw materials and power through changes in legislation. The special economic zones being set up in the Exim policy measures for 2000-01 represent a transitional stage which allows FDI to freely come into the country even as changes in extant laws and procedures are being addressed. It is, however, important to broad base these reforms including labour market flexibility and not allow these zones to become enclaves.

7.29 Policy towards external commercial borrowings (ECBs) has been operated flexibly within the parameters of prudent debt management. While ceilings on approvals have excluded longer maturity ECBs, the approval process keeps in view the consideration about the minimum average maturity of debt. In such a process, priority is accorded to infrastructure and export sectors. The end-use stipulations have been progressively eased except with regard to capital markets and real estate. Prudent management of ECBs should continue with careful monitoring of the exposure to short-term and contingent liabilities. Given the growing exposure to international financial markets in the debt portfolio, appropriate risk and asset liability management strategies assume critical importance in the handling of market and maturity mismatches. Liquidity risks need to be assessed through dynamic liquidity-at-risk models and buttressed with built-in liquidity options and contingent support lines. The policy for ECB also encourages the use of derivatives for hedging interest and exchange rate risks on underlying foreign currency exposures. Over time, the approach to external debt management should expand into overall liability management encompassing the economy's international investment position.

7.30 External debt management policies have yielded positive results in the 1990s. The nominal stock of debt has remained at the March 1995 level, indicative of the consolidation that has occurred. India is presently at the lower bound of the group of moderately indebted countries with almost 40 per cent of the debt stock on concessional terms. Efforts are underway to develop a more comprehensive framework of debt management by setting up benchmarks that lead to optimal currency, interest and maturity mix. In order to consolidate the gains achieved so far, continuing emphasis on reporting, transparency and MIS inputs for debt management decisions assumes importance.

7.31 During the 1990s, the Indian economy began to receive portfolio flows through foreign investment in domestic stock exchanges as well as the Indian issues in foreign stock exchanges. In 1999-2000, the strength and resilience of the macroeconomic fundamentals and the on-going reforms in the capital markets helped to evoke optimistic investor response. Portfolio flows have outstripped FDI in terms of share in net capital flows. Portfolio flows are important in that they often occur alongside FDI and provide an impetus for integration of financial markets. Within this growing integration, Indian financial markets have become increasingly sensitive to asset price movements abroad. Portfolio flows are sensitive to these movements and, therefore, it is necessary to build cushions to guard against sudden movement of portfolio capital in response to international asset prices. One way to protect the economy from the effect of volatility in portfolio flows is to build international reserves, which India has been doing in the past few years.

7.32 An important insight that emerges from the developments in the financial sector during the 1990s is the need to treat financial stability as a dominant objective of macroeconomic management and as a necessary, if not the sufficient, condition for accelerating economic growth. Towards this end, it has become necessary to not only regulate and supervise the financial sector but also to encourage market participants to improve information flows, adopt transparency practices, manage a wide array of risks associated with growth of business and eliminate asset-liability mismatches. Financial stability without efficiency is not a workable proposition from the point of view of growth and development. Competition for funds and introduction of modern technologies based on IT and networking have been the distinct hallmarks of the 1990s enabling freer competition. But profitability and cost minimisation which enable freer competition and financial innovations have remained areas of concern.

7.33 The banking sector is still dominant in the overall financial system in India. Since the adoption of prudential standards in 1993-94 there has been a reduction in non-performing assets (NPAs) in relation to the total assets, especially over the last five years. However, the level of NPAs still remains unduly high, partly because of the carry-over of NPAs in certain sunset industries and the continued existence of weak internal control systems in banks, and partly because of relatively weak legal support to the recovery mechanisms. The large quantum of NPAs, however, poses a major problem for a few banks, identified as weak banks, where the possibility of a return to profitability, without substantial restructuring, is doubtful. The Verma Committee, which looked into the problems of weak banks, made certain recommendations which are under consideration of the Government and the Reserve Bank.

7.34 Any delay in the resolution of the NPA problem could act as a 'drag' on the reforms process itself. It should be recognised that mere compliance to the internationally accepted Core Principles of Banking Supervision will not eliminate the problem. There is a need for not only banks and supervisory authorities to adopt best practices, but also for corporate entities to adopt greater accountability through adoption of disclosures and transparency practices and corporate governance principles. The legal machinery, as reflected in the establishment of a larger number of Debt Recovery Tribunals (DRTs) and Settlement Advisory Committees (SACs) in banks, will need to be activised strongly to enable expeditious recovery of dues of banks and financial institutions. Simultaneously, the on-going initiatives such as the setting up of internal asset-liability management committees (ALCOs) in banks, the pursuit of risk based supervision and the preparation for setting up of a Credit Information Bureau should be vigorously followed, together with upgradations in technology and payment and settlement systems.

7.35 Monetary policy has continued to place emphasis on the twin objectives of pursuing price stability and ensuring adequate availability of credit for productive activities in the economy. These objectives are fundamental not only because they are in line with the provisions of the Reserve Bank of India Act but also because they reflect the economic priorities of the country.

7.36 This does not, however, imply that the monetary policy environment and conduct of monetary policy have remained unchanged. In fact, they have changed in the 1990s all over the world and in India as well. The instruments and operating procedures of monetary policy are, analytically speaking, determined largely by the nature and depth of the institutional infrastructure and arrangements, and the levels of technology and systems in the banking sector, besides the degree of deregulation and globalisation faced by the economy. These factors have played a major role in transforming the Indian financial scene in the last 8 years.

7.37 The flexibility to conduct monetary management in India was recognised and strengthened by the analytical work of the Reserve Bank's Working Group on Money Supply (1998). The Group reported that monetary policy exclusively based on monetary targets set by estimates of money demand could lack precision because while the money demand function exhibited parametric stability, predictive stability was less certain. The gradual emergence of rate variables such as interest rates with their growing sensitivity to financial developments and economic activity has contributed to the information content of quantity variables. Rate variables together with quantity variables would thus need to be used in the framework of multiple indicators to optimise management goals. In other words, the rate variables cannot be regarded as substituting for monetary targeting so long as the rate channel of transmission of policy has not evolved into a robust and reliable one. Such an outcome requires that certain conditions are satisfied, viz., the elimination of fiscal dominance in macroeconomic processes and of the connect between monetary and internal debt management, and the full integration of financial markets.

7.38 It should be understood that efficient functioning of the rate channel is not always a blessing. For instance, monetary policy making in most industrialised countries has become complex in the 1990s mainly because of financial market integration and market sensitivity to rates, generating in the process expectations that may eventually be inconsistent with the final information about the economies. In the short run, the authorities face policy dilemmas as market conditions change and as 'new information' flows. Monetary authorities may announce a nominal anchor such as an inflation target or an exchange rate target, but they would still need to have an operational 'implementation aid' that could be frequently adjusted. In a strict sense, therefore, monetary policy cannot be pre-determined and has to react to evolving conditions and new information flows (Box VII.1). This explains why the interest rate, which was utilised as the operational aid to policy implementation in the US and in the Euro-zone, has been changed several times in the last 18-20 months (Table VII.1).

7.39 In the US for example, the interest rates which ruled at relatively low levels in 1998 have been moved up gradually, in small magnitudes, in 1999 and 2000 so far in order to address the issues of rising external current account deficit and overheating of the economy. The gradual upward hikes in interest rates help to avoid sudden changes in expectations and to ensure that economic confidence is not undermined by uncertainty in policy conduct. The Euro-zone countries, on the other hand, coordinated an interest rate cut in December 1998, going against the policy strategy of the respective countries, essentially to address the unknowns associated with the introduction of the Euro on January 1, 1999 and the subsequent exchange rate evolution. Since February 2000, these countries adopted a restrictive policy in the light of the many uncertainties in outlook such as the oil price movements, the changes in Euro's exchange rates and the growth rates of the Euro-zone countries themselves.

7.40 In the Indian context, the movements in market rates of interest in recent years suggest that (a) the markets have grown with the increase in interest rate flexibility; and (b) markets would get interlinked with financial sector reforms and overall economic liberalisation. Market interest rates in nominal terms were lower in 1999-2000, notwithstanding the increase in the size of Government's borrowing from the market, as compared with the rates prevalent in 1998-99. For most part of 1999-2000, the headline inflation rate was lower than the overall trend of the last five years. This situation raised the real interest rates and enabled capital flows into the economy. The consequential improvement in the liquidity position could meet the revival in loan demand as well as the financing needs of the Government sector and of the corporate sector.

7.41 However, by the end of the first quarter of 2000-01, it was clear that successive interest rate increases in industrialised countries, the continued oil price uncertainties, the rise in the domestic inflation rate mainly on account of administered price hikes and the general bearishness in the capital market would pose serious challenges to monetary management in India. The narrowing of the differential in the interest rates obtaining in the Indian and the overseas markets in the face of the growing demand to meet the payment obligations mainly on account of the oil import bill, has put pressure on the foreign exchange market. In order to curb arbitrage opportunities for investors to borrow from the fairly liquid money market and operate in the foreign exchange market as well as to reduce the impact of ';leads and lags'; on inflows, the Reserve Bank had to tighten liquidity conditions in July 2000. The Reserve Bank will continue to monitor closely the developments in the markets at home and abroad and take such measures as necessary from time to time.

7.42 Against this background, the unveiling of the liquidity adjustment facility (LAF) with repo auctions in June 2000, as an important operating aid to manage liquidity and influence the rate variables, gains importance. It is too early to comment on its effectiveness, but with further enhancement of market integration and with gradual phasing out of refinancing facility, the impact of LAF will become more certain and transparent. From most indications, it is already apparent that the introduction of LAF has helped the market participants to assess liquidity conditions better and has facilitated the gradual adjustment in the interest rates to the realities of the market.

7.43 The year 1999-2000 brought to a close an eventful decade for the Indian economy and its external environment. The international financial system was affected by a number of financial crises which severely undermined its functioning. Towards the end of the decade there emerged a global consensus on the need to strengthen and appropriately regulate domestic financial systems, to pursue consistent and credible macroeconomic policies in an environment of greater accountability and improved governance and to evolve an appropriate international architecture which prevents the occurrence of crises and/or mitigates the burden of adjustment. The work in this area is progressing and India has actively participated in the international financial reform efforts, giving particular emphasis on implementation of core standards and codes that are consistent with the country's circumstances.

7.44 At home, the performance in 1999-2000 proved to be satisfactory but challenges to both fiscal and monetary management emerged early in 2000-01. Notwithstanding recent developments, the prospects of posting yet another year of good real output growth seem to be realistic. Monsoon conditions, in general, have been fairly satisfactory and as per present indications, the agricultural outturn in 2000-01 is likely to be better than in 1999-2000. If industrial recovery is ensured and assuming continued buoyancy in the services sector, real GDP growth during 2000-01 could be about 6.5 per cent. Such an order of growth should have favourable effects on inflation expectations particularly if the fiscal deficit and monetary expansion are kept at reasonable levels. Recent developments in respect of growth of India's exports and invisible receipts are also highly promising which along with a high level of reserves and reasonable capital flows should contribute to external viability.