ECONOMY MATTERS 2

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FOREWORD

SEPTEMBER 2016

The month of September 2016 saw two major central banks, the Bank of Japan (BoJ) and the US Federal Reserve announce their policy decisions. Both of them acted on the expected lines and delivered little surprise. The Fed decided to leave interest rates unchanged, but it strongly sig-

nalled it could still tighten monetary policy by the end of this year as the labor market improved further. BoJ meanwhile revealed a new monetary policy framework in order to stimulate Japanese economy and help it reach the 2 per cent inflation target. Under the new policy framework, the central bank will target interest rates on government bonds to achieve its elusive inflation target, after years of massive money printing that had failed to jolt the economy out of decades-long stagnation. The Bank believes that its monetary policy and the Government’s fiscal policy as well as initiatives for strengthen-ing Japan’s growth potential will produce synergy effects, and thereby will navigate Japan’s economy toward overcoming deflation and achieving sustainable growth.

On the domestic front, although GDP growth moderated to 7.1 per cent during the first quarter of 2016-17 as against 7.5 per cent during the corresponding period last year, there are firm indications that economic conditions would improve in the coming quarters and new growth opportunities would emerge when the anticipated boost in demand takes root propelled by good monsoons, the Pay Com-mission Award and the recent reform initiatives announced by the government. The good performance of the manufacturing sector, which grew at 9.1 per cent is indeed heartening and points towards better co-ordinated policies in this area. Inflationary pressure as measured by CPI has moderated sharply on the back of fall in food prices. The latter has been precipitated by a near normal monsoon so far. Going forward, we expect CPI inflation to settle within the RBI’s target of 5 per cent for March 2017.

In its effort to breathe new life into the Indian corporate bond market, the Reserve Bank of India (RBI) announced a slew of measures. RBI’s measures include, allowing corporate bonds to be accepted un-der the liquidity adjustment facility, higher ceiling on credit enhancements, providing Foreign Portfolio investors (FPIs) direct access to bond trading platforms and increasing the risk weightages for non-rated corporate borrowers. These measures are intended to further market development, enhance participation, facilitate greater market liquidity and improve communication. An active, well-oiled cor-porate bond market can help in channelising savings, both from India and abroad, through the bond route and can complement the traditional banking sector lending.

Chandrajit BanerjeeDirector General, CII

3 SEPTEMBER 2016

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EXECUTIVE SUMMARY

SEPTEMBER 2016

Focus of the Month: Towards a Vibrant Bond Market & Developments in State FinancesThe Reserve Bank of India (RBI) recently announced a series of measures for the development of fixed income markets. The announcements were quite comprehen-sive and aimed to promote both market efficiency and liquidity. This came in the backdrop of the recently an-nounced report of the Working Group on development of corporate bond market in India under the Financial Stability and Development Council (FSDC) sub-com-mittee. The recommendations in the FSDC report aim to promote greater market liquidity, increased market participation and greater transparency. RBI’s measures included, allowing corporate bonds to be accepted un-der the liquidity adjustment facility, higher ceiling on credit enhancements, providing Foreign Portfolio inves-tors (FPIs) direct access to bond trading platforms and increasing the risk weightages for non-rated corporate borrowers. These measures will go a long way in en-hancing investor confidence in the Indian fixed income markets. To achieve the desired results, it is equally im-portant to ensure active participation from non-bank participants. Interlinked with the theme of a vibrant bond market is the importance of healthy condition of State Finances in India especially with the introduction of GST. In this month’s Focus of the Month, experts pro-

vide their viewpoints on these two important topics.

Domestic TrendsGDP growth in the first quarter of the current fiscal came in at 7.1 per cent as compared to 7.5 per cent in the same quarter last year, while gross value added (GVA) at basic prices posted a growth of 7.3 per cent in 1QFY17 as compared to 7.2 per cent in 1QFY16. The sectoral data print reveals interesting insights into the data. Even as investment growth contracted in 1QFY17, government consumption expenditure growth posted double-digit growth. Private consumption growth con-tinued to post respectable growth rate. Going forward, Pay Commission payouts, contained inflation and easy monetary conditions are expected to support demand. Meanwhile, data on Index of industrial production (IIP) fell back into the negative territory, declining by 2.4 per

cent in July 2016 as compared to 2.0 per cent growth in the previous month. Contraction in manufacturing and capital goods output led to the disappointing numbers during the month. On the inflation front, WPI inflation edged up in August 2016 on the back of higher prices recorded in fuel and manufacturing sectors. In contrast, CPI inflation moderated sharply, providing relief to the

policymakers.

Corporate PerformanceThe corporate results at the end of the first quarter of fiscal year 2017 brought a reason for cheer in the form of rising profitability as the financial performance of In-dian companies, especially manufacturing sector firms, improved during the quarter. Manufacturing sector, buoyed by a significant fall in inputs costs following the collapse of global commodity prices, registered a sharp pickup in profitability growth in 1QFY17 as compared to the same quarter a year ago. Worryingly, both bottom-line and top-line of services sector firms has continued to remain weak so far. The analysis factors in the finan-cial performance of a balanced panel of 1749 manufac-turing companies (excluding oil and gas companies) and 815 service firms extracted from the CMIE’s Prow-

ess database.

Global TrendsIn line with expectations, US Federal Reserve main-tained status-quo and kept the Federal funds target range unchanged at 0.25-0.50 per cent in its meeting held over two days on 20-21 September 2016 as it await-ed more evidence of progress toward its goals, while projecting that an increase is still likely by year-end. As regards to its evaluation about the economic activity, the Fed upgraded its assessment of the economic activ-ity on upbeat economic data prints emanating from the economy. Back in Asia, Bank of Japan (BoJ) Governor Haruhiko Kuroda announced a new monetary policy paradigm in order to stimulate Japanese economy and help it reach the 2 per cent inflation target. The intro-duction of “yield curve control,” in which the Bank will press for the decline in real interest rates by control-ling short-term and long-term interest rates, would be

placed at the core of the new policy framework.

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Towards a Vibrant Corporate Bond Market

side issues. However fails to fully address the demand side pressure points. The development of bond markets needs sustained participation of long-term institutional investors across the credit curve, which is a challenge the Indian bond market continues to grapple with.

RBI’s measures include, allowing corporate bonds to be accepted under the liquidity adjustment facility, higher ceiling on credit enhancements, providing Foreign Port-folio investors (FPIs) direct access to bond trading plat-forms and increasing the risk weightages for non-rated corporate borrowers.

RBI’s measures for the development of the fixed in-come and currency markets are a step in the right di-rection and can help broaden the market over the medium- to long-term. These initiatives along with the successful implementation of the bankruptcy laws can help broaden the markets, assuming some of the other issues relating to reissuances, stamp duty and asymme-try of information are addressed in the interim.

The Indian corporate bond market, despite nu-merous efforts by the regulator, continues to be stuck in pursuit of the ‘holy grail’. A truly vibrant

and efficient corporate bond market would be char-acterised by a high degree of depth across the credit curve, greater liquidity, protection of creditor rights and low information asymmetry, among other things. The recent measures by the Reserve Bank of India (RBI) is a welcome step for the development of the bond market and rightly addresses some of the major supply

The Indian Corporate Bond Market in Pursuit of the ‘Holy Grail’

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Higher rated corporates will directly benefit in the short-term due to the last mile efforts of Raghuram Rajan; however the investment guidelines for most in-vestor classes will require changes, to move down the credit curve. Banks and Financial institutions will largely remain the primary source of funding for corporates, particularly stressed corporates. India Ratings esti-mates that the number of borrowers above the thresh-old of Rs 100 billion debt obligation aggregates 50 - out of which potentially 24 are either stressed or fairly vul-nerable.

The measures are likely to give a fillip to the lower rated category bonds in the long run as the banks reduce their reliance on loans as an instrument of providing credit to large corporate issuers. This will incentivise a more dis-ciplined corporate behavior and not necessarily a more diversified investor base for them. In the developed bond markets, the appetite for speculative/non-invest-ment grade bonds remains high and they are issued and traded widely. In the Indian bond market however it is not as easy to place a bond below ‘AA category’ and hence a successful and speedy implementation of the bankruptcy law is keenly anticipated by potential inves-tors with higher risk appetite.

Measure to increase the aggregate partial credit en-hancement ceiling to 50 per cent from the earlier 20 per cent, subject to a single banks exposure of 20 per cent, will help corporates to raise money through bonds. As-suming these partial guarantees help improve the rat-ing of the underlying borrower, this potentially has the scope of widening the market for potential issuers. The development of dedicated institutions to provide credit enhancement and the introduction of the covered bond regulations, among others can be some of the other steps which can spur the bond market.

The RBI has made an attempt to provide liquidity in the bond market by allowing brokers to be part of corpo-rate bond repo facility. In most developed bond mar-kets, corporate bonds are permitted to be used as collateral for liquidity operations. Allowing corporate bonds as collateral for liquidity operations will improve the demand for corporate bonds, from the perspective of banks subscribing to these bonds. This will help de-velop a robust secondary market for ‘AAA rated’ bonds

(assuming the final guidelines restrict it to AAA paper). However, this is unlikely to result in investors moving down the credit curve due to uncertainties relating to recoveries and asymmetry in information sharing. In a scenario, where AAA papers remain in short supply due to bank investments, it could help in the gradual pro-cess of migrating down the rating curve.

Current measures have not addressed issues with re-spect to information asymmetry. A bond holder typi-cally gets information with a lag (especially where the underlying performance is deteriorating) limiting the ability of the investors to go down the credit curve and price the product attractively. Disclosure of covenants and compliance could be made mandatory to improve information asymmetry. The recent SEBI circular relat-ing to information disclosure (including ratios like DSCR among others) is a positive step and it could be further strengthened with disclosures on covenants and com-pliance. This is an international practice that both equity and debt investors can benefit from.

Long term investors namely pension, provident, gratui-ty funds’ among others are major investors in the Indian bond markets and look for long term investment oppor-tunities. The investment policies of these funds need to be aligned with the regulatory changes. The last time changes were made to the investment policies of these funds it resulted in some debt market issuers migrating to the bank loan market. Unless investment policies of these funds are aligned with other regulatory changes, it will be difficult to develop a deep and vibrant corpo-rate bond market in India.

Giving direct access to FPI in the trading platform will add more vigor, especially in the shorter end of the curve. However, it will also mean faster transmission of shocks. Moreover, wide divergences in the normal ticket sizes for FPIs and retail investors compared to the normal market lot of Rs 50 million and the price impact may together deter large scale participation in the near term.

Listed corporates can now park short term surplus cash under the repo facility with banks and primary dealers. Corporates holding on to high short term cash balances or parking funds with banks may turn to this window; however with better returns from liquid funds this

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mode is unlikely to witness a shift in volumes from MFs to banks.

India as a country provides a superior rating distribution, as compared to other emerging markets because of the RBI’s steps to encourage ratings on bank facilities. Fur-ther, realignment of the risk weightages between low rated and unrated corporate borrowers, would improve the quality of information.

RBI’s measures address a lot of the supply side issues facing the corporate bond market. Demand side meas-ures, however are in the domain of multiple regulators and each regulator comes with their own set of regu-lation/investment guidelines. The speed and scale of developments and innovation in the financial markets poses a challenge for constantly improving the regula-tors capacity. Each regulator namely Securities and Ex-change Board of India (SEBI) Pension Fund Regulatory and Development Authority (PFRDA), Insurance Regu-latory and Development Authority of India (IRDA), RBI though right in their own way but often do not have a consensus on the larger goal of development of the cor-porate bond market. Long term measures to develop

investor interest with varying risk appetite would also hinge on increasing the role of alternate investors to banks, who apportion a large dominant part of financial savings in the economy.

Over specifying of regulations creates artificial barriers, thereby leads to distortion and inefficient markets. For example, the credit enhancement scheme which speci-fies the amount per bond issue per bank or the rating grade restrictions for investments by insurance com-panies. Regulations targeted at tackling the risk arising out of such provisions without limiting the ability of markets to innovate would be required. Support from various stakeholders can lead to a vibrant corporate bond market in India, which otherwise continues to be dominated by the public sector and financial institu-tions.

Globally, the amount of sovereign debt with negative yields has touched US$13 trillion. This provides a good opportunity for all the stakeholders to kick start the corporate bond market in India. Steps to develop masa-la bonds could also help corporate issuers to develop an overseas rupee bond market.

(Views expressed are personal)

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SEPTEMBER 2016

Developing the Corporate Bond Market

The regulatory initiatives for development of cor-porate bonds so far have been primarily focused on product innovation (credit default swaps, cor-

porate bond repo) and infrastructure aspect (manda-tory trade reporting, exchange based settlement, elec-tronic bidding platform for private placements). While product development and robust market infrastructure are critical enablers, it is equally necessary to have a di-versified pool of issuers, intermediaries and investors in order to provide adequate depth and breadth to the market. A well-functioning corporate bond market can not only provide the much needed alternative to tradi-tional bank financing, but can also help reduce borrow-ing costs for corporates through market based pricing of credit risk.

The Reserve Bank of India (RBI) has recently announced a series of measures for the development of fixed in-come markets. The announcements are quite compre-hensive and aim to promote both market efficiency and liquidity. This comes in the backdrop of the recently an-nounced report of the Working Group on development of corporate bond market in India under the Financial Stability and Development Council (FSDC) sub-commit-tee. The recommendations in the FSDC report aims to promote greater market liquidity, increased market par-ticipation and greater transparency.

Firstly, the RBI has issued a discussion paper with a view to mitigate credit concentration risks in the banking sys-tem. According to the proposed framework, large cor-porates would need to rely on debt capital markets for

their incremental funding requirements. This measure will give a major boost to the bond market and will lead to greater diversity of issuers in the corporate bond market. However, the investor appetite for issuers across the credit curve would be a key determinant in achieving the desired objective. Investment guidelines of insurance companies and domestic retirement funds may need to be amended for facilitating investment in these bonds.

In order to make bond markets accessible to lower rated issuers, the aggregate limits for partial credit en-hancement provided by banks to corporate bonds have now been enhanced to 50 per cent of the issue size in-stead of 20 per cent earlier. This should enable greater infrastructure financing through bond markets, as the credit enhanced bonds can appeal to a wider category of bond market investors.

In a very significant development, the Parliament has recently passed the Insolvency and Bankruptcy Code, 2016. The key benefits include time-bound resolution of corporate defaults (much on the lines of Chapter 11 fil-ing in the US) and providing a forum to capital market participants for resolution of disputes relating to corpo-rate bankruptcies. This is a very positive development, and once implemented, investors are expected to view lower rated companies more favorably. However, the success of the Bankruptcy Code would depend upon the implementation of the associated legal infrastruc-ture to support the new framework. The progress on this front will be crucial to the bond market and will be

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watched closely.

RBI has permitted Indian corporates to issue Rupee de-nominated bonds overseas. This is a win-win product for both issuers and investors. While issuers can access new pools of investor capital without assuming curren-cy risk, investors can access Rupee exposure in an op-erationally convenient manner. Recently, RBI permitted Indian banks to issue Rupee bonds overseas, both for raising capital and infrastructure lending purpose. Since Indian banks are familiar names in the USD bond space, there would be investor demand for these bonds. This would also help develop the offshore quasi-sovereign Rupee yield curve and will facilitate better price discov-ery for Rupee denominated bond issuances for corpo-rates going forward.

In order to promote the repo market for corporate bonds, RBI has taken positive and concrete measures toward its development. Corporate bonds would be considered as eligible securities for liquidity operations, subject to amendments to the RBI Act. The decision to include corporate bonds as collateral for LAF transac-tions may result in spread compression vis-à-vis govern-ment securities, leading to lower borrowing costs. An electronic dealing platform is also being proposed for repo in corporate bonds. This would introduce central counterparty facility for corporate bond repo transac-tions, which would help reduce counterparty risk, mini-mise documentation and bring more transparency.

For enabling access to markets, RBI has permitted Foreign Portfolio Investors (FPIs) to trade on NDS-OM through primary members. FPIs can also trade directly in corporate bonds without involving brokers. In anoth-er key initiative, RBI has also permitted individual inves-tors to invest in government securities through their de-mat account (even if they don’t have a CSGL account). This would offer operational convenience and liquidity

to individual investors and would help increase retail participation in government securities markets.

A robust corporate bond market demands timely dis-semination of credit sensitive information and high standards of transparency. The FSDC sub-committee recommends mandating credit rating agencies to strict-ly adhere to the regulatory norms with regard to timely disclosure of defaults on the stock exchanges and on their own websites. It also suggests rating agencies to publish their credit rating transition matrix more frequently. This would help strengthen investor confi-dence and increase demand for lower rated issuers.

The measures, as announced by RBI, will go a long way in enhancing investor confidence in Indian fixed income markets. To achieve the desired results, it is equally im-portant to ensure active participation from non-bank participants. This may be achieved through relaxation in investment norms of regulated entities like insurance companies and retirement funds by the respective reg-ulators. Increased participation of non-bank investors in corporate bond markets across the credit curve shall help increase the breadth of the market and will sup-port in enhancing liquidity in the secondary markets. A time-bound plan for implementation of the recommen-dations made in the FSDC sub-committee report is im-portant in this regard.

The above developments, along with other measures, would help broaden the issuer and investor base and would be instrumental in creating a paradigm shift for the corporate bond markets in India. These reforms will set the stage not only for widening and deepening the market itself, but also help to play a supportive role in fi-nancing the country’s growth. An active, well-function-ing corporate bond market can channelize savings, both from India and abroad, through the bond route and can complement the traditional banking sector lending.

(Views expressed are personal)

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SEPTEMBER 2016

Developments in State Finances

State Finances: Assessing Near Term Prospects

India’s federal polity is passing through a historic phase, in which the states have come to occupy a prominent position in shaping India’s growth pros-pects. With central government strongly promoting

the idea of co-operative and competitive federalism, India’s future growth is likely to be determined by the dynamism of its federal structure. Promoting both co-operative and competitive federalism has been an over-arching theme of the present government. While co-op-erative federalism encompasses Centre’s co-operation with states, competitive federalism involves competi-tion between the states. The Niti Aayog talks of com-petitive federalism as a catalyst to achieve the objective of cooperative federalism.

Reinforcing its Cooperative Federalism agenda, the Gov-ernment last year took on board the recommendations of the 14th Finance Commission (FFC). With States now

receiving a higher share of tax devolution from the Cen-tre i.e. 42 per cent as against 32 per cent earlier, along with greater flexibility in expenditure, their role in driv-ing regional growth momentum has been enhanced. In this backdrop, it becomes critical to analyze key issues that are likely to impact the finances of the states in the near to medium term. In particular, we assess factors such as Pay Commission, State Elections and UDAY that are likely to impact prospects of state finances in India.

Performance of All India state level finances

The data for consolidated All India State-level finances as released by RBI till FY16(BE) shows that states have done well to adhere to the mandated fiscal deficit tar-get of 3 per cent under the FRBM Act while steadily im-proving the quality of fiscal health since FY05. While the adverse impact of GFC amid implementation of the 6th

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Pay Commission did put some strain on the finances in FY09 & FY10, states managed to revert to revenue sur-plus in subsequent years of FY12 & FY13.

However, finances of states deteriorated in FY14 & FY15 led by lower revenue receipts and higher revenue spending. In both these years, states at a consolidated level saw re-emergence of revenue deficit for the first time since FY10. Moreover, data on 15 state budgets (mentioned in the table below) shows that trend of

Granular Analysis of FY17 State finances

Granular analysis of 15 state budgets shows that these states have budgeted for an improvement in their defi-cit indicators in FY17. Average fiscal deficit ratio as a percentage of respective state GSDP is expected to im-prove to 2.7 per cent in FY17 (BE) compared to 3.0 per cent in FY16 (which worsened by 30 bps as compared to the Budgeted levels).

Moreover, we find that on average, states diverted greater quantum of incremental revenue receipts for

weakening finances likely continued even in FY16. Our analysis shows that finances of state governments de-teriorated in FY16 with average revenue surplus (for 15 states under review) declining to 0.1 per cent of GSDP from 0.5 per cent budgeted and fiscal deficit rising to an average 3.0 per cent from 2.7 per cent budgeted for FY16. The deterioration in finances in FY16 has been caused mainly by slowdown in state’s revenue receipts- both tax as well as non-tax.

capital spending in FY16 compared to budgeted levels for FY17. On an average, in FY17 ratio of incremental capital outlay to incremental revenue receipts for 15 states under review is budgeted at 0.25 compared to 0.39 in FY16. State-wise data shows that only UP, Pun-jab and Odisha failed to divert greater incremental rev-enue resources to capital spending in post devolution phase of FY16 & FY17 compared to pre-devolution year of FY15. As such, transfer of higher resources towards capex by a majority of larger states following greater tax devolution from Centre is encouraging.

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Near term factors that could influence state finances

States endeavor to improve their deficit indicators is likely to be affected by two factors in the near term: Pay scale revision on the lines of Seventh Pay Commis-sion and UDAY. While elections in key states of Uttar Pradesh and Punjab could add to some pressure on their finances through possible increase in spending, astute management of spending priorities could help to limit the impact.

a) The impact of UDAY

With an objective of financial turnaround of state elec-

tricity distribution companies, the government in Nov-15 announced UDAY (Ujwal DISCOM Assurance Yojana). UDAY aims at financial revival of DISCOMS through (i) improvement in operational efficiencies of DISCOMs; (ii) reduction of cost of power; (iii) reduction in interest cost of DISCOMs; (iv) enforcing financial discipline on DISCOMs through alignment with State finances. More-over, since UDAY seeks to bring to the fore and duly rec-ognize the contingent liabilities of the states, it adds to transparency. Additionally, timely intervention to mend the finances of DISCOMs before the debt on their books became unsustainable is expected to be long term posi-tive for the sector.

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However, in the short term, UDAY could lead to some increase in the liabilities of the state governments. For instance, our analysis shows that while total interest li-ability is expected to be a lower by Rs 170 billion (due to lower funding cost) leading to net interest saving for states and DISCOMS, states may have under budgeted interest liabilities on SDLs to be issued under UDAY. Rajasthan, Uttar Pradesh, Chhattisgarh, Punjab, Bihar,

b) Pay Commission

With states having budgeted fiscal consolidation in FY17, it becomes important to assess the ability of states to absorb the impact of higher revenue spending that is likely to come on board for states post implementation at the Centre. During 6th Pay Commissions, the fiscal deficit of all States combined deteriorated by 1.6 per cent between FY08 and FY10. In order to analyze ability of states to fund Pay Commission relation expenditure,

Jharkhand and Haryana are estimated to have under budgeted their interest liabilities for FY17 by a cumula-tive of Rs 56.50 billion. Moreover we find that the issu-ance of bonds under UDAY along with cash compensa-tion for financial institutions other than banks (leading probably to issuance of additional SDLs) is likely to in-crease the outstanding liabilities of all states but Chhat-tisgarh to a level greater than the mandated 25 per cent of GSDP in FY17.

we rely on two proxy indicators – one, salaries, wages and pension expenses as per cent of respective reve-nue expenditure (for 2015-16 BE) and two, proportion of state government employees in total organized sector.

Basis the above two parameters we arrive at a vulner-ability matrix for states and find that Kerala and Punjab stand out in terms of high pension and wages liabilities while having relatively higher share of state govern-ment employees in the organized sector and as such look most susceptible in terms of pay scale revisions.

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Recommendations and Way Forward

• States need to complement Centre in its endeavor towards fiscal consolidation

While the Centre has consolidated its finances each year between FY13-FY16, by showing restrain in spending, states have expanded their budget deficits during the same period. Given the criticality of fiscal consolidation amid quality spending for inflation management, states need to prioritize expenditure rationalization to contain deficits.

• Need to divert greater resources towards capex

In light of the continued slack in the private capex de-mand anticipated for most of FY17, it is vital for states to complement Centre’s efforts at reviving capex by al-locating greater resources towards capital expenditure.

Data shows that ratio of incremental capital outlay to incremental revenue receipts for 15 states under re-view has been budgeted to decline to 0.25 from 0.39 while being modestly higher than 0.20 in FY15. Given the transfer of higher tax resources by the Centre, there is room for states to allocate greater spending towards capex.

• Success of UDAY rests on states

The DISCOM restructuring plan that was launched in 2012 failed to improve the performance of DISCOMS mainly because of low tariff hikes, lack of progress in reducing losses, higher electricity purchase costs and continuous increase in debt. With UDAY making it com-pulsory for states to absorb losses FY18 onwards, a failure on part of states to improve the performance of DISCOMs through timely revision of tariffs would dilute the purpose for which UDAY was launched.

(Views expressed are personal)

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State Finances: Overcoming Fiscal Imbalances

State finances are slated to be subjected to trans-formational changes with the implementation of the Goods and Services Tax (GST) and the aboli-

tion of the distinction between plan and non-plan ex-penditure. Fortunately, they are in a good fiscal position to handle these changes having overcome the problem of large fiscal imbalances over the last decade and a half.

Deficit and Debt

Recent experience indicates that the state governments have shown significant improvement in the profile of their fiscal imbalances after enacting Fiscal Responsibil-ity Legislations (FRLs). In Chart 1, we depict fiscal defi-cit and revenue surplus relative to GDP from 1990-91 to 2015-16. Individually, states have committed to achieve a balance on revenue account and limit their fiscal defi-cit to 3 per cent of their respective GSDPs or equivalent in terms of interest payments to revenue receipts. The Twelfth Finance Commission (TFC) had suggested that state fiscal deficits considered as an aggregate should be limited to 3 per cent of GDP.

States’ fiscal deficit was at its peak at 4.7 per cent of GDP in 1999-2000. In this year, the revenue deficit was also at its highest at 2.8 per cent. Given these high levels of fiscal imbalances, the Eleventh Finance Commission had introduced a States’ Fiscal Reform Facility (FRF)

scheme for the period 2000-01 to 2004-05 to incentivise states to collectively eliminate revenue deficits. Twelfth Finance Commission linked substantial debt and inter-est rate relief to the enactment of State Fiscal Responsi-bility Legislation. To avail of the incentives recommend-ed by the TFC, this legislation was required to provide, at a minimum, for

(a) Eliminating revenue deficit by 2008-09;

(b) Reducing fiscal deficit to 3 per cent of GSDP or its equivalent defined as ratio of interest payment to revenue receipts.

The Thirteenth Finance Commission recommended that the Debt Consolidation and Relief Facility may be ex-tended to West Bengal and Sikkim, provided they enact their FRBM Acts.

With these successive incentives given by the Finance Commissions, states progressively enacted their re-spective Fiscal Responsibility Legislations (FRLs). Three states had passed their FRLs even before the central government. Five states had passed FRBM Acts before the Twelfth Finance Commission award. Twenty one states enacted FRBM legislations, incentivised by the Twelfth Finance Commission award in terms of debt and interest rate relief. Two states, namely, West Ben-gal and Sikkim enacted their FRBM legislations in 2010 after the recommendations of the Thirteenth Finance Commission.

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Clearly, the FRLs have had a beneficial impact in improv-ing the profile of fiscal imbalances of the state govern-ments. From 2005-06 onwards, the state governments considered together, have always been below the benchmark of 3 per cent of GDP except for 2009-10, when it marginally crossed this limit at 3.01 per cent. In the case of revenue balance, states achieved a revenue surplus in 2006-07 and maintained it up to 2012-13 with the exception of 2009-10, when revenue deficit was at 0.42 per cent of GDP. However, since 2013-14, there has been some deterioration in state finances.

The improvement in fiscal deficit also led to a reduction in the states’ outstanding liabilities to GDP ratio. At its peak, this ratio was close to 32 per cent in 2003-04. It progressively fell to about 22 per cent in 2013-14, that is an improvement of 10 per cent points. This implied a fall in the interest payments-GDP ratio for the state governments facilitating improvement in their revenue account.

While states successfully improved their fiscal balance position, there have been considerable inter-state vari-ations. In Charts 2 and 3, we have shown a comparison between two points reflecting averages over the peri-ods 2003-04 to 2005-06 and 2013-14 to 2014-15/ 2015-16.

Comparing these ratios with a benchmark line drawn at 3 per cent of GSDP, it is seen that earlier most of the states were above this benchmark. In the latter refer-ence period, most of these are below it. The states that have still not achieved the desired level of fiscal consoli-dation are Bihar, Karnataka, Jammu and Kashmir, West Bengal, Himachal Pradesh, Andhra Pradesh and Mizo-ram.

In the case of revenue deficit also, there is noticeable im-provement. In the earlier reference period, it is mostly only the special category states that show revenue sur-plus. This was not on account of fiscal discipline. Rather it was the effect of fiscal transfers that they received from the central government in the form of very large plan and non-plan grants. In the latter reference peri-od, a number of general category states show surplus on revenue account. These are Odisha, Uttar Pradesh, Bihar, Madhya Pradesh, Gujarat, Jharkhand and Karna-taka. Further, there are some general category states which are only marginally in revenue deficit. These are Rajasthan, Maharashtra, Tamil Nadu and Chhattisgarh. Thus, there is a widespread improvement in many of the large states that include some of the low-income states.

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Improvement in Tax Performance

Table 1 shows that the improvement in states’ fiscal imbalance profile was largely due to the improvement in states’ tax-GDP ratio which increased in two notice-able phases, first from 1998-1999 to 2006-07 when it increased from 4.95 per cent to 6.13 per cent. It briefly fell in 2007-08 and 2008-09 on account of the global economic crisis also leading to a fall in India’s growth rate. In the next phase from 2008-09 to 2012-13, it in-creased from 5.51 per cent to 6.83 per cent. Thus, com-paring 1998-99 to 2012-13, there was an overall increase

Goods and Services Tax

With the introduction of the GST, there would be major changes affecting state finances. First, tax autonomy so far vested exclusively with individual states, will now be the joint responsibility of the GST Council. Second, states will share the value added beyond manufactur-ing with the central government. At the same time, they will have the additional power to tax value added in services. In the initial stages, the revenue of the net consuming and net producing states will be affected dif-ferently. The net consuming states would gain while the net producing states would lose but would be brought on par after compensation. Thus, the net gainers would be some of the larger but low income states like Ut-tar Pradesh, Bihar, Madhya Pradesh and Rajasthan. In the present structure of GST, no explicit allowance has been made for mineral-rich states such as Odisha, Mad-hya Pradesh, Jharkhand and Chhattisgarh who are net exporters of minerals. These minerals are inputs and not items of final consumption. Therefore, any GST paid

in states’ own tax revenue to GDP ratio of 1.9 per cent points. This large increase came about first by states agreeing to floor rates in their sales tax regimes and preparing ground for the implementation of VAT. Sub-sequently, they gained from VAT as well as high global crude prices which resulted in relatively high sales tax revenues on petroleum products since these were largely ad-valorem in nature. The fall in the states’ own tax-GDP ratio in more recent period starting 2013-14 could also partially be due to the fall in global crude prices and the corresponding adjustment in the prices of petroleum products in India.

on these minerals will have to be rebated at later stag-es. These states will lose revenue in the long run while suffering from the adverse consequences of the local-ized pollution related to mineral activities which their residents will be forced to suffer. As long as alcohol, petroleum products, electricity and real estate remain outside the purview of the GST, the tax reforms would still not be complete.

The impact of GST on states’ fiscal imbalances would depend on two factors: first, whether the GST rate structure proves to be revenue-neutral and second, dis-tribution of states in the categories of net-consuming vis-à-vis net-producing states. If GST involves revenue losses, at least in the initial stages, the central govern-ment would be a net loser since through the compensa-tion mechanism, if it works efficiently, states would be either net gainers or at least will remain revenue-neu-tral. However, a net revenue loss to the central govern-ment will imply a reduction in grants or transfers that it gives to the state governments.

(Views expressed are personal)

ECONOMY MATTERS 22

DOMESTIC TRENDS

GDP Growth Moderates in 1QFY17

GDP growth in the first quarter of the current fiscal came in at 7.1 per cent as compared to 7.5 per cent in the same quarter last year,

while gross value added (GVA) at basic prices posted a growth of 7.3 per cent in 1QFY17 as compared to 7.2 per cent in 1QFY16. The sectoral data print reveals interest-ing insights into the data. Even as investment growth contracted in 1QFY17, government consumption ex-penditure growth posted double-digits growth. Private consumption growth continued to post respectable growth rate. Going forward, Pay Commission payouts, contained inflation and easy monetary conditions are expected to support demand.

From supply-side, GDP growth driven entire-ly by services sector

From the supply side, agriculture growth moderated to 1.8 per cent in 1QFY17 as compared to 2.6 per cent growth in 1QFY16. However, farm growth is expected to pick up in line with the improvement in monsoons and the increase in Kharif crop sowing. Manufacturing posted robust growth of 9.1 per cent, while construc-tion sector growth moderated sharply in 1QFY17. Go-ing forward, lower interest rates and smart recovery in private consumption expenditure will help drive in-dustrial growth in remaining quarters of FY17. Services sector was the star performer as it grew by 9.6 per cent in the reporting quarter cushioned by strong growth in government spending. However, components such as trade, hotels showed moderation as compared to the same quarter last year.

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DOMESTIC TRENDS

SEPTEMBER 2016

Consumption growth continues to outpace investment growth

At market prices, private consumption expenditure has not shown signs of any significant distress and posted a growth of 6.7 per cent in 1QFY17 from 6.9 per cent in the same quarter last year. Government spending growth was very strong for Q1FY17 as it posted 18.8 growth which was the highest since December 2014. Since the

Going forward, in the short-run, growth will receive a boost from the cumulative impact of economic reforms and improved inflationary expectations. Therefore in

government has a strong commitment to stick to fiscal deficit targets, support on this scale is unlikely to con-tinue in the second half of the year. Gross fixed capital formation continued to remain a drag on growth and given the current balance sheet constraints for corpo-rates, private capex recovery still seems far away. The external sector showed some recovery as exports grew by 3.2 per cent in 1QFY17 as compared to a contraction of 5.7 per cent in 1QFY16.

FY17, CII is projecting a base case of 7.75-8.25 per cent growth, higher than the 7.6 per cent posted in FY16.

ECONOMY MATTERS 24

DOMESTIC TRENDS

Manufacturing output remains lackadaisical

The manufacturing sector contracted by 3.4 per cent in July 2016 as compared to 0.7 per cent in the previous month and 4.8 per cent in the same month last year. The dismal growth in manufacturing sector since November

2015 is a matter of concern and calls for a results orient-ed action from the government. For the April-July 2016 quarter, the sector’s output contracted by 1.4 per cent, as against a growth of 4.0 per cent a year ago. Growth also decelerated in the mining and electricity sectors.

OutlookAlthough GDP growth moderated to 7.1 per cent during the first quarter of 2016-17 as against 7.5 per cent dur-ing the corresponding period last year, there are firm indications that economic conditions would improve in the coming quarters and new growth opportunities would emerge when the anticipated boost in demand takes root propelled by good monsoons, the Pay Commission Award and the recent reform initiatives announced by the gov-ernment. The good performance of the manufacturing sector, which grew at 9.1 per cent is indeed heartening and points towards better co-ordinated policies in this area.

The numbers show that consumption demand has been the main driver of growth in the first quarter of 2016-17 with investment continuing to reflect a subdued performance as compared to last year. CII expects a rebound in investment, going forward, as the government continues to rev up public expenditure and in the process crowd in private investment leading to a new demand cycle in the economy.

Industrial Output Contracts in July 2016

The growth in Index of industrial production (IIP) fell back into the negative territory, declining by 2.4 per cent in July 2016 as compared to 2.0 per cent growth in the previous month. Contraction in manufacturing and capital goods output led to the disappointing numbers during the month. On a cumulative basis, factory output in the April-July 2016 quarter contracted by 0.2 per cent

compared to 3.5 per cent growth in the same period a year-ago. However, going forward, we can expect the industrial output to recover cushioned by the govern-ment’s pro-reform agenda. Overall in FY17, we expect industrial production to grow at a higher rate as com-pared to the previous fiscal on the back of policy aided domestic upturn and low global commodity prices.

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DOMESTIC TRENDS

SEPTEMBER 2016

Capital goods output contracts for the ninth consecutive month

According to use-based classification, the capital goods output witnessed a ninth straight month of contraction in July 2016, thus raising doubts about the recovery of investment cycle in the country. The sector’s output contracted by a hefty 29.6 per cent in July 2016 as com-pared to a decline of 16.7 per cent in the last month partly due to high base of last year. To be sure, indus-trial production excluding the output of the capital goods sector stood at 2.1 per cent during the month as compared to 4.8 per cent in the previous month. Going forward, capital expenditure by the Government will be crucial to support recovery in this segment.

Mirroring IIP output, core sector output too moderates in July 2016

In tandem with the deceleration witnessed in indus-trial output growth, core sector output also slowed to 3.2 per cent in July 2016 as compared to 5.2 per cent growth posted in the previous month, partly due to the impact of monsoon that hit output in sectors such as ce-ment. Among the individual segments, cement sectors’ growth slowed to 1.4 per cent in July 2016 from of the impressive 10.3 per cent posted in June 2016. Similarly, fertiliser production declined to 2.5 per cent in July 2016 from 9.8 per cent in June 2016. Further, electricity gen-

Consumer goods output also decelerates during the month

Consumer goods growth declined to 1.3 per cent in July 2016 as compared to 2.7 per cent in June 2016. Amongst its sub-sectors, consumer non-durables growth moved into the negative territory once again in July 2016, after posting positive growth in June 2016. In contrast, out-put of consumer durables sector quickened to 5.9 per cent in July 2016 as compared to 5.6 per cent posted in the last month. The boost in consumption due to the implementation of 7th Pay Commission report is expect-ed to improve the growth of this sector further, going forward.

eration registered a mere 1.6 per cent in July 2016, which was the lowest since the zero per cent growth in No-vember 2015. Steel production also contracted by -0.5 per cent, the lowest since it shrunk by the same margin in February 2016. Crude oil production also shrunk by -1.8 per cent in the reporting month. On a cumulative basis, core sector output stood at 5.4 per cent during April-July 2016 as compared to 2.5 per cent in the same period last year. In contrast, output of refinery prod-ucts accelerated to 13.7 per cent – the highest growth achieved since 17.9 per cent in April 2016. Natural gas also recorded 3.3 per cent growth in July 2016 after four months of contraction

ECONOMY MATTERS 26

DOMESTIC TRENDS

OutlookThe contraction in industrial output during July 2016 is worrisome as it indicates that industry is performing much below its underlying potential. What is causing concern is that both manufacturing and capital goods sectors are witnessing an anemic trend in output implying that growth impulses are still weak. But we hope that going for-ward, aggregate demand would pick up based on pay rise of government employees and the reform initiatives recently taken by the government to induce demand in the economy.

CPI Inflation Moderates, While WPI Inflation Inches UpWholesale Price Index (WPI) based inflation quickened to a two-year high of 3.7 per cent in August 2016 from 3.55 per cent in July 2016 on high fuel and manufactur-ing inflation. This was the fifth straight month of WPI inflation after continued deflation for over a year. In contrast to a jump in WPI inflation, CPI inflation cooled sharply to 5.1 per cent in August 2016 as compared to

6.1 per cent in the previous month. The main driver be-hind the deceleration in CPI inflation was food inflation which edged down to 5.8 per cent in August 2016 from 7.96 per cent in the previous month. The most signifi-cant development was the sharp plunge in vegetables inflation to 1 per cent in August 2016 from 14 per cent seen in the previous month.

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DOMESTIC TRENDS

SEPTEMBER 2016

OutlookWPI inflation edged up in August 2016 on the back of higher prices recorded in fuel and manufacturing sectors. In contrast, CPI inflation moderated sharply, providing relief to the policymakers. Going forward, CII expects CPI infla-tion to settle within the RBI’s target of 5 per cent for March 2017 as food prices are expected to ease going forward on account of a spate of reforms undertaken by the present government to address the supply bottlenecks and the expectation that monsoon would be normal after two consecutive years of drought. This should spur RBI to resume its rate easing cycle as investments continue to be sluggish.

WPI primary articles inflation moderates in August 2016Coming to WPI sub-categories, inflation in primary ar-ticles slowed down to 7.5 per cent in August 2016 as compared to 9.4 per cent posted in July 2016. Within primary articles, inflation in both food and non-food sub categories decelerated during the reporting month. Pri-mary food inflation moderated to 8.2 per cent (as com-pared to 11.8 per cent in July 2016) while non-food infla-tion stood at 8.4 per cent (as compared to 9.5 per cent in July 2016). A normal monsoon so far has boded well for reining in high food prices.

Inflation in fuel category moves to positive territory after a gap of 21 monthsInflation in the fuel group of WPI moved to the positive territory after a gap of 21 months in August 2016 as it stood at 1.6 per cent. The upward movement in global crude oil prices owing to the ongoing political tensions in Venezuela, Libya and Nigeria has pushed fuel inflation into the positive territory. Inflation in high speed diesel

quickened to 12.2 per cent during the reporting month as compared to 6.6 per cent in July 2016. Petrol infla-tion too moved to -8.6 per cent as compared to -10.3 per cent in the previous month.

Manufacturing inflation quickens in August 2016Inflation in manufactured group quickened to 2.4 per cent in August 2016 – its highest reading since October 2014, as compared to 1.8 per cent posted in the previous month. Manufacturing food inflation which had moved to double-digits in July 2016 continued its upward tra-jectory, rising further to 11.4 per cent in August 2016 from 10.2 per cent in the previous month. Meanwhile manufacturing non-food inflation (popularly called as core inflation and a proxy for demand-side pressures in the economy) too accelerated mildly to 0.6 per cent in the reporting month from 0.1 per cent in the previous month. With core inflation recording an increase after a prolonged period of deflation, there are indications that demand is returning to the economy.

ECONOMY MATTERS 28

DOMESTIC TRENDS

SW monsoon expected to be normal despite 3 per cent monsoon deficit so far

India is heading towards a normal South-west mon-soon this year, notwithstanding the monsoon deficit of 3 per cent below long period average (LPA) till 28th September 2016. The India Meteorological Department (IMD) categorizes rainfall in the 96-104 per cent long-period average range as normal and rainfall between 104-110 per cent of LPA as above normal. Much of the rainfall deficit has been seen in East & Northeast parts and South peninsula of the country, which are either predominantly non-agriculture dependent or are well irrigated.

Record production of kharif foodgrains as per 1st advance estimate

The importance of a normal monsoon this year is par-ticularly crucial given the high food inflation rates seen currently. In this context, the news of 1st advance esti-mates of total kharif foodgrains estimated at a record high of 135.03 million tonnes is heartening. This year the estimated production is higher by 11.02 million tonnes

Kharif crops sowing progressing well, ex-cept for cottonKharif sowing starts with the onset of June and the crop is harvested during September-October. Area sown un-der kharif crops increased to 1067.53 lakh hectares by 23rd September 2016. This is 3.6 per cent higher than the area sown at this time last year. Much of the food inflation last year was driven by high inflation in pulses, but encouragingly pulses have recorded the largest in-crease in area sown to the tune of 29.1 per cent this year so far. As of 23rd September 2016, area under pulses measured 145.84 lakh hectare as compared to 112.93 lakh hectare a year-ago. Among pulses, arhar recorded the maximum increase in acreage. Area sown under

as compared to last year’s kharif foodgrains production of 124.01 million tonnes. Further, kharif foodgrains pro-duction is also higher by 7.65 million tonnes than the last five years’ (2010-11 to 2014-15) average production of 127.38 million tonnes. Notably, production in pulses (which has seen double-digit inflation in the last couple of months) has been estimated at a record level of 8.70 million tonnes which is higher by 3.16 million tonnes than the last year’s production of 5.54 million tonnes.

Kerala records the highest rainfall deficiency so farAmong the major states, rainfall deficiency has so far been the highest for Kerala, with the rainfall gap (from 1st June to 23rd September, 2016) standing at 32 per cent followed by Punjab and Haryana (each at 25 per cent below LPA). North Eastern states have also received large deficit in rainfall so far. In contrast, the states which have received bountiful rainfall so far include- Ra-jasthan (30 per cent above LPA), Madhya Pradesh (18 per cent above LPA), Maharashtra (11 per cent above LPA), Andhra Pradesh (7 per cent above LPA) and Telan-gana (3 per cent above LPA).

rice increased by 2.6 per cent to 387.04 lakh hectare while under coarse cereals expanded by 3.3 per cent to 189.58 lakh hectares in the period 1st June-23rd Septem-ber 2016. Coarse cereals include jowar, bajra, maize and ragi. The acreage under oilseeds, as a group, stood at 189.16 lakh hectares, up 3.0 per cent compared with last year, with groundnut recording a staggering 29.0 per cent increase, chiefly due to the higher plantings in Andhra Pradesh, Rajasthan, Karnataka and Gujarat. A key pres-sure point with regard to the sowing of major kharif crops has been that of cotton, whose acreage has fallen by 11.6 per cent over the last year, mainly due to poor rainfall in Gujarat, which happens to be the key cotton growing state in the country.

Monsoon Deficit: Nothing to Worry About

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DOMESTIC TRENDS

SEPTEMBER 2016

Going forward, improved reservoir levels and high re-sidual soil moisture will be supportive of forthcoming Rabi crop. Rabi crop accounts for nearly 50 per cent of country’s total food output. In addition, Northeast monsoon over October to December are important

for 5 metrological subdivisions of southern India (Tamil Nadu, Coastal Andhra Pradesh, Rayalaseema, Kerala and south interior Karnataka) as they receive 30 per cent of their annual rainfall in these months.

Merchandise exports continued to remain in the nega-tive territory for the second consecutive month, albeit the magnitude of contraction reduced sharply in August 2016, aided by a favorable base. Exports fell by 0.3 per cent on year-on-year basis to US$21.5 billion in August 2016 as compared to contraction to the tune of 6.8 per cent in July 2016.

Export performance improved sharply with 14 out of 30 major commodities posting positive growth as com-pared to 8 commodities seen last month. The key sec-tors posting positive growth during the month were iron ore, fruits & vegetables, marine products, gems & jewellery and electronics. Cereals, oil seeds and pe-troleum products exports contracted sharply. On a cumulative basis, for the period April-August 2016, mer-

chandise exports stood at US$108.5 billion, registering a contraction of 2.98 per cent on a year-on-year basis.

Imports continue to post contraction

Merchandise imports contracted by 14.1 per cent to US$29.1 billion in August 2016 as compared to a decline of 19 per cent in the last month. During April-August FY17, India’s cumulative merchandise imports stood at US$143.2 billion, registering a negative growth of 15.89 per cent on a year-on-year basis. Coming to the sector bifurcation, oil imports during August 2016 contracted by 8.5 per cent to US$6.74 billion during the month. Meanwhile, non-oil imports during August 2016 were estimated at US$22.4 billion which was 15.7 per cent lower than non-oil imports of US$26.1 billion in August 2015.

Magnitude of Contraction in Exports Narrows

ECONOMY MATTERS 30

DOMESTIC TRENDS

Current Account Deficit Contained in 1QFY17

Merchandise trade deficit narrowed marginally to

US$7.7 billion in August 2016 from US$7.8 billion in the

previous month. A much steeper fall in imports vis-a-vis

exports, led to this contraction in trade deficit. Cumu-

latively, during April-August 2016, India’s trade deficit

stood at US$34.7 billion, 40.6 per cent lower than the

Current account deficit (CAD) for the first quarter of the current fiscal (1QFY17) stood at US$0.3 billion or 0.1 per cent of GDP, the same as the preceding quarter. In the same quarter last year, CAD stood at US$6.1 billion or 1.2 per cent of GDP. The contraction in CAD in the June quarter was primarily on account of narrowing of the trade deficit to US$23.8 billion from US$34.2 billion a year ago. On a balance of payments (BoP) basis, mer-chandise imports declined sharply (by 11.5 per cent) as compared to merchandise exports (which declined by 2.1 per cent), leading to a lower trade deficit in Q1FY17.

year-ago period. Going forward, while improving do-

mestic competitiveness through structural reforms is

crucial to improve exports performance; we believe

that this can only materialize in the medium-term. In the

near-term, a weaker rupee can act as a catalyst to revive

competitiveness.

Lower remittances offset by sharp narrow-ing of merchandise trade deficitInvisibles related flows were lower at US$23.5 billion in 1QFY17 as compared to US$28.0billion in the same quar-ter last year. Component wise, net services receipts de-clined on a y-o-y basis, largely due to a fall in net earn-ings on account of travel, financial services and other business services. Private transfer receipts, which rep-resent remittances by overseas Indians, amounted to US$15.2 billion, declining from their level in the preced-ing quarter as well as from a year ago. Going forward there is a risk of further lower inflows from Middle East region amid decline in crude oil prices and economic slowdown in that part of the world.

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DOMESTIC TRENDS

SEPTEMBER 2016

Concerns persist on lower foreign invest-ment frontNet capital account moderated sharply to US$7.1 billion in 1QFY17 as compared to US$18.6 billion in the same quarter last year mainly on account of lower net foreign investment. The global financial market uncertainty, led by the slowdown in China, steep decline in commodity prices and the likely trajectory of US Fed rate hikes, has weighed on the capital flows across EM economies and India was not immune to the trend. To be sure, net foreign direct investment moderated to US$4.1 billion in Q1FY17 from US$10.0 billion in Q1FY16 and US$8.8 billion in the Q4FY16. On the other hand,

We expect CAD to come below 1 per cent of GDP in FY17. The key risk to the outlook is volatility in portfolio relat-ed flows and deceleration in remittance related inflows. From a longer term perspective, although the external

portfolio investment, recorded a net inflow of US$2.1 billion in Q1FY17 as against a marginal outflow in the cor-responding period of last year and an outflow of US$1.5 billion in the preceding quarter, primarily reflecting net inflow in the equity component. Higher repayments un-der external commercial borrowings led to a net out-flow under loans to India in Q1FY17 as against net bor-rowings in the same period last year.

Foreign exchange reserves (on a BoP basis) increased by US$6.9 billion in Q1FY17 as compared with an accre-tion of US$11.4 billion in Q1FY16 and US$3.3 billion in the preceding quarter.

sector performance remains favorable, the sustainabil-ity of the same is still doubtful. Continued weakness in exports performance due to global headwinds is a po-tential risk for the sector.

ECONOMY MATTERS 32

CORPORATE PERFORMANCE

Corporate Profitability on the Upswing in 1QFY17

Manufacturing firms register rising profit-ability in 1QFY17 as compared to 1QFY16

The corporate results at the end of the first quarter of fiscal year 2017 brought a reason for cheer in the form of rising profitability as the financial performance of In-dian companies, especially manufacturing sector firms, improved during the quarter. The manufacturing sec-tor, buoyed by a significant fall in inputs costs following the collapse of global commodity prices, registered a sharp pickup in profitability growth in 1QFY17 as com-pared to the same quarter a year ago. Worryingly, both

bottom-line and top-line of services sector firms has continued to remain weak so far. The analysis factors in the financial performance of a balanced panel of 1749 manufacturing companies (excluding oil and gas com-panies) and 815 service firms extracted from the CMIE’s Prowess database.

Bottom-line of firms on an aggregate basis registers a stellar performance in 1QFY17

In the 1QFY17, the bottom-line of the firms improved to 9.4 per cent on an aggregate basis, as compared to contraction of 10.1 per cent a year ago. Manufacturing companies registered growth in PAT as high as 14.7 per cent as compared to a contraction of 23.2 per cent in the same quarter previous year. Though, profitability in service firms moderated to 2.9 per cent in 1QFY17 from double-digits growth of 13.8 per cent in 1QFY16.

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CORPORATE PERFORMANCE

SEPTEMBER 2016

In contrast, net sales growth is recovering slowlyGrowth in net sales remained a bit of a sore point, even though falling input costs provided a respite. In 1QFY17, net sales growth on an aggregate basis remained low albeit stable as it stood at 0.7 per cent as compared to 0.5 per cent in the same quarter a year ago. Net sales growth of manufacturing sector moved to the positive

Struck with weak domestic and external demand, the Indian companies are trying hard to clutch a straw of hope. Efforts are in force by firms to improve their own production efficiencies and employ cost effective meas-ures. Simultaneously, there are also expectations of

territory in 1QFY17 as compared to contraction a year ago. In contrast, net sales growth of services sector firms moderated to 1.3 per cent in the reporting quarter as compared to 2.0 per cent a fiscal ago. Though, net sales growth has been recovering, it still remains lacka-daisical, reflecting in part the lack of ample demand in the economy. The slowing demand in the external mar-kets has been doing no good either.

some serious economic reforms, some of which have already come in form of necessary rate cuts by the RBI, that would elevate the economy, help pick up sales and raise the profitability for the Indian corporates further in the months to come.

ECONOMY MATTERS 34

POLICY FOCUS

POLICY FOCUS

1. Cabinet approves Agreement and the Protocol between India and Cyprus for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion

The Union cabinet on 24th August, 2016 approved a re-vised India-Cyprus tax treaty that seeks to plug loop-holes used by investors to avoid paying taxes in India. The new agreement, which will replace the 1994 treaty, will enable Indian authorities to tax capital gains on in-vestments routed through Cyprus; it will also lead to the removal of the Mediterranean island nation from an Indian government blacklist on which it was placed for not providing financial information sought by India. The revisions in the treaty are on the lines of the recent changes notified in the India-Mauritius tax treaty and those still being negotiated in the India-Singapore trea-ty. India will get the right to tax capital gains from sale of shares on investments made by Cyprus-based com-panies after 1 April 2017.

2. Cabinet Approves Initiatives to Revive the Construction Sector

The Cabinet Committee on Economic Affairs, chaired by the Prime Minister Shri Narendra Modi on 31st August,

2016 has approved various measures to revive the con-struction sector which has been undergoing stress.

Under the proposal put forward by NITI Aayog and ap-proved by the CCEA, government agencies would pay 75 per cent of the arbitral award amount to an escrow account against margin free bank guarantee, in those cases where the award is challenged.

The escrow account can be used to repay bank loans or to meet commitments in ongoing projects. This is a major step which will allow recovery of loans by banks and allow construction companies to speed up execu-tion of ongoing projects. It will also increase the ability of construction companies to bid for new contracts and the resulting competition will be beneficial in contain-ing the costs of public works. This measure will provide a stimulus to the construction industry and to employ-ment.

Government Departments and PSUs have also been instructed to transfer cases under arbitration to the amended Arbitration Act which has an expedited pro-cedure, with the consent of the contractors. In the long run, other measures are also under consideration, in-cluding changes to bid documents and model contracts,

The important policy announcements by the Government in the months of August-September 2016 are covered in this month’s Policy Focus. Our endeavor through this section is to keep our readers abreast of the latest happenings on

the policy front so that they can take an informed decision accordingly.

35

POLICY FOCUS

SEPTEMBER 2016

and increased use of conciliation. NITI will also examine the idea of creating “claim take out funds” financed by private sector investors, while the Department of Finan-cial Services will examine a suitable scheme for address-ing stressed bank loans in the construction sector.

CII’s Reaction

The Cabinet Committee on Economic Affairs (CCEA)’s announcement of a revival package for the ailing con-struction sector has come at an opportune time as it seeks to destress the liquidity woes of construction companies and the infrastructure sector, said the Con-federation of Indian Industry (CII). “Indian industry wel-comes this positive and timely initiative taken by the government as this would unclog stressed assets and revive projects that have been stuck over years in litiga-tion and courts,” said Mr Chandrajit Banerjee, Director General, CII.

Mr Banerjee added, “The revival package for the con-struction sector by the government will translate into a huge liquidity boost for the system and would save many construction companies from being declared NPAs.” The package will also allow recovery of loans by banks and facilitate construction companies to speed up execution of ongoing projects. Further, it will in-crease the ability of construction companies to bid for new contracts and the resulting competition will be beneficial in containing the costs of public works, he said.

One of the major decisions by the CCEA includes a di-rection to PSUs to pay 75 per cent of award amount to contractors against a margin fee in cases where the PSU has lost the Arbitration case and goes in for appeal in Courts. This amount will infuse liquidity and will be used by the contractors to repay bank loans or to meet com-mitments in ongoing projects.

Government Departments and PSUs have also been instructed to transfer cases under arbitration to the amended Arbitration Act which has an expedited pro-cedure, with the consent of contractors. This will help disputes to be settled expeditiously, with minimum cost and time overruns and unlock stuck money to go back into circulation in the economy. It would be worth mentioning here that an estimated amount of around Rs 70,000 crores is expected to be unlocked due to this measure.

Given the fact that the construction sector generates the highest level of direct and indirect jobs employing about 40 million people with a 2.7x multiplier effect on the economy and being the second largest contributing nearly 8 per cent economic activities to the GDP, these initiatives are all set to trigger massive expansion of the infrastructure sector, industrialization, urbanization, rise in disposable incomes and success of various Gov-ernment initiatives to improve India’s residential and transport infrastructure.

A few suggestions for possible additional amendments that will further streamline ease of doing business could include adoption of ICC’s Uniform Rules for De-mand Guarantees (URDG) which are being followed in most major countries. Also, revision of clauses in Public Contracts so that the interest of both the Client and the Contractor are taken care of, is essential for the full re-covery of this crucial sector.

While the effect of the amendment may be visible after a few months, in the long run these initiatives would en-able Construction Sector to attract foreign investments and help in reviving sectors crucial for rebooting India’s growth story.

3. Cabinet approves creation of GST Council and its Secretariat

The Constitution (122nd Amendment) Bill, 2016, for intro-duction of Goods and Services tax in the country was ac-corded assent by the President on 8th September, 2016, and the same has been notified as the Constitution (101st Amendment) Act, 2016. As per Article 279A (1) of the amended Constitution, the GST Council has to be consti-tuted by the President within 60 days of the commence-ment of Article 279A. The notification for bringing into force Article 279A with effect from 12th September, 2016 was issued on 10th September, 2016.

As per Article 279A of the amended Constitution, the GST Council which will be a joint forum of the Centre and the States, shall consist of the following members: Union Finance Minister will be the Chairperson, the Un-ion Minister of State-in-charge of Revenue will be its Member and the Minister-in-charge of Finance or Taxa-tion or any other Minister nominated by the State Gov-ernments will be its Members as well.

ECONOMY MATTERS 36

POLICY FOCUS

Additionally, the Union Cabinet under the Chairmanship of Prime Minister Shri Narendra Modi has also approved setting up of GST Council and setting up its Secretariat on 12th September, 2016 as per the following details:

(a) Creation of the GST Council as per Article 279A of the amended Constitution;

(b) Creation of the GST Council Secretariat, with its of-fice at New Delhi;

(c) Appointment of the Secretary (Revenue) as the Ex-officio Secretary to the GST Council;

(d) Inclusion of the Chairperson, Central Board of Ex-cise and Customs (CBEC), as a permanent invitee (non-voting) to all proceedings of the GST Council;

(e) Creation of one post of Additional Secretary to the GST Council in the GST Council Secretariat (at the level of Additional Secretary to the Government of India), and four posts of Commissioner in the GST Council Secretariat (at the level of Joint Secretary to the Government of India).

The Cabinet also decided to provide for adequate funds for meeting the recurring and non-recurring expenses of the GST Council Secretariat, the entire cost for which shall be borne by the Central Government. The GST Council Secretariat shall be manned by officers taken on deputation from both the Central and State Govern-ments.

The steps required in the direction of implementation of GST are being taken ahead of the schedule so far.

4. Finance Minister announces the exemp-tion threshold and administrative control mechanism for GST

The two day meeting of the newly constituted GST Council comprising of Union Finance Minister, Union Minister of State for Finance and the State Finance Min-isters concluded on 23rd September, 2016. Based on the proceedings of the meeting, the announcements made by the Union Finance Minister are as follows:

• Exemption threshold for GST has been fixed at Rs 20 lakhs for all the States except the North-Eastern States and other small states. For these states the exemption threshold has been fixed at Rs 10 lakhs.

• State Authorities shall assess the taxpayers with annual turnover not exceeding Rs 1.5 crore.

• For annual turnover above Rs 1.5 crore, the taxpay-ers will be cross examined either by the Central or State Authorities on the basis of risk assessment.

• Centre shall continue to assess the existing Service tax assessees irrespective of their annual turnover till the state officers are trained for said purposes. However, new assessees which would be added to the list shall be divided between Centre and States.

• The Council has also agreed that all cesses shall be subsumed in the GST.

• Union Finance Minister further announced that the GST Council shall try and finalise the tax rate and slabs in the meeting to be held from17 October 2016 to 19 October 2016.

5. Centre Issues Model Guidelines on Direct Selling

The Government on 12th September, 2016 issued model guidelines for State governments to regulate the busi-ness of direct selling and multi-level marketing with an aim to protect consumers from Ponzi schemes. The ‘Direct Selling Guidelines 2016’ framework, released by Food and Consumer Affairs Minister Ram Vilas Pas-wan, prohibits pyramid as well as money circulation schemes. In the guidelines, direct selling has been defined as “marketing, distribution and sale of goods or providing of services as a part of network of direct selling other than under a pyramid scheme”. Pyramid Scheme has been defined in the guidelines as “a multi layered network of subscribers to a scheme formed by subscribers enrolling one or more subscribers in order to receive any benefit, directly or indirectly, as a result of enrolment or action or performance of additional subscribers to the scheme”.

Amongst the major measures, the guidelines make it mandatory for e-retailers and online marketplaces to get prior written consent of the direct selling enti-ties like Amway before soliciting sales. The norms also provided for direct selling companies for setting up a Grievance Redressal Committee to attend to consumer complaints that will necessarily have to carry a unique number through which they can be tracked for redres-

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sal. The guidelines have also made provision for ap-pointment of monitoring authority at both the Centre and State levels to deal with the issues related to direct selling. Further, the guidelines also place conditions on the contract between direct sellers and the direct sell-ing entity, saying that all such agreements should be in writing describing the material impact of the participa-tion.

6. Report Released on “Incentivising Pulses Production through Minimum Support Price (MSP) and Related Policies”

Chief Economic Adviser, Dr. Arvind Subramanian sub-mitted a Report titled “Incentivising Pulses Production through Minimum Support Price (MSP) and Related Policies” to Finance Ministry on 16th September, 2016. The panel was set up in the wake of a recent surge in retail prices of pulses. The major suggestions of the re-port are as follows:

- Government should procure pulses on a “war foot-ing”,

- Government should create buffer stock of 2 million tonnes,

- States should be pushed to delist pulses from Ag-ricultural Produce Market Committee (APMC) and promote development of GM technologies. It also prescribed subsidies to farmers for growing pulses,

- Government should immediately announce higher MSP of gram (chana) to Rs 4,000 a quintal for rabi 2016 and Rs 6,000 a quintal for both urad and tur for kharif season 2017,

- It suggested that new agencies should handle pro-curement under PPP model,

- The report suggested that there should be no bans on exports of pulses or ad hoc controls.

7. Cabinet approves merger of rail budget with general budget; advancement of budget presentation and merger of plan and non-plan classification in budget and accounts

The Union Cabinet on 21st September, 2016 approved the proposals of Ministry of Finance on certain landmark

budgetary reforms relating to (i) the merger of Railway budget with the General budget, (ii) the advancement of the date of Budget presentation from the last day of February and (iii) the merger of the Plan and the Non-Plan classification in the Budget and Accounts. All these changes will be put into effect simultaneously from the Budget 2017-18.

Merger of Railway Budget with the General Budget:

The arrangements for merger of Railway budget with the General budget have been approved by the Cabinet with the following administrative and financial arrange-ments-

(i) The Railways will continue to maintain its distinct entity -as a departmentally run commercial under-taking as at present;

(ii) Railways will retain their functional autonomy and delegation of financial powers etc. as per the exist-ing guidelines;

(iii) The existing financial arrangements will continue wherein Railways will meet all their revenue ex-penditure, including ordinary working expenses, pay and allowances and pensions etc. from their revenue receipts;

(iv) The Capital at charge of the Railways estimated at Rs.2.27 lakh crore on which annual dividend is paid by the Railways will be wiped off. Consequently, there will be no dividend liability for Railways from 2017-18 and Ministry of Railways will get Gross Budgetary support.

The presentation of separate Railway budget started in the year 1924, and has continued after independence as a convention rather than under Constitutional provi-sions.

The merger would help in the following ways:

• The presentation of a unified budget will bring the affairs of the Railways to centre stage and present a holistic picture of the financial position of the Gov-ernment.

• The merger is also expected to reduce the proce-dural requirements and instead bring into focus,

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the aspects of delivery and good governance.

• Consequent to the merger, the appropriations for Railways will form part of the main Appropriation Bill.

Advancement of the Budget presentation:

The Cabinet also approved, in principle, another reform relating to budgetary process, for advancement of the date of Budget presentation from the last day of Febru-ary to a suitable date. The exact date of presentation of Budget for 2017-18 would be decided keeping in view the date of assembly elections to be held in States.

Merger of Plan and Non Plan classification in Budget and Accounts:

The third proposal approved by the Cabinet relates to the merger of Plan and Non Plan classification in Budget and Accounts from 2017-18, with continuance of ear-marking of funds for Scheduled Castes Sub-Plan/Tribal Sub-Plan. Similarly, the allocations for North Eastern States will also continue.

This would help in resolving the following issues:

• The Plan/Non-Plan bifurcation of expenditure has led to a fragmented view of resource allocation to

various schemes, making it difficult not only to as-certain cost of delivering a service but also to link outlays to outcomes.

• The bias in favour of Plan expenditure by Centre as well as the State Governments has led to a neglect of essential expenditures on maintenance of assets and other establishment related expenditures for providing essential social services.

CII’s Reaction

The decision to merge the rail budget with the Union Budget and removal of the distinction between Plan and non-Plan expenditure are commendable initiatives to simplify and streamline decision-making within the government and move towards efficiency of resource use. Purely from a policy point of view, the recent Cabi-net decisions send a clear message that the govern-ment is orchestrating big bang reforms in a major way.

Expediting the passage of the Budget is a move in the right direction as it would facilitate early implementa-tion of Budget decisions. This is a historic move in the direction of less government and more governance, the credo of the present government. Global and domes-tic business sentiment would get a further fillip and so would the environment for doing business in the coun-try.

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Federal Rate Hike on Cards in December 2016

SEPTEMBER 2016

In line with expectations, US Federal Reserve main-tained status-quo and kept the Federal funds target range unchanged at 0.25-0.50 per cent in its meeting

held over two days on 20-21 September 2016 as it await-ed more evidence of progress toward its goals, while projecting that an increase is still likely by year-end. In-terestingly, three members from the hawkish Fed bloc — Esther George, Loretta Mester and Eric Rosengren — dissented from the statement as compared to only one member dissenting in the previous meeting. In the policy statement, the Federal Open Market Commit-tee (FOMC) indicated that the labor market had con-tinued to strengthen and growth of economic activity had picked up from the modest pace seen in the first half of this year. It however added that the household spending had been growing strongly but business fixed investment had remained soft. Further, the Fed state-ment highlighted that it had been concerned about global developments; particularly the Brexit vote and a slowdown in China, however the near-term risks to the economic outlook were put as being roughly balanced.

Fed upgrades its assessment of econom-ic activity

As regards to its evaluation about the economic activ-ity, the Fed upgraded its assessment of the economic activity, citing that “growth of economic activity has picked up from the modest pace seen in the first half of this year” as compared to the moderate rate of growth cited in the last meeting. However, in the Summary of Economic Projections (SEP) that accompanied the statement, the FOMC revised slightly lower its projec-tion for GDP growth for 2016. The median growth pro-jection for 2016 was cut to 1.8 per cent from 2 per cent, mirroring the drop in the longer-run forecast, based on median estimates.

On the inflation front, Fed noted that inflation had con-tinued to run below the Committee’s longer-run objec-tive, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports. Hence, it revised its projection of CPI to 1.3 per cent in the fourth quarter, down from a forecast of 1.4 percent made in June 2016. However, it retained its view that inflation was expected to rise towards the 2 per cent target in the medium-term.

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Notwithstanding the moderation in NFP seen in August, labour market conditions remain upbeatOn the labour market conditions, Fed acknowledged that a range of indicators pointed to “continued strengthening of the labour market”. However, the Au-gust 2016 non-farm payrolls (NFP) came in lower than expectations, increasing by 151,000 in August 2016 as compared with the market consensus of 180,000. While the June 2016 print was revised downwards to 271,000 from 292,000, the July 2016 print was revised up from 255,000 to 275,000. The less volatile three-month aver-age NFP came in above its psychological 200,000 mark at 232,000.

Bank of Japan (BoJ) Governor Haruhiko Kuroda an-nounced a new monetary policy paradigm in order to stimulate Japanese economy and help it reach the 2 per cent inflation target. The introduction of “yield curve control,” in which the Bank will seek for the decline in real interest rates by controlling short-term and long-term interest rates, would be placed at the core of the new policy framework.

Large scale monetary easing has released surfeit of easy money in the economyMore than three years ago, BoJ had introduced Quan-titative and Qualitative Monetary Easing (QQE) in April

In December 2015, the Fed had signaled that four rate increases were likely in 2016, but had scaled back these projections in March 2016 due to a global growth slow-down, financial market volatility and concerns about tepid inflation. In the years ahead, the FOMC sees two hikes in 2017 and three each in 2018 and 2019 that would bring the funds rate to about 2.6 per cent, assuming that each increase would come in quarter-point incre-ments.

Fed rate hike expected in December 2016Going ahead, incoming data and developments in the global and financial markets will remain critical for de-termining the next policy action. However, a rate hike in December 2016 remains on the cards.

2013. In this period, Japan’s economic activity and prices had improved significantly and Japan’s economy was pulled out of deflation. However, despite the Bank’s large-scale monetary easing, the price stability target of 2 per cent had not been achieved. In order to com-plement this policy, in January 2016, the Bank had intro-duced “QQE with a Negative Interest Rate”. Since the introduction of this measure, Japanese government bond (JGB) yields, lending rates and interest rates on corporate bonds and commercial paper had declined considerably, implying that the measure has had sub-stantial effects.

Bank of Japan Introduces New Monetary Policy Paradigm

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In line with market expectation, the Bank of England (BoE) in its monetary policy meeting held on 15th Sep-tember, 2016 kept key policy rate unchanged at 0.25 per cent and Asset Purchase Facility (APF) at GBP 435 billion. All nine members of the Bank’s Monetary Policy Com-mittee (MPC) voted to leave interest rates at a record low, following signs that businesses and households have largely shrugged off the initial shock of Brexit.

BoE adopts dovish stance; rate cut ex-pected most likely by end of 2016However, the accompanying statement was broadly dovish on the stance front but BoE’s assessment of in-coming data was mildly positive, with the Committee highlighting the need to act further if data disappoints. The Monetary Policy Committee (MPC) admitted that

a number of indicators of near-term economic activity had been somewhat stronger than expected. It now expects less of a slowing in UK GDP growth in the sec-ond half of 2016. For now, an internal judgment by Bank staff suggests GDP growth will come in at about 0.2-0.3 per cent in the third quarter, the minutes said. That was stronger than their view at the time of the August rate cut, when they forecast that growth would be close to zero.

The meeting record showed a majority of policymak-ers were still open to another rate cut, probably to 0.1 per cent, before the end of the current year. However, much will depend on the Bank’s next inflation report due on 3rd November, 2016, when it produces new fore-casts for the economy based on the latest indicators.

Bank of England Adopts Dovish Policy Stance

BoJ introduces ‘’ QQE with Yield Curve Control”

But still, price target of 2 per cent had remained elu-sive. Hence, BOJ decided to introduce a new monetary policy framework called as “QQE with Yield Curve Con-trol”, which consists of two major components: the first is “yield curve control” in which the Bank will control short-term and long-term interest rates; and the second is an “inflation-overshooting commitment” in which the Bank has committed itself to expanding the monetary base until the year-on-year rate of increase in the ob-served consumer price index (CPI) exceeds the price stability target of 2 per cent and stays above the target in a stable manner.

In order to achieve the yield control, BoJ has speci-fied guidelines for market operations which enunciate a short-term policy interest rate and a target level of a long-term interest rate. Specifically, short-term interest rates will be decided by applying a negative interest rate of minus 0.1 per cent to the policy-rate balances in cur-rent accounts held by financial institutions at the Bank. The long-term interest rates will be the rate at which the Bank will purchase Japanese government bonds (JGBs) and also ensure that the 10-year JGB yields will remain more or less at the current level (around zero per cent).

The experience so far with the negative interest rate policy shows that a combination of the negative inter-est rate on current account balances at the Bank and JGB purchases is effective for yield curve control.

Further, the Bank also decided to introduce the follow-ing new tools of market operations so as to control the yield curve smoothly:

(i) Outright purchases of JGBs with yields designated by the Bank (fixed-rate purchase operations) and

(ii) Fixed-rate funds-supplying operations for a period of up to 10 years (extending the longest maturity of the operation from 1 year at present).

Achieving inflation target of 2 per cent remains critical for BoJTo sum it, BoJ has showed resolute determination in pursuing “QQE with Yield Curve Control” and achieve the price stability target of 2 per cent at the earliest pos-sible time. The Bank believes that its monetary policy and the Government’s fiscal policy as well as initiatives for strengthening Japan’s growth potential will pro-duce synergy effects, and thereby will navigate Japan’s economy toward overcoming deflation and achieving sustainable growth.

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