In his recent address at the Bank of Japan, the RBI governor Dr. Y.V. Reddy, outlined certain key milestones in the Indian economy's growth story and envisioned the future trajectory. The governor's articulation of the factors driving the economy, explained by us hereunder, lends credibility to the prospects of the financial system hitting the accelerator. This has been recently vetted by the economic growth figure of 9.4% (highest in two decades) clocked in FY07, as released by the CSO.

Demographic dividend and standard of living

With only 2.3% of the world's land area (seventh-largest country), India is the second most populous country in the world with a population of over 1 bn, which is among the youngest in the world. The proportion of population in the working age group of 15 to 64 years is currently around 62.9% and is expected to increase to 70% by 2026. The 'demographic dividend' is expected to extend over the next few decades of this millennium. Real GDP growth averaged 5.8% in the 1980s and 1990s, accelerated to 8.6% in the period FY03 to FY06 and peaked to 9.4% in FY07. If the current GDP growth rate of around 9% is maintained, a person can hope to see the standard of living multiplying by almost five times in his lifetime.

Pillars of the growth story

In the industrial sector, there is a growing realisation of productivity and efficiency gains. In the face of free access to imports and foreign direct investment (FDI), Indian industry is increasingly becoming internationally competitive and is aggressively securing access to international markets on the strength of dynamic competitive advantage. The policy environment has also played a role in this resurgence of Indian industry. The mainstay of the Indian economy currently, is however, the services sector, which constituted 61.9% of GDP in FY07 and contributed two-thirds of average real GDP growth for the period FY02 to FY07. With the economy's IT industry now having evolved, the impulses of growth are now strengthening in other services as well such as engineering and consultancy, communication, entertainment, finance and information services as well as a host of personal services including tourism and hospitality. The Indian development experience is, in fact, regarded by economists as unique in terms of the mutation of growth from a primary economy directly to tertiary activity rather than the conventional path of primary to secondary and then to tertiary stages of growth.

Capital inflows

Since the early 1990s, when we instituted structural reforms widely with a progressive liberalization of the economy, India has been receiving large capital inflows, reflecting international confidence in the underlying fundamentals of the performance of the Indian economy. The ratio of net capital inflows to GDP has almost doubled from 1.5% in FY92 to 2.9% in FY06. In recent years, the capital flows have become even larger, accounting for 15% of global net private capital flows to emerging market economies in 2006. Also, the rising profile of net capital flows has resulted in steady accretions to the foreign exchange reserves, which have more than doubled from US$ 76 bn at the end of FY03 to around US$ 200 bn in FY07 (source: RBI). To put things in perspective, the said reserves exceed a full year's imports as well as the entire external debt. Since 2002, India has turned creditor to the IMF and has engaged in prepaying external debt.

Financial reforms

The efficacy of the financial sector reforms is also reflected in the significant improvement in the asset quality of the banking sector. Currently, all scheduled commercial banks are compliant with the minimum capital adequacy ratio (CAR) of 9%. The overhang of delinquencies (gross NPAs) of the sector has declined from 8.8% of advances in FY03 to 3.3% in FY06. The share of private and foreign banks in total assets increased to 27.6% in FY06 from 24.7% in FY05 and less than 10% at the inception of reforms. The headline inflation rate (WPI) has declined from an average of 11% during 1990 to 1995 to 5.3% during 1995 to 2000 and to 4.9% during 2002 to 2007. The tapering down of inflation has been associated with a significant reduction in inflation volatility, which is indicative of well-anchored inflation expectations, despite the visitations of adverse shocks, both domestic and external.

Outlook

The growth prospects of Indian economy have strengthened considerably and appear well entrenched to build on the current momentum. The challenge at this juncture is to manage the transition to a higher growth path while containing inflationary pressures. The RBI's policy endeavor would be to contain inflation close to 5% in FY08 and in the range of 4% to 4.5% over the medium-term with a view to maintaining self-accelerating growth. The Organization for Economic Cooperation and Development (OECD) last week forecasted that India's growth would slow to 8.5% in 2007 from 9% in 2006, as rising interest rates put the brake on consumer spending. This pace will be lower than only China (expected to expand by 10.4% in 2007) among the world's largest economies. The likely evolution of macroeconomic and financial conditions indicates an environment supportive of sustaining the current growth momentum in India complemented by appropriate emphasis on price stability and anchoring inflation expectations.

DGi