The World

With half of 2005 behind us, the outlook for the rest of the year does appear somewhat indifferent. The year 2004 was a spectacular year for global growth and that the next two years would see a pause was clearly understood. The expected upturn in the Euro-zone and in Japan has to some extent materialised in the first quarter of 2005, and growth in the US economy has not fallen short of expectations. Despite record high crude petroleum prices, inflation in the developed world has been largely contained. The bad news however is that job creation in both the EU and the USA has fallen much below expectations, budget deficits continue to climb in the US and in several large EU countries, and the current account deficit of the USA mounted a new high of $195 billion in the first quarter of 2005 (6.4 per cent of GDP). Choppiness expectedly affected the financial markets with highly volatile movements in the world's principal currencies, a sharp drop in long term bond yields and robust performance by most of the world's equity markets.

The International Monetary Fund (IMF) in its World Economic Outlook (WEO) released in April this year has placed world output growth in 2005 and 2006 at 4.3 and 4.4 per cent, respectively, compared to the 5.1 per cent achieved in 2004.¹ The industrial economies are expected to slow from the 2004 level of 3.4 per cent to 2.6 and 3.0 per cent in 2005 and 2006 respectively, principally because of a return of the US to the trend rate. The outlook for the developing countries of Asia — especially China, India and South East Asia — continues to be favourable as far as economic growth is concerned (see Table 1).

¹World Economic Outlook, International Monetary Fund, April 2005.

Table 1

Forecasts for Real GDP Growth — World, Major Regions & Select Economies IMF in April 2005 and estimates by private banks in June 2005

Unit: per cent

	2002	2003	2004	2005			2006

	Actual*			IMF	JP Morgan	Citi Group	IMF	JP Morgan	Citi Group

World^†	3.0	4.0	5.1	4.3	3.1	3.6	4.4	3.1	3.7
Regions and principal economies
Industrial Economies	1.7	2.0	3.4	2.6	2.5	2.5	3.0	2.6	2.8
U.S.A.	2.2	3.0	4.4	3.6	3.7	3.8	3.6	3.4	3.7
Euro-zone	0.9	0.5	1.6	1.7	1.4	1.8	2.3	1.9	2.2
Japan	−0.3	1.4	2.6	0.8	1.8	1.3	1.9	2.0	1.5
Developing Asia^†	6.4	8.1	8.2	7.4	6.6	6.4	7.1	6.5	6.5
Latin America	−0.1	2.2	5.7	4.1	3.9	4.3	3.7	3.5	3.9
East Europe (incl. CIS)	4.4	4.6	6.1	4.5	4.7	5.9	4.5	4.6	5.5
Australia	3.8	3.4	3.2	2.6	2.2	2.0	3.3	2.3	2.8
Western Europe — major economies
France	1.2	0.5	2.3	2.0	1.6	1.6	2.2	2.0	2.0
Germany	0.2	−0.1	1.7	0.8	1.4	1.1	1.9	1.6	1.2
Italy	0.4	0.3	1.2	1.2	−0.2	−0.2	2.0	1.5	0.8
Netherlands	0.6	−0.9	1.3	1.5	na	0.4	2.2	na	1.4
Sweden	2.1	1.5	3.5	3.0	1.7	2.0	2.5	2.4	2.9
Switzerland	0.2	−0.4	1.7	1.2	0.7	0.8	2.0	1.5	1.7
United Kingdom	1.7	2.2	3.1	2.6	2.4	2.8	2.6	2.4	2.5
East Asia
China	8.0	9.3	9.5	8.5	9.4	9.0	8.0	8.5	8.5
Hong Kong	2.3	3.2	8.1	4.0	5.0	4.5	4.0	5.2	5.0
South Korea	7.0	3.1	4.6	4.0	3.5	3.6	5.2	4.2	4.7
Taiwan	3.6	3.3	5.7	4.0	3.8	3.6	4.3	4.5	4.0
South and South East Asia
India	4.0	7.5	7.3	6.7	7.0	7.5	6.4	7.0	7.4
Indonesia	3.7	4.9	5.1	5.5	6.0	5.6	6.0	6.1	5.9
Malaysia	4.1	5.3	7.1	6.0	4.7	5.5	6.2	5.5	5.5
Philippines	4.4	4.7	6.1	4.7	3.8	4.3	4.5	4.3	4.8
Singapore	2.2	1.4	8.4	4.0	2.7	3.7	4.5	5.0	4.5
Thailand	5.4	6.9	6.1	5.6	4.0	4.0	6.2	6.0	4.7
Vietnam	7.1	7.3	7.7	7.2	na	7.0	7.0	na	7.5
Other emerging economies
Argentina	−10.9	8.8	9.0	6.0	6.0	6.1	3.6	2.9	3.5
Brazil	1.9	0.5	5.2	3.7	3.0	3.0	3.5	3.7	3.7
Chile	2.2	3.3	6.0	6.1	6.0	5.5	5.4	5.0	5.0
Mexico	0.7	1.6	4.4	3.7	3.2	4.2	3.3	3.0	3.7
Czech Republic	2.0	3.7	4.0	4.0	4.0	4.3	3.9	4.0	4.0
Poland	1.4	3.8	5.3	3.5	3.8	3.7	3.7	4.2	4.7
Russia	4.7	7.3	7.1	6.0	5.3	6.5	5.5	4.4	6.0
South Africa	3.6	2.8	3.7	4.0	4.2	4.5	3.5	4.3	3.8

Note: * Actual growth rates for 2002, 2003 and 2004 are from WEO (IMF).
^† IMF weights country GDP by PPP exchange rates, while private banks use market exchange rates. As a result, in the IMF world/regional output measures developing (and faster growing) countries have a larger weight.
Source:(i) World Economic Outlook, International Monetary Fund, April 2005; (ii) Global Data Watch, J.P. Morgan, June 24, 2005. (iii) Global Economic Forecasts, Citi Group, Economic & Market Analysis, June 22, 2005.

The IMF in its World Economic Outlook released in April this year has placed world output growth in 2005 and 2006 at 4.3 and 4.4%, respectively, compared to the 5.1% achieved in 2004.

At Table 1, we have contemporary growth projections of the IMF and two leading international banking groups. While there seems to be a remarkable congruence of views in regard of 2005 — which with six months behind us should not be surprising — it is interesting to note that in regard of 2006 the private banks have a less bullish view relative to the IMF for industrial economies. In large measure this pertains to a somewhat more cautious view of growth prospects in the Euro-zone and in Japan. In regard of the developing countries of Asia, the IMF estimate of growth for China is certainly going to be significantly exceeded in 2005 and perhaps 2006 as well. To a lesser extent, economic growth in India is also likely to be stronger than what the IMF had forecast — both in 2005 and in 2006.

Components of growth in the developed worldU.S.A.

Business fixed investment had shown a smart increase in the last three quarters of 2004, averaging over 13 per cent growth quarter-on-quarter (annualised) and contributed 1.1 percentage points of growth to overall growth of 4.4 per cent in 2004. However, in the first quarter of 2005, non-residential (i.e. business) fixed investment expansion has slowed down to 4 per cent. Residential investment where growth had slowed in 2004 to 9 per cent overall, has picked up fresh steam in 2005 expanding nearly 12 per cent. Inventory build-up also picked up momentum in the fourth quarter of 2004 and has continued further in that direction in the first quarter of 2005. Expenditure on durable consumer goods has slowed to less than 2 per cent in the first quarter of 2005 after having expanded by nearly 7 per cent in 2004. Imports have risen slightly slower and exports have risen slightly faster, in the first quarter of 2005, compared to the full year of 2004, and as a result the (negative) contribution of net exports has dropped marginally.

The rate of expansion at constant prices in the domestic sales of final goods (domestic and imported) after having stayed ahead of GDP, appears to have converged to it and in the first quarter of 2005 it was lower. In 2002, while GDP rose by 1.9 per cent, final domestic purchases had grown by 2.1 per cent; in 2003 GDP rose by 3 per cent, but final domestic sales rose 3.4 per cent. In 2004 however, both items recorded an increase of 4.4 per cent. In the first quarter of 2005, while GDP grew by 3.8 per cent, final domestic purchases grew by 3.5 per cent. The value of final domestic purchases is of course larger in absolute terms relative to GDP and to the extent that it rose faster than did GDP, the current account expanded at a pace much faster than did GDP. The correction in the relative pace of expansion has to consolidate significantly before the magnitude of the current account deficit can reverse direction.

Euro — zone any recovery in the first quarter of 2005?

Euro-zone GDP in the first quarter of 2005 rose by 2.0% (annualised) over the fourth quarter of 2004. However, respect to the corresponding quarter of 2004, the increase was more modest at 1.3%.

Euro-zone GDP in the first quarter of 2005 rose by 2.0 per cent (annualised) over the fourth quarter of 2004. However, with respect to the corresponding quarter of 2004, the increase was more modest at 1.3 per cent.² This is illustrative of improvement in conditions in 2005 relative to 2004, particularly the first half. The biggest improvement was in Germany where first quarter GDP rose by 4.2 per cent (annualised) relative to the fourth quarter of 2004, but with respect to the corresponding quarter of the previous year the increase was much smaller.³ However, it was the reverse in France, with GDP in the first quarter growing by 0.8⁴ per cent (quarter-on-quarter annualised), but by 1.7 per cent with respect to the corresponding quarter of 2004.

² Quarter-on-quarter growth (annualised) gives us an indication of the acceleration or deceleration that has occurred in that quarter (with respect to the immediately preceding one). Change measured with respect to the corresponding quarter of the previous year gives us the cumulative change that has occurred not just in the quarter under review, but also in the other intervening quarters as well — in this case the second, third and fourth quarters of 2004. Thus, if the quarter-on-quarter growth is more than the year-on-year one, it is indicative of acceleration in the quarter under review (compared) to the average of the intervening quarters and vice versa.

³ The June 1, 2005 release of the Eurostat places the year-on-year growth for Germany at 1.1 per cent. However the German Federal Statistical Office continues to report it at 0.0 per cent, which seems to stem from the last official press release dated May 24, 2005 and also is reported as such by the Bundesbank.

⁴ Revised data show that quarter-on-quarter growth was 0.3 per cent, that is, 1.2 per cent on annualised basis, INSEE, release of June 30, 2005.

It was the same case with Belgium where first quarter 2005 growth relative to the last quarter of 2004 (annualised) was 0.4 per cent, much smaller than the growth of 1.9 per cent measured with respect to the corresponding quarter of 2004. Italy travelled the same direction as did France and Italy, with first quarter 2005 showing a contraction of 2.0 per cent (annualised) over the last quarter of 2004, but with respect to the corresponding quarter of 2004 the decline was much smaller at 0.2 per cent.

In the Netherlands, the slippage as evident in the initial data was of a smaller order with first quarter 2005 growth registering −0.4 per cent on quarter-on-quarter basis and −0.3 per cent on year-on-year basis. The latest data release however indicates that the contraction in the first quarter of 2005 was much more severe, the economy having contracted by an enormous 3.2 per cent on a quarter-to-quarter basis (annualised), and by 0.5 per cent relative to the comparable period in the previous year.⁵

⁵“Dutch economy contracts by 0.5 per cent in first quarter 2005”, Statistics Netherlands Press release PB05–078, July 6, 2005.

The push to overall Euro-zone GDP numbers in the first quarter of 2005 seems to have largely been a consequence of improvement in Germany. Italy, France, the Netherlands, Belgium and Finland appear to have gone in the reverse direction, while Spain and Greece have had robust growth.

The push to overall Euro-zone GDP numbers in the first quarter of 2005 seems to have largely been a consequence of improvement in Germany. The other economies — Italy, France, the Netherlands, Belgium and Finland — appear to have gone in the reverse direction, while Spain and Greece have had robust economic growth.

Unemployment in the Euro-zone continues to be high, though admittedly no worse than it was a year ago. For the Euro-zone as a whole, unemployment was 8.8 per cent, a bit lower than the 8.9 per cent in May 2004. In Germany the overall unemployment rate in May 2005 was 9.6 per cent, the same level as it was in May 2004. In France unemployment increased to 9.8 per cent, compared to 9.6 per cent in May of last year. However, there were small declines in the rates of unemployment in both countries with stronger growth (e.g. Spain and Finland) and those without (Italy and the Netherlands).

The level of unemployment was lower (and the direction mildly positive) in Western Europe outside of the Euro-zone. Thus, in the UK it was 4.6 per cent in March 2005 (4.7 per cent in May 2004); in Sweden it was 6.4 per cent in March 2005 (6.8 per cent in May 2004); and in Denmark it was 4.6 per cent in April 2005 (5.2 per cent in May 2004). That was true also of the USA and Japan. In the US, unemployment rates fell to 5.1 per cent in May 2005, compared to 5.6 per cent a year ago. In Japan it was 4.4 per cent in April 2005, compared to 4.6 per cent in May 2004.

The latest survey (second quarter of 2005) conducted by the European Central Bank (ECB) suggests that the mean value of expectations for economic growth in 2005 was 1.6 per cent, with the greatest likelihood that it would be between 1.5 and 1.9 per cent, but with a significant number of observers believing that it would be lower at between 1.0 and 1.4 per cent.⁶ The same survey indicated that observers believed that conditions would improve in 2006 and the mean value of expected GDP growth was 2.0 per cent. On the issue of employment, as many as 59 per cent felt that the unemployment rate would stay more or less where it was in 2005, while over 25 per cent expected it to significantly worsen. Only about 35 per cent expected that employment conditions would improve in 2006, despite believing that there would be faster economic growth. For the record, a year ago, the same survey had indicated better expectations in regard of both growth and employment.

⁶ The ECB Survey of Professional Forecasters (SPF) is a quarterly survey of expectations for the rates of inflation, real GDP growth and unemployment in the euro area for several horizons, together with a quantitative assessment of the uncertainty surrounding them. The survey is called the ECB Survey of Professional Forecasters to reflect the fact that all of the participants are experts affiliated with financial or non-financial institutions based within the European Union.

Several members of the Euro-zone are as is well-known under some fiscal stress and have been in violation of the Stability and Growth Pact (1997) which underlay the process of monetary union.

Several members of the Euro-zone are as is well-known under some fiscal stress and have been in violation of the Stability and Growth Pact (1997) which underlay the process of monetary union. At Table 4 some of the key fiscal numbers are presented. The larger economies — Germany, France and Italy — are not only in breach of the 3 per cent limit, but they also do not appear to be likely to fall in line even as per the European Commission's own estimates. Spain, Belgium, Ireland, Finland and Luxembourg are shoring up the fiscal balance at the other end. These divergent fiscal tendencies are overlaid on widely differing debt levels. These ranged in 2004 from a low of 8 per cent for Luxembourg, 32 per cent for Ireland, 45 per cent for Finland, and 49 per cent for Spain to a high of 111 per cent for Greece, 106 per cent for Italy and 96 per cent for Belgium. Germany and France both had a debt ratio of 66 per cent (in excess of the 60 per cent limit envisaged in the Stability and Growth Pact), Austria and Portugal were close with 65 and 61 per cent respectively, while the Netherlands had a debt ratio of 56 per cent.

Japan

The best that can be said about conditions in Japan is that they do not seem to be getting worse, but whether they are indeed showing sustained signs of improvement is not as of yet clear.

Japan's economy improved in 2004 with growth of 2.7 per cent. In the first quarter of 2005, on quarter-on-quarter basis the economy grew at an annualised (quarter-on-quarter) rate of 4.9 per cent, which was as remarkable as the growth (5.2 per cent) in the first quarter of 2004 (see Table 3). The strong quarter-on-quarter growth in the last quarter of 2003 and first quarter of 2004 did not presage continued expansion through 2004. Further, in the first quarter of 2004, economic growth with respect to the corresponding period of 2003 had been 4.5 per cent, while in the first quarter of 2005 this measure showed expansion of 1.3 per cent, which was an improvement over the last quarter of 2004, but worse than that in the third quarter. There appears to be a distinct improvement in private demand,⁷ with non-residential (business) private fixed investment showing significant improvement in the fist quarter of 2005, after having fallen off in the previous quarter. Private consumption demand however continues to trail GDP growth, although change in net exports has moved into negative territory, possibly a fall-out of high crude petroleum prices. The best that can be said about conditions in Japan is that they do not seem to be getting worse, but whether they are indeed showing sustained signs of improvement is not as of yet clear. Table 2

Relative Contribution by Expenditure Category to GDP growth in USA, Figures are in percentage points of GDP annualised

	Year-on-year growth & components			Quarter-on-quarter growth components annualised*

	2002	2003	2004	2003				2004				2005

				Q1	Q2	Q3	Q4	Q1	Q2	Q3	Q4	Q1

Total GDP	2.2	3.0	4.4	1.9	4.1	7.4	4.2	4.5	3.3	4.0	3.8	3.8
Percentage point contribution to overall real GDP growth by Expenditure Category
Personal consumption expenditure	2.14	2.29	2.65	1.84	2.72	3.58	2.50	2.90	1.10	3.57	2.92	2.52
of which: Durables	0.56	0.63	0.57	−0.01	1.64	1.38	0.33	0.19	−0.02	1.37	0.33	0.15
Non-durable goods	0.51	0.73	0.91	0.97	0.31	1.38	1.01	1.33	0.03	0.94	1.19	1.10
Services	1.08	0.93	1.17	0.87	0.77	0.83	1.15	1.39	1.10	1.26	1.41	1.26
Residential fixed investment	0.22	0.43	0.51	0.36	0.44	1.09	0.50	0.27	0.86	0.09	0.19	0.64
Non-residential fixed investment	−1.02	0.33	1.05	−0.01	1.10	1.50	1.07	0.42	1.21	1.27	1.46	0.44
Change in private inventories	0.42	−0.10	0.44	−0.45	−1.01	0.57	0.47	1.17	0.78	−0.97	0.46	0.72
Net Exports of goods & services	−0.70	−0.43	−0.59	0.14	−0.50	0.64	−0.66	−0.76	−1.06	−0.10	−1.35	−0.58
Government expenditure	0.79	0.52	0.37	0.05	1.35	0.03	0.31	0.48	0.41	0.13	0.16	0.03
O/w: Federal Defence	0.30	0.38	0.33	−0.11	1.49	−0.36	0.50	0.47	0.09	0.45	−0.03	0.02

Note: * These are annualised increases in each quarter with respective to the immediately preceding quarter, using de-seasonalised data series. The components do not necessarily add-up to the total increment for total GDP. This is a result of using different price indices for deflating factor incomes (aggregate GDP) by industry of origin and the expenditures corresponding to aggregate GDP or gross domestic expenditures.
Source: Gross Domestic Product First Quarter 2005 (Final), Bureau of Economic Analysis, US Department of Commerce, June 27, 2005.

Table 3

Growth of GDP and key elements thereof in Advanced Economies

Change over the previous period at seasonally adjusted annual rates^†, Unit: All figures are in per cent

	Year-on-year growth			Quarter-on-quarter growth annualised*

	2002	2003	2004	2003				2004				2005

	full year			Q1	Q2	Q3	Q4	Q1	Q2	Q3	Q4	Q1

Real GDP
USA	1.9	3.0	4.4	1.9	4.1	7.4	4.2	4.5	3.3	4.0	3.8	3.8
Euro-zone	0.9	0.7	2.0	0.0	−0.4	2.0	1.6	2.8	1.6	1.2	0.8	2.0
Japan	−0.3	1.4	2.7	−2.0	2.6	2.2	6.2	5.2	−0.6	−1.0	0.2	4.9
Personal (household) Final Consumption Expenditure
USA	1.9	3.0	4.4	2.7	3.9	5.0	3.6	4.1	1.6	5.1	4.2	3.6
Euro-zone	0.9	1.1	1.3	1.2	0.0	1.2	0.0	2.0	0.4	1.2	2.4	1.2
Japan	0.5	0.2	1.5	−0.5	−1.0	0.9	4.6	2.7	0.2	−0.4	−1.4	4.6
Private Gross Fixed Capital Formation
USA	−4.9	5.1	10.3	2.4	10.9	18.0	10.5	4.5	13.9	8.8	10.5	6.6
Euro-zone	−2.4	0.4	1.9	−3.2	−0.4	1.6	4.0	−2.0	0.8	2.0	3.2	−2.8
Japan	−6.2	4.8	5.2	−1.0	15.3	1.5	21.2	−8.1	13.5	0.7	0.2	7.1
Government Expenditure (Consumption & Investment)
USA	4.4	2.8	1.9	0.2	7.2	0.1	1.6	2.5	2.2	0.7	0.9	0.2
Euro-zone	2.6	1.3	1.4	1.6	2.0	2.8	2.0	1.2	2.8	3.6	0.8	−0.8
Japan	0.8	−1.8	−0.4	−2.3	−3.4	−0.6	−3.8	12.9	−13.1	−0.4	2.0	1.2
Exports
USA	−2.3	1.9	8.6	−1.5	−1.6	11.3	17.5	7.3	7.3	6.0	3.2	8.9
Euro-zone	2.1	0.6	6.1	−6.0	−1.8	10.4	0.8	6.0	10.8	4.0	1.2	0.8
Japan	7.3	9.1	14.3	5.4	2.3	14.0	21.5	22.2	14.4	2.1	5.5	−1.5
Imports
USA	3.4	4.4	9.9	−2.0	2.5	2.8	17.1	10.6	12.6	4.6	11.4	9.6
Euro-zone	0.5	2.5	6.3	−1.2	−0.9	5.6	7.6	1.2	10.8	9.6	3.6	−4.3
Japan	1.3	3.8	8.9	5.1	−9.5	9.1	7.6	15.6	7.8	9.4	8.8	1.9

Note: ^† All at constant prices. For full year the numbers are the increase over the previous year. For quarters, the numbers are the increase over the immediately preceding quarter using seasonally adjusted data series, which are then expressed on annualised basis.
Source: USA: Gross Domestic Product: First Quarter 2005 (Final), Bureau of Economic Analysis, US Department of Commerce, June 29, 2005, www.bea.doc.gov
Euro-zone: European Central Bank, Monthly Bulletin, June 2005 & previous issues http://www.ecb.int/home/html/index.en.html
Japan:The 2nd Preliminary Estimate of National Expenditure(Jan–Mar 2005), June 13,, 2005, http://www.esri.cao.go.jp/index-e.html

⁷ As public expenditure is being inevitably cut back, given that Japan already has a debt to GDP ratio in excess of 170 per cent and a fiscal deficit of more than 6 per cent.

China

China grew by 9.4 per cent in the first quarter of 2005, at about the same pace (9.5 per cent) as it did for the full year of 2004. The industrial sector (secondary industry) grew by 11.1 per cent while the primary sector (agriculture, quarrying & mining) showed growth of 4.6 per cent, and the tertiary sector (services) grew by 7.7 per cent. The value of output in agriculture & allied activities was reported to have risen by 5.0 per cent, while that of animal husbandry increased by 6.4 per cent. Value added in industrial enterprises for the first five (Jan–May) months of 2005 was reported to have increased by 16.3 per cent over the corresponding period in the previous year. Investment in fixed assets in China was reported to have increased by over 26 per cent in the Jan-May period of 2005, showing little sign that the investment boom underlying the high level of economic growth was in any way abating.⁸

⁸ National Bureau of Statistics of China.

InflationInflation — consumer and producer prices

Consumer Price Inflation (CPI) (with respect to the index 12 months back) in the US in the month of May 2005 was 2.8 per cent for CPI-All Urban Consumers (CPI-U) and 2.9 per cent for CPI-Urban Wage Earners and Clerical Workers (CPI-W). This represents a moderation in inflation with respect to previous months when the value had been in excess of 3 per cent, and 3.5 per cent in April 2005. Much of the increase in the rate of inflation was on account of energy prices, and the inflation rate excluding energy had hovered around 2 per cent, where it continued to stay in May 2005.⁹

⁹Consumer Price Indexes — May 2005, Bureau of Labor Statistics, US Department of Labor, June 15, 2005 and data available at BLS website.

Producer Price Inflation (all commodities) in the USA in May 2005 was down to 5.2%, compared to 7.0% in the previous month and having steadily come down from a high of 9.0% in November 2004.

Producer Price Inflation (PPI) (all commodities) in the USA in May 2005 was down to 5.2 per cent, compared to 7.0 per cent in the previous month and having steadily come down from a high of 9.0 per cent in November 2004. PPI inflation for finished goods in May 2005 was down to 3.5 per cent, compared to 4.8 per cent in the previous month and 5.0 per cent in November 2004. The bulk of the inflationary pressure has been coming from energy prices. PPI for finished goods excluding energy and food was at 2.6 per cent, roughly where it has been for the last several months, but higher than the average value of 1.2 per cent in the first half of 2004. For the record the index value of the product group, prices of fuels & power was higher by over 15 per cent in May 2005, compared to a year back, while those of gasoline and diesel were 13 per cent and 41 per cent higher.¹⁰

¹⁰Producer Price Indexes — May 2005, Bureau of Labor Statistics, US Department of Labor, June 14, 2005 and data available at BLS website.

In the EU, consumer price inflation as reflected in the Harmo-nised Index of Consumer Prices (HICP) was expected to rise to be 2.1 per cent in June 2005, according to flash estimates, marginally higher than the 1.9 per cent in May 2005.¹¹

¹¹Euro-zone inflation estimated at 2.1 per cent, Eurostat, Euro-indicators news release 84/2005 dated June 30, 2005.

Thanks largely to the strength of the euro, the impact of higher energy prices has been limited — with the index for energy rising by 6.9 per cent in May 2005 (over the same month in the previous year). Thus while the overall HICP was 1.9 per cent in May 2005, excluding energy would bring the number down to 1.5 per cent. Items that showed strong inflationary movement in May 2005 were housing (4.3 per cent), alcohol & tobacco (3.9 per cent), education (3.4 per cent), transportation services (3.0 per cent) and health care (2.2 per cent).¹² However, with the Euro dropping vis-à-vis the US dollar and crude petroleum prices at new highs in dollar terms, the influence of energy prices in building up inflationary pressures in the Euro-zone will become higher in the short term.

¹²Euro-zone and EU25 inflation down to 1.9 per cent, Eurostat, Euro-indicators news release 78/2005 dated June 16, 2005.

Interest Rates

On June 30, 2005 the Federal Open Market Committee (FOMC) of the US Federal Reserve made the ninth successive 25 basis point (bps) increase in the target Fed Rate to 3.25 per cent, over a period of exactly 12 months. The Bank of England has kept its repo rate unchanged since increasing it to 4.75 per cent in August 2004. However in its June 2005 meeting, a minority of members supported a 50 bps cut in rates. The Reserve Bank of Australia which had kept rates on hold since December 2003, raised the cash rate by a further 25 bps in March 2005 to 5.50 per cent and has left it untouched in its July meeting.

The European Central Bank (ECB) has left rates unchanged for a long while at 2 per cent, despite speculation that they might opt for a long overdue rate cut — partly in response to continuing weakness in economic conditions and in part as a response to the strength of the Euro which would be affecting Euro-zone competitiveness. The Swedish Central Bank on June 21, 2005 cut its repo rate by 50 bps from 2 per cent (aligned to the ECB) to 1.5 per cent, stating that:

“At its meeting on 20 June, the Executive Board of the Riksbank decided to lower the repo rate from 2 per cent to 1.50 per cent. GDP growth slackened more than anticipated at the beginning of the year in both Sweden and the euro area. The forecast for Swedish GDP growth has therefore been revised down substantially for this year and slightly for next year. Over the coming years UND1X inflation is therefore expected to be clearly below the 2 per cent inflation target.”¹³

¹³ Sveriges Riksbank, Press Statement, June 21, 2005. The minutes of the meeting released on July 5, 2005 elaborate the position of focusing on economic conditions, given that inflationary pressures were within bounds (of 2 per cent).

Speculation as to how far the US Fed would continue in its current path of monetary tightening has been rife and the consensus earlier in 2005 was a year-end rate of close to 4.0%.

Speculation as to how far the US Fed would continue in its current path of monetary tightening has been rife and the consensus earlier in 2005 was a year-end rate of close to 4.0 per cent. There are now four scheduled meetings of the FOMC left till the end of 2005, and assuming that it raises the rate 25 bps in each of these four meetings, the Fed rate by year-end would be 4.25 per cent. That is not however what the market seems to be expecting. The Fed Fund futures market, prior to the June 30, 2005 meeting, seems to have had expected a yearend rate of just below 3.75 per cent. The language of the June 30 statement apparently altered expectations towards more tightening and the year-end expected rate now is between 3.75 and 4.0 per cent. That is, broad expectations are at least two more rate hikes, perhaps three, but not more.

With economic conditions as they are today, and with the distinct likelihood that the next year would not be great news either, there does seem cause to conclude that the present round of monetary tightening in the US is perhaps close to an end.

Flattening of Yield Curves

The increase in policy (short-term) rates over the past year has failed to travel up the yield curve. In fact the yield curve in July 2005 much flatter than it had been one year ago, and even flatter than it been two years back. This is evident from a study of Charts 1.1 & 1.2 and Table 5. The Charts 1.1 & 1.2 present the historical yield curve Euro-denominated securities, while at Table 5 is given the term and credit spread for US government and private securities. Chart 1.1Euro-gilt Yield Curves in early July, 2005 compared to the comparable day in 2004 and 2003

Chart 1.2Term Spread in Euro Gilts — 10-Year yield minus 2-Year yield since the beginning of 2004

Table 4

General Government Deficit as a percentage of GDP at market prices

	2000	2001	2002	2003	2004	2005^f	2006^f

Germany	−2.7	−3.7	−3.3	−3.8	−3.7	−3.3	−2.8
France	−1.4	−1.5	−3.2	−4.2	−3.7	−3.0	−3.4
Italy	−0.6	−3.0	−2.6	−2.9	−2.9	−4.9	−4.7
Netherlands	2.2	−0.1	−1.9	−3.2	−2.5	−2.0	−1.7
Portugal	−2.8	−4.4	−2.7	−2.9	−2.9	−4.9	−4.7
Austria	−1.5	0.3	−0.2	−1.1	−1.3	−2.0	−1.7
Greece	−0.7	0.5	−0.5	−1.1	−1.0	1.6	0.1
Spain	−0.9	−0.5	−0.3	0.3	−0.3	0.0	−0.1
Belgium	0.2	0.6	0.1	0.4	0.1	−0.2	−0.6
Ireland	4.4	0.9	−0.4	0.2	1.3	−0.6	−0.6
Finland	7.1	5.2	4.3	2.5	2.1	1.7	1.6
Luxembourg	6.2	6.2	2.3	0.5	−1.1	−1.5	−1.9
Total EU-12	0.1	−1.7	−2.4	−2.8	−2.7	−2.6	−2.7
EU-12 government debt	70.4	69.6	69.5	70.8	71.3	71.7	71.9

Note: ^fForecast.
Source: General Government Data, Directorate General ECFIN, Economic & Financial Affairs, European Commission, Spring 2005.

Table 5

Yields on US securities and term and credit spreads

	31-Dec-03	30-Jun-04	31-Dec-04	31-Mar-05	30-June-05

Fed Fund (target) rate	1.00%	1.25%	2.00%	3.00%	3.25%
10 year G-Sec	4.27%	4.62%	4.24%	4.50%	3.94%
10-year swap	4.66%	5.10%	4.65%	4.96%	4.38%
Aaa corporate bond	5.63%	5.16%	5.63%	5.40%	4.91%
Baa corporate bond	6.61%	6.71%	6.10%	6.14%	5.81%
Conventional mortgage	5.85%	6.21%	5.81%	6.04%	5.53%
Spread over Fed Fund in basis points (bps) - [Term + Credit]
10 year G-Sec	327	337	224	150	69
10-year swap	366	385	265	196	113
Aaa corporate bond	463	391	363	240	166
Baa corporate bond	561	546	410	314	256
Conventional mortgage	485	496	381	304	228
Credit Spreads in basis points (bps)
Aaa over 10 year G-Sec	136	54	139	44	97
Baa over Aaa	98	155	47	74	90
Baa over 10 Year G-Sec	234	209	186	164	187

Source: H.15 - Selected Interest Rates, US Federal Reserve Board.

In the Euro-bond market, what is remarkable is that while the short-end did not move at all (from 2.0%), the 10-year yield which was at 4.0 per cent on July 7, 2003, rose slightly over the course of the next one year to 4.3 per cent on July 5, 2004. However, since then it has fallen sharply back to 3.2 per cent as on July 4, 2005, a level that is much lower than that what had obtained two years earlier.Chart 1.2 shows the steady decline in the spread in Euro-gilts expressed in basis points between 10-year and 2-year paper since the beginning of 2004.

US interest rates at the end of select quarters since the end of 2003 for key instruments are presented at Table 5. The conventional term structure (tenor or maturity) spreads with respect to the Fed Fund rate, show a rapid drop since the middle of 2004. The second part of the table gives the credit spread — for corporate bonds vis-à-vis long government bond — and that too indicates a decline, though of a smaller order than that in the case of tenor/maturity spreads.

Even in the US case, notwithstanding the impact of a sharp rise at the short end of the yield curve, the interpretation of the relative flattening of the US yield curve can not be markedly different from that of the Euro-yield curve.

The normal interpretation of a flattening of the yield curve, ceteris paribus, is that of a change in expectations in favour of slower-than-earlier-expected economic growth which would be reflected in weaker demand for long-term money. That is quite obviously the case with the Euro-yield curve at Charts 1.1 & Charts 1.2, where there has been no change whatsoever in the policy (repo) rate. In the US case (Table 5) although the short end of the curve has moved up from 1.0 per cent to 3.25 per cent, the yields at the longer end have actually come down in absolute terms. Hence, even in the US case, notwithstanding the impact of a sharp rise at the short end of the yield curve, the interpretation of the relative flattening of the US yield curve can not be markedly different from that of the Euro-yield curve.

The alternative way of looking at a flattening of the yield curve is that expected inflation in the medium-term has fallen to somewhere below a trigger rate where the central bank would be inclined to tighten monetary conditions. While, weaker growth expectations would generally subsume a benign inflationary expectation, the disproportionality of longer-term yield movements with respect to central bank policy rates, suggests that working in an inflation-based (hence central bank rate proxy) causality for a decline in term spreads may not be such a good idea.

It would seem far more obvious that a change in expectations regarding the economic outlook and therefore of business investment and hence of counterpart funding would directly depress expected supply of long dated paper in future time periods, while expected demand for such paper is unlikely to be greatly affected by the capital expenditure requirements of firms. This would result in a higher market clearing price of dated paper, and hence of a lower yield.

Indeed the “carry trade” has been calling correctly, for they not only have benefited from the differential yield, but also from an absolute fall in long term yields, which means capital gains on their asset side.

The situation has been aggravated by the demand for long-dated US dollar denominated securities by central banks that have built up large reserve positions and have wished to extend support to the US bond market, hoping thereby amongst other things to help keep interest rates from rising. The so-called “carry trade” has also served to accentuate the flattening, in the case of both the US and Euro yield curves. The “carry trade” is conducted by investors (hedge funds and the like) who borrow short and invest in longer dated securities, expecting to gain from the differential yield at the two ends, net of capital losses as may arise from an increase in long term yields. Indeed the “carry trade” has been calling correctly, for they not only have benefited from the differential yield, but also from an absolute fall in long term yields, which means capital gains on their asset side.

The fixed income market has clearly been betting on weak OECD economic performance and they have by and large called correctly. The only hiccup was in the summer of 2004, when a wave of uncertainty saw 10-year G-Sec yields in the US go past 4.8 per cent, which was partly reflected in Indian yields of similar maturity shooting past 7 per cent.

The improvement in credit spreads, particularly of Baa-rated entities indicates improved corporate profitability and lower net debt on the balance sheet. In general corporates have over the past several years strengthened their balance sheets and stabilised profitability, while governments have seen their fiscal position worsen and other international structural imbalances, particularly the US current account deficit, have become aggravated.

In these conditions, the only conclusion that is reasonable to draw is that the current bout of monetary tightening that began about one-and-a-half years ago is perhaps approaching a premature end. With such a flat yield curve, there is not much that can be served by continuing to raise the short end through policy intervention and in any case given the economic conditions, with inflation relatively benign, despite the high level of petroleum prices, there is little purpose left in pursuing an upward trajectory on rates. In some parts of the advanced world, such as the Euro-zone, there does indeed seem to be reason to consider loosening rates and more might well follow the Swedish example.

In some parts of the advanced world, such as the Euro-zone, there does indeed seem to be reason to consider loosening rates and more might well follow the Swedish example.

If this analysis is indeed true, that lifts a burden from the Indian monetary situation. While reported inflation has come down to below 4 per cent, this is in large measure due to the base effects from the very high rates of inflation in the summer of 2004; the rate of inflation reckoned on a shorter time-scale is certainly higher than that and closer to the 5 – 6 per cent level. However, the latter is closer to our concept of a “normal” range and it is unlikely that a monetary response would be forthcoming if reported year-on-year inflation were to move up to the 5 – 6 per cent range. However, if international interest rates were to have risen further, there might have been pressure — depending on other unfavourable conditions simultaneously materialising — on the currency in the absence of a monetary response. However, it does seem unlikely that we would have to meet that regime of much higher and ever-strengthening international interest rates this time round, with attendant implications for a domestic rate policy driven more by the domestic demand and supply of funds.

India — Economic Developments

A more detailed discussion of developments in the Indian economy is available in the Macro-Overview chapter of this issue, while bond market and interest rate developments are discussed in the chapter after that.

Economic GrowthThe Growth Record

The economy grew by 6.9 per cent in 2004–05 at constant prices, compared to 8.5 per cent in the previous year. In 2004–05, industry grew by 7.7 per cent, the service sector by 8.9 per cent and the non-agricultural sector combined grew by 8.5 per cent. Agriculture & allied activities expanded by 1.1 per cent. GDP at current market prices rose by 12.5 per cent in 2004–05, compared to 12.0 per cent in the previous (2003–04) year.

In the last quarter of 2004–05 (Jan–Mar 2005), the economy grew by 7.0 per cent with respect to the corresponding quarter of 2003–04 (Jan–Mar 2004). Agriculture & allied activities in the quarter grew by 1.8 per cent, industry by 6.7 per cent, services by 9.3 per cent and the non-agricultural sector together by 8.4 per cent.

In the previous (November 2004) issue we had forecast GDP growth for the non-agricultural sector to be 8.4 per cent, as against which actual growth was a tad higher at 8.5 per cent. We had estimated wrongly that GDP arising from agriculture & allied activities would decline by 1 per cent, and hence overall GDP growth would be restricted to 6.3 per cent. Our error arose from taking the available official assessment about the deficiency of the SW monsoon 2004 and its adverse impact on agriculture more seriously than it deserved.

Near-Term Growth Prospects

In the previous issue of this journal, we had argued that savings had increased, and it was likely that this no longer posed a constraint to domestic investment. The national accounts data released at the end of January 2005, served to establish this point with domestic savings measured at 28.1 per cent of GDP in 2003–04. That in itself has generated a controversy of sorts and there is a note on investment and savings in this issue which deals with the matter. The upshot however is fairly simple. In the many decades since Independence, the economy has been seen to face three macro-economic constraints: namely, the availability of savings, that of food and of foreign exchange. Over the past two decades, the constraint of food has been eliminated from the equation. Over the past decade, the constraint of foreign exchange has largely been eliminated. With domestic savings having risen to 28 per cent of GDP, the last constraint is also gone.

In the absence of a sensible business climate in large swathes of infrastructure — electricity being the most glaring example — investors find the likelihood that they would be able to obtain a return on their investments less than adequate.

What now remain as the constraints to lifting the growth process and include the bulk of the population in the benefits that arise from growth, are primarily institutional and administrative difficulties. In the absence of a sensible business climate in large swathes of infrastructure — electricity being the most glaring example — investors find the likelihood that they would be able to obtain a return on their investments less than adequate. In public services, not only does efficiency remain at a discount, but the interests that have come to be vested in the system also actively (and successfully) militate against systemic improvement. Even more than capital asset creation (where inadequacies are abundant), it is in the public services funded out of revenue expenditure (such as primary and secondary schooling and health care) that the inefficacy of expenditure is so outrageous that calls for larger financial outlays are most ill-advised, unless remedial measures are taken to attend to the institutional debilities that have enveloped the delivery mechanism.

Prospects of Growth in 2005–06

There is a wide consensus on the economy growing at “around 7 per cent”, if not a bit higher. The major uncertainty has been with regard to whether the SW monsoon would be normal or not, and what that might mean for agriculture. The Governor of the Reserve Bank of India (RBI) in his Annual Policy Statement for 2005–06 at the end of April stated that:

“ With a normal monsoon, the growth in agriculture can be assumed to be around 3 per cent. Further, it is expected that industry and services sectors would maintain their current growth momentum while absorbing the impact of oil prices. The real GDP growth during 2005–06, on the basis of above assumptions, could be placed around 7.0 per cent for the purpose of monetary policy formulation.”¹⁴

¹⁴Annual Policy Statement for the Year 2005–06, by Dr. Y. Venugopal Reddy, Governor, Reserve Bank of India, para 51, April 28, 2005.

The farm sector saw GDP grow by only 1.1% in 2004–05. In consequence, there is a potential for a small “bonus” in the form of a rebound in 2005–06, which now seems likely to be a good monsoon year, in addition to the benefits that might accrue from supportive policies.

Writing in the first week of July, with the SW monsoon 2005, notwithstanding its slow progress in the middle of June, having enveloped the whole country a few days ahead of schedule and with widespread and abundant rains, it is easier to take a view on agricultural prospects in 2005–06. As we have seen the farm sector saw GDP grow by only 1.1 per cent in 2004–05. In consequence, there is a potential for a small “bonus” in the form of a rebound in 2005–06, which now seems likely to be a good monsoon year, in addition to the benefits that might accrue to the sector from expanded flow of bank credit and other supportive policies.

It is worth explaining the “bonus”. The average annual growth in agriculture & allied activities over the past five years has been 1.8 per cent. If this value were to hold good for the average of 2004–05 and 2005–06 as well, then the fact that the sector grew by only 1.1 per cent in 2004–05, would imply that in 2005–06 in the normal course of things, it would grow by 2.5 per cent. Of course, the average may not hold good for two consecutive years, but then if the SW monsoon does turn out as good as it is promising in the first week of July, then there is a good probability that it indeed might. The greater outreach of credit and other supportive policies might increase the extent of the bounce, but for our purposes we stay with 2.5 per cent growth for the farm sector.

We are into the second longest continuous expansion of manufacturing output since the beginning of economic reforms. In the post-1991 period, the first phase of expansion in manufacturing began in July 1993 and lasted 37 months till August 1996. The average of monthly year-on-year rate of growth was 11.1 per cent, with a standard deviation of 3.3 per cent and a cumulative growth over the period of 39 per cent. The current phase started out in July 2002 and is still under way and is already 34 months long. The average rate of monthly year-on-year growth has been much less at 7.8 per cent and so has the standard deviation at 1.6 per cent. Cumulative growth over the period at 23 per cent is also considerably less than had been the case in the first phase. The industrial production numbers for May and June are not likely to see a break in this phase of growth, which would bring up the 36th month of the expansion phase. The question however is whether the present phase of manufacturing expansion would continue at its current robust pace (of around 8 – 9 per cent) in the fourth year of expansion — that is in July 2005 and beyond.

There is some reason to believe that the current phase of expansion will hold out longer than did the first.

The first phase between mid-1993 and mid-1996 petered out as a result of a combination of circumstances:

Low international commodity prices arising from the disintegration of manufacturing enterprises in the former Soviet Union;

Unrestrained capacity expansion by domestic businesses that failed to appreciate how they would be impacted by domestic and international competition;

A lack of appreciation of financial risk by domestic companies which proceeded to aggressively expand their balance sheet through higher leverage; and

The Asian currency crisis that was to follow shortly thereafter and served to settle commodity prices at low levels for a fairly long period of time.

There exists no destabilising source of supply like the collapsing state enterprises in the former Soviet Union, and capacity creation in the rest of the world has been very restrained, the result of which we are seeing in the escalation of commodity prices today.

External conditions today are far more comfortable and world commodity prices are at unprecedented high levels, assisted both by robust demand from Asian growth as well as non-creation/phasing-out of capacity over the past decade of low commodity prices and environmental sensitivity. There exists no destabilising source of supply like the collapsing state enterprises in the former Soviet Union, and capacity creation in the rest of the world has been very restrained, the result of which we are seeing in the escalation of commodity prices today. Indian businesses, having experienced the pitfalls of unrestrained balance sheet expansion through high leverage, and assisted by generous lending from financial institutions and easy financing from capital markets, have exercised far greater caution in the current phase of expansion. Banks and the capital market have also exercised greater circumspection in financing capital plans. In consequence, the structural weaknesses that accompanied the first phase of expansion of manufacturing output in the post-reform period are absent today.

While export demand continues to be fairly strong, given the slowing in evidence in advanced economies, it would not be surprising that in fiscal years 2005 and 2006 the pace of export growth may turn out to be weaker than in 2004. Domestic demand growth however continues to be strong, as evidenced by the rapid expansion of non-oil import demand of 43 per cent higher during April–May 2005, compared to the same period last year; in fact the increase in non-oil imports significantly exceeded the increase in the value of oil imports in this period.

On the whole, constraints are unlikely to rise from the demand side to the extent that it would end the on-going phase of manufacturing output expansion. This is particularly true, now that the SW monsoon appears well on course, with attendant positive implications for agricultural growth. However, supply side constraints — from infrastructure in general, and electricity in particular, as well as the availability of mineral resources (and their price) — can act as a dampener. With company profitability still rising, balance sheets healthy and excess manufacturing capacity reduced to the bare minimum (in most sectors), investment activity is likely to add to the demand facing the domestic economy.

Thus, while one does not expect manufacturing activity expansion to collapse as it did after August 1996, or for that matter after the short (12 month) period of expansion between May 1999 and April 2000, it would not be unreasonable to expect some moderation in the pace of expansion. Accordingly, we have factored in manufacturing growth of 7.5 per cent in the base case, with an upside potential of averaging 8.5 per cent, provided investment kicks in on a fairly broad basis, particularly in infrastructure. Construction activities ought to receive a fillip during this fiscal year from the rolling out of known investment projects, besides heightened urban commercial and housing construction activities. Coal mining and power generation have had a bad run through most of 2004–05, but both the sectors have seen output growth improve slightly in March and April 2005, and early returns for May 2005 show power generation having grown by 10.5 per cent and coal mining output by 11.2 per cent. A fair amount of thermal power generation capacity is expected to kick in during the current financial year as well as in the next, and as a result there may be some relaxation in the severity of the constraints (hours of load shedding) facing manufacturing, as well as the rest of the economy. The service sector is expected to grow at a pace slightly slower than that of last year, as the telecommunication sector expands on a much enlarged base.

This yields us a range of between 6.9 and 7.5 per cent. The downside case estimates growth in agriculture & allied activities at 2.5 per cent, manufacturing at 7.5 per cent, overall industry at 7.3 per cent, service sector at 8.3 per cent and non-agriculture as a whole growing at 8.0 per cent. The upside case involves agriculture & allied activities growing faster by 3.5 per cent, manufacturing by 8.5 per cent, industry as a whole by 8.1 per cent, services by 8.7 per cent and non-agriculture by 8.5 per cent. In short the situation with the greatest likelihood would be one of overall GDP growth of around 7.2 per cent. The outlook for the next financial year (2006–07) currently differs little from that of the ongoing fiscal.

Balance of PaymentsTrade and Current Account Balance

The data from the Director General of Commercial Intelligence & Statistics (DGCI&S) show that merchandise exports grew by 24 per cent to $79 billion in 2004–05, while imports expanded by 37 per cent to $107 billion, and as a result the trade deficit ballooned by 94 per cent to reach an unprecedented level of $27.8 billion (3.9 per cent of GDP). However, the Balance of Payments (BoP) statistics released by the RBI indicate that merchandise exports grew 25 per cent to $81 billion which is not much different from the DGCI&S numbers. The BoP data however show that merchandise imports shot up by 48 per cent to $119 billion, and the resultant merchandise trade deficit was a whopping $38 billion (5.3 per cent of GDP), and as much as $12 billion (1.7 per cent of GDP) more than brought out by the DGCI&S data.

In years past there has always been some difference between the DGCI&S and BoP data, especially with respect to imports and the trade deficit. However, the magnitude of the difference in 2004–05 was unprecedented.

Now in years past there has always been some difference between the DGCI&S and BoP data, especially with respect to imports and the trade deficit. However, the magnitude of the difference in 2004–05 was unprecedented. Moreover, the differences have cropped up starting from the second quarter (July – Sep) of 2004–05 and have continued to persist by about the same magnitude in the subsequent two quarters (little over $4 billion at the current account level). The position is summarised at Table 6 which gives the situation in 2003–04 as well for the sake of comparison. Table 6

The difference between Merchandise Trade Balance in the BoP and DGCI&S data

Unit: US$ Billion

		Balance of Payments			DGCI & S

	Export	Import	Trade Deficit	Export	Import	Trade Deficit

2004–05
Q1	17.8	23.0	5.2	17.5	23.4	6.0
Q2	18.9	28.5	9.6	18.4	24.3	5.9
Q3	20.9	32.7	11.8	20.5	27.9	7.4
Q4	23.2	34.8	11.6	22.3	29.3	7.0
2003–04
Q1	13.2	18.7	5.6	12.9	17.2	4.3
Q2	14.8	18.6	3.8	14.2	17.4	3.1
Q3	16.4	21.1	4.6	16.4	20.6	4.4
Q4	20.3	21.8	1.5	19.3	21.7	2.5

It would be nice to have an explanation as to why the divergence between the BoP and DGCI&S import and trade balance numbers have re-appeared to the extent that they have an effect of as much as $4.5 billion on the current account. Till such an explanation does emerge, we can only speculate that in the last three quarters of 2004–05, there were large government imports (including defence purchases) which are not recorded in the DGCI&S data but are indeed captured in the BoP statistics.

The increase in the positive balance on invisibles of $5.7 billion was washed out by the huge and unprecedented jump in the BoP merchandise trade deficit of $22.7 billion (147% increase). The net impact of the two was a negative accumulation of $17.0 billion

The net balance on invisibles — that includes non-factor services (including software), remittances from Indians working overseas and investment income (dividends and interest) — has increased from a positive of $26.0 billion in 2003–04 to $31.7 billion in 2004–05, an increase of 22 per cent. The increase in the positive balance on invisibles of $5.7 billion was washed out by the huge and unprecedented jump in the BoP merchandise trade deficit of $22.7 billion (147 per cent increase). The net impact of the two was a negative accumulation of $17.0 billion, which coming on top of last year's positive current account balance of $10.6 billion, yielded in 2004–05, a current account deficit of $6.4 billion.

In the last quarter of 2004–05, the current account was reported to be a surplus $169 million, up from the deficit of $5.47 billion in the previous quarter, purely on account of an enormous increase in the net positive balance in net non-factor services (which includes software). The cumulative balance under net non-factor services in the first three quarters of 2004–05 was $7.9 billion, with the second and third quarters averaging just $2.3 billion. In the fourth quarter the balance jumped to $6.7 billion. The large variation seems to derive purely on account of miscellaneous general services other than software (the net balance on the latter show an intuitively easy to understand gradual growth over the quarters).¹⁵

¹⁵ The net balances on software in each of the four quarters of 2004–05 were $3.7 billion, $3.9 billion, $4.2 billion and $4.8 billion, respectively. For miscellaneous general services the corresponding figures were $3.1 billion, $2.2 billion, $2.4 billion and $6.5 billion. This means that the net balances arising from miscellaneous general services other than software services were: −$0.6 billion, −$1.7 billion, −$1.8 billion and + $1.6 billion, respectively.

Outlook for 2005–06

In the previous issue we had estimated that the net balance on invisibles would be between $32 and $33 billion, which has turned out to be accurate with the actual number being $31.7 billion. Our assessment of the BoP trade deficit at around $27 billion has of course been a large under-estimate, given the actual number coming in at $38 billion.

In the current fiscal, merchandise imports are likely to continue expanding at a pace that is likely to exceed the growth of exports. The trade deficit nearly doubled in the first two months of 2005–06. However, for the year as a whole such an order of increase is unlikely. Merchandise import growth is unlikely to fall much below 25 per cent, while export growth is unlikely to exceed 20 per cent. That gives us a range for the trade deficit between $35 and $40 billion for 2005–06, that is 4.3 per cent to 5.0 per cent of expected GDP for the year. However, this is what corresponds to the DGCI&S statistics. We do not know whether the additional load of $4.0 – 4.5 billion per quarter, evident in the last three quarters of 2004–05 would continue to resurface in 2005–06. For if it does, then that would mean another $12 billion or so for the year, over and above our estimate for the trade deficit of $35 – 40 billion.

On the invisible side, there will be increases on account of higher level of non-factor service net exports, including software and other ITES and tourism, besides modest growth in remittances, offset to an extent perhaps by higher investment income outflows. The net balance on invisibles is likely to be around $37 billion.

That would leave the current account, using our initial estimate of the trade deficit from a small surplus of $2 billion to a deficit of $3 billion. On the average, except for 2004–05, in recent years the BoP trade deficit has been higher than that reported by the DGCI&S to the extent of $2 to $4 billion. Was the order of difference in 2005–06 to be at this level, it would give us a current account with a small deficit of at most $7 billion, about the same level as in 2004–05. However, if in 2005–06 the difference between the BoP and DGCI&S import and hence trade data is of the order of $12 billion, the current account would be in deficit of between $10 and $15 billion, that is, between 1.25 and 1.9 per cent of expected GDP. In the absence of a clear understanding as to the factors that underlay the difference between the BoP and DGCI&S merchandise trade data for the last three quarters of 2004–05, it is simply not possible to come up with a better picture.

Capital inflows

The capital account in 2004–05 had a surplus of $32.2 billion, up from $20.5 billion in the previous year. Foreign investment (mostly portfolio) net inflows were smaller by nearly $3 billion, and due to net outflow of NRI deposits, banking capital flows were also smaller by $2.2 billion. The principal factors behind the elevated level of capital account surplus were:

External assistance (multilateral and bilateral loans) turning from negative to positive; that is, repayments being larger than fresh disbursements (from −$2.7 billion to + $1.9 billion),

A similar situation with respect to commercial borrowings (from −$1.5 billion to + $5.9 billion) and

Higher net balance under “other capital” (increase of $2.2 billion, to $5.0 billion from $2.8 billion)

Other than the item “other capital”, foreign investment, external assistance, commercial loans and banking capital should aggregate in excess of $20 billion in net inflows, which would be adequate to finance the current account deficit even at the outside limit of its value at $15 billion.

In the current fiscal year (2005–06), foreign investment inflows, external assistance and commercial borrowing will continue at similar/elevated levels, but it would be reasonable to expect that the net positive balance under “other capital” would be drawn down to the extent that it reflects time mismatches vis-à-vis trade-related flows. Other than the item “other capital”, foreign investment, external assistance, commercial loans and banking capital should aggregate in excess of $20 billion in net inflows, which would be adequate to finance the current account deficit even at the outside limit of its value at $15 billion.

InflationWholesale Price Index inflation

Fast rising wholesale price index (WPI) inflation had become a hot button issue in the summer and autumn of 2004 — buoyed by rising commodity prices, particularly that of steel, sugar and petroleum.

In its October 2004 Mid-term Review, the RBI had put WPI inflation at 6.5 per cent in March 2005, albeit later qualified by the insertion of the phrase “a downward bias”. In the event at the end of March 2005, WPI inflation (revised) turned out to be a lot lower at 5.1 per cent. However, this number did not capture the increase in crude petroleum prices, since the Oil Market Companies (OMCs) were not permitted to raise their selling prices in line with the increase in the cost of crude. On an admittedly rough-and-ready basis, if a full cost pass-through had been permitted by government, the index would have been significantly higher and the inflation rate at the end of March 2005 would have been very close to 6.5 per cent.

The Policy response to inflation

The mix of fiscal and monetary policy initiatives adopted by government in August and thereafter, served to contain inflation at a pace somewhat faster than had been expected. By the end of December 2004, the WPI inflation rate was down to 5.7 per cent, quite contrary to expectations that something below 7 per cent would be welcome. In part, the rapid pace of the decline was assisted by sharp fall in the price of raw cotton, cotton textiles, oilseeds, edible oil and grain mill products, in the face of policy measures that closed out opportunistic pricing in some sectors where international market conditions were favourable — such as steel and sugar. The refusal of the government to permit the pass-through of higher petroleum prices, particularly since the end of February 2005, of course served to further cap out the inflationary process.

Inflation — the Status and Expectations

With steel prices set to ease further, good monsoon rains likely to soften agricultural product prices and the pass-through of higher crude petroleum prices to refined products unlikely, the WPI inflation rate appears set to stay around 4% for the rest of the summer of 2005.

Wholesale Prices: For the week ending June 25, 2005, WPI inflation stood at 4.1 per cent, marginally higher than in the previous week, notwithstanding the impact of higher gasoline and diesel prices. Manufactured goods showed inflation of 3.5 per cent, down significantly from the level of 5.4 per cent a mere two months ago (end of April 2005). With steel prices set to ease further, good monsoon rains likely to soften agricultural product prices and the pass-through of higher crude petroleum prices to refined products unlikely, the WPI inflation rate appears set to stay around 4 per cent for the rest of the summer of 2005. Manufactured goods prices have risen through March and April 2005, though it has not during May and June. In the coming months, there does not appear to be much likelihood of the overall price index for manufactured goods to increase much on a net basis. This is notwithstanding the fact that prices for some manufactured products (such as cement) are likely to increase in line with strong domestic demand and rising manufacturing costs. However, these will be offset to an extent by the likely softening of steel prices and the general competitive pressure arising from global supply networks, which drives enterprises to try and absorb cost increases through productivity gains in order to preserve market share.

In fact there is a strong likelihood that WPI inflation for manufactured goods (now at 3.5 per cent) will fall further to perhaps well below 3 per cent in July, August and September 2005, before rising subsequently. With the normal seasonality affecting primary food articles and some provision of increase in energy prices, overall WPI inflation is likely to be around 4 per cent at the end of September 2005 and about 5 per cent at the end of December 2005.

Consumer Prices: The inflation measured by the CPI-UNME (urban non-manual employee) in May 2005 stayed at 4.2 per cent, unchanged from that of the previous month. The CPI-IW (industrial worker) dropped off in May 2005 to 3.7 per cent from the 5.0 per cent of the previous month. These may be compared with the average for the second half of 2004–05 which was 3.9 per cent for CPI-UNME and 4.2 per cent for CPI-IW, indicating no significant change in the direction of consumer price inflation. Both the consumer price indices are now registering inflation quite close to that of the WPI index.

Movements in yields

Following the trend in the developed world, the yield curve in this country has also turned flatter. At one level, the yield on long dated government securities has come off from the highs of July 2004 (7.5 per cent for 10-year paper) and settled down to between 6.5 and 6.9 per cent. However, in recent days bond prices have fallen and 10-year yields have climbed back to over 7.1 per cent, possibly reflecting the tightness in the funds market that has brought the trade-off between higher yielding credit and government securities into material play.

At the short-end the reverse repo rate has gone up from 4.5 per cent in July 2004 to 5.0 per cent after the rate increase on April 28, 2005. The rapid increase in credit off-take which has overtaken the pace of deposit growth in recent times has seen the cost of banks’ funds rising, with fairly illustrative instances of large volume certificates of deposit issued at surprisingly high interest rates. In fact since the beginning of 2005, total outstanding certificates of deposit have increased by Rs. 10,656 crore or by a whopping 152 per cent.

Bank Credit

Credit off-take from the banking system by commerce and industry (C&I) was very strong in 2004–05, and came on top of rapid credit expansion in 2003–04 as well. Total non-food credit growth in 2004–05 was an unprecedented Rs. 213,464 crore (net of mergers), nearly double that of the Rs. 125,088 crore during 2003–04. On year-on-year terms, the total stock of outstanding non-food credit grew by 26.5 per cent at the end of 2004–05, compared to 18.4 per cent in the previous March.

The acceleration in credit off-take clearly continues. Little surprise given that with less appetite for government bonds, the result could only be a decline in prices, and therefore a rise in yields.

In the first quarter of 2005–06, the expansion in credit continues. Till June 24, 2005, non-food credit grew by Rs. 57,397 crore over end-March, compared to Rs. 34,926 crore at the same point in time last year. On year-on-year basis, the outstanding stock of non-food credit rose by 29.5 per cent at the end of June 2005, compared to 22.6 per cent at the same point-in-time last year. The acceleration in credit off-take clearly continues. Little surprise given that with less appetite for government bonds, the result could only be a decline in prices, and therefore a rise in yields.

Government Finances

By all accounts there have been improvements in government finances. The revenue deficit of the combined government system has declined, as the NAS 2005 indicates, from 6.1 per cent in 2001–02 to 4.3 per cent in 2003–04. This it is reported has come down further in 2004–05. For the Central government, the revenue deficit (provisional actual) has declined to 2.6 per cent of GDP. The Fiscal Responsibility and Budget Management (FRBM) legislation enacted by the Centre and several state governments (the balance are expected to pass them soon) is providing a politically consensual framework for fiscal consolidation to move apace, notwithstanding the pulls and pressures that naturally arise in an electoral system that has practised competitive populism from time to time.

The tax collection (before devolution to States) and other fiscal numbers of the Central government for the last four years and the budget estimates for 2005–06 are presented at Table 7. Also presented are the year-on-year growth figures, with the last column being the budget estimates for the current fiscal year. Table 7

Finances of the Union Government — 2004–05 and 2005–06 (Budget)

Unit: Rs in crore

	2001–02	2002–03	2003–04	2004–05	2005–06	Annual Change in per cent

	Accounts			Prov. Actual	B.E.	2002–03	2003–04	2004–05	2005–06

Receipts
Corporation Taxes	36,609	46,172	63,562	83,566	110,573	26.1	37.7	31.5	32.3
Personal Income Tax	32,004	36,866	41,379	48,312	66,239	15.2	12.2	16.8	37.1
Union Excise Duties	72,555	82,310	90,774	99,155	121,533	13.4	10.3	9.2	22.6
Customs Duties	40,268	44,852	48,629	57,655	53,182	11.4	8.4	18.6	−7.8
Service & other taxes	5,624	6,066	10,004	16,292	18,498	7.9	64.9	62.9	13.5
Gross Tax Receipts	187,060	216,266	254,348	304,980	370,025	15.6	17.6	19.9	21.3
Less States’ share	52,842	56,122	65,766	78,595	94,959	6.2	17.2	19.5	20.8
Net Tax Receipts of Centre	133,532	158,544	186,982	224,857	273,466	18.7	17.9	20.3	21.6
Non-Tax receipts	67,774	72,323	76,068	80,330	77,734	6.7	5.2	5.6	−3.2
Revenue Receipts	201,306	230,867	263,050	305,187	351,200	14.7	13.9	16.0	15.1
Expenditure
Plan Revenue Expenditure	61,657	71,554	78,537	87,496	115,982	16.1	9.8	11.4	32.6
Non-Plan, Non-Interest
Revenue Expenditure	132,351	150,270	158,510	170,709	196,585	13.5	5.5	7.7	15.2
Interest payments	107,460	117,804	124,261	126,540	133,945	9.6	5.5	1.8	5.9
Total Revenue Expenditure	301,468	339,628	361,308	384,745	446,512	12.7	6.4	6.5	16.1
Direct capex + fresh loan disbursal - Plan & non-Plan^†	60,842	74,535	64,026	81,038	67,832	22.5	−14.1	26.6	−16.3
Recovery of loans^†	16,403	34,191	20,326	28,197	12,000	108.4	−40.6	38.7	−57.4
Capex +34 Net Lending	44,439	40,344	43,700	52,841	55,832	−9.2	8.3	20.9	5.7
Total Expenditure	345,907	379,972	405,008	437,586	502,344	9.8	6.6	8.0	14.8
Disinvestment proceeds	3,646	3,151	16,048	4,424	0	−13.6	409.3	−72.4	−100
Balances*
Revenue Deficit	100,162	108,761	98,258	79,558	95,312	8.6	−9.7	−19.0	19.8
Revenue Deficit	(4.39)	(4.42)	(3.56)	(2.56)	(2.73)
Gross Financing Gap	144,601	149,105	141,958	132,399	151,144	3.1	−4.8	−6.7	14.2
Gross Financing Gap	(6.34)	(6.05)	(5.14)	(4.26)	(4.32)
Fiscal Deficit	140,955	145,954	125,910	127,975	151,144	3.5	−13.7	1.6	18.1
Fiscal Deficit	(6.18)	(5.93)	(4.56)	(4.12)	(4.32)
Primary Deficit	33,495	28,150	1,649	1,435	17,199	−16.0	−94.1	−13.0	1,099
Primary Deficit	(1.47)	(1.14)	(0.06)	(0.05)	(0.49)

Note: ^† We have knocked out Rs. 46,602 crore and Rs 32,665 crore, from both the loan recovery and capital expenditure sides for 2003–04 and 2004–05 in order to achieve comparability with other years. These amounts pertained to pre-payment by state governments of loans taken from the National Small Savings Fund (NSSF) .
* Figures in parentheses are the proportion to GDP at current market prices.
Source: i) Budget 2005–06, Government of India, February 28, 20045
ii) Union finances provisional accounts for 2004–05 - Controller General of Accounts (CGA)

Although, for the first two months of 2005–06 for which the data is available, gross tax collections appear to be up by 29.6%, more than the budgeted growth, it is still too early yet to see in this a pattern for the full year.

The budget estimates for the revenue deficit in 2004–05, are higher than the provisional actual for the previous year. Gross tax collections are budgeted to increase by 21.3 per cent in 2005–06, slightly more than the growth of 19.9 per cent in the previous year. Although, for the first two months of 2005–06 for which the data is available, gross tax collections appear to be up by 29.6 per cent, more than the budgeted growth, it is still too early yet to see in this a pattern for the full year. On the expenditure side, non-interest revenue expenditure was budgeted to rise by 21.1 per cent in 2005–06, as against which the increase in the first two months was much smaller at 8.5 per cent. In consequence, the revenue deficit for the first two months in absolute terms was virtually unchanged at last year's levels (but was lower as a ratio of GDP). Again, although it is too early to say whether through a combination of robust tax growth and expenditure management, the revenue deficit would be lower than that budgeted (and significantly as a proportion of GDP), the possibility certainly does exist.¹⁶

¹⁶ To get to a revenue deficit of 2 per cent of GDP in 2005–06, it would suffice to contain the revenue deficit at about Rs. 70,000 crore.

The fiscal deficit for the year was slated to be Rs. 151,144 crore (4.3 per cent of GDP) and 18 per cent more in absolute terms compared to the previous year. In the first two months of 2005–06, the fiscal deficit was Rs. 47,603 crore, 22 per cent higher than in the corresponding period of last year. This was almost entirely on account of the higher loan recovery during April–May last year of Rs. 13,377 crore (as part of the pre-payment of loans against small savings) vis-à-vis Rs. 189 crore this year. Capital expenditure and net lending in April–May 2005 was Rs. 3,450 crore as against a large negative number in the corresponding period of last year. It is entirely likely that if some savings is realised on the revenue deficit, that might be switched to higher capital outlays; it is unlikely therefore that we would, at best, see more than a small reduction in the fiscal deficit as budgeted.

Political developments

In India we have suffered for so long at the hands of the jehadi terror provided hospitality by our western neighbour, that we do not fall prey to the wishful thinking that seems to have taken its toll amongst so many of the good people of the developed west.

On July 7, 2005 terrorists hit London. It was in a way “expected”, but the reality of the horror has served to bring jehadi terror back into the forefront. After all it is but reasonable that most sane people would like to forget that such insanity persists all around us, and would love to get back to the familiar business of harmless rhetoric and point scoring. In India we have suffered for so long at the hands of the jehadi terror provided hospitality by our western neighbour, that we do not fall prey to the wishful thinking that seems to have taken its toll amongst so many of the good people of the developed west.

The terror attack will help underscore the resolve of the civilised world to contain the jehadis, for rooting it out is a function of politics and attitudes changing dramatically for the better in the Islamic world, which does not seem to be on the table in the short to medium term. The attack will leave its economic and financial fallout in the months to come. For one thing it seems it would precipitate a rate cut by the Bank of England in its next meeting, and might get the ECB to follow suit. That could go some distance in accommodating the slowing pace of economic growth in Europe. It might just increase the resolve of European and other developed nations to place greater emphasis on non-petroleum energy resources, including nuclear power generation, besides working on fuel savings technologies. That might serve to temper the desire for ever-higher oil revenues amongst oil exporting nations, with perhaps a concerted effort on their part to stabilise prices at a level quite a bit lower than the present price-gouging ones.

In India, the UPA government led by Prime Minister Manmohan Singh has completed its first year in office. It has not been an easy ride, notwithstanding the seeming incapacity of the major opposition party, the Bharatiya Janata Party (BJP) to get its act together. The Left parties continue to distinguish themselves (presumably in the eyes of the “masses”) that while they support the Congress-led government, they are “different”. Whether the “masses” are moved by the painful exercise in pointless polemics is doubtful, but clearly the tune plays well to its cadres and core-supporters; hence, perhaps the encores and grandstanding. It would however not be unsurprising if underneath the fine dialogue, there has begun to run a stream of realpolitik. The Left has little influence (outside of fantasy, and who knows sometimes people choose to operate on their fantasies) outside West Bengal, Kerala and Tripura. If horizontal growth is difficult, as every capitalist knows, it is best to consolidate. The Left payout may be retention of the two eastern States and winning the assembly elections in Kerala. For that keeping the status quo in Delhi is far more conducive, than pulling the rug out from under the UPA government and having to explain to the electorate why they did it. It is always easier to criticise than it is to defendand the Left has refined that to quite a fine art. Then too the major player, the CPI-M has the advantage of having its adjutant the CPI doing most of the fist-waving (and clowning), while they play out the understated sombre role. Politics is high theatre, and this one is not about to come to an early end.

Economic Assessment and Outlook