Mid-Term Review of the Annual Policy Statement for 2006-07, RBI Credit Policy: Banknet India

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I. Assessment of Macroeconomic and Monetary Developments during the First Half of 2006-07

Domestic Developments

3. Estimates released at the end of September 2006 by the Central Statistical Organisation (CSO) point to an upswing in domestic economic activity. Real GDP growth during the first quarter of 2006-07 is placed at 8.9 per cent as against 8.5 per cent in the corresponding quarter a year ago. Real GDP growth originating in agriculture, industry and services sectors was 3.4 per cent, 9.7 per cent and 10.5 per cent, respectively, as against 3.4 per cent, 9.5 per cent and 10.1 per cent in the first quarter of 2005-06.

4. Available information indicates that this early acceleration of growth has been sustained in the second quarter (July-September) of 2006-07. Rainfall during the 2006 South-West monsoon season, i.e., June-September was at 99 per cent of its long period average for the country as a whole. Moisture distribution was reasonably even, with deficient rainfall in 10 of the 36 meteorological subdivisions and excess rainfall in 6 subdivisions. First estimates of the Ministry of Agriculture place kharif foodgrains production conservatively at 105.22 million tonnes, below the target of 115.25 million tonnes and also lower than 109.70 million tonnes recorded last year. These early estimates are likely to be revised as the outcome for the kharif season becomes clearer. As on October 19, 2006 live storage in 76 major reservoirs was 89 per cent of the full reservoir level and 26 per cent higher than the last 10 years’ average level. While the improvement in water storage levels strengthens the prospects for rabi production, it is necessary to monitor further developments to make a realistic assessment.

5. Industrial output has picked up momentum, supported by favourable demand conditions, resilient business confidence and strong corporate profitability. The index of industrial production (IIP) increased by 10.6 per cent during April-August 2006 as against 8.7 per cent a year ago. Manufacturing has been the engine of industrial growth, rising by 11.8 per cent (9.6 per cent a year ago), the highest since 1996-97. Mining and electricity generation grew by 3.1 per cent (1.6 per cent) and 5.7 per cent (6.0 per cent), respectively. The acceleration in manufacturing activity was led by basic metals and alloys, non-metallic mineral products, machinery and transport equipment, textile products and basic chemicals and products. The use-based classification indicates a firming up of investment demand as reflected in an increase of 18.6 per cent (13.8 per cent) in capital goods production. Demand pressures were also reflected in a growth of 8.3 per cent (6.9 per cent) in production of basic goods and 9.5 per cent (3.5 per cent) in intermediate goods. Production of consumer goods rose by 11.3 per cent (13.7 per cent), mainly driven by consumer durables. Demand-pull impulses seem to be percolating into the consumer non-durables segment, too. The six infrastructure industries, comprising nearly 27 per cent of the IIP, posted a growth of 6.7 per cent during April-August, 2006 as against 6.1 per cent a year ago. Petroleum refinery products registered double-digit growth and acceleration was recorded in the production of crude petroleum. The growth of cement production, electricity and finished steel decelerated while the growth of coal production was the same as a year ago.

6. Private corporate sector performance seems to have picked up after some moderation that set in during the second half of 2005-06. Sales of sample companies grew by 25.6 per cent in the first quarter of 2006-07 – up from 18.5 per cent a year ago – resulting from robust domestic and export demand conditions, excise duty reduction (e.g., automobiles, information technology (IT) industries), cost saving initiatives (e.g., automobiles, cement, fast moving consumer goods i.e., FMCG), volume growth (e.g., auto, cement, IT) and higher sales realisations (e.g., non-ferrous metals, FMCG, cement). Net profits of the selected companies increased by 34.7 per cent on top of a growth of 54.2 per cent in the corresponding quarter last year. Early results for the second quarter of 2006-07 indicate that the performance of the private corporate sector continued to be impressive in terms of the growth in sales and post-tax profits.

7. The Reserve Bank’s Industrial Outlook Survey indicates cautious optimism on the growth outlook. The business expectations index for July-September, 2006 and October-December, 2006 is lower than in the preceding quarters but higher than in corresponding quarters a year ago. There is an improvement perceived in demand conditions as reflected in order books. Expectations of a rise in capacity utilisation and employment are indicating higher working capital finance requirements. A majority of the respondents reported increase in raw material prices, with raw material and finished goods inventories at around the average level. Business expectation surveys conducted by most other agencies also indicate a cautiously optimistic outlook in terms of overall economic conditions and investment climate. The business confidence index for September-October, 2006 compiled by one agency has risen by 7.6 per cent over the previous round on improved expectations about the overall economic conditions, the investment climate, financial position of firms and some improvement in capacity utilisation which is at its peak level. Seasonally adjusted purchasing managers’ indices signal improvement in operating conditions, driven by strong domestic and overseas demand.

8. A contextual analysis of the co-movement between macroeconomic performance and bank credit in the current phase of the business cycle suggests that factors other than demand may also be at work: financial deepening from a low base; structural shifts in supply elasticities; rising efficiency of credit markets; and competitive pressures augmenting the overall supply of credit. Credit extended by scheduled commercial banks (SCBs) increased by Rs.1,36,643 crore (9.1 per cent) during the current financial year up to October 13, 2006 as compared with the increase of Rs.1,19,168 crore (10.3 per cent) in the corresponding period last year. Food credit declined by Rs.7,246 crore – as against a decline of Rs.2,808 crore in the previous year – reflecting lower procurement of foodgrains during the current financial year. Non-food credit registered an increase of Rs.1,43,889 crore (9.8 per cent) as compared with an increase of Rs.1,21,976 crore (11.0 per cent) in the corresponding period of the previous year.

9. On a year-on-year basis, non-food credit of SCBs exhibited a growth of Rs.3,76,105 crore (30.5 per cent) as on October 13, 2006 on top of an increase of Rs.2,97,903 crore (31.8 per cent) a year ago. Provisional information available from select SCBs for June 2006 indicates that within the services sector which currently absorbs about 49 per cent of non-food bank credit, retail lending rose by 47 per cent on a year-on-year basis with growth in housing loans being 54.3 per cent. As a result, the share of retail credit in total bank credit increased marginally from 26.8 per cent in June 2005 to 27.3 per cent in June 2006. Loans to commercial real estate almost doubled during the period, increasing their share in total bank credit from 1.4 per cent to 2.0 per cent. The year-on-year growth in credit to industry was of the order of 26.6 per cent by June 2006; however, its share in total bank credit fell from 43.2 per cent in June 2005 to 37.8 per cent in June 2006. Substantial increases were observed in credit flow to industries like infrastructure (28.3 per cent), metals (38.0 per cent), textiles (32.2 per cent), engineering (23.0 per cent), vehicles (33.0 per cent), gems and jewellery (46.3 per cent), food processing (25.8 per cent) and construction (59.7 per cent). Shares of bank credit to infrastructure, metals and textile industries in total credit to industry increased from 19.8 per cent, 11.1 per cent and 10.8 per cent, respectively, in June 2005 to 20.1 per cent, 12.1 per cent and 11.3 per cent, respectively, in June 2006. The year-on-year growth in bank credit to agriculture was of the order of 37 per cent by June 2006. The share of agriculture in total bank credit rose marginally from 13.1 per cent in March 2006 to 13.4 per cent in June 2006.

10. Banks’ investments in shares, bonds/debentures and commercial paper increased by 1.8 per cent (Rs.1,466 crore) during the current year up to October 13, 2006 against a decline of 10.5 per cent (Rs.9,828 crore) in the corresponding period last year. SCBs’ investments in instruments issued by all-India financial institutions and mutual funds, however, increased by Rs.11,602 crore as against a decline of Rs.2,805 crore in the corresponding period of the previous year. The total flow of resources from SCBs to the commercial sector increased by 9.4 per cent (Rs.1,45,355 crore) during the current year so far as compared with the increase of 9.3 per cent (Rs.1,12,148 crore) in the corresponding period of the previous year. The year-on-year growth in resource flow was 28.4 per cent over and above the growth of 28.1 per cent a year ago.

11. Aggregate deposits of SCBs increased by Rs.1,85,244 crore (8.8 per cent) in the current fiscal year up to October 13, 2006 as compared with an increase of Rs.1,15,309 crore (6.5 per cent) in the corresponding period of the previous year. On an annual basis, the growth in aggregate deposits at Rs.3,93,849 crore (20.7 per cent) was higher than that of Rs.2,98,229 crore (18.6 per cent) a year ago. Aggregate deposit growth during 2006-07 has to be viewed in the context of several favourable developments during the period, namely, improvement in corporates’ internally generated resources placed with the banking system, the relative attractiveness of bank deposits vis-à-vis small savings – owing to higher interest rates on banking deposits and extension of tax incentives for longer term deposits (five years and above) – as well as active deposit mobilisation strategies mounted by banks to fund the expansion in credit. On the other hand, demand deposits, which have exhibited close correlation with stock market activity in the recent period, have moderated since the equity market turbulence in mid-May and June. Overall, it is useful to note that the incremental non-food credit-deposit ratio during the current year so far, has declined to 77.7 per cent from 105.8 per cent a year ago.

12. SCBs’ investment in Government and other approved securities at Rs.46,914 crore during the current financial year up to October 13, 2006 was higher than that of Rs.3,400 crore in the corresponding period of the previous year. Adjusted for banks’ repo/reverse repo with the Reserve Bank under the Liquidity Adjustment Facility (LAF), their investment in Statutory Liquidity Ratio (SLR) securities increased by Rs.30,806 crore during 2006-07 so far as against an increase of Rs.33,578 crore a year ago. Banks’ net investment in Government securities as a proportion to their aggregate deposits has been decelerating to accommodate the demand for non-food advances. There has also been substantial support from non-bank entities for the market borrowing programme of Central and State Governments. Consequently, commercial banks’ holdings of Government and other approved securities fell to 29.8 per cent of their net demand and time liabilities (NDTL) as on October 13, 2006 from 34.7 per cent a year ago. While these investments exceeded the required SLR by Rs.1,23,010 crore (Rs. 2,07,903 crore a year ago), the excess SLR investment adjusted for LAF holdings amounted to Rs.1,04,770 crore or 4.1 per cent of NDTL.

13. On a year-on-year basis, the growth in money supply (M3) at 19.0 per cent was higher than 16.8 per cent a year ago. On a financial year basis, M3 increased by Rs.2,13,891 crore (7.8 per cent) in 2006-07 up to October 13, 2006 which was higher than the increase of Rs.1,41,555 crore (6.1 per cent) in the corresponding period of the previous year.

14. The year-on-year increase in reserve money was 20.4 per cent as on October 20, 2006 as compared with 14.0 per cent a year ago. On a financial year basis, reserve money increased by Rs.43,884 crore (7.7 per cent) up to October 20, 2006 as compared with the increase of Rs.23,320 crore (4.8 per cent) in the corresponding period of the previous year. While currency in circulation increased by Rs.38,262 crore (8.9 per cent) as compared with Rs.21,877 crore (5.9 per cent), bankers’ deposits with the Reserve Bank increased by Rs.7,047 crore (5.2 per cent) as compared with Rs.3,289 crore (2.9 per cent). Among the sources of reserve money, net Reserve Bank’s credit to the Central Government increased by Rs.15,029 crore as compared with the increase of Rs.5,073 crore in the corresponding period last year. Adjusted for transactions under the LAF, net Reserve Bank’s credit to the Central Government showed an increase of Rs.6,299 crore. The Reserve Bank’s net foreign exchange assets (NFEA) increased by Rs.77,310 crore as against an increase of Rs.25,475 crore during the corresponding period of the previous year. NFEA, adjusted for revaluation, increased by Rs.42,544 crore as compared with an increase of Rs.30,077 crore during the corresponding period of the previous year. The ratio of NFEA to currency increased from 156.3 per cent on March 31 to 160.0 per cent by October 20, 2006.

15. While daily injections under the LAF averaged Rs.11,686 crore during January-March, 2006, the Reserve Bank absorbed Rs.51,490 crore under the LAF on a daily average basis during April-June, 2006 and Rs.36,857 crore in July-September, 2006 with the absorption moderating to Rs.12,956 crore in October (up to October 27, 2006). Additional liquidity amounting to Rs.12,342 crore was absorbed under the market stabilisation scheme (MSS) during 2006-07 up to October 27, 2006. The balances under the MSS increased from Rs.29,000 crore on March 31, 2006 to Rs.41,342 crore by October 27, 2006. On the other hand, the cash balances of the Centre with the Reserve Bank declined from an average of Rs.40,981 crore during January-March, 2006 to Rs.9,569 crore in April-June, 2006 before picking up to Rs.16,029 crore in July-September, 2006 and further to Rs.27,696 crore in October, 2006 (up to October 23, 2006). The average liquidity overhang as reflected in outstandings under the LAF, MSS and surplus cash balances of the Central Government, taken together, increased from Rs.74,334 crore in March, 2006 to Rs.89,786 crore in April-June, 2006 and further to Rs.92,354 crore in July-September, 2006 before declining to Rs.85,196 crore in October, 2006 (up to October 23, 2006).

16. Inflation, measured by variations in the wholesale price index (WPI) on a year-on-year basis, eased from its recent peak of 5.5 per cent on June 17, 2006 to 5.3 per cent by October 14, 2006. On an average basis, annual inflation based on the WPI was 4.5 per cent as on October 14, 2006 as compared with 5.3 per cent a year ago.

17. Disaggregating the movements in year-on-year inflation, it is observed that prices of primary articles (weight: 22.0 per cent in the WPI basket) increased by 7.3 per cent as on October 14, 2006 as compared with an increase of 4.1 per cent a year ago. The rise in prices of primary articles was mainly under food articles and minerals. Prices of manufactured products (weight: 63.8 per cent) increased by 4.4 per cent as compared with 2.8 per cent a year ago. In the category of manufactured products, deceleration/decline in the prices of wood and leather products, chemicals, basic metals and alloys, machinery and transport equipment softened the effects of sharp increases in the prices of paper, non-metallic mineral products, food products, rubber and plastic products.

18. The annual increase in prices of the ‘fuel, power, light and lubricants’ group (weight: 14.2 per cent) at 5.2 per cent as on October 14, 2006 was lower than 10.9 per cent a year ago. Excluding the fuel group, inflation was at 5.3 per cent (3.1 per cent a year ago), the same as headline inflation. The average price of the Indian ‘basket’ of international crude was at around US $ 67.9 per barrel during July-September, 2006 comparable to US $ 67.3 in April-June, 2006 but much higher than US $ 58.5 in July-September, 2005. In the recent period, however, there has been some easing of crude oil prices in the international markets and the average Indian basket crude price has come down to US $ 58.9 per barrel as on October 27, 2006.

19. On a year-on-year basis, inflation based on the consumer price index (CPI) for urban non-manual employees, agricultural labourers and rural labourers showed sharp increase to 6.6 per cent, 7.3 per cent and 7.0 per cent in September 2006 from 4.8 per cent, 3.2 per cent and 3.2 per cent, respectively, a year ago. The year-on-year CPI inflation for industrial workers was also placed far higher at 6.3 per cent in August 2006 as against 3.5 per cent a year ago. The relatively higher increase in consumer prices vis-à-vis WPI inflation needs to be viewed in the context of the rise in prices of food articles which have a relatively higher weight in the CPI than in the WPI.

20. Revenue receipts of the Union Government as a proportion to the budget estimates (BE) improved from 23.1 per cent in April-August, 2005 to 26.4 per cent in April-August, 2006 reflecting both higher tax and non-tax revenue receipts. Total expenditure at 35.5 per cent of the BE was higher than 33.2 per cent of the BE in April-August, 2005. Non-Plan expenditure at 37.4 per cent was higher mainly on account of food and fertiliser subsidy and increased interest payments. Accordingly, as a proportion to the BE, the gross fiscal deficit (GFD) and revenue deficit increased to 61.0 per cent and 93.7 per cent, respectively, during April-August, 2006 as compared with 57.1 per cent and 78.0 per cent in the corresponding period last year.

21. The gross borrowings of the Central Government at Rs.98,000 crore (Rs.84,000 crore a year ago) through dated securities during 2006-07 so far (up to October 27, 2006) constituted 63.2 per cent of the BE while net market borrowings at Rs.62,986 crore (Rs.51,370 crore a year ago) constituted 54.3 per cent of the BE. The weighted average yield and weighted average maturity of Central Government securities issued during 2006-07 so far (up to end-October 2006) were 7.92 per cent and 14.09 years, as compared with 7.34 per cent and 16.90 years, respectively, for those issued during 2005-06. All issuances during the current financial year, except three, were reissuances reflecting efforts towards consolidation of public debt and imparting liquidity to the Government securities market. As against the provisional net allocation of Rs.17,277 crore (gross Rs.23,828 crore) for their market borrowing programme, the State Governments have raised a net amount of Rs.3,669 crore (gross Rs.8,595 crore) up to October 27, 2006.

22. Financial markets continued to remain stable and orderly in the second quarter of 2006-07 although interest rates have firmed up in almost all segments. From mid-September 2006, reduction in liquidity with the banking system on account of sizeable tax outflows and build-up of the Centre’s cash balances was reflected in a sharp drop in the daily volumes of funds offered at the LAF auctions and transient spikes in overnight rates. Liquidity conditions improved in the subsequent weeks with the return flow of tax collections and drawdown of cash balances. Interest rates in the call, market repo and collateralised borrowing and lending obligations (CBLO) segments of the money market averaged 6.73 per cent, 6.40 per cent and 6.26 per cent, respectively, in October (up to October 27, 2006) as compared with 6.58 per cent, 6.17 per cent and 6.19 per cent in March 2006.

23. The primary yields on 91-day Treasury Bills increased to 6.65 per cent on October 27, 2006 from 5.41 per cent at end-April, 2006. Yields on 364-day Treasury Bills recorded a rise to 6.99 per cent up to October 27, 2006 from 5.90 per cent at end-April, 2006. The outstanding amount of CP was Rs.24,419 crore by end-September, 2006 as compared with Rs.12,718 crore at end-March, 2006. The weighted average discount rate on CP declined to 7.70 per cent from 8.59 per cent over this period. In the market for certificates of deposit (CDs), the weighted average discount rate declined from 8.62 per cent at the end of March, 2006 to 7.74 per cent by mid-September, accompanied by an increase of 46.6 per cent in the outstanding amount (i.e., from Rs.43,568 crore to Rs.63,864 crore).

24. In the foreign exchange market, there was improvement in activity in the spot segment from the last week of July, 2006 with two-way movements in the spot exchange rate. Forward premia increased during the second quarter of 2006-07. The average six-month forward premium increased from 1.04 per cent in July, 2006 to 1.51 per cent in October, 2006 (up to October 26). The turnover in the inter-bank as well as merchant segments of the foreign exchange market during the second quarter of 2006-07 was higher than in the corresponding period of 2005-06. While the inter-bank turnover increased from US $ 234 billion (monthly average) during the second quarter of 2005-06 to US $ 339 billion in the second quarter of 2006-07, the merchant turnover increased from US $ 94 billion to US $ 131 billion. The ratio of inter-bank to merchant turnover was 2.6 during the second quarter of 2006-07, the same as a year ago.

25. The yield on Government securities with one-year residual maturity moved up from 6.20 per cent at end-April, 2006 to 7.02 per cent as on October 27, 2006. The yield on Government securities with 10-year residual maturity also firmed up from 7.39 per cent at end-April, 2006 to 7.62 per cent as on October 27, 2006. The yield on Government securities with 20-year residual maturity rose from 7.80 per cent to 7.93 per cent during the same period. The yield spread between 10-year and one-year Government securities narrowed down from 119 basis points to 60 basis points as on October 27, 2006. The yield spread between 20-year and one-year Government securities narrowed down from 160 basis points to 91 basis points during the same period.

26. During April-October, 2006 public sector banks (PSBs) raised their deposit rates across various maturities by 50-75 basis points. Interest rates offered by PSBs for deposits up to one year maturity increased from a range of 2.25-6.50 per cent to 2.75-7.00 per cent. Similarly, deposit rates for over one to three years maturity increased from 5.75-6.75 per cent to 6.25-7.50 per cent and, for above three years maturity, they increased from 6.00-7.25 per cent to 6.50-8.00 per cent over the same period. The adjustments in rates on term deposits made by private sector banks and foreign banks were somewhat mixed. While their maximum deposit rates increased by 50-175 basis points, their minimum deposit rates declined by 50-150 basis points for some maturities.

27. The benchmark prime lending rates (BPLRs) of PSBs and private sector banks increased to a range of 11.00-12.00 per cent and 11.50-15.00 per cent from 10.25-11.25 per cent and 11.00-14.00 per cent, respectively, during April-October, 2006. The range of BPLR for foreign banks remained, however, unchanged at 10.00-14.50 per cent. During the current year, the weighted average BPLR of PSBs increased from 10.71 per cent in March to 11.18 per cent in June and further to 11.33 per cent in September. The weighted average BPLRs of private sector banks also increased from 12.37 per cent in March to 12.80 per cent in June and 12.89 per cent in September. The weighted average BPLRs of foreign banks remained stable at around 12.66 per cent during the period.

28. During the second quarter of 2006-07, equity market activity recorded a pick-up in terms of issuances in the domestic primary segment as well as in international stock exchanges. The BSE Sensex rose from 11,280 in end-March, 2006 to reach a peak of 12,612 on May 10, 2006 before receding to 8,929 on June 14, 2006. Thereafter, banking on robust macroeconomic fundamentals and high private corporate profitability, it rallied with intermittent corrections in the successive months to reach 12,907 on October 27, 2006.