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

Developments in the External Sector

29. Balance of payments data for the first quarter of 2006-07 released at the end of September, 2006 continue to reflect vibrancy and strength in the external sector of the economy. Merchandise export growth at 17.0 per cent was led by manufactures such as chemicals and related products, engineering goods including machinery and instruments, transport equipment, manufactures of metals and petroleum products. Merchandise imports increased by 23.8 per cent mainly on account of a growth of 44.9 per cent in oil imports on the back of a year-on-year rise of 35.5 per cent in average international crude prices facing India. Non-oil imports excluding gold and silver rose by 17.3 per cent during April-June, 2006 led by imports of industrial inputs and capital goods. Accordingly, on a payments basis, the merchandise trade deficit increased to US $ 18.5 billion during April-June, 2006 from US $ 13.6 billion in the corresponding quarter last year. The buoyancy of software exports, remittances from Indians working overseas and various professional and business services enabled an increase in net invisible earnings to US $ 12.4 billion from US $ 10.0 billion a year ago. Invisible payments rose by 21.9 per cent and, coupled with the wider trade deficit, resulted in a current account deficit (CAD) of US $ 6.1 billion which was higher than the CAD of US $ 3.6 billion in the corresponding quarter a year ago.

30. Net capital inflows during April-June, 2006 at US $ 11.9 billion were supported by both debt and non-debt inflows. Foreign direct investment flows increased to US $ 1.7 billion from US $ 1.2 billion a year ago. Debt flows (net) in the form of external assistance, external commercial borrowings, non-resident deposits and short-term credit increased to US $ 5.2 billion in April-June, 2006 from US $ 1.0 billion a year ago. While net external commercial borrowings amounted to US $ 3.6 billion as compared with US $ 1.1 billion a year ago, non-resident Indian (NRI) deposits increased by US $ 1.2 billion in contrast to an outflow of US $ 0.1 billion a year ago. In the wake of stock market turbulence in May, 2006 there was a marginal outflow of US $ 0.5 billion in portfolio investment during April-June, 2006.

31. Net accretion to foreign exchange reserves, excluding valuation changes, amounted to US $ 6.4 billion during April-June, 2006. Valuation gains, reflecting the appreciation of major currencies against the US dollar, accounted for a rise of US $ 4.9 billion in total reserves as against a valuation loss of US $ 4.3 billion in the corresponding period last year. The foreign exchange reserves, including valuation changes, thus recorded an increase of US $ 11.3 billion during this period as against a decline of US $ 3.1 billion a year ago.

32. These early developments seem to have been extended into the second quarter of 2006-07. According to the Directorate General of Commercial Intelligence and Statistics (DGCI&S), exports increased by 22.9 per cent in US dollar terms during April-September, 2006 as compared with 34.1 per cent in the corresponding period of the previous year. Imports rose by 19.0 per cent as against an increase of 46.6 per cent in the corresponding period last year. While the oil import bill increased by 36.8 per cent, reflecting the hardening of international crude oil prices (prior to the recent softening), non-oil import growth decelerated to 11.0 per cent from 48.5 per cent in the corresponding period last year. The slowing down of non-oil import growth mainly reflects a sharp decline of 30.3 per cent in imports of gold and silver during the first quarter of 2006-07 as against an increase of 52.1 per cent a year ago. Available information for subsequent months of 2006-07 indicate that the decline in bullion imports has continued. The overall trade deficit during April-September, 2006 widened to US $ 24.6 billion from US $ 22.3 billion a year ago. Net FII outflows of US $ 1.8 billion in the first quarter of 2006-07 were recouped and net inflows amounting to US $ 1.7 billion were recorded in the second quarter. Net inflows on account of FIIs continued in October. FDI inflows rose to US $ 4.0 billion during April-August, 2006 – nearly 62 per cent higher than the inflow registered in the corresponding period last year. Net capital flows and resilient invisibles financed the trade deficit resulting in the foreign exchange reserves increasing to US $ 166.2 billion on October 20, 2006 up from US $ 151.6 billion at end-March, 2006 (including valuation effects).

33. The Indian foreign exchange market has generally witnessed orderly conditions during the current financial year so far with the exchange rate exhibiting two-way movements. The exchange rate of the rupee, which was Rs.44.61 per US dollar at end-March, 2006 depreciated to Rs.46.95 per US dollar by July 19, 2006 but strengthened to Rs.45.22 per US dollar by October 27, 2006. Similarly, the rupee depreciated to Rs.59.88 per euro on August 7, 2006 from Rs.54.20 at end-March, 2006 but subsequently appreciated to Rs.57.34 by October 27, 2006. Overall, the rupee depreciated by 1.4 per cent against the US dollar, by 5.5 per cent against the euro, by 9.0 per cent against the pound sterling and by 0.5 per cent against the Japanese yen during the current financial year so far (up to October 27, 2006).

34. The exchange rate policy in recent years has been guided by the broad principles of careful monitoring and management of exchange rates with flexibility, without a fixed target or a pre-announced target or a band, coupled with the ability to intervene, if and when necessary. The overall approach to the management of India’s foreign exchange reserves takes into account the changing composition of the balance of payments and endeavours to reflect the ‘liquidity risks’ associated with different types of flows and other requirements.