Third Quarter Review of RBI Monetary Policy 2008-09
I. Macroeconomic and Monetary Developments
5. The global economic environment continues to be uncertain. The world economy, which was passing through unprecedented financial turmoil since August 2007, experienced a jolt in September 2008 when the failure of Lehman Brothers led to widespread panic across global financial markets. The liquidity crisis that ensued not only engulfed developed markets but also quickly transmitted to emerging markets, including India. The US Federal Reserve responded by infusing dollar liquidity into large financial centres through currency swap arrangements with major foreign central banks in addition to massive injection of liquidity in the domestic market through several innovative schemes.
6. Many systemically important commercial banks, investment banks, insurance companies and other financial institutions in the US and Europe have suffered large losses that undermined their capital bases. The credit spreads for corporate paper went up sharply. The US Federal Reserve and other central banks/governments have rescued financial institutions through large bailout packages, but financial markets continue to suffer from a crisis of confidence. The unfolding developments have broader ramifications for both growth and stability in an integrated world where cross-exposures, particularly among banks/financial institutions, and trade links are inextricably large and complex. There is yet no sign of any early resolution as damage to collaterals continues unabated with house prices tumbling in the US and also in parts of Europe.
7. According to the November 2008 update of the World Economic Outlook (WEO) issued by the International Monetary Fund (IMF), global real GDP growth, on a purchasing power parity basis, is projected to decelerate from 3.7 per cent in 2008 to 2.2 per cent in 2009. In market exchange rate terms, the projected deceleration is even sharper from 2.6 per cent in 2008 to 1.1 per cent in 2009. Furthermore, the IMF has cautioned that the downside risks to these global growth projections have further intensified.
8. The US, the UK, the Euro area and Japan, which together accounted for nearly half of world GDP in 2007, are officially in recession. All evidence suggests that contractionary forces are strong: demand has slumped, consumer confidence is at a historic low, production has declined, job losses are on the rise and asset prices continue to fall. Reflecting the slowdown of international demand, crude oil prices declined sharply in the last quarter of 2008. Prices of many other key commodities such as metals, cement, cotton and wheat too have dropped sharply. Consequently, consumer price inflation has declined significantly in many countries including the US, the Euro area, Japan and the UK. The international financial system continues to remain dysfunctional amidst extreme risk aversion, freezing of money and credit markets, and disruption of international capital flows. In response, central banks in advanced countries have reduced their policy interest rates to historically low levels. The major global concern now is to forestall the worst ever recession since the 1930s. While monetary ammunition has been nearly exhausted in many countries, at least in terms of setting nominal interest rates, measures such as quantitative easing, credit easing and fiscal stimulus are on the policy agenda.
Emerging Market Economies
9. The emerging market economies (EMEs), which showed considerable resilience in weathering the crisis up to September 2008 on the strength of domestic demand supported by sustained export growth, came under strain in the last quarter of 2008 through contagion from trade and financial channels. The slowdown of world trade was deeper than anticipated causing reduction in aggregate demand in the EMEs. In a sign of flight to safety, capital flows from developed countries to the EMEs declined sharply in 2008. Reflecting lower flows through both current and capital accounts, currencies of the EMEs depreciated against the US dollar. EME equity markets suffered large losses in the wake of reversal of portfolio flows. Bank lending to the EMEs declined and credit spreads increased sharply due to the prevailing credit crunch in advanced economies. EME exports declined because of tighter trade credit coming on top of slumping export demand. Going forward, exports to advanced economies are expected to decline further posing a major risk to growth in the EMEs.
10. In evaluating the current and potential problems arising from the crisis, it is important to note some broad differences between the advanced economies of Europe and North America and the EMEs. The crisis originated in the financial sector in the US, which led to the near collapse of their largest financial institutions and banks. Because of linkages across the financial system, the crisis spread almost immediately to Europe with European banks reporting very large losses. Both the US and European governments responded through large scale infusion of funds into the banking systems. Furthermore, with the erosion of banks’ balance sheets, mistrust among banks intensified, as a result of which money markets dried up, and inter-bank markets choked. This engendered a credit squeeze which transmitted to the real economy. The first line of defence in fighting the crisis was aggressive monetary policy action, including rate cuts followed by quantitative monetary and credit easing. These measures were also accompanied by a significant expansion of central banks’ direct participation in money markets in several ways.
11. The situation in the EMEs has been quite different. By and large, their financial institutions have not exhibited fragility, inter-bank confidence has been relatively normal and inter-bank money markets have continued to function. Nevertheless, the crisis has affected the EMEs in mainly three ways. The first was the exit of foreign equity which resulted in decline in stock markets, capital flow reversals and pressures on the exchange rate. The second source of impact was the drying up of overseas lines of credit for banks and corporates which shifted demand to the domestic credit market. The third source of impact is the significant deceleration in global trade growth reducing the demand for EME exports. Monetary policy actions by the EMEs have, therefore, been more in response to emerging real economy problems rather than financial sector problems. It is important to keep this distinction in view in designing and evaluating responses to the crisis.
12. Like other EMEs, India too has been affected by the global financial crisis. Real GDP growth moderated to 7.8 per cent in the first half of 2008-09 as against 9.3 per cent in the first half of 2007-08 (Table 1). The third quarter of 2008-09 witnessed signs of further moderation in growth, especially in the industrial sector and some segments of the services sector.
Agriculture and Industry
13. Good sowing and favourable weather conditions suggest that agricultural production during 2008-09 may be close to or better than last year’s record production. During April-November 2008, the index of industrial production (IIP) growth decelerated to 3.9 per cent from 9.2 per cent a year ago. Episodes of large inventory build-up, production cuts and temporary closure in some sectors such as automobiles at the beginning of the second half of 2008-09 indicate a period of stress on account of lack of demand.
14. During the first two quarters of 2008-09, despite high top-line growth, operating margins of the private corporate sector were eroded by higher input costs and significant drop in ‘other’ income. In light of the subsequent slowdown, industrial investment plans are slowing down, although ongoing investment projects appear to be continuing. The erosion in pricing power of corporates was reflected in rising inventories as a proportion to sales. While the downside risk to corporate profitability has increased, this may at least be partly offset by falling input prices and a gradual reduction in borrowing costs.
15. The Reserve Bank’s latest round of quarterly Industrial Outlook Survey shows weak and deteriorating business sentiment among private manufacturing companies for the last quarter of 2008-09. The survey indicates weak demand conditions and decline in sentiment for production, order books, capacity utilisation and exports. Corporates also reported a significant decline in employment expectations for January-March 2009. This picture is consistent with business confidence surveys conducted by other agencies.
16. In terms of lead indicators, service sector activity appears to be moderating in several sub-sectors, barring communications and freight movement. On the positive side, sustained performance of the agricultural sector, fiscal stimulus, falling global crude oil prices and softening of domestic input prices such as energy, cement and steel would have a positive impact on industrial production in the coming months.
17. Headline inflation, as measured by year-on-year variations in the wholesale price index (WPI), fell by more than half from its intra-year peak of 12.91 per cent on August 2, 2008 to 5.60 per cent by January 10, 2009. While prices of primary articles and manufactured products increased, fuel prices declined (Table 2). In terms of relative contribution to decelerating headline inflation between August 2, 2008 and January 10, 2009, petroleum and basic metals (combined weight of 13.2 per cent in WPI) together accounted for 79.4 per cent, followed by ‘oilseeds, edible oils & oil cakes’ (16.4 per cent). Clearly, the fall in commodity prices reflecting global trends has been the key driver of the sharp fall in WPI inflation although effective management of domestic demand too has contributed to this moderation.
18. On the other hand, inflation based on various consumer price indices (CPIs) is still in double digits due to the firm trend in prices of food articles and the higher weight of food articles in measures of consumer price inflation (Table 2). As the decline in input prices percolates over time to the prices of manufactured and other products, consumer price inflation too is expected to soften in the months ahead. For its overall assessment of inflation outlook for policy purposes, the Reserve Bank continues to monitor the full array of price indicators.
19. As a proportion of the budget estimates (BE), both tax and non-tax revenue receipts of the Central Government for the period April-November 2008 were lower than those in the corresponding period of the previous year. On the other hand, both revenue expenditure and total expenditure, as a proportion to the BE, were higher than a year ago. Consequently, the revenue deficit and the gross fiscal deficit (GFD) were significantly higher during April-November 2008 as compared with the corresponding period of the previous year
20. For 2008-09, the Central Government had budgeted gross market borrowing of Rs.1,78,575 crore and net market borrowing of Rs.99,000 crore. Subsequently, the Government presented two supplementary demands, as a result of which the market borrowing programme of the Central Government was raised to Rs.2,52,154 crore (gross) and Rs.1,75,374 crore (net). Against this enhanced borrowing programme, market borrowing of the Central Government was Rs.2,22,154 crore (gross) and Rs.1,51,697 crore (net) during 2008-09 so far (up to January 23, 2009). The weighted average yield and weighted average maturity of central government dated securities issued during 2008-09 (up to January 23, 2009) were at 8.03 per cent and 14.59 years respectively as compared with 8.10 per cent and 14.38 years in 2007-08. The State Governments have borrowed a net amount of Rs.46,327 crore up to January 23, 2009.
21. The evolving scenario raises some concerns on the extent of stress on the fisc in the current year emanating from several factors. First, the Centre is expected to suffer revenue losses from lower direct tax collection on account of the economic slowdown. Second, the Centre is likely to lose further revenues worth about 0.6 per cent of GDP due to cuts in excise and customs duties. Third, there has been a disproportionate growth in expenditure of the Central Government during April-November 2008, particularly in respect of revenue expenditure arising out of increase in subsidies, disbursements as well as implementation of the recommendations of the Sixth Pay Commission and the farm debt waiver scheme. The net cash outgo indicated in supplementary demands for grants would be of the order of 2.8 per cent of GDP (Rs.1,50,310 crore). Thus, additional expenditure coupled with foregone revenue would raise the fiscal deficit from the budget estimate of 2.5 per cent to at least 5.9 per cent of GDP. In addition, special bonds for Rs.44,000 crore and Rs.14,000 crore, amounting to 1.1 per cent of GDP, have been issued to oil marketing companies and fertiliser companies respectively during 2008-09 (up to January 23, 2009). In its latestReview of the Economy (January 2009), the Economic Advisory Council to the Prime Minister has placed the consolidated fiscal deficit of the Central Government, including full issuances of oil and fertiliser bonds, at 8.0 per cent of GDP for 2008-09.
22. The consolidated budgeted revenue surplus of the States in 2008-09 may not, in fact, materialise. Consequently, the consolidated fiscal deficit of the States is expected to rise to 2.6 per cent of GDP. While some of the increase in the revenue and fiscal deficits is on account of post-budget expenditure commitments such as payment of arrears resulting from the Sixth Pay Commission Award, a substantial increase is also due to the economic downturn arising from the impact of the global financial crisis. Although the fiscal stimulus packages have meant deviation from the roadmap laid out by the Fiscal Responsibility and Budget Management (FRBM) Act, reversing the consolidation process of the last several years, they were warranted under the prevailing circumstances. It is critically important, however, that the Centre and States re-anchor to a revised FRBM mandate once the immediacy of the crisis is behind us.
23. Growth in key monetary aggregates – reserve money and money supply (M3) – in 2008-09 so far has reflected the changing liquidity positions arising from domestic and global financial conditions and the monetary policy response to the evolving macroeconomic developments. Reserve money variations during 2008-09 have largely reflected increase in currency in circulation and reduction in the cash reserve ratio (CRR) of banks.
24. Reduction in the CRR has three inter-related effects on reserve money. First, it reduces reserve money as bankers’ required cash deposits with the Reserve Bank fall. Second, the money multiplier rises. Third, with the increase in the money multiplier, M3expands with a lag. While the initial expansionary effect is strong, the full effect is felt in 4-6 months. Reflecting these changes, while the year-on-year increase in reserve money as on January 2, 2009 was lower, it was significantly higher when adjusted for the first round effect of CRR reduction. The annual M3 growth as on January 2, 2009 though lower compared with last year, was higher than the trajectory projected in the Annual Policy Statement
25. Since September 2008, monetary conditions have been evolving following changes in monetary policy in response to global developments and also due to slackening of domestic demand conditions. As the Reserve Bank had to provide dollar liquidity, its net foreign exchange assets (NFEA) contracted. The Reserve Bank sought to compensate the fall in NFEA by expanding its net domestic assets (NDA) through: (i) buy-back of securities held under the market stabilisation scheme (MSS); (ii) purchase of oil bonds; (iii) enlargement of the refinance window; and (iv) repo operations under the liquidity adjustment facility (LAF). Thus, a notable feature of monetary operations during the third quarter of 2008-09 was the substitution of foreign assets by domestic assets to keep the overall liquidity conditions comfortable. Liquidity conditions have indeed improved since mid-November 2008 as reflected in daily absorption under the LAF reverse repo and moderation in market interest rates.
26. The year-on-year (y-o-y) growth in non-food bank credit at 23.9 per cent as on January 2, 2009 was higher than that of 22.0 per cent as on January 4, 2008 (Table 5). Increase in total flow of resources from the banking sector to the commercial sector (i.e., non-food bank credit together with investments in shares/bonds/debentures and commercial papers issued by public sector/private sector companies) was also higher at 23.4 per cent as compared with 21.7 per cent a year ago. Despite the expansion in bank credit, there was a perception of lack of credit availability. This could be attributed to reduced flow of funds from non-bank sources, notably the capital market and external commercial borrowings.
27. During 2008-09 so far, the total flow of resources to the commercial sector from banks and other sources was marginally lower than in the previous year reflecting contraction of funds from other sources
28. At a disaggregated level, the year-on-year increase in bank credit to industry as of December 2008 was sharply higher than that in the previous year reflecting the substitution effect of other sources of funding by bank credit
29. There has been a noticeable variation in credit expansion across bank groups. Expansion of credit by public sector banks was much higher this year than in the previous year, while credit expansion by foreign and private sector banks was significantly lower. The relatively slower pace of credit expansion by foreign and private sector banks has also added to the perception of inadequate credit flow in the system. There has also been perceptible deceleration in growth of deposits with private and foreign banks
30. Commercial banks’ holdings of SLR securities became more liquid on account of two factors. First, banks were permitted to use SLR securities to the tune of 1.5 per cent of their net demand and time liabilities (NDTL) under the LAF to meet the funding requirements of mutual funds, non-banking finance companies (NBFCs) and housing finance companies (HFCs). Second, the reduction in SLR by one percentage point to 24.0 per cent of NDTL in November 2008 released funds for credit deployment. Commercial banks’ SLR holdings declined from 27.8 per cent (28.4 per cent adjusted for LAF) of NDTL in March 2008 to 25.8 per cent (28.1 per cent adjusted for LAF) in mid-October 2008 reflecting the banks’ reliance on the repo facility under the LAF as liquidity conditions tightened. Reversing this trend by early January 2009, banks’ SLR holdings increased to 28.9 per cent of NDTL (27.1 per cent adjusted for LAF) reflecting improved liquidity conditions and increased government market borrowings.
31. Bank deposit and lending rates, which had firmed up during the current financial year up to October 2008, started easing from November 2008. Between November 2008 and January 2009, all public sector banks, several private sector banks and some foreign banks reduced their deposit and lending rates. The magnitude of reduction by public sector banks was larger than that by foreign and private sector banks
32. The interest rate response to monetary policy easing has been faster in the money and bond markets as compared to the credit market because of several structural factors. First, the administered interest rate structure on small savings could potentially constrain the reduction in deposit rates below some threshold. Second, a substantial portion of bank deposits is mobilised at fixed interest rates with an asymmetric contractual relationship. During the upturn of the interest rate cycle, depositors have the flexibility to prematurely terminate the existing deposits and re-deposit the funds at higher interest rates. However, in the downturn of the interest rate cycle, banks have to necessarily carry these deposits at higher rates of interest till their maturity. Third, competition among banks for wholesale deposits for meeting the higher credit demand in the upswing leads to an increase in the cost of funds. Fourth, linkage of concessional lending rates to banks’ BPLRs makes overall lending rates less flexible. Fifth, persistence of the large market borrowing programme of the government hardens interest rate expectations. Sixth, with increase in risk aversion, lending rates tend to be high even during a period with falling credit demand. From the real economy perspective, however, for monetary policy to have demand inducing effects, lending rates will have to come down.
33. Notwithstanding the various factors that impede monetary transmission, market interest rates do respond to changes in policy interest rates. As such, current deposit and lending rates have significant room for further reduction. Interest rates in the money and bond markets have already declined perceptibly since their peaks in October 2008 (Table 10). Major public sector banks have also reduced their term deposit rates in the range of 50-150 basis points. Benchmark prime lending rates (BPLRs) of major public sector banks have come down by 150-175 basis points. Major private sector banks have reduced their BPLRs by 50 basis points, while major foreign banks are yet to do so. As a result of several measures initiated by the Reserve Bank since mid-September 2008, banks’ cost of funds would come down. This should encourage banks to reduce their lending rates in the coming months.
34. The overnight interest rates generally ruled above the ceiling of the LAF rate corridor at the beginning of October 2008 when the domestic money and foreign exchange markets came under pressure. The overnight interest rates eased in mid-October 2008 in response to the successive monetary easing measures by the Reserve Bank which alleviated the liquidity pressures. The overnight interest rates have remained below the upper bound of the LAF corridor since November 3, 2008. Interest rates on various other segments of the money market and government securities market have also softened markedly
35. The rupee had appreciated against major currencies in 2007-08 due to large capital inflows. It depreciated during 2008-09 so far reflecting extraordinary developments in international financial markets and portfolio outflows by foreign institutional investors (FIIs). It has remained range-bound since November 2008
36. Equity markets weakened sharply till end-October 2008 in tandem with global stock markets, particularly Asian markets, reflecting further deterioration in the global financial market sentiment, FII outflows, slowdown in industrial growth and lower corporate profits. The BSE Sensex declined from an all-time high of 20873 on January 8, 2008 to a low of 8451 on November 20, 2008. The equity market has since remained generally range-bound; the BSE Sensex was at 8674 on January 23, 2009.
37. The outlook for the domestic financial markets will be determined largely by the developments in global financial markets and domestic liquidity conditions. The banking system has been in surplus liquidity mode since mid-November 2008. The pressure on the exchange rate of the rupee has eased due to moderation in capital outflows. In addition, the decline in global commodity prices, particularly crude oil, is expected to further ease the pressure on foreign currency on account of oil imports.
38. India’s current account deficit (CAD) of the balance of payments (BoP) widened in the first half of 2008-09 in comparison with the corresponding period of the previous year due to a large trade deficit, reflecting high oil prices even as private transfers and software export earnings were sustained. As net capital flows declined sharply, the overall balance of payments position turned marginally negative during the first half of 2008-09 as against a large surplus in the corresponding period of the previous year (Table 12). Import growth had moderated during October-November 2008 reflecting the fall in international oil prices and slowing domestic demand. During the same period, export growth turned negative reflecting slowing global demand. Going forward, it is expected that imports may slow down faster than exports.
39. The reversal of capital flows has raised concerns about management of the BoP, particularly with reference to outstanding external debt with residual maturity of less than one year. These concerns are somewhat misplaced as the following analysis will show.
40. India’s external debt with residual maturity of less than one year as at end-March 2008 was estimated at around US $ 85 billion (as per revised data), which would mature during the financial year 2008-09. Sovereign debt and commercial borrowings are most likely to be rolled over during 2008-09. Indeed, the BoP data for the first half of the year (April-September 2008) indicate net positive accretions beyond roll-over under both these heads. Current trends indicate that under NRI deposits, not only will the maturing debt be rolled over but there will be net accretions as a result of the upward adjustment in interest rate ceilings on such deposits. Here again, available data up to December 2008 show net accretions. That leaves trade credit of the order of US $ 43.2 billion to be repaid during 2008-09. Of this, as much as US $ 28.1 billion has already been disbursed during April-November 2008 leaving a balance of US $ 15.1 billion. There are reports that large inflows are in the pipeline on account of commitments of buyers’ credit by the importers and oil companies. Even conservatively projecting that only a small portion of this balance would be rolled over, India’s external payment situation remains stable.
41. 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. As capital inflows during 2007-08 were far in excess of the normal absorptive capacity of the economy, there was substantial accretion to foreign exchange reserves by US $ 110.5 billion. The foreign exchange reserves declined by US $ 23.4 billion from US $ 309.7 billion as at end-March 2008 to US $ 286.3 billion by end-September 2008 largely reflecting valuation effects. Excluding valuation effects, the decline was US $ 2.5 billion. Between October 2008 and January 16, 2009 foreign exchange reserves declined by US $ 34.1 billion to US $ 252.2 billion, including valuation effects. India’s current level of foreign exchange reserves remains comfortable.
42. At the heart of the global financial crisis lie the non-functional and frozen financial markets. In sharp contrast to their international counterparts, the financial system in India has been resilient and stable. Barring some tightness in liquidity during mid-September to early October, the money, foreign exchange and government securities markets have been orderly as reflected in market rates, spreads and transaction volumes relative to those observed during normal times. India’s banking system remains healthy, well-capitalised, resilient and profitable. Credit markets have been functioning well and banks have been expanding credit, notwithstanding the perceptions in some quarters of lack of adequate credit from the banks to the commercial sector.
43. Over the last five years, India clocked 8.8 per cent average annual growth, driven largely by domestic consumption and investment even as the share of net exports rose. While the benign global environment, easy liquidity and low interest rates helped, at the heart of India’s growth have been its growing entrepreneurial spirit and rise in productivity. These fundamental strengths continue to be in place. Nevertheless, the global crisis will dent India’s growth trajectory as investments and exports slow. Clearly, there is a period of painful adjustment ahead of us. However, once the global economy begins to recover, India’s turnaround will be sharper and swifter, backed by our strong fundamentals and the untapped growth potential. Meanwhile, the challenge for the Government and the Reserve Bank is to manage the adjustment with as little pain as possible.
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