Mid-Term Review of the Annual Policy Statement for 2008-09, RBI Credit Policy, Reserve Bank of India: Banknet India

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Mid-Term Review of the Annual Policy Statement for 2008-09

Part A-Mid-term Review of the Annual Statement on Monetary Policy for the Year 2008-09

I. Assessment of Macroeconomic and Monetary Developments during the First Half of 2008-09

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Developments in the Global Economy

63. Following the incidents of bailout and default in September, the 3-month US Treasury bill rate fell to 0.0304 per cent on September 17, 2008 - the lowest since 1954 - indicating flight to quality assets such as Treasuries and illiquid repo market conditions. Contagion from the faltering US markets prompted co-ordinated emergency liquidity actions by major central banks on September 18, 2008 and the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, the Bank of Japan and the Swiss National Bank announced co-ordinated measures designed to address the continued elevated pressures in US dollar short-term funding markets. These included the Federal Open Market Committee (FOMC) authorising an expansion of its existing swap lines with the European Central Bank and the Swiss National Bank and institution of new swap facilities with the Bank of Japan, the Bank of England, and the Bank of Canada who could then provide their respective commercial banks with short-term dollar funding. Similar swap lines were established with the Reserve Bank of Australia, the Danmarks Nationalbank, the Norges Bank and the Sveriges Riksbank on September 24, 2008. Later, the FOMC authorised increases in the size of its temporary swap facilities with the Bank of England, the European Central Bank and the Swiss National Bank till April 30, 2009 so that these central banks can provide US dollar funding in quantities sufficient to meet the demand. Central banks also relaxed eligible collateral for liquidity auctions, changed monetary policy operations procedure and varied the auction maturities to enhance their effectiveness. On September 17, the US Securities and Exchange Commission (SEC) banned naked short-selling in any stock, extending the temporary ban adopted on July 16, 2008, to curtail excessive speculation. In the UK, short selling of financial stocks was banned effective September 19, 2008 till January 16, 2009.

64. On September 21, with their share values plummeting, two major US investment banks were allowed by regulators to become Federal Reserve-regulated bank holding companies (BHCs). On September 25, money markets ground to a virtual halt and interbank and repo rates rose to almost record highs. This prompted the US Treasury to announce a plan for a federal fund of US $ 700 billion to clear the bad debt overhang by (i) buying unviable paper to restore liquidity in markets; (ii) allowing orderly restructuring over time without distress sales; (iii) lessening foreclosures; and (iv) helping the Federal Deposit Insurance Corporation (FDIC) in assisting troubled institutions, which was authorised by Congress in early October under the Emergency Economic Stabilization Act. On October 14, 2008 the Board of Governors of the Federal Reserve System, the US Department of the Treasury and the FDIC made a joint statement to protect the US economy, to strengthen public confidence in the financial institutions and to foster the robust functioning of the credit markets through a voluntary capital purchase programme and a temporary FDIC guarantee programme for a broad array of financial institutions. A wave of banking contagion in Benelux, Germany, UK, Spain, Ireland and Iceland required government intervention from late September onwards and some banks were taken into temporary state ownership. The Government in the UK has taken steps for recapitalisation of the UK banking system for stabilising the financial system. The Reserve Bank of Australia and the Reserve Bank of New Zealand have relaxed collateral norms for repo operations. The governments in Australia and New Zealand have announced their decision to guarantee bank deposits.

65. Central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions. In addition to the US dollar swap lines, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, the Sveriges Riksbank and the Swiss National Bank reduced their policy rates by 50 basis points on October 8, 2008. Also, the Bank of Japan expressed its strong support of these policy actions. In order to provide broad access to liquidity and funding to financial institutions, on October 13, 2008 the Bank of England, the European Central Bank, Federal Reserve, the Bank of Japan and the Swiss National Bank jointly announced measures to improve liquidity in short-term US dollar funding markets. As a part of the G-7 action plan, on October 14, 2008 the Bank of Canada announced its intentions to provide exceptional liquidity to the Canadian financial system as long as the situation warrants. The Bank of Japan has increased the frequency and the size of CP repo operations and also broadened the range of eligible collateral.

66. Since December 2007, the Federal Reserve has conducted 21 Term Auction Facility (TAF) auctions amounting to US $ 1,203.3 billion for 28 days maturity each, an auction of US $ 20 billion with 35 days maturity and two auctions of US $ 25 billion each with 84 days maturity and one more auction for 85 days of US $ 138.1 billion up to October 20, 2008. In a bid to ensure continuation of economic growth, the US Treasury has issued fiscal stimulus payments to American households for an amount of about US $ 94 billion during April–September 2008. Also, on August 28, 2008 the Federal Reserve Board announced the launch of an online resource to help consumers make informed choices when refinancing a home loan.

67. Since December 2007, the European Central Bank has conducted 16 overnight US dollar TAF auctions amounting to US $ 880 billion, three auctions of US $ 120 billion of 3 days maturity and one auction of US $ 100 billion of 4 days maturity, two auctions of US $ 206 billion of 7 days maturity, 20 auctions amounting to US $ 460 billion for 28 days maturity each, two auctions of US $ 10 billion each of 84 days maturity and one auction of US $ 20 billion of 85 days maturity up to October 21, 2008. The Bank of Canada has conducted 13 auctions amounting to US $ 35 billion for 28 days and two auctions of US $ 8 billion of 91 days maturity till October 21, 2008. The Swiss National Bank has conducted 24 overnight auctions amounting to US $ 182 billion, three auctions of US $ 15 billion of 7 day maturity, 15 auctions amounting to US $ 87 billion for 28 days each, two 84 days auctions amounting to US 4 billion and an auction of US $ 4 billion for 88 days maturity up to October 22, 2008. Between September 18 and October 22, 2008 the Bank of England has conducted 24 overnight US dollar repo auctions amounting to US $ 312 billion, one 3 days auction for US $ 30 billion, one 6 days auction for US $ 12.5 billion, seven one week auctions of US $ 242 billion and one 28 days auction of US $ 26 billion.

68. Emerging market central banks have also responded in various ways to the events unfolding in the advanced economies. They stepped into money markets in the second half of September 2008 to contain liquidity shocks from the US credit turmoil. Japan, Korea, Taiwan and Australia injected liquidity into the banking systems to help Asian banks which suffered credit losses due to exposure to the troubled US investment banks via hedges and collaterals, and used open market operations to contain declining bond yields and stock prices and stabilise financial market volatility. Monetary policy actions such as reducing required reserves and interest rates to boost liquidity have also been undertaken by some EMEs to stem the financial crisis. The Bank of Korea has introduced a competitive auction swap facility from October 20, 2008 to enhance the effectiveness of foreign currency supply and to promote stability in the foreign currency funding market.

69. On September 30, 2008 the Hong Kong Monetary Authority expanded collateral accepted for accessing the discount window to include US dollar assets of suitable credit quality and waive limitations on using Hong Kong exchange fund paper as collateral. It will extend the duration of funds available on a case-by-case basis and may conduct US/HK dollar swaps with affected banks. All measures have been effective from October 2 and will remain in place until March 2009. On October 14, 2008 the Hong Kong Monetary Authority has taken measures to provide assurance to depositors to use the Exchange Fund to guarantee the repayment of all customer deposits held in authorised institutions in Hong Kong. Secondly, Hong Kong Monetary Authority has established a Contingent Bank Capital Facility for the purpose of making available additional capital to local banks. Both the measures will remain in force until the end of 2010.

70. The Singapore Government has decided to guarantee all Singapore dollar and foreign currency deposits of individual and non-bank customers in banks, finance companies and merchant banks licensed by the Monetary Authority of Singapore until December 2010. Consistent with these regional initiatives, the government of Malaysia and the Bank Negara Malaysia have also guaranteed ringgit and foreign currency deposits with banks and regulated development financial institutions until December 2010. The Bank Negara Malaysia would also extend liquidity facility to non-banks such as insurance companies. For maintaining liquidity in domestic and foreign currency markets on October 14, 2008 Bank Indonesia announced several measures including inter alia extension of foreign exchange swap of tenors ranging from seven days to one month and selling foreign currency reserves through banks for domestic companies. Several central banks in Asia have cut their policy rates in tandem with the advanced economies and have provided assurances of liquidity support to financial markets.

71. The Dow Jones Industrial Average, Standard and Poor’s (S&P) 500 and Nasdaq Composite exhibited considerable volatility and posted declines of 37.2 per cent, 40.5 per cent and 41.3 per cent, respectively, by October 22, 2008 over their levels a year ago. In the fixed income segment, Government bond yields in the major economies, which had firmed up in the first half of 2007, softened thereafter as demand for government debt increased with investors seeking safe haven. The US 10-year bond yield increased from 4.70 per cent at end-December 2006 to 5.29 per cent on June 12, 2007 before falling to 3.60 per cent on October 22, 2008. The 10-year bond yield in the euro area increased from 3.95 per cent at end-December 2006 to 4.67 per cent on July 6, 2007 before falling to 3.80 per cent on October 22, 2008. The Japanese 10-year bond yield has increased from 1.68 per cent at end-December 2006 to 1.97 per cent on July 10, 2007 before falling to 1.53 per cent on October 22, 2008. With the dimming of growth prospects, the EMEs witnessed declines in equity prices and increase in spreads, in various degrees, across countries. The equities sell-off in emerging markets triggered by the US financial meltdown led to a sharp drop in the MSCI Emerging Markets (EM) Index which declined by 52 per cent over the year, up to October 22, 2008 with almost all emerging equity markets falling as higher borrowing costs and credit losses led investors to shun risky assets and, on average, emerging market equities have returned to 2006 levels.

72. On a trade-weighted basis, the US dollar had been depreciating since 2006 with intermittent fluctuations. After the cuts in the Fed funds rates since September 2007, the US dollar had weakened against other currencies. it has, however, strengthened significantly in the recent weeks. The pound sterling moved to the level of US $ 1.63 on October 22, 2008 from the 26-year high of US $ 2.11 reached on November 8, 2007. The euro, which had also been strengthening against the US dollar since June 2007, rose to an intra-day peak of US $ 1.60 on July 15, 2008 before declining to 1.28 on October 22, 2008.

73. Monetary easing in the leading developed countries has increased global liquidity with attendant implications for monetary management in the emerging economies. Some central banks have cut policy rates since the third quarter of 2007 when the financial market turmoil surfaced. Between September 18, 2007 and October 8, 2008 the US Federal Reserve reduced its policy rate by 375 basis points to 1.50 per cent after seventeen increases to 5.25 per cent between June 2004 and June 2006. The Bank of England reduced its Bank Rate to 4.50 per cent by 25 basis points each in February and April 2008 and 50 basis points on October 8, 2008. The European Central Bank reduced its main refinancing operations rate by 50 basis points to 3.75 per cent on October 8, 2008. The Bank of Canada reduced its policy rate to 2.25 per cent by 25 basis points reductions each in December 2007 and January 2008 and 50 basis points each in March and April and by 75 basis points in two stages in October 2008. The Reserve Bank of Australia raised its Cash Rate by 25 basis points each in February-March 2008 to 7.25 per cent before reducing it by 25 basis points to 7.00 per cent on September 3, 2008 and by 100 basis points to 6.00 per cent effective October 8, 2008. The Reserve Bank of New Zealand reduced the Official Cash Rate from 8.00 per cent to 7.50 per cent on September 11, 2008 and further to 6.50 per cent on October 23, 2008. The People’s Bank of China reduced its policy lending rate twice by 27 basis points each time to 6.93 per cent on September 16 and October 9, 2008. It has also reduced the cash reserve ratio by 100 basis points to 16.5 per cent effective September 25, 2008 and further by 50 basis points effective October 10, 2008 after increasing it in phases to 17.5 per cent by June 25, 2008. The Bank of Korea reduced its Base Rate by 25 basis points to 5.00 per cent on October 9, 2008. The Hong Kong Monetary authority changed the formula for determination of its Base Rate, from October 9, 2008 which reduced the spread of 150 basis points above the prevailing Federal Funds Target Rate by 50 basis points.

74. Central banks of some countries such as Japan and Malaysia have not changed their policy rates in 2008.

75. Some central banks that have tightened their policy rates in recent months include Bank Indonesia (BI rate by 150 basis points in April-October 2008); Bank of Thailand (1-day repurchase rate by 25 basis points to 3.75 per cent on August 27, 2008); the Banco Central de Chile (benchmark lending rate to 8.25 per cent by 25 basis points in January and 50 basis points each in June-September 2008 from 6.00 per cent in December 2007), Banco Central do Brasil (overnight Selic rate by 75 basis points to 13.75 per cent on September 10, 2008) and Banco de Mexico (overnight funding rate by 25 basis points each in June-August 2008 to 8.25 per cent).

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