Mid-Term Review of the Annual Policy Statement for 2007-08, RBI Credit Policy, Reserve Bank of India: Banknet India

Newsletter

Daily Rates

Daily News

Book Store

Home

Conferences

Technology

Finance

Main Page of Mid-Term Review of the Annual Policy Statement for 2007-08 click here

Part I. Mid-term Review of Annual Statement on Monetary Policy for the Year 2007-08

Back to External Sector Developments

Overall Assessment ... Click Here For Full Text

Developments in the Global Economy

41. Since late July, global financial markets have experienced bouts of turbulence and high volatility with the unfolding of the US sub-prime mortgage crisis. A freezing of credit markets spread rapidly to equity, currency and bond markets with disorderly re-pricing of risk in all segments. The deterioration in sentiment has affected consumer confidence with apprehensions of potential economy-wide effects in the US. Global economic activity, however, appears so far to have been resilient in the face of the heightening of volatility in international financial markets in the third quarter of 2007. Fundamentals remain strong in other large industrial countries as well as in most emerging market economies, especially in Asia which as a region is running current account surpluses with reduced public debt. Nevertheless, the downside risks to the outlook have increased from a few months ago, accentuated by the recent financial market turmoil. Firm inflationary pressures and high and volatile crude prices are other risks to the outlook. Consensus expectations continue to support a broad-based economic expansion for 2007, although heightening of uncertainties is recognised. According to the World Economic Outlook (WEO) of the International Monetary Fund (IMF) released in October 2007, the forecast for global real GDP growth on a purchasing power parity basis has been retained at 5.2 per cent for 2007 as in the July 2007 update, down from 5.4 per cent in 2006. The IMF has, however, revised the forecast for 2008 down to 4.8 per cent in October from 5.2 per cent in the July 2007 update.

42. In the US, real GDP growth had risen to 3.8 per cent in the second quarter of 2007 as compared with 2.4 per cent a year ago, reflecting growth in net exports, commercial structures and inventories, partly offset by a decrease in residential fixed investment. The IMF’s October 2007 WEO now expects the US economy to grow at a slower pace of 1.9 per cent in 2007 and 2008 as against 2.9 per cent in 2006.

43. Real GDP in the euro area grew by 2.5 per cent in the second quarter of 2007 on a year-on-year basis as compared with 2.9 per cent a year ago. Unemployment held steady in August 2007 for the third month running at a record low of 6.9 per cent. Expansionary economic forces are predicted to prevail in the second half of 2007 in Germany – the largest euro area economy – with pick-up in domestic demand, production and exports. The October 2007 update of the IMF’s WEO has placed average annual real GDP growth of the euro area at 2.5 per cent in 2007 and 2.1 per cent in 2008.

44. The Japanese economy grew by 2.3 per cent in the second quarter of 2007 as compared with 2.1 per cent a year ago and moderate expansion is likely to continue in the second half of 2007, aided by gains in household spending which offset the decline in corporate outlays. Going ahead, business investment should be an important driver, with high capacity utilisation and profits. In addition, the negative contribution from stock building in recent quarters suggests that inventory accumulation would add to growth. The October 2007 WEO of the IMF has projected real GDP growth in Japan at 2.0 per cent in 2007 and 1.7 per cent in 2008.

45. In emerging Asia, economic activity has continued to expand at a sustained pace, especially in the largest economies of the region, despite the existence of a volatile global setting with strengthening commodity prices and abundant liquidity. The Chinese economy grew by 11.5 per cent in the third quarter of 2007 as compared with 10.6 per cent a year ago. The deceleration in China’s economic growth from 11.9 per cent in the second quarter has been attributed to policy efforts to curb high-polluting, energy-intensive industries as well as monetary tightening policies adopted in the first half, reduction of export rebates and restrictions on processing exports. Inflation accelerated to 6.5 per cent in August 2007 from 1.3 per cent a year ago, and moderated only slightly to 6.2 per cent in September. China is expected to grow by 11.5 per cent in 2007 and by 10 per cent in 2008, but inflation may remain at a level higher than the central bank’s target of 3.0 per cent. The impact of losses of China’s financial institutions and the transmission of financial turmoil to China’s markets seems to be limited.

46. The People’s Bank of China (PBC) has raised interest rates seven times since April 2006 to 7.29 per cent and has raised cash reserve requirements eleven times between July 2006 and September 2007. In recent months, the PBC has cut the rebate on VAT taxes and has increased export taxes on some products to discourage the balance of payment surpluses and reduce funds flow to the stock markets which have reached elevated levels. China ran a record US $ 185.7 billion trade surplus in the first nine months of 2007, 69.0 per cent higher than in the same period last year, which has contributed to the overhang of liquidity in the economy. China’s foreign exchange reserves reached US $ 1.4 trillion at the end of September 2007, remaining the key driver of domestic liquidity and contributing to asset price pressures.

47. Among other major Asian economies, the Korean economy grew by 5.8 per cent in the third quarter of 2007, higher than 4.8 per cent a year ago. Exports continue to post robust growth and domestic demand is showing a steady increase, led by consumption. The upward trend of real estate prices has been blunted by the tightening measures taken by the authorities since 2006. The Korean economy is expected to grow by 4.8 per cent in 2007, slower than 5.0 per cent in 2006. Consumer price inflation had accelerated to 2.3 per cent in September 2007 from 1.7 per cent in January 2007. The Bank of Korea has taken tightening steps in 2006 and 2007 by raising its policy rate, increasing reserve requirements, cutting the ceiling on aggregate loans to commercial banks for lending to small and medium enterprises and has attempted to curb the steady rise in property prices by restricting mortgage loan issuance to one contract per person, introduction of price ceilings on new houses and disclosure of construction cost of new homes.

48. In the second quarter, the Thai economy has registered a growth of 4.4 per cent, lower than 5.0 per cent a year ago. The Bank of Thailand introduced a series of measures to stem strong capital inflows into the economy in 2006 and 2007, although monetary policy setting has eased in the context of the moderation in growth. Growth is projected to slowdown to 4.0 per cent in 2007 from 5.0 per cent recorded in 2006, but is expected to recover to 4.5 per cent in 2008.

49. Inflationary pressures remain a key risk to global growth. In the global foodgrains market, prices have been rising in response to the surging demand for major crops such as corn, soybeans and wheat whose prices have increased by 10 per cent, 55 per cent and 51 per cent, respectively, from a year ago. The rally has swept up prices of other commodities such as barley, sorghum, eggs, cheese, oats, rice, peas, sunflower and lentils. The increase in prices has been also driven up by higher energy and fertiliser prices, low levels of inventories, shortfalls in certain crops mainly caused by weather-related factors such as the ongoing drought in Australia and strong increases in the demand for crops. The latter reflects mainly two new emerging sources of demand, which include US Government incentives that are encouraging businesses to turn corn and soybeans into motor fuel and the growing economies of Asia and Latin America which are enabling their large populations to spend more on food. The price of corn, the main feedstock for ethanol production in the United States, rose at the beginning of the year to ten-year highs. As this encouraged US farmers to increase their corn production, they decreased the supply of other agricultural products, with a subsequent upward impact on the prices of these products in world markets.

50. Wheat prices, currently at historically high levels, face a second consecutive small world wheat crop in 2007 and tightening supplies, extremely strong export demand for US wheat and declining world wheat inventories. Production is estimated to be 10.1 million tonnes less than the projected level of world consumption, pointing to a decline in world stocks for the sixth time in seven years. The increasingly tight supply situation has prompted the European Union to scrap limits on grain production imposed 15 years ago which required farmers to set aside 10 per cent of their arable land every year. One month wheat futures at the Chicago Board of Trade (CBOT) rose sharply to US $ 9.53 per bushel on October 1, 2007 from US $ 4.19 on April 3, 2007 before falling to US $ 8.03 on October 26, 2007. The 2007 cereals crop is now estimated to fall below last year’s level of 2.0 billion tonnes because of dry and unusually hot weather in April, followed by adverse summer weather in parts of Europe. At the global level, closing wheat stocks in 2007-08 are expected to fall to a historically low level, especially in the major exporting countries.

51. Global coarse grain imports and exports for 2007-08 are increasing mostly as a result of increased demand for feed-grain supplies in Europe, reflected in higher US exports of corn, sorghum and barley. The futures prices of corn on CBOT, which had moderated somewhat up to July, started moving up thereafter and reached US $ 3.73 per bushel on October 26, 2007. Global rice production is projected at a lower level than a year ago due mostly to a decrease in production in China and North Korea, offset partially by small increases in the US, Iraq and Kazakhstan. Global rice stocks have reached a 30-year low leading to an upward pressure on prices. The futures prices of rice on CBOT rose from US $ 9.76 per bushel in end-March 2007 to US $ 11.75 on September 27, 2007 before declining marginally to US $ 11.65 on October 26, 2007. Sugar prices, which reached a 25-year high in early 2006, have declined steadily since then due to a much larger global output than anticipated in most cane-producing countries, particularly Brazil and India. The futures prices of sugar moderated from US cents 11.51 per pound in January 2007 to US cents 8.45 on June 13, 2007 before moving up to US cents 10.13 on October 26, 2007.

52. Russia is introducing price controls on some basic foods in an effort to prevent spiralling prices, mainly in the form of agreement between the country’s prominent food retailers and producers. The Government intends to freeze prices at October 15, 2007 levels on select food products, viz., bread, cheese, milk, eggs and vegetable oil until the end of the year, with retail mark-up limited on these goods to 10 per cent. The possibility of increasing the export tariff on wheat from 10 per cent to 30 per cent to enhance domestic supplies is also being explored. These indications have lent upward pressure to wheat prices in major world markets. China has also indicated an inclination to impose food price controls; Egypt, Jordan, Bangladesh and Morocco are increasing subsidies or cutting import tariffs to lower domestic prices. Even advanced economies such as Italy are affected by the food price increases with visible popular discontent.

53. Metal prices have increased by 1.6 per cent during the first nine months of 2007, over and above the increase of 53.6 per cent in 2006 and 36.3 per cent in 2005. According to the futures markets, aluminium, zinc and lead prices are showing an upward trend. Copper prices have been buoyed up by the depreciating US dollar. Future price of copper on New York Metal Exchange increased to a record level of US $ 3.75 per pound on July 20, 2007 but moderated subsequently to US $ 3.53 on October 26, 2007. Spot gold rose to US $ 785 an ounce on October 26, 2007 – the highest since January 1980 - as the dollar fell to a record low against the euro, boosting the demand for the precious metal as an alternative asset.

54. Crude oil prices, which softened from the July-August 2006 peak of US $ 78 per barrel to around US $ 53 per barrel in January 2007, have rebounded since July 2007 to close at a record level of US $ 91.7 on October 26, 2007 on renewed tension in the Middle East, low US crude stocks, weak US economic data and the easing of the US dollar against other major currencies. Futures prices for crude oil have moved up to US $ 91.86 per barrel. Barring a slowdown in oil demand growth, continued high demand and low surplus capacity leave the crude oil scenario vulnerable to unexpected supply disruptions through 2008. According to the Energy Information Administration (EIA), the price of West Texas Intermediate (WTI) crude oil is expected to remain at US $ 68.84 per barrel in 2007 and US $ 73.50 per barrel in 2008.

55. In the US, consumer prices increased from 2.1 per cent in January 2007 to 2.8 per cent in September 2007, after declining to 2.0 per cent in August 2007. In the euro area, inflation has increased to 2.1 per cent in September 2007 from 1.7 per cent a year ago. Inflation became negative at (-) 0.2 per cent in Japan in September 2007 from 0.6 per cent in September 2006. In the UK, CPI inflation declined to 1.8 per cent in September 2007 from 2.4 per cent a year ago. At the retail level, (Retail Prices Index) inflation rose to 4.8 per cent in the UK in March 2007 - the highest since 1991 - but declined thereafter to 3.8 per cent in July 2007 before increasing to 3.9 per cent in September 2007. Inflation pressures have raised concerns in some of the emerging market economies (EMEs) such as China, Malaysia, Indonesia and Chile.

56. Core CPI inflation in the US decelerated to 2.1 per cent in August 2007 and remained at the same level in September 2007 as against 2.2 per cent in July 2007. In the UK, core CPI inflation has been declining in tandem with the headline rate and stood at 1.5 per cent in September, down from 1.8 per cent in August 2007. In the euro area, core CPI inflation declined to 1.8 per cent in September 2007 after remaining at 1.9 per cent over February-August 2007. Core inflation in Japan remained negative (-0.3 per cent) in September 2007 as compared with (-) 0.2 per cent in August 2007. Overall, the expected persistence of high food prices, sustained elevated oil prices along with continued high prices of other commodities, pose significant inflation risks for the global economy, which are likely to set continuing challenges for monetary policy worldwide.

57. There was a sudden fall in credit market confidence in late July brought on by the spread of risks from exposure to the US sub-prime mortgages. Downturn in sentiment affected higher quality asset classes fairly rapidly including equity, currency, corporate bond and emerging market debt segments. These unusual developments indicated heightening uncertainties and emerging challenges for the conduct of monetary policy, especially for EMEs. In the subsequent weeks, these risks became accentuated by solvency threats to hedge funds and even large international banks, especially in Europe, with their usual lenders stopping short-term credit lines. Financial markets remained highly unsettled over the next few days amidst fears of a global credit crunch spreading into corporate bond markets and equity markets.

58. The responses of the central banks to the recent events in financial markets have shown that concerns for financial stability can assume overriding importance. This is evident in the fact that central banks initially reacted by injecting liquidity, including through special facilities and the expansion of eligible securities for collateral, rather than through interest rate cuts. Central bankers have indicated their willingness to consider other courses of action in favour of protecting growth. In order to prevent a spike in short-term interest rates (which in Europe shot up to 4.7 per cent as against the European Central Bank’s benchmark rate of 4 per cent), the European Central Bank and the Fed have intervened since August 9 by providing liquidity to the inter-bank market. They were joined by central banks in Canada, Japan, Australia, Norway and Switzerland. Major central banks have continued to inject liquidity since then and the Bank of England has provided liquidity support to a mortgage lending bank, while giving a blanket guarantee to depositors on the safety of their deposits. The US Federal Reserve has highlighted “unusual funding needs because of dislocations in money and credit markets.” While the European Central Bank described its operations as fine-tuning, it noted that there are tensions in the euro money market notwithstanding the normal supply of aggregate euro liquidity. The US Federal Reserve cut its policy rate by 50 basis points on September 18, 2007 both to promote growth and in the interest of financial stability.

59. There are several features characterising the recent turmoil in financial markets which distinguishes it from the historical experience. First, the instability in the financial markets has stemmed from exposures of financial institutions to lower grade credit in the US, in sharp contrast to earlier crises which were associated with turbulence emanating from EMEs as in May-June 2006 and in February 2007. Second, in contrast to earlier episodes, instability is not restricted to a crunch in the credit markets but is spilling into money markets (including for commercial paper) as well as currency, equity and corporate bond markets. Third, these developments have sparked off a flight to safety and investors are increasingly abandoning riskier assets and less collateralised/ lower rated assets in favour of US treasuries. Fourth, there is widespread concern that the purveyors of the current bout of turbulence are either too lightly regulated or not regulated at all. In this context, the role of external credit rating agencies has come in for considerable criticism for not responding in a timely fashion and for misjudging credit risk embedded in complex derivative instruments. Fifth, although the current turmoil appears to have been triggered by solvency threats to major hedge funds, the impact on financial markets has been cushioned by a combination of large private bail-outs, limits on redemptions and orderly winding ups. Sixth, the insufficiency of private effort is reflected in the coordinated and sizeable liquidity injections conducted by major central banks in order to prevent volatility in money markets and adverse effects on banks. Seventh, intervention of some central banks has included the acceptance of mortgage-backed securities in open market operations. While this has prevented massive sell-offs of good quality assets, there are fears that this has amounted to regulatory forbearance and would eventually cascade into either large official bail-outs and/or force an easing of monetary policy contrary to the commitment to anchoring inflation expectations. In mid-October 2007, in an effort to reassure financial markets by providing easier funding and to complement other solutions, the US Treasury has facilitated a plan led by major US banks to set up a fund of about US $ 100 billion which is expected to act as a buyer for highly rated assets from structured investment vehicles for a set period of time. This plan is still under discussion and is yet to be implemented. These efforts to restore liquidity to credit markets have provoked some scepticism about appropriate valuations, manner of disbursements and realistic assessments of risks embedded in the structured products involved in the refinancing.

60. Despite the volatility in the US equity markets in the third quarter of 2007 (July-September), the Dow Jones Industrial Average ended the quarter by posting a 3.6 per cent rise while the S&P 500 managed a quarterly increase of 1.5 per cent and the technology-laden Nasdaq Composite posted gains of 3.8 per cent for the quarter. Globally, considerable volatility was experienced in the world equity markets especially in EMEs – with indicators reporting record single day falls in mid-August. With the strong recovery in EME stock markets thereafter, diversified emerging markets funds gained substantially in the third quarter. Developed markets turned in mixed results. Tracking US stocks, the international large-cap growth category posted a quarterly advance of 4.3 per cent, while funds with a value-stock orientation struggled to break even. Currency markets have recorded a tentative return to stability and re-establishment of carry trades, but worries about emerging market currencies – that were previously relatively isolated from the turmoil – have surfaced with emerging market bonds coming under selling pressure. In the US, corporate bond spreads have widened across all credit grades and are currently around their highest levels in several years. Spreads on emerging market sovereign bonds have also widened over the past two months, although to a lesser extent than those on lower-rated corporate bonds in the US. A notable aspect of the reduced investor appetite for corporate debt has been the cancellation or postponement of a number of leveraged buyout (LBO) debt issues.

61. Government bond yields in the major economies, which had until recently firmed up, have softened more recently. 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 4.40 per cent on October 26, 2007. The 10-year bond yields in the euro area increased from 3.95 per cent at end-December 2006 to 4.68 per cent on July 9, 2007 before falling to 4.17 per cent. The Japanese 10-year bond yield has increased from 1.68 per cent at end-December to 1.97 per cent on June 13, 2007 before falling to 1.62 per cent. These recent developments are indicative of evolving uncertainties in international financial markets with implications for EMEs.

62. On a trade-weighted basis, the US dollar has been depreciating since 2006 with intermittent fluctuations. After the 50 basis points cut in the Fed funds rates announced on September 18, 2007, the US dollar has weakened against other currencies. The pound sterling rose to the level of US $ 2.05 on October 26, 2007 – fractionally lower than the 26-year high of US $ 2.06 reached on July 24, 2007 – amidst concerns relating to the sub-prime mortgage market. The euro, which has also been strengthening against the US dollar since June, rose sharply on July 24 on investor apprehensions about sub-prime mortgage exposures and surged to a fresh high of US $1.44 on October 26, 2007. The Canadian dollar appreciated against the US dollar to a 33-year high to reach US $ 1.04 on October 26, 2007. Turkey experienced a sharp appreciation in its currency vis-a-vis the US dollar on October 5, 2007 to reach the level of 84.98 cents, before declining to 84.28 cents on October 26, 2007. The New Zealand dollar had appreciated to 81.10 cents to reach a 22-year peak against the US dollar on July 24, 2007 before declining to 76.53 cents on October 26, 2007.

63. Several central banks have cut policy rates during the third quarter of 2007 after financial markets were significantly affected by turbulence. On September 18, 2007 the US Federal Reserve cut back its policy rate by 50 basis points to 4.75 per cent after seventeen increases of 25 basis points each between June 2004 and June 2006. The Banco Central do Brasil has cut the Selic rate target eighteen times between September 2005 and September 2007 to 11.25 per cent. Earlier, policy rates have been reduced by Bank Indonesia (BI) (BI rate reduced from 12.50 per cent in May 2006 to 8.25 per cent in July 2007) and the Bank of Thailand (1-day repurchase rate reduced from 4.75 per cent in January 2007 to 3.25 per cent in July 2007 in four stages).

64. The central banks that have tightened their policy rates include the European Central Bank which has raised its policy rates eight times since December 2005 by 25 basis points each to 4.00 per cent (main refinancing rate); the Bank of England (repo rate raised in August and November 2006, January, May and July 2007 by 25 basis points to 5.75 per cent); the Bank of Japan (uncollateralised overnight rate target at 0.25 and 0.50 per cent in July 2006 and February 2007, respectively, after maintaining a zero interest rate policy since September 2001); the Bank of Canada to 4.50 per cent (in July 2007); the Reserve Bank of Australia (Cash Rate raised by 25 basis points each in August and November 2006 to 6.25 per cent and in August 2007 to 6.50 per cent); the Reserve Bank of New Zealand (Official Cash Rate raised to 8.25 per cent by five 25 basis points hikes in December 2005 and March, April, June and July 2007); the People’s Bank of China (lending rate raised seven times to 7.29 per cent between April 2006 and September 2007); the Bank of Korea (target overnight call rate raised by 25 basis points each in August 2006, July and August 2007 to 5.00 per cent); the Banco de Mexico (benchmark overnight lending rate raised to 7.50 per cent in October 2007 from 7.25 per cent in April 2007); and the Banco Central de Chile (benchmark lending rate raised to 5.75 per cent in September 2007 from 5.00 per cent since January 2007).

65. A few central banks in Asia have used supplementary measures for tightening, besides increasing key policy rates. In China, the required reserve ratio was raised by 50 basis points each effective from July 5, August 15 and November 15 in 2006 and on January 15, February 25, April 16, May 15, June 5, August 15, September 25 and October 25 in 2007. The required reserve ratio in China is currently 13.0 per cent. The Bank of Korea raised reserve requirements from 5 per cent to 7 per cent for local currency deposits and short-term foreign currency deposits, after a gap of 17 years, in November and December 2006, respectively, in addition to other measures referred to earlier. Meanwhile, in several EMEs including China and Korea, central bank bonds have continued to absorb liquidity from the banking system. The only central bank that has kept policy rates steady is the Bank Negara Malaysia (Overnight Policy Rate at 3.5 per cent since April 2006).

Click here for Highlights of Mid-Term Review of the Annual Policy Statement for 2007-08

Click Here For Macroeconomic and Monetary Developments: Mid-Term Review 2007-08