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

43. During the first nine months of 2008, the slowdown in global growth spread across developed economies in an environment of heightened uncertainty. Global economic prospects have been dampened by the weakening of the US economy, the wider repercussions of the ongoing financial market crisis and volatility in the energy, food and commodity prices. Concerns about the emergence of protectionist pressures and the possibility of disorderly adjustments to the financial turmoil also carry downside risks to the outlook. According to the World Economic Outlook (WEO) of the IMF released in October 2008, global real GDP growth on a purchasing power parity basis is expected to decelerate from 5.0 per cent in 2007 to 3.9 per cent in 2008 (4.1 per cent in WEO Update, July 2008) and further to 3.0 per cent in 2009 (3.9 per cent in WEO Update, July 2008).

44. In the US, real GDP growth slowed to 2.8 per cent in the second quarter of 2008 from 3.8 per cent a year ago. In the third quarter, labour markets weakened with the unemployment rate rising to 6.1 per cent in September 2008 - the highest in almost five years. Industrial production declined by 6.0 per cent in the third quarter of 2008, mainly on account of hurricanes and production stoppages in September. The rate of capacity utilisation for industry at 76.4 per cent in September 2008 was 4.6 percentage points below the average for 1972-2007. The index of leading indicators increased in September 2008 - the first increase in the index in the last five months. US home prices posted a fall of 16.3 per cent in July 2008 on a year-on-year basis. New home sales in the US decreased by 34.5 per cent in August 2008 from a year ago despite the sharp drop in home prices. Housing starts fell 6.3 per cent in September – a 17-year low – as home-builders sought to reduce the number of unsold homes. Single-family starts fell by 12 per cent to the lowest level since August 1982. In September 2008, US retail sales recorded a year-on-year decline of 1.0 per cent and consumer sentiment dropped sharply in October. The October 2008 WEO of the IMF expects the US economy to slow from 2.0 per cent in 2007 to 1.6 per cent in 2008 and further to 0.1 per cent in 2009.

45. Real GDP in the euro area grew by 1.4 per cent in the second quarter of 2008 on a year-on-year basis as compared with 2.5 per cent a year ago. The economic climate in the euro area has worsened further in the third quarter of 2008. Unemployment in the euro area rose to 7.5 per cent in August 2008 from 7.4 per cent a year ago. Industrial production and business confidence continue to be subdued. While real disposable income is starting to increase as inflation decelerates, weak labour markets are dampening private consumption demand. The October 2008 WEO of the IMF has placed real GDP growth of the euro area at 1.3 per cent in 2008 and 0.2 per cent in 2009 as against 2.6 per cent in 2007.

46. In the Japanese economy, real GDP declined by 3.0 per cent in the second quarter of 2008 as compared with an increase of 2.3 per cent a year ago due to the effects of earlier increases in energy and materials prices and weaker growth in exports. In the third quarter, business fixed investment has declined with corporate profits decreasing on account of deterioration in the terms of trade. Private consumption has been relatively weak, mainly due to slow growth in household income and the increase in prices of petroleum products and food. The recovery in housing investment has been stalled. Public investment, meanwhile, has been sluggish. The October 2008 WEO of the IMF has projected that Japan’s economy will grow by 0.7 per cent in 2008 and 0.5 per cent in 2009 as compared with 2.1 per cent in 2007.

47. The Chinese economy grew by 9.9 per cent in the third quarter of 2008 - the slowest pace in more than five years – as compared with 12.2 per cent a year ago as industrial production and construction slowed because of weak exports and a sluggish real estate market. China’s trade surplus narrowed by 2.6 per cent on a year-on-year basis to US $ 180.9 billion in September on account of regulations to control the surplus and rising energy costs. The total foreign exchange reserves, however, increased to US $ 1.91 trillion in September 2008, recording an increase of US $ 377 billion in the first nine months of 2008 as against US $ 367 billion in the corresponding period of 2007. The CSI 300 Index, which tracks yuan-denominated A shares listed on China’s two exchanges, fell by 66.5 per cent over the year to October 22, 2008. The October 2008 WEO of the IMF has projected that the Chinese economy will grow by 9.7 per cent in 2008 and by 9.3 per cent in 2009 as compared with 11.9 per cent in 2007.

48. Elsewhere in Asia, the Korean economy grew by 4.8 per cent in the second quarter of 2008 as against 4.9 per cent a year ago. In the third quarter, domestic economic activity in Korea has slackened due to sluggish domestic demand although exports continue to post robust growth. A high degree of uncertainty surrounds future economic developments, largely due to the ongoing international financial market turmoil and the global economic slowdown. In Thailand, economic activity grew by 5.3 per cent in the second quarter of 2008 as against 4.3 per cent a year ago.

49. Globally, inflation has softened in several countries in recent months. In the US, consumer price inflation eased from 5.6 per cent in July 2008 to 4.9 per cent in September 2008. In the euro area, inflation decelerated to 3.6 per cent in September 2008 from the peak of 4.1 per cent in July 2008. In Japan, inflation decelerated to 2.1 per cent in August 2008 from the peak of 2.3 per cent in July 2008 on account of falling oil and food prices. In the UK, however, CPI inflation accelerated to 5.2 per cent in September 2008 from 1.8 per cent a year ago. At the retail level (in terms of retail prices index or RPI) too, inflation rose to 5.0 per cent in September 2008 – the same level as in July 2008 – after dipping to 4.8 per cent in August 2008.

50. Core CPI inflation in the US increased to 2.5 per cent in July-September 2008 from 2.4 per cent in June 2008. In the UK, core CPI inflation increased to 2.2 per cent in September 2008 from 2.0 per cent in August 2008. In the euro area, core CPI inflation increased to 1.9 per cent in August-September 2008 from 1.7 per cent in July 2008. Core inflation in Japan softened to zero in August 2008 as compared with 0.2 per cent in July 2008.

51. The increase in producer price indices (PPI) is beginning to moderate in several industrial economies. In the US, PPI inflation decelerated to 8.7 per cent in September 2008 from the peak of 9.8 per cent in July 2008. In the euro area, it moderated to 8.5 per cent in August 2008 from 9.0 per cent in July 2008. In the UK, it decelerated to 8.5 per cent in September 2008 from 10.0 per cent in July 2008. Wholesale price inflation in Japan fell to 6.8 per cent in September 2008 from 7.2 per cent in August 2008.

52. Inflationary pressures have also begun moderating across emerging market economies (EMEs) in Asia, Latin America and Africa. In China, inflation decelerated from a peak of 8.7 per cent in February 2008 to 4.6 per cent in September 2008. Consumer price inflation in Korea decelerated to 5.1 per cent in September 2008 from 5.9 per cent in July 2008. In Thailand, consumer price inflation softened to 6.0 per cent in September 2008 from 9.2 per cent in July 2008. Inflation showed some signs of deceleration from elevated levels in Brazil, Chile and Mexico. In some EMEs in Asia such as Indonesia and Malaysia, however, inflation has accelerated, induced by high commodity prices. Producer price inflation in EMEs – both in Asia and elsewhere – has been substantial in the first three quarters of 2008 with marginal deceleration in only a few EMEs in the recent months.

53. There has been an overall decrease in prices of food, crude oil and metals since July 2008 which has contributed to the easing in consumer price inflation. The Food and Agriculture Organisation (FAO) Food Price Index, which had risen steadily since early 2006 to a record level of 219 in June 2008, has declined continuously to 188 in September 2008 on encouraging indications of good harvests and rising stocks. In the global foodgrains market, prices of major crops such as corn increased by 5.0 per cent, whereas soyabean and wheat prices have declined by 11.6 per cent and 37.3 per cent, respectively, by October 22, 2008 from their levels a year ago. Food prices, which had risen to a peak in June 2008, eased to a nine-month low in September 2008, reflecting the softening of international prices of all major food and fodder commodities. There has also been a downturn in energy prices in the recent months since the record levels reached in July 2008 with the prospect of a general slowdown in global economic growth. The IMF’s metal price index had increased to 201.1 in March 2008 before declining steadily to reach 164.1 by September 2008.

54. The FAO has placed its latest forecast for world cereal production in 2008 at 2,232 million tonnes, 4.9 per cent up from last year and a new record, on account of better than expected harvests throughout Europe, for maize, in particular, in the US and also for coarse grains and rice in east Asia. Cereal production is expected to exceed utilisation in 2008-09 for the first time in four years. With stocks likely to increase, prices of most cereals have started to come down in 2008. Given the outlook for a relatively strong recovery in grain production in 2008 in major exporting countries, the ratio of their aggregate grain supplies to normal market requirements is estimated at 123 per cent in 2008-09 from the relatively low levels in the preceding two years.

55. The cereal production of Low-Income Food-Deficit Countries (LIFDCs) is forecast to increase by 1.7 per cent in 2008. However, as a result of the limited growth in these countries’ production this year after the decline in the previous season, they will continue to rely heavily on imports to cover their consumption needs in 2008-09. Global food import expenditure is forecast to reach US $ 1,035 billion in 2008, i.e., 26 per cent higher than the previous peak in 2007.

56. The global wheat output in 2008 is now forecast at 677 million tonnes, a substantial increase of 11 per cent from the previous year and well above the average of the previous five years. In Europe, the latest estimates now point to an increase in production by 25 per cent on above-average yields and a strong recovery in several countries from drought in 2007. International wheat prices have fallen considerably in the past two months after their peak in February 2008. Near-month wheat futures at the Chicago Board of Trade (CBOT) declined from US $ 12.80 per bushel on February 27, 2008 to US $ 5.18 on October 22, 2008. On the same day, futures prices for wheat were quoted higher at US $ 5.38 for March 2009, at US $ 5.64 for July 2009 and at US $ 5.81 for September 2009.

57. Global paddy output is forecast at a record level of 672 million tonnes, which is about 2 per cent above the 2007 level. Favourable weather conditions as well as attractive market prices and fiscal incentives are expected to boost planted areas and yields. International near-month futures price of rice on the CBOT has declined to US $ 14.63 per hundredweight on October 22, 2008 from a peak of US $ 24.50 on April 23, 2008. On October 22, 2008 futures prices were quoted higher at US $ 14.91 for January 2009, US $ 15.24 for March 2009 and US $ 15.16 for September 2009.

58. The FAO’s latest forecast for world production of coarse grains in 2008 has been revised upwards to 1, 106 million tonnes, 2.6 per cent higher than a year ago. The increase is mostly attributed to improved yield prospects for the maize crop in the US as well as better results from the coarse grain harvests throughout Europe. Record high crops have already been gathered in South America. However, market conditions for coarse grains are expected to remain tight with the anticipated total utilisation remaining close to world production on account of the rising use of maize for bio-fuels. The near-month futures prices of corn on CBOT rose to US $ 3.85 on October 22, 2008. On the same day, futures prices for corn were quoted higher at US $ 4.01 for March 2009, at US $ 4.22 for July 2009 and at US $ 4.31 per bushel for September 2009.

59. Metal prices have fallen by 18.4 per cent up to September over the peak of March 2008 following the decline of 8.1 per cent during 2007. Lead and copper prices have increased on supply concerns and dwindling stocks. However, prices of other base metals have softened in the recent period on concerns about global growth which might impact demand. Futures price of copper on the New York Mercantile Exchange (Nymex) increased to a record level of US $ 4.08 per pound on July 2, 2008 from US $ 3.54 a year ago. As on October 22, 2008 the near-month futures price for copper stood at US $ 1.85 per pound, US $ 1.87 for December 2008, US $ 1.87 for March 2009 and US $ 1.85 for September 2009. Spot gold declined from US $ 1,032.70 an ounce on March 17, 2008 - the highest since January 1980 - to US $ 757.50 an ounce on October 22, 2008 as the US dollar strengthened and oil prices declined.

60. The spot price of West Texas Intermediate (WTI) crude oil increased to a record level of US $ 145 per barrel on July 3, 2008 on account of perceptions of tenuous supply in several of the major exporting countries before declining to US $ 65.85 on October 22, 2008. Prices of crude oil, which have rebounded since July 2007, declined by 24.8 per cent up to October 22, 2008 from their level a year ago. According to the Energy Information Administration’s (EIA) forecasts as on October 7, 2008 the average price of WTI crude oil is expected to be at US $ 111.57 per barrel in 2008 and US $ 112.0 per barrel in 2009. Near-month futures prices reached the level of US $ 66.8 per barrel on October 22, 2008 dipping from US $ 146.5 recorded on July 3, 2008. On October 22, 2008 oil futures ruled marginally higher at US $ 67.2 for January 2009, US $ 68.1 for March 2009 and US $ 71.2 for September 2009. The Organization of the Petroleum Exporting Countries’ (OPEC) crude oil production is expected to rise to 32.7 million barrel per day during the third quarter of 2008, increasing by 1.7 million barrel per day from a year ago. The OPEC crude oil production may decline to 32.4 million barrel per day in the fourth quarter of 2008 and fall through 2009 to an average of 31.6 million barrel per day. The non-OPEC crude supply is expected to decline by about 0.1 million barrel per day during the second half of 2008 from the level a year earlier due to a series of supply disruptions and the impact of hurricanes in the Gulf of Mexico. Consequently, non-OPEC supply in 2008 is now expected to decline for the first time since 2005.

61. Strains in global financial markets have increased significantly in the third quarter of 2008. Equity markets have weakened significantly as valuations reflected disappointing earnings data in the financial and other cyclical sectors. Pressures in inter-bank money markets, which had persisted since May 2008, began to intensify further during the third quarter of 2008. In response to the rapidly unfolding international financial turmoil, there are continuing measures from monetary policy authorities for active liquidity management, some of which are set out below.

62. For the resolution of various issues thrown up by the financial turmoil, the US Treasury and the Federal Reserve have adopted a multi-pronged approach of introducing and enhancing the effectiveness of liquidity facilities, allowing financial support, mergers, conversions and outright bankruptcies, affecting large investment and savings banks, and even a major insurance firm. In early September, the two large US government-sponsored mortgage banks were put into conservatorship by the government. In mid-September, a major investment bank filed for bankruptcy as government support was not forthcoming and a major insurance firm was given central bank assistance. To ameliorate the strains in the money market consequent upon these developments, in addition to the Term Auction Facility (TAF), Primary Dealer Credit Facility (PDCF) and Term Securities Lending Facility (TSLF) instituted earlier and enhanced subsequently, the Federal Reserve announced several initiatives to provide additional support to financial markets. The initiatives introduced in early October included the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility which provides finance to banks in their purchases of high-quality asset-backed commercial paper (ABCP) from money market mutual funds with a view to assisting in meeting redemptions demands and fostering liquidity in the ABCP market, and the Commercial Paper Funding Facility (CPFF) which provides a liquidity backstop to the US issuers of commercial paper to finance the purchase of highly-rated unsecured ABCP from eligible issuers via eligible primary dealers. On October 21, 2008 the Federal Reserve Board announced the creation of the Money Market Investor Funding Facility (MMIFF), which will provide funding to purchase assets including US dollar-denominated CDs and CPs issued by highly-rated financial institutions with 90-day maturities or less from money market mutual funds to provide liquidity to US money market investors.

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