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

Developments in the Global Economy ... Click Here For Full Text

Overall Assessment

66. Growth in agricultural output in the first quarter was expected to benefit from the strong improvement in the 2006-07 rabi output, particularly, wheat, coarse cereals and pulses; however, the overall strength of the supply response from the sector has turned out to be above consensus expectations. In the second quarter, agricultural activity has been well supported by moisture conditions, with rainfall in the current season being above normal and reasonably well-distributed, and reasonably high reservoir levels. Kharif sowing has been higher than in last year’s season and first estimates are reflecting expectations of higher production than in the preceding year. These developments have improved the outlook for agriculture which appears set to return to its trend growth in 2007-08. The positive prospects for agriculture augur well for the economy as a whole in terms of both aggregate supply conditions and food prices which, until early 2007, were the main drivers of inflation.

67. Notwithstanding a modest deceleration in the growth of overall industrial activity in the first five months of 2007-08, the manufacturing sector continued to record double-digit growth. There are indications that industrial activity continues to be sustained by strong fundamentals. Growth in basic metals, chemicals, wood and wood products and machinery and equipment has retained buoyancy, together contributing more than half of the growth in industrial production in April-August 2007. Growth in electricity a key infrastructural input has accelerated in the current financial year. The growth of capital goods production has remained strong and higher than headline industrial output growth, suggesting continued capacity expansion. Contraction in output has occurred mainly in the consumer goods segment, transport equipment, metal products, paper and textiles, which could be reflecting transitory factors.

68. While industrial activity continues to display an inherent momentum, there are indications that headline industrial growth is being affected by the large variations recorded in the preceding year. Accordingly, on the basis of available data as well as the uncertainties surrounding global developments, marginal moderation in overall industrial activity over the rest of 2007-08 may not be ruled out within the generally positive prospects for the industrial sector.

69. Despite some moderation reflected in lead indicators, the services sector has continued to grow at a sustained pace, particularly in the financial sub-sector, trade, transport, hospitality and construction, reflecting robust investment activity as well as a pick-up in demand with farm incomes rising on the back of the improvement in agricultural performance in the first quarter of 2007-08. These impulses have been supported by the growth of insurance premiums, telecommunication subscribers and tourist arrivals. While there has been some deceleration in railway freight traffic, lead indicators generally support a positive outlook for service sector activity although, due to the uncertainty surrounding the evolution of the global economy, the possibility of marginal moderation in growth over the rest of 2007-08 cannot be ruled out.

70. Aggregate demand conditions have remained firm and on the uptrend. First, the key driver of the economy appears to be the substantial increase in gross fixed investment in the first quarter of 2007-08, indicative of the strong pace of capacity building underway. In contrast, the growth in private consumption and exports has been relatively modest. Investment-driven growth is supported primarily by saving rates, currently at around 32-33 per cent of GDP and higher by ten percentage points from the beginning of the decade. The step-up in gross domestic saving has been enabled by private corporate saving which has nearly doubled between 2002-03 and 2005-06 on the back of strong growth in profitability. There has also been some improvement in public sector saving which has turned positive after persistent dis-saving up to 2003-04. Interestingly, the momentum in investment has not been affected by changes in the interest rate cycle and spending on capital expenditure and infrastructure has weathered the transient slack in industrial activity in the second quarter. Second, the key monetary aggregates, i.e., reserve money and money supply have been running well above initial projections, reflecting the impact of higher than expected deposit growth and the exogenous expansionary effects of capital inflows as well as the drawdown of fiscal cash balances. Within the monetary expansion, bank credit growth appears to have been slowing down, but from excessively high rates of the preceding four years. Third, the merchandise trade deficit has widened sizeably, despite reasonably strong export growth, attesting to the spillover of domestic demand into the external sector. Fourth, asset prices remain at elevated levels, although there is some anecdotal evidence of stabilising real estate prices. On the other hand, equity prices are at record highs. Fifth, although inflation in terms of wholesale prices appears to have eased considerably, it still remains high in terms of consumer prices, particularly those facing agricultural workers and rural labourers.

71. Key monetary and banking aggregates have exhibited contrasting variations in the second quarter of 2007-08. On the one hand, reserve money expansion has been sizeable, persisting above 23.8 per cent throughout the quarter, and has been driven up mainly by the Reserve Bank’s net foreign currency assets and variations in the Centre’s cash balances, partly offset by liquidity absorptions under the MSS and the LAF. Against the backdrop of primary liquidity movements, the rate of money supply, which has averaged 20.9 per cent year-on-year through the quarter in contrast to indicative projections for policy purposes, has warranted intensified monitoring. Propelling money supply is the sustained buoyancy in time deposits, reflecting the migration of current, savings and postal deposits in response to relatively attractive returns and tax benefits for longer term bank deposits, corporate profits and banks’ investments in mutual funds (which reappear as mutual funds’ deposits with the banking system), apart from the environment of expansion in the monetary base. On the other hand, non-food credit growth has moderated in alignment with the trajectory set in the Annual Policy Statement of April 2007. Sectoral data suggest that this moderation has been in respect of all the major sectors, while incremental non-food credit offtake in respect of the industrial sector has increased. With deposit growth remaining strong, the deceleration in non-food credit as well as disinvestment of non-SLR assets has resulted in augmenting market liquidity, partly mitigated by a build up of SLR–eligible securities. Critical indicators such as a rising incremental investment/deposit ratio, a decline in non-food credit deposit ratio and sustained profit growth are reflecting these shifts and point to signs of growing resilience in the banking system’s balance sheet with favourable implications for financial stability, going forward.

72. The expansionary monetary and financial conditions characterising the second quarter of 2007-08 and the policy response in the form of active liquidity management operations launched in the First Quarter Review were reflected in a generally orderly evolution of market liquidity. Consequent upon the withdrawal of the ceiling on daily reverse repos under the LAF with effect from August 6, absorptions of liquidity by the Reserve Bank resumed after a hiatus spanning March-July. Initial large daily reverse repo bids moderated in subsequent weeks but remained close to an average of Rs 30,000 crore until September interspersed by periods of relatively lower absorptions. Since October 1, 2007 ample liquidity in financial markets has resulted in large daily absorptions through LAF reverse repo auctions, despite sizeable absorptions under the MSS. The Central Government vacated ways and means advances/overdrafts, but cash balances of the Centre exhibited considerable volatility within an overall downward movement that augmented market liquidity through August and the first half of September. In the following week, these cash balances were built up coincident with the quarterly advance tax payments, but have been drawn down through October augmenting market liquidity. Broadly, however, the primary source of liquidity expansion was the sizeable accretion to the Reserve Bank’s net foreign currency assets. In response, sterilisation through the MSS operations picked up in early August and increased steadily over the remaining part of the quarter. Surplus liquidity conditions were also reflected in excess SLR holdings by banks and their investments in mutual funds.

73. A notable development in the second quarter of 2007-08 has been the steady retreat of headline WPI inflation from mid-July. The receding of WPI inflation over July-October 2007 has been discernible across commodities and also in exclusion-based measures (WPI excluding energy; WPI excluding food and energy), but pronounced in the category of primary food articles and, particularly, under vegetables, milk, rice and oilseeds. On the other hand, inflation in the category of manufactured products and non-food primary articles has been relatively less relenting.

74. While the recent headline inflation outcomes, juxtaposed with expectations survey results and information from financial markets, are indicative of reasonably well-anchored inflation expectations, some of the recent developments have shown that there are major risks to this assessment that are still evolving. First, CPI inflation rose in July with the price rise for rural and agricultural labourers exceeding 8.5 per cent in August, i.e., the softening of wholesale food prices has not set in at the retail level. Second, the global environment is fraught with uncertainties. International crude prices are volatile at new highs, having breached the level of US $ 90 per barrel while elevated food and metal prices would, in current circumstances, pass through to domestic inflation. The incomplete pass-through of international prices of crude, metals, food and commodities in general to consumer prices is indicative of suppressed inflation which carries destabilising potential into the future. Third, the state of monetary and liquidity conditions evoke traditional concerns that they could carry the seeds of future inflation. Fourth and most importantly, the expansion of global liquidity conditions in the wake of the recent financial market turmoil has occurred in a period when concerns about firm inflation expectations were being reflected in a withdrawal of accommodation in the monetary policy stance of countries across the world, both mature and emerging. The massive injection of liquidity by mature central banks reflects a deviation from their stance on inflation in order to ensure financial stability which could potentially weaken their ability to fight inflationary pressures.

75. Domestic money markets have exhibited orderly behaviour and surplus liquidity conditions generally, except when equity markets turned volatile primarily in response to global developments. A notable feature is the muted impact of mid-September advance tax outflows on money markets in the current financial year, indicative of active monetary and liquidity management. In the foreign exchange market, large inflows have imposed persistent upward pressures on the exchange rate of the rupee which have become accentuated in the wake of the 50 basis points cut in the US Federal Funds target rate on September 18. In the Government securities market, orderly conditions have prevailed through the quarter with yields firming mildly during mid-July to mid-August in response to the sub-prime crisis in the US. Thereafter, yields have edged down, reflecting underlying liquidity conditions and benign inflation expectations.

76. Finances of the Central Government appeared to be under some strain during April-August 2007. Buoyant tax collections seem to have been neutralised by higher expenditure on interest payments and subsidies. Consequently, the revenue deficit exceeded the BE for 2007-08 by July 2007. Transfer of surplus from the Reserve Bank and the accounting of the SBI stake sale under non-tax revenue (as against under non-debt capital receipts indicated earlier) enabled some pull-back of the revenue deficit vis-à-vis the BE in August 2007. The gross fiscal deficit, even adjusted for the SBI stake sale was also above BE in April-August reflecting, in addition to the revenue deficit, a sharp rise in non-defence capital expenditure. As regards financing, market borrowings for the first half of 2007-08 have been completed broadly in accordance with the announced calendar. There has, however, been a higher recourse to short-term borrowings and WMA/overdraft from the Reserve Bank in comparison to the position last year, mainly on account of the SBI stake sale.

77. While there has been some progress in fiscal rectitude, it is important to take note of some adverse features in the finances of the Central Government during 2007-08 so far. Excluding the transfer of the Reserve Bank’s stake in the SBI, the revenue deficit for April-August 2007 is placed at 122.9 per cent of the BE for the full year (2007-08) as compared with 93.7 per cent a year ago. Furthermore, there has been a sharp increase in expenditure under all categories with total expenditure rising by 40 per cent over the level in the corresponding period of the previous year. In view of the priority attached to ensuring stability in the context of the recent heightening of global uncertainties, it is necessary to persevere with fiscal consolidation consistent with the FRBM Rules through prudent expenditure management while also ensuring the quality of expenditure by both the Centre and the States.

78. Several aspects of recent developments in the external sector of the economy merit attention. First, domestic demand pressures are strongly in evidence, driving up non-oil imports and the merchandise trade deficit in the first half of 2007-08, notwithstanding some saving on account of subdued POL import growth. Second, while merchandise exports have continued to exhibit innate dynamism and resilience in the face of adverse price/cost and global developments, moderation in pace seems to be setting in when viewed in perspective against the recent high growth phase, i.e., 2003-07. Third, lead indicators suggest that the buoyancy characterising net invisible receipts has been sustained. In view of these developments, the current account deficit in the first half of 2007-08 is expected to have been contained at the level of a year ago. Fourth, net capital flows to India have increased substantially in the wake of the recent turmoil in international financial markets and the response of major central banks in terms of injecting liquidity into money markets in their economies. In particular, the sizeable turnaround in portfolio flows in the current financial year has been noteworthy. Fifth, while FDI to India has been running higher in the current financial year, it is necessary to note that a significant proportion of these flows are attributable to private equity and venture capital which are essentially in the nature of portfolio flows. Sixth, an important feature of external sector developments is the rising volume of FDI from India, representing the silent transformation in India’s interface with the world being driven by Indian corporates leveraging their domestic balance sheets to gain scale, scope and global scan. Seventh, the increasing size of debt flows – mainly ECB and trade credits, since NRI deposits are responding to policy initiatives – and consequently, increasing external indebtedness needs to be noted. Eighth, India recorded the third highest accretion to foreign exchange reserves in April-September, 2007 among all EMEs. At US $ 261 billion at mid-October 2007, India holds the world’s fifth largest stock of international reserves, sufficient to cover 15 months of imports/17 months of debt service/ 127 per cent of external debt/ 69 per cent of international liabilities.

79. The First Quarter Review of July, 2007 warned of the dark shadow cast by the under-priced and widely diffused risks emanating from the unfolding of the US sub-prime mortgage crisis. Since late July, global financial markets have experienced unusual volatility, strained liquidity and heightened risk aversion. There have been sharp movements in major financial markets, in particular in money and credit markets since early August. While the trigger was the rising default rates on sub-prime mortgages in the US, the source of the problem was arguably not macro-global imbalances but certainly significant mis-pricing of risks in the financial system. Easy monetary policy in major financial centres, globalisation of liquidity flows, wide-spread use of highly complex structured debt instruments and inadequacy of banking supervision in coping with financial innovations also contributed to the severity of the crisis. The persistent under-pricing of risks was suspected by several central banks for quite some time, but it was felt by many that since risks were now widely dispersed through financial innovation they would not pose any serious problems to the system. When the sub-prime crisis did occur, however, it triggered a wide contagion affecting many of the largest of the world’s financial institutions. Banks, in particular, appear to have ceased to trust each other’s creditworthiness leading to freezing of money markets in the US, Europe and the UK and hence lack of liquidity. This has resulted in each financial institution shoring its own liquidity to meet its obligations. The problems of maturity mis-matches in the conduits or structured investment vehicles (SIVs) created by the banks for purposes of securitisation manifested themselves in a sudden great demand for liquid assets. This is deemed necessary in order to cope with adjustments which could potentially arise, including the possible need to take back the conduits or SIVs into the balance sheets of sponsoring banks or the winding up of such vehicles. During the process of adjustment, which is apparently still underway, there are problems of marking-to-market of securitised debt instruments in highly illiquid markets and transparency in regard to counter-party risks. Contrary to initial expectations, even with the release of end-September accounts of major international banks, the picture remains somewhat unclear.

80. The central banks in major countries have had to take recourse, in appropriate mix, to three instruments to avoid serious spill-over of these issues in money or credit markets into the wider economy : (i) adjustment of interest rates for borrowing and lending; (ii) money market operations designed to inject special liquidity in order to avoid a break-down in payment systems among banks, and (iii) to put in mechanisms for financial transactions among the largest of the financial intermediaries which automatically impact the second and third rung intermediaries. Central banks in major industralised economies, by and large, responded with injection of liquidity for a longer period than is usually done; they also resorted to dilution in the quality of collateral required for liquidity support, and in some cases, reduction in rates. Most of these operations have not been conducted at the penal rates expected in such situations. This is an unprecedented package which, some observers believe, is indicative of the seriousness of the underlying problems. In addition, there were two specific-institution oriented operations, namely, in Germany to bail out a public sector bank and in the United Kingdom to bail out a private sector bank, coupled with open-ended Government guarantee for all public deposits in financial institutions. The US Federal Reserve has been the most aggressive in terms of monetary policy actions, with a higher than expected rate cut, reflecting the concerns over impact of housing issues on consumption and, hence, growth. These measures have restored some order to the financial system, though concerns remain on how the situation will unfold.

81. There are several immediate issues which need to be visited constantly to track the evolution of the resolution of the problem and consequent impact on India. First, there is debate as to how smoothly the new injection of liquidity will impact global liquidity and potential inflation. Second, there are concerns about the size, location and impact of credit infirmities. There is a view that credit infirmities are small and, in any case dispersed; there is another view that mutual funds, pension funds and insurance companies, which are perceived to be less rigorously regulated than banks, may be adversely affected. In the latter case, households could be severely impacted. Third, while some believe that the adjustment will be smooth since it is only a mismatch of maturities in asset-liabilities, others argue that equity and currency markets cannot but be affected at some stage. In other words, there is a view that the current situation could have the potential for serious financial contagion globally. Fourth, an issue of special interest is whether the problem will remain confined to the financial sector and get resolved over time sooner or later, or whether there would be a real sector impact. It is believed that some large corporates have been active in the financial sector through treasury operations and commodity markets. While the impact on consumption in the US is anticipated, a fiscal impact is not ruled out. Fifth, there is a view that US housing prices have to undergo a significant correction. There is, however, debate over what period this will happen, whether it will have significant consumption and saving effects and the manner in which it will spill over into the global economy. Another issue of interest is whether there will be similar housing price corrections in other countries since housing prices are seen by many to be inflated in many economies. Finally, as far as emerging markets are concerned, there could be a negative impact if the credit markets are affected through the real economy. In select cases, some EMEs may turn out to be second order safe-havens with consequent implications for capital flows, exchange rates and their alignment with economic fundamentals.

82. It is also useful to recognise some positive elements in the global economy. First, the global economy has proved to be strong and resilient in recent years. The real economy is robust, except in a few countries, notably the US, which, in turn, has impressive flexibilities. Second, EMEs, by and large, have a better macro-environment than before and can hence contribute possibly to global output and stability. Third, globally, corporate balance sheets are strong and less leveraged than in the past, thus adding to comfort. Fourth, the large financial intermediaries are perhaps adequately capitalised to absorb the shocks of credit infirmities. Fifth, the inflation environment has been, on the whole, benign though incipient pressures, especially due to oil prices, food grains, ample liquidity and possible transmission of upward pressure on prices in China, in the recent past, should not be ignored.

83. There are five determining factors in the manner in which the current issues would unfold as the exit from the current turbulence occurs. First, how quickly and durably the counterparty transparency would be established among the large financial intermediaries, despite the common interest in resolving the issue. The major hurdle would be the fact that the financial markets are integrated globally while the regulatory and transparency regimes are national. The issues of burden-sharing among the institutions/jurisdictions could impact the search for early and meaningful transparency. For example, an issue is the method of marking to market, in a credible manner, instruments that are virtually illiquid and opaque. Second, it is now recognised that there has been excessive leverage and hence the next steps should be de-leveraging on a massive scale, with implications for cost of capital for such an exercise. Third, it is also recognised that excessive disintermediation by the banks has been an important factor. Hence, the next steps should be re-intermediation, namely, bringing the off-balance sheet items of banks back on to their balance sheets with attendant calls on capital of banks at a time when confidence in financial system is under stress. In brief, there are reasons to believe that risks are so widespread and financial innovations have enabled such multi-layering at the expense of transparency that significant segments of the financial sector are closer to a black box than ever before.

84. The most important issue for India is the possible impact of these developments in financial markets and policy responses by central banks in major economies. For convenience, the analysis could be made in terms of financial sector, balance sheet, trade and inflation channels. In regard to the financial sector channel, the primary channel in India is through the equity markets. The currency markets are affected through equity market players or in the guise of equity market players. It is possible to take positions in equity even if the sole motive is currency speculation or ‘carry trade’. However, the movements in currency cannot but affect the real sector as a whole, not merely exporters, as is often believed. Domestic industry could be impacted through the pressure of higher imports since trade is open but this will only become evident with a time lag. In terms of balance sheets, Government, households, corporates and financial intermediaries have, relative to many other EMEs, lower exposure but are not immune to the impact. Large corporates with overseas borrowings or plans for mergers and acquisitions may face constraints due to possible re-pricing of risks and risk aversion in credit markets. The trade channel will also be an important channel, especially if there were to be a slowdown in the US. India’s export basket is diversified but software exports are critical. Past experience shows that there are occasions when a slowdown in the US did not dampen the off-shoring to India. However, the impact on the competitiveness of software due to large movements in currency could be a new factor yet to be fully assessed. Finally, the inflation channel could be critical both from demand and supply side. Liquidity that is injected in the US and the euro area to manage the financial turmoil cannot be fully confined to those economies, thus potentially adding to excess liquidity in India also through renewed capital flows. The supply side pressures in regard to oil and food do not appear to be abating. The evolution of inflation pressures requires enhanced vigilance. In brief, as far as first order effects are concerned, the major issues relate to financial contagion, and potential inflation, and the possibility of real sector impact as the second order effect. The policy challenge is to ensure financial stability and persevere with managing inflation – the tasks identified in the First Quarter Review of the monetary policy and the emerging challenges appear to be daunting. As of now, only a marginal slowdown in global output growth is anticipated and by all indications output growth in India in the short-run may be marginally impacted. The immediate task for public policy in India, therefore, is to manage the possible financial contagion which is in an incipient stage with highly uncertain prospects of being resolved soon.

85. At the current juncture and looking ahead, there are several complexities facing the conduct of monetary policy in India. On the domestic front, the biggest challenge is the management of capital flows and the attendant implications for liquidity and overall stability. A visible reflection of the sheer magnitude of the inflows is the accretion to the foreign exchange reserves which has been of the order of US $ 62 billion during the current financial year up to October 19, of which US $ 48 billion has been built up since end-June 2007. In response, the Reserve Bank has engaged in an active management of liquidity through a combination of instruments at its disposal. The total amount of issuances under the MSS has gone up by 159 per cent over the end-March 2007 level and by 102 per cent over the end-June 2007 level, enabling sterilisation of capital flows of the order of Rs.1,12,292 crore during the current financial year so far up to October 26, 2007. In addition, liquidity absorbed in the form of net reverse repos under the LAF has been Rs.47,320 crore since end-March 2007 – five times the amount in the corresponding period of 2006-07. The CRR was raised by 100 basis points in July 2007 over and above the cumulative increase of 100 basis points during December 2006-March 2007. During 2007-08 up to October 26 on a fortnightly average basis, a total amount of Rs.54,198 crore has been additionally impounded through the CRR from SCBs, an increase of 235 per cent over that absorbed in the corresponding period of the preceding year.

86. While monetary policy has operated reasonably well on the domestic demand-supply and credit-deposit balances even as liquidity emanating from capital flows has been absorbed in the short run, the key future challenge is liquidity management, taking into account the current levels of capital flows. The persistence of these flows has implications for domestic financial stability and future inflation with potential lagged effects on aggregate demand. Consequently, monetary policy will have to address not only the liquidity overhang but also incremental flows in the future if they continue at present levels. In this regard, there are some signs of efforts towards active management of capital flows in public policy which needs to be taken into account in setting the monetary policy stance. It is necessary, however, to continuously and carefully monitor how persistent and effective these measures will be in terms of their impact on managing expectations in financial markets.

87. Yet another challenge for the conduct of monetary policy in the context of recent domestic developments is the rapid escalation in asset prices, particularly equity and real estate, which are significantly driven by capital flows. These pools of capital, which are private, often opaque, highly leveraged and largely unregulated, have the potential for heightening risks to the domestic financial system and posing threats to overall financial stability as well as the prospects for growth. In view of the size of business accruing to these flows in mergers and acquisition activity, stock markets and in real estate, monetary policy will have to contend with the risks to overall macroeconomic stability and threats to inflation expectations emanating from fluctuations in asset prices, the re-pricing of risks and their diffusion across the financial system.

88. Threats to inflation in the future emanate not only from domestic liquidity conditions but also from the underlying global pressures. The possible impact of injection of liquidity by central banks to meet the recent turbulence in global financial markets on global inflation is not yet clear. In any case, globally, pressures on future inflation are embedded in the high and volatile levels of international crude prices as well as prices of food and metals. Furthermore, the sharp increase in inflation in China can get transmitted to major trading partners, given the dominant position of China in the global economy today. Hence, over the next twelve to eighteen months, risks to inflation and inflation expectations would continue to demand priority in policy monitoring.

89. It is important to recognise that large fluctuations in financial markets have deep-seated and lasting effects on the real sectors of the economy, output and employment. At this stage of development of the Indian economy, the formulation of monetary policy has to be acutely sensitive to the impact of excessive market volatility on the real sector with feedback effects on the financial sector. Furthermore, the burden on monetary policy is larger in view of the limited room for manoeuvre for fiscal policy. It is in the context of these developments that monetary policy has to be vigilant and proactive in cushioning the real economy from excess volatility in financial markets.

90. In the overall assessment, the strategy of active liquidity management with a combination of measures used flexibly and often pre-emptively in view of the recognition of their lagged and cumulative effects appears to be yielding positive outcomes. First, domestic developments reflect the dominance of investment demand which has favourable implications in terms of expanding future aggregate supply. Second, there have been strong and sustained imports of capital goods which would augment productive capacity and enhance the elasticity of the supply response in the period ahead. Third, notwithstanding some moderation in headline industrial production, the production of capital goods has maintained its growth momentum, reinforcing aggregate supply conditions and attesting to the underlying strength of investment demand and the ongoing expansion of capacity in conjunction with imports of capital goods. Fourth, business confidence has generally remained buoyant in recognition of the strength of the fundamentals and the resilience of macroeconomic management. Fifth, while there has been a decline in the production of consumer durables, it is important to recognise elements of correction, normalising the excesses of the past that are being reflected in rising defaults on bank lending to the sector. Sixth, there has been a moderation of the mismatch in banks’ balance sheets and rebalancing between credit and deposit growth has occurred.

91. Despite these positive developments, monetary aggregates such as reserve money, money supply and liquidity are expanding at unacceptably high levels, essentially driven by capital inflows, warranting priority in policy attention and posing extraordinary challenges for the conduct of monetary policy going forward. Furthermore, the escalated level of prices of real estate, the role of private foreign equity and non-bank financial companies, and the still strong pace of growth in bank lending to the sector is a cause for concern. In addition, the sizeable off-balance sheet exposures of select banks could pose some risks in a few cases. On balance, domestic conditions, by and large, have evolved so far in line with policy objectives and expectations as set out in the Annual Policy Statement in April 2007. In the period ahead, continuous watchfulness in regard to food and crude prices, asset prices, monetary and liquidity conditions and, above all, developments in global financial as well as commodity markets would be critical. The policy challenge for the Reserve Bank is to manage the current transition to a higher growth path while containing inflationary pressures and focusing on financial stability. Contextually, maintaining enhanced vigilance to be able to respond appropriately to the prevailing heightened uncertainties in global financial and monetary conditions assumes vital importance.

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