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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Overall Assessment

76. Aggregate supply conditions in the Indian economy have shown resilience in the second quarter of 2008-09 in the face of a deteriorating global macroeconomic and financial environment. There are, however, growing indications that the underlying economic cycle is turning in tune with global economic developments and that domestic economic activity is straddling a point of inflexion. While the 2008 south-west monsoon season has been near normal as anticipated, large temporal variations have resulted in some production losses on account of floods in June in some north-eastern, eastern and northern States and deficient rainfall in July over the north-east, central India and Kerala. At the all-India level, the area sown under various crops is close to the normal cropping coverage but lower by about 2.6 per cent in relation to the high level a year ago. Acreage under key crops such as rice and oilseeds has increased on a year-on-year basis but there are downside risks for the prospects of crops such as sugarcane, coarse cereals, pulses and jute. First advance estimates of the production of foodgrains in 2008-09 from the Ministry of Agriculture suggest that some improvement in these key crops could occur as these early indications firm up into a clearer picture on the final level of output for the year and the overall outlook on agriculture.

77. Industrial activity in the second quarter of 2008-09 has shown mixed developments with indications of a moderation in pace diffusing across the sector. While the pick-up in industrial production in July 2008 surprised consensus expectations, occurring as it did after an uneven trough during November 2007-June 2008, base effects weighed heavily on the growth rates observed in August and could continue to cast a shadow in some of the months ahead, especially in October-December 2008. Slackening of momentum is essentially located in the basic and intermediate goods sectors, weighed down by the decline in production of fertilisers, steel, aluminum products, yarns and fibre, organic pigments and the like. The rebound in capital goods production in July after a sag in the preceding two months was not sustained in August, indicative of considerable uncertainty in the evolving investment climate. On the other hand, the sustained turnaround in consumer goods output, particularly durables, indicates that the strength of consumption demand is inducing supply responses, aided by the return of pricing power in an environment of high inflation. Manufacturing activity is being driven by industries such as chemicals, machinery and transport equipment and beverages and tobacco products. In fact, excluding items such as wood and products, leather and paper products, textiles, rubber, plastic, petroleum and coal products which have recorded a decline/negligible growth in production and together have a weight of only 26 per cent in the IIP, the growth of industrial output would be 6.5 per cent, somewhat above the observed headline growth of 4.9 per cent in April-August, 2008. Surveys of corporate finances are indicating a worsening outlook with erosion of profitability due to rising expenditures relative to sales, particularly in respect of raw materials and other inputs, staff costs and exchange losses. Various surveys suggest that overall business confidence is flagging. Service sector activity appears to be moderating in several sub-sectors except in communication and freight movement in terms of lead indicators. Construction activity may pick up in the coming months on the back of some improvement in cement and steel production.

78. Widening gaps in the physical infrastructure, markedly in power but elsewhere too except in coal production, could impose a binding constraint on growth. Capacity addition in the power sector has remained far short of tenth Plan targets, worsening the persisting large shortage in the country. Electricity output appears to have been sharply affected by the downslide in hydro power generation, with the energy content of reservoirs posting a shortfall of 27 per cent of the full reservoir level (FRL) at the all-India level up to mid-October 2008. While thermal power generation has provided support, delays in commissioning/commercial operations, high moisture content in coal due to the monsoon as well as the loss of 3.8 billion units of generation during April-August due to shortages of coal reported by utilities across the country are debilitating factors. Shortages of fuel have also resulted in a loss of 1.2 billion units in the first five months of 2008-09 under nuclear power generation.

79. Aggregate demand conditions continue to be mainly investment-driven, although some slackening which set in during the first quarter of 2008-09 appears to have become broad based. So far, however, investment intentions remain strong as indicated by the memoranda/letters of intent/direct industrial licences posted with the Department of Industrial Policy and Promotion. Private consumption, the mainstay of aggregate domestic demand in India, appears to be firming up steadily since the third quarter of 2007-08 and is expected to benefit from fiscal stimuli on account of enhanced expenditures of subsidies, the farm loan waiver and salaries consequent upon the Sixth Pay Commission award that could come into play during the second half of the year.

80. Reflecting the aggregate demand pressures, key monetary and banking aggregates – money supply, deposit and non-food credit growth – have been expanding during the year so far at rates that are significantly elevated relative to indicative trajectories given in the Annual Policy Statement of April 2008. Money supply has continued to rise at the expansionary rates of 2003-08, propelled by the sustained pace of credit growth. In the July 2008 Review, concerns relating to the significantly overdrawn state of the banking system due to elevated credit growth were expressed in this context. Supervisory review processes have been initiated with selected banks with a view to putting in place appropriate adjustments in their operations. The unabated bank credit growth relative to the sources of funds and the whittling down of excess SLR investments warrants serious policy surveillance in the context of overall financial stability and the efficiency of financial intermediation.

81. The developments in monetary conditions resulted in a tightening of liquidity conditions in domestic financial markets through the second quarter of 2008-09. The strains on market liquidity were aggravated by sizeable fluctuations in the Central Government’s cash balances, advance tax payments in mid-September, higher than anticipated credit growth as well as the heightening of volatility in domestic equity and foreign exchange markets in the wake of the sudden deterioration in international financial markets. In the money market, overnight interest rates generally ruled above the upper bound of the corridor albeit in a narrow range with a peak in the second week of October 2008 as the international financial turbulence intensified. While the measures announced by the Reserve Bank in September-October 2008 alleviated these pressures, considerable uncertainty surrounds the evolution of liquidity conditions in the months ahead, given the fragile international environment. In response to the measures announced by the Reserve Bank, interest rates have moderated across the overnight market segments.

82. In the Government securities market, high demand for SLR securities depressed yields across the spectrum from mid-July with intermittent spurts on liquidity concerns. Yield curve inversion became persistent through the quarter, with the yield on the benchmark 10-year security ruling consistently below those on lower maturity securities in reflection of the uncertain macroeconomic outlook and to some extent, the softening of international crude prices.

83. In the foreign exchange market, activity picked up mainly on rising import demand induced by volatile international crude prices, portfolio outflows and uncertainties surrounding the global outlook. There was considerable volatility in the spot segment with the exchange rate slipping to multi-year lows as the extraordinary developments in international financial markets unfolded. Forward premia rose sharply at end-June and remained at elevated levels up to July 2008 after which the premia have tended to ease albeit unevenly across all maturities. The forward premia went into discount due to dollar shortages towards end-September 2008 but recovered modestly in October 2008. The equity markets have weakened sporadically on cues from global markets, and particularly those in Asia. These developments in domestic financial markets render the macroeconomic outlook unsettled and uncertain.

84. Signs of deterioration in the fiscal situation appear to be adding to aggregate demand pressures in the economy. The revenue deficit of the Central Government has exceeded 177 per cent of the budget estimates during April-August 2008 and overshooting is also observed in the other deficit indicators. While tax revenues were buoyant and direct taxes raised their contribution to gross tax collections to 45 per cent, current expenditures on subsidies, social and other economic services eroded these gains and widened the deficits at all levels. Impending expenditures on subsidies and salary revisions could bring additional pressures to bear on the fisc and consequently, on aggregate demand. The Government will need to address the issue of providing subsidies to the public sector oil marketing and fertiliser companies directly in cash instead of the current practice of issuance of oil and fertiliser bonds.

85. Excess demand conditions are also reflected in the merchandise trade deficit which has expanded by close to 43 per cent in April-August 2008 on a year-on-year basis, though mainly in response to the increase of 77 per cent in the average price of the Indian basket of crude. Although the outlook remains uncertain at the current juncture, the softening of international crude prices in subsequent months should have a salutary effect in terms of containing the merchandise trade deficit over the rest of the year. Non-oil import growth has remained elevated, albeit considerably moderated from the increase recorded a year ago. While exports are regaining momentum and international commodity prices, including crude, seem to be retreating, the widening of the trade deficit needs to be viewed in the context of the turmoil in international financial institutions and markets and the evolving environment for capital flows. The initial conduits of contagion have been equity and currency markets with portfolio investors seeking to wind down positions to meet capital requirements. There are growing concerns about the risks of a more broad-based tightening of external credit conditions setting in with implications for the access of Indian entities to ECBs and short-term trade credits, although ECB norms have been liberalised recently. For the Indian economy, the sizeable increase in foreign direct investment inflows in the first half of 2008-09 provides a measure of comfort. Furthermore, the turnaround in non-resident deposits and in Indian issuances in international stock markets, coupled with the enduring strength of inward remittances are operating as built-in stabilisers in the balance of payments. The level of foreign exchange reserves is adequate in the context of prospective external payment obligations for over a year.

86. At the time of the First Quarter Review in July 2008, headline WPI inflation was close to 12 per cent and June CPI inflation in the range of 7-9 per cent. It was noted that the escalation in inflation has become a global phenomenon, that the rise in inflation in India was not proportionately different from elsewhere and that a noticeable decline in inflation could occur towards the last quarter of 2008-09. While CPI inflation has climbed further in July-September, there is some ebb since mid-August in the underlying momentum of WPI inflation, mainly on account of free-priced petroleum products, edible oils and textiles. more incoming information will be needed to identify a trend if it is forming. Of the increase of 369 basis points in WPI inflation during 2008-09 up to early October, about 55 per cent was due to the rise in prices of POL, food articles, metals and oilseeds/edible oil/oil cakes all of which reflect the global demand-supply balances. Global prices of these commodities had risen sizeably over the same period, leading to sharp increases in inflation across the world, and more so in producer (input and output) prices. Domestically, these imported inflation pressures have been keeping headline inflation at elevated levels with considerable uncertainty as to where it will peak and when. In the absence of further shocks, however, these factors cannot sustain a generalised inflation, especially with money supply contained at the average rate of 2003-08, a period when inflation was low and stable. It needs to be noted, however, that just as the elevation of international commodity prices were not fully passed on to domestic prices, the effect of softening international commodity prices on inflation in India could be similarly muted. The challenge for the setting of monetary policy is to balance the costs of lowering inflation in terms of output volatility, particularly in the context of the moderation in industrial and service sector activity, against the risk of current levels of inflation persisting and getting embedded in inflation expectations. While there are considerable uncertainties associated with this judgment, it is important to remain focused on bringing inflation down to levels that are compatible with a high but stable momentum of growth in the economy and financial stability.

87. Since the First Quarter Review of July 2008, global economic prospects have weakened further. The global economy is facing the deflationary effects of the financial crisis. After the contraction of output in major advanced economies, except the US, in the second quarter of 2008, global growth prospects have worsened in consonance with financial conditions in the third quarter. Retail sales have continued to fall in the third quarter along with consumer confidence in the major economies and unemployment has gone up. The sharp tightening of lending conditions since August could precipitate a dropping away of demand by aggravating the pains of the adjustment underway in the residential sector in several advanced economies. The corporate sector is also adjusting to the pressures from weakening demand and high input costs, which in turn enhances the downside risks to employment. In the US, the erosion of disposable incomes and household wealth is reflecting the decline in real personal consumption. Housing starts and permits plunged in August, weighed down by excess supply of housing units, rise in fixed-rate mortgage rates and expectations of further declines in house prices.

88. There is increasing evidence that the US slowdown is spreading via the trade and financial channels. In the euro area, retail sales are also pointing to weaker activity. The residential downturn appears to have deepened in several economies although household financial conditions remain strong. More recent manufacturing orders growth suggests that business investment in the euro area is also turning down. For the Japanese economy, the outlook has deteriorated sharply in recent months with the weakening of industrial production and retail sales on top of large terms-of-trade losses. Business confidence has declined in the third quarter of 2008, especially among small firms with employment and nominal wage growth slowing in recent months. In the UK, economic activity has slowed sharply and the near-term outlook has weakened sharply with the intensification of financial distress. The deterioration of real incomes associated with higher inflation in conjunction with the squeeze in money and credit conditions is restraining spending. The depreciation of sterling also poses new inflation risks. In other major advanced economies, economic activity has been weakening as well and for the relatively open economies such as Canada, terms-of-trade shifts could dampen otherwise resilient domestic demand. Consensus forecasts place growth in industrial economies in 2008 at 1.5 per cent, still a moderate expansion but with significant downside risks.

89. The outlook for the emerging economies remains positive, but uncertainties about their resilience to the global shocks have increased. Industrial production and export volumes have slowed, while equity markets have fallen sharply in tandem with those in advanced economies and bond spreads have widened. In Latin America, equity price declines have shadowed the softening of commodity prices; in Asia, they have been driven down by portfolio investors switching to safe havens. In some EMEs, banking sectors have witnessed some weakening. Domestic demand, however, continues to be strong, supported by rising household incomes and reflected in still rapidly expanding bank credit. The outlook for exports from emerging economies is less robust, and terms-of-trade effects could dampen domestic demand. Concerns about growth prospects and, more importantly, inflation is impacting sentiment relating to these countries as regards the macroeconomic outlook, capital flows and asset prices. While estimates of capital flows do not indicate sharp reversals, there are indications of a sizeable drop from the second quarter of 2008 onwards in relation to the preceding quarters. With the turmoil in major financial centres, issuances of international equity and debt securities have been constricted and spreads have widened to levels that impede access to external financing. Banking flows have also been affected by the financial turbulence with a drying up of commercial and trade credits and restrictions on rollovers. Many emerging market currencies have depreciated against the US dollar. Investor sentiment relating to emerging economies appears to have been dampened by inflation concerns and expectations of contagion from the slowdown in advanced economies. Among the vulnerable emerging economies are those with large current account deficits and relatively greater reliance on short-term external debt, high fiscal deficits and public sector indebtedness, volatile currencies, inverted yield curves and high inflation. In the period ahead, the soundness and resilience of the financial sector in these economies will have a crucial bearing on growth prospects.

90. Headline inflation still remains high worldwide. Consensus forecasts for industrial economies consumer price inflation have risen from 2.2 per cent in 2007 to 3.6 per cent in 2008 with an even larger increase for emerging economies, driven by food and energy prices. For the latter, there are upward revisions to inflation forecasts for 2008 and 2009 across all regions. Efforts to cushion the impact on retail prices by preventing a full pass-through has weakened fiscal positions in several of these economies. For emerging economy inflation targeters, 13 out of 15 are encountering inflation above the target for some time now and informal targets in other regimes have also been breached persistently. Central banks in these economies have generally responded by tightening monetary policy; for several, however, the risks to growth have emerged as concerns. While some emerging economies have engaged in exchange market interventions to curb inflationary exchange rate depreciation, these efforts are more recently being scaled back. In many emerging economies, strong real domestic bank credit growth has accompanied the inflationary pressures. Upward price pressures are also feeding into core inflation in the advanced economies. The sharp increase in commodity prices in the first half of 2008 that showed up in surging producer price inflation is getting transmitted through to retail levels. The pass-through of input prices to output prices, however, has so far been limited. On the other hand, the recent easing of crude and other commodity prices and indications from futures markets imply that these prices could stabilise over the near term. Considerable uncertainty surrounds both scenarios. If growth slows as the consensus forecasts suggest, the decline in inflation could be more than currently predicted. So far, there is little evidence of generalised increase in wages which would have a determining influence on inflation persistence. Nominal wages are reported to be rising rapidly in some emerging economies. While market-based inflation expectations have fallen in some of the advanced economies, consumers’ inflation expectations have remained elevated with implications for the formations of inflation expectations in the period ahead.

91. The international financial system is gripped by extreme risk aversion in the wake of spectacular failures among the world’s largest financial institutions, including several credited with history and tradition. Fears of further disclosure on write-downs/losses/foreclosures/buy-outs and rising concerns about ‘toxic assets’ spilling over into a more broad-based deterioration in credit quality have exacerbated investor pessimism. Announcements of sizeable public policy bail-outs, guaranteeing of deposits with banking systems and restructuring of weak institutions have not sufficiently assuaged the sense of panic or returned markets to normalcy as yet. Financial markets have experienced an intensification of pressures since May 2008, with the events of September-October 2008 triggering a crisis of confidence that could fundamentally alter the financial landscape in the advanced economies, and in particular, the US. Funding pressures in money markets have been amplified by the unwinding of long US dollar exposures of European banks to non-banks. Central banks and financial regulators have responded with massive liquidity injections, coordinated operations (including swaps and rate cuts) and the banning of certain financial transactions such as short sales. Equity markets have been going through synchronised downturns across the world alongside the weakening of the US dollar against major currencies.

92. As mortgage-related losses widen in their ambit, credit losses and write-downs are spilling out of securitisation and capital market related segments to the more traditional banking book. Across the financial system there is an acute shortage of capital, provoking large rights issues by European banks which, by diluting holdings of existing shareholders, could have actually dampened equity market sentiment. The decline in banks’ share prices has reduced the market capitalisation of global banks by close to US $ one trillion, with market value of net assets below book value in a growing number of cases. Banks’ capacity to raise capital has been severely circumscribed by these large share price declines. In response, policy authorities in some industrial economies have stepped in to recapitalise troubled financial entities. Sovereign wealth funds and official institutions that provided most of the capital in 2007 have turned cautious. At the same time, asset sales are encountering large losses and questions about the incentive structure in regulatory systems to enable such distressed sales. Weaker real sector activity and in particular, the housing sector and the residential mortgage market, has generally added to the pressures on the financial system, notwithstanding fiscal efforts to support US government-sponsored enterprises (GSEs) whose share prices continue to be weak and credit default swap spreads on subordinated debt have widened significantly in relation to the last quarter.

93. In summary, conditions in global financial markets have worsened with the freezing of inter-bank markets in US and Europe necessitating massive liquidity injection facilities from central banks in these economies including dollar swap arrangements, coordinated monetary policy actions in terms of both liquidity injections and reduction of policy rates, recapitalisation of troubled private banks by governments, coordinated action by European governments to bail out weak banks and guaranteeing of all deposits in the banking system in many countries. These problems have been compounded by falling prices in already weak housing markets and the unwinding of complex derivatives with attendant mark-to-market losses impacting the health of balance sheets, and falling equity prices. With the spread of contagion through indirect effects due to financial integration to countries outside the epicenter of the crisis, authorities in these economies, particularly in east Asia, have taken steps to guarantee deposits and injected liquidity into banking systems, besides undertaking monetary policy actions in the form of reducing required reserves and interest rates.

94. In the overall assessment, global economic conditions have worsened and the future path of their evolution has turned highly uncertain. The broadening slowdown of economic activity in the advanced economies is beginning to impact the macroeconomic prospects of emerging economies, with those reliant on exports and on international financial markets for external financing needs likely to be the most vulnerable. Inflation remains elevated and a key risk to global economic prospects. While commodity prices have been coming off their recent heights and are expected to soften further by the futures markets, the pass-through of the recent prolonged escalation is still seeping into headline inflation and may keep it firm at current levels in the near-term. At the current juncture, the deepening of the financial crisis could impact the weakening macroeconomic outlook in advanced economies with second round effects across the rest of the world. Consequently, monetary policy action against inflation in advanced and emerging economies alike appears to be getting increasingly circumscribed by the more overarching concerns relating to the economy and the financial system. Domestically, lowering inflation as soon as feasible to tolerable levels and anchoring inflation expectations remains a key concern. The momentum in industrial and service sector activity is somewhat moderated in relation to the recent high growth phase of 2005-08. The expected improvement in agricultural output should augment aggregate supply and assuage the inflationary pressures. While the financial system in India has so far been reasonably insulated from the carnage in international financial markets, cataclysmic events including the sheer spread of the turmoil and the type of financial institutions that have plunged under, regardless of reputation or size, warrants an intensified watchfulness with a readiness to act swiftly to cushion the economy and the domestic financial system from external shocks.

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