Second Quarter Review of Monetary Policy 2009-2010
-Announced on the 27th October 2009
Part A. Monetary Policy
II. Stance of Monetary Policy
57. As a part of the accommodative monetary policy followed since mid-September 2008, the Reserve Bank has provided ample rupee and dollar liquidity and maintained a market environment conducive for the continued flow of credit to productive sectors at lower cost. The important measures initiated include reduction of the policy rates under the LAF to their historically low levels, lowering of reserve requirements, institution of sector-specific liquidity facilities and a forex swap facility, relaxation in the ECB guidelines, countercyclical prudential measures of adjustment in risk weights and provisioning, and conditional special regulatory treatment for restructured assets.
58. Consistent with its accommodative monetary stance, the Reserve Bank expanded its domestic assets through open market operations (OMO) and unwinding of market stabilisation scheme (MSS) securities to provide primary liquidity to support the required monetary expansion. Several measures taken by the Reserve Bank since mid-September 2008 have augmented actual/potential liquidity in the system on the aggregate by Rs.5,85,000 crore.
59. As a result of the extraordinary monetary easing by the Reserve Bank, the banking system has been awash with liquidity since November 2008. This is reflected most prominently in the absorption under the LAF window of a daily average of almost Rs.1,20,000 crore. The utilisation of the several refinance facilities instituted by the Reserve Bank too has been low, further evidencing the ample liquidity situation. Interest rates in all the markets have declined significantly over the last one year as detailed before. The transmission of lower policy rates to the credit market has materialised with a lag. With most commercial banks reducing their deposit rates, the cost of funds has declined enabling banks to reduce their BPLRs. The effective lending rates have also come down as nearly three-fourths of bank lending takes place at rates below their BPLRs as alluded to before.
60. During the first quarter of 2009-10, real GDP recorded a growth of 6.1 per cent, lower than the growth of 7.8 per cent in the corresponding quarter of 2008-09, but marginally higher than the 5.8 per cent growth in the second half of 2008-09. The south-west monsoon rainfall this year has been the weakest since 1972 affecting both yield and acreage of agricultural crops. This will impact Kharif production and the performance of agricultural production during the Rabi season will be critical for supply management. On the whole, agricultural production in 2009-10 is expected to be lower than in last year.
61. While external demand has continued to contract, large fiscal and monetary stimulus measures have bolstered domestic consumption and helped the recovery in the industrial sector. The prospects of the industrial sector have become more promising than they were at the time of the First Quarter Review. With the recovery in the stock market, the primary segment of the capital market has also witnessed increased activity in the recent period. This, combined with the easing of international financing conditions, augurs well for a pick-up in investment activity. The business confidence surveys also point to further improvement in outlook despite weak perception of export demand.
62. Various services sector activities, which have slowed down significantly in the recent period, should also catch up, albeit with a lag, in tandem with improved industrial growth. Assuming a modest decline in agricultural production and a faster recovery in industrial production, the baseline projection for GDP growth for 2009-10 is placed at 6.0 per cent with an upside bias (Chart 7). Thus, the GDP projection for 2009-10 for policy purposes remains unaltered from that made in the First Quarter Review of July 2009.
63. Headline WPI inflation turned negative during June-August 2009 due to the large statistical base effect. As anticipated in the First Quarter Review, WPI inflation has returned to positive territory, albeit a few weeks sooner than expected, in the wake of large increase in prices of food items and increase in global crude oil prices.
64. The upside risks on account of deficiency in monsoon rainfall indicated in First Quarter Review of July 2009 have now materialised as prices of food items have risen sharply. Going forward, Rabi crop prospects would be critical in shaping the path of food inflation. The large stock of foodgrains with public agencies should help mitigate any significant adverse impact due to supply constraints. The improved terms of trade for agriculture in recent years should provide an incentive to the sector.
65. Global commodity prices, which had bottomed out in early-2009, rebounded ahead of global recovery. The global oil prices present a mixed picture. Crude oil prices, which increased from their low levels of January-March 2009, have remained range-bound since June 2009. Large global liquidity due to easy monetary policy followed by major central banks has led to sizeable financialisation of the commodities market, especially for those products that are prone to demand supply gaps. These developments may induce greater volatility in commodity prices in the coming years.
66. Inflation assessment has become increasingly complex in recent times with the WPI inflation rate remaining negative or low and the various CPI inflation measures remaining close to or above the double digits for an extended period. CPI inflation has remained at an elevated level since March 2008 and did not decline as expected in line with fall in WPI inflation. Indeed, it hardened due to sharp increase in essential commodity prices. The situation was aggravated by the deficient monsoon rainfall and drought condition in several parts of the country. The Reserve Bank monitors an array of measures of inflation, both overall and disaggregated components, in conjunction with other economic and financial indicators, to assess the underlying inflationary pressures and articulates its policy stance in terms of WPI. The Government took a decision on October 19, 2009 to reduce the frequency of the current series of Wholesale Price Index (base:1993-94) from weekly to monthly. The available indices, WPI and the four measures of CPI, fail to adequately capture the underlying inflationary conditions because of inadequate coverage and also because the respective base years do not capture the changed production and consumption patterns. This underscores the need to expedite the revision of coverage and updating of the base year for the WPI series as also the proposed two consumer price indices, i.e., CPI-Urban and CPI-Rural.
67. The First Quarter Review of July 2009 projected WPI inflation for end-March 2010 at around 5.0 per cent. The July Review indicated that the risk to this projection was on the upside. Though the year-on-year WPI inflation was 1.21 per cent as on October 10, 2009, it has already increased by 5.95 per cent on a financial year basis though some of the increase is seasonal and is likely to soften. However, the base effect, which resulted in negative WPI inflation during June-August 2009, is now expected to work in the reverse direction accentuated by high food prices. The Reserve Bankís quarterly inflation expectations survey for households indicates that while inflationary expectations remain contained, a majority of the respondents expect inflation rate to increase over the next three months as also over the next year.
68. Keeping in view the global trend in commodity prices and the domestic demand-supply balance, the baseline projection for WPI inflation at end-March 2010 is placed at 6.5 per cent with an upside bias (Chart 8). This is higher than the 5.0 per cent WPI inflation projected in the First Quarter Review of July 2009 as the upside risks have materialised.
69. As always, the Reserve Bank will endeavour to ensure price stability and anchor inflation expectations. The conduct of monetary policy will continue to condition and contain perception of inflation in the range of 4.0-4.5 per cent. This will be in line with the medium-term objective of 3.0 per cent inflation consistent with Indiaís broader integration with the global economy.
70. The year-on-year growth in money supply (M3) increased from 18.6 per cent in end-March 2009 to 18.9 per cent by October 9, 2009. A major source of M3 expansion this year has been the banking systemís financing of the large market borrowing of the Government, including OMO purchases by the Reserve Bank. The growth in bank credit to the commercial sector has moderated significantly to 10.7 per cent from the high level of 27.4 per cent a year ago.
71. The First Quarter Review of July 2009 raised the indicative trajectory of M3 growth to 18.0 per cent from 17.0 per cent envisaged in the Annual Policy Statement of April 2009 to ensure that the increased government market borrowing programme did not crowd out the credit flow to the private sector. Over 80 per cent of the market borrowing programme for 2009-10 is now completed. In 2009-10 (up to October 9, 2009), credit has expanded by Rs.1,14,800 crore. Thus, to attain the projected growth of 20 per cent, banks will need to expand credit by Rs.4,40,000 crore in the remaining part of the year, which will be difficult unless demand for retail credit accelerates. Also, access of corporates to non-bank sources of financing, both domestic and international, has eased, which could lead to substitution of bank credit. While credit demand is expected to pick up during the second-half of 2009-10, attaining the projected growth of 20 per cent is unlikely.
72. Keeping in view the borrowing requirement of the government and of the commercial sector in the remaining period of 2009-10, the indicative projection of money supply growth of 18.0 per cent set out in July 2009 is revised downwards to 17.0 per cent. Consistent with this, aggregate deposits of scheduled commercial banks are projected to grow by 18.0 per cent. The growth in adjusted non-food credit, including investment in bonds/debentures/shares of public sector undertakings and private corporate sector and CPs, is also revised downwards to 18.0 per cent from 20.0 per cent set out in the Annual Policy Statement and the First Quarter Review. Banks are urged once again to step up their efforts towards credit expansion while preserving credit quality which is critical for revival of growth.
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