Part I. Annual Statement on Monetary Policy for the Year 2006-07
I. Review of Macroeconomic and Monetary Developments during 2005-06
5. Real GDP growth projections for 2005-06 for the purpose of monetary policy formulation were revised upwards in two stages from around 7.0 per cent in the Annual Statement for 2005-06 to a range of 7.5 to 8.0 per cent in the Third Quarter Review of January 24, 2006 drawing from indications of a firming up of the recovery in agriculture and sustained momentum of expansion in industry and services. This upward revision turned out to be in alignment with the advance estimate of the Central Statistical Organisation (CSO) released in February 2006 placing real GDP growth during 2005-06 at 8.1 per cent, up from 7.5 per cent in the previous year.
6. Real GDP originating from agriculture and allied activities is estimated to have registered a growth of 2.3 per cent, reviving from a low of 0.7 per cent in the previous year. According to the advance estimates of the Ministry of Agriculture, foodgrain production is placed at 209.3 million tonnes in 2005-06. The outlook for sugarcane is bright while production of oilseeds is expected to be moderately above the level of the preceding year. Production improved in respect of horticulture, livestock, fisheries and plantation crops, imbuing resilience to the real GDP originating from agricultural and allied activities.
7. The growth of real GDP originating in industry is estimated by the CSO to have stepped up to 8.0 per cent in 2005-06 from 7.4 per cent in the previous year. The improvement in industrial activity in 2005-06 was mainly due to acceleration of manufacturing growth from 8.1 per cent in the preceding year to 9.4 per cent. Sustained expansion in domestic as well as export demand, increased capacity utilisation, augmentation of capacities and positive business and consumer confidence underpinned the strength of the manufacturing sector.
8. The index of industrial production (IIP) recorded an increase of 8.0 per cent during April-February 2005-06 on top of 8.2 per cent a year ago, led by manufacturing which recorded a growth of 9.0 per cent, comparable to 8.9 per cent growth in the corresponding period of the previous year. The production of capital and consumer goods industries increased by 16.5 per cent and 11.7 per cent, respectively. The basic goods segment registered a growth of 6.4 per cent as against 5.3 per cent a year ago. The overall growth in six infrastructure industries was lower at 4.5 per cent during April-February, 2005-06 as compared with 5.8 per cent a year ago due to decline in crude petroleum and deceleration in refinery products and finished steel, somewhat offset by the pick-up in cement and coal. Electricity generation rose by 5.3 per cent as against 5.4 per cent in the preceding year.
9. A review of the financing pattern of the corporate sector over the first half of the current decade indicates that corporates took advantage of the declining interest rate cycle by readjusting their debt portfolio in favour of low cost resources, by increased recycling of internal resources and access to external sources. It is also evident that corporates focused on minimising financing costs and boosting investment income to supplement normal business income. These developments, in conjunction with stronger sales growth, lower tax rates, downsizing and restructuring led to high growth in after-tax profits from mid-2003 until the second quarter of 2005-06, which helped in improving business confidence. During 2005-06, private corporate sales growth moderated from 18.5 per cent and 16.4 per cent during the first and second quarters, respectively, to 13.2 per cent in the third quarter. The growth in net profits slowed from 54.2 per cent and 27.5 per cent in the first and second quarters, respectively, to 27.0 per cent in the third quarter. Corporate investment intentions as also the proposals for capital expenditure indicate prospects of substantial growth and consolidation during 2006-07. The outlook for the corporate sector in terms of financing needs would be important for assessing the credit flow from the banking system to the commercial sector.
10. In response to the Reserve Bank’s Industrial Outlook Survey, nearly half of the respondents indicated an improvement in the overall business situation whereas another 40 per cent respondents felt that the situation may be similar to the previous quarter. The survey results indicate seasonal decline in output and order books during April-June 2006 though not as steep as in the preceding years. As regards the overall financial situation, capacity utilisation, employment and working capital finance requirements and availability, most respondents were positive although a majority expects some increase in the cost of raw materials.
11. Real GDP originating in the services sector is estimated to have increased by 10.1 per cent during 2005-06 as against 10.2 per cent a year ago with most sub-sectors sharing this buoyancy. The growth of construction was sustained at 12.5 per cent in 2004-05 and 12.1 per cent in 2005-06, supported by increasing cement and steel production. The growth of trade, hotels and restaurants, transport, storage and communication rose from 10.6 per cent in 2004-05 to 11.1 per cent. Financing, insurance, real estate and business services posted a growth of 9.5 per cent during 2005-06 as against 9.2 per cent a year ago. Community, social and personal services registered a growth of 7.9 per cent in 2005-06 as against 9.2 per cent a year ago.
12. Financing requirements associated with the pick-up in real economic activity were reflected in a robust expansion of bank credit for the second year in succession. Several features distinguish bank credit growth in 2005-06. First, the fact that March 31, 2006 was the balance sheet date for banks coinciding with the last reporting Friday has lent an upward bias to banking data for 2005-06 which had 27 reporting fortnights instead of the usual 26 fortnights. Scheduled commercial banks’ (SCB) credit rose by
36.0 per cent (Rs.3,96,045 crore) during 2005-06, over and above 27.0 per cent (Rs.2,26,761 crore), net of conversion of a financial institution into a bank, in the previous year. Food credit increased by Rs.667 crore as against an increase of Rs.5,159 crore in the previous year. Non-food credit remained the key driver of banking activity, growing by 37.3 per cent (Rs.3,95,379 crore) on top of 27.5 per cent (Rs.2,21,602 crore), net of conversion, a year ago. Even after excluding the end-March build-up, the year-on-year increase in non-food bank credit during 2005-06 (over April 1, 2005) was 30.8 per cent (Rs.3,42,493 crore).
13. Second, distinct shifts in the pattern of deployment of non-food bank credit have become increasingly evident as highlighted by successive monetary policy reviews in 2005-06. During April–January, 2005-06 credit to services sectors emerged as the dominant category, increasing by 36.2 per cent as against 25.1 per cent a year ago and accounting for 63.1 per cent of the incremental non-food credit. Within this category, retail lending has risen rapidly. Retail credit expanded at rates ranging between 22-41 per cent since 2001-02 and accounted for 26.7 per cent of the incremental non-food credit in 2005-06. It is pertinent to note that the share of advances to ‘individuals’ increased from about 10 per cent of total bank credit in March 2002 to nearly 25 per cent in January 2006. Loans to commercial real estate rose by 84.4 per cent in 2005-06, constituting 4.4 per cent of incremental non-food credit. Housing loans increased by 29.1 per cent and accounted for 14.6 per cent of incremental non-food credit. While the flow of credit to industry as a whole showed a modest increase of 15.6 per cent in 2005-06 from 11.3 per cent a year ago, bank credit to the infrastructure industries, especially power, rose by 28.8 per cent on top of 32.9 per cent a year ago. Substantial increases were observed in credit flow to industries like food processing, iron and steel, cotton textiles, vehicles, chemicals, gems and jewellery and construction. Agricultural credit increased by 22.4 per cent as compared with 18.9 per cent in the corresponding period of the previous year.
14. Third, credit growth outpaced deposit growth by a substantial margin. The aggregate deposits of SCBs increased by 22.8 per cent (Rs.3,87,471 crore) during 2005-06 as against an increase of 12.8 per cent (Rs.1,92,269 crore), net of conversion, in the previous year. Excluding the end-March effect referred to earlier, the year-on-year increase in aggregate deposits during 2005-06 (March 31, 2006 over April 1, 2005) was 16.9 per cent (Rs.3,02,534 crore). The year-on-year incremental non-food credit-deposit ratio continued to remain high at 113.2 per cent during 2005-06 as compared with 117.4 per cent a year ago. Significantly, the incremental non-food credit deposit ratio jumped from 90.4 per cent in the first half of 2005-06 to 132.3 per cent in the second half of the year.
15. Fourth, banks’ efforts to raise deposits to fund the credit demand has led to a visible shortening of the maturity profile of deposits in the banking system and an escalation at the margin in the cost of raising deposits. Demand deposits registered a year-on-year growth of 21.4 per cent in 2005-06, up from 16.1 per cent a year ago. While time deposits increased by 16.1 per cent (as against 14.9 per cent a year ago), this was mainly on account of short-term wholesale deposits up to one year maturity at rates which were bid up to a range of 8.0-8.5 per cent. In consonance, discount rates on certificates of deposit (CDs) also rose beyond 8.0 per cent from February, 2006. Banks’ deposit mobilisation efforts seem to have turned in favour of non-core bulk deposits of corporates instead of core retail deposits. Bulk deposits raised at relatively higher rates cannot sustain a higher credit demand on an enduring basis and have a potential for adverse consequences for balance sheet management and profitability. It is, therefore, necessary to reiterate the need for banks to review their policies in this regard and make sustained efforts towards mobilising stable retail deposits by providing wider access to better quality of banking services. This would sustain prudent business expansion without facing undue asset-liability mismatches.
16. Fifth, the drive to expand non-food credit induced shifts in banks’ portfolios. The decline in statutory liquidity ratio (SLR) investments accommodated the higher credit demand to a large extent. For the first time since the nationalisation of banks in 1969, investment by SCBs in Government and other approved securities declined by Rs.11,576 crore in contrast to an increase of Rs.49,373 crore, net of conversion, in 2004-05. Thus, major support to the market borrowing programme of Central and State Governments came from non-banks.
17. Sixth, banks’ investments in bonds/debentures/shares of public sector undertakings and the private corporate sector and commercial paper (CP) declined by 13.0 per cent (Rs.12,238 crore) as compared with an increase of 5.3 per cent (Rs.4,775 crore) in the previous year. The year-on-year increase in total flow of funds from SCBs to the commercial sector, including non-SLR investments, was 27.4 per cent (Rs.3,30,866 crore) as against 30.2 per cent (Rs. 2,79,326 crore) a year ago.
18. As regards money supply (M3), it is necessary to factor in the end-March effect. M3 increased by 20.4 per cent (Rs.4,58,456 crore) in 2005-06 as compared with 12.1 per cent (Rs.2,42,260 crore), net of conversion, in the previous year. Even after excluding the end-March effect, the year-on-year M3 growth was 16.2 per cent (Rs.3,77,238 crore) in 2005-06 (March 31, 2006 over April 1, 2005) reflecting the features discussed above. The year-on-year increase in bank credit to the commercial sector, which excludes the end-March effect, was 26.7 per cent (Rs.3,55,251 crore), which was higher than the increase of 24.3 per cent (Rs.2,54,035 crore), net of conversion, in the previous year. On the other hand, net bank credit to Government increased by 3.8 per cent (Rs.28,819 crore) as against 0.9 per cent (Rs.6,776 crore), net of conversion, a year ago. Banks’ credit to Government (excluding the Reserve Bank credit to Government) declined by Rs.11,460 crore. The banking sector’s net foreign exchange assets increased by 10.2 per cent (Rs.65,962 crore) year-on-year, primarily reflecting the increase in net foreign exchange assets of the Reserve Bank by 10.1 per cent (Rs.61,545 crore).
19. The total overhang of liquidity as reflected in outstandings under the Liquidity Adjustment Facility (LAF), the Market Stabilisation Scheme (MSS) and surplus cash balances of the Central Government taken together increased marginally from an average of Rs.1,14,192 crore in March 2005 to Rs.1,15,258 crore in October 2005. Thereafter, there was a steady decline in the liquidity overhang to Rs.74,334 crore in March 2006. The IMD redemption at end-December, 2005 accounted for about Rs.32,000 crore of this decline of Rs.40,924 crore. During the year, the financial markets shifted from surplus mode to deficit in terms of LAF. On a net basis, the average daily LAF reverse repo absorption was Rs.22,481 crore and Rs.25,409 crore in the first and the second quarters, respectively, but declined to Rs.7,825 crore in the third quarter, and finally shifted into average daily repo injection of Rs.11,686 crore during the last quarter.
20. Pressures on market liquidity warranted appropriate monetary operations to obviate wide fluctuations in market rates and to ensure reasonable stability in financial markets consistent with the monetary policy stance. In October, liquidity conditions firmed up with the onset of festival demand for currency, superimposed upon sustained credit demand. Accordingly, average reverse repo levels under the LAF declined in relation to the preceding month. With resumption of the market borrowing programme of the Central Government under the indicative calendar for the second half of the year, liquidity conditions tightened further in November. There was a release of net liquidity of the order of Rs.5,500 crore in November through MSS redemptions as the Reserve Bank refrained from fresh auctions under the scheme in the second half of the month. Market conditions improved subsequently and the Reserve Bank returned to absorption mode with a steady build-up of reverse repos under the LAF, including under the second LAF. Thereafter, liquidity tightened again in the run-up to quarterly advance tax outflows in the middle of December, the redemption of IMD at the end of December and on account of accretions to cash balances of the Central Government. Declining reverse repo levels were accompanied by repos from December 16, and generally there were net injections of liquidity. There was a further unwinding of MSS of the order of Rs.19,522 crore during December. On a review of liquidity conditions including the IMD redemption at the end of December 2005, the Reserve Bank announced suspension of the issue of treasury bills and dated securities under the MSS, while retaining the flexibility of conducting auctions under the scheme from time to time after giving sufficient notice to the market.
21. The outstanding balances under MSS increased from Rs.65,481 crore at end-March 2005 to a peak of Rs.80,585 crore in early September and thereafter declined by Rs.51,585 crore to Rs.29,000 crore by end-March 2006 reflecting the unwinding of MSS balances. During January-March 2006, Rs.17,578 crore was released through unwinding of MSS securities.
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