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Assessment of Macroeconomic and Monetary Developments- Third Quarter Review 2005-06

Domestic Developments

Macroeconomic activity has firmed up as evident from estimates of Gross Domestic Product (GDP) for the second quarter (Q2 or July-September) of 2005-06 by the Central Statistical Organisation showing real GDP growth at 8.1 per cent for the first half of the year, one percentage point higher than in the first half of last year. More recent data also suggest that growth is, by and large, well spread across various sectors of the economy.

The progress of the North-East monsoon has been satisfactory, although somewhat concentrated in a few regions. According to the India Meteorological Department, cumulative rainfall up to December 31 was 10 per cent above normal for the country as a whole with excess/normal rain in 17 out of the 36 meteorological sub-divisions. The total water storage in the 76 major reservoirs in the country was 63 per cent of capacity at the full reservoir level up to January 13, 2006, higher than 43 per cent a year ago as well as the ten-year average of 50 per cent. These conditions augur well for rabi production. The progress of rabi activity and advance estimates of kharif production are encouraging. Thus, the foodgrains production target of 215 million tonnes is within striking range and sizeable year-on-year increases are also anticipated in the production of non-food crops. Accordingly, real GDP originating from agriculture and allied activities is poised to show higher growth in the second half of 2005-06 than 2.0 per cent estimated for the first half of the year.

The pick up in growth of real GDP originating in industry to 8.8 per cent in the first half of the year as against 8.3 per cent in April-September, 2004 was led by an expansion of 10.2 per cent in the manufacturing sector. In subsequent months, industrial activity has remained resilient on the back of sustained growth in the manufacturing sector, despite some slowdown in the performance of the infrastructure industries. During April-November, 2005 the index of industrial production (IIP) rose by 8.3 per cent as against 8.6 per cent in the corresponding period of the preceding year. Manufacturing output recorded a growth of 9.4 per cent as against 9.1 per cent a year ago. Mining and quarrying and electricity generation decelerated. The production of capital goods and consumer goods – both durable and non-durable – recorded double-digit growth rates with the expansion of the capital goods sector at its peak for April-November since 1997-98. While the production of basic goods picked up, intermediate goods recorded a subdued performance.

During April-November, 2005 the overall growth of infrastructure industries at 4.4 per cent was lower than 6.7 per cent a year ago. The slowdown was mainly on account of a decline in the output of crude petroleum and petroleum refinery products as well as deceleration in the production of coal and electricity. Cement production, however, has risen significantly reflecting increased demand from housing and construction as well as exports. The moderate improvement that is underway in the production of finished steel and electricity could, in the normal circumstances, improve the prospects of infrastructure and the overall industrial sector in the ensuing months.

The buoyancy in manufacturing activity has been well supported by export demand across a wide spectrum of industries, expanding bank credit, rising capacity utilisation/expansion, sustained corporate performance and growing business and consumer confidence. The Reserve Bank’s Industrial Outlook Survey reports an improvement in overall business expectations in October-December, 2005 over the previous quarter based on a more positive outlook on output growth, access to working capital and finance requirements, exports and capacity utilisation. The Business Expectations Index was at its highest level in October-December, 2005 since the inception of the Survey in 1998. Surveys conducted by other agencies also indicate similar improvements in business confidence for the second half of 2005-06 showing overall invigoration of the growth momentum.

During the first half of 2005-06, growth of the private corporate sector was sustained, albeit with some signs of slowing down. Year-on-year growth in sales decelerated from an average of around 23.0 per cent in 2004-05 to 18.5 per cent in the first quarter of 2005-06 and 16.4 per cent in the second quarter. The growth in net profits, which was sustained above 45.0 per cent till the first quarter of 2005-06, decelerated to 27.5 per cent in the second quarter and further to around 20.0 per cent in the third quarter. While the slack in capacity has narrowed, corporates have accumulated significant internal resources to support investment decisions already taken. Unlike in the mid-1990s when investments were undertaken in anticipation of demand, it appears that investments are now driven by global competitiveness and demand generated domestically. Moreover, the impact of new technologies is reflected in shortening of gestation lags in various industries. Accordingly, the overall outlook for the corporate sector continues to be encouraging.

Real GDP originating in the services sector rose by 9.7 per cent in the first half of 2005-06 as against 8.4 per cent a year ago, with all constituent sub-sectors sharing this buoyancy. The growth of construction, up from 4.8 per cent in the first half of 2004-05 to 7.6 per cent in April-September, 2005-06 is expected to pick up further, supported by increasing cement and steel production. The growth of trade, hotels, transport and restaurants, which rose from 11.9 per cent to 12.2 per cent, would benefit in the coming months from the increase in sales of commercial vehicles (11.4 per cent in April-November), railway freight revenue (9.5 per cent in April-October), airline passengers at domestic terminals (22.5 per cent in April-October), cargo handled at major ports (11.7 per cent in April-October), foreign tourist arrivals (12.7 per cent in April-October) and telephone connections (87.1 per cent in April-October). Financing, insurance, real estate and business services posted a growth of 9.1 per cent in the first half of 2005-06 as against 6.2 per cent a year ago. Community, social and personal services had risen by 6.4 per cent in the first half of 2005-06 as against 5.4 per cent a year ago. Overall, the outlook for the services sector is bright.

Bank credit has expanded significantly reflecting, to a large extent, the strengthening of economic activity. Scheduled commercial banks’ credit increased by 23.3 per cent (Rs.2,56,441 crore) during the year up to January 6, 2006 as compared with 19.9 per cent (Rs.1,67,041 crore), net of conversion, in the corresponding period last year. Due to lower procurement for public distribution/stocking, food credit increased moderately by Rs.1,979 crore as against an increase of Rs.9,098 crore a year ago. Non-food credit increased by 24.0 per cent (Rs.2,54,462 crore) on top of the increase of 19.6 per cent (Rs.1,57,943 crore), last year, net of conversion. On a year-on-year basis, non-food credit growth at 32.0 per cent as on January 6, 2006 was higher than 26.6 per cent, net of conversion, a year ago.

Banks’ non-food credit operations over the preceding two years point to some shifts in the pattern of deployment. During 2005-06 (up to October), credit to industry increased by 11.5 per cent. Significant increases in credit off-take were recorded by power, iron and steel, automobiles, chemical and chemical products, textiles, gems and jewellery, petroleum, coal products and nuclear fuels, roads and ports and engineering. Bank credit to the services sector increased by as much as 20.7 per cent, accounting for 58.7 per cent of the incremental non-food credit. The growth in credit to the services sector was led by housing, commercial real estate and personal loans which together accounted for over a third of incremental non-food credit in 2005-06. Credit to commercial real estate and personal loans have been rising significantly above trend rates of growth. Credit to agriculture has been growing at over 39.1 per cent on a year-on-year basis since 2004-05, constituting 11.8 per cent of incremental non-food credit.

Scheduled commercial banks’ investments in bonds/debentures/shares of public sector undertakings and the private corporate sector, commercial paper (CP) and other instruments declined by 15.4 per cent (Rs.14,474 crore) up to January 6, 2006 as against a decline of 7.2 per cent (Rs.6,404 crore), net of conversion, in the corresponding period last year. Despite this, the total flow of resources from scheduled commercial banks to the commercial sector showed a significant increase of 20.8 per cent (Rs.2,39,988 crore) as compared with the increase of 16.9 per cent (Rs.1,51,539 crore), net of conversion, in the corresponding period last year. The year-on-year growth in resource flow was also higher at 28.3 per cent as against 23.2 per cent, net of conversion, a year ago.

Aggregate deposits of scheduled commercial banks rose by 14.1 per cent (Rs.2,39,442 crore) during 2005-06 up to January 6, 2006 as compared with an increase of 10.0 per cent (Rs.1,50,094 crore), net of conversion, in the corresponding period of the previous year. On a year-on-year basis, the growth in aggregate deposits was 17.0 per cent as compared with 14.5 per cent, net of conversion. Demand deposits rose faster by 30.3 per cent as against 19.8 per cent a year ago while time deposits increased by 14.8 per cent, higher than 13.7 per cent, net of conversion, last year.

Money supply (M3) increased by 12.4 per cent (Rs.2,80,483 crore) during 2005-06 up to January 6, 2006 as compared with 8.8 per cent (Rs. 1,76,906 crore), net of conversion, in the corresponding period last year. On a year-on-year basis too, the growth in M3 was higher at 15.9 per cent than 13.5 per cent, net of conversion, a year ago. The larger expansion of money supply in 2005-06 so far has been driven mainly by the sharp increase in non-food credit.

Reserve money increased by 13.2 per cent (Rs.64,725 crore) during 2005-06 up to January 13, 2006 as against an increase of 5.9 per cent (Rs.25,831 crore) in the corresponding period last year. Currency in circulation increased by 13.3 per cent (Rs.49,028 crore) as compared with 9.6 per cent (Rs.31,556 crore). Bankers’ deposits with the Reserve Bank increased by 15.2 per cent (Rs.17,319 crore) as compared with a decline of 4.8 per cent (Rs.5,017 crore). As regards the sources of reserve money, net RBI credit to the Central Government increased by Rs.69,955 crore as against a decline of Rs. 27,012 crore. The Reserve Bank’s net foreign exchange assets (NFEA) increased by Rs.10,719 crore, adjusted for revaluation, as compared with the increase of Rs.60,875 crore in the corresponding period last year. The ratio of NFEA to currency declined from 166.2 per cent in March 2005 to 146.9 per cent by January 13, 2006. The year-on-year increase in reserve money was at 19.8 per cent as on January 13, 2006 as compared with 17.3 per cent a year ago.

Total liquidity, as reflected in outstandings under Liquidity Adjustment Facility (LAF), Market Stabilisation Scheme (MSS) and surplus cash balances of the Central Government taken together, had risen to a daily average level of Rs. 1,23,826 crore in September from Rs.1,18,044 crore in April 2005. Sizeable shifts in liquidity conditions characterised the third quarter of 2005-06. Broadly, pressures on market liquidity were partly frictional and arising from seasonal and transient factors including the redemption of India Millennium Deposits (IMD), and partly cyclical, associated with the pick up in growth momentum and the induced demand for bank credit. This warranted appropriate monetary operations to obviate wide fluctuations in market rates and ensure reasonable stability 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 the auctions under the Scheme from time to time with sufficient notice to the market.

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