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First Quarter Review of Monetary Policy click here

First Quarter Review of Monetary Policy 2009-2010
-Announced on the 28th July 2009

II. Stance of Monetary Policy

52. The thrust of the various policy initiatives by the Reserve Bank since mid-September 2008 has been on providing ample rupee liquidity, ensuring comfortable dollar liquidity and maintaining a market environment conducive for the continued flow of credit to productive sectors. The important measures initiated include reduction of the repo and reverse repo rates, reduction of the CRR and the SLR, institution of several sector-specific liquidity facilities, establishment of a forex swap facility and relaxation in the guidelines for raising external commercial borrowings (ECBs). Also, the Reserve Bank allowed restructuring of stressed assets by banks in order to increase the flow of credit for productive purposes.

53. In the Annual Policy Statement of April 2009, the reverse repo and repo rates were reduced by 25 basis points each. Currently, the reverse repo rate is at 3.25 per cent and the repo rate is at 4.75 per cent. These are at their historically lowest levels. Liquidity Impact

54. The actions of the Reserve Bank since mid-September 2008 have resulted in augmentation of actual/potential liquidity of Rs.5,61,700 crore (Table 20). In addition, the permanent reduction in the SLR by one per cent of NDTL has made liquid funds of the order of Rs.40,000 crore available for credit expansion. Analytically, the various policy actions by the Reserve Bank since mid-September 2008 have resulted in expansion of its domestic assets, through open market operations (OMO) and redemptions of bonds under the Market Stabilisation Scheme (MSS), among others, for creating base money to support the required monetary expansion. Liquidity expansion has been consistent with the Reserve Bank’s stance of ensuring a policy regime that will enable credit expansion at viable rates while preserving credit quality.

55. The liquidity situation has remained comfortable as evidenced by the LAF window being in an absorption mode since mid-November 2008. During the current financial year, the Reserve Bank has been absorbing over Rs.1,20,000 crore on average daily basis under the LAF window. Call money rates have generally been close to or below the lower bound of the LAF corridor. Other money market rates such as those for CBLO and market repo, and discount rates of CDs and CPs, have also declined significantly in tandem with the call money rates. Most commercial banks have reduced their deposit and benchmark prime lending rates. As the overall liquidity conditions remain comfortable, the total utilisation under the special refinance/ liquidity facilities made available by the Reserve Bank has been low. However, bankers have indicated that the existence of these facilities – even if they have not been fully tapped – has provided the much needed comfort to them as a potential fall back option.

56. Since the crisis intensified in September 2008, the Reserve Bank has been taking necessary actions in order to cushion the economy from its worst impact. For this purpose, the Reserve Bank used a variety of instruments such as the repo and reverse repo rates, cash reserve ratio, statutory liquidity ratio, open market operations including the liquidity adjustment facility, the market stabilisation scheme, special market operations and sector-specific liquidity facilities. The Reserve Bank has also used prudential tools to modulate the flow of credit to certain sectors consistent with the objective of financial stability. The Reserve Bank will continue to rely on these multiple instruments to modulate the liquidity and interest rate conditions in line with the evolving global and domestic macroeconomic conditions.

Growth Projection

57. In 2008-09, real GDP increased by 6.7 per cent, in line with the projection in the Reserve Bank’s Annual Policy Statement of April 2009. However, the growth pattern was uneven as real GDP growth decelerated from 7.7 per cent in the first half of the year to 5.8 per cent in the second half. This was mainly because of the global financial crisis, which affected external demand, domestic private consumption and investment demand. The overall macroeconomic scenario continues to be uncertain, although it is expected that the fiscal and monetary stimulus measures will boost domestic demand in 2009-10.

58. Domestic and external financing conditions are also now more favourable than they were in the second half of 2008-09. The business outlook has turned positive signalling a revival of industrial activity. On the other hand, keeping in view the sharp contraction in world trade projected during 2009, export demand will continue to remain weak. Similarly, during the earlier part of 2009-10, the services sector may experience the drag of sluggish external demand and the lagged adverse impact of the weak industrial growth. Also, the onset of the south-west monsoon has been delayed and it remains below normal, increasing the downside risks to agricultural production. On balance, an uptrend in the growth momentum is unlikely before the middle of 2009-10. On current assessment, the growth projection for GDP for 2009-10 is placed at 6.0 per cent with an upward bias. This updated growth projection for 2009-10, thus, marks a slight improvement over the growth expectations of around 6.0 per cent indicated in the Annual Policy Statement.

Inflation Projection

59. Headline WPI inflation turned negative in June 2009 as anticipated in the Annual Policy Statement of April 2009. However, negative WPI inflation in India is due to the statistical base effect and, as indicated in the April Statement, it should not be interpreted as a contraction in demand. This transitory negative WPI inflation may not persist beyond a few more months. However, food price inflation continues to remain elevated. This is reflected in stubbornly high CPI inflation. The uncertain monsoon outlook could further accentuate food price inflation. Moreover, the sharp decline in WPI inflation has not been commensurately matched by a similar decline in inflation expectations.

60. Pressures from global commodity prices, which had been abating markedly since August 2008 on account of the slump in global demand, seem to have bottomed out in early 2009. In fact, commodity prices have rebounded ahead of global recovery. The Reserve Bank’s inflation expectations survey shows that while inflation expectations remain well anchored, a majority of the respondents expect inflation to rise over the next three months to one year.

61. In the Annual Policy Statement of April 2009, WPI inflation at end-March 2010 was projected at around 4.0 per cent. On a financial year basis, WPI inflation has already increased by 3.5 per cent by July 11, 2009. The base effect, which is generating the negative WPI inflation, is projected to completely wear off by October 2009. Thereafter, the year-on-year WPI inflation will creep up even without any major supply shock. Keeping in view the global trend in commodity prices and the domestic demand-supply balance, WPI inflation for end-March 2010 is projected at around 5.0 per cent. This is higher than the projection of 4.0 per cent made in the Annual Policy Statement of April 2009.

62. As always, the Reserve Bank will endeavour to ensure price stability and anchor inflation expectations. Towards this objective, the Reserve Bank will continue to take into account the behaviour of all the price indices and their components. 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 India’s broader integration with the global economy.

Monetary Projection

63. During 2008-09, money supply (M3) increased by 18.6 per cent. The year-on-year growth in M3 has remained over 20.0 per cent throughout the current financial year so far reflecting easy liquidity conditions. The major source of M3 expansion has been the large increase in bank credit to the Government, which also included OMO by the Reserve Bank, while credit to the commercial sector decelerated. The Reserve Bank remains committed to providing ample liquidity for all productive activities on a continuous basis. In this context, it is important that the increased government market borrowing programme does not crowd out credit flow to the private sector. As such, money supply will have to be higher than envisaged in the Annual Policy Statement of April 2009. Accordingly, for policy purposes, money supply (M3) growth for 2009-10 is placed at 18.0 per cent, up from 17.0 per cent projected in the Annual Policy Statement. Consistent with this, aggregate deposits of scheduled commercial banks are projected to grow by 19.0 per cent. The growth in adjusted nonfood credit, including investment in bonds/ debentures/shares of public sector undertakings and private corporate sector and CPs, has been retained at 20.0 per cent as in the Annual Policy Statement. As always, these numbers are provided as indicative projections and not as targets. Overall Assessment

64. At the global level, the financial sector seems to be stabilising, but the real sector continues to be in recession. In recent months, there have been some positive signals relating to consumer spending, credit spreads and financing conditions. However, the signals are too tentative and weak to suggest any firm turnaround. Both households and firms are still in the process of rebuilding their balance sheets ruptured by the crisis. As such, despite some measured optimism of a turnaround sooner than expected, a firm recovery at the global level is unlikely before 2010. This continued uncertainty in the immediate outlook is reflected in the downward revision of global growth for 2009 by the IMF from (-)1.3 per cent made in April 2009 to (-)1.4 per cent in July 2009.

65. Since the release of the April 2009 Policy Statement, there have been progressive signs of recovery in India: food stocks have increased; industrial production has turned positive; corporate performance has improved; business confidence surveys are optimistic; leading indicators show an upturn; interest rates have declined; credit off-take has picked up after May 2009; stock prices have rebounded; the primary capital market has witnessed some activity; and external financing conditions have improved. On the other hand, there are some negative signs: delayed and deficient monsoon; food price inflation; rebound in global commodity prices; continuing weak external demand; and high fiscal deficit.

66. On balance, the risks to the current projections of real GDP growth and inflation for 2009-10 are on the upside. The comfortable levels of foodgrains stocks should help mitigate the risks in the event of price pressures from the supply side. The Reserve Bank also will closely monitor the level of liquidity so as to contain inflationary expectations if supply side price pressures were to rise.

67. The growth of 6.7 per cent during 2008-09 was better than most analysts had expected, and decidedly better than the performance of most other economies. The growth projection for the current year of 6.0 per cent with an upward bias reflects the absence of any firm signs of definite recovery in the world economy. The challenge for us is to return the economy to the high growth rate of 9 per cent that we averaged in the period 2005-08. Notwithstanding the temporary hiccups of the crisis period, India is not a demand constrained economy; it is a supply constrained economy. The critical requirement for accelerated growth is to raise the level of investment, particularly in infrastructure.

68. Since the outbreak of the crisis in mid-September 2008, the Reserve Bank has maintained an accommodative monetary stance. It will be the endeavour of the Reserve Bank to maintain a policy stance that will aid return of the economy to the high growth path. At the same time, there are factors – stubborn food price inflation, rebound in world commodity prices, expansionary monetary and fiscal policies – that could potentially build inflationary pressures. Accordingly, the task of returning the economy to a high growth path, viewed from the current perspective, throws up some important challenges. These are highlighted below.

69. First, the immediate challenge for the Reserve Bank is to manage the balance between the short-term compulsions of providing ample liquidity and the potential build-up of inflationary pressure on the way forward. As indicated earlier, the negative WPI inflation numbers are only a statistical feature and do not have any structural significance. Within WPI inflation, inflation of primary articles, particularly food articles, remains significantly positive. Even as inflation of manufactured products is negative, inflation of manufactured food products is close to double digits. Moreover consumer price indices (CPIs) have remained elevated, indeed also hardened in recent months. The task for the Reserve Bank is to maintain the accommodative monetary stance till demand conditions further improve and the credit flow takes hold, but to be ready with a roadmap to reverse the expansionary stance quickly and effectively thereafter.

70. The second challenge for the Reserve Bank is to manage the Government’s borrowing programme for 2009-10. As indicated earlier, Government borrowing expanded very rapidly in 2008-09. During the current year, the budgeted net borrowing of the Central Government is 33 per cent higher than the already elevated borrowing of last year. Despite active liquidity management by the Reserve Bank, yields on government securities firmed up from a low of 5.8 per cent in January 2009 to around 7.0 per cent in July 2009. The hardening of yields has clearly militated against the low interest rate regime that the economy requires in the current situation. Private credit demand remains subdued as of now, but is likely to pick up. In order to manage the government borrowing without crowding out present or potential private credit demand, the Reserve Bank will continue with its active liquidity management policy. It may be noted in this context that during the first half of 2009-10, planned OMO purchases and MSS unwinding will add primary liquidity of Rs.1,50,000 crore, which by way of monetary impact is equivalent to reduction of CRR by over 3.5 percentage points.

71. By way of challenges, the third is to spur private investment demand which has been dented by the crisis. The growth of gross fixed capital formation, with a weight of nearly 32 per cent in the real GDP, dropped from 12.9 per cent in 2007-08 to 8.2 per cent in 2008-09. Accelerating this ratio back to the pre-crisis level and indeed improving on that is critical for sustainable growth in the medium-term. Of particular importance is increased investment in infrastructure. The Reserve Bank has maintained a consistent stance of monetary accommodation over the last nine months in order to maintain a soft interest rate regime. The banks have responded to the monetary stance by reducing deposit and lending rates, although there is scope for further reduction. Going forward, the Reserve Bank will meet the challenge of spurring private credit demand by maintaining policy rates and liquidity conditions conducive for revival of private credit demand.

72. Shifting from the immediate to the short-to-medium term, the fourth challenge is fiscal consolidation. In order to make up for the deceleration in private consumption and investment demand, it was necessary for the Government to resort to countercyclical public spending. This has, in a large way, insulated the economy from the worst impact of the crisis. The large and abrupt increase in government borrowing has, however, led to hardening of yields on government securities which have impeded monetary transmission. Furthermore, large fiscal deficits, if continued strictly beyond the recovery period, can crowd out private investment and trigger inflationary pressures. The Government will, therefore, need to return to a path of fiscal consolidation. This entails two facets on the way forward. The first is to lay down the roadmap for fiscal consolidation. This has to go beyond merely indicating revised FRBM targets to giving out the details of the adjustment that will take place on the revenue and expenditure fronts. That will lend credibility to the fiscal stance and also give predictability to economic agents. The second facet is to focus on the quality of fiscal adjustment even while pursuing quantitative targets.

73. Finally, the big medium-term challenge is to improve the investment climate and expand the absorptive capacity of the economy. Development experience clearly demonstrates that no country has been able to sustain a high growth episode without a sustained increase in investment together with improvements in productivity. This entails two tasks. The first is to move on with financial sector reforms to promote financial inclusion, further widen and deepen financial markets and strengthen financial institutions. In doing so, we will inevitably have to factor in the lessons of the global economic crisis. The second task is a big thrust on governance reforms that should inspire the trust and confidence of potential investors.

Policy Stance

74. On the basis of the above overall assessment, the stance of monetary policy for the remaining period of 2009-10 will be as follows:

• Manage liquidity actively so that the credit demand of the Government is met while ensuring the flow of credit to the private sector at viable rates.

• Keep a vigil on the trends and signals of inflation, and be prepared to respond quickly and effectively through policy adjustments.

• Maintain a monetary and interest rate regime consistent with price stability and financial stability supportive of returning the economy to the high growth path.

75. It is worth reiterating that the Reserve Bank will maintain an accommodative monetary stance until there are definite and robust signs of recovery. This accommodative monetary stance is, however, not the steady state stance. On the way forward, the Reserve Bank will have to reverse the expansionary measures to anchor inflation expectations and subdue inflationary pressures while preserving the growth momentum. The exit strategy will be modulated in accordance with the evolving macroeconomic developments.

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