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click here for Main Page of Third Quarter Review

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

Overall Assessment

On an overall assessment, the outlook for the Indian economy has brightened considerably in the first three quarters of 2005-06. Inflation, although drifting from an end-August trough, remains well within acceptable limits. Proactive policy responses have contributed to this congenial configuration of macroeconomic performance. The Reserve Bank, on its part, has moved promptly to head off potential excess demand pressures that typically manifest themselves in an expansionary phase of the growth cycle. LAF rates have been raised three times by 25 basis points each since October 2004 with a view to reining in excess liquidity from feeding into demand pressures. In addition, concerns about the quality of credit growth have been underscored for focused public attention. Surveillance over exposure limits in the banking system in respect of sensitive sectors such as equity markets has been stepped up. Risk weights for calculation of capital adequacy have been increased in respect of housing and real estate. In addition, the Reserve Bank has instituted a pro-cyclical provisioning policy. It has also set up a selective supervisory review for banks with relatively risky profiles. It is hoped that these measures will extend the current expansionary phase of the growth and credit cycles in India.

Since the Mid-term Review of October 25, 2005 aggregate demand appears to be on the upswing. Both employment and salaries in the organised services sector are rising. Investment is picking up and consumer spending remains buoyant. The demand for banks’ non-food credit is very strong. Corporate performance continues to be robust and based on sound fundamentals. Asset prices – housing, equity, bullion – have continued to accelerate. However, there is some moderation in the growth of exports and industrial output. The deterioration in the performance of the infrastructure industries could potentially impose a supply constraint. Hence, improvements in the availability and the quality of the physical infrastructure would considerably ease the supply constraints on growth.

The global economy has turned out to be stronger and more resilient than initially expected. When a fuller picture emerges, world GDP growth in 2005 could well be higher than 4.3 per cent projected by the IMF. This has been accompanied by an acceleration in the growth of world trade. On the other hand, recent global developments as described below have amplified the existing downside risks, particularly for emerging economies like India.

First, international crude prices continue to remain the major risk to both growth and inflation. Geopolitical tensions threatening supply have not abated even as the range of forecasts converges to an expansion in global demand for petroleum products in 2006. International crude prices have been edging up in recent weeks and are projected to remain at elevated levels through 2006. In this context, the imminent possibility of higher orders of pass-through to consumer prices and second order effects can assume the form of generalised price increases that could adversely impact inflationary expectations.

Second, rising asset prices in conditions of abundant liquidity pose a risk for households’ balance sheets and indebtedness. Consequently, policy authorities are on guard against adverse effects on consumption spending while instituting monetary policy actions, given the potential repercussions on asset prices. Sudden reversals in other asset prices such as gold and equity could also have contractionary effects.

Third, although inflation expectations have stabilised in the US, they appear to be at elevated levels in some parts of the world, particularly among developing countries.

Fourth, the risks from currency movements have increased significantly with the widely expected correction in the US dollar not materialising. Notwithstanding a current account deficit of US $ 195.8 billion in the third quarter of 2005, the US dollar rose by 3.5 per cent in trade-weighted terms during the year. This is attributed to strong appetite for US dollar denominated assets on the back of widening interest rate differentials between the US and the rest of the world. While it is difficult to base monetary policy action on the possibility of currency adjustments, authorities need to be well prepared for such an eventuality. In the final analysis, these developments have increased the uncertainty surrounding currency movements.

While policy responses to these developments have been varied in the context of the country-specific situations, the general direction of policy actions has been towards withdrawal of accommodation. There is also some consensus that the extent of perseverance with this policy stance would be limited by reaching the ‘neutral’ rate of interest, i.e., the rate at which economic activity is neither spurred nor retarded. There is also some agreement that the level of the neutral rate is currently lower than indicated by historical experience. In view of evolving conditions and assuming that the potential risks do not materialise, it is likely that the withdrawal of accommodation in monetary policy will reach the somewhat ill-defined levels of the neutral rate of interest sometime in 2006.

Real GDP growth in India has averaged 8.0 per cent over the past nine quarters. So far, growth has been led by manufacturing activity despite large gaps in the infrastructure. Accordingly, adequate investment in infrastructure holds the key for pushing up the potential growth of the economy. Along with reinforcing the signs of consolidation in public finances that is underway, it is important, therefore, to step up budgetary expenditures on the infrastructure sectors and improve the regulatory environment for adequate resource flow to the private sector. Improvement in gross domestic saving, essential for maintaining the growth momentum with stability, is contingent upon reduction in the revenue deficits of the Centre and the States. Assuming that the global environment does not turn adverse, that there are no unanticipated shocks, and that appropriate and timely policy initiatives are taken in the agriculture, infrastructure and, above all, fiscal areas, real GDP growth could be maintained in 2006-07 at a level close to those in 2004-05 and 2005-06.

Inflation in India has been contained so far in spite of global developments, particularly the elevated and volatile levels of international crude prices. At the current juncture, the pass-through of international oil price increases to domestic prices has been managed through burden-sharing/cross-subsidisation between oil companies, the government and consumers. In the aggregate analysis, the pass-through remains incomplete in respect of LPG, kerosene and, to some extent, in respect of petrol and diesel. Assuming that current prices represent a permanent component, the need to align with international prices and the probability being assigned to higher crude prices in the year ahead imparts an upside risk to inflation in 2006-07. The step up in credit growth, movement in asset prices and growth in monetary aggregates pose further risks of potential inflationary pressures. Aggregate demand management will, thus, pose a challenge for which careful and continuous vigil over domestic and global developments is warranted. Globally, the uncertainties surrounding currency movements, interest rate movements and oil prices are the key risks to monetary policy objectives. The outlook for inflation in 2006-07 will depend on the evolution of these risks and timely response of monetary policy, recognising that the policy measures have a lagged effect. Against this background, a policy setting aimed at containing inflation in 2006-07 at the level not exceeding that in 2005-06 is appropriate. The overriding importance of maintaining well-anchored inflation expectations is critical for sustaining the growth momentum and assuring macroeconomic and financial stability.

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