Mid-Term Review of the Annual Policy Statement for 2008-09
Part A-Mid-term Review of the Annual Statement on Monetary Policy for the Year 2008-09
II. Stance of Monetary Policy for the
Remaining Period of 2008-09
95. This Mid-Term Review is set in the context of several complex and compelling policy challenges. The global financial system is in a crisis of unprecedented dimensions. The problem that originated in delinquencies in the US sub-prime mortgage market and the associated ballooning of the market for complex derivatives in August 2007, snowballed into a financial sector turmoil spanning the entire financial sector. What started off as a liquidity problem quickly turned into a solvency problem triggering a crisis of confidence in the financial markets. The crisis spread rapidly from the US to Europe and then partially to the rest of the world with some spillover of the contagion from the financial sector to the real sector. There have been severe disruptions in international money markets, sharp declines in stock markets across the world and evidence of extreme risk aversion among financial sector participants. Governments, central banks and financial regulators around the world are responding to the crisis with aggressive, radical and unconventional measures to restore calm and confidence to the markets and bring them back to normalcy and stability.
96. India’s financial sector is stable and healthy. All indicators of financial strength such as capital adequacy, ratios of non-performing assets (NPA) and return on assets (RoA) for our commercial banks, which account for 88 per cent of banking assets, are robust. While many banks and quasi-banking financial institutions in advanced countries suffered large losses and needed substantial capital infusion and bail out packages, Indian banks have been affected only peripherally as they do not have direct financial exposure to the US sub-prime assets. Mark-to-market losses on the financial instruments held in the overseas portfolio of foreign branches and foreign subsidiaries of Indian banks are due to the general widening of credit spreads. The overall capital adequacy ratio of commercial banks in India is 12.7 per cent, well above the regulatory minimum of 9 per cent and the Basel Accord requirement of 8 per cent. In fact, all commercial banks in India have a capital adequacy ratio above 10 per cent. Furthermore, the regulatory mandate of keeping 25 per cent of net demand and time liabilities as SLR and 6.5 per cent as CRR provides an inherent strength to the Indian banks. The most prominent symptom of the problem in the financial sectors of advanced countries has been the freezing up of inter-bank markets. On the contrary, the inter-bank market in India has been functioning in an orderly manner and transaction volumes in recent weeks have been comparable to, or oftentimes above, those in the previous six months.
97. Nevertheless, the global developments have had some indirect, knock-on effects on domestic financial markets. Money markets have experienced unusual tightening of liquidity in recent weeks as a result of global developments which were amplified by transient local factors such as advance tax payments. The foreign exchange market experienced some pressure on account of portfolio investment outflows by FIIs and the enhanced foreign exchange requirements of oil and fertiliser companies resulting from higher international prices and import volumes. Constraints in access to external financing as also repricing of risks and higher spreads resulted in additional demand for domestic bank credit with attendant hardening of interest rates across the spectrum. The combined impact of these factors was a perception of credit pressures despite a sizeable increase in the growth of bank credit during the current financial year so far. Domestic equity markets were significantly affected by the global de-leveraging of assets and the adverse sentiment from overseas markets.
98. Liquidity conditions in the domestic markets tightened abruptly in mid-September. The overnight call money rate jumped from around 9 per cent on September 8 to over 13 per cent on September 16. While this spurt was partly triggered by the scheduled mid-September advance tax outflows, it was soon clear that the tightness in liquidity was not solely due to local and seasonal factors as the call rate climbed to close to 15 per cent on September 29. Volumes in the LAF repo auctions, which had averaged around Rs.12,500 crore in the first half of September, rose to above Rs.68,000 crore in the second half of the month.
99. During the last financial year, as against a current account deficit of 1.5 per cent of GDP, India received net capital flows of the order of nearly 10 per cent of GDP. While these inflows were partially sterilised by the issuance of MSS securities and successive increases in the CRR, they had an expansionary effect on domestic liquidity conditions. As the global liquidity crisis deepened over the last two months, capital inflows dried up and increased the demand for credit from the domestic banking system, thereby aggravating liquidity pressures.
100. In the wake of the stress on our financial markets as a result of the global financial crisis, the immediate challenge for the Reserve Bank was to infuse confidence by augmenting both domestic and foreign exchange liquidity. Accordingly, the Reserve Bank announced the following measures on September 16, 2008:
Reserve Bank assured financial market participants that it would continue to sell foreign exchange to augment supply in the domestic foreign exchange market or even intervene directly to meet any demand-supply gaps at the prevailing market rates and as per market practice.
A second LAF was also re-introduced on a daily basis as an assurance to market participants of liquidity in the event of market stress.
The interest rate ceilings on FCNR (B) deposits of all maturities and on deposits under the NR(E)RA for one to three years maturity were increased by 50 basis points.
As an ad hoc and temporary measure, banks were allowed to avail of additional liquidity support under the LAF to the extent of up to one per cent of their net demand and time liabilities and seek waiver of penal interest.
101. Liquidity conditions tightened even further after October 7 as contagion from the US financial crisis spread to Europe and Asia. Globally, money markets froze up and the stock markets turned highly volatile as even coordinated policy actions by monetary authorities in America, Europe, Asia and Australia failed to inspire the confidence of financial markets. In the fortnight ending October 10, 2008 there was a sizeable expansion in bank credit of the order of Rs.65,000 crore which was the highest for any fortnight during 2008-09 so far. Consequently, in the domestic money market, call money rates touched a peak of 19.8 per cent on October 10 with LAF repo volumes crossing Rs.90,000 crore through the early part of October. In view of the persisting uncertainty in the global financial situation and its impact on India, and continuing demand for domestic market liquidity, the following measures were taken in October 2008:
In view of the continuing uncertain global situation, these measures were augmented by a cumulative reduction of 250 basis points in the CRR effective from the fortnight beginning October 11.
A special 14-day repo facility for a notified amount of Rs.20,000 crore was instituted to alleviate liquidity stress faced by mutual funds and banks were allowed temporary access to SLR-eligible securities by an additional 0.5 per cent of NDTL exclusively for this purpose.
Commercial banks and All India term lending and refinancing institutions were allowed to lend against and buy back CDs held by mutual funds for a period of 15 days.
At the request of the Government, the Reserve Bank agreed to provide the sum of Rs.25,000 crore as the first instalment under the Agricultural Debt Waiver and Debt Relief Scheme to commercial banks, RRBs and co-operative credit institutions immediately.
The interest rate ceilings on FCNR (B) deposits of all maturities and on deposits under the NR(E)RA for one to three years maturity were further increased by 50 basis points each.
Banks were permitted to borrow funds from their overseas branches and correspondent banks to the extent of 50 per cent of their unimpaired Tier I capital or US $ 10 million, whichever is higher.
The Reserve Bank also announced that it would institute special market operations to meet the foreign exchange requirements of public sector oil market companies against oil bonds when they become available.
102. On October 20, 2008 in order to alleviate the pressures on domestic credit markets brought on by the indirect impact of the global liquidity constraint and, in particular, to maintain financial stability, it was decided to reduce the repo rate under the Liquidity Adjustment Facility (LAF) by 100 basis points to 8.0 per cent with immediate effect.
103. Taken together, the measures taken since mid-September 2008 have substantially assuaged liquidity stress in domestic financial markets arising from the contagion of adverse external developments. The total liquidity support through reductions in the CRR, the temporary accommodation under the SLR and the first instalment of the agricultural debt waiver and debt relief scheme was of the order of Rs.1,85,000 crore. In the inter-bank call money market, rates have eased from well above 10 per cent to a range near the LAF reverse repo rate. There has been a steady improvement in call money turnover which constituted a third of total volumes transacted in the overnight markets. The LAF window saw a mode reversal from a net injection of Rs.91,720 crore on October 1, 2008 to a net absorption through reverse repos of the order of Rs.27,745 crore on October 22, 2008. Yields in the Government securities market have reflected the improvement in liquidity conditions with the benchmark 10 year yield easing from 8.30 per cent on October 3, 2008 to 7.58 per cent on October 22, 2008. Furthermore, it is expected that the cut in the repo rate effected on October 20, 2008 will ease the constraints in money and credit markets, restore their orderly functioning and sustain financial stability.
104. The task of monetary management has always centred around managing a judicious balance between price stability, sustaining the growth momentum and maintaining financial stability. The relative emphasis between these objectives has varied from time to time depending on the underlying macroeconomic conditions. Prudent regulatory surveillance and effective supervision have ensured that our financial sector has been and continues to be robust. The global financial turmoil, has, however, reinforced the importance of putting special emphasis on preserving financial stability. At the same time, inflation, which is still in double digits, and the moderation in growth continue to be critical policy concerns. Consequently, the central task for the conduct of monetary policy has become more complex than before, with increasing priority being given to financial stability. The current challenge, accordingly, is to strike an optimal balance between preserving financial stability, maintaining price stability, anchoring inflation expectations, and sustaining the growth momentum. To manage this challenge, the Reserve Bank has deployed and will continue to deploy both conventional and unconventional tools.
105. The First Quarter Review of July 2008 placed the projection of real GDP growth in 2008-09 at around 8.0 per cent for policy purposes. Since then, there have been significant global and domestic developments which have rendered the outlook uncertain, and have increased the downside risks associated with this projection. In particular, the global downturn may be deeper and more protracted than expected earlier. Consequently, the adverse implications through trade and financial channels for emerging economies, including India, have amplified. If the recession is deeper and the recovery is long drawn as is the current expectation, emerging economies have also to contend with second round effects in the form of potential terms of trade losses, erosion of export competitiveness and restricted external financing. These adverse developments are overlaid on the moderation of growth in the industrial and services sectors in the first half of 2008-09. The south-west monsoon conditions and water storage levels support the prospects of maintaining the medium-term trend growth rate in agriculture in 2008-09. Taking these developments and prospects into account, the Reserve Bank has revised the projection of overall real GDP growth for 2008-09 to a range of 7.5-8.0 per cent.
106. Globally, pressures from commodity prices, including crude, appear to be abating, though they continue to rule at elevated levels. Domestically, prices of food articles are moderating and the beneficial effects of the south-west monsoon should enable a further easing in the coming months. There are also incipient signs of some softening in prices of some manufactured goods. Consequently, WPI inflation, excluding food articles and the fuel category, is showing some plateauing albeit at high levels. Moreover, the decline in the price of the Indian basket of crude to around US $ 70 in recent weeks has reduced the probability of upward revisions in administered prices in the period ahead. The moderation in key global commodity prices, if sustained, would contribute to reduction in inflationary pressures from the current levels. On the other hand, consumer price inflation for agricultural and rural labourers has risen to double digits in August and September for the first time in nearly a decade. Within the wholesale price segment too, inflationary pressures from non-food articles - mainly cotton, edible oils and metals – are as yet unyielding; indeed there has been some firming up in recent weeks. It is possible that these prices would also soften if the global slowdown is more severe than expected. All in all, it is the Reserve Bank’s assessment that inflation continues to be a concern and that we cannot afford to let the guard slip on our inflation vigil.
107. The First Quarter Review of July 2008 noted that this round of inflation emanated, in part, from global supply pressures, and that inflation over the past year has not been proportionately different from elsewhere. However, inflation in double digits is well beyond our tolerance levels and is clearly unacceptable. As indicated in past policy reviews, it will be the Reserve Bank’s endeavour to bring down inflation to a tolerable level of below 5 per cent at the earliest, while aiming for convergence with the global average inflation of around 3.0 per cent over the medium-term. Keeping in view the supply management measures taken by the Government and the lagged demand response to the monetary policy measures taken by the Reserve Bank over the last one year, the earlier projection of inflation of 7.0 per cent by end-March 2009 appears to be valid. It has, therefore, been decided to maintain this estimate for policy purposes.
108. Going forward, the Reserve Bank’s policy endeavour would be to modulate the monetary overhang generated by the sustained expansion of money supply since 2005-06. This is necessary in order to ensure that inflationary pressures are not fuelled and that the current stance of monetary policy is not attenuated by expansionary monetary conditions. Accordingly, as stated in the First Quarter Review, it is necessary to moderate the rate of money supply to 17 per cent in 2008-09. This translates to a requirement of growth in aggregate deposits in 2008-09 to 17.5 per cent and the growth of non-food credit, including investments in bonds/debentures/shares of public sector undertakings and private corporate sector and CP, to around 20 per cent. The enhanced borrowing requirement of the Central Government in the second half of 2008-09, however, is an upside risk to the realisation of these projections and will have implications for the conduct of monetary policy.
109. Non-food credit has posted a growth of 29 per cent on a year-on-year basis as of October 10, 2008. This is well beyond the projection of 20 per cent for 2008-09. This higher rate of credit growth could possibly be due to the additional demand on domestic credit because of constraints in excess to external credit as noted earlier. Even so, such a rapid rate of credit growth is a cause for concern and will warrant intensified monitoring and continued correction. While maintaining credit quality has always been our central concern, the global financial crisis has reinforced risks of allowing rapid and unbridled credit expansion and the resultant systemic threat to financial stability. Banks should continue to lend for productive purposes and, in particular, permit drawals of sanctioned limits guided by their usual commercial judgment. Banks should also consider restructuring the dues of small and medium enterprises on merits. At the same time, they should pay attention to maintaining credit quality. In pursuit of this objective, banks should focus on stricter credit appraisals on a sectoral basis, monitor loan to value ratios and calibrate their credit portfolio in tune with their asset-liability projections. The Reserve Bank will monitor the rate of credit growth and credit quality closely and will, as necessary, engage with select banks which are outliers on the norms.
110. India’s balance of payments continues to reflect strength and resilience in a highly unsettled international environment. A resumption in the vigour of export growth in the second quarter of 2008-09 is a comforting factor. Moreover, the significant softening of international crude oil prices in recent weeks can be expected to moderate the trade deficit in the second half of the current fiscal year. However, the volatility in international crude oil prices warrants continues monitoring. In the capital account, the sustained inflows in the form of FDI and the turnaround in NRI flows have mitigated the impact of the outflows under portfolio investment. Overall, the current account deficit may be somewhat higher in 2008-09 than in the preceding year but it is expected that net capital flows would meet the external financing requirement in 2008-09.
111. Given the uncertainty in the global financial situation, monitoring and maintenance of domestic financial stability warrants continuous attention. There are some positive aspects of our financial system. Corporate balance sheets are healthy and leverage levels are within normal ranges. The interest burden of corporates too is low by historical standards. On the negative side, pressures on liquidity could emerge from anywhere in the deep chain of the financial system. These could potentially be a source of vulnerability. The Reserve Bank will maintain a close vigil on the entire financial system to prevent pressures building up in the financial markets. This will include enhancing liquidity if pressures persist. This could also mean curtailing liquidity if the recent liquidity easing measures are seen to have injected excess liquidity, thereby stoking inflationary pressures.
112. The management of the global financial crisis has highlighted two important aspects. First, that resolution of a crisis of this magnitude and complexity demands going beyond the rule book to unconventional, unorthodox and swift policy actions. Second, there is need for close coordination between the Government and the regulatory agencies without at the same time eroding institutional integrity and independence. These aspects are important and relevant for India too. India has well functioning institutional arrangements, both formal and informal for inter-regulatory agency coordination. These have stood the test of time. All the same, there is need to constantly endeavour to build on these arrangements to further refine and strengthen them.
113. The global financial situation, described as the worst since the Great Depression, continues to be uncertain and unsettled. There are continuing concerns about the nature and depth of the crisis, the manner of and the time frame for its resolution and the response to the policy measures announced so far. Furthermore, the deflationary impact of the financial turmoil is intertwined with a distinct weakening of global growth. In what is clear evidence of the depth and degree of financial integration, this uncertainty is transmitting also to countries outside the epicenter of the crisis. India cannot be immune to these global developments. These external pressures coming on top of already existing domestic pressures pose complex challenges for monetary management. This is uncharted territory with no standard or conventional solutions. The Reserve Bank has endeavoured to be proactive, and has taken measures to manage the rapid developments and ease pressures stemming from the global crisis. In conclusion, the Reserve Bank reiterates that it is confident of managing the situation and minimising the adverse impact of the global crisis on the Indian economy. Our financial system is strong and healthy, and our economic fundamentals are strong. Once the global situation is managed and calm and confidence are restored, we will return to our higher growth trajectory.
114. Based on the above overall assessment of the macroeconomic situation, the stance of monetary policy for the rest of 2008-09 will be as follows :
Ensure a monetary and interest rate environment that optimally balances the objectives of financial stability, price stability and well-anchored inflation expectations, and growth;
Continue with the policy of active demand management of liquidity through appropriate use of all instruments including the CRR, open market operations (OMO), the MSS and the LAF to maintain orderly conditions in financial markets;
In the context of the uncertain and unsettled global situation and its indirect impact on the domestic economy in general and the financial markets in particular, closely and continuously monitor the situation and respond swiftly and effectively to developments, employing both conventional and unconventional measures;
Emphasise credit quality and credit delivery, in particular, for employment-intensive sectors, while pursuing financial inclusion.
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