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click here to return to main page of Mid-term Review of Annual Policy for the year 2004-05
Mid-term Review of Annual Policy 2004-05- 26th Oct 2004
I. Mid-term Review of Macroeconomic and Monetary Developments in 2004-05
External Developments
28. The International Monetary Fund (IMF) in September 2004 projected world output to grow by 5.0 per cent in 2004 and 4.3 per cent in 2005. Global recovery is backed by world trade that has been projected by the IMF to grow in volume terms by 8.8 per cent in 2004 and 7.2 per cent in 2005. However, the downside risks have increased primarily on account of persistence of uptrend in global oil prices.
29. With the ongoing growth rebound, the US Fed has started moving monetary policy to its neutral level by raising the overnight target policy rate thrice by 25 basis points each since June to 1.75 per cent by September 2004. Bank of England has raised its policy rate by 125 basis points in stages since November 2003 to 4.75 per cent by August 2004, largely on account of domestic concerns on asset price inflation. Similarly, central banks in other countries such as Hong Kong SAR, Mexico, Poland, Russia, Singapore, Switzerland and Thailand have raised policy rates during 2004. In euro area, growth has been relatively subdued and the key policy rate has been left unchanged at 2.0 per cent since June 2003. Bank of Japan has indicated that it would be continuing with the current policy of quantitative easing till such time as the consumer price deflation ends on a sustainable basis. In fact, central banks in some countries such as Argentina, Brazil, South Africa and Sweden have reduced their policy rates during 2004. Overall, therefore, while the central banks displayed mixed reactions in terms of preferences for soft, neutral and hardening biases, the choice of a specific stance by a country/region seems to have been preponderantly guided by its own domestic economic considerations.
30. Notwithstanding the strengthening of growth momentum, global demand for oil and higher oil prices have outpaced expectations. In international oil markets, crude prices have risen to record nominal highs and the uptrend continues with increased volatility. In addition, tight inventory position and greater geopolitical uncertainties have encouraged speculative activities in the futures markets. If this scenario continues, it will significantly undermine the global growth prospects, with a disproportionately larger burden on oil importing emerging markets like India. Admittedly, the current oil shock is not as intense as the previous major oil shocks consequent on a reduction in the oil intensity of global output. For example, in the earlier oil price shocks, nominal crude oil prices had increased by 252 per cent during 1973-74, 179 per cent during 1978-80, 58 per cent during 1989-90 and 57 per cent during 1999-2000. Nevertheless, oil prices continue to be a key determinant of global economic prospects. International crude prices have already risen over 60 per cent since January 2004. As developing countries have not reduced their dependence on oil as much as developed countries, they remain particularly vulnerable. The International Energy Agency (IEA) has warned that a US $ 10 price increase per barrel of oil sustained over one year could trim about 0.8 per cent of Asia's overall economic growth. The IMF has estimated that US $ 5 per barrel increase in oil prices would reduce global growth by about 0.3 percentage point after one year.
31. Another major downside risk facing the global economy continues to emanate from global imbalances and the associated possibility of disruptive currency adjustments and persistent structural problems in the euro area and Japan. The US fiscal balance has deteriorated rapidly from a surplus position in 2000 to a large deficit which has added to the pressures for an expanding current account deficit. Further, the fiscal correction in some euro area countries has been less than anticipated. Many emerging markets are experiencing current account surpluses vis-á-vis the US. The fiscal deficit in the US, which was earlier being financed by the domestic private sector, is now being substantially financed by central banks of Asia. The twin deficits in the US economy constitute a major challenge confronting the international community.
32. The deflationary expectations that prevailed over last two years have now given way to some inflation concerns in most advanced economies, though the consumer price inflation as well as core inflation still remains at relatively low levels. The concern over inflationary impact of global oil prices, however, remains muted mainly because of three factors: First, the productivity gains in many economies have helped build resilience to shocks. Second, increasing trade liberalisation has given the opportunity to source goods and services from least cost sources; resultant competition in tradable goods has lowered consumer prices. Third, the oil intensity of global output has reduced over time. However, if current hardening of global oil prices persists, it could feed through input costs and transport costs that could also impact landed prices of traded goods. If general prices or inflation expectations are impacted, wage costs could rise, which in turn could lead to persistence of price pressures. Conversely, there is a view that oil prices would moderate with easing of demand pressures given the long positions in the futures market.
33. The impact of rising oil prices depends on the structure of the economy and the stage of the business cycles in which it is placed. For oil importing emerging markets like China and India, the impact would be relatively more significant given the increasing oil intensity and lower energy efficiency. Nevertheless, the global macroeconomic environment, in spite of the increase in the oil prices and some hardening of interest rates, remains supportive of international capital flows.
34. The broadening of global recovery has had a positive impact on the health of financial intermediaries. External financing conditions for emerging markets have also improved. New issuance through bonds, equities and syndicated loans, by either sovereign borrowers or corporate borrowers in emerging market countries so far this year, has been higher than last year. Global financial markets today appear largely stable with efforts being made to reduce bad loans in several countries, and equity markets turning less volatile. Moreover, international financial markets have remained calm despite some transition to higher interest rates. Interest rate forward markets suggest that if rate hikes in future remain modest, markets could adjust without much negative effect.
35. The Indian forex market generally witnessed orderly conditions during the current financial year so far (April-October 2004). The exchange rate of the rupee, which was Rs.43.39 per US dollar at end-March 2004, depreciated by 5.2 per cent to Rs.45.77 per US dollar by October 21, 2004. It also depreciated by 7.9 per cent against Euro, by 4.3 per cent against Pound sterling and by 1.9 per cent against Japanese yen during the period. Foreign exchange reserves increased by US $ 7.6 billion from US $ 113.0 billion at end-March 2004 to US $ 120.6 billion as on October 21, 2004.
36. In recent years, the annual policy Statements as well as mid-term Reviews have attempted to bring into sharper focus the main lessons emerging from our experience in managing the external sector during periods of external and domestic uncertainties. As articulated in the policy Statements in the recent years, the broad principles that have guided exchange rate management are:
Careful monitoring and management of exchange rates without a fixed target or a pre-announced target or a band. Flexibility in the exchange rate together with ability to intervene, if and when necessary.
A policy to maintain a level of foreign exchange reserves which takes into account not only anticipated current account deficits but also ‘liquidity at risk’ arising from unanticipated capital movements.
A judicious policy for management of the capital account.
37. As pointed out in all the recent policy Statements, the overall approach to the management of India’s foreign exchange reserves in recent years has reflected the changing composition of the balance of payments (BoP), and has endeavoured to reflect the ‘liquidity risks’ associated with different types of flows and other requirements. The policy for reserve management is thus judiciously built upon a host of identifiable factors and other contingencies. Taking these factors into account, India’s foreign exchange reserves are at present comfortable and consistent with the rate of growth, the share of the external sector in the economy and the size of risk-adjusted capital flows.
38. It is necessary to take a medium-term view of the macroeconomic outlook, in particular the external sector, in arriving at the desirable level of reserves. In this regard, the potential for different magnitudes of current account deficit, as the GDP growth accelerates, should be recognised. In view of the level of comfort provided by the international financial architecture, apart from considering reserves as an insurance against volatility in capital flows, there is need to provide cushions against shocks. These could arise from uncertain monsoon conditions in the real sector, variations in global oil prices in the external sector and high levels of public debt in the fiscal arena. There is considerable merit in taking a national balance sheet approach to the external sector and to provide cushions through official reserves in response to increasing external liabilities on account of the private sector. Further, it is useful to recognise the comfort and the confidence provided to the investors by the level of reserves in the context of volatility in capital flows.
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