Stance of Monetary Policy- Third Quarter Review 2005-06
The Mid-term Review of October 25, 2005 reaffirmed the stance of monetary policy set out in the Annual Policy Statement of April 29 while rebalancing the priorities assigned to policy objectives in the context of the assessment of the economy and, particularly, the outlook on inflation. In response to the risks that had emerged – credit quality concerns, rising asset prices especially housing, high and volatile international crude prices with a substantial part of the increase in crude prices being regarded as permanent, the widening trade deficit and the upturn in the international interest rate cycle – greater emphasis was placed on price stability. Consistent with this stance, the Reserve Bank committed to ensuring a conducive interest rate environment and the provision of appropriate liquidity to meet genuine credit needs of the economy for maintaining the growth momentum. The Reserve Bank also stated that it would consider measures in a calibrated and prompt manner to stabilise inflation expectations in response to evolving circumstances. Stating that without a policy response, it would be difficult to contain inflation within the projected range of 5.0-5.5 per cent, the fixed reverse repo rate under the LAF was increased by 25 basis points to 5.25 per cent while retaining the spread between reverse repo and repo rates at 100 basis points.
Macroeconomic and financial developments since then are in support of the monetary policy stance. First, inflation expectations have stabilised in a manner consistent with policy projections. Appropriate timing of the pass-through of international crude prices has significantly muted the second round effects of oil price hikes anticipated earlier. Demand pull factors have remained reasonable though there has been a significant pick up in overall activity. Excluding mineral oils, inflation was 2.7 per cent, while the headline inflation was 4.2 per cent on January 7, 2006. The modest ebbing of crude prices from their highs in August-September and the softening of global prices of agricultural products has also mitigated the pressures from imported inflation. Second, the widening of the trade deficit under the impact of high international crude prices and buoyant industrial demand for imported inputs has been financed by capital flows. The exchange rate of the rupee vis-à-vis the US dollar has appreciated by about 2.0 per cent by mid-January 2006 since the beginning of November 2005. Third, appropriate and flexible liquidity management by the Reserve Bank through the LAF, MSS and standing facilities under both surplus and deficit conditions has calmed financial markets, enabling market expectations about inflation and policy responses to evolve synchronously with the policy stance. In the event, the overhang of liquidity has declined by Rs.60,472 crore between September 2005 and January 2006 from Rs.1,23,826 crore to Rs.63,354 crore.
In response to the needs of market participants, the Reserve Bank introduced a second LAF with effect from November 28, 2005 as an additional instrument to fine-tune liquidity management. It has proved to be reasonably effective in maintaining appropriate liquidity in the system, especially in the wake of the IMD redemption.
The baseline outlook on growth has further brightened in recent months. First, apprehensions of monsoon stress have definitely subsided and the prospects for the rabi crop are favourable at the current juncture. This has made the foodgrains target set for the year as well as a return to trend growth of GDP originating in agriculture realisable. Second, overall industrial growth has been sustained by the strength of manufacturing activity, notwithstanding the drag imposed by the infrastructure sector. Industrial performance has been amply supported by buoyant and broad-based bank credit, high corporate profitability which has boosted internal funding for investment, sustained export demand and business optimism. Third, the all-round expansion of the services sector has imbued confidence into aspirations of higher growth of the economy, backed by rising international competitiveness. Fourth, the Reserve Bank’s liquidity management operations have contributed to stability in financial markets and have also enabled a smooth switch in banks’ portfolios in favour of commercial credit. Fifth, international investor appetite for the Indian economy has strengthened, endorsing the improvement of the macroeconomic fundamentals. This has found reflection in large portfolio flows as well as a sizeable increase in direct investment flows and international bank lending to India. All these factors tend to place an upside bias to growth prospects.
There are indications of a pick up in aggregate demand during the third quarter of 2005-06. A number of surveys point to improvement in consumer and business confidence. The strength of domestic demand is also evident in terms of rising asset prices, sustained sales growth, growth in final output demand, surge in indirect tax collections and stronger than anticipated expansion in monetary and credit aggregates. The coincident growth of capital and consumer goods industries has supported the absorption of final demand. The robust year-on-year non-food credit growth, and particularly to industry, infrastructure and retail sectors, shows that the expansion in demand is getting broad-based. Overall aggregate demand has been managed reasonably well in 2005-06 so far, facilitated by appropriate liquidity management by the Reserve Bank and muted pressures from the fisc, given the modest improvement evident in the Centre’s finances. Recent developments, however, point to according high priority to aggregate demand conditions, especially fiscal developments, warranting careful and continuous monitoring for the effective conduct of monetary management.
While strong credit growth, which is well diversified, is a reflection of greater credit penetration and investment activity, there are concerns about credit quality in the expansion phase. The Reserve Bank has already announced some measures and sensitised the banks in this regard. Recent trends in credit growth warrant a reiteration of these concerns. Banks are urged to undertake a comprehensive review of credit quality, including a segment-wise analysis of activities with special reference to those sectors where credit is expanding rapidly.
In reviewing the monetary policy stance at this juncture, it may also be appropriate to consider potential downside risks to the outlook. First, international crude prices remain a potent threat to overall price stability. While the pass-through of international crude prices has been managed well so far, further escalations could immediately endanger the fragile balance that currently prevails between the fisc, oil companies and consumers. Second, portfolio switches and liquidity mismatches that have emerged have produced sizeable volatility in reserve money with an upward pressure on money supply, combined with a shortening of maturity of deposits in the banking system. Demand deposits have grown faster than time deposits and CDs have become an important source of funding for certain banks. These developments warrant continuous and careful monitoring so as to be on guard against the incipient build-up of potential demand pressures. Third, the possible strain on credit quality continues to be an area of concern especially in the context of ensuring financial stability and thereby deriving synergies with macroeconomic and price stability. Fourth, the surge in imports has produced a sizeable expansion in the current account deficit in the first half of 2005-06. In this context, it is important to keep a continuous vigil on the external front and to ensure stable financing of the current account deficit. Fifth, in view of the upward pressures on aggregate demand including pick up in investment activity, a reduction in the revenue deficit and further improvement in the fiscal deficit will add comfort to macroeconomic management.
As mentioned in the last review, recent developments in the BoP seem to indicate that the Indian economy has entered an expansionary phase of the business cycle. The current account deficit of the order of US $ 13 billion in the first half of 2005-06 needs to be regarded as consistent with the scaling up of the growth path that has occurred in the current financial year. Underlying the widening of the merchandise trade deficit is the sizeable growth in non-oil imports, emanating from capital goods, export-related inputs and a range of intermediate goods including fertiliser, non-ferrous metals and iron and steel. It needs to be noted that non-oil imports have an intrinsic growth-linked character and the recent high growth in these imports attests to the onset of a durable pick up in the economy. Besides, the large expansion in imports is also spurring a vigorous export growth. In this sense, the merchandise trade deficit has acquired a growth-leading dimension and could be seen as a positive development.
The appropriate level of the current account deficit (CAD) is a dynamic concept and has to be assessed over a medium-term perspective. The size of the CAD is a function of the underlying growth momentum in the economy – a faster growing economy is likely to run a higher CAD than one with relatively slower growth. In recent years, there has been some acceleration in the growth of current receipts within which growth rates of software earnings and a wide variety of business services lend comfort. Besides, private transfer receipts, comprising mainly remittances from Indians working abroad, seemed to have acquired a more enduring character and have risen steadily to constitute around 3 per cent of GDP in recent years. These factors strengthen the capability of the Indian economy to manage higher CADs than what was considered sustainable in the past. Net capital flows have so far exceeded the CAD requirements reflected in large accretions to the reserves. During the first half of 2005-06, the CAD has been financed by net capital flows with US $ 6.5 billion added to the foreign exchange reserves. The current widening of the CAD essentially represents the simultaneous expression of the impact of the crude oil prices and the pick up in domestic investment. It is expected that the sizeable expansion in imports of capital goods and embodied technology will further boost the competitiveness of India’s merchandise exports which hold the key to the strength of the external sector. It is, however, necessary to closely monitor export competitiveness and exercise continued vigil on external developments while being ready to respond to any uncertainties and shocks.
Taking into account the foregoing assessment of macroeconomic and monetary conditions and near term prospects, for the purpose of monetary management, (i) GDP growth in 2005-06 is placed in the range of 7.5-8.0 per cent based on the current assessment of a pick up in agricultural output and in the momentum in industrial and services sectors, and (ii) inflation is placed in the range of 5.0-5.5 per cent as projected earlier. Expansion in M3 is expected to be significantly higher than 14.5 per cent projected in the Annual Policy Statement of April 29, 2005 and growth in aggregate deposits would also be sizeably higher than Rs.2,60,000 crore projected earlier. Non-food bank credit including investments in bonds/debentures/shares of public sector undertakings and private corporate sector, CP and others, is expected to be significantly higher than 19.0 per cent projected earlier. It is necessary to take careful note of the potential upward bias in monetary and credit aggregates for 2005-06, even while ensuring appropriate liquidity to sustain the growth momentum.
The commitment to price and financial stability will require continuous and careful monitoring of global developments, in particular, movements in international interest rates and the ongoing adjustments of global imbalances, the international oil price scenario, the booming levels of credit and asset market activity in India and the rising trade and current account deficits. While prospects for growth have improved in recent months, it is critical to ensure that these gains are neither dissipated by inflationary pressures nor by any threat to financial stability. The Reserve Bank has consistently emphasised the quality of credit while nurturing a buoyant growth in non-food credit to support export and investment demand in the economy. While domestic factors continue to dominate over external factors in the growth and inflation outlook for the economy, at the current juncture there is a need to recognise the growing impact of external conditions on the Indian economy. While recognising that the current configuration of macroeconomic and financial factors favour growth with stability in India, it is important to extend these gains by continuing the greater emphasis on price stability. The risks to inflation from both domestic and global developments remain high, persisting well into 2006-07. In particular, the remaining pass-through of international crude prices into domestic prices of LPG and kerosene portends an upward bias to inflation in 2006-07.
Indications of pick up in aggregate demand are getting stronger with some manageable spill-over into the external sector in the form of widening trade and current account deficits. It is important to respond in a timely and even pre-emptive manner to these developments to ensure that generalised inflation spirals do not develop in an environment of higher than anticipated expansion in money supply and bank credit with large shifts in liquidity. A measured policy response at this juncture would stabilise inflation expectations and prevent corrosive effects on growth. It would also avert the compulsion of undertaking larger and more drastic adjustments in the future, should the prevailing situation evolve in a manner that threatens macroeconomic and price stability. The Reserve Bank would strive for maintaining stable inflationary expectations and orderly financial markets while ensuring the continuation of the positive investment climate. Against this background, the stance of monetary policy from time to time would depend on emerging demand and supply factors, both domestically and globally, while taking into account the lagged effects of monetary policy.
The Reserve Bank will continue to ensure that appropriate liquidity is maintained in the system so that all genuine requirements of credit are met, consistent with the objective of price and financial stability. Towards this end, the Reserve Bank will continue with its policy of active demand management of liquidity through OMO including MSS, LAF and CRR, and use all the policy instruments at its disposal flexibly, as and when the situation warrants.
In sum, based on an informed assessment of macroeconomic developments including the outlook on growth and inflation in a forward looking manner, and barring the emergence of any adverse and unexpected developments in various sectors of the economy, the overall stance of monetary policy at the current juncture will be:
• To maintain the emphasis on price stability with a view to anchoring inflationary expectations.
• To continue to support export and investment demand in the economy for maintaining the growth momentum by ensuring a conducive interest rate environment for macroeconomic, price and financial stability.
• To provide appropriate liquidity to meet genuine credit needs of the economy with due emphasis on quality.
• To consider responses as appropriate to evolving circumstances.
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