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Click Here For Highlights of RBI's Annual Policy Statement for 2005-06
Part I. Annual Statement on Monetary Policy for the Year 2005-06
I. Review of Macroeconomic and Monetary Developments during 2004-05
Developments in the Global Economy
40. The world economy expanded by 5.1 per cent during 2004 recording its highest growth rate since the mid-1970s. The International Monetary Fund (IMF) has projected the world economic growth to slow to 4.3 per cent during 2005 and 4.4 per cent in 2006. Even this pace of expansion is higher than the average growth recorded in the last two decades. The buoyancy in the world economy has been aided by productivity gains, cost cutting by corporates, trade expansion, financial stability, benign inflation and low interest rates. Global economic expansion has been largely driven by accelerated growth in the US, some newly industrialized Asian economies, Commonwealth of Independent States (CIS) and other emerging markets and developing countries, especially, Russia, China and India. Growth in sub-Saharan Africa has also distinctly improved.
41. Consumer price inflation in the US has increased over last two years, but remained low in the Euro area, Japan and other advanced economies. Inflation in other emerging markets and developing countries also declined to 5.7 per cent in 2004 from 6.0 per cent in the preceding year, with perceptible decline in Africa, central and eastern Europe, CIS countries and Latin America. Inflation in developing Asia, however, increased from 2.6 per cent in 2003 to 4.2 per cent in 2004 with inflation in China edging up from 1.2 per cent to 3.9 per cent. Nevertheless, general inflation has remained low in spite of sharp increase in commodity prices in 2004 with oil prices rising by over 30 per cent and non-fuel commodity prices rising by nearly 19 per cent. Going forward, the risks that inflation may turn out to be higher and growth lower than currently anticipated has increased.
42. The rise in oil prices appears to have a large permanent component and this makes it important to factor in the second round effects in assessing the inflationary impact. As per IMF estimates, a permanent US $ 5 per barrel increase in oil prices was expected to lower global GDP growth by up to 0.3 percentage points. However, the adverse impact on growth was not apparent during 2004 because the oil price increase reflected acceleration in demand. The large increase in export earnings of oil-exporting countries have supported strong growth and have resulted in fiscal and current account surpluses in these countries. While some non-oil producing countries have benefited from strong growth in oil-producing countries, higher oil prices have the potential for adverse balance of payments effects and could lead to substantial adjustment in domestic consumption with attendant adverse impact on growth. If capacity pressures seen in some industries persist and labour market conditions tighten, inflationary pressures could emanate both from the demand and supply side. Overhang of liquidity in some emerging markets, fuelled by large capital flows amidst global external imbalances could also accentuate inflationary pressures.
43. Risks to growth arise from current account and fiscal imbalances and excessive leveraging in some advanced economies which has necessitated current account and exchange rate adjustments. Global expansion has been largely imbalanced with hesitant recovery amidst structural rigidities in some advanced economies, leaving the prospects of global growth in near term somewhat uncertain. Current account deficit of advanced economies has widened to 1.0 per cent of GDP, with the US running a deficit as high as 5.7 per cent of GDP. Fiscal gaps in the US, the Euro area and Japan remain large. Unemployment rates in advanced economies have declined very little in relation to pick up in economic activity. Currency adjustments are still not over in spite of 20 per cent real effective exchange rate depreciation of the US dollar over last two years and a 13 per cent appreciation in the Euro. Policy rates have been raised in the US but are still below the neutral level in major advanced economies, except the UK. Short-term market interest rates in advanced economies have hardened by more than 50 basis points in the first quarter of 2005. Though long-term interest rates have not moved as much, the transmission could follow. While net private capital flows to emerging markets increased sharply by 32 per cent in 2004 to nearly US $ 200 billion, the levels may not be sustained in the coming years. If unanticipated macroeconomic or geopolitical developments occur against this background, the extent of required adjustment could get amplified.
44. The global financial system today is far more stable than in the latter half of the 1990s as a result of robust world economic growth over the past three years and good corporate earnings. The financial institutions addressed issues arising out of bad loan problems and strengthened their capital base as well as risk management systems. In the emerging market economies, improved economic fundamentals coupled with enhanced policy credibility resulted in a series of upgrades on sovereign credit ratings. This has contributed to the benign financial market conditions and tightening of spreads. However, world financial markets are known to be characterised by multiple equilibria where good state of markets could change into a bad state within a very short period. Abundant global liquidity and low short-term interest rates over the past few years have also contributed to asset price rise and leveraging of corporate and household balance sheets in several parts of the world, covering both the emerging and the matured markets. Furthermore, considering that economic expansion may be at a very advanced stage of business cycle in some systemically important matured markets, it may be difficult to sustain the current high levels of corporate earnings. There is an even greater need now to keep a vigil on potential bubbles in the asset markets since real estate market valuations have, in the recent past, been supported by low-interest consumer debt. Current equity valuations, which still look good in most markets, could move very quickly if corporate earnings drop. Currency adjustments have proceeded in an orderly manner over last two years, but if required adjustments in current account and fiscal gaps of advanced economies do not take place over the next few years, interest rates may have to rise to clear the markets. In such an event, the impact on balance sheets could be much larger than is currently being anticipated. Finally, if oil prices continue to firm up at a pace seen so far in 2005, financial markets could see a major reaction as pace of economic activity slackens, corporate earnings fall and external imbalances sharpen.
45. Over the years, India’s commercial and financial linkages with the rest of the world has been increasing with trade liberalisation and openness on the capital account. This is reflected in the transmission of international impulses to the real sector and domestic financial markets. Trends in international prices have now significant influence on domestic prices. Indian corporates and institutions are increasingly accessing international markets with consequent asset diversification. While this process has provided important opportunities, it has also brought in new challenges and risks, necessitating fine-tuning of macro policies in a much broader context.
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