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Click here to return to main page of Annual Policy Statement 2006-07

Part I. Annual Statement on Monetary Policy for the Year 2006-07

I. Review of Macroeconomic and Monetary Developments during 2005-06

Developments in the Global Economy

46. Global growth moderated in the fourth quarter (Q4) of 2005, but is estimated to have risen to 4.8 per cent by the International Monetary Fund (IMF) for the full year in view of the broad-based expansion in economic activity. The strength of world GDP growth, well above its long-run average of 3.8 per cent, has been accompanied by a growing resilience to large systemic shocks. While oil prices doubled between 2003 and 2005, the impact on world growth has been well absorbed. The world economy is expected to continue to grow at about the same pace during 2006 and 2007. The US economy remains the main engine of global growth, but the sustained dynamism in China, India and a few other large developing economies as well as some recent signs of upturn in Japan considerably brightens the outlook for the global economy.

47. According to the World Bank, growth in the OECD countries is expected to have slipped from 3.1 per cent in 2004 to 2.7 per cent in 2005, but is expected to strengthen to 2.9 per cent in 2006 as a result of the recovery in Japan and Europe. In the United States, high oil prices, rising short-term interest rates, cooling housing markets and the hurricanes in September contributed to slowing of real GDP growth to 3.5 per cent in 2005 from 4.0 per cent in 2004. Nonetheless, low long-term interest rates boosted domestic demand. Consequently, the US current account deficit widened to 6.4 per cent of GDP in 2005 from 5.7 per cent in 2004. The current account deficit continued to be financed by foreign purchases of US financial assets. GDP growth in the US is expected to record a robust pace of 3.4 per cent in 2006.

48. In the euro area, a recovery is underway with real GDP growth rising to 1.4 per cent in 2005 and projected at 1.7-2.5 per cent in 2006 and 1.5-2.5 per cent in 2007. There are signs that the recovery in Japan is becoming more firmly entrenched with real GDP growth rising in Japan by 2.7 per cent in 2005 on top of 2.6 per cent in 2004. Growth remained robust in the developing countries in 2005, led by China (9.9 per cent), Hong Kong (7.3 per cent) and India (7.6 per cent). In Russia and Latin America, too, growth has been buoyant.

49. Consumer price inflation in the advanced economies recorded a decline in the first quarter of 2006. In the US, consumer prices increased to 4.1 per cent in January on account of oil prices but dipped to 3.6 per cent in February. In the euro area too, inflation edged down to 2.2 per cent in March from 2.3 per cent in the previous month. Although deflation continued in Japan with overall consumer prices falling by 0.1 per cent in February, the drop was smaller than in the fourth quarter of 2005. In major industrial countries, inflation appears to be low and the second-round effects of oil price increases in the form of wage increases have been moderate so far. Though price stability has been maintained in these countries in the face of the oil shock, risks loom large in the form of lagged second order effects of oil price increases, geopolitical tensions, the probability of disorderly and rapid adjustment of current account imbalances and the risks emanating from the housing market, particularly when the cycle turns down. Non-energy commodity prices have been increasing through 2005 and the first quarter of 2006 albeit at decelerated rates as compared with 2004.

50. As in the past few years, the oil market was characterised by extreme uncertainty during 2005 on account of two destructive hurricanes in the US Gulf Coast, Middle East tensions, political unrest in some other oil exporting countries and slim upstream and downstream capacity creation. International crude prices firmed up above the US $ 60 level from January 2006 on account of seasonal demand for heating fuel and disturbances in key producing countries. Oil markets are currently characterised by high inventories co-existing with high prices and geopolitical and other uncertainties about future supply. Recent events in Nigeria, Iran and Iraq have been of particular concern and are contributing to nervous market sentiment. Global oil demand growth is expected to accelerate from the levels of 2005 with both China and North America driving the rebound. World spare oil production capacity is projected to increase only modestly during 2006 and 2007. On the whole, the outlook for the oil economy in the near term appears to be tilting in favour of higher prices and greater volatility.

51. The international pass-through of oil prices to domestic retail prices has been varied across countries, with varying implications for future inflation. While domestic retail prices (including tax) of petrol in US dollar terms, increased on a year-on-year basis in March 2006 by 15.3 per cent in the US and 12.6 per cent in Canada, they increased by relatively smaller margins ranging up to 1.5 per cent in the major European economies and Japan and declined by 2.5 per cent in Italy. Similarly, diesel prices increased by 15.5 per cent in the US, by 11.6 per cent in Canada and between 0.2 per cent and 4.3 per cent in the major European economies and Japan. Comparatively, India’s domestic retail prices of petrol and diesel (average of four metros) increased by 14.6 per cent and 13.0 per cent, respectively, by March 2006 over March 2005. End-use taxes range between 17 per cent in the US and 68 per cent in the UK. Net of taxes, the retail prices of petrol and diesel have generally increased in the developed world. While the increase in petrol prices, net of taxes, varied in the range of 18.9 per cent in UK, 18.5 per cent in the US and 6.1 per cent in Italy, increases in diesel prices varied in the range of 19.1 per cent in the US and 7.0 per cent in Spain. Net of taxes, the domestic retail prices of petrol and diesel in India (average of four metros) is estimated to have increased by about 25.0 per cent and 15.0 per cent, respectively, by March 2006 over March 2005. The cross-country experience indicates that, by and large, incidence of taxation on petroleum products has not changed significantly from the period prior to the escalation of crude prices since mid-2003.

52. Global imbalances widened further during 2005 in an environment of rising interest rates worldwide and ample liquidity in global financial markets. The current account deficit of the US surpassed US $800 billion, matched by increased surpluses elsewhere, particularly in Europe, East Asia and oil-exporting countries. More than two-thirds of all global capital flows go to finance the US current account deficit. The concomitant rise in the net foreign liability position of the US raises the risks of abrupt and disorderly adjustment of major currencies as the global imbalances unwind. The global investment rate has been on a long-term declining trend, reaching a historic low in 2002 and has remained below 22 per cent of world output. Given this lack of investment activity, the imbalances have been financed easily thus far and the large and growing current account imbalances appear to be continuing unabated in 2006. While the deficit is still increasing, the location of the surplus appears to be changing recently. The current account surpluses of the oil-exporting countries of the Middle East are close to those of emerging Asia.

53. With the doubling of oil prices during 2003-05, oil export revenue for the group of oil-exporting countries has risen from US $ 262 billion in 2002 to an estimated US $ 614 billion in 2005 which corresponds to an extra 40 per cent of pre-boom GDP for oil exporters. Additional import spending by these countries has been moderate relative to the two previous oil shocks (1974-76 and 1979-81), when almost 90 per cent was spent on such imports. This suggests that a large part of the increase in oil revenue has been saved. The deployment of oil revenue surpluses by governments of these countries has taken varied forms including repayment of external debt, investment in social and physical infrastructure and deployment in oil stabilisation funds. With relatively lower spending on consumption, oil exporters are now a significant source of foreign savings in the world and are close to becoming more important than Asia in 2006.

54. Less than a third of the combined current account surplus of the oil-exporting countries has been reflected in their foreign exchange reserves which rose by about US $ 90 billion in 2005. There are some indications that the oil surpluses have been deployed in more diversified avenues through new investment agencies and oil stabilisation funds which could be invested in assets other than bank deposits. Oil exporters appear to have taken advantage of emerging investment opportunity in booming stock markets and real estate. Oil exporters’ preference for investing their petro-dollars in the US has been diversified away from treasuries to large stakes in private equity abroad through intermediaries based in large financial or offshore centres. Such inflows could have helped to keep long-term interest rates as also the emerging market bond spreads low, even as the policy rates are rising.

55. In the absence of any unwinding of global imbalances so far, recent global financial developments have been broadly positive, although concerns remain about the pricing of risk in financial markets. In an environment of above trend growth in the world economy, unusually low volatility in financial markets and strong profitability in banking systems in most countries, investors have been prepared to purchase risky assets at relatively high prices in 2005. The perceived risks arise mainly out of global imbalances and the outlook for oil prices, particularly in the light of the emerging geo-political situation. Most market participants seem to sense these risks but this sentiment does not appear to be reflected yet in the pricing of risks. Risks do not disappear but they get transferred to another part of the system. The macro policies in emerging markets, in particular, have to factor in these risks while continuously balancing financial sector reform and stability considerations. More important, monitoring where the risk lies has become very difficult for the regulators, due to emergence of large conglomerates, sophisticated market instruments such as derivatives and presence of players like hedge funds.

56. In this environment, any volatile and unpredictable changes in asset prices could become a source of financial instability. To maintain confidence in the financial system, it is necessary to prevent shocks from spreading through contagion. Surveillance of the institutions in the financial sector and their interactions, both amongst themselves and with lenders and borrowers outside the financial sector, strengthening the financial infrastructure and, as a last resort, crisis management, are crucial in this respect. But, financial crises need not necessarily involve just banks. There is an increasing overlap and interaction between banks and securities markets, and further with the insurance and household sectors. Some of these segments may not have the same rigorous risk management systems or regulatory oversight as banks. There are also market segments, particularly over the counter, which are not tightly supervised but could be of systemic importance such as hedge fund operations and structured credit derivatives. In this scenario, the financial risks have a tendency to be shifted from well-regulated to weakly or less regulated segments, the household sector being the most vulnerable at one end of the spectrum.

57. For developing countries, access to international finance has improved over the past year. Private capital inflows to emerging market economies increased in 2005; market access continued to be favourable and external financing costs dropped sharply. These conditions have favoured the emerging market economies in particular as low risk premiums prevailed for the external borrowing by these countries in global financial markets. In the first quarter of 2006, asset prices in bonds, equities and currencies of emerging markets have rallied to record highs reflecting steady improvement in many countries’ fundamentals as well as investors’ heightened appetite for risk. Problem-loan expenses in many banking systems have declined, and the current global default rate on high-risk bonds has reduced siginificantly. Measures of implied volatility extracted from option prices in most major foreign exchange, interest rate and equity markets have been at their lowest levels in several years, suggesting that these favourable developments are expected by the markets to continue. The main exception to this general pattern is commodity prices which have shown considerable volatility in recent years.

58. Long-term bond yields continue to be well below their long-run averages. Ten-year bond yields in Japan, the euro area and the US currently stand at 1.93 per cent, 3.95 per cent and 5.03 per cent, respectively. As long-term yields declined, short-term rates in the US and the euro area edged upwards following policy rate increases by the Federal Reserve and the European Central Bank (ECB). As a consequence, yield curves have flattened, but market participants appeared to be relaxed about the outlook for growth. This general phenomenon is reflected in the low level of credit spreads on bonds issued even by emerging markets and companies with low credit ratings which are around their lowest levels since 1997. Partly in response to these very positive borrowing conditions, an increasing number of emerging market countries have been able to issue long-term debt in their own currency and thereby reduce foreign currency exposure and rollover risk. There has also been strong growth in structured credit markets.

59. Of the major central banks, the US Federal Reserve has raised its policy rate by 25 basis points each on fifteen occasions from 1.0 per cent in June 2004 to 4.75 per cent by March 2006 while hinting at the need for further rate hikes on account of possible increases in resource utilisation, in combination with the elevated prices of energy and other commodities as having the potential to add upward pressures on inflation. The Bank of England had raised its policy rate to 4.75 per cent in August 2004, which was brought down to 4.50 per cent in August 2005 and has been kept at that level in response to slowing domestic growth. The ECB has raised its policy rate twice since December 2005 by 25 basis points each in response to rising inflationary expectations, after holding it unchanged at 2.0 per cent since June 2003. The Bank of Japan (BoJ) has announced on March 9, 2006 that it will end quantitative easing and introduce a comfort range for core inflation of 0-2 per cent. The policy instrument was switched from outstanding current account balances with the BoJ to the overnight call rate.

60. Monetary policy has been tightened or kept unchanged in several economies in emerging Asia. The Bank of Korea has increased its rate by 25 basis points in February 2006 to 4.0 per cent, but kept it unchanged since then. In Malaysia, the policy rate was hiked to 3.0 per cent in end-November 2005 and kept at that level till a 25 basis point hike in February. Bank Indonesia has kept its rate unchanged after raising its policy rate by 50 basis points to 12.75 per cent on December 6, 2005 which was the tenth successive increase. In Thailand, the 14-day repurchase rate was increased for the ninth time since January 2005 from 2.0 per cent to 4.75 per cent in April 2006. Monetary authorities in Singapore and Hong Kong have tightened their policy rates over December 2005.

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