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Click here to return to main page of Annual Policy Statement 2007-08



Part I. Annual Statement on Monetary Policy for the Year 2007-08


I. Review of Macroeconomic and Monetary Developments during 2006-07


Developments in the Global Economy

49.The world economy expanded strongly in 2006, shrugging off initial expectations of a deceleration in relation to 2005, and achieved a four-year run of sustained growth that began in 2003. Moreover, the expansion was broad-based; while the US economy slowed somewhat in the second half of the year, the momentum of growth in Europe and Japan continued to be firm. Robust growth in China and India led the strong macroeconomic performance of emerging and developing countries. Strong growth has also been recorded in low-income countries, especially in sub-Saharan Africa. The International Monetary Fund (IMF) has projected in its World Economic Outlook of April 2007 that global real GDP growth on a purchasing power parity basis is expected to decelerate from 5.4 per cent in 2006 to 4.9 per cent in 2007 and 2008. World real GDP growth, on the basis of market exchange rates, is estimated to decelerate from 3.9 per cent in 2006 to 3.4 per cent in 2007 before accelerating fractionally to 3.5 per cent in 2008.

50.In the US, real GDP rose by 3.3 per cent in 2006 as compared with 3.2 per cent in 2005. Acceleration in consumer and government spending, exports and a downturn in imports underpinned the growth momentum, offset partially by lower investment in inventories, equipment and software. Despite heightened risks from the contraction in housing, the US economy is expected to achieve moderate growth in 2007 as indicated by high employment and industrial output data in the first quarter, with continuing upside risks to inflation. Continuing weakness in the housing market and volatility in the major stock indices remain a cause for concern. Real GDP growth in the euro area picked up to 2.6 per cent in 2006 from 1.4 per cent in 2005 and is expected to grow by 2.3 per cent in 2007. Growth in the euro area is expected to be fuelled by consumer spending on the back of increased hiring and spending in major European countries, indicating improved consumer confidence. The unemployment rate in the eurozone fell in February to 7.3 per cent - the lowest level since 1993. While fiscal deficits in the EU states have been narrowing and there is a likelihood of continuing appreciation of the euro, risks to the medium-term outlook for price stability remain and could tighten monetary conditions in the euro area, going forward. The Japanese economy grew by 2.2 per cent in 2006 and is expected to grow by 2.3 per cent in 2007. According to the Bank of Japan, the economy is expanding moderately, aided by increasing public investment, buoyant exports and business fixed investment fed by high corporate profits, firm trends in private consumption and a moderate increase in housing investment. With the rise in demand, both at home and abroad, production has also been on an increasing trend and this is expected to continue.

51.In the emerging market economies (EMEs), growth has continued to be firm on account of availability of financial resources, strong commodity prices and abundant global liquidity. Concerns have, however, arisen regarding the sustainability of some of these factors. Growth forecasts for 2007 continue to be optimistic, but some uncertainties persist, especially with the Chinese economy which accelerated by 10.7 per cent in 2006 and contributed about a tenth of global growth, marking the fourth consecutive year of growth of at least 10 per cent. Inflation in China for 2006 was at 2.8 per cent. While China is expected to grow by 10.0 per cent in 2007 with inflation at 2.2 per cent, this growth is perceived to be unstable and environmentally unsustainable by Chinese authorities. High investment growth, excessive lending, overhang of liquidity, strengthening retail demand and imbalances in trade and international payments were some of the factors causing concern. China ran a record US $ 177.5 billion trade surplus in 2006 which has contributed to the overhang of liquidity in the economy. Consumer price inflation has risen steadily from less than 1 per cent in February 2006 to 3.3 per cent in March 2007. In the first quarter of 2007, the Chinese economy accelerated by 11.1 per cent, following which the Chinese authorities aim to take further steps to keep the economy from overheating. The People’s Bank of China has raised interest rates three times since April 2006 to reach 6.39 per cent and has raised cash reserve requirements six times in the past one year to reach 10.5 per cent. Any slowdown in the Chinese economy would ultimately affect the countries which supply inputs for manufacturing activity in China.

52.Among the other major Asian economies, the Korean economy is expected to grow by 4.4 per cent in 2007, slower than 5.0 per cent in 2006. In Korea, consumer price inflation has accelerated in 2007 to 2.20 per cent in March from 1.70 per cent in January. The Bank of Korea (BoK) has already taken tightening steps in 2006 by raising its policy rate to 4.5 per cent, increasing reserve requirements and cutting the ceiling on aggregate loans to commercial banks by 20 per cent for lending to small and medium enterprises. Korean authorities are concerned about the steady rise in property prices in recent months. A series of measures were announced in January 2007 to stabilise property prices: restricting mortgage loan issuance to one contract per person, introduction of price ceilings on new houses, and disclosure of construction cost of new homes.

53.In Thailand, slowing demand has led the Bank of Thailand (BoT) to cut its growth forecasts for 2007 to 4.5 per cent from 5.0 per cent recorded in 2006. Headline inflation had been gradually easing during 2006 and 2007 (up to March 2007) in response to policy rate increases in January 2006, March 2006, April 2006 and June 2006. The BoT introduced a series of measures to stem strong capital inflows into the economy in 2006. To enhance the efficiency and transparency of the BoT’s monetary policy implementation as well as to facilitate continued development of the Thai financial markets, the MPC changed the policy rate to the 1-day repurchase rate, instead of the 14-day repurchase rate, effective from January 17, 2007. In order to stimulate the economy, BoT has cut this policy rate by 100 basis points since January 2007.

54.Most Asian EMEs (AEMEs) have recorded strong growth with reasonably well-anchored inflation expectations, aided by strong global demand for their exports, favourable terms of trade, easy access to external financing and comfortable foreign currency reserves along with reduced external debt as percentage of GDP. Their banking systems have also been strengthened through improved restructuring and supervisory systems. The resilience to external shocks is reinforced by a combination of lower balance sheet exposure to exchange rate risks, lower refinancing risks in debt structures, strong financial systems and with greater policy flexibility. However, there are several challenges facing these fast-growing AEMEs. Concerns about inflationary pressures are being reinforced by ample liquidity and rapidly rising credit, largely driven by excess capital flows. The existence of significant current account surpluses in many AEMEs and large capital flows in recent months and years have posed new challenges for macroeconomic and external sector management in these countries. Just as capital flows are robust at the present time, partly reflecting accommodative monetary policies in the mature economies in recent years, such flows do have the potential of reversing rapidly in response to the withdrawal of monetary accommodation now taking place. In response to these dilemmas, each AEME has evolved its own mix of policies so as to manage rather than resolve them. The currency appreciation or depreciation of countries enjoying current account surplus could, at times, be steep and sudden, resulting in possible disruption in the real sector. Therefore, they have felt the need for containing excess volatility in foreign exchange markets through foreign exchange market intervention accompanied by sterilisation. However, such policies have their own limitations and such actions have also been accompanied by differing strategies for liquidity management, including raising cash reserve requirements, issuances of central bank securities, ceilings on lending to specific sectors, the use of prudential tools and the like. Furthermore, aligning the operations of large financial conglomerates and foreign institutions with local public policy priorities remains a challenge for domestic financial regulators in many AEMEs.

55.International foodgrains prices, in particular, wheat and maize, scaled record levels in 2006 as global cereal output fell by 2.7 per cent from the previous year, largely due to reduced plantings and adverse weather conditions in some of the world’s major producing and exporting countries, including the United States, several European countries and Australia. With the overall strength of demand vis-à-vis supply and low stock positions the world over, global wheat prices are expected to rise further. Apart from weather conditions, fast growing demand for bio-fuel production has also led to excessive demand and high prices for grains. The strong demand for grains from bio-fuels has contributed to the fall in global corn and wheat stockpiles to about 25-year lows in terms of days of consumption. International prices of wheat (and products thereof such as flour) have been steadily rising in recent months. There are, however, favourable prospects for world cereal crops in 2007, mainly following expansion of plantings in Europe and North America, coupled with generally satisfactory weather conditions. Although the bulk of the decline in world cereal output in 2006 was among the major producing and exporting countries, cereal production in low-income food-deficit countries increased significantly. As a result, cereal import requirements, including food aid, declined in 2006-07 in many of these countries, mostly in Africa. world trade in wheat in 2006-07 has remained at the high levels recorded in the previous year, mainly due to larger imports by Brazil and India. Corn prices doubled since the start of 2006 and reached a 10-year high in March whereas wheat futures prices reached a 10-year high in February. Current high prices are expected to spur large crops and more abundant world stocks.

56.Metal prices have increased by 4.0 per cent during the first three months of 2007, over and above the increase of 53.6 per cent in 2006 and 36.2 per cent in 2005. Low stock levels, increasing demand and the recent firmness in crude oil prices have kept most metal prices high and these high levels are likely to persist in the near term. Gold prices, which had sharply risen to their highest level in 26 years in May 2006, are expected to remain firm in 2007 because of contracting mine supply, an expected decline in the dollar and lower sales by Europe’s central banks.

57.Spot crude oil prices softened from the July-August 2006 peak of US $ 78 per barrel to around US $ 53 per barrel in January 2007 due to unusually warm weather and change in funds flow to the oil sector, despite production cuts by the Organization of Petroleum Exporting Countries (OPEC) since December 2006. Thereafter, crude prices have gone up to US $ 63.5 per barrel on April 20, 2007 due to geopolitical tensions in the Middle East. In April 2007, the Energy International Administration has projected that the West Texas Intermediate (WTI) crude oil price would be at US $ 63.9 per barrel in 2007 and US $ 63.83 per barrel in 2008.

58.In the US, consumer prices increased from 2.0 per cent in November 2006 to 2.8 per cent in March 2007. In the Euro area, inflation declined from 2.3 per cent during August 2006 to 1.9 per cent in March 2007. Inflation turned negative in Japan to -0.2 per cent in February 2007 from 0.9 per cent in August 2006. In the UK, inflation has been exceeding the target of 2.0 per cent since May 2006 and stood at 3.1 per cent in March 2007 following which the Governor of the Bank of England has written an open letter to the Chancellor on April 16, 2007, as required by the monetary policy remit. The letter explains that the rise in inflation to 3.1 per cent from 1.8 per cent a year ago was due to a sharp increase in domestic energy prices in the second half of 2006, rise in food prices, recovery in pricing power of corporates and spending, and capacity pressures. The letter also states that, at its May meeting, the Monetary Policy Committee will have an opportunity to assess the inflation and other data before reaching its next decision on interest rate. In the April meeting of the MPC held on April 5, 2007 the BoE had kept its repo rate unchanged at 5.25 per cent. At the retail level, RPI inflation rose to 4.8 per cent in the UK in March 2007 - the highest since 1991.

59.The acceleration in headline inflation in the US was reflected in core inflation, indicating that underlying inflationary pressures persist. Core inflation in March 2007 was 2.5 per cent as against 2.7 per cent in February 2007. In the UK, core inflation has been increasing in tandem with the headline rate and stood at 1.9 per cent in March, up from 1.7 per cent in February 2007. In the Euro area, core inflation has remained at the level of 1.9 per cent in March – the same as in February 2007. Core inflation in Japan was negative (-0.30 per cent) in February 2007 as compared with no change in January 2007. globally, headline inflation has picked up in the wake of increase in commodity prices, and core inflation has also generally remained firm. This is likely to pose risks to inflation expectations as international crude prices have started rising again.

60.Despite the good growth prospects for the global economy for 2007, it must be recognised that the growth projected for 2007 involves a deceleration of about 0.5 per cent from 5.4 per cent in 2006 to 4.9 per cent in 2007. In addition, there are a number of risks emanating from the behaviour of oil prices, adverse developments in the US housing market, persistence of global imbalances, large leveraged positions in financial markets, and possible emergence of inflationary pressures. It is important to recognise the risk of an abrupt and disorderly adjustment of global payments imbalances, particularly between the US and Asia. With financial globalisation, the exposure of emerging markets to risky financial assets in mature markets has increased. Similarly, the risk appetite of institutional investors has also increased in search of higher yields. This is reflected in the compression of spreads for emerging market financing which cannot be fully justified by improved fundamentals. Overall, the financial risks have increased. In the event of a loss of risk appetite and consequent unwinding of leveraged positions, there could be serious adverse effects in emerging markets.

61.Volatility in international financial markets has increased in recent months with notably, a sharp pick-up in loan arrears in sub-prime residential mortgages in the US, the deterioration in asset values of hedge funds and global stock market turbulence. In addition, complex derivative products, widely used by hedge funds to manage risks, have diffused these risks and complicated the challenge facing regulators. The announcement of measures to control stock market activities in China at end-February 2007 led to a sharp fall in the Chinese stock market and widespread turmoil in the global capital markets, including capital markets in the developed economies. The Chicago Board Options Exchange Volatility Index rose sharply during the turmoil as investors displayed shared anxiety about the stock market, underlining the extent of global integration in recent years. If the recent sell-off is compared to the event in May-June 2006, it emerges that the initial conditions in both the cases were similar where the stock markets had reached very high levels of valuation and were looking for a trigger to correct. However, the reasons starting the sell-off were somewhat different. In May-June 2006, concerns about tightening of monetary policy globally, especially in the US and sharp declines in record-level global commodity prices led to the fall in stock prices. In the February 27, 2007 episode, the announcements by Chinese authorities and subsequent correction in the Chinese market acted as the trigger for decline in all the markets. The initial fall was exacerbated by the strengthening of the yen, following the Japanese policy rate increase on February 21, 2007 which led to some unwinding of carry trade on anticipation of decline in profitability.

62.Looking ahead, it is important to recognise market concerns that the reversal of carry trades may intensify further, portending a liquidity crisis. These developments cast a shadow on the short-term prospects for EMEs if there is a flight to safety by global funds, as in the May-June 2006 sell-off. World stock markets have regained buoyancy and growth by April 2007. The Dow Jones Industrial Average rose to a record level by April 19, 2007 on the back of strong corporate results, and favourable news about the housing sector and inflation in the US. Financial markets have reacted relatively calmly to events that, in the past, might have been the catalyst for disruptive adjustments.

63.Recent developments have also seen a small rise in credit spreads on emerging market debt and lower-rated corporate debt, but these spreads remain at levels that are historically low. For lower-rated corporate bonds in the United States, spreads have fallen by about two-thirds since late 2002, with the default rate on high-yield bonds reaching a 25-year low of 1.57 per cent in 2006. Since 2002, spreads on emerging market sovereign bonds have also fallen noticeably.

64.The levels of government bond yields in the major economies also remain low. The US 10-year bond yield increased from 4.70 per cent at end-December 2006 to 4.78 per cent in April 20, 2007, reducing the extent of inversion of the yield curve. The 10-year bond yield in the Euro area increased from 3.95 per cent at end-December to 4.20 per cent. The Japanese 10-year bond yield has increased from 1.68 per cent at end-December to 1.69 per cent. On a trade-weighted basis, the US dollar which had depreciated during October-December, rose to a seven-week high against major currencies on January 9, 2007 following concerns expressed by Fed officials about inflation, but has eased in the subsequent weeks recording a 15-year low against the British pound on April 17, 2007.

65.The US current account deficit is projected by the OECD to reach 6.5 per cent of GDP in 2007 with substantial surpluses elsewhere, particularly in Asia, giving rise to continuing global imbalances. 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 and abundant liquidity, investors have been prepared to purchase risky assets at relatively high prices. The perceived risks arising mainly out of the prospects of withdrawal of liquidity and global imbalances does not appear to be reflected in the pricing of risks. Also, monitoring risks has become very difficult for the regulators, due to emergence of large conglomerates, sophisticated market instruments such as derivatives, presence of players like hedge funds and shifting of financial risks from well-regulated to weakly or less regulated segments.

66.By and large, globally monetary policy authorities are inclined to continue to regard inflation as a major global risk and are vigilant about threats to inflation expectations. They are also watchful about the emergence of excessive volatility in asset prices, underpricing of risks and disorderly conditions in currency markets. They have generally displayed a preparedness to act pre-emptively against the possibility of these risks materialising.

67.Some central banks have recently paused in their policy cycles, particularly the US. The pause of the Federal Reserve during August 2006-March 2007 came after seventeen increases by 25 basis points each between June 2004 and June 2006. Other central banks that have kept their policy rates steady include the Bank of Canada at 4.25 per cent (since May 2006); Bank Negara Malaysia (Overnight Policy Rate at 3.5 per cent since April 2006); and the Banco de Mexico (benchmark overnight lending rate at 7.0 per cent since April 2006).

68.Some other central banks have cut back their policy rates in recent months, usually on the back of earlier strong actions to contain inflation. These include Bank Indonesia (BI) (BI rate reduced from 12.50 per cent in May 2006 to 9.00 per cent in March 2007); the Banco Central do Brasil (Selic rate target cut between September 2005 and April 2007 to 12.50 per cent); the Banco Central de Chile (benchmark lending rate reduced to 5.00 per cent in January 2007 from 5.25 per cent in July 2006) and the Bank of Thailand (1-day repurchase rate reduced from 4.75 per cent to 4.50 per cent in February 2007 and further to 4.00 per cent in April 2007).

69.The central banks that have tightened their policy rates include the ECB which has raised its policy rates seven times since December 2005 by 25 basis points each to 3.75 per cent (main refinancing rate); the Bank of England (repo rate raised in August and November 2006 and January 2007 by 25 basis points to 5.25 per cent), the Bank of Japan (uncollateralised overnight rate target at 0.25 and 0.50 per cent since July 2006 and February 2007, respectively, after maintaining a zero interest rate policy since September 2001); the Reserve Bank of Australia (Cash Rate raised by 25 basis points each in August and November 2006 to 6.25 per cent); the Reserve Bank of New Zealand (Official Cash Rate raised to 7.50 per cent by two 25 basis points hikes in December 2005 and March 2007); the People’s Bank of China (lending rate raised thrice to 6.39 per cent by March 19, 2007); and the Bank of Korea (target overnight call rate raised by 25 basis points to 4.50 per cent on August 10, 2006).

70.A few central banks have reinforced the increases in key policy rates with increases in reserve requirements. In China, the required reserve ratio was raised by 50 basis points each effective from July 5, August 15, November 15, 2006, January 15, 2007, February 25, 2007 and April 16, 2007. The Bank of Korea raised reserve requirements from 5 per cent to 7 per cent for local currency deposits and short-term foreign currency deposits after 17 years in November and December 2006, respectively. Meanwhile, in China and Korea, central bank bonds have continued to absorb liquidity from the banking system.


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