Mid-term Review of Annual Policy 2004-05- 26th Oct 2004
I. Mid-term Review of Macroeconomic and Monetary Developments in 2004-05
46. In sum, from an overall policy perspective and in qualitative terms, some of the areas that need further attention could be as follows:
(a) A striking development during the year relates to growth of non-food credit in the first half, which is traditionally a slack season for credit off-take: credit during the first half typically accounts for 20-40 per cent of the total credit for the year as a whole. A noticeable feature in the recent years was the subdued growth in non-food credit, though the second half of 2003-04 witnessed some pick-up. In addition to the liquidity conditions, the mid-term Review of November 2003 had addressed credit delivery as one of the central themes. While expressing a sense of satisfaction with credit growth in the later part of 2003-04, the annual policy Statement had anticipated credit pick-up to continue, and had accordingly stressed continuation of efforts to stimulate credit growth. A review of developments so far in the current year confirms that there has been a revival of investment activity. There is some evidence of expansion plans being brought forward and scaling up of production plans. To the extent manufacturing industry is showing signs of robust growth, the credit needs will witness higher growth than that in the past which was dominated by growth in the services sector. As a result of the current policy thrust, credit to agriculture is also picking up from its low base and could initiate greater credit penetration by displacing non-institutional lenders. The fast growing housing and consumer credit sectors also represent some degree of higher penetration, but the quality of lending needs to be ensured. Overall, the pick-up in investment activity and growth in non-food credit appear to be broad based and are not temporary phenomena. These favourable outcomes point to the need for enabling liquidity conditions and a continued thrust on credit delivery to the productive sectors of the economy.
(b) Growth in GDP is likely to be less than originally projected mainly due to deficient monsoon conditions and partly due to high and volatile oil prices, despite a better than anticipated outlook for manufacturing industry and export demand. The initiation of accelerated growth in manufacturing industry amidst global competitive pressures is a positive development and needs to be supported by policy to ensure its momentum. It is worth noting that manufacturing provides a good base for tax revenues in India. In view of the impressive business confidence, both domestically and internationally, it would be prudent for the policy to be predicated on an efficient and growing manufacturing sector, with resultant higher demands for credit.
(c) In regard to prices, the annual policy Statement had referred to the overhang of problems on account of oil prices and large domestic liquidity. As it turned out, while overhang of excess liquidity was being managed, a supply shock emanated out of global developments, mainly on account of oil and a few other key commodities like iron & steel. Some pressures were anticipated, but not the magnitude of the supply shock and its persistence. Current indications are that the situation of uncertainty, high and volatile oil prices may persist during the rest of the year. Further, the full impact of oil price increases is yet to be absorbed in domestic prices. The supply factors, therefore, will continue to dominate the price situation, while demand management seems to invite closer attention than before, particularly for stabilising inflationary expectations in a credible manner. It is also necessary to recognise the risks of stronger adjustments that may be needed if less than adequate adjustments are made at the appropriate time, though the timing, the magnitudes as well as the instruments are based as much on judgements as on facts and projections.
(d) The financial markets have, by and large, exhibited stability. The equity markets, which exhibited exceptional volatility in mid-May, have settled down to a normal state. The money market and forex market continue to be stable. The government securities market has tended to show some nervousness in recent months and was characterised by an overall bearish sentiment. Several inter-related aspects might have contributed to such a sentiment. First, the market was in need of correction from excessive optimism; second, there was an unexpected surge in inflation; third, the sharp increase in non-food credit has also put some pressure on expectations; fourth, the global environment has tended towards some hardening of interest rates in recent months. While these developments were not fully unanticipated, and RBI had invited attention to them in the annual policy Statement, some market participants appear to have been less than fully prepared as the events unfolded. The Reserve Bank will continue to give some weight to consideration of stability but the markets should be prepared for the uncertainties. The extent of liquidity available as well as the strength of the external sector provides cushions against any undue pressure on financial markets. The market participants, in particular banks, have acquired some experience and considerable expertise in facing the uncertainties inherent in a market economy.
(e) Conduct of monetary policy, in the best of times, is complex since it has to be forward looking and based on current and sometimes outdated data relative to rapid changes. Additional complexities arise in the case of an emerging market which is transiting from a closed to a progressively open economy. The overhang of liquidity impacts on the pace of change in the stance of monetary policy as also on the effectiveness of some operating instruments. Currently, the combination of factors that complicate monetary management includes: globally transmitted supply shock; less than normal monsoon conditions; persistence of liquidity overhang; and long-awaited pick-up in non-food credit.
The policy has been responding to the evolving circumstances based on analysis and some judgements. First, in November 2003, there was a widespread expectation of further progress in soft bias in interest rate regime. A view was taken that the interest rate cycle had reached the bottom. Second, a judgement had to be made on capital flows in the early part of the current calendar year as to what part of the capital inflows should be treated as temporary. In this regard, the fact that international financial markets react asymmetrically to the same magnitude of growth in forex reserves (positively) and to the depletion in forex reserves (very negatively) cannot be lost sight of. Third, empirical evidence indicates that the perceptions of the financial markets in the context of changes in political executives in the Government cannot be ignored while monitoring developments. Fourth, when some central banks start moving from easy to more neutral policy and hike policy interest rates, there is an inevitable impact on Indian financial markets. In response to these developments, decisions have to be made on an ongoing basis, about the weight to be given to stability in financial markets relative to the possible costs of not altering the approaches. Fifth, when faced with a severe oil-shock, the first of its kind in the liberalised market-oriented environment in a semi-open economy, the governing thought in making judgements is the harmonisation of the communications and policy responses of RBI along with corresponding fiscal and corporate initiatives. Thus, the conduct of policy in the first half of the year was characterised by responses to developments on an ongoing and measured basis, giving appropriate weights, contextually, to global and domestic factors, to growth and price stability, to efficiency and financial stability and to over-riding concerns for the common person. Operationally, it is expected that the challenge for the rest of the year would broadly remain the same, viz., management of liquidity in tune with the draining of the overhang, progress of borrowing programme of the Government, the evolving domestic and global situation, especially oil prices and global interest rate environment, but with equal weight to considerations of maintaining growth momentum and stabilising inflationary expectations.
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