Part I. Annual Statement on Monetary Policy for the Year 2006-07
I. Review of Macroeconomic and Monetary Developments during 2005-06
61. On an overall assessment, the performance of the Indian economy during 2005-06 turned out to be stronger than expected. Real GDP growth turned out to be higher than projected in the Annual Policy Statement of 2005-06 and, thus, the two upward revisions to this projection that were made during the course of the year were justified. Inflation was contained well within the range projected in the monetary policy stance for 2005-06 and inflation expectations have remained firmly anchored. This has been reflected in the relative stability of long-term interest rates. Financial markets were generally stable during the year, adapting to the shift in liquidity conditions from surplus to deficit with considerable resilience. Appropriate liquidity management by the Reserve Bank played a crucial role in fashioning the market response. There are indications of improvement in the fiscal situation and the return to the path of correction set by the Fiscal Responsibility and Budget Management Rules augurs well for macroeconomic stability. On the other hand, non-food credit growth, deposit growth and money supply growth were higher than the projections made at the beginning of the year. In the external sector, balance of payments developments have evolved in concert with the strength of the macroeconomic fundamentals. While the trade and current account deficits have widened modestly, they have posed no financing constraint, given the strong international investor interest in India and the growing access of Indian entities to international financial markets. The redemption of the IMD has been managed well and the foreign exchange reserves have been quickly rebuilt in the aftermath of the redemption.
62. While these outcomes have imparted considerable optimism for 2006-07, it is important to undertake a careful assessment of the favourable factors and the downside risks, global as well as domestic, that could weigh upon the medium-term outlook. Recent developments indicate that while domestic factors continue to be significant, the global factors are gaining greater importance in determining the near-term outcome and accordingly, in the monetary policy response.
63. There are several positive factors in recent global developments. World economic growth remained reasonably strong and broad-based in 2005 and is expected to continue at the current pace in the near-term. In particular, global growth has exhibited considerable resilience in the face of high and volatile oil prices, geo-political tensions and supply shocks. World trade has expanded pari passu and some rebalancing of the sources of growth is underway with the maturing of the cyclical recovery in a number of economies and the associated unwinding of policy accommodation. Financial flows to emerging market economies have been robust, returning to the pre-Asian crisis levels and several developing countries have successfully launched issuances of debt and equity in international markets, benefiting from the compression in credit spreads and the appetite for emerging market paper.
64. Nevertheless, a number of downside risks loom over the global economy that have implications for the medium-term prospects of countries like India for which the channels of global integration are getting stronger over time. The key global risks for emerging economies are potential escalation and volatility in international crude prices, a disorderly unwinding of the macroeconomic imbalances of the major economies and a hardening of international interest rates along with the direction of movement in setting monetary policy, at least over the ensuing year. Oil prices remain high and upwardly volatile with no signs of easing in conditions of tight supply, growing demand, geo-political concerns, impairment to production and refining capacities caused by natural disasters and other incidents. With global oil demand growth expected to pick up to 2 per cent in 2006, oil prices may impact growth and inflation more strongly than before as the corporate sector’s absorptive capacity as also the scope for fiscal maneuverability gets stretched.
65. In several countries across the world, the housing boom has already started to flatten out. This could set off chain reactions in terms of a slowing down of consumption, job creation and real wage growth. In the U.S., for instance, the negative household savings rate is becoming increasingly unsustainable. An abrupt cooling of housing markets would take away a major source of support to world demand, jeopardising growth prospects in other parts of the world. In Japan and Europe, more substantive reforms are generally advocated to spur growth.
66. In the international financial markets, investors’ appetite for risk has driven down risk premia on a wide variety of risky assets — equities, corporate bonds, emerging markets debt, housing and real estate property assets and government bonds. There has also been a significant reduction in price volatility in these asset classes as well as in major currencies and commodity prices with the exception of oil and energy. Despite the major macroeconomic risks presented by the large and widening external current account imbalances and large structural fiscal deficits in key countries, financial markets are not reflecting such risks, suggesting a disconnect between medium-term risks and current perceptions thereof. This poses a key challenge to financial stability worldwide.
67. Over the medium term, the prospects for the global economy are by and large positive, but characterised by significant downside risks. For the Indian economy, the evolving economic and business environment exhibits a number of encouraging signs that suggest reinforcement of the robust economic growth exhibited in recent years. First, increase in the gross domestic saving rate to levels around 30 per cent, coupled with sustained absorption of external savings of 2 to 3 per cent of GDP, would provide the potential for attainment of an accelerated growth trajectory. Each of the saving segments, households, private corporate sector, and the public sector are contributing to the enhancement of the gross domestic saving rate. Particularly noteworthy is the turnaround of public sector saving from negative levels in recent years to positive levels now. This tendency will get reinforced if fiscal rectitude is followed by both the Centre and the States consistent with FRBM objectives.
68. Second, productivity growth in both the real and financial sector bodes well for consistent economic growth with price stability. The micro structural reforms undertaken over the years have enabled continuing productivity gains in the real sector with enhanced access of Indian business to technology, increased competitive pressures, along with evidence of greater attention to R&D and other productivity enhancing activities. The reform process involving widening and deepening of the financial sector, along with improved regulation and supervision, has also yielded encouraging results as seen from the improvement of almost all productivity measures relevant for the sector.
69. Third, there is evidence of increasing business confidence as measured by various business expectation surveys and improvement in the investment climate. This is also corroborated by some signs of enhanced levels of foreign direct investment. Moreover, the robust performance of Indian merchandise exports in recent years also testifies to the attainment of higher competitiveness of Indian manufacturing, which itself promotes business confidence.
70. Fourth, the most progressive and dynamic Indian companies are manifesting increasing levels of global presence through acquisitions and higher outward foreign direct investment. The attainment of domain knowledge through such activities, along with best practice business knowledge, and other intangibles such as economies of scale in marketing will further enhance the productivity growth of Indian business.
71. Fifth, it is noteworthy that Indian business has managed to exhibit high growth in recent years in terms of most parameters despite the presence of significant constraints posed by infrastructure and labour rigidities. It has also displayed great resilience in terms of the ability to cope with adverse developments such as oil price increases, exchange rate and interest rate changes, as they have emerged at different times. This has been enabled by a high degree of innovative capacity that has been displayed in terms of finding solutions in the face of adversity.
72. Finally, the sustenance of business confidence, enhancement of productivity and maintenance of growth momentum will depend on policy improvements in agriculture, improved quantity and quality of physical infrastructure and progress in fiscal consolidation. No doubt, a credible commitment to price and financial stability will continue to be necessary for desired positive outcomes.
73. The prospects and policy responses for the near-term need to be viewed in this medium-term context. In the near-term also, there have been several positive domestic developments that brighten the outlook for the Indian economy. The recent growth record of the Indian economy has been noteworthy in a global perspective. The recovery in agriculture, alongside the sustained momentum of growth in industry and services, augurs well for the Indian economy. Food processing being recognised as a priority sector will help to boost farm sector growth as also the thrust on rural development programmes and the increase in budgetary allocation for 2006-07 for rural welfare programmes. The availability of viable credit to agriculture would need to be pursued with equal emphasis on credit quality. There is a gathering confidence that the economy is possibly poised on the threshold of a structural step-up in the growth trajectory. The containment of inflation, and particularly inflation expectations, has boosted growth prospects in an environment of stability and confidence. Timely and even pre-emptive monetary measures reinforcing the policy stance paid dividends in terms of low and stable inflation which, in turn, provided conducive conditions for the undisrupted expansion of economic activity while maintaining macroeconomic and financial stability. The successes gained in external sector management in the context of the large trade deficit have also demonstrated the resilience of the Indian economy. Increasingly, the international community is regarding India as a preferred destination for investment.
74. The progressive diffusion of fiscal responsibility at the sub-national level is yet another positive development that has beneficial effects for the overall fiscal consolidation effort. It needs to be recognised that adhering to the trajectory of reform will require greater commitment and forward looking strategies to ensure credibility. Simultaneously, there has to be a reorienting of the mix of public spending towards infrastructure and agriculture to support the drive to achieving India’s growth potential that is increasingly appearing realisable at the current juncture.
75. While the recent performance of the economy has been impressive, it is necessary to recognise the risks embedded in domestic developments which could potentially stall the growth momentum. Sustaining the growth of manufacturing, the key driver of industrial recovery, would depend critically on bridging the large gaps in physical infrastructure. Structural reforms will have to focus on quantum jumps in the provision of physical and social infrastructure. Getting infrastructure right will hold the key to maintaining real GDP growth in 2006-07 and 2007-08 at the level achieved in 2005-06, assuming that the global economic environment remains conducive and that there are no severe unanticipated shocks. Fiscal policy will obviously have to play a key role in improving the delivery of infrastructure services, in fostering public-private partnerships and in crowding in private investment. A key factor will be the progress in fiscal consolidation. While there has been some improvement in the revenue and fiscal deficits, the larger market borrowing programme envisaged for 2006-07 will have to be managed in the context of the overall liquidity situation and, particularly, the conditions in the debt market.
76. The outlook on inflation as well as the choice of the appropriate manner of dealing with the pass-through of oil prices remains clouded at the current juncture. The Indian economy needs to prepare for higher orders of pass-through into consumer prices, in respect of the overhang as well as the possibility of additional increases in crude prices in the future. While the recommendations of the Rangarajan Committee are being debated, it is increasingly becoming clear that there has to be a fuller pass-through of increases in international crude prices. In the event, inflation could turn out to be higher in 2006-07 than the current benign levels. Regardless of the manner in which the future scenario for crude oil prices unfolds, there is a need for continuous and close monitoring and appropriate policy responses to contain its inflationary impact. This is being increasingly reflected in the stance of central banks the world over. Going forward, therefore, a dominant objective for both monetary and fiscal policy would be to modulate aggregate demand in tune with the evolving circumstances. In an environment fraught with pressures from aggregate demand embodied in rising bank credit, high asset prices and above-trend growth in monetary aggregates as well as global risks from larger macroeconomic imbalances and higher oil prices than before, containing inflation in the medium-term at the current levels is going to test the conduct of stabilisation policies in the ensuing year. In this context, it is useful to reiterate that while there are compelling reasons to maintain the momentum in growth of output, low and stable inflation will enable higher growth on a sustained basis in an environment of overall stability. Further, in the absence of firm and timely responses by all concerned, the present rate of high credit growth and increase in asset prices seem to pose a downside risk to overall financial stability.
77. It appears that globally as well as in India, underlying inflation conditions are perhaps not being appropriately reflected in prices facing consumers and financing imbalances are growing in the presence of abundant liquidity, rising asset prices and a marked increase in risk appetite. It is in this context, and consistent with the multiple indicator approach adopted by the Reserve Bank, that monetary policy in India has consistently emphasised the need to be watchful about indications of rising aggregate demand embedded in consumer and business confidence, asset prices, corporate performance, the sizeable growth of reserve money and money supply, the rising trade and current account deficits and, in particular, the quality of credit growth. In retrospect, this risk sensitive approach has served us well in reining in aggregate demand pressures and second round effects to an extent. It has also ensured that constant vigil is maintained on threats to financial stability through a period when inflation was on the upturn and asset prices, especially in housing and real estate, are emerging as a challenge to monetary authorities worldwide. Significantly, it has also reinforced the growth momentum in the economy. It is noteworthy that the cyclical expansion in bank credit has extended over an unprecedented 30 months without encountering any destabilising volatility but this situation warrants enhanced vigilance.
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