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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
Overall Assessment
71.The distinguishing feature of India’s macroeconomic performance in 2006-07 has been the strong acceleration of growth. Industry and services, comprising 82 per cent of the economy, registered double-digit growth. The step-up in the overall growth momentum, setbacks to agriculture notwithstanding, occurred inter alia in an environment of building international interest, and rising business and consumer confidence domestically, in the strength and dynamism of the economy. Real GDP growth, which averaged under three per cent in the 1970s picked up to 5.8 per cent in the 1980s and 1990s but lost pace in the subsequent period and slowed to 4.6 per cent in 2000-03. Since then, however, there seems to have occurred an upward shift in trajectory, with real GDP growth averaging 8.5 per cent in the period 2003-04 to 2006-07.
72.While there seems to be evidence of structural changes taking place in the economy, there are indications that the upsurge of demand pressures in 2006-07 may contain a cyclical component. First, as regards structural changes, the recent growth momentum is driven by a step-up in the investment rate, which, in turn, is supported by a sizeable increase in the rate of gross domestic saving. This noteworthy improvement is attributable mainly to a distinct increase in corporate saving, reflecting the sustained 18-quarter buoyancy in corporate profitability which has provided internally generated resources for investment funding. Another positive development is the turnaround in public sector dissaving from 2003-04 onwards. Household saving continues to remain the mainstay of gross domestic saving. Second, India’s linkages with the global economy are getting stronger, underpinned by the growing openness of the economy. The ratio of merchandise exports to GDP has been rising since the 1990s reflecting growing international competitiveness. This has been supported by buoyancy in export of software and business services, indicative of the knowledge advantage and the sophistication setting into the domestic services sector. At the same time, the ratio of imports (including services) to GDP has been steadily rising as domestic entities have expanded access to internationally available raw material and intermediate goods as well as quality inputs for providing the cutting edge to domestic production and export capabilities. Sustained inflows of capital, reflecting the international confidence in macro fundamentals of the economy, have considerably eased the external financing constraint, enabling steady accretions to foreign exchange reserves that have taken their level to 12.5 months of imports or 124.3 per cent of external debt. Third, there are indications of some improvement in capital use, a turnaround in total factor productivity in manufacturing since 2002-03, restructuring during the period 1996-2003, and a steady improvement in productivity growth in the services sector.
73.At the same time, it is important to take note of various cyclical factors underlying the recent growth experience. First, robust global GDP growth, which exhibited four years of strong expansion has been supportive of high growth in India. Second, the persistent high growth in bank credit and money supply, the pick-up in non-oil import growth and the widening of the trade deficit in recent years together indicate upside pressures on aggregate demand. Third, cyclical forces are also evident in the steady increase in prices of manufactures, resurgence of pricing power among corporates, indications of wage pressures in some sectors, strained capacity utilisation and elevated asset prices.
74.Against this backdrop, it is important to assess the optimism generated by India’s recent macroeconomic performance against the evolving configuration of risks which are likely to shape the outlook. First, the buoyant growth in industry and services has been somewhat marred by the setback to agriculture which has suffered substantial deceleration and instability. It is now widely recognised that the performance of agriculture is critical not only for output and employment but also, particularly for price stability. There has been a virtual stagnation in the output of major food crops such as rice, wheat, pulses and oilseeds over the past decade. In the more recent period, shortfalls in wheat (accompanied by depleting stocks), oilseeds and pulses have emerged and the supply situation in respect of these crops is further complicated on account of weather related adverse international conditions. The decline in the global production of wheat in 2006 has turned out to be the largest in ten years with depletion in carry over stocks and loss of cereal acreage in favour of bio-fuel production.
75.Second, in the domestic economy, there are indications that supply constraints are impacting the growth momentum. Alongside shortfalls in agricultural performance, large gaps have emerged in the physical infrastructure. In fact, infrastructural bottlenecks are emerging as the single most important constraint on the Indian economy. Rapid growth in demand for infrastructure with a less than proportionate supply response in the prevailing investment climate has resulted in stretching capacity utilisation in electricity generation, roads, ports and major airports to overheating. Against the targeted capacity addition of 41,110 megawatts of electricity over the period 2002-07, the actual capacity addition has been less than 57 per cent, taking the peak electricity deficit to an eight year high in 2006-07. Capacity addition in roads and highways has been delayed over the last two years. Seaports are reported to be operating at close to full capacity utilisation. Capacity constraints at the major airports in Mumbai and Delhi are causing restrictions to be imposed on the number of flights that can be operated during peak hours by domestic airlines. Managing the supply situation is emerging as a formidable challenge, especially as constraints on the supply response to the momentum of growth have become more binding than before.
76.Third, a significant worrisome feature of domestic developments in 2006-07 is the firming up of inflation through the year. Currently ruling above indicative projections in terms of wholesale prices and at unconscionable levels in terms of consumer prices, inflation represents the key downside risk to the evolving macroeconomic outlook. It is important to undertake a careful assessment of the manner in which inflation is evolving. Primary food articles, unlike in recent years, have contributed significantly to inflation during 2006-07. Accounting for a fourth of headline WPI inflation, they can be interpreted to originate from supply side pressures, including the cost push imposed by the international prices of cereals. At the same time, prices of manufactured products account for well above 50 per cent of headline inflation. Strains on domestic production capacities in respect of basic and intermediate goods imposed by the industrial growth momentum are showing up as inflationary pressures, contributing roughly a quarter of the headline WPI increase. Domestic prices are firming up in sympathy with international prices. In conjunction with emerging strains on capacity, elevated asset prices and the surging demand for bank credit, the rising prices of manufactures constitute the demand pressures on inflation. The recent hardening of international crude prices has heightened the uncertainty surrounding the inflation outlook and has brought forward the need to prepare for the potential consequences for domestic prices of petroleum products and second round effects. Globally too, policy authorities are bracing up to the increasing probability of a renewal of escalation in international crude prices even while core inflation has generally remained firm.
77.Monetary and financial conditions are reflecting these demand-supply gaps as well as the onset of a durable pick-up in aggregate spending. Banks’ non-food credit is beginning to dip after expanding above 30 per cent for three years in succession, driving up money supply and squeezing overall liquidity. The growth of bank credit has favoured retail lending, particularly housing, real estate, trade, transport and professional services and non-banking financial companies – sectors which hitherto were not significant in the credit market. While banks’ exposures to some of these new sectors is still relatively small, given the low base, the high rates of growth have raised worries about the quality of these assets and potential non-performance. Default rates in regard to credit card receivables and personal loans have been rising. While buoyant deposit growth has, to an extent, alleviated the financial constraints on banks, incremental non-food credit deposit ratios remain high and investments in gilts have been drawn down to close to the statutory minimum of the SLR. These developments are likely to pose challenges to banks in managing liquidity.
78.Financial markets have experienced some volatility in the fourth quarter of 2006-07 alongside sizeable swings in liquidity and a hardening of interest rates across the spectrum. Money markets experienced spells of tightening of liquidity in November, from mid-December to early February and again in the second half of March 2007, interspersed with periods of easing. During episodes of tightness, contrasting conditions were often observed when short-term interest rates had firmed up despite the availability of funds through the LAF, but long-term rates had declined in the Government securities market. From December onwards, there was an inversion of the yield curve and a narrowing of yield spreads. Forward premia firmed up across the board in concert with the hardening of short-term interest rates in the domestic money market segments. On the other hand, asset prices, particularly equity prices, have risen to record highs.
79.Global real GDP growth, both at market exchange rates and on a purchasing power parity basis, is expected to decelerate by about 50 basis points relative to the preceding year. In the mature economies, continuing weaknesses in housing markets and volatility in equity markets remain concerns in the context of the growth outlook. In the emerging economies, there are heightened concerns about the sustainability of capital flows, commodity prices and global liquidity, with potential adverse consequences for otherwise firm growth prospects. International foodgrains prices have risen to record levels and global cereal output has declined. Low stocks and rising demand have kept most metal prices at elevated levels which could persist in the near term. International crude prices have firmed up recently and remain highly volatile, reflecting geopolitical tensions, with implications for inflation expectations. Headline inflation has picked up globally and core inflation has remained firm.
80.Volatility in international financial markets has increased in recent months with deterioration in the sub-prime segment of the US mortgage market in early 2007, concerns on systemic implications of hedge fund failures and the wide diffusion of risks through derivative markets. There are also worries that a sharp reversal of carry trades could precipitate liquidity stress and affect near-term prospects of emerging market economies, should there occur a generalised search for safe haven. Risk spreads are at historically low levels and the dispersion of credit risks obscures an understanding of where the risks ultimately lie. Consequently, monitoring of risks has become much more complex than before. There are, therefore, serious concerns that financial markets/investors may be assigning insufficient weight to downside risks.
81.While capital flows to emerging market economies and, in particular, to Asia in 2006 have reflected the improvement in macroeconomic performance, they were also driven by a search for yields and a stronger appetite for risk. Consequently, reversals of capital flows can pose challenges to emerging economies, particularly in the context of withdrawal of monetary accommodation in developed economies. It is useful to evaluate the challenges and risks from capital flows in the context of underlying global developments. Since the technology stocks meltdown in 2000, there has been a massive monetary accommodation by the major economies – the US, Euro area and Japan – and it is estimated that between one-half and two-thirds of US currency supply is held outside the US. There is clear evidence of abundant excess liquidity reflected in the macro imbalances between the US and Asia. It is important to recognise that while India has a current account deficit, most of the rest of Asia runs surpluses. Consequently, while the overall imbalances vis-à-vis the rest of the world in India and the rest of Asia are not different, given the current account situation, real sector implications for India as a result of the excess liquidity flowing out of mature economies, need to be carefully assessed.
82.Monetary policy in India has to also contend with the burden of challenges emanating from other sectors. First, it is recognised that monetary policy has to bear the burden of fiscal dominance. Fiscal imbalances remain large by international standards and have to be managed in a non-disruptive manner, keeping in view the interaction of the financial markets and the real economy as well as the given legal, institutional and public policy environment. However, the recent salutary improvement in the fiscal position of States and significant consolidation in the finances of the Centre have alleviated the extent of the burden that monetary policy has to bear on this account.
83.Second, as pointed out in the Third Quarter Review of January 2007 the enduring strength of foreign exchange inflows has complicated the conduct of monetary policy. In the event of demand pressures building up, increases in interest rates may be advocated to preserve and sustain growth in a non-inflationary manner. Such monetary policy responses, however, increase the possibility of further capital inflows, apart from the associated costs for growth and potential risks to financial stability. Thus, foreign exchange inflows can potentially reduce the efficacy of monetary policy tightening by expanding liquidity.
84.Third, in India, levels of livelihood of large sections of the population are inadequate to withstand sharp financial fluctuations which impact real activity. Accordingly, monetary policy has to also bear the burden of protecting these segments of the economy from volatility in financial markets often related to sudden shifts in capital flows.
85.Fourth, a situation in which aggregate supply is not elastic domestically imposes an additional burden on monetary policy. While open trade has expanded the supply potential of several economies, it does not seem to have had any significant short-term salutary effect on supply elasticities. There is a view that monetary policy cannot impact supply conditions and, therefore, should not react to supply pressures. In this context, it is important to take note of caveats to this view. If supply is inadequate in relation to demand, even a normal level of demand shows up as excess demand, warranting a policy response. Moreover, there are some commodities and services to which headline inflation is sensitive. Accordingly, persisting supply shocks to prices of these commodities can impart a lasting impact on inflation expectations. It is for this reason that monetary policy has to focus on the permanent component of supply shocks to the inflation process. If there is a supply side problem and the assessment is that it is merely a temporary disruption of supply, it is in order for monetary policy to treat it as a supply shock. Faced with longer term, structural bottlenecks in supply with less than adequate assurance of timely, convincing and demonstrated resolution, monetary policy has to respond appropriately. The burden and the dilemmas, in fact, are greater in the event of a structural supply problem on account of its persistent effects on inflation.
86.It is useful to recall the several complexities affecting the conduct of monetary policy at the current juncture. First, globalisation has brought in its train considerable fuzziness in reading underlying macroeconomic and financial developments, obscuring signals from financial prices and clouding the monetary authority’s gauge of the performance of the real economy. Consequently, dealing with the impossible trinity of fixed exchange rates, open capital accounts and discretion in monetary policy has become more complex than before. Second, there is considerable difficulty faced by monetary authorities across the world in detecting and measuring inflation, especially inflation expectations. Third, global macro imbalances have increased even as financial markets have remained benign and continue to under-price the risks that these imbalances contain. Fourth, global growth has remained strong in spite of elevated crude and asset prices, amplifying the uncertainty surrounding the prospects of resolution. Fifth, despite sizeable movements in major international currencies, the pass-through to domestic inflation has been muted.
87.The operation of monetary policy in India is also constrained by some uncertainties in transmission of policy signals to the economy. First, despite the progressive deregulation since the early 1990s, some categories of interest rates continue to be administered, thereby muting the impact of monetary policy on the structure of interest rates. Second, external sector management is complicated by the incentives for some elements of capital flows provided by public policy setting. Thus, the magnitudes and direction of capital flows to select sectors in the domestic economy are beset with uncertainties in regard to the global and domestic environment not necessarily related to economic fundamentals or the monetary policy setting. Third, the operation of monetary policy has to be oriented around the predominantly public sector ownership of the banking system which plays a critical role not only in the transmission of monetary policy signals but also in other public policy considerations.
88.To sum up the assessment, global growth is strong but expected to moderate in 2007 relative to 2006. Inflationary pressures are evident along with elevated levels of commoditty and asset prices and the withdrawal of monetary accommodation is likely to persist. In the global financial markets, current indications suggest that the risks, including geopolitical risks, remain under-priced and diffused. On the domestic front, there is evidence of some cyclical elements though a significant structural change is taking place in the Indian economy. There is a gathering confidence that the economy is possibly poised on the threshold of a step-up in the growth trajectory. However, demand pressures appear to have intensified alongside robust growth and there are increased supply side pressures in evidence.
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