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Click here to return to main page of Annual Policy Statement 2008-09



Part I. Annual Statement on Monetary Policy for the Year 2008-09


Overall Assessment 72. While aggregate supply capacities expanded and alleviated domestic macro-imbalances in 2007-08 to some extent, available indicators suggest that economic activity in India currently continues to be mainly demand-driven. The rate of gross fixed capital formation at current prices rose by 2.1 percentage points of GDP at current market prices in 2007-08, more than compensating for the decline of 0.3 percentage points in the rate of private final consumption expenditure and that of 0.2 percentage points in the rate of government final consumption expenditure. Looking ahead, the Union Budget for 2008-09 is likely to provide a stimulus to both private and government consumption in view of the proposals for effective reduction of the tax burden under personal income and excise as well as the revenue expenditure implications emanating from the recommendations of the Sixth Pay Commission. The dominance of investment demand in the economy is likely to persist in 2008-09 and beyond, supported as it were by the buoyancy in corporate saving in view of the sustained resilience of sales and profitability, and the ongoing improvement in public sector saving. Furthermore, patterns of domestic industrial output and imports remain skewed in favour of capital goods, indicative of ongoing expansion in capacity, both new and existing. Moreover, resources raised through public issues as well as investment intentions more than doubled in 2007-08, pointing to the corporate sector's positive assessment of evolving demand conditions and underlying plans for expanding production capacities. Finally, the sharp widening of the merchandise trade deficit reflects the spillover of domestic demand into the external sector with implications for the year ahead.

73. The pick-up in inflation during the fourth quarter of 2007-08 has, however, mainly emanated from supply-side pressures such as the one-off increase in domestic petrol and diesel prices to partially offset the global crude oil price increase over the year; continuous hardening of prices of petroleum products that are not administered, rising prices of wheat and oilseeds and the adjustment in steel prices in March 2008 due to the surge in international prices. In recognition of the unanticipated supply-sided origin of pressures in the recent months, partly due to global developments, the first response of public policy to the hardening of inflation has been in terms of reducing import duty on rice and edible oils, followed by a ban on exports of non-basmati rice and pulses, an increase in the minimum export price relating to basmati rice, reduction of customs duty on butter, ghee and maize, and administrative measures to enable imposition of stock limits on selected agricultural products. There are growing concerns that this upsurge in inflation in India has occurred at a time when global commodity prices have been volatile at historically elevated levels and central banks in mature and emerging economies alike have been articulating heightened inflation concerns. Consequently, there are concerns that demand pressures, which have been reasonably contained so far, are being coupled with supply-side factors which, if not temporary in view of global demand-supply imbalances, could impact domestic inflation significantly.

74. Monetary and financial conditions appear to have gone through underlying shifts in the fourth quarter of 2007-08. While the rate of money supply has dipped from mid-February 2008 in tandem with a moderation in the growth of time deposits, it remains high in relation to indicative projections. On the other hand, the moderation in non-food credit growth that was evident in the first half of 2007-08 appears to have extended into the fourth quarter of the year. The deceleration has been marked in respect of interest-sensitive sectors such as housing, personal loans and real estate as well as in some categories of services such as trade, professional and other services, shipping, transport operators, tourism, hotels and restaurants which had been recording significantly elevated growth rates in preceding years. These movements in banking aggregates have enabled a better balance between banks' sources and uses of funds than before, as reflected in the decline in the incremental non-food credit deposit ratio to below 75 per cent for the first time since August 2004.

75. During the fourth quarter of 2007-08, financial markets were impacted by unusual swings and high volatility in foreign exchange flows as well as in cash balances of the Government with the Reserve Bank with consequent shifts in liquidity conditions. These variations were smoothened by active liquidity management through a combination of instruments such as the MSS, the LAF and the CRR so that volatility in overnight interest rates was broadly contained within the informal LAF corridor. As a result, advance tax payments did not produce the usual spikes in money market rates. Generally orderly conditions were also observed in the Government securities market with some widening of yield spreads across maturities on concerns about rising inflation domestically, recent escalations in food, energy and metal prices internationally, and the atmosphere of heightened uncertainty. In the credit market, while deposit rates have been adjusted downwards, lending rates have edged up. In the foreign exchange market, two-way movements in spot rates have been in evidence in the fourth quarter of 2007-08 and in April 2008. On the other hand, asset prices, particularly equity prices, rose to record highs in January 2008 before declining dramatically in February-March 2008.

76. Finances of the Central Government have undergone further consolidation in 2007-08 in consonance with the path charted under the FRBM. Sustained buoyancy in corporation and personal income taxes lifted gross tax revenues above the budgeted level by 0.8 percentage points of GDP. Reflecting the fruits of a better balancing of the tax structure, marked improvement in compliance and efficiency gains in tax administration, the tax-GDP ratio has moved up from 9.2 per cent in 2003-04 to 12.5 per cent in 2007-08 and is likely to reach 13.0 per cent in 2008-09. While aggregate expenditure was 0.7 percentage points of GDP higher than budgeted, this was essentially on account of revenue (non-Plan) expenditure in the form of interest payments and subsidies. Capital expenditure, however, declined in relation to budget estimates. There was also a sizeable recourse to mobilisation of resources through extra-budgetary transactions in the form of issuances of securities to public sector entities. These developments are indicative of potential pressures in the period ahead, notwithstanding the marginal reduction achieved in the revenue deficit and in the gross fiscal deficit in relation to GDP.

77. Within India's growing integration with the global economy, some aspects of India's external sector developments in 2007-08 merit attention. First, there has been a sizeable widening of the trade deficit on sustained demand for non-oil imports particularly for capital goods, export-related inputs and bullion and as a result of escalating international crude oil prices. Second, net capital flows in April-December 2007 were 2.7 times those in April-December 2006 and 1.8 times of the net flows in the full year 2006-07. Gross capital inflows to India constituted 18 per cent of gross private capital flows to emerging and developing economies in 2007 reported by the IMF's WEO. Third, outward FDI has more than doubled, reflecting the growing global reach of the Indian corporate sector. Fourth, the level of reserves is currently the third largest stock of reserves among the EMEs but still lower than India's international liabilities at US $ 371 billion at book value at end-September 2007.

78. The global economic outlook has worsened since the Third Quarter Review of January 2008. Until October 2007, there appeared to have been reasonable confidence in the resilience of the world economy to cope with the freeze in US financial markets world GDP growth was expected by the IMF to be 0.3 percentage points above its initial April 2007 forecast for 2007 but lower by 0.1 percentage points for 2008. Since January 2008, this confidence appears to have eroded rapidly. In April 2008, the IMF's forecast for 2008 has been lowered by 1.2 percentage points and by 1.1 percentage points for 2009 from the April 2007 projections. Risks of contagion from the financial turmoil are regarded as high with a 25 per cent probability of it spreading into a global recession world real GDP growth of 3 per cent or less. According to the IMF, a one per cent reduction in US GDP growth leads to a 0.5 percentage points decline in growth in advanced European economies with a six month lag, and about a 0.75 percentage points decline in the growth of EMEs, taking into account the joint effect of a slowdown in the US and Europe. World trade is also expected to decelerate by 1.2 percentage points by the IMF and by 1.0 percentage points by the World Trade Organisation in 2008 reflecting the expectations of slower global growth.

79. Globally, inflation has risen considerably from its level a year ago in mature economies and EMEs alike. While the upsurge in inflation is reflected in varying degrees in consumer prices, both headline and core, the increase in producer prices on the back of commodity price pressures has been relatively higher reflecting the sharp increase in input costs. The resurgence of inflation risks worldwide from food and energy prices has also exacerbated the concerns about slowdown in activity in the context of compressed real disposable incomes and consumer purchasing power. Other factors imparting upside pressures to inflation are persistent strength in underlying demand, especially from EMEs, and low levels of inventories. Supply side pressures are expected to persist in the coming months with considerable uncertainties surrounding the evolution of key commodity prices and second order effects.

80. Growth forecasts for EMEs have been moderated in the face of the financial turbulence and the anticipated slowdown in the US economy. The underlying macroeconomic fundamentals of the EMEs remain resilient and the robust momentum of domestic demand in large emerging economies of Asia and Latin America could withstand a protracted weakening of growth in advanced economies. They, however, remain vulnerable to negative effects in terms of slower export growth and volatility in financial flows. Furthermore, asset prices have declined and equity markets in EMEs seem coupled and volatile in tandem with US markets, indicating that some rebalancing is still underway. A key risk to the outlook for EMEs is rising food, energy and commodity prices that are already imparting inflationary pressures and raising concerns about impacting the momentum of growth in these economies. Several EMEs are increasingly having to deal with rising public intolerance to high food inflation which appears to be setting into a structural phenomenon due to more frequent crop failures than before and diversion of acreage for bio-fuels, supported in the US by fiscal subsidies. Moreover, the rising international commodity prices have impacted EMEs differently with commodity exporters benefiting from sizeable terms of trade gains while commodity importers have experienced wider trade deficits and higher domestic inflation. Finally, the recent monetary policy responses in the US have also heightened the uncertainties facing EMEs by widening interest rate differentials and increasing the costs of sterilisation, especially in a period when inflationary pressures warrant tightening. It is in the context of these concerns that EMEs have generally been reluctant to lower key policy rates in consonance with the US. Some EMEs have recently raised policy rates on domestic economy considerations while the majority have kept interest rates on hold.

81. The outlook for the global financial system is overcast by the rising incidence of losses and write-offs in banking systems in the US and Europe amidst dislocations in the securitised credit market. Banks are facing capital constraints, as credit/market risks associated with off-balance sheet investments have to be re-intermediated. Credit to housing is the worst affected. Banks in the US and Europe have reported a widespread tightening in credit standards. There are also growing uncertainties surrounding the viability of financial guarantors and doubts about their business models as well as the approach of rating agencies with potential systemic implications. Global financial markets have exhibited heightened uncertainty and bearish sentiment in the early months of 2008, exacerbated by weakening macroeconomic prospects. Credit markets continue to be seized up with spreads even on investment grade credits continuing to remain widened and those on sub-investment grade credits at prohibitive levels. Global equity markets dropped sharply in January 2008 and weakened again in March-April with volatility well above long-term averages. In the continuing turmoil, bond markets have re-emerged as safe havens. In the currency markets, the US dollar has been weakening against the backdrop of monetary policy actions, already undertaken and prospective.

82. In the overall assessment, there have been significant shifts in both global and domestic developments in relation to initial assessments. While global growth was expected to moderate in the Annual Policy Statement of April 2007, the outlook for the global economy deteriorated from the time of the Mid-Term Review of October, and sharply after the Third Quarter Review of January 2008. The dangers of global recession have increased at the current juncture although consensus expectations do not rule out a soft landing. Globally, inflationary pressures were evident in April 2007 in the elevated levels of commodity and asset prices. From January 2008, the upside pressures from international food and energy prices appear set to impart a degree of persistent upward pressure to inflation globally. At the end of July 2007, risks from financial markets had enhanced the vulnerability of the global financial system, with amplified exchange rate fluctuations and large changes in the magnitude and direction of capital flows. There was growing uncertainty as to when, how and to what extent would the withdrawal of liquidity take place and impact economies like India. By January 2008, it was clear that the subprime mortgage crisis carries by far the gravest risks for the world economy. On the domestic front, the outlook remained positive up to January 2008, with indications of moderation in industrial production, service sector activity, business confidence and non-food credit, as anticipated. In the ensuing months, consensus assessment of the prospects for growth in the year ahead have been trimmed. Since January 2008, risks to inflation and inflation expectations from the upside pressures due to international food, crude and metal prices have become more potent and real than before. Volatile capital flows, large movements in the cash balances of the Government and consequent changes in liquidity conditions continue to complicate monetary management.

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