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Full Text of First Quarter Review of Annual Monetary Policy for 2008-09 click here

First Quarter Review of Annual Monetary Policy for 2008-09

I. Assessment of Macroeconomic and Monetary Developments

Domestic Developments... Click Here
Developments in the External Sector... Click Here
Overall Assessment... Click Here

Developments in the Global Economy

45. During the first half of 2008, global economic activity decelerated in an environment of surging inflation and heightened uncertainty. There are indications that the slowdown is deepening in the advanced economies and could affect emerging market economies (EMEs), notwithstanding the strength of domestic demand. Despite some abatement in the global financial turbulence and the continuing process of balance sheet repair for key institutions, financial risks remain high and concerns about rising losses have exacerbated the pessimism on the macroeconomic outlook.According to the update of World Economic Outlook (WEO) of the International Monetary Fund (IMF) released in July 2008, global real GDP growth on a purchasing power parity basis is expected to decelerate from 5.0 per cent in 2007 to 4.1 per cent in 2008 (3.7 per cent in WEO, April 2008) and further to 3.9 per cent in 2009 (3.8 per cent in WEO, April 2008).

46. In the US, real GDP grew by 1.0 per cent in the first quarter of 2008 as compared with 0.6 per cent a year ago. The pick-up in growth in the early months of 2008 reflected positive contributions from personal consumption expenditures (PCE) for services, exports of goods and services, federal government spending and private inventory investment.On the other hand, there was a decline in residential fixed investment, imports and PCE on durable and non-durable goods.Labour markets weakened with the unemployment rate rising to 5.5 per cent in May-June 2008. Industrial production dropped by 3.1 per cent in the second quarter of 2008 vis-à-vis the first quarter of 2008. The rate of capacity utilisation for industry moved up to 79.9 per cent, a level 1.1 percentage points below the average for 1972-2007. US home prices, which had recorded a steep decline in the first quarter of 2008, posted a fall of 15.3 per cent in April 2008 as compared with a year earlier. Single-family housing starts declined to their lowest level in 17 years in June. The July home-builder confidence fell to a record low for the third consecutive month. In June, US retail sales recorded an increase of 3.0 per cent on account of fiscal stimulus payments. Consumer sentiment also improved in July from the 28-year low recorded in June. The index of leading indicators declined marginally in May-June, continuing the downward trend that began in the middle of 2007. The IMF's July 2008 update of its WEO expects the US economy to slow from 2.2 per cent in 2007 to 1.3 per cent in 2008, with the gains in the first quarter being moderated during the second half of the year as consumption is dampened by rising commodity prices and tight credit conditions.The US economy is projected to grow at 0.8 per cent in 2009.

47. Real GDP in the euro area grew by 2.2 per cent in the first quarter of 2008 on a year-on-year basis as compared with 3.0 per cent a year ago. Growth is forecast to slow down considerably in the coming quarters.Industrial production is losing momentum and expectations polled in business surveys are declining. While unemployment in the euro area fell to 7.2 per cent in May 2008 from 7.5 per cent a year ago, real disposable income growth is likely to remain weak with increases in nominal wages eroded by high inflation rates. Private consumption is expected to grow only modestly in 2008.The expansion of investment is also likely to moderate.The July 2008 update of the IMF's WEO has placed real GDP growth of the euro area at 1.7 per cent in 2008 and 1.2 per cent in 2009 as against 2.6 per cent in 2007.

48. The Japanese economy grew by 3.3 per cent in the first quarter of 2008 as compared with 2.6 per cent a year ago. The pace of growth of business fixed investment and exports has slowed, corporate profit has deteriorated and business sentiments have become more cautious. Growth in private consumption has recently turned sluggish due to continued increase in food and fuel prices.The July 2008 WEO of the IMF has projected that Japan's economy will grow by 1.5 per cent each in 2008 and 2009 as compared with 2.1 per cent in 2007.

49. The Chinese economy grew by 10.1 per cent in the second quarter of 2008 as compared with 11.9 per cent a year ago. Currency appreciation, higher wages and rising raw material costs are being reflected in an erosion of China's export competitiveness. China's trade surplus for June 2008 was US $ 21.4 billion as against US $ 26.9 billion in June 2007 on account of deceleration in exports, particularly to the US.The total foreign exchange reserves, however, increased to US $ 1.81 trillion in June 2008, recording an increase of 35.7 per cent over June 2007. The CSI 300 Index, which tracks yuan-denominated A shares listed on China's two exchanges, has fallen by 30.9 per cent over the year to close at 2939 on July 25, 2008. The July 2008 WEO of the IMF has projected that the Chinese economy will grow by 9.7 per cent in 2008 and by 9.8 per cent in 2009 as compared with 11.9 per cent in 2007.

50. Elsewhere in Asia, the Korean economy grew by 4.8 per cent in the second quarter of 2008 as against 4.9 per cent a year ago. Economic activity is expected to decelerate in 2008 due to slowdown in domestic demand, rising fuel costs and moderation in export growth.In Thailand, economic activity grew by 6.0 per cent in the first quarter of 2008 as against 4.2 per cent a year ago.

51. Inflation has become a global phenomenon in recent months with no noticeable signs of abatement in the near future. In the US, consumer prices increased from 2.7 per cent in June 2007 to 5.0 per cent in June 2008. In the euro area, inflation increased to 4.0 per cent in June 2008 from 1.9 per cent in June 2007. In Japan, inflation increased to 2.0 per cent in June 2008 from (-)0.2 per cent a year ago on account of rising oil and food costs. In the UK, CPI inflation accelerated to 3.8 per cent in June 2008 from 2.4 per cent a year ago. At the retail level (in terms of retail prices index or RPI), inflation rose to 4.8 per cent in the UK in March 2007 – the highest since July 1991. RPI inflation has remained elevated since then and was 4.6 per cent in June 2008.

52. Core CPI inflation in the US increased to 2.4 per cent in June 2008 from 2.3 per cent in May 2008. In the UK, core CPI inflation increased to 1.6 per cent in June from 1.5 per cent in May 2008. In the euro area, core CPI inflation increased to 1.8 per cent in June 2008 from 1.7 per cent in May 2008. Core inflation in Japan was at 0.1 per cent in June 2008 as compared with(-) 0.1 per cent in May 2008. The increase in producer prices has been sharper than in consumer prices, reflecting increased input costs. In the US, producer prices increased to 9.2 per cent in June 2008 from 3.3 per cent in June 2007. In the euro area, producer prices increased to 7.1 per cent in May 2008 from 2.5 per cent in May 2007. In the UK, producer prices increased to 10.0 per cent in June 2008 from 2.5 per cent in June 2007. Wholesale price inflation in Japan increased to 4.7 per cent in May 2008 from 1.7 per cent in May 2007. Overall, the persistence of high food and oil prices at elevated levels and continued high prices of other commodities pose significant inflation risks for the global economy and challenges for monetary policy worldwide.

53. Inflation pressures have raised serious concerns in EMEs across Asia, Latin America and Africa, mainly on account of supply-demand imbalances in food, fuel and commodity markets. In China, inflation decelerated from a peak of 8.7 per cent in February to 7.1 per cent in June 2008 to 8.7 per cent as compared with 4.4 per cent in June 2007. The Peoples' Bank of China has raised the required reserve ratio in phases to 17.5 per cent on June 25, 2008. Consumer price inflation in Korea accelerated to 5.5 per cent in June 2008 from 2.5 per cent in June 2007. In Thailand, inflation increased to 8.9 per cent in June 2008 from 1.9 per cent in June 2007. Other EMEs such as Brazil, Chile and Mexico in Latin America have witnessed acceleration in their inflation rates in the wake of high inflation in commodity prices.Producer price inflation in EMEs – both in Asia and elsewhere – has been substantial in the first half of 2008, driven by escalating commodity prices, particularly energy and food.

54. In recent months, high food prices have led to serious difficulties in the form of erosion of purchasing power and inadequate supplies, especially for vulnerable population groups that spend a substantial part of their incomes on food. For many developing countries, the steady rise in world prices of all cereals has pushed up the food import bill, generating widespread increases in domestic food prices on imported pressures. The food price index of the Food and Agricultural Organisation (FAO) increased by 44 per cent on a year-on-year basis up to June 2008, resulting in a doubling of global food prices over the past two years.In the global foodgrains market, prices of major crops such as corn, soyabean and wheat have increased by 82.7 per cent, 84.2 per cent and 28.1 per cent, respectively, by July 25, 2008 from their levels a year ago in response to surging demand, sparking food riots in several countries.

55. Global food imports are forecast by the FAO to be US $ 1,035 billion, i.e., an additional US $ 215 billion over the level recorded in 2007. The food import bill of the Low-Income Food-Deficit Countries (LIFDCs) is likely to climb to US $ 169 billion in 2008, 40 per cent more than in 2007.While the expected good harvest in the current year may exert a dampening effect on inflation, food prices are unlikely to ease significantly in view of the escalated cost of inputs and sustained demand including the need to replenish stocks. A major factor pushing up international prices of basic foods has been the low level of exportable surpluses resulting from domestic utilisation outstripping production for several crops in a number of major exporting countries. Restrictions on exports announced by major foodgrain-exporting nations such as Argentina, Kazakhstan and Russia for wheat and Cambodia, Egypt, India, Pakistan and Vietnam for rice continue, imposing pressures on the global food price inflation. Concerns about weather-related production losses, surging oil prices and the weaker dollar have also fuelled speculative demand for agricultural products.

56. The FAO has placed its latest forecast for world cereal production in 2008 at a record 2,180 million tonnes, 2.8 per cent up from last year's record level. The bulk of the increase is expected in wheat which is forecast at 658 million tonnes, representing an increase of 8.3 per cent over the level in 2007. Bigger harvests are expected in all regions with the exception of Asia. Strong demand in domestic and world markets has, however, depleted stocks in major exporting countries where production in 2007 suffered from exceptionally poor yields. World wheat stocks at the close of the season in 2007-08 are forecast at 151.2 million tonnes, down 6.0 per cent from their already reduced opening level. World wheat stocks are, however, expected to increase by 11.5 per cent and reach 169 million tonnes by the close of the crop season in 2008-09. Wheat prices have remained generally firm and volatile since October 2007. One-month wheat futures at the Chicago Board of Trade (CBOT) declined fromUS $ 9.15 per bushel on January 2, 2008 to US $ 8.11 on July 25, 2008. On the same day, futures prices for wheat were quoted higher for December 2008 at US $ 8.35, for March 2009 at US $ 8.55 and for July 2009 at US $ 8.82 per bushel.

57. Global paddy production in 2008 may rise by 1.4 per cent to 666 million tonnes as producers in all regions have responded to high market prices in the first half of the year by increasing rice cultivation. International near-month futures price of rice on the CBOT has fallen to US $ 16.72 per hundredweight on July 25, 2008 after a rise of 80.5 per cent since January 2008 to a high of US $ 24.50 on April 23, 2008. On July 25, 2008 futures prices were quoted higher at US $ 17.00 for November 2008, US $ 17.61 for March 2009 and at US $ 18.21 for July 2009.

58. The FAO's forecast for global coarse grains output in 2008 at 1,078 million tonnes is virtually unchanged from last year's record high. The growth in world coarse grain utilisation is forecast to slow down in 2008-09 to 1.6 per cent from over 5 per cent in 2007-08 on account of tighter supplies which would boost usage of wheat and non-grain alternatives for animal feed. Strong demand for ethanol is the main driver of high prices in the global coarse grain markets. The futures prices of corn on CBOT, which had moderated somewhat up to August 2007, started moving up thereafter and reached US $ 5.77 per bushel on July 25, 2008. On the same day, futures prices for corn were quoted higher for December 2008 at US $ 5.97, for March 2009 at US $ 6.16 and for July 2009 at US $ 6.38 per bushel.

59. Metal prices have increased by 14.6 per cent during the first six months of 2008 after declining by 8.1 per cent during 2007. Prices of metals such as aluminium have softened in the recent period on concerns about global growth which might impact demand. However, lead and copper prices have increased on supply concerns and dwindling stocks. Futures price of copper on the New York Mercantile Exchange (Nymex) increased to a record level of US $ 4.08 per pound on July 2, 2008 from US $ 3.50 a year ago. As on July 25, 2008, the near-month futures price for copper stood at US $ 3.70 per pound, US $ 3.61 for September 2008, US $ 3.59 for December 2008 and US $ 3.50 for July 2009. Spot gold rose to US $ 1002.30 an ounce on March 17, 2008 - the highest since January 1980 - as the dollar fell to a record low against the euro and on concerns about declining supply on mine shutdowns in South Africa, before declining to US $ 922.71 an ounce on July 25, 2008 from US $ 661.62 a year ago.

60. Prices of crude oil, which have rebounded since July 2007, increased by 60.0 per cent up to July 25, 2008 from their level a year ago. Near-month futures prices reached the level of US $ 122.51 per barrel on July 25, 2008 dipping from US $ 145.31 recorded on July 3, the highest since trading began on the Nymex in 1983. On July 25, oil futures ruled higher at US $ 123.26 for September 2008, US $ 124.62 for December 2008 and US $ 124.83 for July 2009. According to the Energy Information Administration (EIA), the oil supply system continues to operate at near capacity and remains vulnerable to both actual and perceived supply disruptions. World oil markets have been particularly tight during the first half of 2008, with year-on-year growth in world oil consumption outstripping growth in non-Organisation of the Petroleum Exporting Countries (OPEC) production by over 1 million barrel per day.The combination of rising global demand, fairly normal seasonal inventory patterns, slow gains in non-OPEC supply and low levels of available surplus production capacity is providing firm support for prices.

61. Net non-OPEC production, especially from Russia, the North Sea and Brazil, could be lower than expected, leading to both higher demand for OPEC oil and higher prices than currently projected. Even with increased Saudi Arabian output at 9.7 million barrels per day from July, available surplus production capacity during the third quarter would be only 1.2 million barrels per day. World oil consumption is projected to rise by 1.2 million barrels per day during the second half of 2008 and by 1.4 million barrels per day in 2009.According to the EIA, the average price of West Texas Intermediate (WTI) crude oil is expected to be at US $ 127.39 per barrel in 2008 and US $ 132.75 per barrel in 2009.

62. In the global financial markets, sentiment has been adversely affected by concerns relating to a deep and prolonged recession in the US, somewhat alleviated by recent data on consumer sentiment, durable goods orders, consumer spending and oil prices. In addition, losses to the financial sector continue to mount in addition to rising debt defaults.Inter-bank stress remains high despite unprecedented and sustained central bank interventions. Banks' wholesale funding remains weak, especially in the asset backed commercial paper (ABCP) market. There has also been continued weakness in equities and bond markets in recent months. The easing of the turmoil does not appear to be in sight with news about fresh write-downs and job losses emanating every day, indicating renewed dislocations.

63. The Dow Jones Industrial Average, Standard and Poor's (S&P) 500 and Nasdaq Composite exhibited considerable volatility and posted declines of 17.5 per cent, 17.2 per cent and 10.6 per cent, respectively, by July 25, 2008 over their levels a year ago. In the fixed income segment, Government bond yields in the major economies, which had firmed up in the first half of 2007, have softened thereafter as demand for government debt increased with investors seeking safe haven on the likelihood that the economy is already in a recession. The US 10-year bond yield increased from 4.70 per cent at end-December 2006 to 5.29 per cent on June 12, 2007 before falling to 4.11 per cent on July 25, 2008. The 10-year bond yield in the euro area increased from 3.95 per cent at end-December 2006 to 4.68 per cent on July 9, 2007 before falling to 4.62 per cent on July 25, 2008. The Japanese 10-year bond yield has increased from 1.68 per cent at end-December 2006 to 1.97 per cent on June 13, 2007 before falling to 1.58 per cent on July 25, 2008. In emerging markets, however, especially in Asia, there has been sustained growth in public issues during 2008 so far, despite a credit crunch in the US and its attendant fall-out on the rest of the global economy.

64. On a trade-weighted basis, the US dollar has been depreciating since 2006 with intermittent fluctuations. After the cuts in the Fed funds rates since September 2007, the US dollar has weakened against other currencies. The pound sterling moved to the level of US $ 1.99 on July 25, 2008 – close to the 26-year high of US $ 2.11 reached on November 8, 2007 – amidst concerns relating to the US subprime mortgage market. The euro, which has also been strengthening against the US dollar since June 2007, rose to an intra-day peak of US $ 1.60 on July 15, 2008 before declining to US $ 1.57 on July 25, 2008. The New Zealand dollar had appreciated to 81.10 cents to reach a 22-year peak against the US dollar on July 24, 2007 before declining to 74.11 cents on July 25, 2008.

65. Central banks have continued to work together and to consult regularly on liquidity conditions in financial markets. In view of the persistent liquidity pressures in some term funding markets, the European Central Bank (ECB), the Federal Reserve and the Swiss National Bank (SNB) announced an expansion of their liquidity measures on May 2, 2008.Since December 2007, the Fed has conducted fifteen auctions amounting to US $ 790 billion for 28 days maturity each and an auction of US $ 20 billion with 35 days maturity up to July 14, 2008. It has also announced an offer of US $ 75 billion in 28 days credit through its term auction facility (TAF) on July 28, 2008. In a bid to ensure continuation of economic growth, the US Treasury has issued fiscal stimulus payments to American households for an amount of about US $ 91 billion during April 28-July 11, 2008.

66. Since December 2007, the ECB has conducted thirteen US dollar TAF auctions amounting to US $ 235 billion up to July 17, 2008 for 28 days maturity each. The Bank of Canada (BoC) has conducted nine 28-day auctions amounting to US $ 16 billion till June 12, 2008. On June 23 and July 8, 2008, the BoC has stated that it will not renew the term purchase and resale agreements (PRA) transactions maturing on June 26 and July 10, 2008. The SNB has conducted ten auctions amounting to US $ 56 billion for 28 days each up to July 15, 2008. The Bank of England (BoE) increased liquidity injections from £ 2.85 billion to £ 11.35 billion for its operations in December 2007-January 2008 of which £ 10 billion was offered for 3-month maturity. It also announced that long-term repo operations would be held against a wider range of high quality collateral. In April 2008, the BoE launched a scheme to allow banks to swap their high quality mortgage-backed and other securities temporarily for UK Treasury Bills. The BoE has, up to July 15, 2008 allotted an amount of £ 54.9 billion for three months’ maturity in six long-term repo auctions since December 2007 against an extended range of collaterals.

67. The confluence of slowdown in growth and mounting inflation alongside financial vulnerabilities has complicated the task of monetary authorities across the world and rendered the future direction of policy setting highly uncertain.Monetary easing in the leading developed countries has increased global liquidity with attendant implications for monetary management in the emerging economies.Some central banks have cut policy rates since the third quarter of 2007 when the financial market turmoil surfaced. During September 18, 2007 to April 30, 2008 the US Federal Reserve reduced its policy rate by 325 basis points to 2.00 per cent after seventeen increases to 5.25 per cent between June 2004 and June 2006. The BoE reduced its Bank Rate to 5.0 per cent by 25 basis points each in February and April 2008 but has left it unchanged since then. The BoC reduced its policy rate to 3.0 per cent by 25 basis points reductions each in December 2007 and January 2008 and 50 basis points each in March and April 2008. The Reserve Bank of New Zealand reduced the Official Cash Rate from 8.25 per cent to 8.0 per cent on July 24, 2008.

68. Central banks of some countries such as Japan, Korea, Malaysia and China have not changed their policy rates in 2008.

69. Some central banks that have tightened their policy rates in recent months include the ECB (main refinancing operations rate raised by 25 basis points to 4.25 per cent on July 3, 2008); the Reserve Bank of Australia (Cash Rate raised by 25 basis points in February-March 2008 to 7.25 per cent); Bank Indonesia (BI rate raised by 75 basis points in April-June 2008); Bank of Thailand (1-day repurchase rate raised by 25 basis points to 3.50 per cent on July 16, 2008); the Banco Central de Chile (benchmark lending rate raised to 7.25 per cent by 25 basis points in January and 50 basis points each in June and July 2008 from 6.00 per cent in December 2007), Banco Central do Brasil (overnight Selic rate raised by 125 basis points to 13.00 per cent in June-July 2008) and Banco de Mexico (inter-bank 1-month rate by 25 basis points each in June-July 2008 to 8.00 per cent).

Click Here For Highlights of First Quarter Review of its Annual Policy Statement for 2008-09

Click Here For Macroeconomic and Monetary Developments: First Quarter 2008-09


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