First Quarter Review of Annual Monetary Policy for 2008-09
I. Assessment of Macroeconomic and
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70. Leading indicators of aggregate supply conditions are emitting mixed signals in an environment of heightened uncertainty. The outlook for agriculture is generally positive on the back of the satisfactory progress of the South-West monsoon across the country so far which has also improved water storage conditions and enabled a substantial increase in sowing area in respect of key crops. There are, however, concerns in some quarters that deficient rainfall received in the monsoon season so far in Andhra Pradesh, Gujarat, Karnataka and Maharashtra may adversely affect the prospects of crops such as oilseeds, pulses, cotton and sugarcane. A sizeable step-up in procurement operations enabled by the record foodgrains production in the preceding year has been supported by expansion in food credit extended by banks under a consortium arrangement.Going forward, the rising level of buffer stocks and prospects for overall improvement in foodgrains production would assuage supply shortages, dampen inflation expectations, economise on imports and fortify food security in the context of the intensifying food crisis worldwide. In this context, it is worthwhile, however, to explore the implications of this rapid build-up in buffer stocks, in particular, the possible unintended consequences of limiting market supplies at a time when demand-supply gaps are strained and reflected in elevated food prices.
71. Headline industrial growth has moderated and turned somewhat volatile during September 2007-May 2008 following a sustained expansion that began in 2003-04 and peaked in November 2006. In May 2008, however, the growth of industrial production slowed below consensus expectations across all constituent sectors, after appearing to have regained some momentum in April. While production has picked up in some industries such as beverages and tobacco, chemicals and transport equipment, and consumer goods production has been buoyed up by a turnaround in the production of consumer durables out of a trough in January-March 2008, there appears to be a slackening of pace in the basic and intermediate goods segments. The slowing sectors include labour-intensive and small and medium-scale manufacturing industries such as textiles, non-metallic mineral products, rubber, plastic and coal products which together account for about a fourth of manufacturing activity. Output has declined in respect of food products and metal products and parts.Capital goods production, which had held up resiliently so far, weakened in May 2008 and joined other use-based categories in dragging down overall industrial growth. The continuing slowdown in infrastructure is impacting the outlook for the industrial sector.
72. Construction activity may be affected in view of the sluggishness in steel and cement production. More critically, the sharp deceleration in electricity generation is a cause for concern. There are indications of moderation in growth in some of the services sectors, particularly under trade, hotels and restaurants, transport, construction as well as in some categories of financing, real estate and business services.Business confidence surveys and purchasing managers' indices are indicating some moderation in expectations relating to manufacturing and service sector performance over the months ahead. The recent slackening of growth in the manufacturing sector, in particular, warrants a careful and disaggregated analysis to study the impact of escalated input costs, delays in project implementation due to lags in public policy clearances and competitive pressures from imports with a view to designing medium-term strategies to improve the supply response of India's manufacturing sector as well as its external competitiveness.
73. Aggregate demand pressures appear to be strongly in evidence, exacerbated by the slack in the supply response.First, inflation has surged to a 13-year high and inflation expectations have been driven up by unrelenting pressures partly emanating from international commodity prices, particularly crude oil, oilseeds/edible oils and metals. Second, the sharp escalation of inflationary pressures has occurred in an environment of high growth in monetary and banking aggregates which continue to rule above indicative policy projections for the fourth year in succession, warranting concern in the context of the monetary overhang created by large capital inflows in 2006-07 and particularly in 2007-08. Third, investment demand continues to be strong, growing in the range of 14-19 per cent since 2002-03 and currently constituting 36 per cent of GDP. Furthermore, consumption demand appears to be reviving the production of consumer goods, especially durables. Fourth, with merchandise imports running ahead of exports, the trade deficit has widened sizeably in April-May 2008, reflecting the pressure of domestic demand. There has also been some tightening of external financing conditions in the ongoing global financial turmoil. Fifth, there are indications of growing fiscal stress in the volume of off-budget borrowings by the Centre, impending expenditures on account of food, fertilizer and POL subsidies, the debt waiver scheme and the award of the Sixth Pay Commission with consequent pressures on aggregate demand.
74. The upsurge in inflation during the current financial year reflects a combination of forces at work. First, on a year-on-year basis, about 30 per cent of headline WPI inflation is contributed by mineral oils, partly reflecting the pass-through of international crude prices to domestic administered prices effected on June 5, 2008. In addition, prices of petroleum products which are not administered have gone up pari passu with international crude prices, exerting considerable pressure on headline inflation. Unlike in some developed economies, the pass-through is not occurring on a continuous basis in developing economies including India which are tailoring their policy responses to suit domestic conditions. Second, there are inflationary pressures in addition to crude oil prices. Even after excluding fuel and food, WPI inflation has remained close to or higher than the headline during the year so far.There are also indications that consumer price inflation is catching up with producer prices so that inflationary pressures at the retail level appear to be broadening in their ambit.Prices of manufactured products have contributed nearly 50 per cent of headline inflation mainly on account of food products, metal products and chemicals which have been impacted by the steep rise in input costs, including import prices. Primary articles have contributed about a fifth of headline inflation, mainly driven by prices of oilseeds, raw cotton and milk. Movements in international prices of key commodities indicate elevated upside pressures for domestic prices of a number of commodities such as coal, edible oil, rice and steel in view of the linkages between global and domestic demand-supply balances, with implications for the evolving scenario.
75. There are some signs of moderation in key monetary and banking aggregates in response to monetary measures which have withdrawn liquidity from the system and tightened interest rates across the term structure. The rate of money supply and deposit growth have started to dip in consonance since June, edging towards the trajectory set for 2008-09.The balancing of monetary and liquidity conditions has not, however, impacted the demand for bank credit which has accelerated on a year-on-year basis.In particular, food credit has recorded a turnaround to support the large-scale operations in food procurement by public agencies. While credit to the petroleum sector has risen sizeably due to the funding requirements of oil companies in the context of the escalation in international crude prices, bank credit to other sectors has also picked up, particularly to infrastructure, cement, chemicals, transport operators and professional and other services, reflecting resilient activity in these sectors. On the other hand, bank credit flowing to agriculture, housing, real estate, construction, metal products, textiles, gems and jewellery and engineering has moderated on account of sector-specific factors which have impacted input costs and impeded the flow of credit.It is noteworthy that the growth in credit during 2008-09 so far has taken the incremental non-food credit-deposit ratio to 82.4 per cent which appears high given the prescribed CRR/SLR and banks' preference for holding excess reserves on a day-to-day basis.
76. Financial markets have generally experienced some tightening of liquidity conditions and hardening of interest rates, particularly since the second half of May as monetary measures took effect.In the money markets, interest rates moved towards the ceiling of the LAF corridor, rising even beyond in June with advance tax payments and in the following weeks, albeit within a narrow range above the repo rate. In the Government securities market, yields have risen across the spectrum on inflation concerns; with short-term yields responding to monetary measures, there has been a flattening of the yield curve with intermittent inversions.In the foreign exchange market, the spot exchange rate has been under sustained downward pressure from international crude prices, portfolio outflows and uncertainty surrounding the outlook. Forward premia have, however, risen sharply in the recent period as market participants have engaged in adjustments in their positions in response to the shift in the underlying trend of the spot market.The credit market has experienced some tightening in view of banks raising both deposit and lending rates in response to monetary policy action.
77. Fiscal developments in the early months of 2008-09 indicate some stress on the financial position of the Union Government. The headline deficit indicators have generally worsened in April-May 2008 from their levels a year ago. Gross tax revenues have remained buoyant with direct taxes constituting 43 per cent, up from their share of 36 per cent in the first two months of2007-08. Aggregate plan revenue expenditure on social and other economic services as well as grants to States has risen significantly. Capital outlay has also risen, mainly on account of non-defence spending. In contrast, the growth of non-plan expenditure has been somewhat muted. In view of the enhanced outgo on subsidies, interest payments, farm loan waiver and salaries that is likely to occur over the coming months, public finances have emerged as a source of concern from the point of view of macroeconomic management.
78. In the external sector, the growth of both exports and non-oil imports has moderated in April-May 2008.POL imports, however, have expanded sizeably on account of elevated international crude oil prices. A noteworthy development in recent years has been the buoyancy in POL exports, particularly since 2003-04 with growth averaging close to 60 per cent per annum up to 2007-08.As a result, the POL deficit (POL exports minus POL imports), which was 118.8 per cent of the overall merchandise trade deficit in 2003-04, declined to 67.9 per cent by 2007-08. Net invisibles continue to provide a stable source of support to the balance of payments. Capital flows are exhibiting mixed developments.While FDI has more than doubled, there have been episodes of reversals of portfolio flows from institutional investors reflecting continuing risk aversion and concerns about the global slowdown. On the other hand, issuances of equity and debt instruments by Indian entities in stock exchanges abroad have picked up.While there has been some drawdown of the foreign exchange reserves during the current financial year, external financing conditions continue to remain viable. The level of reserves is equivalent of more than a year's imports and exceeds the level of external debt.
79. Downside risks to global economic prospects appear to have intensified since the Annual Policy Statement of April 2008. The slowdown of growth seems to be spreading from the US to several other advanced economies with housing and labour markets weakening sharply. The deepening financial turbulence in major financial centres has worsened the macroeconomic outlook further by erosion of consumer and business sentiment and tightening of financing conditions with indications that a generalised credit squeeze may take hold. In the US, the downturn in the housing sector is contracting residential and non-residential investment and consumption demand even as household indebtedness has risen. A positive feature is the strength of export growth which augurs well for investment in the tradeable sector.In the UK, economic activity has continued to slow in 2008 with consumption spending being dragged down by tightening of credit conditions and falling consumer confidence. The slowing housing sector is also impacting construction activity.While growth in the euro area has been somewhat more resilient, business confidence has declined and private consumption has decelerated along with exports. The Japanese economy has expanded in the first half of 2008 on the back of strong exports and relatively robust consumption and employment growth, although falling residential investment and deteriorating business sentiment appears to be tempering domestic demand. Consensus forecasts suggest that the global economy will slow significantly in 2008 but whether or not it will avoid a sharp and synchronised downturn is yet unclear.
80. The impact of the slowdown in developed economies on EMEs cannot but be adverse, but it has so far been limited by the strength of domestic demand, particularly investment, and consumption spending has remained stable. The slowing of import demand from developed economies could, however, pose a risk to the growth outlook for these economies.Equity markets in many emerging economies have weakened in 2008 partly on lower growth expectations.Tightening of financing conditions in international markets is a growing risk for emerging economies with current account deficits and relatively large reliance on cross-border bank borrowing. In particular, terms of trade losses have impacted the external positions of some emerging economies that are net commodity importers. The impact of the global financial turmoil has so far been restricted to portfolio flows and bank lending to EMEs while foreign direct investment has remained strong.On the other hand, outward direct investment from emerging economies, particularly Asia, has increased significantly. Consensus growth forecasts for EMEs have declined in recent months but continue to remain reasonably optimistic about the near term.
81. Inflation has emerged as the biggest risk to the global outlook, having risen to very high levels across the world, levels that have not been generally seen for a couple of decades.Developed and emerging economies alike are reporting multi-year highs in inflation, driven mainly by escalating commodity prices, particularly of energy, food and metals. In terms of consumer prices, developed economies are reporting increases up to 170 basis points since January 2008. For emerging economies, the increase in inflation has been even higher i.e., in the range of 120-570 basis points. In terms of producer prices, inflation is rapidly heading to or is already at double-digit levels in most developed and emerging economies. Core measures of inflation and survey-based inflation expectations have also risen markedly.There are growing concerns across economies that rising food and energy prices are triggering a more generalised inflation spiral through second-round effects. Crude futures do not indicate any let-up in the current level of prices up to December 2008.Steel prices have increased in the range of 69-88 per cent in June 2008 on a year-on-year basis and are set to harden even further.At the current juncture, globally food prices are likely to remain high at least up to end-2008, constrained by record low inventories and restrictions on exports by major foodgrain producers. In several emerging economies, higher inflation has become associated with increasing volatility in currency and equity markets as well as financial sector fragility. By and large, while inflation was expected to rise, the size of the change in 2008 so far on a global scale has been clearly unanticipated.Policy responses have also been constrained in some countries by concerns about the speed and depth of the slowdown in growth.
82. Developments in the global financial system have heightened the uncertainty characterising the outlook. While a possible crisis in global finance seems to have been averted, several vulnerabilities persist in the leading financial centres. The ultimate size of losses among the largest financial institutions and the requirement of capital continues to be opaque at this stage, even as defaults on residential loans appear to be rising, balance sheets have become extremely sensitive to repricing and valuation changes and market liquidity remains frozen despite massive central bank interventions.For the developed economies affected by the turmoil, balance sheet positions of corporates as well as those of households - already weakened by rapid increase in debt and the fall in house prices - have become increasingly vulnerable to widening spreads and tighter credit conditions.Banks have been the most severely affected entities with large write-downs related to mortgage exposures and a decline in profitability.Investment banking has suffered from a large decline in profits and near-failure episodes with the urgent need to infuse substantial amounts of new capital.Central bank interventions in this context have also been extraordinary and on a scale not seen since the Great Depression, demonstrating a resolve to act decisively against threats to financial stability.With the exception of monoline insurers, the effect of the financial turmoil on insurance companies has been less severe than on banks and exposures are not as wide-spread.In the early months of 2008, hedge funds, private equity and leveraged buy-outs have experienced significant pressure and poor performance in a challenging market environment.
83. Since the end of May 2008, there are incipient signs of financial markets tending towards some normalcy with financial institutions being more proactive in disclosing losses, deleveraging and raising new capital.Spreads have retreated from their peaks; however, market activity remains somewhat strained.The full truth about the extent of losses and exposures is not yet known and perceptions of a pronounced increase in default risk continues to prevail as evident in high credit default swap (CDS) spreads.Money markets remain dislocated and, despite central bank liquidity injections alleviating pressures, uncertainty about future liquidity supply and counterparty risk persists.Equity markets have dropped sharply in 2008 with the worsening of the macroeconomic outlook and renewed credit related concerns.Between April 2008 and July 2008, global share prices have fallen considerably with an increase in volatility and a decline in investors' risk tolerance.Bond yields, which stabilised since mid-March, have started to recover in developed economies and a flight to safety is leading up to a shortage of paper.Longer term real yields have declined sharply on recession fears.In the foreign exchange market, the US dollar and the pound sterling depreciated in effective terms whereas the euro, the yen and the Swiss franc appreciated along with several Asian currencies.Some currencies that had proved to be resilient in 2007 such as the Canadian dollar, the Korean won and the South African rand have depreciated, in some cases substantially, in 2008 so far. Concerns about a more widespread slowdown, rising inflation and perceptions of overvaluation have been weighing on emerging market asset classes in 2008 with spreads on sovereign debt widening.
84. In the overall assessment, several risks looming over the global economy at the time of the Annual Policy Statement of April 2008 have either materialised or intensified with implications for every national economy, including India. The outlook is highly unclear and the prospects of resolution of the multiple disequilibria embedded in global developments are fraught with uncertainty. Although the IMF has revised its forecast of global growth for 2008 up by 0.4 percentage points in July over its April projection, theconsensus now appears to be that the slowdown of growth is deepening and broader in its span than initially expected with more significant slowing likely in the period ahead. In view of the international linkages that are stronger now than before, macroeconomic prospects for the EMEs, that have so far remained relatively unscathed, are overcast with downside risks from knock-on and lagged effects of the downturn. Globally, inflation pressures brought on by the elevated levels of crude, metal and some food prices show no signs of abating and instead, appear to be getting entrenched into inflation expectations. While high inflation is now a worldwide phenomenon, country responses have differed widely depending on perceptions of the nature of the shock, how long it will last and the stage of the inflation cycle in terms of the onset of the second-order impact. In some developed countries, the policy response to inflation has been proscribed by relatively overarching concerns for financial stability in the context of the ongoing financial turmoil. While vestiges of calm appear to have been restored in financial markets by end-June, the dangers of further deepening of the crisis and potential contagion have, in fact, increased. In emerging economies like India, these effects are already in evidence in the currency and equity markets and phases of capital outflows have occurred from some of these countries.Accordingly, heightened vigilance and stress testing of the preparedness to deal with these developments assumes critical importance as recent weeks have shown.
85. Domestically, some moderation appears to be underway with slower momentum in industrial and service sector activity, while the outlook for agriculture provides a silver lining in terms of food availability and the mitigating effect on inflation expectations. Nevertheless, inflation risks have increased sharply and appear to be persistent at this juncture. The conduct of monetary policy in the context of bringing down inflationary pressures and anchoring inflation expectations is, however, complicated by global developments and domestic demand pressures.
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