Review of Macroeconomic and Monetary
Developments during 2002-2003
3. The Central Statistical Organisation (CSO) recently released the latest estimates of national income for the year 2001-02. According to these estimates, the growth rate of real GDP in 2001-02 at 5.6 per cent was marginally higher than envisaged earlier, i.e. 5.4 per cent. This was mainly due to an upward revision in growth rates of the manufacturing, trade, transport and communication sectors. Growth rate of the services sector was revised upwards from 6.2 per cent to 6.5 per cent and that of industrial sector from 2.9 per cent to 3.2 per cent. However, the growth rate of agriculture and allied activities remained steady at 5.7 per cent.
4. For the year 2002-03, the mid-term Review of Monetary and Credit Policy released on October 29, 2002 had projected the GDP growth in the range of 5.0 to 5.5 per cent taking into account available data on the performance of the South-West monsoon. The advance estimates for 2002-03 released by the CSO in January 2003 has placed GDP growth at 4.4 per cent, which reflects an estimated decline in the output from agriculture and allied activities by as much as 3.1 per cent. The earlier projection in the Reserve Bank’s mid-term Review of October 2002 was based on a much lower decline of 1.5 per cent in agricultural output. The overall growth performance of the industrial sector, as per CSO advance estimates, at 5.8 per cent is, however, much higher than that of 3.2 per cent in the previous year. The services sector is estimated to grow by 7.1 per cent as against 6.5 per cent in the earlier year, mainly on account of higher growth in construction, domestic trade and transport sectors. The CSO has also placed the growth of financing, real estate and business services sector at 6.5 per cent for 2002-03 as compared with 4.5 per cent in 2001-02.
5. The annual rate of inflation as measured by variations in the wholesale price index (WPI), on a point-to-point basis, remained below 4.0 per cent up to mid-January 2003 and rose thereafter to 6.2 per cent by end-March 2003 mainly on account of increase in prices of non-food articles and mineral oils. During 2002-03, the prices of manufactured products (weight: 63.7 per cent) registered an increase of 4.8 per cent compared with no increase in prices in the previous year. Prices of primary articles (weight: 22.0 per cent) showed an increase of 5.9 per cent as against an increase of 3.9 per cent in the previous year. Similarly, there was a higher increase of 10.8 per cent in “fuel, power, light and lubricants” group (weight: 14.2 per cent) as against an increase of 3.9 per cent a year ago. Besides fuel items, the steep increase in prices of oilseeds, sugarcane and cotton have been major items in the overall price rise in 2002-03. In the WPI basket, while some items are affected by drought conditions, others have sharply responded to external supply shocks. The weight of such items, where prices have increased very sharply, works out to 15.4 per cent. Excluding the price increases due to such items (mineral oils, oilseeds, edible oils, oil cakes and fibres) from the basket, the inflation rate works out to 2.7 per cent on a point-to-point basis at the end of March 2003 as compared with 1.5 per cent last year.
6. The annual rate of inflation in 2002-03 as measured by the increase in WPI, on an average basis, for the year as a whole was, however, lower than that in the previous year: 3.3 per cent as against 3.6 per cent a year ago. On an average basis, the annual change in consumer price index for industrial workers (up to February 2003) was identical to the previous year at 4.1 per cent.
7. Monetary and credit aggregates for the year 2002-03 reflected the impact of mergers that took place in the banking industry. During 2002-03, the growth in money supply (M3) was 15.0 per cent (Rs.2,24,576 crore) as against 14.2 per cent (Rs.1,86,782 crore) a year ago. However, net of mergers, M3 increased by 12.1 per cent (Rs.1,81,984 crore) which was well within the projected trajectory. Among the components, growth in aggregate deposits of scheduled commercial banks (SCBs) at 12.2 per cent net of mergers (16.1 per cent with mergers), was lower than that of 14.6 per cent in the previous year. The expansion in currency with the public was lower at 12.5 per cent (Rs.30,263 crore) as against 15.2 per cent (Rs.31,849 crore) in the previous year.
8. An important feature of monetary developments during 2002-03 was the lower increase in reserve money despite a sharp increase in foreign exchange assets of RBI. The increase in reserve money during 2002-03 was 9.2 per cent (Rs.30,960 crore) as compared with an increase of 11.4 per cent (Rs.34,659 crore) observed in the previous year. While currency in circulation rose by 12.5 per cent (Rs.31,338 crore) as compared with an increase of 15.0 per cent (Rs.32,769 crore) in the previous year, bankers’ deposits with RBI declined by 1.0 per cent (Rs.801 crore) as compared with an increase of 3.3 per cent (Rs.2,670 crore). On the sources side, RBI’s net foreign exchange assets rose by 35.7 per cent (Rs.94,275 crore) compared with an increase of 33.9 per cent (Rs.66,794 crore) in the previous year. On the other hand, net domestic assets of RBI declined on account of a fall in both net RBI credit to government and credit to banks and commercial sector. Notwithstanding RBI’s subscription to fresh government dated securities of Rs.36,175 crore, net RBI credit to the Central Government actually declined by Rs.25,369 crore due to net open market sales of government securities of Rs.53,780 crore. RBI’s claims on banks and commercial sector also showed a fall of Rs.6,468 crore as compared with a decline of Rs.9,575 crore in the previous year reflecting comfortable liquidity conditions.
9. A favourable development during 2002-03 has been a sustained increase in credit flow to the commercial sector reflecting industrial recovery. During 2002-03, non-food credit of scheduled commercial banks (SCBs) registered a high growth of 26.2 per cent (Rs.1,40,144 crore) and, net of mergers, it rose by 17.8 per cent (Rs.95,599 crore), as against an increase of 13.6 per cent (Rs.64,302 crore) in the previous year. The incremental non-food credit-deposit ratio during 2002-03 at 79 per cent is the highest recorded over the last five years. This is indicative of the fact that a substantial part of lendable resources of banks has been deployed for productive purposes. This is also borne out by the strong growth of 10.3 per cent in demand deposits in 2002-03, which is mainly used for working capital requirements. The increase in total flow of funds from SCBs to the commercial sector during 2002-03, including banks’ investments in bonds/debentures/shares of public sector undertakings and private corporate sector, commercial paper (CP) etc., was also higher at 24.5 per cent (Rs.1,51,569 crore) as against 12.7 per cent (Rs.69,483 crore) in the previous year. The total flow of resources to the commercial sector, including capital issues, global depository receipts (GDRs) and borrowings from financial institutions was at Rs.1,88,262 crore as compared with Rs.1,42,082 crore in the previous year.
10. The feedback on industry-wise credit flows received from banks for 2002-03 (April-February) reveals that, at a disaggregated level, there was significant increase in credit to iron & steel, other metal & metal products, cotton & jute textiles, electricity, paper & paper products, fertilisers, drugs & pharmaceuticals, cement, gems & jewellery, construction, food processing, computer software, power and roads & ports. On the other hand, decline in credit was observed in coal, all engineering, sugar, tobacco & tobacco products, telecommunications and petroleum.
11. As a result of subdued procurement due to lower foodgrains production, and higher off-take of foodgrains, the buffer stock of foodgrains declined from 54.5 million tonnes on March 1, 2002 to 36.2 million tonnes as on March 1, 2003. Consequently, there was a decline in food credit of Rs.4,499 crore during 2002-03 as against an increase of Rs.13,987 crore in the previous year. The large buffer stock with the Government acted as a deterrent to price increase of food items as also the general price level in the wake of severe drought conditions witnessed during the year.
12. According to the revised estimates in the Union Budget, the fiscal deficit of the Central Government for 2002-03 was Rs.1,45,466 crore as against the budget estimate of Rs.1,35,524 crore. During 2002-03, net market borrowings of the Central Government at Rs.1,04,118 crore (gross Rs.1,51,126 crore) was higher than the budget estimate by Rs.8,259 crore but lower than the revised estimate by Rs.8,747 crore. The state governments’ net market borrowings of Rs.13,622 crore for 2002-03 were supplemented by additional borrowings of Rs.15,442 crore. Although the combined slippage in the borrowings of the Centre and States was as much as Rs.23,701 crore, it did not exert undue pressure on interest rates due to decline in the demand for food credit, reduction in CRR, comfortable liquidity position resulting from the foreign exchange inflows and judicious debt management by RBI. As such, the weighted average cost of government borrowings through primary issuances of dated securities at 7.34 per cent during 2002-03 was lower by 210 basis points than that of 9.44 per cent in the previous year. While unfavourable effects of large fiscal deficits on the interest rate scenario have not so far been evident, it is necessary, in a medium-term perspective, to aim at fiscal consolidation and substantially lower fiscal deficits to facilitate efficient monetary and debt management operations.
13. During 2002-03, the state governments accessed the market for additional borrowings for an amount of Rs.15,442 crore in two tranches. This amount includes Rs.10,000 crore for the debt swap scheme mutually agreed between the Central Government and state governments towards repayment of high cost debt of States to the Centre. Though repayment of high cost debt is desirable, large borrowings for this purpose, in addition to high level of approved market borrowings for other purposes, put pressure on interest rates. The timing of issuance and pricing of the securities also become difficult, particularly during periods when there is a bunching of borrowing requirements for various purposes. These difficulties are compounded if there are periodic defaults by some States or their PSUs in meeting their guarantee obligations. It is of utmost importance that overall borrowing requirements are kept at a reasonable level, and that all sovereign obligations, including guarantees, are fully honoured on time.
14. As emphasised in various policy Statements, overall monetary management becomes difficult when a large and growing borrowing programme of the Government puts pressure on the absorptive capacity of the market. The banking system already holds government securities of about 39 per cent of its net demand and time liabilities (NDTL) as against the statutory minimum requirement of 25 per cent. In terms of volume, such holdings above the statutory liquidity ratio (SLR) amounted to Rs.1,95,974 crore in March 2003 which is much higher than the gross borrowings of the Government. Further, such a scenario exposes banks to substantial interest rate risk which has adverse implications for sustained financial stability. In addition, the increasing interest payments have raised concerns about the sustainability of a large public debt. A reduction in fiscal deficit would release resources for infrastructure and industrial financing, which in turn would help in realising the long-term potential of the economy. Fiscal consolidation will also have a favourable effect on inflationary expectations and hence on the interest rate scenario in the economy.
15. The two-way movement in interest rates during 2002-03, has confirmed that banks should in their interest take steps to build up investment fluctuation reserves in a smooth and phased manner for better risk management. It may be recalled that in January 2002, RBI proposed that banks should build up investment fluctuation reserve (IFR) to a minimum of 5 per cent of their investment portfolio under the “held for trading” and “available for sale” categories, by transferring the gains realised on sale of investments within a period of five years. They were also advised to make adequate provisions for unforeseen contingencies in their business plans, and to fully take into account the implications of changes in the monetary and external environment on their operations. In the light of their own risk assessment, banks are free to build up higher percentage of IFR up to 10 per cent of their portfolio depending on the size and composition of their portfolio, with the concurrence of their Boards.
16. The monetary policy stance in recent years has underlined the Reserve Bank’s commitment to maintain adequate liquidity in the market with a preference for soft interest rates to the extent the evolving situation warrants. During 2002-03, it was possible to maintain adequate liquidity on account of sustained inflows of foreign exchange and decline in demand for food credit. As the inflationary situation remained benign for the most part of the year, it was feasible to maintain a soft interest rate environment despite a high level of government borrowing. This is evident from the fact that the call money rate declined from 6.97 per cent in March 2002 to 5.86 per cent by March 2003. The discount rate of prime-rated CP (61-90 days) showed an even sharper decline by 302 basis points from 9.02 per cent to 6.00 per cent between March 2002 and March 2003. The cut-off yields on 91-day and 364-day Treasury Bills declined from 6.13 per cent and 6.16 per cent, respectively, in March 2002 to 5.89 per cent each by March 2003. An interesting development during the year has been that the interest rates in money market instruments converged to a narrow band of 5.5 to 6.0 per cent reflecting easy liquidity conditions.
17. There was also a distinct downward drift in secondary market yields on government securities across the maturity spectrum during the year. The yield on government securities with 1-year residual maturity declined by 60 basis points from 6.10 per cent in March 2002 to 5.50 per cent by March 2003. There was a sharper decline of 115 basis points in yield on government securities with 10-year residual maturity from 7.36 per cent in March 2002 to 6.21 per cent by March 2003. The term structure of interest rates reveals a flattening of the yield curve with long-term interest rates declining more sharply than the short-term rates. For example, the spread between the yields on 10-year government securities and 91-day Treasury Bills narrowed from 123 basis points in March 2002 to 32 basis points by March 2003 reflecting moderation of inflationary expectations.
18. Interestingly, yields on non-government bonds witnessed a sharper reduction than yields on government securities during 2002-03, and yields on such bonds are now closer to sovereign bonds than was the case earlier. For example, the spread between the prime-rated CP (61-90 days) and 91-day Treasury Bills narrowed from 289 basis points in March 2002 to 11 basis points by March 2003. In the case of longer maturities also, the risk premium on the private sector bonds has fallen sharply as measured by the yield spread between highly rated corporate paper and government securities for residual maturity of 5 years. For example, the spread between AAA-rated corporate bonds and the yield on government securities narrowed from about 177 basis points in March 2002 to about 87 basis points by March 2003.
19. It is necessary to impart greater flexibility to the interest rate structure in India consistent with the underlying macroeconomic conditions. Further progress in this direction could be made if banks move over to a variable interest rate structure on longer term deposits as early as possible. Since interest rates could vary in both directions, depending on the phase of business cycle and inflationary outlook, a variable interest rate regime on long-term deposits does not necessarily imply lowering of the average interest rate earned by depositors over a period of time (as compared with a fixed rate regime, which favours old deposits over new deposits when interest rates are coming down, and vice versa when rates are moving in the opposite direction). In addition, banks need to reduce their operating costs over time by improving productivity and increasing their volume of lending. This should be possible with proper upgradation of technology in areas which, at present, are contributing to higher costs because of relatively low productivity.
20. The term deposit rates of public sector banks for maturities up to 1-year moved down from a range of 4.25-7.50 per cent in March 2002 to 4.00-6.00 per cent by March 2003. The reduction in deposit rates was more pronounced for longer term deposits as the public sector banks have reduced their deposit rates above 1-year from a range of 7.25-8.75 per cent in March 2002 to 5.25-7.00 per cent by March 2003. While the typical short-term deposit rate (15-29 days) of the public sector banks declined by 50 basis points during 2002-03, the rate for longer term deposits (over 3 years) declined by as much as 200 basis points. As a result, there has been a flattening of the term structure of deposit rates. The typical interest rate on 3-month and 1-year certificates of deposit (CDs) also declined from 7.38 per cent and 10.0 per cent in March 2002 to 5.25 per cent and 5.75 per cent, respectively, by March 2003.
21. In consonance with lower cost of funds, banks have reduced their prime lending rates (PLRs). The PLRs of public sector banks declined from a range of 10.0-12.5 per cent in March 2002 to 9.0-12.25 per cent by March 2003. The public sector banks reduced their PLRs in the range of 25-125 basis points, private sector banks by 50-225 basis points and foreign banks by 15-325 basis points. The number of public sector banks whose PLR was 11.5 per cent or below, has gone up from 10 to 22 between March 2002 and March 2003.
22. In the present interest rate environment, it is not reasonable to keep very high spreads over PLR. In the annual policy Statement of April 2002, RBI had urged banks to review their spreads over PLR and reduce them wherever they were unreasonably high. In response, a number of banks have reduced their spreads over PLR. The number of banks charging maximum spread of less than 4 per cent over PLR increased from 2 in March 2002 to 15 by March 2003 in the case of public sector banks, from 5 to 12 in the case of private sector banks and from 12 to 14 in the case of foreign banks. One major public sector bank has reduced the maximum spread over PLR to 2.5 per cent.
23. In recent years, there has been a persistent downward trend in the interest rate structure reflecting moderation of inflationary expectations and comfortable liquidity situation. Changes in policy rates reflected the overall softening of interest rates as the Bank Rate has been reduced in stages from 8.0 per cent in July 2000 to 6.25 per cent by October 2002, which is the lowest rate since May 1973. Similarly, the repo rate has been moderated from 8.0 per cent in March 1999 to 5.0 per cent by March 2003. Simultaneously, the weighted average call money rate has come down from over 13.06 per cent in August 2000 to 5.86 per cent by March 2003.
24. In the annual policy Statement of 2002, RBI had spelt out its intention of collecting the maximum and minimum interest rates on credit advanced by banks and place the same in public domain with a view to enhancing transparency. Accordingly, bank-wise lending rates have been placed on the RBI website for the quarters ended June, September and December 2002.
25. Liberalisation in the domestic economy combined with the increasing integration of the domestic markets with the international financial market poses new challenges for monetary management. It involves constant monitoring of both domestic and international indicators and fine-tuning of policies in line with the evolving conditions. Though the overall monetary conditions are at present comfortable in the light of moderate inflation, easy liquidity and soft interest rate environment, the Reserve Bank will continue to keep a constant watch on the domestic and external situation to conduct its monetary management and also to provide more robustness to the country’s financial architecture.