First Quarter Review of Monetary Policy 2009-2010
-Announced on the 28th July 2009
I. Macroeconomic and Monetary Developments
21. The headline inflation, as measured by year-on-year variations in the wholesale price index (WPI), decelerated from a peak of 12.91 per cent on August 2, 2008 to 0.84 per cent at end-March 2009 and turned negative in June 2009. The increased volatility in WPI inflation needs to be seen in the context of the behaviour of the global commodity prices. Reflecting the sharp increase in oil and metal prices, WPI inflation had risen to double digits in June 2008 and remained elevated till October 2008 tracking the firm global commodity prices. As the global commodity prices moderated from their peak levels, domestic prices also adjusted, setting off a converse movement in WPI inflation. That volatility in WPI flowed largely from international commodity prices is evident from the trend in WPI inflation excluding mineral oils and metals (weight in WPI: 15.3 per cent), which is less volatile than the overall WPI inflation (Chart 1).
22. WPI inflation for the week ended July 11, 2009 was (-)1.17 per cent. The negative WPI inflation is expected to persist for a few more months till the base effect wears off. The evolution of WPI inflation so far has been along the lines anticipated in the Annual Policy Statement of April 2009. The currently observed negative WPI inflation largely reflects the statistical effect of the high base of last year and should not be interpreted as structural deflation arising from demand contraction.
23. At a disaggregated level, WPI inflation, on account of food articles, is ruling high and WPI inflation for essential commodities (weight in WPI: 17.8 per cent) is also in double digits. On a financial year basis, WPI has already increased by 3.5 per cent in 2009-10 (up to July 11) as against an increase of 5.6 per cent in the corresponding period of the previous year. Various consumer price indices (CPIs) are also ruling at elevated levels. All these would suggest that the negative year-on-year WPI inflation cannot be attributed to structural deficiency in demand (Table 6).
24. The divergence between WPI and CPI inflation rates has become more pronounced in the recent period with the WPI inflation turning negative, while the CPI inflation is ruling in the range of 8.6-11.5 per cent. This is in contrast to the historical trend when CPI inflation has tracked WPI inflation, albeit with a lag, as wholesale price changes are followed by retail price changes. In recent months, CPI inflation has remained stubborn at elevated levels due to increased prices of food items, which have a higher weight in the CPI basket than in the WPI. As would be expected, CPI inflation tracks the essential commodities component of WPI inflation quite closely (Chart 2). The divergence in various price indices evidently increases the complexity of inflation assessment. For its overall assessment of inflation outlook for policy purposes, therefore, the Reserve Bank, as always, monitors the full array of price indicators.
25. The ratio of tax receipts to GDP of the Central Government has declined from a peak of 12.6 per cent of GDP in 2007-08 to 11.8 per cent in 2008-09, and is budgeted to drop further to 10.9 per cent in 2009-10 due to the combined impact of the economic slowdown and the fiscal stimulus measures in terms of tax cuts to support growth (Table 7). On the other hand, aggregate expenditure has increased mainly on account of the implementation of the Sixth Pay Commission Award, the debt waiver scheme for farmers, the rural employment programme and spending on infrastructure.
26. As a result of fiscal stimulus measures, coupled with the reduction in the tax-GDP ratio, all the deficit indicators deteriorated sharply and deviated significantly from the targets stipulated under the Fiscal Responsibility and Budget Management (FRBM) Rules. The fiscal deficit increased from 2.7 per cent of GDP in 2007-08 to 6.2 per cent (pre-actual) in 2008-09. Of the increase in fiscal deficit due to the stimulus measures (3.5 per cent of GDP), a major portion (3.3 percentage points) has been on account of increase in expenditure. The revenue deficit also went up from 1.1 per cent of GDP in 2007-08 to 4.6 per cent in 2008-09. The primary surplus in 2007-08 turned into a deficit in 2008-09.
27. The consolidated fiscal deficit of the States for 2008-09 is expected to have risen to 3.0 per cent of GDP taking the estimated combined deficit of the Centre and the States to 9.1 per cent of GDP, a level last seen in 2002-03. Including the issuance of bonds to oil marketing and fertiliser companies, the combined deficit for macroeconomic purposes adds up to around 10.9 per cent of GDP in 2008-09.
28. Owing to the fiscal stimulus packages as also additional post-budget items of expenditure, the combined net market borrowings of the Central and State Governments in 2008-09 were nearly two and half times their net borrowings in 2007-08. As per budget estimates, the combined net borrowing requirements of the Central and State Governments for 2009-10 are estimated to be higher than the 2008-09 actual borrowings by as much as 34 per cent (Table 8).
29. The large government market borrowing in 2009-10, as projected in the Interim Budget, called for active liquidity management by the Reserve Bank. Accordingly, the Reserve Bank indicated its intention to purchase government securities under open market operations (OMO) for an indicative amount of Rs.80,000 crore during the first half of 2009-10. Considering the higher borrowing programme indicated in the Union Budget 2009-10, the revised borrowing calendar for Q2 (July-September) of 2009-10 was released on July 16, 2009. According to this revised calendar, the net market borrowing of the Central Government through dated securities during the first half will be Rs.2,65,911 crore (higher by Rs.58,000 crore from the Interim Budget).
30. It may be noted that nearly 63 per cent (Rs.1,67,911 crore) of the borrowing programme for the first half of the year has been completed by July 27, 2009. An additional amount of Rs.28,000 crore has been raised through de-sequestering MSS balances. The open market operations undertaken so far have been of the order of Rs.33,439 crore, accounting for about 42 per cent of the notified amount of Rs.80,000 crore. There is, therefore, sufficient headroom available to the Reserve Bank to manage the balance borrowing smoothly (Table 9).
31. The weighted average yield of dated securities issued under the Central Government borrowing programme, which increased from 8.42 per cent in Q1 of 2008-09 to 9.24 per cent in Q2, softened to 6.68 per cent in Q4 of 2008-09. The weighted average yield for the quarter ended June 2009 was, however, higher at 6.93 per cent. The weighted average maturity of securities issued during 2009-10 so far has been 11.5 years, shorter when compared with the average maturity of 15.2 years last year.
32. The net borrowings of the Centre and the States completed during 2009-10 (up to July 27, 2009) were higher as compared with the corresponding period of last year (Table 10).
33. The movements in monetary aggregates since mid-September 2008 have been driven by the changes in liquidity conditions arising from the monetary policy response to global and domestic macroeconomic conditions. Reserve money (RM) changes largely reflect the changes in the transaction demand for currency and reductions in the cash reserve ratio (CRR) of banks. RM growth decelerated significantly as on July 3, 2009 (y-o-y) in comparison with last year mainly due to the sharp reduction in the CRR in phases beginning October 2008. Adjusted for the first round effect of the CRR changes, the decline in RM growth was less pronounced (Table 11).
34. The money supply (M3) growth on a year-on-year basis at 20.0 per cent as on July 3, 2009 has been well above the 17.0 per cent trajectory projected in the Annual Policy Statement of April 2009 (Table 11). The major driver of monetary expansion has been bank credit to Government which increased by 48.0 per cent.
35. Monetary management since mid-September 2008 has been guided by the continued need to provide liquidity to mitigate the impact of the global financial crisis and to improve the growth prospects in the medium-term. The Reserve Bank continued with its commitment to ensure comfortable domestic and foreign exchange liquidity and endeavoured to complete the large market borrowing programme of the Government in a non-disruptive manner. Accordingly, it provided foreign exchange liquidity to contain the volatility in the foreign exchange market, especially during the first two anxious months (September-October 2008). This led to a decline in the Reserve Bank’s net foreign exchange assets (NFEA) and that was made up by an expansion of net domestic assets (NDA). The Reserve Bank’s intervention helped in maintaining orderly conditions in the foreign exchange market and ensuring overall comfortable liquidity in the system. The phenomenon of substitution of foreign assets by domestic assets, which began in the second half of 2008-09, continued during the first two months of the current year. Liquidity conditions have remained comfortable since mid-November 2008 with the call money rate remaining near or below the lower bound of the LAF corridor, consistent with the stance of monetary policy. During 2009-10 (up to July 24, 2009), the average daily amount absorbed by the Reserve Bank under the LAF window was Rs.1,20,368 crore, suggesting a large surplus with the banking system, equivalent to nearly 3 per cent of net demand and time liabilities (NDTL).
36. As on July 3, 2009, the year-on-year expansion in non-food credit was 16.3
per cent, lower than the growth of 25.5 per cent a year ago. The deceleration in the overall credit flow has mainly been due to subdued overall demand and lower credit requirement of oil marketing companies. While year-on-year growth in bank credit by public sector banks was more than the envisaged trajectory of 20 per cent indicated in the Annual Policy Statement 2009-10, credit expansion by private banks was substantially lower, and credit expansion by foreign banks was negative. While the deposit growth of public sector banks accelerated, that of private and foreign bank groups decelerated (Table 12).
37. During the current financial year (up to July 3, 2009), non-food credit expanded by 0.4 per cent as compared with 1.6 per cent last year. It is not unusual for non-food bank credit expansion to decelerate in the early part of the year due to seasonal factors. However, during April-May 2009, non-food credit growth turned negative mainly due to a sharp decline in credit to petroleum and fertiliser companies (decline of Rs.18,796 crore in contrast to an increase of Rs.6,530 crore in the same period of last year). During the recent three fortnights of June 5, June 19 and July 3, 2009, non-food credit expansion has been higher at Rs.62,104 crore as compared with an increase of Rs.48,014 crore during the corresponding period of 2008.
38. As a result of the large deposit expansion coupled with moderation in credit demand, the scheduled commercial banks’ investment in SLR securities (including securities acquired under the LAF) increased to 30.5 per cent of their NDTL as on July 3, 2009 compared with 27.7 per cent a year ago. Adjusted for LAF, their SLR investments were at 26.9 per cent of NDTL as on July 3, 2009. Excess SLR investments, over the prescribed SLR of 24 per cent of NDTL, were at Rs.2,83,086 crore as on July 3, 2009 (Rs.1,26,431 crore adjusted for LAF).
39. According to disaggregated data drawn from 49 banks accounting for 95 per cent of total bank credit, the year-on-year growth in bank credit to industry as of May 2009 was lower than that in the previous year. While the credit flow to agriculture, industry, real estate and NBFCs was sustained, it was significantly lower for housing (Table 13).
Total Flow of Financial Resources to the Commercial Sector
40. During 2008-09, the total flow of financial resources to the commercial sector declined as compared with the previous year, reflecting moderation in both bank credit and funds from other sources. While credit conditions have eased, the declining trend continued through Q1 of 2009-10, reflecting subdued credit demand conditions (Table 14).
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