Annual Monetary Policy Statement for the Year 2011-12- 3rd May 2011
Part A. Monetary Policy
I. The State of the Economy
9. The global economy during the first quater of 2011 continued with the momentum of late 2010. The global manufacturing purchasing managers’ index (PMI) for February 2011 was close to a record high, while the global services PMI recorded its fastest pace of expansion in almost five years. Although these indices slipped somewhat in March 2011, they signalled continuing expansion. However, consumer confidence in major countries, which improved during January-February 2011, moderated in March 2011 on the back of higher oil prices.
10. GDP growth in the US, which was strong at 3.1 per cent (q-o-q seasonally adjusted annualised rate) in Q4 of 2010, slipped to 1.8 per cent reflecting a decline in government spending, deceleration in private consumption and increase in imports. Clearly, a number of weaknesses persist. The US housing market remains weak. More generally, unemployment rates continue to remain elevated in major advanced economies, albeit with some improvement in the US. Concerns about sovereign debt in the euro area have now been reinforced by developments in the US. Finally, and most importantly, commodity price increases have accelerated, engendering global inflationary fears and posing downside risks to growth.
11. The Brent crude price surged from an average of US$ 75 a barrel during May-September 2010 to US$ 123 a barrel by April 2011. The International Monetary Fund's (IMF) in its April 2011 World Economic Outlook (WEO) has assumed US$ 107 a barrel for the full year 2011. Initially, oil prices were buoyed by strong global demand and excessive liquidity. Since February 2011, oil prices have come under further pressure on account of apprehensions about supply disruptions due to political developments in the Middle East and North African (MENA) region. The demand for oil is expected to increase with the possibility of Japan substituting some of its shut-in nuclear power capacity with oil-based generation, combined with higher energy usage once reconstruction gets underway.
12. In the recent period, commodity prices have been under pressure due to strong demand from emerging market economies (EMEs) and the financialisation of commodity markets. Global consumption of most base metals is estimated to have reached new highs in 2010. According to the Food and Agriculture Organisation (FAO), international food prices rose by 37 per cent (y-o-y) in March 2011, reflecting both higher demand and weather related supply disruptions. The increase in global food prices was led by the prices of cereals (60 per cent), edible oils (49 per cent) and sugar (41 per cent).
13. Commodity prices are now exerting a direct impact on inflation in advanced economies, despite substantial negative output gaps. They have also accentuated inflationary pressures in EMEs, which were already experiencing strong revival in demand. While major EMEs have been tightening monetary policies for more than a year now, the European Central Bank has recently raised its policy rate - the first central bank to do so among the major advanced economies - after maintaining them at historically low levels for almost two years. Central banks in other advanced economies are also under pressure to withdraw monetary accommodation. The above trend poses appreciable downside risks to global economic activity.
14. The Indian economy is estimated to have grown by 8.6 per cent during 2010-11. Agricultural growth was above trend, following a good monsoon. The index of industrial production (IIP), which grew by 10.4 per cent during the first half of 2010-11, moderated subsequently, bringing down the overall growth for April-February 2010-11 to 7.8 per cent. The main contributor to this decline was a deceleration in the capital goods sector. However, other indicators, such as the manufacturing PMI, tax collections, corporate sales and earnings growth, credit off-take by industry (other than infrastructure) and export performance, suggested that economic activity was strong.
15. According to the Reserve Bank’s Order Books, Inventories and Capacity Utilisation Survey (OBICUS), the order books of manufacturing companies grew by 7 per cent in October-December 2010 as against 9 per cent in the previous quarter indicating sustained demand albeit with some moderation. The Reserve Bank’s forward looking Industrial Outlook Survey (IOS) shows a decline in the business expectations index for January-March 2011 after two quarters of increase.
16. Leading indicators of services sector suggest continuing growth momentum. Credit to the services sector grew by 24 per cent in 2010-11 as compared with 12.5 per cent in the previous year. Other indicators such as commercial vehicles production and foreign tourist arrivals also showed an acceleration. However, the services PMI for March 2011 showed some moderation as compared with the previous month.
17. Inflation was the primary macroeconomic concern throughout 2010-11. It was driven by a combination of factors, both structural and transitory. Based on drivers of inflation, the year 2010-11 can be broadly divided into three periods. In the first period from April to July 2010, the increase in wholesale price index (WPI) by 3.5 per cent was driven largely by food items and the fuel and power group, which together contributed more than 60 per cent of the increase in WPI. During the second period from August to November 2010, while WPI showed a lower increase of 1.8 per cent, more than 70 per cent of the increase was contributed by food and non-food primary articles and minerals. In the third period from December 2010 to March 2011, WPI increased sharply by 3.4 per cent, driven mainly by fuel and power group and non-food manufactured products, which together contributed over 80 per cent of the increase in WPI. Thus, the inflationary pressures, which emanated from food, clearly became generalised as the year progressed.
18. As food price inflation moderated, consumer price index (CPI) measures of inflation declined to 8.8-9.1 per cent in March 2011 from 13.3-15.0 per cent in April 2010. Over the same period, WPI inflation remained elevated reflecting increases in non-food primary articles prices and importantly, non-food manufactured product prices. This led to a broad convergence of WPI and CPI inflation by the end of 2010-11.
19. Broad money supply (M3) growth at 15.9 per cent (year-on-year) during 2010-11 was lower than the Reserve Bank’s indicative trajectory of 17 per cent due to slow deposit growth and acceleration in currency growth. The higher currency demand slowed the money multiplier. Consequently, M3 growth slowed despite a significant increase in reserve money. This suggests that money supply growth was not a contributing factor to inflation.
20. Non-food credit growth, which had been trending upwards from the beginning of the year, reached an intra-year high of 24.2 per cent (year-on-year) in December 2010. It slowed down subsequently to 21.2 per cent by March 2011, which was marginally higher than the Reserve Bank’s indicative projection of 20 per cent.
21. The Reserve Bank’s estimates show that the total flow of financial resources from banks, domestic non-bank and external sources to the commercial sector during 2010-11, at `12,00,000 crore, was 12.3 per cent higher than that in the previous year. There was a decline in non-bank sources of funds in 2010-11 as compared with that in the previous year. The decline was particularly noticeable in foreign direct investment. However, this was more than offset by the higher flow of funds from the banking sector.
22. Data on sectoral deployment of bank credit show significant increases in credit flow to industry and services. Within industry, credit growth to infrastructure was robust. Credit flows improved in respect of metals, textiles, engineering, food processing, and gems and jewellery, among others. Within services, credit growth accelerated to commercial real estate and non-banking financial companies. Housing and vehicle loans recovered in 2010-11.
23. The Base Rate system replaced the Benchmark Prime Lending Rate (BPLR) system with effect from July 1, 2010. Major scheduled commercial banks (SCBs), constituting about 81 per cent of total banking business, raised their Base Rates by 50-165 basis points between October 2010 and March 2011. Base Rates of 64 major banks with a share of around 98 per cent in the total bank credit were in the range of 8.00-9.50 per cent (March 2011), reflecting greater convergence in Base Rates announced by major banks. The weighted average lending rate in the banking system was 10.5 per cent as at end-March 2010. Data from select banks indicate that the weighted average yield on advances, which is a proxy measure for effective lending rates, is projected to increase from 9.7 per cent in 2010-11 to 10.3 per cent in 2011-12. This suggests that the Base Rate system has improved the transmission from the policy rates to banks’ lending rates.
24. After remaining in surplus for 18 months, liquidity conditions transited to a deficit mode towards end-May 2010. This was the consequence of a large build-up in government cash balances as a result of higher than expected proceeds from spectrum auctions. Beginning October 2010, liquidity conditions became even tighter. Both frictional factors such as the above-normal build up in government cash balances and structural factors such as high currency demand growth and credit growth outpacing deposit growth contributed to tight liquidity conditions. Although a systemic liquidity deficit was consistent with the anti-inflationary stance of monetary policy, the extent of tightness since October 2010 was outside the comfort level of (+)/(-) one per cent of net demand and time liabilities (NDTL) of SCBs.
25. The Reserve Bank initiated several measures to ease the liquidity situation. These were: (i) additional liquidity support under the liquidity adjustment facility (LAF) to SCBs up to one per cent of their NDTL by temporary waiver of penal interest for any shortfall in maintenance of statutory liquidity ratio (SLR) - for a brief period the limit was two per cent of NDTL, which was reduced to one per cent following the permanent reduction in the SLR; (ii) reduction in the SLR by one per cent; (iii) conducting open market operations; and (iv) conducting the second LAF (SLAF) on a daily basis.
26. Liquidity conditions have eased significantly in recent weeks, following a sharp reduction in government cash balances and moderation in the credit-deposit ratio of banks. Consequently, net liquidity injected by the Reserve Bank through its repo operations declined from a daily average of around ` 1,20,000 crore in December 2010 to around ` 81,000 crore in March 2011. The average daily net liquidity injected by the Reserve Bank fell sharply to `19,000 crore in April 2011 as government balances moved from positive to negative.
27. In order to facilitate better liquidity management, the Reserve Bank extended the two liquidity easing measures, viz., additional liquidity support under the LAF to SCBs up to one per cent of their NDTL and the SLAF on a daily basis up to May 6, 2011.
28. Yields on government securities eased during the first quarter of 2010-11 in expectation of an improved fiscal position due to higher than anticipated revenues in spectrum auctions. Yields hardened thereafter till January 2011 on account of increase in inflation and consequent rate hike expectations as well as tight liquidity conditions. Yields, however, moderated in February and March 2011 on the back of improvement in liquidity conditions, lower than expected budgeted fiscal deficit and the projected market borrowing programme for the first half of 2011-12. Significantly, the stability of long-term yields, despite the current high rates of inflation, suggests that inflationary expectations remain anchored.
29. The Union Budget for 2011-12 has emphasised the Government’s commitment to carry on the process of fiscal consolidation by budgeting a lower fiscal deficit (4.6 per cent of GDP in 2011-12 as compared with 5.1 per cent in 2010-11). The revenue deficit to GDP ratio is estimated to remain unchanged at 3.4 per cent in 2011-12.
30. During 2010-11, the rupee dollar exchange rate showed two-way movements in the range of ` 44.03-47.58 per US dollar. On an average basis, the 6-currency real effective exchange rate (REER) appreciated by 12.7 per cent in 2010-11, the 30-currency REER by 4.5 per cent and the 36-currency REER by 7.7 per cent.
31. The current account deficit (CAD) during April-December 2010 was US$ 38.9 billion, up from US$ 25.5 billion during the corresponding period of 2009. During the fourth quarter of 2010-11, exports grew at a robust pace of 46.6 per cent, while growth in imports decelerated to 22.8 per cent. Consequently, the CAD, which was 3.1 per cent during April-December 2010, is now estimated to moderate to around 2.5 per cent of GDP for 2010-11 as against 2.8 per cent during 2009-10.
32. Although net capital inflows increased significantly to US$ 52.7 billion during April-December 2010 (US$ 37.6 billion a year ago), the composition shifted towards volatile flows such as FII investments and trade credits. Net inflows under FDI were lower. As the CAD is expected to be significant in 2011-12, the sustainability of financing it becomes important.
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