Third Quarter Review of Annual Statement on Monetary Policy for 2006-07
II. Stance of Monetary Policy
72. At the end of October 2006, i.e., at the time of the Mid-Term Review, the outlook for global growth and inflation was positive but uncertain with no definitive indications for the course of monetary policy. On the other hand, early signs of overheating in the domestic economy were recognised as too risky to ignore. Accordingly, the repo rate under the LAF was raised by 25 basis points with immediate effect on October 31, 2006 while keeping the reverse repo rate unchanged. In continuation of the stance of the Annual Policy Statement of April 2006 and the First Quarter Review of July, the Mid-Term Review of October set the stance of monetary policy for the period ahead in terms of ensuring a monetary and interest rate environment that sustains the growth momentum while securing price stability and anchoring inflation expectations. The emphasis on macroeconomic and financial stability was reinforced with a readiness to consider appropriate, immediate measures and all possible measures promptly in response to the evolving global and domestic outlook.
73. In the subsequent months, macroeconomic performance has turned out to be somewhat better than anticipated on the back of strong growth in manufacturing and services. Against this background, with a view to draining excess liquidity and pre-empting upward pressures on inflation expectations, it was decided to increase the CRR of the SCBs, regional rural banks (RRBs), scheduled state co-operative banks and scheduled primary (urban) co-operative banking system by one-half of one percentage point of their NDTL in two stages, to 5.25 per cent and 5.50 per cent, effective from the fortnights beginning December 23, 2006 and January 06, 2007, respectively. With this increase in the CRR, an amount of about Rs.13,500 crore of resources of banks was sought to be absorbed. The increase in the CRR announced on December 8, 2006 was consistent with the stance of the Mid-Term Review of October 2006 of containing inflation expectations in the current environment and consolidating gains achieved so far in regard to stability in order to sustain the momentumof growth on an enduring basis.
74. Financial markets have responded to these developments with some tightening of liquidity conditions, re-pricing and corrections in valuations. Except for the first half of December, short-term interest rates have generally risen. Contrastingly, long-term yields have declined, resulting in a narrowing of yield spreads and an inversion of the yield curve. In the credit market, buoyant deposit growth has considerably alleviated the financing constraint on the banking system. Nevertheless, both deposit and lending rates have edged up in recent months. In the foreign exchange market, sustained inflows, aided by a combination of global and domestic developments, have comfortably accommodated a modest current account deficit and have been reflected in an appreciating exchange rate. Equity markets have been driven up by strong rallies, with some intermittent corrections. The policy incentive structure for external investment is favourable to real estate and the capital market, leading to sizeable inflows and rising asset prices.
75. Real GDP growth originating from agricultural and allied activities has been somewhat lower than expected in the first half of 2006-07, based on the likely production in the kharif season. Pending a clearer assessment of the kharif crop performance and taking into account the favourable water storage conditions that should augur well for the rabi season, it is reasonable to expect that agriculture will maintain its trend growth of 3.0 per cent as anticipated in the Annual Policy Statement and the Mid-Term Review. On the other hand, the momentum of growth has been sustained in the industrial and service sectors and the outlook remains bright. Accordingly, real GDP growth for 2006-07 is currently expected to be in the range of 8.5-9.0 per cent as compared with around 8.0 per cent projected in the Mid-Term Review and 7.5-8.0 per cent in the Annual Policy Statement and the First Quarter Review.
76. Against this backdrop, the outlook for inflation assumes criticality in terms of policy monitoring and action. Prices of food articles will have considerable impact on headline inflation over the rest of the year. The seasonal decline in prices of food articles in the second half of the year has been less than normal. Prices of manufactures are firming up and were close to the headline level by the end of December, 2006. The recent initiatives by the Government of India should give comfort to the inflation outlook on account of both primary articles and manufactured products. The benefit of the reduction in prices of petrol and diesel, which came into effect in end-November, should help moderate the pressures. As regards the outlook on international crude prices, the probability of current levels being maintained is high, though some geo-political risks remain. The recent monetary policy measures, in particular, the increase in the CRR in December 2006 should work towards containing inflation expectations. On the way forward, it should be possible to build on the timely and pre-emptive actions taken so far to address issues of price stability and related expectations.
77. It is generally recognised that persistence of high inflation not only operates as a tax on the poor but also undermines economic growth and macroeconomic stability in several ways. While the objectives of monetary policy in India are growth and price stability, the relative emphasis depends on the context. In the prevailing conditions of growth, price and financial stability, unequivocal relative emphasis on stability is warranted in the current context for several reasons. High growth benefits all but the benefits to the poor accrue in a lagged fashion. While the benefits of high growth often percolate to the poor with a time lag, the impact of high prices has no such time lag and is, in fact, immediate. Furthermore, the impact of inflation is asymmetrical in our society since only about ten per cent of the work-force, which is in the organised sector, has an inflation hedge, while the rest do not have any inflation hedging mechanism. Moreover, the adverse impact of inflation on the poor would be particularly severe if the prices of basic necessities of life increase. Hence, a determined and co-ordinated effort by all to contain inflation without unduly impacting the growth momentum is not only an economic necessity but also a moral compulsion. To the extent the current inflationary pressures are attributable to monetary conditions, it is essential to undertake appropriate measures, in continuation of those already taken and in the light of anticipated developments.
78. In our economy, large segments of economic agents may not have adequate resilience to withstand volatility in currency and money markets. A large segment of population is at a level of living which would warrant minimising the risk of large disruption in their monetary and financial conditions, however temporary it may be. These factors lend additional weight in favour of monetary stability and avoidance of imbalances in the financial system. The Reserve Bank’s policies are, therefore, vigilant to any indications of volatility in currency and money markets.
79. On the basis of available evidence, global growth continues to be strong but is exhibiting mixed patterns. Global imbalances continue to grow, but no immediate correction or hard landing is anticipated. In the global financial markets, current indications suggest that the risks remain under-priced and it is debatable as to whether this is on account of ex ante excess saving or under-investment. There are indications that the risks have become more diversified. It is important to recognise, however, that these risks do not disappear. Consequently, there is an increasing discomfort of the possibility of tail risk materialising. The incentive mechanism of large financial intermediaries, especially hedge funds, tends to under-price risks in such situations. International futures markets are predicting that current levels of crude prices may hold, at least over the next six months. Consequently, the concern surrounding the imbalances has shifted to the evolution of global liquidity and unknown risks. There are some forecasts which suggest that external flows to emerging markets would moderate in the coming months and, along with monetary policy tightening and reduction in oil surpluses, would reduce global liquidity. In brief, the outlook is more unclear than before and geo-political risks remain significant, requiring a close and careful monitoring of their evolution.
80. The experience of several emerging economies in recent months has shown that sharp movements in exchange rates can take place in a very short period even when no changes in fundamentals are noticed. It is true that recent episodes in the EMEs did not involve contagion and that these economies have shown resilience in bouncing back, aided by prompt and appropriate policy responses. The fact remains that in these affected EMEs, there has been extreme volatility in financial markets, unrelated to fundamentals, which cause disruptions to normal activity and leave some permanent impact on the real sector balance sheets. There is, therefore, increasing recognition among policymakers of the need to contain extreme volatility in capital flows and, in some cases, consequent liquidity conditions also.
81. At this point in time, the conduct of monetary policy is confronted with three important issues. First, demand pressures appear to have intensified, reflected in rising inflation, high money and credit growth, elevated asset prices, strains on capacity utilisation, some indications of wage pressures and widening of the trade deficit. Second, there are increased supply side pressures in evidence from prices of primary articles. Third, monetary policy will have to contend with the lagged response of productive capacity and infrastructure to the ongoing expansion in investment. By current indications, monetary policy may have to reckon with the accentuation of some of the identified pressures warranting reinforcement of the stance and actions articulated in the Annual Policy Statement of April 2006 and subsequent reviews. As in the past, the conduct of monetary policy depends on multiple indicators and recourse to multiple instruments which encompasses, besides the standard monetary measures, prudential measures as well, due to segmentation in the financial markets and evolving market orientation of large financial intermediaries.
82. Evolving conditions underscore the importance of persevering with further withdrawal of policy accommodation in a timely manner to ensure both price and financial stability. A judicious balancing of weights assigned to monetary policy objectives would accord priority to stability in order to support growth on a sustained basis. Accordingly, an appropriate response in terms of policy stance and monetary measures is warranted at this juncture. In essence, the conduct of monetary policy in India at the current juncture involves operating on three mutually influencing and interacting tracks: ensuring price stability while recognising the objective reality of lags in monetary policy efficacy; anchoring inflation expectations which, in turn, depend on public perceptions as well as the sources of inflationary pressures; and contending with rising asset prices.
83. It is essential to recognise the links between accelerating inflation and escalating asset prices, even when no view is taken on the appropriateness of such levels of asset prices. Large movements in asset prices impact consumer demand through wealth effects and often, accelerating inflation tends to encourage investments in assets as a hedge. Thus, concerted actions in fiscal, external, monetary and prudential policies would be appropriate to meet such mutually reinforcing situations. In this background, provisioning requirements in the banking sector are being enhanced to sectors such as real estate, capital markets and consumer loans.
84. The continued high credit growth in the real estate sector, outstanding credit card receivables, loans and advances qualifying as capital market exposure and personal loans is a matter of concern. Furthermore, the data reveal higher default rates in regard to credit card receivables and personal loans. It has, therefore, become imperative to increase the provisioning requirement in respect of the standard assets in the aforesaid four categories of loans and advances (excluding residential housing loans) to two per cent from the existing level of one per cent. The provisioning requirement in respect of residential housing loans will remain unchanged at 0.4 per cent for loans up to Rs.20 lakh and at one per cent for loans in excess of Rs.20 lakh. It has also been decided to increase the provisioning requirement for banks’ exposures in the standard assets category to the non-deposit taking systemically important non-banking financial companies (NBFCs) to two per cent from the existing level of 0.4 per cent and to increase the risk weight for banks’ exposure to such NBFCs to 125 per cent from the existing level of 100 per cent. Provisioning requirements and risk weights for banks’ exposures to asset finance companies will remain unchanged. In order to ensure continued and adequate availability of credit to highly productive sectors of the economy, the risk weights for all other categories of exposures also remain unchanged. Similarly, the provisioning requirements in regard to agricultural loans, loans to SMEs and loans to industry, in general, remain unchanged.
85. Asset prices in capital markets as well as in real estate are influenced by relative fiscal incentives and external sector policies, in addition to overall liquidity conditions. There is merit in moderating additions to liquidity from large capital inflows and, hence, some changes in administered rates relating to non-resident deposits are considered appropriate. These have to be viewed as part of several measures undertaken to moderate liquidity with a view to enabling continuous re-balancing in the relative emphasis between growth and price stability, including financial stability.
86. A sizeable increase in Non-Resident (External) Rupee Account [NR(E)RA] and Foreign Currency Non-Resident (Banks) [FCNR(B)] deposits has been observed in 2006-07 so far. At the same time, there are reports of large growth in advances being granted against such deposits. It may be recalled that, based on the prevailing monetary conditions, the interest rate ceilings on NR(E)RA and FCNR(B) deposits have been reviewed on an ongoing basis and have been adjusted on several occasions. In the current context, it has been decided to reduce the interest rate ceilings on NR(E)RA and FCNR(B) deposits by 50 basis points and 25 basis points, respectively. Furthermore, keeping in view the objective of making these facilities available to individual NRIs and considering the prevailing monetary conditions, there is merit in avoiding upward pressure on asset prices in sensitive sectors through utilisation of this facility. Pending a review of the extent of large advances to high net worth individuals, banks are being prohibited from granting fresh loans in excess of Rs. 20 lakh against the NR(E)RA and FCNR(B) deposits, either to depositors or to third parties. Banks are also being advised not to undertake artificial slicing of the loan amount to circumvent the ceiling.
87. In recognition of the rising inflationary pressures, the Government of India has moved in a determined fashion in recent weeks to contain inflation expectations. With a view to reducing manufacturing costs, customs duty on specified capital goods and parts thereof, project goods and extensions has been reduced from 12.5/10 per cent to 7.5 per cent. The duty on inorganic chemicals, base metals of primary and semi-finished form, ferro-alloys, stainless steel and other alloy steel has been reduced to 5.0 per cent. Portland cement has been exempted from customs duty. In order to contain pressures from prices of essential commodities, the customs duty on edible oils has been reduced, in addition to exempting maize, wheat and pulses. Furthermore, a ban has been imposed on forward trading of tur and urad to minimise price volatility. While the recent actions taken by the Government are welcome and support the continuum of monetary measures undertaken since October 2004, it is important to reiterate that effective containment of inflationary pressures is best served by a combination of fiscal, external and supply management policies, supplemented and complemented by ongoing implementation of monetary measures.
88. Inflation, to the extent it is a monetary phenomenon, demands timely and credible monetary policy actions, recognising the lagged effects of such policies. Thus, the current package of measures should be viewed not only as complementing the lagged effects of the actions already taken but also as meeting the emerging pressures on price stability, and more importantly, inflationary expectations. The monetary measures are meant to complement the fiscal and supply-side measures already undertaken in the recent period. This is in consonance with the Annual Policy Statement for 2006-07 as well as the Mid-Term Review which state that the policy endeavour is to contain year-on-year inflation for 2006-07 in the range of 5.0 to 5.5 per cent. The objective of the policy measures being undertaken at the current juncture would be to bring the inflation as close as possible to the stated range of 5.0 to 5.5 per cent at the earliest, while continuing to pursue the medium-term goal of a ceiling on inflation at 5.0 per cent.
89. Over the remaining part of the year, management of liquidity would receive priority in the policy hierarchy. Consequent to the tightening of market liquidity, the impact of monetary policy is expected to be stronger than before. The Reserve Bank would use all policy instruments, including the CRR, to ensure the appropriate modulation of liquidity in responding to the evolving situation. It is important to note that bank credit continues to grow at a rapid pace for the third year in succession and the rates of growth are clearly excessive, warranting measures to moderate growth even after accounting for the relatively low level of credit penetration in our country and the structural transformation of the economy that is underway. Banks have been drawing down their investments in gilts sizeably to accommodate credit demand, including to levels close to the minimum SLR in some cases. Mismatches between the sources and uses of funds persist. The system level incremental non-food credit-deposit ratio remains high at 91 per cent, but at even higher levels for some banks. The depletion of SLR investments by banks has resulted in anomalous situations in which call rates have firmed up to the ceiling of the LAF corridor and beyond even when reverse repo bids have been received under the LAF and funds have been absorbed from the system. This indicates that some banks are clearly overdrawn in terms of both collateral and cash, necessitating recourse to rollovers at the short end of the market spectrum and consequent pressures on liquidity and interest rates. Banks need to recognise that shortage of SLR securities could constrain their recourse to LAF liquidity, which can turn adverse in critical times, forcing them to resort to uncollateralised exposures and attendant risks. Banks should be aware that accessing the Reserve Bank’s window for funds should be for very temporary periods and for equilibrating very short-term mismatches. The use of such resources for on-lending by banks needs to be eschewed.
90. The Reserve Bank will ensure that appropriate liquidity is maintained in the system so that all legitimate requirements of credit are met, particularly for productive purposes, consistent with the objective of price and financial stability. Towards this end, the Reserve Bank will continue with its policy of active demand management of liquidity through open market operations (OMO) including the MSS, LAF and CRR, and using all the policy instruments at its disposal flexibly, as and when the situation warrants.
91. In sum, barring the emergence of any adverse and unexpected developments in various sectors of the economy and keeping in view the current assessment of the economy including the outlook for inflation, the overall stance of monetary policy in the period ahead will be:
To reinforce the emphasis on price stability and well-anchored inflation expectations while ensuring a monetary and interest rate environment that supports export and investment demand in the economy so as to enable continuation of the growth momentum.
To re-emphasise credit quality and orderly conditions in financial markets for securing macroeconomic and, in particular, financial stability while simultaneously pursuing greater credit penetration and financial inclusion.
To respond swiftly with all possible measures as appropriate to the evolving global and domestic situation impinging on inflation expectations and the growth momentum.