Third Quarter Review of RBI Monetary Policy 2008-09
II. Stance of Monetary Policy
44. Since September 2008, international developments have largely circumscribed domestic policy responses. There have been severe disruptions in the international money and foreign exchange markets since September 2008. Policymakers in governments, central banks and in other regulating agencies of financial institutions around the world responded to the crisis with aggressive, radical and unconventional measures to restore calm and confidence in financial markets and bring them back to normalcy. The immediate challenge was to maintain financial stability, which moved up in the hierarchy of objectives.
Earlier Policy Measures
45. Global financial crisis also had spillover effects on financial markets in India causing an unusual tightening of liquidity in mid-September, which was compounded by transient local factors such as advance tax payments. The domestic equity market was severely affected by the global meltdown of asset prices. The foreign exchange market also came under pressure. Access to external financing was constrained following re-pricing of risks and higher credit spreads. Responding to the evolving situation, the Reserve Bank announced the following measures on September 16, 2008:
• A firm assurance to meet any demand-supply gaps of foreign exchange in the domestic foreign exchange market.
• A second LAF was re-introduced on a daily basis.
• Interest rate ceilings on FCNR(B) and NR(E)RA deposits were increased by 50 basis points each to LIBOR/swap rates minus 25 basis points and LIBOR/swap rates plus 50 basis points respectively.
• As a temporary measure, scheduled banks were allowed to avail of additional liquidity support under the LAF to the extent of up to one per cent of their net demand and time liabilities from their SLR portfolio and seek waiver of penal interest.
46. Liquidity conditions tightened further in October 2008 as contagion from the US financial crisis spread to Europe and Asia. Many central banks took co-rdinated actions to infuse liquidity in their jurisdictions. In addition, in order to enhance dollar liquidity, the US Fed provided currency swap lines to select central banks. Financial markets in Asia and Australia were also severely affected. The call money rate in the domestic market touched a peak of 19.8 per cent on October 10, 2008 with LAF repo volume crossing Rs.90,000 crore during the early part of October 2008. In view of persisting uncertainty in global financial markets and its impact on India and continuing shortage of liquidity reflected in repo volume, the following measures were taken by the Reserve Bank in October 2008:
• The CRR was reduced by 250 basis points from 9.0 per cent to 6.5 per cent effective from the fortnight beginning October 11, 2008.
• A 14-day special repo facility for a notified amount of Rs.20,000 crore was instituted to alleviate liquidity stress faced by mutual funds, and banks were allowed temporary use of SLR securities for collateral purposes by an additional 0.5 per cent of NDTL exclusively for this purpose.
• Commercial banks and all-India term lending and refinancing institutions were allowed to lend against and buy back certificates of deposit (CDs) held by mutual funds.
• The Reserve Bank temporarily provided a sum of Rs.25,000 crore as the first instalment under the Agricultural Debt Waiver and Debt Relief Scheme to scheduled banks and NABARD immediately, pending Parliamentary sanction and consequent release of funds by the Central Government.
• Interest rate ceilings on FCNR(B) and NR(E)RA deposits were increased further by 50 basis points each to LIBOR/swap rates plus 25 basis points and LIBOR/swap rates plus 100 basis points respectively.
• Banks were permitted to borrow funds from their overseas branches and correspondent banks to the extent of 50 per cent of their unimpaired Tier-I capital or US $ 10 million, whichever is higher.
• The Reserve Bank announced that it would institute special market operations to meet the foreign exchange requirements of public sector oil marketing companies against oil bonds when they become available.
• On October 20, 2008 the repo rate under the LAF was reduced by 100 basis points to 8.0 per cent.
• The systemically important non-deposit taking non-banking financial companies (NBFCs-ND-SI) were permitted to raise short-term foreign currency borrowings.
47. On the eve of announcement of the Mid-Term Review, external commercial borrowings (ECBs) up to US $ 500 million per borrower per financial year were permitted for rupee expenditure and/or foreign currency expenditure for permissible end-uses under the automatic route. Further, the all-in-cost ceiling for ECBs of average maturity period of three years and up to five years was raised to 300 basis points, and over five years, to 500 basis points above 6-month LIBOR.
48. Global financial conditions continued to remain uncertain and unsettled. Early signs of a global recession were evident by late October. Globally, commodity prices, including crude, began to abate which reduced domestic inflationary pressures. On the growth front, it was important to ensure that credit requirements for productive purposes were adequately met so as to support the growth momentum of the economy. Accordingly, the following measures were taken on November 1, 2008:
• The repo rate under the LAF was reduced by 50 basis points to 7.5 per cent with effect from November 3, 2008.
• The CRR was reduced by 100 basis points from 6.5 per cent to 5.5 per cent of NDTL.
• The statutory liquidity ratio (SLR), which was relaxed on a temporary basis earlier, was made permanent and reduced to 24 per cent of NDTL effective November 8, 2008.
• In order to provide further liquidity comfort, a special refinance facility for scheduled commercial banks (excluding RRBs) up to 1.0 per cent of each bank’s NDTL as on October 24, 2008 was introduced under Section 17(3B) of the Reserve Bank of India Act, 1934 up to a maximum period of 90 days.
• On October 15, 2008 the Reserve Bank introduced a 14-day special repo facility allowing banks to avail additional liquidity support exclusively for the purpose of meeting the liquidity requirements of mutual funds to the extent of 0.5 per cent of their NDTL. Subsequently, this facility was extended for NBFCs and the relaxation in the maintenance of the SLR was enhanced to the extent of up to 1.5 per cent of their NDTL.
• Buy-back of MSS dated securities was announced to provide another avenue for injecting liquidity to be calibrated with the market borrowing programme of the Government of India.
49. On November 7, 2008 Indian public and private sector banks that have foreign branches or subsidiaries were provided a forex swap facility of tenor up to three months with the Reserve Bank. Further, for funding the swap, banks were allowed to borrow under the LAF for the corresponding tenor at the prevailing repo rate.
50. There were indications that the global slowdown was deepening with a larger than expected impact on the domestic economy, particularly for the medium and small industry sector and export-oriented units. In the context of these developments, further augmenting rupee and forex liquidity, and strengthening and improving credit delivery mechanisms were needed for sustaining the growth momentum. Accordingly, the following measures were taken on November 15, 2008:
• The special term repo facility introduced for the purpose of meeting the liquidity requirements of MFs and NBFCs, was extended till end-March 2009. Banks can avail of this facility either on an incremental basis or on a rollover basis within the entitlement of up to 1.5 per cent of their NDTL.
• Interest rate ceilings on FCNR(B) and NR(E)RA deposits were further raised by 75 basis points each to LIBOR/swap rates plus 100 basis points and LIBOR/swap rates plus 175 basis points respectively.
• Housing finance companies (HFCs) registered with the National Housing Bank (NHB) were permitted to raise short-term foreign currency borrowings under the approval route.
• The Reserve Bank permitted Indian corporates to prematurely buy back their FCCBs at prevailing discounted rates.
• The period of entitlement of the first slab of pre-shipment rupee export credit was extended from 180 days to 270 days.
• The aggregate limit of export credit refinance (ECR) facility for scheduled banks (excluding RRBs) was enhanced from 15 per cent to 50 per cent of the outstanding export credit eligible for refinance.
• SIDBI and the NHB were allocated Rs. 2000 crore and Rs.1000 crore respectively against banks’ estimated shortfall in priority sector lending in March 2009.
• Banks were encouraged to use the special refinance facility under Section 17(3B) of the Reserve Bank of India Act, 1934 for the purpose of lending to micro and small enterprises.
• The provisioning requirements for all types of standard assets were reduced to a uniform level of 0.40 per cent, except in the case of direct advances to the agricultural and SME sectors which continue to attract provisioning of 0.25 per cent, as hitherto.
• Risk weights on banks’ exposures to all unrated claims on corporates, claims secured by commercial real estate and claims on NBFCs-ND-SI were reduced to 100 per cent from 150 per cent.
51. On November 28, 2008 the Reserve Bank announced the following measures for liquidity management and improving credit flows:
• The special refinance facility under Section 17(3B) of the Reserve Bank of India Act, 1934 introduced on November 1, 2008 was extended up to June 30, 2009.
• The special term repo facility was expanded to enable banks to accommodate the funding needs of HFCs. The facility was extended up to June 30, 2009.
• The forex swap facility of tenor up to three months was extended up to June 30, 2009.
• The period of entitlement of the first slab of post-shipment rupee export credit was extended from 90 days to 180 days.
52. The global outlook deteriorated further during December 2008. There were indications that the recession would be deeper and the recovery longer than anticipated earlier. There was also increasing evidence of slackening of domestic economic activity. The available data indicated that the demand for bank credit started moderating despite comfortable liquidity. The reduction in prices of petrol and diesel announced on December 5, 2008 further eased inflationary pressures. To improve the credit flow to productive sectors at viable costs so as to sustain the growth momentum, the Reserve Bank took the following measures on December 6 and 11, 2008:
• The repo rate was reduced under the LAF by 100 basis points from 7.5 per cent to 6.5 per cent and the reverse repo rate by 100 basis points from 6.0 per cent to 5.0 per cent, effective December 8, 2008.
• A refinance facility was introduced for SIDBI, NHB and EXIM Bank for Rs. 7,000 crore, Rs.4,000 crore and Rs.5,000 crore respectively. This facility will be available up to March 31, 2010.
• Authorised Dealers Category-I banks were permitted to consider applications for premature buy-back of FCCBs from their customers.
• Loans granted by banks to HFCs for on-lending for housing up to Rs.20 lakh per dwelling unit were classified under priority sector.
• Commercial real estate exposures restructured up to June 30, 2009 were allowed to be treated as standard assets. As a one-time measure, the second restructuring done by banks of exposures (other than exposures to commercial real estate, capital market exposures and personal/consumer loans) up to June 30, 2009 was also made eligible for concessional regulatory treatment.
• The prescribed interest rate as applicable to post-shipment rupee export credit (not exceeding BPLR minus 2.5 percentage points) was extended to overdue bills up to 180 days.
53. While domestic financial markets continued to function in an orderly manner, India’s growth trajectory was impacted both by the global financial crisis and the follow-on global economic downturn. This impact turned out to be deeper and wider than earlier anticipated. Concurrently, because of fall in global commodity prices coupled with supply and demand management measures at home, headline inflation was on the decline. Even as some public sector and private sector banks had cut lending rates in response to the Reserve Bank’s monetary policy stance, concerns over rising credit risk together with the slowing of economic activity appeared to have moderated credit growth. Accordingly, in order to stimulate growth, the Reserve Bank took the following further measures on January 2, 2009:
• The repo rate under the LAFwas reduced by 100 basis points from 6.5 per cent to 5.5 per cent with effect from January 5, 2009.
• The reverse repo rate under the LAF was reduced by 100 basis pointsfrom 5.0 per cent to 4.0 per cent with effect from January 5, 2009.
• The CRR was reduced from 5.5 per cent to 5.0 per cent of NDTL effective from the fortnight beginning January 17, 2009.
54. The Government has announced the setting up of a special purpose vehicle (SPV) for addressing the temporary liquidity constraints of systemically important non-deposit taking non-banking financial companies (NBFCs-ND-SI). The mechanism would be as follows: The SPV would issue government guaranteed securities to the Reserve Bank. The SPV will, in turn, use the funds to acquire only investment grade commercial papers and non-convertible debentures of the NBFCs. During its appraisal, the SPV will ensure that the NBFCs use the money only for addressing liquidity constraints and not for business expansion. The total support from the Reserve Bank will be limited to Rs.20,000 crore with an option to raise it by a further Rs.5,000 crore. The facility will be available for a limited period to address current liquidity concerns of NBFCs.
55. The cumulative reduction in the CRR by 400 basis points since mid-September 2008 released additional Rs.1,60,000 crore of primary liquidity. Unwinding of MSS has released primary liquidity of a little over Rs.63,000 crore. Further, potential liquidity has been made available through various refinance facilities for banks and financial institutions to the tune of Rs.80,000 crore. The term repo facility gives an additional potential liquidity of Rs.60,000 crore. The SPV for NBFC will augment potential liquidity by another Rs.25,000 crore. In sum, the actions of the Reserve Bank since mid-September 2008 have resulted in augmentation of actual/potential liquidity of over Rs.3,88,000 crore. In addition, the permanent reduction in SLR by 1.0 per cent of NDTL has made available liquid funds of the order of Rs.40,000 crore for the purpose of credit expansion
56. The liquidity situation has improved significantly following several measures taken by the Reserve Bank. The overnight call money rate, which generally hovered above the repo rate during September-October 2008, has softened considerably and has moved towards the lower bound of the LAF corridor since early November 2008. Other money market rates such as discount rate of CDs, CPs and CBLO rate softened in tandem with the overnight call money rate. The yield on 10-year government securities has remained below 6 per cent since mid-December 2008. The LAF window has been generally in an absorption mode since mid-November 2008. The liquidity problem faced by mutual funds appears to have eased considerably. Many commercial banks have reduced their benchmark prime lending rates since mid-November 2008.
57. The Reserve Bank’s Mid-Term Review of October 2008 had estimated real GDP growth for 2008-09 in the range of 7.5–8.0 per cent. Since then the outlook on real GDP growth has been affected further and the downside risks to growth have amplified because of slowdown of industrial activity and weakening of external demand as reflected in decline in exports. Services sector activities are likely to further decelerate in the second half of 2008-09. Keeping in view the slowdown in industry and services and with the assumption of normal agricultural production, the projection of overall real GDP growth for 2008-09 is revised downwards to 7.0 per cent with a downward bias.
58. Pressures on commodity prices have abated markedly around the world, reflecting slump in global demand. The sharp decline in crude oil prices together with the slide in prices of metals, foodgrains and cement has influenced inflation expectations in most parts of the world. In the domestic market, inflation in terms of the wholesale price index is already below 7.0 per cent, which was projected earlier for end-March 2009. While prices of manufactured products and of the fuel group have declined in line with international trends, inflation on account of primary articles still remains at the double digit level, reflecting sustained price pressures, particularly on food articles. As per current assessment, the inflation rate is expected to moderate further in the last quarter of 2008-09. Keeping in view the global trend in commodity prices and the domestic demand-supply balance, WPI inflation is now projected to decelerate to below 3.0 per cent by end-March 2009.
59. Notwithstanding the projected decline in headline WPI inflation, it needs to be noted that consumer price inflation is yet to moderate and the decline in inflation expectations has not been commensurate with the sharp fall in WPI inflation. Even within aggregate WPI inflation, the primary articles inflation is still in double digits. Similarly, WPI inflation excluding food and fuel remains higher this year as compared with the previous year. In view of the divergent movement of various price indices and their components, and overall increase in global economic uncertainties, an assessment of underlying inflation for policy purposes becomes inherently complex. With WPI inflation having moderated significantly, consumer price inflation would also decline, though with a lag. Towards its policy endeavour of ensuring price stability with well-anchored inflation expectations, the Reserve Bank will take into account the behaviour of all the price indices and their components.
60. The conduct of monetary policy would continue to condition and contain perception of inflation in the range of 4.0-4.5 per cent so that an inflation rate of around 3.0 per cent becomes the medium-term objective, consistent with India’s broader integration into the global economy and with the goal of maintaining self-accelerating growth over the medium-term. However, it is recognised that the headline WPI inflation could fall well below 3.0 per cent in the short-run partly because of the statistical reason of high base, and the global trends caused by exceptionally high oil and commodity prices in early 2008.
61. Monetary and credit aggregates continue to expand at a higher rate than projected in the Annual Policy Statement of April 2008. The liquidity overhang built-up in recent years due to unprecedented surge in capital inflows, however, is gradually diminishing. The Reserve Bank is committed to provide adequate liquidity for all productive activities on a continuous basis. As the upside risks to inflation have declined, monetary policy has been responding to slackening economic growth in the context of significant global stress. Accordingly, the projection of money supply (M3) growth for 2008-09 is raised to 19.0 per cent from 16.5-17.0 per cent earlier. Consistent with this, the aggregate deposit growth for 2008-09 is revised to 19.0 per cent from 17.0 per cent earlier. The projection of growth of adjusted non-food credit, including investment in bonds/debentures/shares of public sector undertakings and private corporate sector and CP, for 2008-09 is revised to 24.0 per cent from 20.0 per cent earlier. As always, these numbers are provided as indicative projections and not as targets.
62. As indicated earlier, India has been affected by the global financial crisis through the financial and real channels. There is considerable dismay about why this should be the case when, in fact, India’s financial system is sound and healthy, and its merchandise exports constitute only 13.5 per cent of GDP. The answer clearly is that India has rapidly integrated into the global system and has linkages with the rest of the world not just through trade channels, but also through two-way movements of capital and finance. As an integral part of a globalising world, India cannot be expected to remain immune to a global crisis of this nature and magnitude; and in responding to the crisis, India has to share the uncertainty on the way forward just like the rest of the world.
63. Both the Government and the Reserve Bank have acted to protect the economy from the adverse impact of the crisis. While the Government has announced two major fiscal stimulus packages, the endeavour of the Reserve Bank has been to provide ample rupee liquidity, ensure comfortable dollar liquidity and maintain a monetary policy environment conducive for the continued flow of credit to productive sectors. Towards this endeavour, the Reserve Bank has adopted both conventional measures such as, for example, reduction of the CRR, as well as unconventional measures such as, for example, the dollar swap facility for banks.
64. Measures aimed at expanding rupee liquidity included significant reduction in the CRR, a special repo window under the LAF for banks for on-lending to non-banking financial companies, housing finance companies and mutual funds, and a special refinance facility that banks can access without any collateral. The Reserve Bank is also unwinding the MSS securities roughly synchronised with the government borrowing programme in order to manage liquidity. In addition, an SPV is being set up to provide liquidity support to NBFCs.
65. Measures aimed at managing forex liquidity include upward adjustment of the interest rate ceilings on the FCNR(B) and NR(E)RA deposits, substantial relaxation of the ECB regime, allowing NBFCs/HFCs access to foreign borrowing and allowing corporates to buy back FCCBs to take advantage of the discount in the prevailing depressed global markets. The Reserve Bank has also instituted a rupee-dollar swap facility for banks with overseas branches to give them comfort in managing their short-term funding requirements.
66. Measures to encourage flow of credit to sectors that are coming under pressure include extension of the period of pre-shipment and post-shipment credit for exports, expansion of the refinance facility for exports, counter-cyclical adjustment of provisioning norms for all types of standard assets barring some exceptions, reduction of risk weights on banks’ exposure to certain sectors which had been increased earlier counter-cyclically, and expansion of the lendable resources available to the Small Industries Development Bank of India, the National Housing Bank and the Export-Import Bank of India.
67. To improve the flow of credit to productive sectors at viable costs so as to sustain the growth momentum, the Reserve Bank signalled a lowering of the interest rate structure by significantly reducing both its key policy rates – the repo rate and the reverse repo rate. The SLR has also been reduced by one percentage point releasing funds to banks for credit deployment.
68. In the context of tightening liquidity in the recent period, the major challenge for the Reserve Bank has been to infuse liquidity in the system and assure the markets that it will continue to maintain a comfortable liquidity position. Accordingly, the policy actions of the Reserve Bank since mid-September 2008 have resulted in the augmentation of active/potential liquidity in the system of over Rs.3,88,000 crore. The Reserve Bank has also assured market participants that it will endeavour to maintain the overnight money market rates within the LAF corridor. The Reserve Bank will continue to pursue this stance of ensuring ample liquidity in the market and maintaining the overnight money market rates within the LAF corridor. In order to do so, the Reserve Bank will, as in the past, employ both conventional and unconventional measures.
69. The Reserve Bank has acted aggressively and pre-emptively on monetary policy accommodation, particularly through interest rate cuts in terms of both magnitude and pace. In the space of just one quarter, the repo rate has been reduced from 9.0 per cent to 5.5 per cent and the reverse repo rate from 6.0 per cent to 4.0 per cent, thereby bringing down both of them to historically lowest levels. The transmission of the policy interest rate signal has been effective in the money and government securities markets; however, the transmission in the credit market has so far been subdued. Most banks have reduced lending and deposit rates to some extent, but a few have yet to do so. In the Reserve Bank’s view, the policy easing done by it in the last few months allows for considerable room for banks to respond more actively to the policy cues.
70. As indicated earlier, the demand for credit from the banking sector has increased as other sources of funds to the commercial sector have shrunk. Available information (as on January 23, 2009) suggests that the total flow of resources to the commercial sector from all sources, estimated at about Rs.4,85,000 crore during the fiscal year 2008-09 so far, has been lower than about Rs.4,99,000 crore in the corresponding period of the previous year. While bank credit has substituted for the shortfall in other sources of funds to some extent, a complete substitution has so far not taken place.
71. Given the uncertain outlook of resource availability from both external and non-bank domestic sources, the Reserve Bank has raised its indicative projection of total flow of credit from the banking sector to the commercial sector to 24.0 per cent for 2008-09 from 20.0 per cent envisaged in the Annual Policy Statement. With a view to enabling banks to sustain the current level of credit flow alongside an enhanced government market borrowing programme, the Reserve Bank’s monetary operations will be conducted so as to be consistent with the revised indicative money supply projection of 19.0 per cent for 2008-09, higher than the 16.5-17.0 per cent envisaged in the Annual Policy Statement.
72. To arrest the moderation in economic growth, it is critical that banks expand the flow of credit to productive sectors of the economy and do so at viable rates. At the same time, banks should monitor their loan portfolios and take early action to prevent delinquencies down the road, and safeguard the gains of the last several years in improving asset quality. The Reserve Bank appreciates that risk management is a difficult task in normal circumstances; it is even more challenging in an environment of uncertainty and downturn. Towards this shared endeavour of maintaining the flow of credit to productive sectors, the Reserve Bank will take calibrated monetary policy actions as necessary and at the appropriate time.
73. Although the origins of the crisis are common around the world, the crisis has impacted different economies differently. Importantly, in advanced economies where it originated, the crisis spread from the financial sector to the real sector. In emerging economies, the transmission of external shocks to domestic vulnerabilities has typically been from the real sector to the financial sector. Countries have responded to the crisis depending on their specific country circumstances. In particular, while policy responses in advanced economies have had to contend with both the financial crisis and recession, in India, the policy response has been predominantly driven by the need to arrest moderation in economic growth. Our ability to respond has been facilitated by the continued smooth functioning of our financial markets and the well-capitalised and healthy banking system. Thus, even as policy responses across countries are broadly similar, their precise design, quantum, sequencing and timing have varied. This has been the case with India too. While we have certainly studied and evaluated measures taken by other central banks around the world, we have calibrated and designed our responses keeping in view India’s specific economic context.
74. Keeping in view the above assessment of the global scenario and domestic economy, particularly the outlook on growth and inflation, the stance of monetary policy for the rest of 2008-09 will be as follows:
• Provision of comfortable liquidity to meet the required credit growth consistent with the overall projection of economic growth.
• Respond swiftly and effectively with all possible measures as warranted by the evolving global and domestic situation impinging on growth and financial stability.
• Ensure a monetary and interest rate environment consistent with price stability, well-anchored inflation expectations and orderly conditions in financial markets.
75. Given the uncertain outlook on the global crisis, it is difficult to precisely anticipate every development. The Reserve Bank will continue to maintain vigil, monitor domestic and global developments, and take swift and effective action to minimise the impact of the crisis and restore the economy to its potential growth path with price stability. The response to the Reserve Bank’s policy actions over the last several months is still unfolding. As demonstrated in the recent past, the Reserve Bank will act swiftly and decisively as and when evolving external and domestic conditions so warrant.
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