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Click Here For Highlights of RBI's Annual Policy Statement for 2005-06



Part I. Annual Statement on Monetary Policy for the Year 2005-06


II. Stance of Monetary Policy for 2005-06


50. Against the background of developments during 2004-05, the stance of monetary policy will depend on several factors, including macroeconomic prospects, global developments and the balance of risks. First, the outlook for growth in 2005-06, which should be noticeably better than the previous year, may get moderated by the conditions in oil markets which remain tight. Second, if the impact of mineral oil prices on WPI is isolated, the underlying inflationary pressures appear moderate. The supply factors will continue to dominate the price situation, while demand management seems to invite close attention. Third, the non-food credit during 2004-05 recorded its second highest growth in 55 years. There is evidence of increase in credit-elasticity of GDP and credit penetration. Hence, adequate credit growth needs to be ensured for productive sectors and the borrowing programme of governments accommodated, while closely assessing the implications for demand-management to maintain macro and price stability. In these circumstances, the liquidity management becomes critical. The interest rate outlook should take into account these domestic challenges but the increasing integration warrants some attention to global factors. Fourth, the borrowing programme of the Centre was unusually low in 2004-05. While the borrowing programme for 2005-06 is significantly higher than the previous year, it is in line with the magnitudes in 2002-03 and 2003-04, though the credit growth was sluggish in those years. Fifth, the current account, which was in surplus for three consecutive years, is turning into a deficit. The capital account continues to be in surplus in a significant way. Current indications are that these trends will continue in 2005-06 and, consequently, the external sector will exhibit strength and resilience, though unanticipated, globally-transmitted shocks cannot be ruled out.

51. The India Meteorological Department (IMD) in its forecast of South-West monsoon for the current year has placed the expected rainfall at 98 per cent of its long period average. With a normal monsoon, the growth in agriculture can be assumed to be around 3 per cent. Further, it is expected that industry and services sectors would maintain their current growth momentum while absorbing the impact of oil prices. The real GDP growth during 2005-06, on the basis of above assumptions, could be placed around 7.0 per cent for the purpose of monetary policy formulation.

52. A factor that complicates the conduct of monetary policy during certain periods is the difficulty encountered in precisely assessing the potential inflationary pressures based on the available data for the current period. First, the liquidity overhang which was reduced to a significant extent by December 2004, has since increased to levels witnessed at the beginning of 2004-05. Second, the international oil prices have again turned volatile with an upward pressure. Third, besides oil, the other primary commodity prices remain firm in international markets. Fourth, the full pass-through of international oil prices to domestic price has not taken place and fiscal manoeuvrability on this front is getting limited. Fifth, credit growth continues to remain buoyant. Finally, as against these factors, it must be recognised that there is evidence of increasing productivity in several sectors in the economy that could moderate pressures on prices. The level of food stocks and forex reserves provide cushions against some price increases. Further, the contextual analysis of WPI excluding mineral oils, on a point-to-point basis in 2004-05, worked out to 3.5 per cent as against 4.7 per cent in the previous year, which gives some indication of supply shock elements of WPI as distinct from what may be construed as core components of inflation. In view of these considerations governing current trends, the inflation rate in 2005-06, on a point-to-point basis, may be placed in a range of 5.0-5.5 per cent subject to the growing uncertainties on the oil front both in regard to global prices and their domestic absorption.

53. Consistent with the real growth of GDP and inflation, the projected expansion of money supply (M3) for 2005-06 is placed at 14.5 per cent. In tune with this order of growth in M3, increase in aggregate deposits of scheduled commercial banks is set at Rs.2,60,000 crore which is higher by 15.0 per cent over its level in the previous year. Non-food bank credit including non-SLR investments of banks is projected to increase by around 19.0 per cent. This magnitude of credit expansion is expected to meet adequately the credit needs of all the productive sectors of the economy.

54. For the year 2005-06, the Union Budget has placed the fiscal deficit at 4.3 per cent of GDP and the net market borrowing programme of the Centre is budgeted at Rs.1,10,291 crore as compared with Rs.46,050 crore in the previous year. While the borrowing programme of the Centre is much higher than that in the previous year, taking into account the normal market borrowing programme of States and the comparable level of borrowings of Centre and States in the years prior to 2004-05, the Reserve Bank expects to conduct debt management within the monetary projections for 2005-06 barring unexpected developments. In this regard, there is scope for accommodating continued growth in credit needs as well as the higher borrowing programme to the extent it is possible to unwind MSS to provide appropriate liquidity consistent with macro objectives.

55. Monetary policy would continue to enhance the integration of various segments of the financial market, improve credit delivery, nurture credit culture and enhance the quality of financial services. Given the volatility in the inflation rate during 2004-05, there is also a need to consolidate the gains obtained in recent years from reining in inflationary expectations. It is important to appreciate that, while sustained efforts over time have helped to build confidence in price stability, inflationary expectations can turn adverse in a relatively short time if noticeable adverse movements in prices take place. In the world economy, after a prolonged period of low inflation, there are signs that inflation may be edging up. The global oil markets continue to remain tight with higher prices and increased volatility. Credible commitment of policy to fight inflation is critical to stop translation of higher oil prices into wage-price spirals. In addition, the international prices of non-oil primary commodities may continue to remain firm. On the domestic front, the manoeuvrability on oil prices is getting limited and corporates have a higher probability of gaining their pricing power with a better industrial outlook. The pricing pressure, if it were to occur from the supply side, could get complicated by continuing overhang of excess domestic liquidity. While the economy has the resilience to withstand supply shocks, the upside risks do exist. As such, the inflationary situation needs to be watched closely and there could be no room for complacency on this count.

56. In the context of current inflation scenario, an issue of policy interest for financial management by banks and other market participants is whether the interest rate cycle has turned from the low observed during 2003-04. As is well known, the outcome for interest rates depends mainly on the outlook for inflation, growth prospects and investment demand and it is not possible to predict short-run movements in interest rates, either up or down, without taking cognizance of possible movements in all other macroeconomic variables. These variables are also subject to unanticipated changes because of unforeseen domestic or external developments. However, the system has to recognise interest rate cycles and strengthen risk management processes to cope with eventualities so that financial stability could be maintained and interest rate movements could be transited in a non-disruptive manner. In this regard, it is instructive to observe global trends as the Indian economy is progressively getting linked to the world economy. While there is an overhang of domestic liquidity, partly mirroring abundant global liquidity, the trends in global interest rates, inflation expectations and investment demand would also have some relevance in the evolution of the domestic interest rates. It will, therefore, be desirable to contain inflationary pressures to stabilise domestic financing conditions both for the governments and the private sector.

57. The Reserve Bank will continue to ensure that appropriate liquidity is maintained in the system so that all legitimate requirements of credit are met, consistent with the objective of price stability. Towards this end, RBI will continue with its policy of active demand management of liquidity through OMO including MSS, LAF and CRR, and using the policy instruments at its disposal flexibly, as and when the situation warrants.

58. In sum, barring the emergence of any adverse and unexpected developments in various sectors of the economy and keeping in view the inflationary situation, the overall stance of monetary policy for the year 2005-06 will continue to be as set out in the mid-term Review of October 2004, namely:

Provision of appropriate liquidity to meet credit growth and support investment and export demand in the economy while placing equal emphasis on price stability.

Consistent with the above, to pursue an interest rate environment that is conducive to macroeconomic and price stability, and maintaining the momentum of growth.

To consider measures in a calibrated manner, in response to evolving circumstances with a view to stabilising inflationary expectations.

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