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Banking > Policies> Monetary and Credit Policy 2001-2002             Click here for FULL credit policy

Stance of Monetary Policy for 2001-02

39. During March 2001, the equity markets experienced considerable turbulence and uncertainty leading to problems in certain stock exchanges as well as liquidity/insolvency problems in some co-operative banks, which in turn affected certain commercial banks also. An important priority of the Reserve Bank during this difficult period was to try and minimise the "contagion" spreading from equity markets to money and government securities markets or to the banking system as a whole. In order to achieve this objective, it was necessary to provide assurance of sufficient collateralised liquidity to banks, and to take early action to prevent the problem affecting particular co-operative banks in one region from spreading to other financial institutions. By and large, so far, money market as well as government securities market have continued to function normally. Further, there has been no reduction in market liquidity in spite of some cases of payment delays/defaults. There has also been no immediate adverse impact of stock market turbulence on interest rates.

40. The recent experience in equity markets, and its aftermath, have thrown up new challenges for the regulatory system as well as for the conduct of monetary policy. It has become evident that certain banks in the co-operative sector did not adhere to their prudential norms nor to the well-defined regulatory guidelines for asset-liability management nor even to the requirement of meeting their inter-bank payment obligations. Even though such behaviour was confined to a few relatively small banks, by national standards, in two or three locations, it caused losses to some correspondent banks in addition to severe problems for depositors. In the interest of financial stability, it is important to take measures to strengthen the regulatory framework for the co-operative sector by removing "dual" control by laying down clear-cut guidelines for their management structure and by enforcing further prudential standards in respect of access to uncollateralised funds and their lending against volatile assets. In the light of recent experience, some corrective steps to prevent commercial banks from taking undue risks in their portfolio management are also outlined in Part III of this Statement.

41. The overall macroeconomic indicators, despite recent developments in the equity market, continue to be favourable for growth with price stability. As mentioned earlier, GDP growth is likely to be about 6.0 per cent in 2000-01 in line with the projection indicated in the Mid-term Review. The "headline" inflation rate at 4.9 per cent turned out to be lower than expected in the Mid-term Review. Excluding the petroleum sub-group, the inflation rate was 2.6 per cent as on March 31, 2001. The external sector was also comfortable during the year as a whole with exports doing well and current account deficit expected to be considerably lower than 2.0 per cent of GDP. Money supply growth was also by and large in line with projected trajectory and the recent Budget has signalled a firm commitment towards fiscal consolidation and reduction in fiscal deficit. The interest rates, after some hardening in mid-year, had softened in the later part of 2000-01. The primary yields in Treasury Bills of various maturities which had risen from a range of 7.0-9.2 per cent in April 2000 to close to 11.0 per cent in August 2000 have since declined to a range of 8.8-9.1 per cent by March 2001. The primary yield on 10-year government securities has fallen from a peak of 11.7 per cent in October 2000 to 10.7 per cent in January 2001. The secondary market yields have also moved in tandem with the primary market.

42. While there is still considerable uncertainty, it is widely expected that the world GDP growth would be substantially lower in 2001 compared with a high growth of about 5.0 per cent in the previous year, driven by the slowdown of the US economy. A favourable factor this year is that the international inflationary environment is reasonably benign. Low inflationary expectations have facilitated substantial reduction in international interest rates in order to revive economic activity in major industrial countries. India cannot but reckon the impact of these global developments though for several reasons, including its relatively small share of trade, GDP growth in India is unlikely to be as seriously affected by these developments, as in many other countries. While merchandise exports growth may slightly moderate, software exports with more diversified destinations and private remittances may still be maintained. The size of current account deficit is, therefore, expected to continue to be well within 2.0 per cent of GDP.

43. The fiscal deficit of the Central Government is budgeted at 4.7 per cent of GDP for 2001-02 and the borrowing programme of the Centre at Rs.1,18,852 crore (gross) and Rs.77,353 crore (net). While the borrowing programme in respect of some States has come under stress, RBI expects to conduct debt management without serious pressure on overall liquidity and interest rates.

44. Against this background, the Reserve Bank proposes to continue to ensure that all legitimate requirements for credit are met consistent with price stability. Towards this objective, the Reserve Bank will continue its policy of active demand management of liquidity through OMO, including two-way sale/purchase of Treasury Bills, and further reduction in CRR as and when required. Unless circumstances change unexpectedly, or current problems in some segments of the market are not resolved soon, on the present reckoning, it should also be possible to maintain the current interest rate environment, and explore the possibility of some further softening in medium and long-term rates over time, following the stance of interest rate flexibility announced in the recent Budget. However, as emphasized last year as well as in Part I of this Statement, in formulating their business plans, banks and financial institutions should be prepared for a reversal or tightening of monetary policy in case the underlying inflationary situation turns adverse or there are unfavourable and unexpected external developments.

45. A realistic projection of the overall growth rate for the current year 2001-2002 is presently difficult in view of uncertainties pertaining to the outlook for industrial growth. As mentioned above, the objective conditions for revival of growth are favourable, but the trend in growth of output and investment demand in the last quarter of the previous year has not been very encouraging. Assuming revival of the industrial sector from the next quarter, reasonable monsoon, and good performance of exports, for purposes of monetary policy formulation, for the year as a whole, growth rate of real GDP may be placed at 6.0 to 6.5 per cent. The rate of inflation is assumed to be close to that in the previous year, i.e., within 5.0 per cent; the projected expansion in broad money (M3) for 2001-02 is about 14.5 per cent. Consistent with prevailing elasticities, this order of growth in M3 would lead to an increase in aggregate deposits of scheduled commercial banks at about the same rate (or about Rs.1,34,000 crore). Non-food bank credit adjusted for investment in commercial paper, shares/debentures/bonds of PSUs and private corporate sector is projected to increase by 16.0 to 17.0 per cent. This magnitude of credit expansion is expected to adequately meet the credit needs of the productive sectors of the economy.

46. The Mid-term Review of October 1999 underlined the need to undertake concrete steps to remove certain inherent rigidities so that the interest rate structure can be made more flexible during different phases of the business cycle. Since then, there has been some easing of constraints on the flexibility of interest rates in the financial system as a whole. Assuming a continued positive outlook for inflationary expectations, further flexibility would be facilitated if consistent progress is made in certain directions. As emphasised in the Budget, there is urgent need for consistent and credible fiscal adjustment combined with flexibility in administered interest rates. The financial system should also improve its operational efficiency and aim at further reduction in cost of intermediation. In this regard, there is a need to improve the debt recovery system so that the burden of NPAs on the financial system is eased. Although banks have been given the freedom to quote flexible and variable rates on deposits, the bulk of the deposits are still at fixed rates which become unsustainable when lending rates are lowered. It is necessary for banks to undertake further improvements in operational efficiency and active liability management for interest rate flexibility in line with changes in the inflationary outlook. A reduction in fiscal deficit and overall government borrowing programme could facilitate easing the regulatory burden in the banking system by reducing the relatively high level of CRR. There is also a need to rationalise the tax regime so that tax-induced distortions in effective rates of return between different instruments and markets are avoided.

47. The Bank Rate changes by RBI combined with CRR and repo rate changes have emerged as signalling devices for interest rate changes and important tools of liquidity and monetary management. The Liquidity Adjustment Facility (LAF) introduced since June 2000 has proved to be an effective mechanism for absorbing and/or injecting liquidity on a day-to-day basis in a more flexible manner and, in the process, providing a corridor for the call money market. The experience with LAF has been satisfactory and RBI’s endeavour will be to make it more efficient, by removing some of the existing institutional, procedural and technological constraints. The Reserve Bank will also continue with its effort to bring about orderly development and smooth functioning of financial markets and takes further steps in financial sector reforms.

48. In sum, under normal circumstances and barring emergence of any adverse and unexpected developments in domestic or external sectors, the overall stance of monetary policy for 2001-02 will be:

Provision of adequate liquidity to meet credit growth and support revival of investment demand while continuing a vigil on movements in the price level.

Within the overall framework of imparting greater flexibility to the interest rate regime in the medium-term, to continue the present stable interest rate environment with a preference for softening to the extent the evolving situation warrants.

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