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Stance of Monetary Policy for 2003-04

48. The overall stance of monetary policy in 2002-03 outlined in annual policy Statement of 2002 was as follows:

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

· In line with the above, to continue the present stance on interest rates including preference for soft interest rates.

· To impart greater flexibility to the interest rate structure in the medium-term.

49. In line with its monetary policy stance, liquidity conditions during the year were very comfortable. This is evident from the higher average volume of repo tenders under the liquidity adjustment facility (LAF) during the year. The average outstanding volume of LAF repo was higher around Rs.11,300 crore during 2002-03 as compared with Rs.3,500 crore during 2001-02. Though the real GDP growth turned out to be lower than that expected in the annual policy Statement of April 2002 because of widespread drought, the Reserve Bank continued with the policy of ensuring adequate liquidity in the financial system for supporting industrial revival noticed during the year.

50. The sharp accretion to foreign currency assets of RBI posed some challenges for liquidity management during the year. During 2002-03, the net foreign currency assets of RBI (net of revaluation) increased by as much as Rs.82,090 crore. The monetary impact of such large inflows had to be neutralised by conduct of substantial outright OMO sales. The net outright OMO sales of government securities were Rs.53,780 crore during the year. As a result, the reserve money expansion was Rs.30,960 crore. Despite the intervention of RBI through sterilisation, the interest rate did not firm up as adequate liquidity could be maintained in the system through judicious LAF operations of RBI.

51. Notwithstanding the comfortable liquidity position emanating from the foreign exchange build up, RBI made further progress in meeting its medium-term objective of reduction in the cash reserve ratio (CRR). The CRR was reduced from 5.5 per cent to 5.0 per cent in June 2002 and further to 4.75 per cent in November 2002 augmenting the lendable resources of banks by about Rs.10,000 crore.

52. In order to stabilise interest rate expectations, the Reserve Bank had signalled its intention, in advance, of reducing the Bank Rate by up to half a percentage point (50 basis points) in the annual policy Statement of April 2002 if warranted by the evolving liquidity and credit situation. After reviewing the liquidity and monetary conditions, the Bank Rate was reduced by 25 basis points to 6.25 per cent, and repo rate under the LAF was also reduced by 25 basis points to 5.5 per cent in the mid-term Review of October 2002. The repo rate under the LAF was further reduced to 5.0 per cent on March 3, 2003.

53. As inflation remained benign for most part of the year, despite the impact of drought and higher oil prices, there was general reduction in market interest rates. The overnight call money rates remained stable and almost overlapped the repo rate. The yields on 91-day and 364-day Treasury Bills and dated government securities of various maturities ruled much lower than yields at the beginning of the financial year. This enabled the large market borrowing programme of the Government to be completed at a low cost without unduly affecting the general interest rate structure. During the last three years (March 2000 - March 2003), the yields on 91-day Treasury Bills, 364-day Treasury Bills and government securities of residual maturity of 10 years have declined substantially from 9.17 per cent, 9.93 per cent and 10.85 per cent in that order to the level of 5.89 per cent, 5.89 per cent and 6.21 per cent, respectively.

54. Despite drought conditions and volatility in international oil prices, the inflation rate remained benign till January 2003 but has picked up since then. The point-to-point inflation rate in 2002-03 (on March 29, 2003) was significantly higher at 6.2 per cent (as compared with 1.6 per cent on March 30, 2002). The recent price increase was, however, confined to a few commodities - essentially mineral oils (because of the Iraq war), and drought-related items (oilseeds, edible oils, oil cakes and fibres). Excluding price increase due to such items (with an aggregate weight of 15.4 per cent), the inflation rate for the remaining basket works out to 2.7 per cent as compared with 1.5 per cent last year. Considerable uncertainties still remain on the inflation front due to current geopolitical uncertainties. Further, from the viewpoint of the domestic economy, the progress of the South-West monsoon is important so that supply constraints, which could have an adverse impact on inflation, do not emerge. Movements in international oil prices over the next few months cannot also be predicted as there are uncertainties in the aftermath of the Iraq war. As such, the inflationary situation needs to be watched closely. There is no room for complacency on this account. For the present, however, it is proposed to continue with the policy of maintaining adequate liquidity in the system and a soft interest rate environment. In case demand pressures emerge and the inflationary situation worsens, which hopefully will not be the case, the present monetary policy stance may have to be reviewed.

55. The monetary policy framework has changed over the recent period in response to reforms in the financial sector. The Reserve Bank’s endeavour has been to enhance the allocative efficiency of the financial sector, preserve financial stability and improve the transmission mechanism of monetary policy by moving from direct to indirect instruments. A number of steps have been taken to ensure balanced development of various segments of the financial market as also to preserve its integrity and transparency. The operationalisation of the Clearing Corporation of India Limited (CCIL), negotiated dealing system (NDS), introduction of collaterialised borrowing and lending obligation (CBLO), prudential limits on uncollateralised call/notice money market and encouragement of collateralised repo transactions, and introduction of interest rate options would increase the depth of the financial market. This process would get a further boost with the operationalisation of the real time gross settlement (RTGS) system.

56. The Reserve Bank is committed to the implementation of the “Core Principles for Effective Banking Supervision” drawn up by the Basel Committee on Banking Supervision. In order to achieve full compliance with these principles, steps have been taken in a phased manner, to move towards a system of consolidated supervision, for enhancing the role of external auditors, strengthening corporate governance, internal controls and audit procedures, increasing transparency and disclosure in the balance sheets of banks. An off-site monitoring system was introduced gradually and extended to cover co-operative institutions also.

57. In addition to the initiatives in areas of regulation and supervision, RBI continues to foster institutional structures and mechanisms which would strengthen the existing financial infrastructure. These include setting up of a Credit Information Bureau (CIB), introduction of a mechanism for corporate debt restructuring (CDR), NPA management, technology upgradation and legal aspects. Banks and financial markets have responded well to RBI’s regulatory and advisory initiatives. The perceptible improvement recorded by banks is reflected in certain key performance parameters, viz. reduction in net NPA ratio and increase in the capital adequacy ratio.

58. The fiscal deficit of the Central Government, which was budgeted at 5.3 per cent of GDP for 2002-03, was revised upwards to 5.9 per cent. For the year 2003-04, the fiscal deficit is placed at 5.6 per cent of GDP and the market borrowing programme of the Centre is estimated at Rs.1,66,230 crore (gross) and Rs.1,07,194 crore (net). While the market borrowing programme in respect of some States has come under stress, RBI hopes to conduct debt management without serious pressure on overall liquidity and interest rates unless there is a change in the overall macroeconomic situation due to unanticipated domestic or external developments.

59. For the purpose of monetary policy formulation, real GDP growth in 2003-04 is placed at about 6.0 per cent after taking into account the current trends in the various macroeconomic factors. Subject to satisfactory spatial distribution, if rainfall is around 96 per cent of the long term average (as per advance forecast released by India Meteorological Department on April 16, 2003), recovery in agricultural output may be over 3.1 per cent during 2003-04 (which is the estimated decline in output during 2002-03). A recovery in agricultural output coupled with the continuance of the upturn in the industrial and the services sectors should help in achieving the projected growth for 2003-04.

60. While assessing the inflationary outlook for 2003-04, the following major developments in the economy will have to be borne in mind:

· The higher base level of prices at the end of March 2003.

· The expected decline in oil prices (which had picked up during the last quarter of 2002-03).

· Expectation regarding behaviour of the monsoon in 2003-04.

Based on the present assessment of relevant factors, the inflation rate in 2003-04 on a point-to-point basis may be placed in the range of 5.0 to 5.5 per cent. As pointed out earlier, the increase in inflation in the last quarter for 2002-03 was dominated by certain commodities such as edible oils, oil cakes and mineral oils. While prices of edible oils increased sharply because of drought, domestic mineral oil prices increased substantially in the wake of the sharp rise in international oil prices. The prices of these items are, as of now, expected to decline during the course of the year. It is important to initiate measures which, through a strong “pass through” effect, will help to soften the prices of commodities which showed unusual rise last year. Timely domestic action would help in further reducing the projected rate of inflation, which would be highly desirable for monetary and financial management.

61. Consistent with the expected GDP growth and inflation, the projected expansion in broad money (M3) for 2003-04 is placed at 14.0 per cent. As the projected expansion of money supply is on a higher base, including the mergers that took place in the banking industry, the volume of liquidity would be adequate to meet the credit needs of the productive sectors of the economy. Consistent with this order of growth in M3, an increase in aggregate deposits of scheduled commercial banks is set at Rs.1,79,000 crore. Non-food bank credit including investments in commercial paper, shares/debentures/bonds of PSUs and private corporate sector is projected to increase by 15.5-16.0 per cent, which should be adequate to facilitate the sustenance of growth in industrial activity during 2003-04.

62. The Bank Rate changes, combined with CRR and repo rate changes, have emerged as important tools of liquidity and monetary management. The LAF has evolved as 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 prudential limits placed on banks and PDs in their operations in the call money market, and gradual phasing out of non-banks from the call money market, are expected to bring integrity to this market, contribute to development of repo/term money market and further help to strengthen the channels of monetary transmission. With most of the procedural and technological upgradation being put in place, RBI’s efforts to make LAF more effective will continue. The Reserve Bank will also continue its efforts to bring about development and smooth functioning of the financial markets.

63. An issue of policy interest for financial management by banks and other market participants is whether, after a sharp decline in the past 2-3 years, interest rates have bottomed out. As is well known, the outcome for interest rates depends heavily on the outlook for inflation, growth prospects and investment demand and it is not possible to predict short-run movement 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.

64. On balance of probabilities, given normal conditions and overall stability in macroeconomic environment, in view of several structural constraints, the present nominal and real interest rates are relatively low. There may not be significant potential for further sizeable downward movement in interest rates. Some important structural factors that contribute to inflation and nominal interest rates in India – which are generally somewhat higher than those in industrial or fast-growing emerging market economies – are:

(a) the fixation of some food and other procurement prices by the Government which has an important impact on determining the prices of these items, which have a high weightage in price indices;

(b) the need for adjusting several administered food and other subsidies that increase the burden on current expenditure, which contributes to continuing high fiscal deficit; and

(c) the existence of relatively rigid wage structures with built-in inflation related increases in wages, dearness allowances etc. in the organised sector.

65. The above structural factors, which are generally not prevalent in most industrial and emerging market economies, impart an upward bias to sustained price increases from year to year, particularly during the upward phase of the business cycle. It is important to continue efforts over the medium-term to reduce the impact of these factors in order to facilitate greater downward flexibility and a sustainable soft interest rate climate.

66. In sum, as per present assessment and barring the emergence of any adverse and unexpected developments in the various sectors of the economy, the overall stance of monetary policy for 2003-04 will be:

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

· In line with the above, to continue with the present stance of preference for a soft and flexible interest rate environment within the framework of macroeconomic stability.

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