Part I. Annual Statement on Monetary Policy for the Year 2006-07
II. Stance of Monetary Policy for 2006-07
78. The Third Quarter Review of January 24, 2006 noted that risks to growth and stability are high from rising domestic demand, the incomplete pass-through of crude prices into domestic prices and from global developments. Emphasising the need to shore up the gains of recent high growth, the monetary policy stance was articulated in favour of a greater emphasis on price stability through measured but timely and even pre-emptive policy action to anchor inflation expectations. Accordingly, the fixed reverse repo rate and the repo rate under the LAF were increased by 25 basis points each, thereby maintaining the corridor of 100 basis points. Given the emphasis on price stability, the Reserve Bank resolved to ensure a conducive interest rate environment and to provide appropriate liquidity to meet genuine credit needs and thereby support export and investment demand.
79. Developments in the ensuing months vindicate this pro-active monetary policy stance. With inflation contained and inflationary expectations evolving consistent with the policy stance, real growth has quickened in an environment of price and financial stability, raising expectations of a structural shift in the medium-term growth path of the economy. Monetary policy has been particularly effective in ensuring that the cost-push impulses from oil prices have not fed through into aggregate demand conditions. In the external sector, the current account deficit has remained within manageable proportions, comfortably financed by buoyant capital flows. The exchange rate has exhibited two-way movements.
80. Monetary management during 2005-06 was conducted broadly in conformity with the stance of the policy set out in the policy statements during the year. First, in terms of macroeconomic outcome, the GDP growth rate turned out to be better than anticipated. Second, the headline inflation was lower than projected earlier. Third, while interest rates firmed up at the shorter end, the long-term interest rates were stable, possibly indicating more stable inflation expectations. Fourth, though non-food credit growth exceeded the earlier projections, a substantial part of it came from a shift in asset portfolio by reduction in banks’ investments which was made possible because of unwinding of MSS securities without undue pressure on interest rates. Fifth, deposit growth and money supply growth were higher than the projections made at the beginning of the year. Sixth, the money and government securities markets have, by and large, been stable and there was a large shift of overnight transactions from the uncollateralised market to the collateralised markets. Seventh, the movements in the exchange rate continue to be orderly despite volatility in major currencies. Eighth, the current account remained in deficit due to a larger trade deficit partly capturing the impact of oil prices and, more importantly, reflecting improved buoyancy in economic activity. There was a modest increase in foreign exchange reserves though capital inflows were sustained. Ninth, the domestic business outlook continues to remain buoyant. Notwithstanding these favourable outcomes, monetary management faced some challenges in maintaining stable liquidity conditions particularly in the last quarter of 2005-06.
81. While the concerns on price and financial stability have been reasonably managed, an important aspect of the conduct of monetary policy in recent months has been the modulation of liquidity in tune with the evolving situation. The Third Quarter Review characterised pressures on liquidity as partly frictional and arising from seasonal and transient factors such as the IMD redemption, and partly cyclical and associated with the upturn in credit demand. Since mid-January 2006, however, the recourse of market participants to primary liquidity support from the Reserve Bank suggests that there has been an overlap between frictional and structural liquidity on account of two factors. First, some market participants had not prepared for the liquidity implications of the movements in the interest rate cycle as also the one-off impact of IMD redemption and, as a consequence, found themselves facing a shortage of liquidity as well as eligible securities with which to access the Reserve Bank’s liquidity facilities or even the collateralised money markets. Second, the banking system as a whole was significantly overdrawn in order to sustain the credit disbursements and mismatches between the sources and uses of funds became persistent, forcing them to seek recourse to borrowing and rolling over on an overnight basis, thereby putting pressure on interest rates and liquidity conditions.
82. Observing the emergence of such trends, the monetary policy statement of April 2005 specifically alluded to the liquidity risks in the following manner: "… banks are taking increasing recourse to non-deposit resources to fund their assets. Against this background, banks are urged to refocus on deposit mobilisation…". Recourse to external borrowings or capital market instruments for raising resources and also for deployment of resources in the conditions prevailing in our country are meant basically to smoothen the diversified business of banks and not become their core activity. The banks are again urged to review their business strategies so that they are in a position to combine longer term viable financing with profitability in operations, recognising the reality of business cycles and counter cyclical monetary policy impulses. Greater efforts aimed at financial inclusion will also contribute to robust deposit mobilisation. A key aspect of the commitment to stability will be a renewed emphasis on credit quality, while simultaneously pursuing greater credit penetration and financial inclusion. Banks would need to focus on stricter credit appraisals on a sectoral basis, monitor loan to value ratios and generally ensure the health of credit portfolios on a durable basis.
83. The growth in money supply in 2005-06 was above the trend. This situation of above normal growth in money supply coupled with a perception of liquidity issues in the banking sector warrants some exploration. While it is difficult to precisely define, assess or measure such factors, it is possible to note some relevant developments in this regard. First, mutual funds have considerable access to funds on a large scale. During 2005-06, mobilisation by mutual funds increased manifold, partly reflecting a low base, as against 16.9 per cent year-on-year growth in bank deposits during the same period. Second, the equity markets have displayed considerable buoyancy. Capital issues have experienced no difficulty in garnering resources and most have been oversubscribed. Third, the real estate sector gives an impression that there are no significant resource constraints for that sector.
84. Turning to the outlook, while global growth has broadened further over the past few months, the risks to sustaining this expansion have remained significant. First, oil prices remain volatile with an upside bias. The risks of higher energy prices are difficult to gauge; although the full impact of recent oil price increases may take time to materialise, a more complete pass-through to both growth and inflation can be expected in the future as capacities for absorbing these increases are progressively declining. Second, current account imbalances seem set to widen over the next two years, with the US current account deficit exceeding 7 per cent of GDP in 2007, while China, Japan, the oil-exporting countries and, to a smaller extent, emerging Asia, move into larger surpluses. There is a growing consensus that the size of the imbalances has exceeded the capacity of markets to bring about an adjustment and that there has to be concerted policy intervention of some form to enable a soft landing. Third, a number of monetary authorities have moved in the direction of tightening their monetary policy stance in response to global uncertainties including potential inflationary pressures. In major advanced economies, interest rates are being raised in tandem and the indications are that further tightening is due in the rest of 2006. While financial markets have generally coped well with the shift in the global interest rate cycle, the potential adverse consequences for consumption demand, household debt, equity and other asset prices and the ability of developing countries to raise and service external debt amplifies the risks and uncertainties emanating from recent global developments. These factors will have a crucial bearing on the conduct of monetary management as India progressively integrates into the global economy.
85. India’s linkages with the global economy are getting stronger and are increasingly reflected in BoP developments. Robust improvements have occurred on several fronts, underpinning the growing openness of the economy. Merchandise exports have surged ahead of the growth of world trade, drawing strength from a distinct firming up of activity in the domestic economy and sustained external demand. Software exports remained resilient and vigorous in the face of the IT slowdown worldwide and remittances from expatriate Indians rose strongly, making India one of the largest recipients of such flows. Accordingly, the degree of openness – merchandise and invisibles transactions taken together instead of the conventional ratio based on merchandise trade alone – is estimated to have reached 45 per cent of GDP in 2004-05 from about 20 per cent in 1990-91. The growing integration is driven not by a greater import dependence but by rising foreign exchange earnings, with the share of current receipts to GDP having improved from 8.2 per cent in 1990-91 to 22.1 per cent in 2004-05. In the capital account too, there are distinct signs of openness, with the ratio of foreign investment to GDP rising from negligible levels in 1990-91 to 1.7 per cent by 2004-05 and expected to rise further in 2005-06. Equity flows constitute more than half of net capital flows to India. In contrast to the 1980s, when more than 80 per cent of net capital flows comprised official flows, it is private capital flows which dominate the capital account currently. By March 2006, India had accumulated the sixth largest stock of international reserves in the world, sufficient to finance 11 months of imports and nearly five years of debt servicing. On the other hand, the debt/GDP ratio declined from 28.7 per cent in 1990-91 to 17.4 per cent in 2004-05.
86. As part of the recent changes in the institutional framework of monetary policy in India, a Technical Advisory Committee (TAC) on Monetary Policy with external experts in the areas of monetary economics, central banking, financial markets and public finance was set up by the Reserve Bank in July 2005 with a view to strengthening the consultative process of policy formulation. The TAC meets on a quarterly basis, reviews macroeconomic and monetary developments and advises on the stance of monetary policy. The TAC has met four times since its inception and has contributed to enriching the inputs and processes of policy setting.
87. The Government of India is considering amendments to the Reserve Bank of India Act, 1934 and Banking Regulation Act, 1949 for enhancing the Reserve Bank’s operational flexibility. The proposed amendments to the RBI Act pending approval from the Parliament, inter alia, propose to give more manoeuvrability to the Reserve Bank in its monetary management by giving discretion to decide on cash reserve ratio (CRR) and statutory liquidity ratio (SLR).
88. These developments, including the FRBM Rules, warrant a review of the operating framework of monetary policy in India. Within the multiple indicator approach adopted in India, there has been a distinct preference for indirect instruments over direct instruments. Furthermore, underlying changes in the market conditions, the emergence of the call money market as a pure inter-bank market, migration of activity from the uncollateralised call money market to the collateralised segments such as market repos and CBLO, the withdrawal of the Reserve Bank from primary financing of the fiscal deficit and the emergence of sizeable fiscal cash balances as an offset to market liquidity provide evidence of a paradigm shift in the operating environment. Open market operations (OMO) are set to increase in importance as an operating instrument. The MSS was designed as an instrument of sterilisation to deal with foreign exchange inflows of a durable nature so that the LAF window is essentially utilised for the purpose of day-to-day liquidity management and not a tool for absorption/injection of liquidity by the Reserve Bank on a sustained basis. In fact, with the operationalisation of the MSS in April 2004, the pressure on the LAF for sterilisation declined considerably. In the context of the FRBM, the activation of OMO will further enable the LAF to be even more focused on the role for which it has been designed.
89. Typically, the overnight market rate should lie in the middle of the policy corridor. In India, LAF repo/reverse repo rates provide the corridor within which short-term interest rates are expected to fluctuate. Over the years, the LAF rate corridor has emerged as an important tool of monetary management and any variation in LAF rate(s) is perceived by the market as short-term interest rate signals arising from a change in the monetary policy stance. In India, however, in surplus conditions, the overnight rate has typically remained near the lower end of the LAF corridor, swiftly rising to the upper end of the corridor in deficit conditions. Thus, the overnight rates are reflective of market conditions and the weighted average overnight rate, which effectively reflects activity in the money market should be providing guidance for fine tuning monetary policy operations. There has also been a progressive narrowing of the corridor from 200 basis points up to March 2004 to 150 basis points in April 2004, to 125 basis points in October 2004 and finally to 100 basis points since April 2005.
90. The India Meteorological Department is yet to release its forecast for the South-West monsoon rainfall for the current year. However, under the assumption of a normal monsoon, an accelerated growth in agriculture is possible. Despite some uncertainties, the overall industrial outlook continues to be positive. Services sector growth is expected to sustain its momentum. Overall, for policy purposes, GDP growth may be placed in the range of 7.5-8.0 per cent during 2006-07 assuming accelerated growth in agriculture under normal monsoon conditions and barring domestic or external shocks.
91. Headline inflation for 2005-06 was lower than anticipated. While increased competition and productivity gains in several sectors have also contributed to some moderation in inflation in the recent period, policy measures have ensured low and stable inflation expectations. The pass-through of international oil price increase has been only partial and the second round effects in India have so far turned out to be lower than anticipated earlier. Taking into account the real, monetary and global factors having a bearing on domestic prices, containing inflationary expectations would continue to pose a challenge to monetary management. The policy endeavour would be to contain the year-on-year inflation rate for 2006-07 in the range of 5.0-5.5 per cent.
92. For the purpose of monetary policy formulation, the expansion in M3 is projected at around 15.0 per cent for 2006-07. While this indicative projection is consistent with the projected GDP growth and inflation, since there is an overhang of above-trend growth in money supply in the preceding year, in normal circumstances, the policy preference would be for maintaining a lower order of money supply growth in 2006-07. The growth in aggregate deposits is projected at around Rs.3,30,000 crore in 2006-07. Non-food bank credit including investments in bonds/debentures/shares of public sector undertakings and private corporate sector and commercial paper (CP) is expected to increase by around 20 per cent. It needs to be noted that this projected growth of non-food credit implies a calibrated deceleration from a growth of above 30 per cent ruling currently.
93. Higher oil prices and improvement in absorptive capacity of the economy have resulted in a larger trade deficit. This was partly offset by net invisibles, indicative of the rising international competitiveness of India’s invisible exports and remittances from Indian nationals working overseas. The current account has remained in deficit for the second consecutive year in 2005-06. Net capital inflows have adequately financed the current account deficit and, as per the current assessment, these trends are likely to continue in 2006-07. The current account deficit appears largely sustainable in the light of continued resilience of the external sector.
94. The Union Budget has placed the fiscal deficit at 3.8 per cent of GDP for the year 2006-07 as against 4.1 per cent in the previous year in the spirit of the FRBM Act, 2003. The net market borrowing programme of the Centre for 2006-07 is budgeted at Rs.1,13,778 crore as against Rs.95,370 crore in the previous year. While the size of the Government borrowing programme is relatively larger than in the previous year, this has to be viewed in the backdrop of the buoyant growth of the economy, growing appetite of non-banks for government securities and the need for many banks to strengthen their SLR portfolio for statutory as also for liquidity management purposes.
95. Against the backdrop of developments during 2005-06 so far, the stance of monetary policy would depend on macroeconomic developments including the global scenario. A key factor is the assessment of the risks in as accurate a manner as is feasible. In this context, it is necessary to be in readiness to act as warranted to meet the challenges posed by the evolving situation, given the unfolding of the risks.
96. Domestic macroeconomic and financial conditions support prospects of sustained growth momentum with stability in India. It is important to recognise, however, that there are risks to both growth and stability from domestic as well as global factors. At the current juncture, the balance of risks is tilted towards the global factors. The adverse consequences of further escalation of international crude prices and/or of disruptive unwinding of global imbalances are likely to be pervasive across economies, including India. Moreover, in a situation of generalised tightening of monetary policy, India cannot afford to stay out of step. It is necessary, therefore, to keep in view the dominance of domestic factors as in the past but to assign more weight to global factors than before while formulating the policy stance.
97. 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 and financial 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 all the policy instruments at its disposal flexibly, as and when the situation warrants.
98. 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 at this juncture will be:
• To ensure a monetary and interest rate environment that enables continuation of the growth momentum consistent with price stability while being in readiness to act in a timely and prompt manner on any signs of evolving circumstances impinging on inflation expectations.
• To focus on credit quality and financial market conditions to support export and investment demand in the economy for maintaining macroeconomic, in particular, financial stability.
• To respond swiftly to evolving global developments.
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