Part I. Annual Statement on Monetary Policy for the Year 2007-08
II. Stance of Monetary Policy for 2007-08
89.Against the backdrop of sustained momentum of growth in the industrial and service sectors, somewhat clouded by supply pressures from deceleration in agriculture, the Third Quarter Review of January 31, 2007 noted that the outlook for inflation assumes criticality in terms of policy monitoring and action. A judicious balancing of weights assigned to monetary policy objectives warranted priority to stability to support growth on a sustained basis. At the time of the Third Quarter Review, the conduct of monetary policy was confronted with a variety of challenges; demand pressures appeared to have intensified; and increased supply side pressures in terms of primary articles as well as some manufactured items seemed to be in evidence. Recognising the lagged response of productive capacity and infrastructure to the ongoing expansion in investment, the Third Quarter Review warned of the possibility of accentuation of inflationary pressures in the period ahead. Drawing from the analysis of inflation dynamics, it was emphasised that effective containment of inflation is best served by a combination of fiscal, external and supply management policies supplemented and complemented by ongoing monetary measures.
90.It was indicated that inflation, to the extent it is a monetary phenomenon, demands appropriate timely and credible monetary policy actions. Timing of measures is key, conditioned by the recognition that monetary policy operates cumulatively and with variable, often long, lags. Accordingly, a three-pronged approach was adopted in the Third Quarter Review – a measured 25 basis points increase in the LAF repo rate to address demand pressures; enhanced provisioning requirements and risk weights in specific sectors to shore up the quality of credit in the context of persisting high growth in bank credit; and, tightening of ceilings on interest rates on non-resident deposits coupled with prohibition on fresh loans in excess of a specified threshold to depositors or third parties so as to modulate these interest-sensitive inflows from abroad to ensure effective liquidity management. The overall stance of monetary policy for the period ahead reinforced the emphasis on price stability and well-anchored inflation expectations so as to enable continuation of the growth momentum. The priority assigned to credit quality and orderly financial markets was reinforced alongside the pursuit of greater credit penetration and financial inclusion. The policy stance was underpinned by a commitment to respond swiftly with all possible measures to developments impinging on inflation expectations and the growth momentum.
91.In the aftermath of the issue of the Third Quarter Review, some notable developments prompted a swift reinforcement of the monetary policy stance. With the pace of growth accelerating further as reflected in the buoyancy in industrial output and non-food bank credit, concerns about the accentuation of excess demand pressures seemed to be considerably heightened, particularly with the tightening of the supply constraints. Headline inflation surged to a two-year peak by end-January, with potential upside risks to inflation expectations and, therefore, warranting an immediate policy response. In sharp contrast, aggregate deposit growth rose to a 11-year high as banks aggressively mobilised funds to support over-extended credit portfolios. Consequently, the liquidity adjustment facility (LAF), which had been in an injection mode persistently during January 7–February 7, 2007 flipped into absorption mode in the following week (February 8-13) with additional liquidity absorbed under the MSS. Reflecting the large reversal of liquidity, the call money rate which was ruling 25-85 basis points above the repo rate, eased below the middle of the LAF corridor, indicating easing of liquidity conditions. It was considered necessary on February 13, 2007 to increase the CRR in two stages of 25 basis points each effective from the fortnights beginning February 17 and March 3, 2007. The increase in the CRR was intended to drain excess liquidity, pre-empt the stoking of demand pressures and contain inflation expectations. It was also consistent with the stance set out in the Third Quarter Review of responding swiftly to developments impinging on inflation expectations and the growth momentum.
92.Liquidity conditions emerged in the ensuing period as the dominant feature of the evolving situation. Consequently, liquidity management assumed priority in the policy hierarchy as prognosticated in the Third Quarter Review. Despite the cumulative increase in the CRR of 100 basis points between December 23, 2006 – March 3, 2007 which absorbed close to Rs.30,000 crore, the LAF continued to remain in sizeable absorption mode, indicating the continued prevalence of surplus liquidity in financial markets. A two-tiered approach was adopted on March 2, 2007 to deal with the large swings in liquidity and the analytical assessment of some durability in external inflows. First, it was decided to modulate the mix of Treasury bills and dated securities issued under the MSS with a view to draining away, for relatively longer periods, liquidity associated with those flows that were deemed to be of a more durable character. Accordingly, dated MSS securities amounting to Rs.16,000 crore with average residual maturity of 2.4 years were issued in March 2007 in addition to calendar-based Treasury bill auctions within the annual ceiling resulting in a total absorption of Rs.64,863 crore. Additional dated securities amounting to Rs.9,000 crore were issued in April 2007 (up to April 20, 2007). In view of the augmented and more active MSS operations envisaged, daily liquidity absorption under the LAF was restricted to a ceiling of Rs.3,000 crore. In consonance with this measure, strict adherence to LAF business rules was underscored. It was also indicated that the recourse to the LAF by market participants should not be persistent in order to fund balance sheets for credit needs of customers. Banks can utilise the LAF for inter-bank lending as part of normal money market functioning for management of temporary mismatches.
93.While indications of the sustained momentum of growth continued to firm up, inflation in terms of the WPI ruled stubbornly around 6.5 per cent up to March 23, 2007 with this persistence threatening to impact inflation expectations. In terms of consumer prices, inflation was even higher in the range of 7.6-9.8 per cent. Other indicators of demand pressures were also emitting warning signals - money supply at 22.0 per cent; non-food credit growth at 29.5 per cent; capacity constraints; pending import orders; pricing power of corporates as exemplified in the cement and steel sectors; wage pressures in some sectors; and rising input costs. Alongside these developments, there were large swings in liquidity and associated heightened volatility in the financial markets inconsistent with the prevailing monetary policy stance of tightening aggregate demand conditions to contain inflationary pressures and stabilise expectations. In spite of sizeable injections through the LAF, call money rates spiked to 50-60 per cent. There was also a large build-up of the cash balances of the Government with the Reserve Bank to Rs.77,726 crore on March 22, 2007 and the unwinding of these balances thereafter portended a large reversal of liquidity in April and a return to sizeable surplus conditions. In April 2006, i.e., a year ago, the reversal of these cash balances and consequent injection of liquidity into the system was of the order of Rs.70,000 crore. Furthermore, the mobilisation of deposits and expansion of non-food credit that typically occurs in the last fortnight of March, unwinds in April resulting in a return flow of liquidity. In April last year, this unwinding was of the order of Rs.48,000 crore. An additional source of autonomous liquidity injection into the system was from the increase in net foreign assets of the Reserve Bank and corresponding release of rupee liquidity into the system. During January 27–March 23, 2007 the Reserve Bank’s net foreign assets adjusted for revaluation increased by Rs.72,734 crore.
94.It is in the context of this scenario that it was considered necessary to reinforce the measures already taken for maintaining price stability and anchoring inflation expectations in order to sustain the growth momentum. Accordingly, the Reserve Bank announced monetary measures on March 30, 2007 with the objective of draining out liquidity and improving the efficacy of interest rate signals in the period ahead. The fixed repo rate under the LAF was increased by 25 basis points to 7.75 per cent with immediate effect. The CRR was increased by 50 basis points in two stages of 25 basis points each, effective from the fortnights beginning April 14 and April 28, 2007. The interest rate on eligible CRR balances was reduced from 1.0 per cent per annum to 0.5 per cent per annum beginning April 14, 2007. It was also indicated that the policy of withdrawal of semi-durable and durable elements of liquidity through the MSS would continue along with other arrangements relating to the operation of the LAF. The objective was to continue to demonstrate that inflation beyond the tolerance threshold of the Reserve Bank is unacceptable and that the resolve to ensure price stability is always backed by timely and appropriate policy responses.
95.Turning to the outlook for the Indian economy, growth prospects have brightened considerably in the wake of the 2006-07 record and appear well entrenched to build on the current momentum. There are indications that the pace of growth will continue to be supported by steady increases in the rate of gross domestic saving and some improvement in the efficiency of capital use. Accordingly, it is reasonable to expect that the underlying strength of investment demand is likely to be sustained in the medium-term, supported by consumption demand as per capita incomes grow. Currently, the expansion in demand is spurring sizeable additions to supply capabilities in terms of both addition of new capacity as well as more intensive and efficient utilisation/capitalisation of existing capacity. It is important to recognise, however, as pointed out in the Third Quarter Review of January 2007 that the addition to aggregate supply will occur with a lag. Lumpiness and ‘gestation’, that are inevitable in building production capacities, tend to delay the supply response to the impetus from aggregate demand and realisation of the capacity expansion could be constrained over the next two years. It should be recognised that international trade cannot, by its nature, fully mitigate all supply side issues among all sectors. Looking ahead, therefore, it is prudent to recognise that the first effects of the expansion in demand would be reflected in inflationary pressures and risks to macroeconomic and financial stability. These factors have been in evidence in the form of sustained demand for capital goods and consumer durables, high rates of money and credit, indications of wage pressures in some sectors, rising input costs and the emergence of pricing power. The overarching policy challenge is to manage the transition to a higher growth path while containing inflationary pressures.
96.On the basis of initial forecasts of rainfall at 95 per cent of the long period average for the country as a whole in the 2007 south-west monsoon season and a resumption of trend growth in agriculture, it is expected that the impulses for expansion will emanate from the industrial and service sectors in which growth seems to indicate an innate buoyancy going forward. At the same time, it is necessary to recognise that global GDP growth is expected to decline by 50 basis points in 2007 in relation to the preceding year. In view of these factors, overall, for policy purposes, real GDP growth in 2007-08 may be placed at around 8.5 per cent, assuming no further escalation in international crude prices and barring domestic or external shocks.
97.In view of the lagged and cumulative effects of monetary policy on aggregate demand and assuming that supply management would be conducive, capital flows would be managed actively and in the absence of shocks emanating in the domestic or global economy, the policy endeavour would be to contain inflation close to 5.0 per cent in 2007-08.
98.It may be recalled that the Reserve Bank had articulated a self-imposed medium-term ceiling on inflation at 5.0 per cent. There are indications supporting the belief that this approach has had a salutary effect on inflation expectations and the socially tolerable rate of inflation has come down. In recognition of India’s evolving integration with the global economy and societal preferences in this regard, the resolve, going forward, would be to condition policy and perceptions for inflation in the range of 4.0–4.5 per cent. This objective would be conducive for maintaining self-accelerating growth over the medium-term.
99.Money supply has remained well above indicative projections in 2005-06 and 2006-07. While high expansion in money supply has become a worldwide phenomenon, resulting in its progressive de-emphasis in monetary analysis, in a medium-term perspective and given the monetary overhang of 2005-07, it is important to contain monetary expansion in 2007-08 at around 17.0-17.5 per cent in consonance with the outlook on growth and inflation. Consistent with the projections of money supply, the growth in aggregate deposits in 2007-08 is placed at around Rs.4,90,000 crore. Based on an overall assessment of the sources of funding, a graduated deceleration of non-food credit including investments in bonds/debentures/shares of public sector undertakings and private corporate sector and commercial paper (CP) to 24.0-25.0 per cent in 2007-08 from the average of 29.8 per cent over 2004-07 is consistent with the monetary projections.
100.Recent trends in the evolution of the external sector of the economy are expected to continue to shape the outlook for the balance of payments. On the whole, the overall trade and current account deficits in 2007-08 are expected to be of the same order as in 2006-07. Net capital flows are also likely to adequately finance the expected current account deficit in 2007-08.
101.The Union Budget for 2007-08 has placed the fiscal deficit at 3.3 per cent of GDP for the year 2007-08 as against 3.7 per cent in the previous year in the spirit of the FRBM Act, 2003. The net market borrowing programme of the Centre for 2007-08 is budgeted at Rs.1,09,579 crore as against Rs.1,07,453 crore in the previous year. While the size of the Government borrowing programme is moderately higher than in the previous year, this has to be viewed against the backdrop of the buoyant growth of the economy, growing appetite of the non-bank segment for government securities and the need for many banks to strengthen their SLR portfolio for statutory as also for liquidity management purposes.
102.The stance of monetary policy in 2007-08 would be conditioned by the patterns in which the global and, more particularly, the domestic environment unfolds. The likely evolution of macroeconomic and financial conditions indicates an environment supportive of sustaining the current growth momentum in India. It is important to reiterate that monetary policy, while contributing to growth, has to ensure and maintain conditions of price and financial stability. Accordingly, the policy preference for the period ahead is strongly in favour of reinforcing the emphasis on price stability and anchoring inflation expectations.
103.The Reserve Bank will ensure that appropriate liquidity is maintained in the system so that all legitimate requirements of credit are met, particularly for productive purposes, consistent with the objective of price and financial stability. Towards this end, the Reserve Bank will continue with its policy of active demand management of liquidity through open market operations (OMO) including the MSS, LAF and CRR, and using all the policy instruments at its disposal flexibly, as and when the situation warrants.
104.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 in the period ahead will continue to be :
•To reinforce the emphasis on price stability and well-anchored inflation expectations while ensuring a monetary and interest rate environment that supports export and investment demand in the economy so as to enable continuation of the growth momentum.
•To re-emphasise credit quality and orderly conditions in financial markets for securing macroeconomic and, in particular, financial stability while simultaneously pursuing greater credit penetration and financial inclusion.
•To respond swiftly with all possible measures as appropriate to the evolving global and domestic situation impinging on inflation expectations and the growth momentum.
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