Part I. Annual Statement on Monetary Policy for the Year 2008-09
II. Stance of Monetary Policy for 2008-09
83. The Third Quarter Review of January 29, 2008 had noted with concern the unfolding of global developments and the responses of monetary authorities which seemed to provide an indication of the threat to growth and financial stability worldwide. Consequently, developments in global financial markets in the context of the subprime crisis warranted more intensified monitoring and swift responses with all available instruments to preserve and maintain domestic macroeconomic and financial stability. In addition, risks to inflation from high and volatile international prices of fuel, food and metal prices had intensified, complicating the task of monetary authorities in assuaging liquidity and solvency stress in financial markets and institutions. It was also indicated that liquidity management will continue to assume priority in the conduct of monetary policy. In this context, financial markets continued to be under careful and continuous surveillance with a readiness to respond flexibly and pre-emptively to ensure orderly liquidity conditions, particularly in the context of the management of volatile and large movements in capital flows. Against this backdrop, it was emphasised that monetary policy has to be vigilant and proactive in cushioning the real economy from excess volatility in financial markets while recognising that India cannot be totally immune to global developments. Accordingly, the Third Quarter Review reaffirmed the stance of monetary policy set out in the Annual Policy Statement of April 2007 and subsequent Reviews of reinforcing the emphasis on price stability and well-anchored inflation expectations while ensuring a monetary and interest rate environment conducive to continuation of the growth momentum and orderly conditions in financial markets. While credit quality continued to receive priority, credit delivery, in particular, for employment-intensive sectors was emphasised while pursuing financial inclusion. Reckoning global factors as becoming increasingly relevant even though domestic factors dominated the policy stance, the Third Quarter Review committed to monitor the evolving heightened global uncertainties and the domestic situation impinging on inflation expectations, financial stability and the growth momentum in order to respond swiftly with both conventional and unconventional measures, as appropriate.
84. It is observed that domestic financial markets have not been seriously impacted by the turbulence overseas, except for equity markets which have reflected the widespread risk aversion and the increase in uncertainty in the international financial environment. On the other hand, localised factors such as banks' balance sheet adjustments in the run-up to the year-end closure of accounts, advance tax flows and sizeable movements in Government cash balances produced large swings in market liquidity. Consequently, the LAF switched from an absorption mode up to mid-February into persistent daily injections during the rest of the month. In the first half of March, the LAF returned to moderate daily absorption, but switched into sizeable liquidity injections during March 17-31, as expected. In accordance with the priority assigned to liquidity management in the Third Quarter Review, MSS auctions were held in abeyance from mid-February 2008 in view of the tightening of liquidity conditions. Furthermore, in pursuance of the policy of active demand management of liquidity using all the policy instruments flexibly, including the option to conduct overnight or longer term repo/reverse repo under LAF, additional arrangements were instituted at the request of a number of banks in view of the schedule of advance tax payments in mid-March 2008 and the subsequent bank holidays (March 20-22, 2008). As stated earlier, additional LAF operations on March 14, 17 and 31, 2008 were held to enable banks to manage year-end liquidity conditions. MSS auctions were resumed from April 9, 2008 in conjunction with LAF reverse repos to manage large surpluses in financial markets. These liquidity management operations have, by and large, smoothed market interest rates and enabled their orderly evolution. It is important to recognise, however, that the unwinding of the specific factors currently in evidence will have implications for the evolution of market liquidity in the period ahead in an environment of heightened uncertainty and volatility in global markets and the danger of potential spillovers to domestic equity and currency markets. Against this backdrop, liquidity management will continue to receive priority in the hierarchy of policy objectives, going forward. In particular, the volatility in capital flows and in cash balances of the Government will continue to necessitate active liquidity management with a combination of instruments as warranted.
85. Notwithstanding the moderation in industrial activity which was anticipated in the Mid-Term Review and the Third Quarter Review, the outlook for sustaining the underlying growth momentum appears to be reasonably well embedded into the medium-term. In the Third Quarter Review, it was indicated that while the moderation in private consumption expenditure merits consideration, a disaggregate analysis of supply and demand factors across select sectors would enable appropriate public policy responses. The recent measures announced in the Union Budget 2008-09 to inter alia raise personal disposable incomes and to reduce and rationalise excise duties reflects this approach. Institutional and procedural changes to improve credit delivery to productive sectors, especially those with relatively higher employment intensity, have been undertaken by the Reserve Bank. Going forward, the combination of these measures should provide a conducive environment for the revival of consumption demand. Investment demand is robust and likely to remain the driving force of overall economic activity, powered by rising domestic saving, ongoing improvement in productivity and the actualisation of the sizeable expansion of supply capabilities that has been underway since 2003-04. At the same time, it is important to recognise that the threats to growth and stability from global developments have increased considerably with highly uncertain likelihood of early resolution. Besides the dangers surrounding the unfolding of events in international financial markets referred to earlier, potential inflationary pressures from international food and energy prices appear to have amplified and, by current indications, are likely to remain so for some time. Furthermore, there is now much higher probability of a global economic and credit slowdown than was anticipated till recently.
86. Initial forecasts predict a near-normal rainfall at 99 per cent of the long period average for the country as a whole in the 2008 south-west monsoon season, auguring well for the sustenance of trend growth in agriculture. The expected decline in world GDP growth in 2008 in relation to the preceding year could temper the prospects of growth in the industrial and service sectors at the margin although the underlying momentum of expansion in these sectors is likely to be maintained. In view of these factors, overall, for policy purposes, real GDP growth in 2008-09 may be placed in the range of 8.0 to 8.5 per cent, assuming that (a) global financial and commodity markets and real economy will be broadly aligned with the central scenario as currently assessed and (b) domestically, normal monsoon conditions prevail.
87. 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 new adversities emanating in the domestic or global economy, the policy endeavour would be to bring down inflation from the current high level of above 7.0 per cent to around 5.5 per cent in 2008-09 with a preference for bringing it as close to 5.0 per cent as soon as possible, recognising the evolving complexities in globally transmitted inflation. The resolve, going forward, would continue to be to condition policy and perceptions for inflation in the range of 4.0-4.5 per cent so that an inflation rate of around 3.0 per cent becomes a medium-term objective consistent with India's broader integration into the global economy and with the goal of maintaining self-accelerating growth over the medium-term.
88. Money supply has risen above indicative projections persistently through 2005-07 on the back of sizeable accretions to the Reserve Bank's foreign exchange assets and a cyclical acceleration in credit and deposit growth, particularly the latter, in 2007-08. In view of the resulting monetary overhang, it is necessary to moderate monetary expansion and plan for a rate of money supply in the range of 16.5-17.0 per cent in 2008-09 in consonance with the outlook on growth and inflation so as to ensure macroeconomic and financial stability in the period ahead. Consistent with the projections of money supply, the growth in aggregate deposits in 2008-09 is placed at around 17.0 per cent or around Rs.5,50,000 crore. Based on an overall assessment of the sources of funding and the overall credit requirements of the various productive sectors of the economy, the growth of non-food credit including investments in bonds/debentures/shares of public sector undertakings and private corporate sector and commercial paper (CP) is placed at around 20.0 per cent in 2008-09 consistent with the monetary projections.
89. The escalated levels of international food and crude prices carry some pressures for the external sector. On the whole, it is prudent to assume for policy purposes a continued strong and sustainable external sector though with a marginally higher order of overall trade and current account deficits in 2008-09 than in the preceding year. It is likely that net capital flows would comfortably meet the external financing requirements in 2008-09.
90. The Union Budget for 2008-09 has placed the GFD at 2.5 per cent of GDP for 2008-09, down from 3.1 per cent in the revised estimates for 2007-08 and within the FRBM target. The revenue deficit has been placed at 1.0 per cent of GDP in 2008-09, rescheduled from the target on account of enhanced allocations for the social sector. The net market borrowing programme of the Centre for 2008-09 is budgeted at Rs.99,000 crore as against Rs.1,10,727 crore in the previous year. The moderate reduction in the size of the Government borrowing programme is consistent with the path of the GFD envisaged in the FRBM.
91. Fiscal developments, especially on account of evolving expenditure commitments related to the implementation of the farm debt waiver scheme, the recommendations of the Sixth Pay Commission, issuance of Government bonds to oil and fertiliser companies to cover their under-recoveries/subsidy need to be continuously monitored in view of the prevailing conditions characterised by high and volatile global food prices and the incomplete pass-through of the escalation of international crude prices to prices of domestic petroleum products.
92. The heightened uncertainty surrounding global financial markets and the unusual policy responses of major central banks provides some indications of the threats to global growth and stability that loom over the near-term horizon. High volatility, still frozen credit markets and massive losses suffered by large financial institutions could impact India's external financing conditions — trade, capital flows and asset prices — and, therefore, the evolving monetary policy stance in 2008-09. While India's foreign trade is well-diversified and the reliance on external finance has averaged around one per cent of GDP, domestic activity and sentiment cannot remain immune to these developments. The major source of the direct impact is through the financial flows, in particular, in the equity markets and, consequently, on the foreign exchange market in India.
93. Recent global developments have considerably heightened the uncertainty surrounding the outlook on capital flows to India, complicating the conduct of monetary and liquidity management. In view of the strong fundamentals of the economy and massive injections of liquidity by central banks in advanced economies, there could be sustained inflows, as in the recent past. If the pressures intensify, it may necessitate stepped up operations in terms of capital account management and more active liquidity management with all instruments at the command of the Reserve Bank. At the same time, it is necessary in the context of recent global events not to exclude the possibility of reversals of capital flows due to any abrupt changes in sentiments or global liquidity conditions. In this scenario, it is important to be ready to deal with potentially large and volatile outflows along with spillovers. In this context, there is headroom with the Reserve Bank to deal with both scenarios in terms of the flexibility in the deployment of instruments such as the MSS, the CRR, the SLR and the LAF for active liquidity management in both directions, complemented by prudential regulations and instruments for capital account management.
94. In assessing the prospects for the global economy in 2008-09, it is useful to recognise the anticipated global slowdown and heightened uncertainties in addition to mounting inflationary pressures. Whether the slowdown would have a moderating effect on inflationary pressures or whether the global economy would slip into stagflation is not yet clear. Inflationary pressures seem common to the global and our domestic economy with some elements of contagion. Overall, uncertainties in regard to the Indian economy, however, appear less relative to those in the global economy and moderation in growth rather than a significant slowdown appears likely in the case of India. In regard to the interaction between global and national economies, some early signs of revival of protectionism are seen globally, especially in regard to food and fuel policies. This makes the assessment of impact of the global economy on India, particularly in regard to inflation and capital flows, extremely difficult. However, domestic factors will continue to dominate the policy setting, with a contextual emphasis on inflation expectations while recognising the significance of maintaining hard-earned gains in terms of both outcomes of and positive sentiments on India's growth momentum.
95. In brief, given the unprecedented complexities involved and the heightened uncertainties at this juncture, there are some key factors that govern the setting of the stance of monetary policy for 2008-09. First, there is the immediate challenge of escalated and volatile food and energy prices which possibly contain some structural components. It is necessary, however, to recognise that there are also cyclical components in their evolution. Second, while demand pressures persist, there has been some improvement in the domestic supply response alongside a build-up of additional capacities, enabled by a conducive policy environment. Accordingly, even as investment demand remains strong, supply elasticities can be expected to improve further and new capacities should come on stream in the months ahead. Third, monetary policy has lagged and cumulative effects as demonstrated in the positive outcomes relating to growth and stability at the current juncture, barring recent episodes of external shocks. Calibrated monetary policy actions undertaken since September 2004 thus continue to have some stabilising influence on the economy. Further, the very recent initiatives in regard to supply-management by the Government of India and measures relating to the cash reserve ratio by the Reserve Bank are in the process of impacting the economy, while a more reliable assessment of crop prospects is underway. Fourth, critical to the setting of monetary policy is the importance of anchoring expectations relating to both global and domestic developments. Accordingly, policy responses for managing expectations should consider the evolving global and domestic uncertainties surrounding the slowing down of global output growth and also the potential for exaggerated bearishness in the Indian context. Fifth, while monetary policy has to respond proactively to immediate concerns, it cannot afford to ignore considerations over a relatively longer term perspective of, say, one to two years, with respect to overall macroeconomic prospects. At the same time, it is critical at this juncture to demonstrate on a continuing basis a determination to act decisively, effectively and swiftly to curb any signs of adverse developments in regard to inflation expectations. In view of the above unprecedented uncertainties and dilemmas, it is important to take informed judgements with regard to the timing and magnitude of policy actions; and such judgements need to have the benefit of evaluation of incoming information on a continuous basis.
96. The Reserve Bank will continue with its policy of active demand management of liquidity through appropriate use of the CRR stipulations and open market operations (OMO) including the MSS and the LAF, using all the policy instruments at its disposal flexibly, as and when the situation warrants.
97. In sum, barring the emergence of any adverse and unexpected developments in various sectors of the economy, assuming that capital flows are effectively managed, and keeping in view the current assessment of the economy including the outlook for growth and inflation, the overall stance of monetary policy in 2008-09 will broadly be:
To ensure a monetary and interest rate environment that accords high priority to price stability, well-anchored inflation expectations and orderly conditions in financial markets while being conducive to continuation of the growth momentum.
To respond swiftly on a continuing basis to the evolving constellation of adverse international developments and to the domestic situation impinging on inflation expectations, financial stability and growth momentum, with both conventional and unconventional measures, as appropriate.
To emphasise credit quality as well as credit delivery, in particular, for employment-intensive sectors, while pursuing financial inclusion.
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