Annual Policy Statement for the Year 2009-10- 21st April 2009
Part I Annual Statement on Monetary Policy for the Year 2009-10
II. Stance of Monetary Policy 2008-09
53.The policy responses in India since September 2008 have been designed largely to mitigate the adverse impact of the global financial crisis on the Indian economy. The conduct of monetary policy had to contend with the high speed and magnitude of the external shock and its spill-over effects through the real, financial and confidence channels. The evolving stance of policy has been increasingly conditioned by the need to preserve financial stability while arresting the moderation in the growth momentum.
54.The thrust of the various policy initiatives by the Reserve Bank has been on providing ample rupee liquidity, ensuring comfortable dollar liquidity and maintaining a market environment conducive for the continued flow of credit to productive sectors. The key policy initiatives taken by the Reserve Bank since September 2008 are set out below:
• The policy repo rate under the liquidity adjustment facility (LAF) was reduced by 400 basis points from 9.0 per cent to 5.0 per cent.
• The policy reverse repo rate under the LAF was reduced by 250 basis points from 6.0 per cent to 3.5
• The cash reserve ratio (CRR) was reduced by 400 basis points from 9.0 per cent of net demand and time liabilities (NDTL) of banks to 5.0 per cent.
• The statutory liquidity ratio (SLR) was reduced from 25.0 per cent of NDTL to 24.0 per cent.
• The export credit refinance limit for commercial banks was enhanced to 50.0 per cent from 15.0 per cent of outstanding export credit.
• A special 14-day term repo facility was instituted for commercial banks up to 1.5 per cent of NDTL.
• A special refinance facility was instituted for scheduled commercial banks (excluding RRBs) up to 1.0 per cent of each bank’s NDTL as on October 24, 2008.
• Special refinance facilities were instituted for financial institutions (SIDBI, NHB and Exim Bank).
• The Reserve Bank sold foreign exchange (US dollars) and made available a forex swap facility to banks.
• The interest rate ceilings on non-resident Indian (NRI) deposits were raised.
• The all-in-cost ceiling for the external commercial borrowings (ECBs) was raised. The all-in-cost ceiling for ECBs through the approval route has been dispensed with up to June 30, 2009.
• The systemically important non-deposit taking non-banking financial companies (NBFCs-ND-SI) were permitted to raise short-term foreign currency borrowings.
• The risk-weights and provisioning requirements were relaxed and restructuring of stressed assets was initiated.
55. A detailed listing of various policy measures undertaken by the Reserve Bank since September 2008 is set out in Annex I.
56. The actions of the Reserve Bank since mid-September 2008 have resulted in augmentation of actual/potential liquidity of over Rs.4,22,000 crore. In addition, the permanent reduction in the SLR by 1.0 per cent of NDTL has made available liquid funds of the order of Rs.40,000 crore for the purpose of credit expansion
57. The liquidity situation has improved significantly following the measures taken by the Reserve Bank. The overnight money market rates, which generally hovered above the repo rate during September-October 2008, have softened considerably and have generally been close to or near the lower bound of the LAF corridor since early November 2008. Other money market rates such as discount rates of CDs, CPs and CBLO softened in tandem with the overnight money market rates. The LAF window has been in a net absorption mode since mid-November 2008. The liquidity problem faced by mutual funds has eased considerably. Most commercial banks have reduced their benchmark prime lending rates. The total utilisation under the recent refinance/liquidity facilities introduced by the Reserve Bank has been low as the overall liquidity conditions remain comfortable. However, their availability has provided comfort to the banks/FIs, which can fall back on them in case of need
58. The Reserve Bank has multiple instruments at its command such as repo and reverse repo rates, cash reserve ratio (CRR), statutory liquidity ratio (SLR), open market operations, including the market stabilisation scheme (MSS) and the LAF, special market operations, and sector-specific liquidity facilities. In addition, the Reserve Bank also uses prudential tools to modulate flow of credit to certain sectors consistent with financial stability. The availability of multiple instruments and flexible use of these instruments in the implementation of monetary policy has enabled the Reserve Bank to modulate the liquidity and interest rate conditions amidst uncertain global macroeconomic conditions.
59. The India Meteorological Department in its forecast of South-West monsoon expects a normal rainfall at 96 per cent of its long period average for the current year. The fiscal and monetary stimulus measures initiated during 2008-09 coupled with lower commodity prices could cushion the downturn in the growth momentum during 2009-10 by stabilising domestic economic activity to some extent. However, any upturn in the growth momentum is unlikely in view of the projected contraction in global demand during 2009, particularly decline in trade. While domestic financing conditions have improved, external financing conditions are expected to remain tight. Private investment demand is, therefore, expected to remain subdued. On balance, with the assumption of normal monsoon, for policy purpose, real GDP growth for 2009-10 is placed at around 6.0 per cent.
60.On account of slump in global demand, pressures on global commodity prices have abated markedly around the world. The sharp decline in prices of crude oil, metals, foodgrains, cotton and cement has influenced inflation expectations in most parts of the world. This is also reflected in the domestic WPI inflation reaching close to zero. Prices of manufactured products have decelerated sharply, while that of the fuel group have contracted, though inflation on account of food articles still remains high. Keeping in view the global trend in commodity prices and domestic demand-supply balance, WPI inflation is projected at around 4.0 per cent by end-March 2010.
61.The WPI inflation, however, is expected to be in the negative territory in the early part of 2009-10. However, this should not be interpreted as deflation for policy purposes. This expected negative inflation in India has only statistical significance and is not a reflection of demand contraction as is the case in advanced economies. This transitory WPI inflation in negative zone may not persist beyond the middle of 2009-10. The consumer price inflation as reflected in various indices is expected to moderate from its present high level but would continue to remain in positive territory through 2009-10 unlike WPI inflation. Moreover, it may also be noted that the sharp decline in WPI inflation has not been commensurately matched by a similar decline in inflation expectations.
62.It would be the endeavour of the Reserve Bank to ensure price stability and anchor inflation expectations. Towards this objective, the Reserve Bank will, as always, continue to take into account the behaviour of all the price indices and their components. The conduct of monetary policy would continue to condition and contain perception of inflation in the range of 4.0-4.5 per cent so that an inflation rate of around 3.0 per cent becomes the 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.
63.Monetary and credit aggregates have witnessed deceleration since their peak levels in October 2008. The liquidity overhang emanating from the earlier surge in capital inflows has substantially moderated in 2008-09. The Reserve Bank is committed to providing ample liquidity for all productive activities on a continuous basis. As the upside risks to inflation have declined, monetary policy has been responding to slackening economic growth in the context of significant global stress. Accordingly, for policy purposes, money supply (M3) growth for 2009-10 is placed at 17.0 per cent. Consistent with this, aggregate deposits of scheduled commercial banks are projected to grow by 18.0 per cent. The growth in adjusted non-food credit, including investment in bonds/debentures/shares of public sector undertakings and private corporate sector and CPs, is placed at 20.0 per cent. Given the wide dispersion in credit growth noticed across bank groups during 2008-09, banks with strong deposit base should endeavour to expand credit beyond 20.0 per cent. As always, these numbers are provided as indicative projections and not as targets.
64.The global financial and economic outlook continues to be unsettled and uncertain. The latest assessment by major international agencies projecting sharp contraction in global trade volumes in 2009 has exacerbated the uncertainty. The current assessments project little chance of global economic recovery in 2009. Despite large scale recapitalisation, write-offs and asset substitutions, sizeable chunks of assets of systemically important banks and financial institutions remain impaired. It is also not clear if the deleveraging process is complete. In such a scenario, external financing conditions for emerging market economies may continue to remain tight and constrain their growth prospects.
65.Governments and central banks all over the world have responded to the ongoing global financial crisis by initiating several large, aggressive and unconventional measures. There is, however, a contentious debate on whether these measures are adequate and appropriate and when, if at all, they will start showing the desired results. There is a separate debate on whether the measures taken so far, responding as they are to short-term compulsions, are eroding long-term sustainability. Many difficult issues will need to be addressed going forward. There is unprecedented co-ordinated policy action on monetary, fiscal, regulatory and institutional reforms to address the ongoing financial and economic crisis and strengthen the international financial architecture. In this context, the initiatives by the leaders of the G-20 announced in April 2009 to: (i) restore confidence, growth, and jobs; (ii) repair the financial system to restore lending; (iii) strengthen financial regulation to rebuild trust; (iv) fund and reform the international financial institutions to overcome the crisis and prevent future ones; (v) promote global trade and investment and reject protectionism to underpin prosperity; and (vi) build an inclusive, green and sustainable recovery, should help overcome the uncertainty surrounding the financial and economic outlook.
66. Here in India, there are several immediate challenges facing the economy which would need to be addressed going forward. First, after five years of high growth, the Indian economy was headed for a moderation in the first half of 2008-09. However, the growth slowdown accentuated in the third quarter of 2008-09 on account of spillover effects of international developments. While the moderation in growth seems to have continued through the fourth quarter of 2008-09, it has been cushioned by quick and aggressive policy responses both by the Reserve Bank and the Government. Notwithstanding the contraction of global demand, growth prospects in India continue to remain favourable compared to most other countries. While public investment can play a critical role in the short-term during a downturn, private investment has to increase as the recovery process sets in. A major macroeconomic challenge at this juncture is to support the drivers of aggregate demand to enable the economy to return to its high growth path.
67. The second challenge going forward is meeting the credit needs of the non-food sector. Although, for the year 2008-09 as a whole, credit by the banking sector expanded, the pace of credit flow decelerated rapidly from its peak in October 2008. This deceleration has occurred alongside a significant decline in the flow of resources from non-bank domestic and external sources. The deceleration in total resource flow partly reflects slowdown in demand, drawdown of inventories by the corporates and decline in commodity prices. The expansion in credit, however, has been uneven across sectors. There is, therefore, an urgent need to boost the flow of credit to all productive sectors of the economy, particularly to MSMEs, to aid the process of economic recovery. The Reserve Bank continues to maintain and will maintain ample liquidity in the system. It should be the endeavour of commercial banks to ensure that every creditworthy borrower is financed at a reasonable cost while, at the same time, ensuring that credit quality is maintained.
68. It may be noted that bank credit had accelerated during 2004-07. This, combined with significant slowdown of the economy in 2008-09, may result in some increase in NPAs. While it is not unusual for NPAs to increase during periods of high credit growth and downturn in the economy, the challenge is to maintain asset quality through early actions. This calls for a focused approach, due diligence and balanced judgment by banks.
69. Third, the Reserve Bank was able to manage the large borrowing programme of the Central and State Governments in 2008-09 in an orderly manner. The market borrowings of the Central and State Governments are expected to be higher in 2009-10. Thus, a major challenge is to manage the large government borrowing programme in 2009-10 in a non-disruptive manner. Large borrowings also militate against the low interest rate environment that the Reserve Bank is trying to maintain to spur investment demand in keeping with the stance of monetary policy. The Reserve Bank, therefore, would continue to use a combination of monetary and debt management tools to manage government borrowing programme to ensure successful completion of government borrowings in a smooth manner. The Reserve Bank has already announced an OMO calendar to support government market borrowing programme through secondary market purchase of government securities. During the first half of 2009-10, planned OMO purchases and MSS unwinding will add primary liquidity of about Rs.1,20,000 crore which, by way of monetary impact, is equivalent to CRR reduction of 3.0 percentage points. This should leave adequate resources with banks to expand credit.
70.Fourth, another challenge facing the Indian economy is to restore the fiscal consolidation process. The fiscal stimulus packages by the Government and some other measures have led to sharp increase in the revenue and fiscal deficits which, in the face of slowing private investment, have cushioned the pace of economic activity. However, it would be a challenge to unwind fiscal stimulus in an orderly manner and return to a path of credible fiscal consolidation. In this context, close monitoring of the performance of the economy and the proper sequencing of the unwinding process would have to be ensured.
71.Fifth, a continued challenge is to preserve our financial stability. The Reserve Bank would continue to maintain conditions which are conducive for financial stability in the face of global crisis. A sound banking sector, well-functioning financial markets and robust payment and settlement infrastructure are the pre-requisites for financial stability. The banking sector in India is sound, adequately capitalised and well-regulated. By all counts, Indian financial and economic conditions are much better than in many other countries of the world. The single factor stress tests carried out as part of the report of the Committee on Financial Sector Assessment (CFSA) (Chairman: Dr. Rakesh Mohan and Co-Chairman: Shri Ashok Chawla) have revealed that the banking system in India can withstand significant shocks arising from large potential changes in credit quality, interest rate and liquidity conditions. These stress tests for credit, market and liquidity risk show that Indian banks are generally resilient.
72.Sixth, the Reserve Bank has injected large liquidity in the system since mid-September 2008. It has reduced the CRR significantly and instituted some sector-specific facilities to improve the flow of credit to certain sectors. The tenure of some of these facilities has been extended to provide comfort to the market. While the Reserve Bank will continue to support all the productive requirements of the economy, it will have to ensure that as economic growth gathers momentum, the large liquidity injected in the system is withdrawn in an orderly manner. It is worth noting that even as the monetary easing by the Reserve Bank has potentially made available a large amount of liquidity to the system, at the aggregate level this has not been out of line with our monetary aggregates unlike in many advanced countries. As such, the challenge of unwinding will be less daunting for India than for other countries.
73. Finally, we will have to address the key challenge of ensuring an interest rate environment that supports revival of investment demand. Since October 2008, as the inflation rate has decelerated and the policy rates have been reduced, market interest rates have also come down. However, the reduction in interest rates across the term structure and across markets has not been uniform. Given the cost plus pricing structure, banks have been slow in reducing their lending rates citing high cost of deposits. In this context, it may be noted that the current deposit and lending rates are higher than in 2004-07, although the policy rates are now lower. Reduction in deposit rates affects the cost only at the margin since existing term deposits continue at the originally contracted cost. So lending rates take longer to adjust. Judging from the experience of 2004-07, there is room for downward adjustment of deposit rates. With WPI inflation falling to near zero, possibly likely to get into a negative territory, albeit for a short period, and CPI inflation expected to moderate, inflationary risks have clearly abated. The Reserve Bank’s current assessment is that WPI inflation could be around 4.0 per cent by end-March 2010. Banks have indicated that small savings rate acts as a floor to banks’ deposit interest rate. It may, however, be noted that small savings and bank deposits are not perfect substitutes. Banks should not, therefore, be overly apprehensive about reducing deposit interest rates for fear of competition from small savings, especially as the overall systemic liquidity remains highly comfortable. There is scope for the overall interest rate structure to move down within the policy rate easing already effected by the Reserve Bank. Further action on policy rates is now being taken to reinforce this process.
Policy Stance for 2009-10
74.On the basis of the above overall assessment, the stance of monetary policy in 2009-10 will broadly be as follows:
• Ensure a policy regime that will enable credit expansion at viable rates while preserving credit quality so as to support the return of the economy to a high growth path.
• Continuously monitor the global and domestic conditions and respond swiftly and effectively through policy adjustments as warranted so as to minimise the impact of adverse developments and reinforce the impact of positive developments.
• Maintain a monetary and interest rate regime supportive of price stability and financial stability taking into account the emerging lessons of the global financial crisis.
75. Over the last several months, the Reserve Bank has been actively engaged in policy action to minimise the impact of the global crisis on India. The policy response of the Reserve Bank has helped in keeping our financial markets functioning in a normal manner and in arresting the growth moderation. The Reserve Bank will continue to maintain vigil, monitor domestic and global developments, and take swift and effective action to minimise the impact of the crisis and restore the economy to a high growth path consistent with price and financial stability.
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