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Main Page of First Quarter Review of Annual Monetary Policy 2006-07
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Assessment of Macroeconomic and Monetary Developments
Overall Assessment
45. There are several positive factors in domestic developments during 2006-07 so far which support an optimistic near-term outlook for the Indian economy. First, corporate performance remains reasonably robust, despite some deceleration. Second, investment activity is picking up in an environment of rising capital expenditures of corporates, a surge in capital goods production in April and May, continuing expansion of investment intentions and strong demand for bank credit. Third, most business confidence surveys report growth in new order books, increase in capacity utilisation and improvement in financing conditions notwithstanding some hardening of interest rates. Fourth, even as non-food bank credit has continued to expand at the high rates recorded over the last couple of years, deposit growth has picked up and overall liquidity in the system has been ample. Banks continue to hold over Rs.1,50,000 crore of excess SLR investments which could, to some extent, accommodate the demand for bank credit. Fifth, financial markets have responded to these shifts in financing conditions, on the whole, in an orderly fashion. Sixth, inflation has stabilised since mid-June, despite increases in administered prices of petroleum products and the spike in food prices. Price stability has created conducive conditions for growth to continue undisrupted.
46. On the external front, export growth remains strong. Although early indications suggest that non-oil import growth appears to have slackened somewhat, the continuing sharp growth of POL imports, driven by soaring international crude prices, has resulted in a higher trade deficit. Invisible earnings and capital flows have, however, enabled the financing of the rising trade deficit while adding to the reserves during the year so far.
47. Some developments in the first quarter of 2006-07 do suggest the need to remain on guard against the emerging risks. The changes in administered prices of petrol and diesel in June 2006 imparted a direct effect of 45 basis points on headline inflation. Given that catch-up of domestic POL product prices with the possible permanent component of international prices remains incomplete, the upside risks to inflation are evident. In the recent period, these risks have become amplified by the renewed hardening of international crude prices to new highs, due to escalating geopolitical tensions. The recent increases in domestic food prices occurring in an environment in which international food prices are also hardening is a relevant factor in this regard, though some seasonal elements in movements in domestic prices of food items are possible. These risks to inflation are being carefully monitored with appropriate supply-side policy responses of the Government.
48. Non-food bank credit growth on a year-on-year basis remains high and comparable to the elevated rates recorded since 2004-05. The growth of monetary aggregates is also higher on a year-on-year basis. Interest rates in various segments of the financial markets have hardened with the exception of the money markets which reflect contrasting conditions of excess liquidity. Accordingly, call, market repo and CBLO rates have eased with absorption of liquidity of about Rs 60,000 crore, and even beyond, on a daily basis in the LAF during mid-May to early June and again in the first week of July. By contrast, the tightening of yields in the Government securities market needs to be noted. These developments would warrant closer policy attention in response to evolving circumstances. On the whole, financial markets in India, despite the noticeable volatility in equity markets, have exhibited resilience relative to most other emerging market economies.
49. The Annual Policy Statement of April 2006 warned of three key risks from global developments for emerging economies including India: potential escalation and volatility in international crude prices; a disorderly unwinding of the global imbalances; and a hardening of international interest rates along with the direction of movement in setting monetary policy. Since then, the evolution of the global economy seems to indicate that each of these risks is materialising; in fact, these risks appear to have heightened in recent months. First, international crude prices have risen from an average level of US $ 57 per barrel at end-2005 to above US $ 73 per barrel currently. By all indications, crude oil prices are expected to remain at elevated levels until the end of 2007 with no respite in sight. Second, global imbalances are likely to persist in 2006. Large misalignment among major currencies is now in evidence with sharp cross-currency movements characterising recent months. Third, while core inflation appears contained, headline inflation has hardened across countries in the second quarter of 2006, driven up mainly by crude prices and some pressure from non-energy prices. Fourth, since the announcement of the Annual Policy Statement, monetary policy has been tightened further with increases in key policy rates in some advanced economies such as the US, the Euro area, Canada, Japan and Australia as well as in some emerging economies like China, Korea and Chile, with some of them even acting simultaneously in early June. Market expectations seem to reflect apprehensions of further tightening in the coming months. Fifth, along with the recent shifts in portfolios away from the emerging markets and commodity exchanges, financial markets are currently re-pricing risks in an environment of uncertainty and, in particular, in emerging market economies.
50. The prospects for growth in the world economy in 2006 are considered bright and indicators of business confidence and unemployment in major economies lend credence to this optimism for the near-term. However, it is widely recognised that several features of the current global upswing are causes for concern: large fiscal deficits, low household savings and low investment in some large economies; unprecedented and growing current account imbalances; narrowing or closing in of output gaps in many economies; record highs in oil prices accompanied by uncertainties about their future evolution; and the outlook for inflation firming up.
51. In the global financial markets, the period since the Annual Policy Statement has been characterised by significant re-pricing of risks. The first four months of 2006 saw a continuation of the shift by investors towards higher-risk asset classes, with marked increase in equity, commodity and high-yield debt prices. There were, however, some initial signs of discomfort in financial markets in February 2006 attributed to unwinding of carry trades and the steep fall in select equity markets. There was also some evidence of increased uncertainty in foreign exchange markets, globally. A clear reversal of direction in many markets came to the fore in mid-May. The prices of highly rated government bonds rose, while those of riskier assets fell. The mid-May correction was felt acutely by emerging market economies – especially in equity markets - including India. Currencies of some emerging market economies depreciated significantly against the US dollar. It is clear that fundamentals could not have changed in such a dramatic fashion in a short time and, hence, it is reasonable to suggest that those economies that had gained most from lower pricing of risks in recent years felt the impact of reversal in direction since mid-May the most. The two important questions in assessing the outlook are: whether the process of re-pricing of risks, in general, is complete; and whether corrections are incomplete in the economies which benefited from lower-priced risks in the past. The overall macroeconomic and geopolitical global environment is admittedly indicative of marked downside risks.
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