Stance of Monetary Policy for the Remaining Period of 2006-07
52. The Annual Policy Statement for 2006-07 had stated that in the context of macroeconomic developments and the global scenario, 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. It had also indicated that the balance of risks was tilted towards the global factors and that in a situation of generalised tightening of monetary policy, India cannot afford to stay out of step. While keeping in view the dominance of domestic factors as in the past, the Annual Policy Statement assigned more weight to global factors than before while formulating the policy stance. The overall stance of monetary policy for the year as a whole was expressed in terms of ensuring 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. A key element of the stance was the focus on credit quality and financial market conditions to support export and investment demand in the economy for maintaining macroeconomic, and in particular, financial stability. Emphasis was laid on responding swiftly to evolving global developments.
53. Since the announcement of the Annual Policy Statement in April 2006, there was definitive evidence of widespread and simultaneous monetary policy tightening among several countries in early June. This had to be viewed against the backdrop of marked and heightened volatility in the financial markets. Though not entirely unanticipated, the virtual global coverage, nature and timing of these developments posed a serious threat to
the domestic economy which, thus far, had been spared of turbulence in the debt and foreign exchange markets. These developments, viewed in the light of the prevailing monetary and credit environment underscored compulsions of swift action, as indicated in the Annual Policy Statement. Accordingly, on June 8, 2006 the LAF reverse repo/repo rates were increased by 25 basis points. The spread between repo and reverse repo rate under the LAF was retained at 100 basis points.
54. In India, the prospects of sustaining the high growth momentum of recent years appear favourable at the current juncture with the outlook on agriculture somewhat positive and industrial and services sector activity remaining robust in the early months of 2006-07. Inflationary pressures have, by and large, been contained so far by appropriate monetary policy action and supply-side policy measures that have been put in place to head off the cost-push effects of the recent hardening of food prices. Business confidence continues to be healthy on the acceleration of growth in industrial production, particularly capital goods and exports. The economy can also be expected to benefit from the brightened growth prospects of the global economy. As regards the balance of payments, despite the growing oil import bill, the anticipated current account deficit in 2006-07 is manageable, as in the past, due to the continuing underlying strength of merchandise exports, invisibles and capital flows.
55. There is also a need to note that within the domestic economy, demand pressures continue to be in evidence. First, the year-on-year money supply and credit growth indicates that aggregate demand conditions continue to be strong. Second, there has been a significant turnaround in the liquidity conditions from considerable tightness in the last quarter of 2005-06 to a large overhang of surplus liquidity. Third, factors like increased prices of primary food articles and industrial raw materials are new forces impinging on domestic inflation expectations. This is in addition to the incomplete pass-through of global oil price increases which is largely being regarded now as containing a significant permanent component. Against this background, it is critical that underlying inflationary pressures are contained and that inflationary expectations are anchored for supporting economic growth and financial stability.
56. The Annual Policy Statement had alluded to the liquidity risks embedded in a system which was significantly overdrawn in terms of credit portfolios. Banks need to recognise the reality of business and credit cycles and the worldwide concern that
is currently surrounding their evolution. Analytical assessment of these realities could justify counter-cyclical switches in portfolios between loans and investments. Ensuring credit quality remains a priority in the context of financial stability. Banks would need to focus on mobilisation of retail deposits which have durability, stricter credit appraisals on a sectoral basis, monitor loan-to-value ratios and generally ensure the health of credit portfolios on an enduring basis.
57. The outlook for the global economy presents, in some sense, a complex combination of strong growth and heightened uncertainties, especially the volatility in equity, and to some extent, in currency and bond markets, particularly in emerging economies, in addition to the concerns relating to oil prices. The responses of monetary authorities to developments in financial markets in the second quarter of the calendar year 2006 indicate greater resilience among most economies, developed as well as emerging, as financial markets re-price their risks aggressively, although some nervous sentiments on the way forward are evident. In the circumstances, the response of our monetary policy to global developments should be pre-emptive at signs of heightened uncertainties but should also be willing to discern possible trends towards normalcy. Thus, monetary policy may not be unidirectional for a prolonged period, recognising that the pace of changes in the global economic and financial environment is far more rapid now than ever before.
58. Some uncertainty continues to surround the progress of the monsoon. As of now, it is reasonable to assume that real GDP originating in agriculture would maintain its trend growth of 3.0 per cent. The overall industrial outlook continues to be positive and services sector growth is expected to sustain its momentum. Overall, for policy purposes, the forecast for GDP growth is retained in the range of 7.5-8.0 per cent during 2006-07 as projected in the Annual Policy Statement, barring domestic or external shocks.
59. There is some evidence that while increased competition and productivity gains in several sectors have contributed to some moderation in inflation, commodity prices and input costs are currently rising with producers increasingly prone to passing on the squeeze on margins to consumers. The pass-through of international oil price increases is expected to be higher in the future than before and policy authorities have to be on guard against second round effects. Taking into account the real, monetary and global factors, containing the year-on-year inflation rate for 2006-07 in the range of 5.0-5.5 per cent warrants appropriate priority in policy responses.
60. For the purpose of monetary policy formulation, the expansion in M3 was projected at around 15.0 per cent for 2006-07 in the Annual Policy Statement. The growth in aggregate deposits was 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 CP was expected to increase by around 20 per cent. Developments during the first quarter of 2006-07 indicate that money supply, deposit and credit growth are running well above the indicative projections, warranting caution by all concerned in this regard.
61. Central bankers all over the world revel over the dream run of low inflation coupled with high growth in recent years. They are confronted with the confusing realities presented by financial markets, oil markets and inflation uncertainties. They face the uncertainties of the future more acutely than ever before, since an increasingly globalised world is making assessments as well as policy options in the domestic arena very constrained. India is no exception to this, but a greater complexity is imparted since structural transformation of the economy and its gradual integration with the global economy add to the uncertainties. Yet, the trade-offs and judgments have to be made, keeping in view the criticality of timeliness in actions and flexibility to respond appropriately. For our economy, the domestic considerations continue to dominate and maintaining growth momentum is of the highest importance, but if, contextually, priority has to be accorded to demand management, price stability, inflation expectations and financial stability, there should be no hesitation to do so. The current situation calls for some stabilising influences while keeping all the options open for the future to maintain a successful and dynamic balance between growth and stability that has been the hallmark of our macroeconomic policies during the reform period.
62. Our current assessment points to the domestic economy exhibiting strong fundamentals and displaying considerable resilience. At the same time, there are disturbing signs of demand pressures, especially continuing high credit growth, that could exert upward pressure on prices when associated with supply shocks such as from oil. These pressures have the potential for impacting stability and inflation expectations. Against this background, as usual, judgments are necessary as to the relative weights to be accorded to growth and price stability, recognising lags in monetary policy. While domestic developments continue to dominate our economy, global factors tend to gain more attention now than before. The global outlook for growth is positive but downside risks in regard to inflation and re-pricing of risks in financial markets need to be recognised. Hence, it is necessary to strike a balance between reinforcing the resilience of our economy against global risks and taking advantage of global expansion. Both domestic and global factors are delicately balanced in terms of growth vis-à-vis price stability with a tilt towards the possibility of identified downside risks materialising in the near-term being more likely than before. The unfolding path of the identified risks, however, is naturally unclear at this stage. On balance, a modest pre-emptive action in monetary policy is appropriate at this juncture while being ready to respond flexibly and promptly by closely monitoring the related developments.
63. The Reserve Bank will continue to 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 MSS, LAF and CRR, and using all the policy instruments at its disposal flexibly, as and when the situation warrants.
64. 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 be:
• To ensure a monetary and interest rate environment that enables continuation of the growth momentum while emphasising price stability with a view to anchoring inflation expectations.
• To reinforce the focus on credit quality and financial market conditions to support export and investment demand in the economy for maintaining macroeconomic and, in particular, financial stability.
• To consider measures as appropriate to the evolving global and domestic circumstances impinging on inflation expectations and the growth momentum.