Third Quarter Review of the Annual Policy Statement for 2007-08
I. Assessment of Macroeconomic and
Developments in the Global Economy
42. During the fourth quarter of 2007, financial markets in developed economies experienced tight conditions following the turbulence witnessed since July 2007 in response to the US subprime mortgage crisis. Reduced financial leverage, lower credit availability and negative wealth effects have emerged as risks to consumption and growth, especially in the US. Firm inflationary pressures from food prices and high and volatile crude prices are other risks to the outlook. Substantial downside risks continue to be associated with respect to housing developments in the US and Europe and the fall-out on financial institutions/markets in an environment of heightened systemic risks and high volatility. According to the World Economic Outlook (WEO) of the International Monetary Fund (IMF) released in October 2007, the forecast for global real GDP growth on a purchasing power parity basis is placed at 5.2 per cent for 2007 as compared with 5.4 per cent in 2006, and is expected to decelerate further to 4.8 per cent in 2008.
43. In the US, real GDP growth had risen to 4.9 per cent in the third quarter of 2007 as compared with 1.1 per cent a year ago. In the fourth quarter, labour markets weakened with the unemployment rate rising to 5.0 per cent in December 2007 and job growth the weakest since August 2003. The home builders' housing market index stayed at a 22-year low for the fourth straight month in January 2008 with mortgage delinquencies rising to the highest level since 1986. Real GDP growth is expected to slow down from the fourth quarter of 2007 onwards as the deepening housing market correction and ongoing financial market turmoil are expected to curb growth more severely, although exports could play a mitigating role. Industrial production declined by one per cent in the fourth quarter and capacity utilisation declined further in December 2007 from the peak reached in August 2007. Durable goods orders were weak reflecting sluggish investment spending. The IMF's October 2007 WEO expects the US economy to grow at a slower pace of 1.9 per cent in 2007 and 2008 as against 2.9 per cent in 2006.
44. Real GDP in the euro area grew by 2.7 per cent in the third quarter of 2007 on a year-on-year basis as compared with 2.8 per cent a year ago. Unemployment fell in November 2007 to a record low of 7.2 per cent. In the German economy _ the largest in the euro area _ however, the business climate has worsened in December after a brief improvement in November and the cyclical dynamics are seen as weakening for the next six months. With rising defaults on consumer loans, the credit crisis appears to be adversely impacting financial conditions in Europe. A more restrictive credit policy by banks is likely to affect companies with weak credit ratings. The October 2007 update of the IMF's WEO has placed average annual real GDP growth of the euro area at 2.5 per cent in 2007 and 2.1 per cent in 2008.
45. The Japanese economy grew by 2.6 per cent in the third quarter of 2007 as compared with 1.4 per cent a year ago. Surveys reveal that the business sentiment of large Japanese manufacturers was worse than expected during the quarter ending December 31, and is forecast to deteriorate further in the coming quarter. The Bank of Japan expects the pace of Japan's economic growth to decelerate due to a big drop in housing investment and the slowdown is likely to persist for some time. Consumer sentiment in Japan has been worsening with higher crude oil prices and the rising prices of daily necessities. The October 2007 WEO of the IMF has projected real GDP growth in Japan at 2.0 per cent in 2007 and 1.7 per cent in 2008.
46. In emerging Asia, economic activity has continued to expand at a sustained pace, especially in the largest economies of the region, despite the volatile global setting. The Chinese economy grew by 11.4 per cent in 2007 as compared with 11.1 per cent recorded in 2006, despite policy efforts to curb growth by controlling high-polluting, energy-intensive industries as well as monetary tightening policies, reduction of export rebates and restrictions on processing exports. Inflation accelerated to 6.9 per cent in November 2007 as compared with 1.9 per cent in November 2006. In 2008, the Chinese economy is expected to moderate to a growth of 10.0 per cent as tightening policies take effect. The impact of losses of China's financial institutions and the transmission of financial turmoil to China's markets seems to be limited. Deceleration of export growth reflecting weaker demand from the Organisation for Economic Cooperation and Development (OECD) countries and China's domestic policies restraining low-end exports could reduce GDP growth.
47. In recent months, the Chinese authorities have cut the rebate on value added taxes (VAT) and have increased export taxes on some products to discourage balance of payment surpluses and reduce funds flow to the stock markets which have reached elevated levels. China ran a record US $ 262.2 billion trade surplus in 2007, despite slowdown in export growth and the negative impact of the US subprime crisis, which is 48.0 per cent higher than in the preceding year, contributing to the overhang of liquidity in the economy. China's foreign exchange reserves reached US $ 1.53 trillion at the end of 2007.
48. Among other major Asian economies, the Korean economy grew by 5.5 per cent in 2007, higher than 5.0 per cent in 2006, led by exports, due to higher sales in emerging markets such as China. Consumer price inflation had accelerated to 3.6 per cent in December 2007 from 3.0 per cent in October 2007. In Thailand, the economy is expected to grow at 4.8 per cent in 2007, driven by robust export growth and expansionary public expenditures that support the economy at the time when private expenditures have been slowing down. In 2008, the Thai economy is forecast to grow in the range of 4.5-6.0 per cent. Inflation decelerated to 3.2 per cent in 2007 from 3.50 per cent in 2006.
49. In the US, consumer prices increased from 2.5 per cent in 2006 to 4.1 per cent in 2007. In the euro area, inflation increased to 3.1 per cent in 2007 from 1.9 per cent a year ago. In Japan, inflation increased to 0.7 per cent in 2007 from 0.3 per cent a year ago. In the UK, CPI inflation declined to 2.1 per cent in 2007 from 3.0 per cent in 2006. At the retail level (in terms of retail prices index or RPI), inflation rose to 4.8 per cent in the UK in March 2007 _ the highest since 1991 _ but declined thereafter to 3.8 per cent in July 2007 before increasing to 4.0 per cent in December 2007. Inflation pressures have also raised concerns in some of the emerging market economies (EMEs) such as China, Malaysia, Indonesia and Chile.
50. Core CPI inflation in the US increased to 2.4 per cent in December 2007 from 2.3 per cent in November 2007. In the UK, core CPI inflation has been declining in tandem with the headline rate and stood at 1.4 per cent in December, down from 1.5 per cent in October 2007. In the euro area, core CPI inflation increased to 1.9 per cent in October-December 2007 from 1.8 per cent in September 2007. Core inflation in Japan remained negative (-0.1 per cent) in November-December 2007 as compared with (-0.3 per cent) in October 2007. Overall, the persistence of high food prices, oil prices sustained at elevated levels and continued high prices of other commodities pose significant inflation risks for the global economy and challenges for monetary policy worldwide.
51. Globally, inflationary pressures have re-emerged as a key risk to global growth. In the global foodgrains market, prices of major crops such as corn, soyabeans and wheat have increased by 22.4 per cent, 75.2 per cent and 87.7 per cent, respectively, from a year ago in response to surging demand. The rally has swept up prices of other food items as well. The increase in prices has gained momentum from higher energy and fertiliser prices, low levels of inventories, shortfalls in certain crops mainly caused by weather-related factors such as the ongoing drought in Australia and strong increases in the demand for crops. According to the Food and Agriculture Organisation (FAO), 37 countries are facing food crises due to conflict and disasters. The FAO's global food price index rose 40 per cent in 2007 to the highest level on record. Food costs in the world's poorest countries _ including Iraq, Afghanistan, Nepal, Pakistan, and 20 African countries _ rose 25 per cent to US $ 107 billion in 2007.
52. Wheat prices remained generally firm and volatile in October 2007-January 2008 and reached a record high in December 2007 on account of repeated downward revisions of production forecasts in a number of major exporting countries, most notably Australia. World wheat output is now estimated to have risen by only 1.3 per cent in 2007. One month wheat futures at the Chicago Board of Trade (CBOT) rose from US $ 9.53 per bushel on October 1, 2007 to US $ 9.74 on December 19, 2007 before falling to US $ 9.36 on January 25, 2008. Trade is expected to contract because of high and volatile prices, coupled with soaring freight rates.
53. Strong demand for animal feed as well as for ethanol is the main driver in global coarse grain markets but supply tightness in several exporting countries is also providing support to prices. International prices have declined in recent months but they still remain well above the previous season's levels. Trade is expected to increase despite high prices caused by import demand and shortages of feed wheat that have encouraged importers to switch to major coarse grains, especially maize and sorghum. The futures prices of corn on CBOT, which had moderated somewhat up to July 2007, started moving up thereafter and reached US $ 5.12 per bushel on January 14, 2008 before declining to US $ 4.99 on January 25, 2008.
54. According to FAO's All Rice Price Index, international rice prices continued to increase for most of 2007. Rice inventories in the five major exporting countries indicate that world market conditions may remain tight in 2008. The futures prices of rice on CBOT rose from US $ 11.71 per hundredweight on October 1, 2007 to US $ 14.53 on January 25, 2008. Sugar prices have firmed up in recent months due to a shortfall in supply and expanding investor interest. The futures prices of sugar increased from US cents 9.93 per pound on October 1, 2007 to US cents 12.45 on January 17, 2008 before declining to US cents 11.94 on January 25, 2008.
55. Metal prices have declined by 8.1 per cent during 2007 after increasing by 53.6 per cent in 2006 and 36.3 per cent in 2005. In the futures markets, aluminium, zinc and lead prices are showing a downward trend since October 2007. Copper prices have been buoyed up by the depreciating US dollar and high demand. Futures price of copper on the New York Mercantile Exchange (Nymex) increased to a record level of US $ 3.75 per pound on July 20, 2007 but moderated subsequently to US $ 3.18 on January 25, 2008. Spot gold rose to US $ 923.73 an ounce on January 25, 2008 _ the highest since January 1980 _ as the dollar fell to a record low against the euro and on concerns about declining supply on mine shutdowns in South Africa.
56. Prices of crude oil have increased by 69 per cent up to January 25, 2008 from a year ago and futures prices have risen to US $ 90.33 per barrel, somewhat lower than the peak of US $ 99.29 on November 21, 2007 _ the highest since trading began on the Nymex in 1983. Crude oil prices, which softened to around US $ 53 per barrel in January 2007, have rebounded since July 2007 to close at a record level of US $ 99.6 on January 2, 2008 on account of disturbances in Nigeria before declining to US $ 90.39 on January 25, 2008 over concerns about global growth prospects. According to the Energy Information Administration (EIA), the main drivers of recent oil price movements are fundamentals such as strong world economic growth, moderate production increase by the OPEC, low spare production capacity, inventory tightness in developed countries, worldwide refining bottlenecks, ongoing geopolitical risks and concerns about supply availability. Continued high demand and low surplus capacity leave the crude oil scenario vulnerable to unexpected supply disruptions through 2008. According to the EIA, the price of West Texas Intermediate (WTI) crude oil is expected to be at US $ 87.21 per barrel in 2008 and US $ 81.67 per barrel in 2009.
57. The turbulence in the international financial markets since July 2007, triggered by massive payment defaults in the US subprime mortgage market, appears to have deepened in subsequent months. Payment defaults were felt worldwide by financial institutions which consequently undertook high write-offs, with some of the largest international banks recording considerable declines in profits. These unusual developments indicated heightened uncertainties and emerging challenges for the conduct of monetary policy, especially for EMEs.
58. Concerns about write-offs and uncertainty surrounding the health of large financial institutions have imparted considerable volatility in the US equity markets. The Dow Jones Industrial Average, Standard and Poor's (S&P) 500 and Nasdaq Composite exhibited considerable volatility and posted declines of 2.4 per cent, 6.4 per cent and 4.4 per cent, respectively, by January 25, 2008 over their levels a year ago. On January 21, 2008 equity markets across the world experienced sharp declines over concerns about the US slowdown. While the Dow Jones Industrial Average declined by about 1.0 per cent on the following day, Asian stocks fell more sharply. Crude oil prices declined to a five-week low on the Nymex. Confronted by the deep panic in global financial markets, the US Federal Reserve lowered its policy rates in the inter-meeting period by 75 basis points to 3.50 per cent on January 22, 2008. The Fed indicated that it has taken the decision in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labour markets. On the same day, the Bank of Canada reduced its policy rate. Other major central banks have, however, maintained their rates.
59. Government bond yields in the major economies, which had until recently firmed up, have softened more recently. The US 10-year bond yield increased from 4.70 per cent at end-December 2006 to 5.29 per cent on June 12, 2007 before falling to 3.56 per cent on January 25, 2008. The 10-year bond yields in the euro area increased from 3.95 per cent at end-December 2006 to 4.68 per cent on July 9, 2007 before falling to 3.97 per cent. The Japanese 10-year bond yield has increased from 1.68 per cent at end-December 2006 to 1.97 per cent on June 13, 2007 before falling to 1.48 per cent. These recent developments are indicative of evolving uncertainties in international financial markets with implications for EMEs.
60. On a trade-weighted basis, the US dollar has been depreciating since 2006 with intermittent fluctuations. After the cuts in the Fed funds rates since September 2007, the US dollar has weakened against other currencies. The pound sterling moved to the level of US $ 1.98 on January 25, 2008 - lower than the 26-year high of US $ 2.11 reached on November 8, 2007 - amidst concerns relating to the US subprime mortgage market. The euro, which has also been strengthening against the US dollar since June 2007, rose to US $ 1.47 on January 25, 2008, albeit lower than the peak of US $ 1.49 reached on November 26, 2007. The Canadian dollar appreciated against the US dollar to a 33-year high to reach US $ 1.09 on November 6, 2007 before declining to US $ 0.99 on January 25, 2008. Turkey experienced a sharp appreciation in its currency vis-a-vis the US dollar to reach the level of 86.95 cents on January 10, 2008 before moving to 84.27 cents on January 25, 2008. The New Zealand dollar had appreciated to 81.10 cents to reach a 22-year peak against the US dollar on July 24, 2007 before declining to 76.96 cents on January 25, 2008.
61. With the beginning of the turbulence, central banks of advanced economies undertook an increasingly expansive monetary policy course by cutting policy rates (US Federal Reserve) and also supplying financial markets with additional liquidity. On December 12, 2007 the Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank and the Swiss National Bank (SNB) announced measures to alleviate elevated pressures in short-term funding markets. Actions taken by the Federal Reserve include the establishment of a temporary Term Auction Facility (TAF) against a wide variety of collateral that can be used to secure loans at the discount window, and the establishment of foreign exchange swap lines with the ECB and the SNB which will provide dollars in amounts of up to US $ 20 billion and US $ 4 billion to the ECB and the SNB, respectively, for use in their jurisdictions. Four auctions have been conducted by the US Federal Reserve so far and it may conduct additional auctions in subsequent months, depending in part on evolving market conditions. The other four central banks have also conducted several auctions.
62. During December 2007 and January 2008, the US Federal Reserve injected about US $ 70 billion (up to January 14, 2008) through three auctions. The ECB provided 648.6 billion euros through four auctions for 5-16 days; the Bank of England injected 11.35 billion pounds through two auctions; the Bank of Canada released 4 billion Canadian dollars through two auctions and the SNB injected US $ 4 billion in one auction. The US Federal Reserve has announced an auction of US $ 30 billion on January 28, 2008. Since the announcement and subsequent auctions, pressures in short-term money markets have eased considerably from their earlier peaks, although spreads have not yet returned to historical levels.
63. Some central banks have cut policy rates during the third and fourth quarters of 2007 after financial markets were significantly affected by turbulence. During September 18, 2007 to January 22, 2008 the US Federal Reserve cut its policy rate by 175 basis points to 3.50 per cent after seventeen increases to 5.25 per cent between June 2004 and June 2006. The Bank of England reduced its repo rate by 25 basis points to 5.50 per cent on December 6, 2007. The Bank of Canada reduced its rate to 4.0 per cent by two 25 basis points reductions on December 4, 2007 and January 22, 2008.
64. Central banks of several countries, including the euro area, New Zealand, Japan, Korea, Malaysia, Thailand and Brazil have not changed their rates in the last quarter of 2007.
65. The central banks that have tightened their policy rates in recent months include the Reserve Bank of Australia (Cash Rate raised by 25 basis points in November 2007 to 6.75 per cent); the People's Bank of China (lending rate raised to 7.47 per cent in December 2007 from 7.29 per cent in September 2007); the Banco Central de Chile (benchmark lending rate raised to 6.25 per cent in January 2008 from 5.75 per cent in October 2007) and Banco de Mexico (policy rate raised by 25 basis points to 7.50 per cent in October 2007).
66. Several central banks that have been confronted with volatile and large capital flows have employed a variety of measures to manage and stabilise these flows with a view to reducing overheating, currency appreciation and the economy's vulnerability to sharp reversals of flows. A common feature among the policies adopted by most of them is monetary tightening involving either hikes in policy rates or hikes in reserve requirements or both. In China, the required reserve ratio was raised from 8 per cent in July 2006 to 15 per cent in January 2008. After a gap of 17 years, the Bank of Korea raised reserve requirements from 5 per cent to 7 per cent for local currency deposits and short-term foreign currency deposits in November and December 2006, respectively. Meanwhile, in several EMEs including China and Korea, central bank bonds have continued to absorb liquidity from the banking system.
67. Measures directly aimed at managing capital flows are also in evidence in many EMEs. On December 18, 2006 Thailand imposed unremunerated reserve requirements (URR) of 30 per cent on most capital inflows, requiring them to be deposited with the central bank for one year. These controls have been substantially relaxed since their inception by (a) providing a fully hedged option as an alternative to the reserve requirement, particularly for loans and for investment in fixed income securities and mutual fund units, and (b) waiving the reserve requirement on investments in equity-like securities, namely, warrants and exchange-traded fund units. In addition, regulations on foreign currency deposit and transfer have been relaxed. In May 2007, Colombia introduced a package of measures, including a 40 per cent URR on external borrowing to be held for six months in the central bank. Additionally, a new ceiling on the foreign exchange position of banks, including gross positions in derivative markets, was stipulated to limit circumvention of the URR and banks' exposure to counterparty risk. The PBC raised the amount of foreign currencies that lenders must keep as reserves to 5 per cent from 4 per cent of their foreign-currency deposits from May 15, 2007. The Bank of Korea is investigating large volume trading of currency forward contracts by exporters and financial companies to limit gains in the won, which appreciated to a 10-year high in 2007. Brazil's central bank has bought up substantial amount of inflows from the spot market to add to reserves and also conducted sizeable operations in the forward markets.