Third Quarter Review of the Annual Policy Statement for 2007-08
I. Assessment of Macroeconomic and
68. Real GDP originating in agriculture and allied activities has accelerated in the first half of 2007-08 in comparison with April-September 2006. Advance estimates of kharif output have been placed somewhat higher than a year ago, which augurs well for the prospects of growth in agriculture in the third and also the fourth quarters of 2007-08. The outlook on rabi output is somewhat mixed and unclear at this juncture. While there has been some initial slack in rabi sowing, a catch-up appears to be underway. In the face of shortfalls in the spread and intensity of North-East monsoon rainfall, reasonable levels of water storage in major reservoirs across the country provide some cushion against inclement weather conditions. These developments seem to confirm the positive outlook for agriculture envisioned in the Annual Policy Statement of April 2007 and in subsequent Reviews. By current indications, growth in agriculture in 2007-08 is poised to return to trend.
69. Industrial activity appears to have moderated in the third quarter of 2007-08 with manufacturing and electricity generation impacted by 'high base' effects. A positive aspect of industrial performance is the continuing capacity expansion that is driving growth in manufacturing, supported by electricity generation and mining activity. Industries such as chemicals and chemical products, wood and wood products, jute textiles, leather and leather products and food products recorded acceleration in April-November, 2007, contributing about 30 per cent of the growth of overall industrial production. Industries such as basic metals and alloys, machinery and equipment, transport equipment and parts which together contributed over 30 per cent of industrial production are set to catch up although, on a cumulative basis, their growth rates appear somewhat moderated in relation to a year ago. There are downside risks emanating from high international crude prices, rising input costs and the uncertain global environment wherein the possibility of some slowdown in economic activity and, consequently, in export demand seems to be gaining ground. Under the circumstances and recognising that the high base effects may be reflected in the relevant indices, moderation in the rate of industrial growth over the remaining part of 2007-08 needs to be reckoned. On balance, assuming that there are no exogenous shocks, either global or domestic, the prospects for the industrial sector over the rest of 2007-08 remain reasonably positive at this juncture.
70. In the services sector, all constituent sub-sectors except community, social and personal services have recorded double-digit growth in the first half of 2007-08. The outlook for the services sector has improved with lead indicators such as the growth in railway revenue earning freight traffic, sales of passenger and commercial vehicles, cargo handled at major ports, telephone connections, tourist arrivals and civil aviation traffic indicating a pick-up in the pace of growth of transport and communication services in coming months. Headline indicators also suggest continuing high growth in financial and business services while construction activity is expected to continue to expand strongly on the back of investment demand. On the other hand, activity relating to trade, hotels and restaurants and community, social and personal services has recorded some slackening in the second quarter of 2007-08. On balance, therefore, the prospects for services continue to be favourable at this juncture; however, uncertainties surrounding the evolution of global developments cloud the outlook as noted in the Mid-Term Review of October 2007.
71. Key indicators point to the persistence of aggregate demand pressures, including into the near-term. First, the disposition of GDP by expenditure in the first half of 2007-08 indicates that there has been a distinct step-up in fixed capital formation as a proportion to GDP at constant market prices. On the other hand, private final consumption expenditure has moderated. The strength of investment demand is also reflected in the growth of capital goods production - at its highest for April-November since 1993-94 - the continuing high growth in imports of capital goods and the increase in intermediate goods production - highest for April-November since 1995-96. The sustained pace of construction activity is also reflective of the driving force of investment demand. Furthermore, resources raised through public issues have increased sizeably. Second, since the time of the Mid-Term Review, both reserve money and money supply have accelerated, reflecting the significant expansionary effects of large capital inflows embodied in the Reserve Bank's foreign currency assets (adjusted for revaluation) being 289 per cent higher than the increase in the corresponding period of the previous year. Non-food credit, which had been slowing down in the first half of 2007-08, appears to have picked up, which may restrain any slowdown in aggregate deposit growth that has been running well above indicative projections throughout 2007-08 so far. Third, with non-oil imports recording a sharp acceleration in growth in October and November, the merchandise trade deficit has expanded in spite of the pace of export growth, pointing to the pressure from domestic demand. Fourth, inflation in terms of wholesale prices, has started to rise since December after a prolonged trough beginning in mid-July 2007. With the wholesale prices of key food articles firming up in recent weeks along with prices of some manufactures, further softening of inflation in terms of consumer prices may not accrue, going forward. Fifth, the incomplete pass-through of the indeterminate permanent component of the increase in international oil prices is indicative of potential upward pressure on inflation. Finally, escalated and volatile levels of equity, gold and real estate prices are visibly reflecting the strain imposed by aggregate demand conditions.
72. Headline WPI inflation has been edging up moderately since early December 2007, coming out of the mid-October-end-November trough that started to form in mid-July. The upturn is largely attributable to the onset of base effects that could prevail up to mid-February 2008. The main contributors to the recent rise in headline inflation are milk, rice, raw cotton and oilseeds in the primary articles category, non-administered petroleum products in the fuel group and edible oil, oilcakes, iron and steel, cement, drugs and medicines and electrical machinery in the category of manufactured products which together accounted for nearly 100 per cent of WPI inflation. Consumer prices continue to rule at elevated levels, despite some softening in the third quarter of 2007-08.
73. It is important to note that indications are getting stronger of upside inflationary risks in the period ahead. First, exclusion-based measures, i.e., WPI excluding food and energy, place inflation higher than the headline, indicative of the underlying aggregate demand pressures. Second, disaggregated analysis suggests that the favourable effects of the cuts in petrol/diesel prices in 2006-07, which facilitated benign inflation conditions over the greater part of 2007-08, have ceased since December 2007. Prices of non-administered petroleum products (naphtha, furnace oil, aviation fuel and the like) have increased in the range of 28-37 per cent. Accordingly, fuel prices, even if unchanged, are set to drive up headline inflation going forward, in contrast to their dampening role hitherto. In view of the new highs to which international crude prices have recently been lifted, the threats to domestic price stability have risen and turned extremely volatile, representing a serious risk to inflation expectations. It is difficult to differentiate, ex ante, the permanent and temporary components of the elevated international crude prices but, in any case, at current levels, it is necessary to recognise the need for some more pass-through from international crude prices and implications for domestic inflation conditions.
74. The softening of inflation in terms of manufactures through the year and primary food articles since mid-July 2007 is increasingly becoming vulnerable to the adverse global developments in the period ahead. International foodgrain prices, which have escalated to historic peaks, are poised to enter a prolonged period of hardening, with demand projected to run well ahead of supply and historically low stocks, exacerbated by bio-fuel diversion. The weighted average price paid on wheat import tenders during June-November 2007 were significantly higher than a year ago. In the primary non-food category, the upside inflation risks emanating from the oilseeds/edible oil group have increased substantially, both domestically and globally. The outlook on international metal prices remains uncertain with demand pressures from Asia continuing to be sustained by robust growth in the region.
75. While CPI inflation has moderated by about 200 basis points between August and November due to the easing of food price inflation, this could be a short-lived phenomenon in view of the uncertainty surrounding rabi output and the deteriorating international environment. Furthermore, domestic monetary and liquidity conditions continue to be more expansionary than before and are likely to be amplified by global factors, particularly, the recent massive injections of liquidity by major central banks to activate frozen money markets. It is also necessary to recognise that despite the turmoil in international financial markets, asset prices continue to rule at escalated levels, fuelled by the abundance of liquidity.
76. A sizeable swing in liquidity was experienced towards the middle of the third quarter of 2007-08. With the 50 basis point increase in the CRR announced in the Mid-Term Review becoming effective from November 10, 2007 and aided by festival demand for cash, a build-up of the Government's cash balances and advance tax outflows, the large daily LAF reverse repo absorptions that characterised August-October 2007, ceased. Daily injections through the LAF repos commenced through November 2007-December 2007 with brief interruptions and reversion to the absorption mode in the last week of December 2007 and early January 2008. Liquidity injections reached a peak on December 26, 2007. The Central Government's cash balances exhibited a generally unidirectional upward movement, rising to a peak on December 22, 2007 coincident with advance tax payments, and further constricted liquidity although in the following weeks these balances have been drawn down, augmenting market liquidity. In view of the liquidity conditions, maturing securities under the MSS were allowed to be redeemed during November 23, 2007 to January 11, 2008. Notwithstanding these contrasting movements in components, there was a large increase in the total overhang of liquidity (LAF, MSS and Government cash balances taken together) over the third quarter of 2007-08, reflecting the sizeable expansion in primary liquidity generated by the large accretions to the Reserve Bank's net foreign assets. The banking system generally remained in surplus mode with large investments in mutual funds and a moderate increase in excess SLR holdings in comparison to a year ago.
77. Overnight money market rates, which were hovering around the LAF reverse repo rate till November 11, 2007 rose thereafter to rule around the repo rate up to end-December, before easing again to reverse repo rate levels in January 2008 with the resumption of surplus liquidity conditions, barring some spikes in the second half of the month. A notable feature is the muted impact of mid-December advance tax outflows on money markets indicative of the success of active monetary and liquidity management. In the foreign exchange market, large inflows have imposed persistent upward pressures on the exchange rate of the rupee which have become accentuated in the wake of cuts in the US Federal Funds target rate over September 2007-January 22, 2008. In the Government securities market, orderly conditions have prevailed through the quarter with yields declining across all maturities.
78. There has been some improvement in the finances of the Central Government during April-November 2007. On the revenue account, there has been a strong growth in non-tax revenues in the form of interest receipts which has supported the underlying buoyancy of tax revenues. Some moderation in the growth of revenue expenditures has been enabled by a slower growth of non-Plan spending. Accordingly, there has been a decline in the revenue deficit in absolute terms on a year-on-year basis. Higher interest receipts have also enabled a gross primary surplus in contrast to a deficit in the corresponding period of the previous year. Higher allocations to States and Union Territories, transport and highways, rural development and health were the principal forces driving up Plan expenditure. While capital expenditure (net of transactions related to the transfer of the Reserve Bank's stake in the SBI) was moderately higher than a year ago, it has remained lower as a proportion to budget estimates, and the expansion in capital outlay remains modest. The gross fiscal deficit has declined in absolute terms as well as in terms of its proportion to the budget estimates, indicating that adherence to the Fiscal Responsibility and Budget Management (FRBM) rules in the current financial year is on track.
79. There are indications of some changes underway in India's external sector developments which carry implications for the period ahead. First, there has been a widening of the trade deficit in the first half of 2007-08 on account of the sustained demand for non-oil imports - particularly for capital goods, export-related inputs and bullion - notwithstanding the moderation in the quantity of PoL imports. Second, the sources of growth driving invisible receipts appear to be changing. While there was some deceleration in exports of software and business services in the first half of 2007-08, remittances from Indians working overseas and investment income receipts associated with the deployment of foreign exchange reserves have increased sharply, more than compensating for the slack in software export growth and enabling a higher invisible surplus than a year ago. Accordingly, the current account deficit during April-September 2007 remained broadly at the same level as a year ago as a proportion to GDP. Third, net capital flows have risen nearly three-fold and all categories, barring non-resident deposits, have recorded sizeable increases. Net FDI inflows have accelerated, preferring manufacturing, business and computer services. Outward FDI has more than doubled, reflecting the growing global reach of the Indian corporate sector. Net inflows on account of external commercial borrowings and short_term trade credits have also gone up sizeably. Fourth, while the accretion to reserves during the current financial year has been unprecedented by historical standards, from the national balance sheet perspective, India's international liabilities at US $ 322 billion at book value at end-June 2007 were substantially in excess of the foreign exchange reserves and this gap has widened at end-December 2007 with net capital flows set to exceed the level of 5 per cent of GDP recorded in 2006-07.
80. Developments in global financial markets since the Mid-Term Review of October 2007 present several issues that need to be monitored carefully in the context of the implications for EMEs. First, alongside inter-bank term interest rates, corporate credit spreads and those on mortgage-backed securities have widened since early October as concerns relating to the possibility of prolonged disruption to credit intermediation have deepened. In the credit markets, investors are increasingly demanding risk premia for product complexity and exposure to asset-backed commercial papers (ABCPs) and structured investment vehicles (SIVs). Second, the impact of the recent financial market turmoil has been sizeable on banks, particularly internationally active banks from both sides of the Atlantic. Several large banks have already recognised substantial losses on holdings of collaterailised debt obligations (CDOs), mortgage-backed leveraged products and the picture continues to unfold. Market perceptions of increasing systemic risk in the banking system are being reflected in declines in bank share prices, a sharp increase in spreads on credit default swap (CDS) and growing concerns relating to off-balance sheet positions. Third, as pointed out in the Mid-Term Review, the responses of central banks to recent events have demonstrated that ensuring financial stability can, under certain circumstances, assume overriding importance relative to other more explicitly pursued goals.
81. Global macroeconomic prospects in the near-to-medium term are expected to be influenced by the rebalancing that has been underway over the last few years towards Europe, Japan and the EMEs. In this context, the role of EMEs in supporting the global economy and in cushioning global downturns is conditioned by the environment for decoupling from the US. It is important to recognise that the extent of decoupling will depend on the impact of developments in the financial sector in general and real sector developments in the US economy in particular. First, in the near-term, EMEs face risks from tightening of credit standards in advanced economies. Second, dependence on imports and higher energy intensity of output may make EMEs more exposed to inflation shocks. Third, international financial markets respond differently to the same macroeconomic or political development depending on whether it is an EME or an advanced economy. Hence, EMEs have to follow a more pragmatic and contextual policy. Fourth, the self-correcting mechanisms in financial markets happen to operate more efficiently in advanced economies and far less efficiently in the EMEs, particularly during highly uncertain global economic conditions. Hence, the extent of or lack of self-correcting mechanisms in an economy should be treated as given, in the short_term, and a suitable policy of intervention has to be pursued accordingly. Fifth, real sector flexibilities may be far less in EMEs. Hence, the real sector responses to exchange rate movements are not likely to be as flexible as in the advanced economies. Sixth, the distinction between flexibility and volatility in the context of financial markets in EMEs has to be based on the preparedness of the markets and the market participants. It is in this context that the decoupling of EMEs from the US remains to be tested.
82. There are indications of significant changes in the global macroeconomic and financial environment in the fourth quarter of 2007 that could have a bearing on the outlook for growth and inflation. Financing conditions in a number of major economies have tightened. There are also growing concerns relating to the vulnerability of the banking system to potential losses, the true magnitude of which is still unknown, and the associated systemic risks. Conditions in the US housing sector have worsened. A sharp depreciation in the US dollar and soaring crude prices are other factors that have produced shifts in the balance of risks to the global economy. In recent months, forward-looking indicators, including global purchasing managers' indices and consumer and business confidence, have deteriorated in major industrial economies. Consensus forecasts so far indicate a slowing of the global economy in 2007 and 2008 with risks currently seen as weighed to the downside. So far, spillovers from the credit markets to the real economy have been small, except for some retrenchment in consumer spending. There are, however, risks of exogenous shocks such as a disruptive decline in the US dollar. Forecasts for other advanced economies have been pared and the US subprime crisis, food and crude prices pose the gravest risks.
83. Headline inflation has trended up in the US, the euro area, Japan and China in November 2007. The recent sharp rise in commodity prices has added uncertainty to global inflation prospects. Food prices are pushing up inflation in many EMEs and are expected to remain high over the medium-term. Higher oil prices pose the risk of aggravating inflation risks directly as well as through the demand for oil substitutes which, in turn, contributes to the rise in food prices. Wage pressures in the context of strong labour market conditions are posing inflation risks in advanced and emerging economies across the world, in conjunction with higher input costs. Overall, inflationary pressures have firmed up with implications for the outlook for 2008.
84. In the overall assessment, the domestic outlook remains positive with continued favourable prospects of sustaining the growth momentum in an environment of price and financial stability. There are some indications of moderation in industrial production, corporate sales and profitability, business confidence and non-food credit. Domestic activity continues to be investment driven, supported by external demand. Building up of supply capacities, both new and existing, is strongly underway as reflected in the sustained demand for domestic and imported capital goods. Monetary and financial conditions as well as asset prices are reflecting these expansionary impulses. The external sector developments are dominated by the extraordinarily large capital flows, to a considerable extent reflecting sustained international investor confidence in India. In contrast to domestic prospects, the outlook for the global economy has worsened somewhat from the time of the Mid-Term Review with risks to both growth and inflation having accentuated. While the dangers of global recession are relatively subdued at the current juncture and consensus expectations seem to support a soft landing, the upside pressures on inflation have become more potent and real than before. Food and energy prices are set to impart a permanent upward shock to inflation globally and, in particular, in EMEs. The future evolution of the subprime mortgage crisis carries by far the gravest risks for the world economy. For EMEs in particular, the probability attached to tail risks has, in fact, increased over recent months as information is getting revealed on the extent of contaminated financial assets and the extent of contagion. Several EMEs are likely to face the dilemma of responding to slackening of growth induced by global developments even as inflationary pressures remain firm. Furthermore, the overarching objective of ensuring financial stability would pose a testing challenge for the conduct of monetary policy in the period ahead.