Third Quarter Review of the Annual Policy Statement for 2007-08
II. Stance of Monetary Policy
85. The Mid-Term Review noted that at this stage of development of the Indian economy, the formulation of monetary policy has to be acutely sensitive to the impact of excessive market volatility on the real sector with feedback effects on the financial sector, particularly in view of the limited room for manoeuvre for fiscal policy. On the domestic front, it was indicated that risks to inflation and inflation expectations would continue to demand priority in policy monitoring, with the biggest challenge being the management of capital flows and the attendant implications for liquidity and overall stability, especially in the context of the rapid escalation in asset prices driven by capital flows. Threats to inflation were also seen as emanating from global factors _ injection of liquidity by central banks; the high and volatile levels of international commodity prices; and the sharp increase in inflation in China.
86. Against this backdrop, the Mid-Term Review persisted with the stance set out in the Annual Policy Statement for 2007-08 and the First Quarter Review of reinforcing the emphasis on price stability and well-anchored inflation expectations while ensuring a monetary and interest rate environment that supports export and investment demand in the economy so as to enable continuation of the growth momentum. Credit quality and orderly conditions in financial markets for securing macroeconomic and, in particular, financial stability were re-emphasised while simultaneously pursuing greater credit penetration and financial inclusion. While reiterating a readiness to respond swiftly with all possible measures as appropriate to the evolving global and domestic situation impinging on inflation expectations, financial stability and the growth momentum, the Mid-Term Review resolved to take recourse to all possible options for maintaining stability and the growth momentum in the economy in view of the unusually heightened global uncertainties, and the unconventional policy responses to the developments in financial markets.
87. The unfolding of global developments in recent weeks and the responses of monetary authorities provide an indication of the threat to growth and financial stability worldwide, bearing out the Reserve Bank's stance of enhanced vigilance to be able to respond appropriately to global financial and monetary conditions. In addition, risks to inflation from high and volatile international prices of fuel, food and metal prices appear to have intensified. Consumer price inflation has hardened in a number of countries, complicating the task of monetary authorities in assuaging liquidity and solvency stress in financial markets and institutions. Domestically, managing the expansionary effects of large capital inflows on liquidity, monetary aggregates and asset prices has posed a testing challenge for the conduct of monetary policy. With the 50 basis point increase in the CRR announced in the Mid-Term Review coming into effect from November 10, 2007 the strategy of active liquidity management with a combination of measures has been successful in managing overall liquidity conditions consistent with the policy stance. Overnight interest rates rose to the upper reaches of the LAF corridor in an orderly manner up to December 2007, followed by some intermittent softening in January 2008 as surplus liquidity conditions resumed. Nevertheless, financial markets continue to warrant careful and continuous monitoring with a readiness to respond flexibly and pre-emptively to ensure orderly liquidity conditions, particularly in the context of the management of volatile and large movements in capital flows.
88. On balance, the prospects for the domestic economy over the remaining part of 2007-08 are consistent with policy expectations. First, there has been a modest deceleration in output growth in the second and third quarters. Second, aggregate supply conditions have continued to expand in all constituent sectors and the ongoing investment boom should entrench the improvement in supply elasticities, going forward. Third, corporate profitability and business confidence continue to be sustained by the underlying macroeconomic fundamentals, positive sentiment in financial markets and resilient export demand, especially in view of the global economic and financial environment. Fourth, inflation has so far been within tolerance thresholds at the wholesale level. Fifth, prudential and profitability indicators suggest that banks' balance sheets have become stronger and sounder than before. Sixth, domestic financial markets have been orderly and insulated so far from the turmoil in global markets on account of the subprime crisis though there has been unusual volatility in equity markets that is to some extent influenced by global developments. Seventh, in the external sector, the current account deficit remains well within sustainable limits, with net invisible surpluses offsetting the merchandise trade deficit to a considerable degree. Accordingly, the build-up in the foreign exchange reserves during the current financial year has been historically unprecedented. On the other hand, the expansion of monetary and liquidity conditions as well as asset prices contain risks of upward inflationary pressures for the Indian economy, alongside international price pressures particularly on account of oil and food prices. Most importantly, in the period ahead, developments in global financial markets in the context of the subprime crisis would warrant more intensified monitoring and swift responses with all available instruments to preserve and maintain macroeconomic and financial stability.
89. Real GDP originating in agriculture and allied activities has recorded above-trend growth in the first half of 2007-08 with kharif foodgrains production placed higher than in the preceding year. More information will be necessary to make a full and realistic assessment of rabi production, including the extent to which reservoir storage will have a mitigating effect on shortfalls in the winter North-East monsoon. On the other hand, industrial activity appears to be experiencing some transient and cyclical effects affecting manufacturing performance. With the momentum of growth in the services sector expected to be sustained, drawing from leading indicators, the projection of overall real GDP growth in 2007-08 is maintained at around 8.5 per cent for policy purposes, assuming no further escalation in international crude prices and barring domestic or external shocks.
90. Headline inflation has picked up since the beginning of December 2007 with attendant implications at the retail/consumer level. While this is largely attributable to base effects that may extend up to February 2008, escalated and volatile international crude prices and the heightened levels of food prices pose clear and present risks to the inflation outlook at the current juncture, especially if and when some pass-through to domestic petroleum product prices becomes inevitable. In the overall assessment, in view of the lagged and cumulative effects of monetary policy on aggregate demand and assuming ongoing improvement in supply management, capital flows would be managed actively and in the absence of shocks emanating in the domestic or global economy, the policy endeavour would be to contain inflation close to 5.0 per cent in 2007-08. In recognition of India's evolving integration with the global economy and societal preferences in this regard, the resolve, going forward, would be to condition expectations in the range of 4.0-4.5 per cent so that an inflation rate of around 3.0 per cent becomes a medium-term objective consistent with India's broader integration into the global economy.
91. The rate of money supply has picked up since the Mid-Term Review of October 2007, coincident with a jump in the growth of reserve money over this period, driven by the accretion to the Reserve Bank's foreign exchange assets. This has been reflected in the acceleration in the growth of banks' aggregate deposits driven by cyclical factors in the upturn. Over the greater part of 2007-08, deposit growth has been running ahead of the projection of Rs.4,90,000 crore for 2007-08 as a whole, mainly driven by aggressive rate setting behaviour of banks. Non-food credit (inclusive of non-SLR investments), although below the projected growth of 24.0-25.0 per cent given in the Annual Policy Statement, has been picking up since mid-August 2007. Moderating money supply in alignment with the indicative projections of 17.0-17.5 per cent set out in the Annual Policy Statement of April 2007 may warrant appropriate responses, given the considerations for ensuring macroeconomic and financial stability going forward.
92. At the current juncture, global uncertainties have increased considerably in the context of the downside risks to growth and financial stability. Global financial markets continue to experience unusual volatility, strained liquidity and credit conditions as well as heightened risk aversion. While these pressures have been sought to be addressed through coordinated actions by several leading central banks, the impact and outcomes of these recent actions of monetary authorities still appear unclear for the near-term outlook for financial markets and for the longer term on the real economy in terms of growth and stability. Some major central banks have engaged in lowering policy rates _ sizeably in January 2008 even by historical standards _ in view of the weakening economic outlook and the continuing deterioration in broader financial market conditions, in spite of the judgement that it will be necessary to monitor inflation developments carefully.
93. Recent global events were not entirely unanticipated, as already articulated in previous monetary policy statements, but the intensity appears to be severe and the duration uncertain. It appears that a process of reordering of global economic balances is underway and hence, the process is likely to continue to be complex with significant implications for trade flows, financial flows, asset prices and balance sheets. In terms of the impact of such a process on India, our external trade is, relative to many other EMEs, well diversified. Similarly, on a systemic basis, most parts of the balance sheets of both the public sector and the private sector are relatively less exposed to foreign currencies. However, more recently, several large corporates have expanded their foreign currency exposures which have to be managed carefully. The major source of impact is through the financial flows, in particular, in the equity markets and, consequently, on the foreign exchange market in India. The second order effects on account of financial contagion or real sector developments are somewhat indeterminate at this stage.
94. In view of the risks associated with international financial developments impacting balance sheets of corporates with sizeable external liabilities, banks are urged to review large foreign currency exposures and to put in place a system for monitoring such unhedged exposures on a regular basis so as to minimise risks of instability in the financial system under the current highly uncertain conditions. Internal limits as deemed appropriate may be made applicable for foreign currency loans on the basis of a well laid out policy approved by banks' boards. Banks are also urged to carefully monitor corporate activity in terms of treasury/trading activity and sources of other income to the extent that embedded credit/market risks pose potential impairment to the quality of banks' assets.
95. In the context of a more open capital account and the size of inflows currently, public policy preference for a hierarchy of capital flows with a priority for more stable components could necessitate a more holistic approach, combining sectoral regulations with broader measures to enhance the quality of flows and make the source of flows transparent. In this context, it is critical for public policy to effectively, demonstrably and convincingly indicate commitment to managing capital flows consistent with macro fundamentals through appropriate and decisive policy actions.
96. While the focus has generally been on managing the excess capital inflows and volatility in regard to the excess, it is essential not to exclude the possibility of some change in course, due to any abrupt changes in sentiments or global liquidity conditions, despite strong underlying fundamentals of the Indian economy. Events in the second and third week of January 2008 indicate a potential for reversal in capital flows, though it is not yet clear how transient such events will turn out to be. Strategic management of the capital account would warrant preparedness for all situations, and the challenges for managing the capital account in such an unexpected turn of events may be quite different.
97. The setting of monetary policy in India has been rendered complex in the light of these developments. On the one hand, the underlying fundamentals of the economy remain strong and resilient and the outlook continues to be positive. At the same time, while there is no visible or immediate threat to financial stability in India from global developments, the need for continued but heightened vigilance has increased with an emphasis on readiness to take timely, prompt and appropriate measures to mitigate the risks to the extent possible. As noted in the Mid-Term Review, the immediate task for public policy in India is to manage the possible financial contagion that seems to have highly uncertain prospects of being resolved soon. Accordingly, monetary policy has to be vigilant and proactive in cushioning the real economy from excess volatility in financial markets while recognising that India cannot be totally immune to global developments.
98. The developments in the domestic economy are broadly in line with the policy expectations and in the normal course would not warrant any significant monetary policy initiatives at this juncture. However, moderation in the growth of the industrial sector may need further exploring to assess whether some of the segments are reflecting correction of the excesses in the previous years or whether there are sector-specific factors which require attention. While growth in investment demand is likely to ease the supply constraints in future by adding to capacities, the moderation in private consumption expenditure warrants consideration. Such a disaggregated analysis of supply and demand factors across select sectors would enable appropriate public policy responses keeping in view the employment intensity of some of these sectors. Monetary policy, per se, can essentially address issues relating to aggregate demand but the associated policies in the financial sector could, to the extent possible, take account of the evolving circumstances as reflected in the disaggregated analysis. In view of the prevailing liquidity conditions and the sustained profitability of banks as reflected in net interest margins, there is a need for banks to undertake institutional and procedural changes for enhancing credit delivery to sectors that are employment-intensive.
99. Over the period ahead, liquidity management will continue to assume priority in the conduct of monetary policy. Liquidity conditions are being shaped by several underlying factors which appear to exert conflicting pulls and pose challenges for designing the appropriate policy response. First, money supply has been expanding well above indicative projections in 2007-08 driven up by high deposit growth despite successive increases in the CRR with no remuneration. Expansionary liquidity conditions engendered by capital flows, have not, however, prompted banks to reduce deposit/lending rates which have been broadly maintained at the elevated levels of the preceding year. Consequently, effective interest rates on time deposits at the margin are currently ruling above the LAF repo rate. Apparently, there have been little or no adverse effects on banks' net interest margins and profitability has remained high, boosted by operating income. Notwithstanding the surplus liquidity conditions, bank credit growth has moderated. Despite comfortable liquidity conditions, banks have not expanded credit proportionately; instead, banks have preferred to make excess investments in SLR securities including MSS issuances, money market mutual funds and the LAF reverse repo, despite earning apparently lower interest rates thereon. Furthermore, reflecting the continuing uncertainty in global financial markets, significant volatility has also been observed in the Indian capital markets with the associated impact on liquidity. These developments have implications for liquidity management going forward and warrant appropriate and timely action.
100. The Reserve Bank will continue with its policy of active demand management of liquidity through appropriate use of the CRR stipulations and open market operations (OMO) including the MSS and the LAF, using all the policy instruments at its disposal flexibly, as and when the situation warrants.
101. For the purpose of formulating the stance of monetary policy, domestic factors, which are better balanced, stable and remain positive, dominate while global factors are reckoned to be increasingly relevant. 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 growth and inflation, the overall stance of monetary policy in the period ahead will broadly continue to be:
To reinforce the emphasis on price stability and well-anchored inflation expectations while ensuring a monetary and interest rate environment conducive to continuation of the growth momentum and orderly conditions in financial markets.
To emphasise credit quality as well as credit delivery, in particular, for employment-intensive sectors, while pursuing financial inclusion.
To monitor the evolving heightened global uncertainties and domestic situation impinging on inflation expectations, financial stability and growth momentum in order to respond swiftly with both conventional and unconventional measures, as appropriate.