Macroeconomic and Monetary Developments in the Third Quarter of 2011-12
-Released on January 23, 2012
Highlights of Macroeconomic and Monetary Developments in the Third Quarter of 2011-12 :
CAD risks have amplified as capital flows moderate
Early indicators suggest that the current account came under increased pressure during Q3 of 2011-12. Notwithstanding rupee depreciation, exports decelerated but import demand remained strong, with inelastic demand for oil and rising gold imports. Upward risks to CAD have become more pronounced with likely moderation of software earnings.
As capital flows also moderated since August 2011, financing pressure on the CAD translated into exchange rate pressures. Currencies of other EDEs running CAD came under similar pressures. Following the revival of equity flows in January 2012, exchange rate pressures have reduced somewhat.
The composition of capital inflows has shifted in favour of debt, with a rise in the proportion of short-term flows. Vulnerability indicators have weakened moderately, though the net international investment position has improved. Going forward, there is need to reduce dependence on debt flows by encouraging renewed equity flows through acceleration of policy reforms aimed at improving the investment climate
Monetary and Liquidity Conditions
Monetary growth keeps pace even as money market liquidity tightens
Money market liquidity tightened significantly since November 2011 partly due to dollar sales by RBI. However, monetary growth has kept pace with projections, on account of a rising money multiplier. The liquidity stress was handled by the Reserve Bank by injecting liquidity through open market operations, including repos under the LAF.
Credit growth slowed below the indicative projection due to demand as well as supply side factors. Demand for credit weakened in response to slack in real activity. Supply also slowed down with rising risk aversion stemming from deteriorating macroeconomic conditions and rising non-performing loans.
Monetary policy has been significantly tightened since February 2010 with an effective increase of 525 bps in policy rates and a 100 bps increase in CRR. Factoring in increased downside risks to growth and the expected moderation in inflation, the policy rate was kept on hold in December 2011. The trajectory of the monetary cycle ahead will be shaped by the evolving growth-inflation dynamics.
Financial markets come under pressure from global spillovers
Global spillovers and macroeconomic deterioration resulted in pressures on the equity and currency markets. The sharp depreciation of the rupee during August-December 2011 contributed to a drop in foreign equity inflows which in turn, further weakened the rupee. The sudden stop in equity inflows also impacted investment financing. The impact was compounded by poor resource mobilisation in the primary capital market.
The stress in the financial markets was mitigated by policy measures that included infusion of rupee and dollar liquidity. As a result, the rupee exchange rate appreciated and equity markets recovered in January 2012. Call money rates have largely remained within the interest rate corridor and spikes were effectively contained.
Inflation is trending down, but upside risks remains significant
Inflation is moderating led by sharp decline in food inflation and is broadly in line with the 7 per cent projection for March 2012.
Primary food inflation declined sharply reflecting seasonal fall in vegetable prices and high base. However, as protein inflation continues due to structural demand-supply imbalances, the decline is expected to be short-lived.
Inflation in non-food manufactured products remains persistently high, reflecting input cost pressures, partly resulting from the rupee depreciation that has offset the impact of softer global prices of some commodities.
Upside risks to inflation persist from insufficient supply responses, exchange rate pass-through, suppressed inflation and an expansionary fiscal stance.
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