Third Quarter Review of Annual Statement on Monetary Policy for 2006-07, RBI Credit Policy

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Third Quarter Review of Annual Statement on Monetary Policy for 2006-07 click here

Third Quarter Review of Annual Statement on Monetary Policy for 2006-07

I. Assessment of Macroeconomic and Monetary Developments

Overall Assessment

56. The improvement in aggregate supply conditions, noted in the Mid-Term Review of October 2006, seems to have been sustained in the ensuing period, driven by double-digit growth in manufacturing and services. Industrial activity has gathered momentum on the back of manufacturing activity, supported by mining and electricity generation. Lead indicators point to the sustained strength of growth in the services sector. Agricultural performance, on the other hand, has not been as sanguine with output growth decelerating in the first half of 2006-07 in relation to a year ago. Supply-side pressures due to declines in the production of rice, coarse cereals, oilseeds, pulses and cotton have emerged as a source of concern for the near-term outlook, especially in view of the relatively low levels of food stocks. A fuller assessment of the rabi prospects would enable a more informed forward-looking evaluation.

57.There are continuing signs of aggregate demand firming up. First, the pick-up in investment intentions and synchronous high growth of capital goods production and capital goods imports suggest that investment demand is strengthening further. Corporates are also reporting sustained business optimism and rising capital expenditure. Second, double-digit growth in the production of consumer durables is reflecting the buoyancy of consumer demand. Third, the demand for bank credit remains high, extending the high growth phase that began in 2004. Accordingly, concerns remain relating to credit quality and that some banks may be overextended in terms of the balance between sources and uses of funds, as reflected in high credit-deposit ratios. The growth in banks’ investments in Government and other approved securities appears to be low relative to credit growth. Excluding LAF holdings, banks’ SLR investments are close to the statutory minimum which has implications for liquidity management. Credit growth is also being reflected in the sizeable and higher than anticipated expansion in money supply. Fourth, on the external front, the trade deficit, which is a relevant indicator of domestic demand conditions had expanded to 6.5 per cent of GDP in 2005-06 and is set to rise even higher in the current financial year. Export growth has regained vigour, but there are shifts in the pattern of imports. There are reports that expansion of capacity may be constrained in terms of pending import orders. Fifth, there is increasing evidence that the infrastructural bottlenecks are becoming tighter and more binding. Sixth, some indications of wage cost pressures seem to be in evidence. Surveys of corporate activity show that the staff costs of the sampled firms increased sizeably in the first half of 2006-07, particularly for information technology (IT) and services companies. While staff costs in manufacturing firms have increased at a more moderate pace, they are likely to face incipient pressures on margins from rising input costs. Seventh, elevated asset prices are generating wealth effects which are fuelling aggregate demand.

58. In the Mid-Term Review of October 2006, the Reserve Bank had indicated the need to reckon with the dangers of possible overheating even though there was no conclusive evidence thereof. In the subsequent period, the relevant signs, especially in terms of aggregate demand, have firmed up as explained above. Investment demand is strong and is augmenting productive capacity. But it is also important to recognise that the addition to productive capacity occurs with a lag and the first sign of a step up in investment is reflected in an expansion of aggregate demand. Meanwhile, sizeable capital inflows appear to have flowed into sectors such as real estate which add to demand pressures, contributing to sharp increases in asset prices as well as greater volatility in financial markets.

59. It is important to recognise that signs of overheating could be transitional in nature. There is evidence of substantial investment taking place, accompanied by overall productivity increases which should add to potential output. Furthermore, the data indicate an upward shift in gross domestic saving and investment rates which could provide the underpinnings for a higher level of the structural component of growth. Hence, the policy challenge is to manage the transition to a higher growth path while containing inflationary pressures so that potential output and productivity are firmly entrenched in order to sustain growth at the current level with the potential for further acceleration. The objective of recent monetary policy initiatives is to continue to maintain conditions of stability that contribute to sustaining the momentum of growth on an enduring basis. In this regard, it is relevant to note that when the CRR was increased in December, 2006 it was indicated inter alia that expansion of capacity is underway but the realisation could be constrained over the next two years.

60. Financial markets have, by and large, remained stable. Money markets experienced generally orderly conditions along with spells of tightening of liquidity in November and again from mid-December. During these episodes, contrasting conditions have often been observed when short-term interest rates have firmed up despite LAF absorptions but long-term rates have declined in the Government securities market. In December, there was an inversion of the yield curve and a narrowing of yield spreads. Forward premia have firmed up in November and December across the board in concert with the hardening of short-term interest rates in the domestic money market segments. On the other hand, asset prices, particularly equity prices, have risen to record highs.

61. Up to November, 2006 total expenditure of the Union Government had been higher than a year ago in relation to the budget estimates in spite of cutbacks in capital expenditure. The substantial increase in non-plan expenditure had been partly accommodated by buoyant tax and non-tax revenue receipts. Accordingly, the gross fiscal deficit seems to have moderated from its level a year ago as a proportion to the budget estimates. The market borrowing programme is on course with a large part having been successfully completed with some shortening of the weighted average maturity and firming up of yields. There are also indications of some improvement in State finances as reflected in the steady increase in their cash balances and lower recourse to Ways and Means Advances/overdrafts.

62. Merchandise export growth has resumed strongly from a dip in October, 2006. At the same time, imports of POL have increased sizeably as in the previous year, but reflecting a sharp increase in import volume in the current year. Non-oil import growth, which remained subdued in the early months of 2006-07, has picked up during the third quarter in consonance with industrial activity. There are also reports of a substantial pick up in bullion imports in October-November. While the merchandise trade deficit has consequently widened, the sustained surplus on account of invisibles is expected to contain the current account deficit at well under two per cent of the GDP. The capital flows to India have recovered from the moderation during May-June 2006. Accordingly, the current account deficit is expected to be comfortably financed in the remaining part of the year.

63. It is important to undertake a careful assessment of factors affecting inflation expectations. First, prices of primary food articles continue to remain firm and the usual seasonal decline since November has been muted during the current financial year. Second, prices of manufactured products have also exhibited upward movement. Third, surveys of business suggest that capacity utilisation in the manufacturing sector has risen. Fourth, indications of demand pressures have been incipiently building up as reflected in increasing consumption and investment demand. Fifth, the sizeable expansion in the demand for bank credit continues to pose concerns. Sixth, asset prices appear to have risen even beyond the elevated levels at the time of the Mid-Term Review. Seventh, international crude prices have moderated considerably and are expected to remain around the current levels in the near future. Accordingly, the pass-through to domestic prices of petrol and diesel can be assumed to be complete. However, it is necessary to recognise that headline inflation has hardened and has moved beyond the projection of the Reserve Bank only on four occasions during the fiscal year, viz., in the weeks ending October 21 and December 30, 2006 and January 6 and January 13, 2007. These spikes in inflation have been contributed to by base effects, supply-side constraints and demand pressures. Overall, the impact of these developments on inflation perceptions due to rise in prices of food articles and on inflation expectations, in general, warrant a determined policy response by all concerned to quell such adverse developments for several critical reasons.

64. In recognition of the cumulative and lagged effects of monetary policy, the Reserve Bank began a graduated withdrawal of accommodation in mid-2003 in spite of inflation being within its tolerance band. Since September, 2004 repo/reverse repo rates have been increased by 125/150 basis points, the CRR has been raised by 100 basis points, risk weights have been raised in the case of housing loans (from 50 per cent to 75 per cent), commercial real estate (from 100 per cent to 150 per cent) and consumer credit (from 100 per cent to 125 per cent) and general provisioning requirement for standard advances in specific sectors has been raised to 1.0 per cent of standard advances. The stance of monetary policy has progressively shifted from an equal emphasis on price stability along with growth to one of reinforcing price stability with immediate monetary measures and to take recourse to all possible measures promptly in response to evolving circumstances.

65. In the global economy, the balance of growth seems to be shifting away from the US towards the euro area, Japan and the emerging economies. There is some evidence that the slowing in housing in the US has significant elements of an inventory correction. Non-residential investment remains strong. Pressure from energy prices has ebbed, while unemployment appears to have fallen. In Japan, domestic demand is seen as holding the key to sustaining the recovery. In the Euro area, domestic demand and employment are picking up and the outlook for growth is optimistic. In emerging Asia and in Latin America, the outlook for growth remains positive, supported by external demand, although there are concerns relating to the possible US slowdown. In the overall assessment, the global outlook continues to be favourable for the prospects of countries like India, although persisting geopolitical risks remain a potential threat to growth and stability worldwide.

66. In industrial countries, headline inflation has eased somewhat, but core inflation has remained firm. While global oil prices may have stabilised, non-oil inflation has been rising steadily and it is feared that sooner or later, wage pressures would build up. Monetary policy authorities in inflation-targeting countries are facing the difficult situation of inflation prevailing above the target over a prolonged period. Even as long-term inflation expectations have trended down, interpreting short-run fluctuations is becoming complicated by uncertainty about how strongly these expectations could get revised and which factors might trigger the revision. Therefore, while there are several factors holding down inflation expectations, central banks consider it important to strengthen the pursuit of price stability.

67. Global financial markets have been reasonably stable while re-pricing risks. Short-term interest rates have firmed up since October, but long-term bond yields have fallen, translating into a steeper inversion of the yield curve. Foreign exchange markets have been recording lower levels of volatility in recent weeks than before. Most emerging market currencies have made modest gains against the US dollar. Global equity markets have posted steady gains, except in Japan, boosted by the ebbing of crude prices and the pause in US policy rates. A pick-up in merger and acquisition activity has also supported equity prices. It is important to recognise that in the current environment of relatively low interest rates which, in turn, affect risk-pricing by financial markets, even small changes in interest rates can produce large changes in asset prices and associated volatility, as noticed in the global sell-offs in equity markets during May-June, 2006. Accordingly, policy authorities as well as market constituents need to be watchful and prepared for sudden fluctuations in asset prices which can have significant real sector effects.

68. In line with developments in the major markets, emerging equity markets in Asia and Latin America have continued to recover from the May-June sell-off. The markets which suffered the largest losses have more than recouped earlier losses. Perceptions of sound fundamentals in many emerging economies, reflected in stable ratings and the resurgence of investor interest in dedicated emerging market funds, have enabled international issuances of debt and equity from these economies, with some countries replacing foreign currency debt by local currency debt. Private issuances have far exceeded sovereign issues as firms took advantage of favourable market conditions.

69. In India, recent developments, in particular, the combination of high growth and firming inflation, coupled with escalating asset prices and tightening infrastructural bottlenecks, have complicated the conduct of monetary policy. The enduring strength of capital inflows poses a challenge to monetary and liquidity management. In the event of demand pressures building up, increases in interest rates may be advocated to sustain growth in a non-inflationary manner but such action, apart from associated costs for growth and potential risks to financial stability, increases the possibility of further capital inflows so long as a significant part of these flows is interest sensitive and explicit policies to moderate flows are not undertaken. These flows can potentially reduce the efficacy of monetary policy tightening by enhancing liquidity.

70. In the overall assessment, there are shifts underway in the patterns of global growth even while inflation expectations remain stable at present. While risks to the outlook from the contraction in the US housing market, rising food and metal prices remain, global financial markets remain vulnerable to sudden shifts in expectations and volatility, as experienced in the recent period. There are concerns relating to the uncertainty surrounding international crude prices. While crude prices have moderated recently, geo-political risks remain. Central banks are, by and large, persisting with withdrawal of monetary accommodation. Global factors, by themselves, do not seem to warrant a policy response; however, corporates and financial intermediaries need to be aware of sudden reversals in sentiment in global financial markets unrelated to economic fundamentals, especially if triggered by geo-political factors. Banks are, therefore, advised to ensure the hedging of their exposures and to undertake pre-emptive strategies to insulate their balance sheets from currency and interest rate risks.

71. In the light of the above, a three-pronged approach is warranted at this juncture. First, early warning signals emanating from rising inflation in an environment of high money and credit growth indicate that monetary policy is still accommodative, warranting a policy response. Accordingly, a measured increase in interest rates should be appropriate in assuaging demand pressures. Second, there are also abiding concerns relating to the persistently high credit growth and the potential for erosion in the quality of credit. It is in this context that balance sheets of banks need to be fortified against the build-up of loan delinquencies by precautionary provisioning and a greater sensitivity to underlying risks by enhancement of risk weights applied to advances to specific sectors in which banks’ exposures have been rising at a fast pace. Third, there are also indications that capital inflows are likely to be sustained with expansionary effects carrying potential inflationary pressures and attenuating monetary and liquidity management. In particular, inflows into non-resident deposit schemes have recorded sizeable increases during the year in response to interest rate differentials. Therefore, it is important to modulate these flows appropriately so as to ensure effective liquidity management. In all the three areas, a continuous process of rebalancing the relative emphasis between growth and stability is critical while devising specific measures from time to time.