Third Quarter Review of Monetary Policy 2009-2010
-29th January 2010
I. The State of the Economy
2. The global economy is showing increasing signs of stabilisation. The growth outlook in virtually all economies is being revised upwards steadily, with the Asian region experiencing a relatively stronger rebound. Global trade is gradually picking up, but other indicators of economic activity, particularly capital flows and asset and commodity prices are more buoyant. However, even as most of the forecasts on recovery are generally optimistic, significant risks remain. The recovery in many economies is driven largely by government spending, with the private sector yet to begin playing a significant part. There are signs that high levels of global liquidity are contributing to rising asset prices as well as rising commodity prices. Emerging market economies (EMEs) are generally recovering faster than advanced economies. But they are also likely to face increased inflationary pressures due to easy liquidity conditions resulting from large capital inflows.
3. While conditions in the beginning of 2010 are significantly better than they were at the beginning of 2009, a different set of policy challenges has emerged for both advanced economies and EMEs. In 2009, while advanced economies were focused on dealing with the financial crisis, especially reviving the credit market and restoring the health of the financial sector, EMEs were engaged in mitigating the adverse impact of the global financial crisis on their real economies. In 2010, the effort in advanced economies will be to further improve the financing conditions and strengthen the growth impulses, while the endeavour in the EMEs will be to strengthen the recovery process without compromising on price stability and to contain asset price inflation stemming from large capital inflows.
4. As stated in the Second Quarter Review of October 2009, India's macroeconomic context is different from that of advanced and other EMEs in at least four respects. One, India is facing rising inflationary pressures, albeit largely due to supply side factors. Two, households, firms and financial institutions in India continue to have strong balance sheets, although there is a need to encourage domestic consumption and investment demand. Three, since the Indian economy is supply-constrained, pick-up in demand could exacerbate inflationary pressures. Four, India is one of the few large EMEs with twin deficits - fiscal deficit and current account deficit.
5. Growth during Q2 of 2009-10, at 7.9 per cent, reveals a degree of resilience that surprised many. Subsequent data releases, whether on industrial production, infrastructure or exports, confirm the assessment that the economy is steadily gaining momentum. Based on this better-than-expected performance, growth forecasts for 2009-10 have generally been revised upwards. As reassuring as this recovery is, it is still unbalanced. Public expenditure continues to play a dominant role and performance across sectors is uneven, suggesting that recovery is yet to become sufficiently broad-based.
6. For several months, rapidly rising food inflation has been a cause for concern. More recently, there are indications that the sustained increase in food prices is beginning to spill over into other commodities and services as well. The increases in the prices of manufactured goods have accelerated over the past two months. While food products, understandably, contribute significantly to this, pressures in other sectors are also visible. Further, prices of non-administered fuel items have increased significantly in line with rising international prices. With growth accelerating in the second half of 2009-10 and expected to gain momentum over the next year, capacity constraints could potentially reinforce supply-side inflationary pressures.
7. The inflation risk looms larger when viewed in the context of global price movements. As already indicated, global commodity prices are showing signs of firming up, driven both by the recovery in demand and the asset motive. Significantly, prices of important food items are also firming up. Going by the Food and Agriculture Organisation (FAO) data, the global rates of increase in the prices of sugar, cereals and edible oils are now appreciably higher than domestic rates. The opportunity to use imports as a way to contain domestic food prices is, therefore, quite limited.
8. Monetary aggregates during 2009-10 have so far moved broadly in line with their projections. However, non-food bank credit growth decelerated significantly from its peak of over 29 per cent in October 2008 to a little over 10 per cent in October 2009. Thereafter, it recovered to over 14 per cent by mid-January 2010. This credit performance should be seen in the context of improved access of corporates to non-bank sources of funds this year. Rough calculations show that the total flow of financial resources from banks, domestic non-bank and external sources to the commercial sector during 2009-10 (up to January 15, 2010) at Rs.5,89,000 crore was only marginally lower than Rs.5,95,000 crore in the corresponding period of the previous year. These numbers suggest that non-bank sources of finance have, to a large extent, mitigated the impact of the slow down in bank credit growth.
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