Third Quarter Review of Monetary Policy 2009-2010
-29th January 2010
I. The State of the Economy
9. Our previous Reviews have commented on the monetary transmission during the crisis period. While the changes in the Reserve Bank's policy rates were quickly transmitted to the money and government securities markets, transmission to the credit market was slower. Evidently, the transmission is still in progress. The effective average lending rate of scheduled commercial banks declined from 12.3 per cent in March 2008 to 11.1 per cent in March 2009. Although relevant information for the subsequent period is not available, the effective average lending rates may have declined further as banks' benchmark prime lending rates (BPLRs) softened by 25-100 basis points during this period.
10. Financial markets have remained orderly. Overnight money market rates remained below or close to the lower bound of the liquidity adjustment facility (LAF) corridor. Liquidity conditions remained comfortable with the Reserve Bank absorbing about Rs.1,09,000 crore on a daily average basis during the current financial year. Yields on government securities could potentially have increased sharply because of the abrupt increase in government borrowings. However, the upward pressure on yields was contained by lower commercial credit demand, open market operation (OMO) purchases and active liquidity management by the Reserve Bank. Equity markets are behaving in a manner consistent with global patterns. Real estate prices have firmed up as has been the trend in several other EMEs. Increasing optimism about the recovery and high levels of liquidity are driving up real estate prices although they are still some distance away from the pre-crisis peaks.
11. On the fiscal front, the stimulus by the government in the second half of 2008-09 has clearly contributed significantly to the recovery. It may be recalled that the crisis-driven stimulus by way of reduction in excise levies, interest rate subventions and additional capital expenditure came on top of structural measures already built into the budget such as the Sixth Pay Commission Award and farm debt waiver.
12. We will have to await the forthcoming budget in end-February 2010 for the Government's decision on phasing out the transitory components of the stimulus. As regards the structural components, even though they were one-off, some of their impact is expected to continue over the next couple of years, as state governments and public sector enterprises align their compensation structures with the recommendations of the Sixth Pay Commission.
13. Managing the government borrowing programme to finance the large fiscal deficit posed a major challenge for the Reserve Bank. In order to address this, the Reserve Bank front-loaded the government borrowing programme, unwound MSS securities and undertook OMO purchases.
14. On the external front, exports have begun responding to the revival in global demand. Right through the difficulties of 2008-09 and the early months of the current financial year, there was never any pressure on the current account. However, capital outflows in the third quarter of 2008-09 led to some stress on the balance of payments, but we rode this out on the strength of our forex reserves. The Reserve Bank, however, had to initiate some conventional and non-conventional measures to ease the pressure on forex and rupee liquidity. In the space of a year, the situation has clearly stabilised.
15. The current account deficit during April-September 2009 was US$ 18.6 billion, up from US$ 15.8 billion during April-September 2008. Over the first half of 2009-10, capital inflows resumed, but were not significantly in excess of the current account deficit. India's improving growth prospects, combined with persistently high levels of global liquidity, may result in a significant increase in net inflows over the coming months. Depending on how these are handled, there will be implications in terms of a combination of exchange rate appreciation, larger systemic liquidity and the fiscal costs of sterilisation.
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