Mid-Term Review of the Annual Policy Statement for 2006-07, RBI Credit Policy: Banknet India

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II. Stance of Monetary Policy for the Second Half of 2006-07

62. The First Quarter Review of July, 2006 noted that the global growth outlook has brightened and the prospects of sustaining high growth in India appear favourable with inflationary pressures contained. Nevertheless, the First Quarter Review pointed to demand pressures continuing to be in evidence within the domestic economy and that it is critical that inflationary expectations are anchored for supporting economic growth and financial stability. Accordingly, while reiterating the stance of the Annual Policy Statement for 2006-07 of being in readiness to meet the challenges posed by the unfolding of various risks, the First Quarter Review sought to ensure a monetary and interest rate environment that enables continuation of the growth momentum while emphasising price stability with a view to anchoring inflation expectations. The focus on credit quality and financial market conditions for maintaining macroeconomic and, in particular, financial stability was reinforced while supporting export and investment demand in the economy. In response to the evolution of macroeconomic and overall monetary conditions, a modest pre-emptive action was considered appropriate. The fixed reverse repo/repo rates under the LAF were raised by 25 basis points each with immediate effect on July 25, 2006 while retaining the spread between the reverse repo rate and the repo rate at 100 basis points. The First Quarter Review also committed the Reserve Bank to consider measures as appropriate to the evolving global and domestic circumstances impinging on inflation expectations and the growth momentum.

63. The course of macroeconomic and financial developments in the ensuing months has shown that the monetary policy stance was appropriate. First, recent macroeconomic performance has been impressive in terms of the first half-year growth record, justifying the relatively higher weight assigned to sustaining the growth momentum in the stance set out in the First Quarter Review of July, 2006. This positive development seems to be reviving expectations of a structural upward shift in the medium-term growth path of the economy, as alluded to in the Annual Policy Statement of April, 2006. Second, the acceleration of growth and its widening ambit has been enabled by an environment of moderate inflation and reasonable financial stability. Third, inflation expectations have remained well-anchored around the policy threshold, drawing confidence from the combination of fiscal and monetary measures recently undertaken. Fourth, financial markets have responded to monetary policy signals. Long-term rates, in particular, have moderated sizeably, flattening the yield curve and a general revival of positive sentiment seems to be pervading all segments of the market continuum. Fifth, trade and current account deficits have been accommodated by continued net capital inflows.

64. The Annual Policy Statement for 2006-07 and subsequently, the First Quarter Review emphasised the need to ensure the quality of bank credit in the context of financial stability. It is important to reiterate these concerns, particularly in the context of preserving the recent gains in macroeconomic performance and productivity. Diligent monitoring of the health of credit portfolios would lead to reduction in non-performing assets, economy in the requirements of regulatory capital and, therefore, a greater freeing up of resources resulting in augmenting the ability of banks to expand lending further. Banks need to recognise this cycle in the monitoring of their loan portfolios.

65. As per current indications, real GDP originating in agriculture is poised to maintain trend growth of 3.0 per cent. The overall industrial outlook has improved in relation to the assessment made in July and services sector growth is expected to sustain its momentum. Overall, for policy purposes, the forecast for GDP growth may be placed at around 8.0 per cent during 2006-07 as compared with the range of 7.5-8.0 per cent projected in the Annual Policy Statement and the First Quarter Review.

66. Inflation conditions so far have been as per expectations. Globally, however, there are incipient pressures on prices of cereals, sugar and pulses in addition to metals. Crude prices have moderated but remain at elevated levels with an uncertain outlook. Observers note the possible elevation of capacity utilisation levels in industries globally. In the domestic economy, the major source of pressure has been from prices of primary products. While some seasonal correction in prices of food articles is possible during the remaining part of the year, policy intervention may be expected in terms of active supply management such as enhanced procurement and effective distribution through the public distribution system. On the demand side also, there are some indications of pressures and possible spillover into inflation expectations. Accordingly, containing the year-on-year inflation rate for 2006-07 in the range of 5.0-5.5 per cent assumes policy priority in terms of watchful monitoring and appropriate policy responses.

67. Monetary and credit aggregates seem to be mirroring the accelerated pace of overall economic activity during the current year. Recognition of this pick-up in momentum is reflected in the upward revision of the forecast for real GDP growth in 2006-07 relative to the projections made in the Annual Policy Statement of April 2006 and the First Quarter Review. The expansion in money supply above indicative projections in the recent period is, to some extent, being driven by the high growth in bank credit. There seems to be anecdotal evidence of ongoing expansion in productive capacity which is perhaps muting inflationary pressures that are traditionally associated with high monetary expansion. Moreover, credit penetration in India remains low, even by emerging economy standards, and the growing financial intermediation is possibly being reflected in monetary and credit aggregates in a manner that standard approaches fail to capture. There is also empirical evidence of a structural break in the evolution of the elasticity of bank credit with respect to output, with an upward shift since the end of the 1990s. Faster growth in credit demand is being supported by a wider dispersal across sectors, and particularly towards households. These factors complicate the assessment of the extent of excess demand pressures.

68. The expansion in M3 was projected at around 15.0 per cent for 2006-07 in the Annual Policy Statement. The growth in aggregate deposits was projected at around Rs.3,30,000 crore in 2006-07. Non-food bank credit including investments in bonds/debentures/shares of public sector undertakings and private corporate sector and CP was expected to increase by around 20 per cent. By current indications, the growth in monetary and credit aggregates is now expected to be somewhat higher than the initial indicative projections. It is, however, important to reiterate the concerns expressed in the First Quarter Review and take careful note of the higher expansion in money supply, deposits and credit while assessing liquidity conditions.

69. In brief, recent global developments and the outlook do not provide any definitive indication for further monetary policy action. Hence, the increasing importance of global factors, by itself, would not warrant any change in the policy stance at this stage, though the evolving monetary policy actions of major economies need to be watched. In the domestic economy, there are signs of demand pressures in addition to possible transient supply constraints in respect of primary commodities. It is also possible to argue that lagged effects of monetary policy actions would influence the future path of output and prices in the desired direction. While there is no conclusive evidence of overheating, and though traditional indicators may overestimate demand pressures, it will be risky to ignore the prevalence and relevance of these factors. Furthermore, containing inflation expectations in the current environment and consolidating gains achieved so far in regard to stability would warrant appropriate, immediate measures and willingness to take recourse to all possible measures in response to evolving circumstances promptly. The objective is to continue to maintain conditions of stability that contribute to sustaining the momentum of growth on an enduring basis. Towards this objective, the monetary policy stance and measures will need to be in a process of careful rebalancing and timely adjustment.

70. The Reserve Bank will ensure that appropriate liquidity is maintained in the system so that all legitimate requirements of credit are met, particularly for productive purposes, consistent with the objective of price and financial stability. Towards this end, the Reserve Bank will continue with its policy of active demand management of liquidity through open market operations (OMO) including the MSS, LAF and CRR, and using all the policy instruments at its disposal flexibly, as and when the situation warrants.

71. 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 inflation, the overall stance of monetary policy in the period ahead will be:

• To ensure a monetary and interest rate environment that supports export and investment demand in the economy so as to enable continuation of the growth momentum while reinforcing price stability with a view to anchoring inflation expectations.

• To maintain the emphasis on macroeconomic and, in particular, financial stability.

• To consider promptly all possible measures as appropriate to the evolving global and domestic situation.