Second Quarter Review of the Monetary Policy for 2010-11
Press Statement by Dr. D. Subbarao, Governor-2nd November 2010
Monetary and Liquidity Aggregates
11. The overall liquidity situation has been in the news over the last few weeks. Let me explain the evolving situation and the underlying dynamics.
12. The present tight liquidity is a result of both structural and frictional factors. On the structural side, the deposit growth rate of the banking system has been sluggish even as the credit growth improved. On the frictional side, government cash balances had built up as a result of more than anticipated tax receipts. On top of it, there were large capital outflows on account of refund of over-subscription of Coal India IPO.
13. Tight liquidity conditions are admittedly desirable from the viewpoint of inflation management, but there are legitimate concerns about the deficit as the injection through the LAF window had become too large in recent weeks, in excess of the Reserve Bank’s comfort zone of (+/-) 1 per cent of NDTL
14. With a view to alleviating the frictional liquidity pressure, the Reserve Bank decided to conduct a second LAF (SLAF) on a daily basis and also allowed banks to avail additional liquidity support under the LAF to the extent of up to 1 per cent of their NDTL up to November 4, 2010. In order to address the structural liquidity problem, earlier today, the Reserve Bank announced an OMO for purchase of government securities amounting to `12,000 crore.
15. In view of the current assessment of the growth-inflation dynamics, It is expected that monetary aggregates will evolve along the projected trajectory indicated in our July Review. Accordingly, for policy purposes, we have retained the earlier projections of money supply (M3) at 17 per cent and of non-food bank credit growth at 20 per cent. As always, these numbers are indicative projections and not targets.
16. Let me now move to external sector management which has assumed a lot of importance in the recent period owing to global developments. The current account deficit in the balance of payments widened in the first quarter of 2010-11. If the current trend persists, the current account deficit as a percentage of GDP for the full year will be significantly higher than in last year. It is generally perceived that a current account deficit above 3 per cent of GDP is difficult to sustain over the medium-term. The challenge, therefore, is to rein in the deficit over the medium-term and finance it in the short-term. The medium-term task has to receive policy focus from both the Government and the Reserve Bank. The short term task is to see that the current account is fully financed while ensuring that capital flows are not far out of line with the economy’s absorptive capacity and that the component of long-term and stable flows in the overall capital flows is high.
17. In the context of today’s increases in policy rates, let me now turn to another important issue. It has often been argued that the widening of interest rate differential between the domestic and international markets will result in increased debt-creating capital flows. While it is true that large interest rate differential makes investment in domestic debt instruments and external borrowings by domestic entities more attractive, we need to keep in view three aspects in the Indian context. First, the economy’s capacity to absorb capital flows has expanded as reflected in the widening of the current account deficit. Second, despite the already large differential between domestic and international interest rates, capital flows in the recent period have been predominantly in the form of portfolio flows into the equity market. This suggests that the interest rate differential is not the only factor that influences capital flows. Third, in line with our policy of preferring equity to debt-creating flows, we still maintain some controls in respect of debt flows.
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An analytical review of macroeconomic and monetary developments: Second Quarter Review 2010-11, was issued on 26th July 2010, which serves as a background to the Second Quarter Review of Monetary Policy 2010-11.
Full Text of Second Quarter Review of the Monetary Policy for 2010-11....Click Here
Mixed reactions from Banks, Economists, India Inc on RBI Annual Policy ....Click Here