Macro-Economic Development

RBI OF INDIA

Macroeconomic and Monetary Developments 2009-10

Highlights:
Global Economic Conditions
Global economy has started exhibiting tentative signs of recovery, signalling the winding down of global recession. Global recovery is, however, widely perceived to remain slow and gradual, with receding but significant downside risks.
After a series of successive and frequent downward revisions to the growth outlook of the world economy for 2009, the IMF has revised the projected growth upwards for the first time from (-) 1.4 per cent to (-) 1.1 per cent in October 2009.
According to the WTO, world merchandise exports increased by about 8.0 per cent in the second quarter of 2009 over the preceding quarter, even though year-on-year growth continued to decline by 33.0 per cent.
Estimates of the Institute of International Finance (IIF) suggest that net private capital flows to the Emerging Market Economies (EMEs), which had recovered in the second quarter of 2009, gained pace in the third quarter; 30 EMEs are projected to receive US$ 349 billion in 2009. This, however, will still be only about one fourth of the peak level of net flows received in 2007.

Outlook:

Indian Economy Output
In India, GDP growth in the first quarter of 2009-10 at 6.1 per cent represents a modest recovery over the 5.8 per cent growth recorded during the preceding two quarters in the second half of 2008-09. In comparison to the high average growth of 8.8 per cent recorded during the five-year period 2003-08, however, the first quarter growth in 2009-10 still points to persistence of slowdown.

Information available on various lead indicators in the second quarter of 2009-10 suggests that because of deficient monsoon, kharif output may be adversely affected.
Industrial sector has started exhibiting recovery, with 5.8 per cent growth during April-August 2009, as compared with 4.8 per cent during the corresponding period of the previous year.
Growth in core infrastructure witnessed notable acceleration in August 2009, and for April-August 2009 it was higher at 4.8 per cent as against 3.3 per cent during the corresponding period of the previous year.

Lead indicators for services suggest pick up in activities relating to construction and telecommunication, even though external demand dependent services, such as, tourism and cargo handled at ports, continue to be depressed. Aggregate Demand
Deceleration in aggregate demand that was witnessed in the second half of 2008-09 continued during 2009-10. Growth in private consumption demand fell to as low as 1.6 per cent in the first quarter of 2009-10. Investment demand also decelerated further, and the high growth in government consumption demand that was witnessed in the last two quarters of 2008-09 moderated.

Corporate performance data indicate that growth in sales declined in the first quarter of 2009-10, though profitability showed improvements.
Deficient monsoon and the associated drought like conditions in several parts of the country, and the more recent floods in some other parts, could also dampen rural demand.

Given the predominant role of domestic demand in conditioning the growth outlook in India, weak private consumption and investment demand continue to impede faster recovery.
Reflecting the continuation of the expansionary fiscal response to the growth slowdown, key deficit indicators of the Central Government, viz., revenue deficit and gross fiscal deficit were significantly higher during April-August, 2009 over the corresponding period of the previous year. Slowdown induced decline in revenue receipts, though, partly contributed to this trend.

External Economy:
External demand continues to be weak. Trade data show that during April-August 2009, merchandise exports and imports declined by 31.0 per cent and 33.4 per cent, respectively, over the corresponding period of the previous year.

On a balance of payments basis, during the first quarter of 2009-10 while exports declined, imports increased over the preceding quarter, primarily reflecting higher oil prices, resulting in a higher trade deficit. The surplus in net invisibles, led by buoyant remittance inflows financed close to 78 per cent of the trade deficit.

The current account, thus, remained in deficit of about US$ 5.8 billion. Reflecting India’s resilience to the crisis in 2008-09 and the growth prospects of the economy, capital flows, which had turned negative in the last two quarters of 2008-09, reversed in the first quarter. This ensured financing of current account deficit without any recourse to foreign exchange reserves.
The rebound in capital inflows persisted through the second quarter of 2009-10. Including valuation gains on foreign exchange reserves and the SDRs allocated by the IMF to India, India’s foreign exchange reserves increased by US$ 32.8 billion during 2009-10 (up to October 16, 2009) to a level of US$ 284.8 billion.

Monetary Conditions
The accommodative monetary policy stance adopted by the Reserve Bank in response to the global financial crisis, particularly post-September 2008, has continued so far in 2009-10. The aim of this policy stance has been to provide ample rupee liquidity, ensure comfortable dollar liquidity and maintain a market environment conducive for flow of credit to the productive sectors.

The liquidity conditions remained in surplus on a sustained basis, which was absorbed by the Reserve Bank through reverse repo operations under the Liquidity Adjustment Facility (LAF).
Growth in broad money (M3) exhibited modest moderation in the recent period, but at 18.9 per cent (as on October 09, 2009) it remained higher than the Reserve Bank’s indicative trajectory of 18.0 per cent for 2009-10.

On the sources side, monetary expansion was driven by the large borrowing programme of the Government, while bank credit to the commercial sector continued to decelerate (with a growth of 10.7 per cent).

Financial Markets:
Financial markets in India, which functioned normally even at the height of the crisis, posted further decline in risk spreads and higher transaction volumes. The overnight call rate hovered around the floor of the LAF corridor reflecting the abundant liquidity in the system.
In the collateralised segments, namely, market repo and collateralised borrowing and lending obligation (CBLO), interest rates remained below the inter-bank call rates while there was increase in activities. Volumes in the CP and CD markets also increased.

In the government securities market, 80.4 per cent of the net borrowing requirement has been completed so far; weak demand for credit in the private sector and comfortable liquidity conditions helped contain the pressures on yields.

Corporate bond yields increased somewhat but the risk spread fell to the pre-Lehman levels.
In the credit market, the gradual moderation in lending and deposit rates continued through the second quarter of 2009-10. The flow of credit to the private sector, however, remained sluggish due to subdued overall private consumption and investment demand.

Flow of resources from the non-banking sources increased marginally, led by domestic sources in the form of issuance of CPs and private placements.
In the foreign exchange market, the rupee appreciated by about 10.0 per cent against the US dollar over its end-March level.

Equity market outperformed most of the EMEs in terms of the extent of recovery in stock prices seen since April 2009. The primary market activities also picked up significantly, with higher funds mobilised through public issues and private placements, large oversubscription of certain new issues indicating the return of risk appetite in the market, and manifold increase in mobilisation of resources by mutual funds.

Inflation Situation:
The sharp decline in headline WPI inflation from its peak level of 12.9 per cent in August 2008 had created the space for adoption of growth-supportive accommodative monetary policy to mitigate the impact of the global crisis.

After remaining negative for 13 consecutive weeks, WPI inflation turned modestly positive in September 2009. Despite the low headline WPI inflation (year on year) at 1.2 per cent (as on October 10, 2009), inflationary pressures have started to emerge, which is evident from WPI showing 5.9 per cent increase over its March 2009 level and CPI inflation remaining stubbornly elevated at double digit levels.

The changing inflation environment, however, is being driven by strong escalation in prices of food articles, which have increased by 14.4 per cent (year-on-year) so far. Excluding food items, the WPI inflation remains negative at (-) 3.4 per cent.

From the stand point of monetary policy, anchoring inflation expectations in the face of sustained high inflation in essential commodities will be a key challenge. Growth and Inflation Outlook
The current growth outlook for 2009-10 has both upside prospects as well as down side risks. Upside prospects to growth include the impact of the growth supportive fiscal-monetary policy stance, recovery in industrial production and core infrastructure sector, significant upturn in overall business confidence as per different surveys, strong recovery in the stock market with higher mobilisation of resources, return of capital inflows and improving outlook for the global economy which could boost the sluggish consumer and investor confidence.

The downside risks include the unexpectedly large deceleration in private consumption demand and some decline in corporate sales in the first quarter of 2009-10, the impact of deficient monsoon and recent flood in certain parts of the country on agricultural output and rural demand, sustained deceleration in credit growth and decline in exports.
The Reserve Bank’s professional forecasters survey points to downward revision to the growth outlook from 6.5 per cent to 6.0 per cent in 2009-10.

Inflation outlook is currently driven by the emerging signs of inflationary pressures, even though certain developments could neutralise the pressures. These include sluggish aggregate demand and negative output-gap, stabilisation of oil prices in last few months – notwithstanding the increase in October 2009, adequate buffer stocks of foodgrains and the prospects of a better rabi crop that could partly offset the adverse impact of deficient kharif, selective import of certain commodities and the normal trend reversal seen in prices of food articles over different crop seasons.

Emerging inflationary pressures may also persist and escalate further on account of the fading away of the base effect, cost push pressures through wage-price revisions in the face of elevated CPI inflation, challenges in improving the supply situation of essential commodities in the short-run, gradual pressure on global commodity prices along with global recovery, and rising inflation expectations on account of elevated CPI inflation.

The overall economic outlook is, therefore, a mixture of upside prospects of recovery and downside risks. Managing the trade-off between supporting growth and reining in inflation expectations poses a complex policy challenge.

Alpana Killawala,

Chief General Manager,

RBI OF INDIA

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Review of Monetary Policy

RBI OF INDIA

Review of Monetary Policy 2009-10
Statement by Dr. D. Subbarao, Governor, RBI.

"This morning, I had a meeting with the chiefs of major banks where we discussed recent economic developments and where I announced the Second Quarter Review of the Reserve Bank’s Monetary Policy for 2009-10. In the run up to this policy review, we consulted with a wide array of stakeholders and took their views on board.
Banks generally welcomed the Reserve Bank’s policy stance. They agreed with the Reserve Bank’s emphasis on credit flows, particularly to agriculture and micro, small and medium enterprises to support the revival of growth. They indicated that while underlying economic activity has picked up, credit demand remains muted because the access of financing from external and domestic non-bank sources has eased significantly. Banks felt that credit growth prospects remain favourable going forward. Apart from credit offtake, discussion centred around specific issues such as the new liberalised policy on branch authorisation, changes in provisioning norms, infrastructure financing, currency management, priority sector lending certificates (PSLCs), and the recommendations of the Working Group on BPLR. Banks welcomed the liberalised policy on branch authorisation, which together with the liberalised business correspondents model, according to them, should promote financial inclusion and increase credit flow. As regards infrastructure financing by banks, the view was that while banks have a role in infrastructure financing, eventually it should be done through the corporate bond market with participation by long-term institution investors. Banks recognised the role of take-out financing and indicated that they are working with India Infrastructure Finance Company Ltd. (IIFCL) on this issue. While banks welcomed the move to increase the provisioning requirement on commercial real estate exposures, they suggested certain modifications in the calculation of the provisioning cover and requested for more time. The Reserve Bank emphasised the importance of using modern technology, including note sorting machines. There was a general feeling that the merits and demerits of PSLCs need to be carefully examined. Banks were urged to generate the debate through seminars and workshops on the recommendations of the Working Group on BPLR.

Global Economy:
There has been a discernable improvement in the global economy since the last review in July 2009. The recovery is underpinned by output expansion in emerging market economies, particularly in Asia. World output improved in the second quarter, manufacturing activity has picked up, trade is recovering, financial market conditions are improving, and risk appetite is returning. A sharp recovery in equity markets has enabled banks to raise capital to repair their balance sheets. There are concerns, however, that the recovery is fragile. Even as output is reviving, unemployment is expected to increase to over 10 per cent. Investment is also expected to remain weak due to ruptured balance sheets, excess capacity and financing constraints. Bank collapses are continuing. World trade still remains below its level a year ago. On balance, while global economic prospects have improved, uncertainties remain about the pace and sustainability of economic recovery.

Indian Economy:
In India, too, there are definitive indications of the economy attaining the ‘escape velocity’ and reverting to the growth track. This is despite the continuing contraction in exports and the worst drought since 1972. The performance of the industrial sector has improved markedly in recent months. Domestic and external financing conditions are on the upturn. Capital inflows have revived. Activity in the primary capital market has picked up and funding from non-bank domestic sources has eased. Liquidity conditions have remained easy and interest rates have softened in the money and credit markets.
At the same time, some concerns persist. There are clear signs of rising inflation stemming largely from the supply side, particularly from food prices. Private consumption demand is yet to pick up. Agricultural production is expected to decline. Services sector growth remains below trend. Bank credit growth continues to be sluggish.

Government Borrowing:
Management of the large government market borrowing programme in a non-disruptive manner has been a major challenge for the Reserve Bank. Consistent with the accommodative monetary stance, the Reserve Bank expanded its domestic assets through open market operations (OMO) and unwinding of market stabilisation scheme (MSS) securities to provide primary liquidity to support the borrowing programme. During 2009-10 so far, the Central Government has already completed over 80 per cent (Rs.3,19,911 crore) of its net market borrowing and State Governments have mobilised Rs.58,683 crore (net) through the market borrowing programme. Because of the front-loading of the market borrowing programme, net issuances under the Central Government borrowing programme in the remaining period of 2009-10 will be only around Rs.62,500 crore. In the context of the debate on raising the held to maturity (HTM) investment limit for banks, on considerations of the merits and demerits of the issue, the Reserve Bank has determined that it is not advisable to raise the HTM ratio.
Liquidity Situation and Interest Rates
The liquidity situation has remained comfortable since mid-November 2008 as evidenced by large absorption of nearly Rs.1,20,000 crore on a daily average basis under the liquidity adjustment facility (LAF) window of the Reserve Bank. With most commercial banks reducing their deposit rates, the cost of funds has declined enabling banks to reduce their lending rates.
Growth Outlook
On current assessment, the growth projection for GDP for 2009-10 has been retained at 6.0 per cent with an upward bias, unaltered from that made in the July review. This assumes a modest decline in agricultural production, as the South-West monsoon rainfall this year has been the weakest since 1972 affecting both yield and acreage of agricultural crops, but a faster recovery in industrial production.

Inflation Outlook:
Inflation assessment has become increasingly complex in recent times in view of the wide divergence between the inflation rate based on the WPI and the various CPI inflation measures. The situation was aggravated by the deficient monsoon rainfall and drought condition in several parts of the country. While CPI inflation is now in double digit, the WPI inflation rate remains low.
Taking into account the global trend in commodity prices and the domestic demand-supply balance, the base line projection for WPI inflation at end-March 2010 is placed at 6.5 per cent with an upward bias. This is higher than that of 5.0 per cent WPI inflation projected in the July 2009 Review as the upside risks have materialised.

Money Supply:
Keeping in view the borrowing requirement of the Government and of the commercial sector in the remaining period of 2009-10, the indicative projection of money supply growth of 18 per cent set out in July 2009 Review is revised downwards to 17 per cent. Consistent with this, aggregate deposits of scheduled commercial banks are projected to grow by 18 per cent. The growth in adjusted non-food credit, including investment in bonds/debentures/shares of public sector undertakings and private corporate sector and CPs, is also revised downwards to 18 per cent from 20 per cent set out earlier. Banks are urged once again to step up their efforts towards credit expansion while preserving credit quality, which is critical for revival of growth.

Managing the Recovery: Some Issues
The attention around the world, as also in India, has shifted from managing the crisis to managing the recovery. The policy dilemma for India is different in some important respects from that of advanced economies as well as other emerging market economies for the following reasons:
Most of these countries do not face an immediate risk of inflation, whereas India is actively confronted with an upturn in inflation.
India has the challenge of reviving domestic consumption and investment demand, the traditional, dominant drivers of our growth, although households, firms and financial institutions in India are not struggling with impaired balance sheets unlike in advanced economies.
India has traditionally been a supply constrained economy in contrast to advanced economies which are demand starved. The supply constraints, which remained subdued during the crisis period due to weak demand, will re-emerge and may indeed become binding.
India is one of the few large emerging economies with twin deficits – fiscal and current account deficits. Exit Strategy
Around the world there is an active debate on the timing and sequencing of exit from the expansionary monetary stance. ‘Exit’ is a central issue in our policy matrix too. The challenge for the Reserve Bank is to support the recovery process without compromising on price stability. Growth drivers warrant a delayed exit, while inflation concerns call for an early exit. Premature exit will derail the fragile growth, but a delayed exit can potentially engender inflation expectations. This calls for a careful management of trade-offs.
We have studied all the arguments for and against reversal of monetary easing. These arguments are detailed in the policy review document. The balance of judgment at the current juncture is that it may be appropriate to sequence the ‘exit’ in a calibrated way so that while the recovery process is not hampered, inflation expectations remain anchored.

Monetary Policy Stance:
On the basis of the above overall assessment, the stance of monetary policy for the remaining period of 2009-10 will be as follows:
Keep a vigil on the trends in inflation and be prepared to respond swiftly and effectively through policy adjustments to stabilise inflation expectations.
Monitor the liquidity situation closely and manage it actively to ensure that credit demands of productive sectors are adequately met while also securing price stability and financial stability.
Maintain a monetary and interest rate regime consistent with price stability and financial stability, and supportive of the growth process. Way Forward
The Reserve Bank will continue to monitor the price situation in its entirety and will take measures as warranted by the evolving macroeconomic conditions swiftly and effectively.

Monetary Policy Measures:
For now, the Reserve Bank has decided to keep the policy repo rate unchanged at 4.75 per cent, the reverse repo rate unchanged at 3.25 per cent and the CRR of banks unchanged at 5 per cent of their NDTL.
The following measures constitute the first phase of ‘exit’:
The statutory liquidity ratio (SLR), which was reduced from 25 per cent of demand and time liabilities to 24 per cent, is being restored to 25 per cent.
The limit for export credit refinance facility, which was raised to 50 per cent of eligible outstanding export credit, is being returned to the pre-crisis level of 15 per cent.
The two unconventional refinance facilities: (i) special refinance facility for scheduled commercial banks; and (ii) special term repo facility for scheduled commercial banks [for funding to mutual funds (MFs), non-banking financial companies (NBFCs), and housing finance companies (HFCs)] are being discontinued with immediate effect. Further, the liabilities of scheduled banks arising from transactions in collateralised borrowing and lending obligations (CBLO) with Clearing Corporation of India Ltd. (CCIL) would now be subject to the maintenance of the cash reserve ratio (CRR).

Developmental and Regulatory Issues:
Let me now turn to development and regulatory issues. While India has been less affected by the crisis than most other countries, there are lessons from the crisis for India too, which include: (i) further strengthening regulation at the systemic and institutional levels; (ii) making our supervision more effective and value adding; and (iii) improving our skills in risk management. Further, we need to actively pursue the challenge of financial inclusion. I will highlight a few actions being taken by us:
Financial Stability
Releasing of the first Financial Stability Report for India by December 2009. Interest Rates
Considering the recommendations of the Working Group on the Benchmark Prime Lending Rate (BPLR) system after receiving feedback. Financial Market Products
Proposal to introduce plain vanilla over-the-counter (OTC) single-name Credit Default Swaps (CDS) for corporate bonds for resident entities subject to appropriate safeguards. The operational framework will be finalised in consultation with market participants.
Permitting recognised stock exchanges to offer currency futures contracts in currency pairs of Rupee-Euro, Rupee-Pound Sterling and Rupee-Japanese Yen, in addition to the existing Rupee-US dollar contracts. Regulatory Measures
Increasing the provisioning requirement for advances to the commercial real estate sector classified as ‘standard assets’ from 0.4 per cent to 1.0 per cent.
Liberalising the extant branch authorisation policy for domestic non-RRB scheduled commercial banks.
Allowing banks to build up capital for take-out exposures in a phased manner.
Advising banks to augment their provisioning cushions consisting of specific provisions against non-performing assets (NPAs) as well as floating provisions so that their total provisioning coverage ratio, including floating provisions, reaches 70 per cent by September 2010.
Issuing guidelines to private sector and foreign banks with regard to sound compensation policies.
Introducing a category of NBFCs as ‘infrastructure NBFCs’, defined as entities which hold minimum of 75 per cent of their total assets for financing infrastructure projects.
Linking the risk weights of banks’ exposure to infrastructure NBFCs to the credit rating assigned to the NBFC by external credit assessment institutions (ECAIs). Financial Inclusion
Allowing banks to (i) appoint the additional entities as business correspondents (BC); and (ii) collect reasonable service charges from the customer in a transparent manner for delivering the services through BC.
Advising the lead banks to take steps to draw up a road map by March 2010 to provide banking services through a banking outlet in every village having a population of over 2,000, by March 2011.
Constituting a Working Group to examine the issues involved in the introduction of priority sector lending certificates (PSLCs). Currency Management
Mandating banks to install note sorting machines in all their branches in a phased manner in terms of a road map to be approved by the Reserve Bank.
" G. Raghuraj"
Deputy General Manager,
RBI OF INDIA

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