– By Dr. D. Subbarao, Governor, RBI (Reserve Bank of India)
1. The Monetary Policy for 2010-11 is set against a rather complex economic backdrop. Although the situation is more reassuring than it was a quarter ago, uncertainty about the shape and pace of global recovery persists. Private spending in advanced economies continues to be constrained and inflation remains generally subdued making it likely that fiscal and monetary stimuli in these economies will continue for an extended period. Emerging market economies (EMEs) are significantly ahead on the recovery curve, but some of them are also facing inflationary pressures.
2. India’s growth-inflation dynamics are in contrast to the overall global scenario. The economy is recovering rapidly from the growth slowdown but inflationary pressures, which were triggered by supply side factors, are now developing into a wider inflationary process. As the domestic balance of risks shifts from growth slowdown to inflation, our policy stance must recognise and respond to this transition. While global policy co-ordination was critical in dealing with a worldwide crisis, the exit process will necessarily be differentiated on the basis of the macroeconomic condition in each country. India’s rapid turnaround after the crisis induced slowdown evidences the resilience of our economy and our financial sector. However, this should not divert us from the need to bring back into focus the twin challenges of macroeconomic stability and financial sector development.
3. This statement is organised in two parts. Part A covers Monetary Policy and is divided into four Sections: Section I provides an overview of global and domestic macroeconomic developments; Section II sets out the outlook and projections for growth, inflation and monetary aggregates; Section III explains the stance of monetary policy; and Section IV specifies the monetary measures.Part B covers Developmental and Regulatory Policies and is organised into six sections: Financial Stability (Section I), Interest Rate Policy (Section II), Financial Markets (Section III), Credit Delivery and Financial Inclusion (Section IV), Regulatory and Supervisory Measures for Commercial Banks (Section V) and Institutional Developments (Section VI).
4. Part A of this Statement should be read and understood together with the detailed review in Macroeconomic and Monetary Developments released yesterday by the Reserve Bank.
Part A. Monetary Policy
I. The State of the Economy
Global Economy
5. The global economy continues to recover amidst ongoing policy support and improving financial market conditions. The recovery process is led by EMEs, especially those in Asia, as growth remains weak in advanced economies. The global economy continues to face several challenges such as high levels of unemployment, which are close to 10 per cent in the US and the Euro area. Despite signs of renewed activity in manufacturing and initial improvement in retail sales, the prospects of economic recovery in Europe are clouded by the acute fiscal strains in some countries.
6. Core measures of inflation in major advanced economies are still moderating as the output gap persists and unemployment remains high. Inflation expectations also remain well-anchored. In contrast, core measures of inflation in EMEs, especially in Asia, have been rising. This has prompted central banks in some EMEs to begin phasing out their accommodative monetary policies.
Domestic Economy
7. The Reserve Bank had projected the real GDP growth for 2009-10 at 7.5 per cent. The advance estimates released by the Central Statistical Organisation (CSO) in early February 2010 placed the real GDP growth during 2009-10 at 7.2 per cent. The final real GDP growth for 2009-10 may settle between 7.2 and 7.5 per cent.
8. The uptrend in industrial activity continues. The index of industrial production (IIP) recorded a growth of 17.6 per cent in December 2009, 16.7 per cent in January 2010 and 15.1 per cent in February 2010. The recovery has also become more broad-based with 14 out of 17 industry groups recording accelerated growth during April 2009-February 2010. The sharp pick-up in the growth of the capital goods sector, in double digits since September 2009, points to the revival of investment activity. After a continuous decline for eleven months, imports expanded by 2.6 per cent in November 2009, 32.4 per cent in December 2009, 35.5 per cent in January 2010 and 66.4 per cent in February 2010. The acceleration in non-oil imports since November 2009 further evidences recovery in domestic demand. After contracting for twelve straight months, exports have turned around since October 2009 reflecting revival of external demand. Various lead indicators of service sector activity also suggest increased economic activity. On the whole, the economic recovery, which began around the second quarter of 2009-10, has since shown sustained improvement.
9. A sharp recovery of growth during 2009-10 despite the worst south-west monsoon since 1972 attests to the resilience of the Indian economy. On the demand side, the contribution of various components to growth in 2009-10 was as follows: private consumption (36 per cent), government consumption (14 per cent), fixed investments (26 per cent) and net exports (20 per cent). The monetary and fiscal stimulus measures initiated in the wake of the global financial crisis played an important role, first in mitigating the adverse impact from contagion and then in ensuring that the economy recovered quickly.
10. However, the developments on the inflation front are worrisome. The headline inflation, as measured by year-on-year variation in Wholesale Price Index (WPI), accelerated from 0.5 per cent in September 2009 to 9.9 per cent in March 2010, exceeding the Reserve Bank’s baseline projection of 8.5 per cent for March 2010 set out in the Third Quarter Review. Year-on-year WPI non-food manufactured products (weight: 52.2 per cent) inflation, which was (-) 0.4 per cent in November 2009, turned marginally positive to 0.7 per cent in December 2009 and rose sharply thereafter to 3.3 per cent in January 2010 and further to 4.7 per cent in March 2010. Year-on-year fuel price inflation also surged from (-) 0.7 per cent in November 2009 to 5.9 per cent in December 2009, to 8.1 per cent in January 2010 and further to 12.7 per cent in March 2010. Despite some seasonal moderation, food price inflation remains elevated.
11. Clearly, WPI inflation is no longer driven by supply side factors alone. The contribution of non-food items to overall WPI inflation, which was negative at (-) 0.4 per cent in November 2009 rose sharply to 53.3 per cent by March 2010. Consumer price index (CPI) based measures of inflation were in the range of 14.9-16.9 per cent in January/February 2010. Thus, inflationary pressures have accentuated since the Third Quarter Review in January 2010. What was initially a process driven by food prices has now become more generalised.
12. Growth in monetary and credit aggregates during 2009-10 remained broadly in line with the projections set out in the Third Quarter Review in January 2010. Non-food bank credit expanded steadily during the second half of the year. Consequently, the year-on-year non-food credit growth recovered from its intra-year low of 10.3 per cent in October 2009 to 16.9 per cent by March 2010. The increase in bank credit was also supplemented by higher flow of financial resources from other sources. Reserve Bank’s estimates show that the total flow of financial resources from banks, domestic non-bank and external sources to the commercial sector during 2009-10 at Rs.9,71,000 crore, was higher than the amount of Rs.8,34,000 crore in the previous year.
13. Scheduled commercial banks (SCBs) raised their deposit rates by 25-50 basis points between February and April 2010 so far, signalling a reversal in the trend of reduction in deposit rates. On the lending side, the benchmark prime lending rates (BPLRs) of SCBs have remained unchanged since July 2009 following reductions in the range of 25-100 basis points between March and June 2009. However, data from select banks suggest that the weighted average yield on advances, which is a proxy measure for effective lending rates, is projected to decline from 10.8 per cent in March 2009 to 10.1 per cent by March 2010. The Base Rate system of loan pricing, which will replace the BPLR system with effect from July 1, 2010, is expected to facilitate better pricing of loans, enhance transparency in lending rates and improve the assessment of monetary policy transmission.
14. Financial markets functioned normally through the year. Surplus liquidity that prevailed throughout the year declined towards the end of the year consistent with the monetary policy stance. The Reserve Bank absorbed about Rs.1,00,000 crore on a daily average basis under the liquidity adjustment facility (LAF) during the current financial year up to February 12, 2010, i.e., before the first stage of increase in the cash reserve ratio (CRR) came into effect. During February 27- March 31, 2010, the average daily absorption of surplus liquidity declined to around Rs. 38,200 crore reflecting the increase in the CRR, year-end advance tax outflows and higher credit demand from the private sector. However, as the overall liquidity remained in surplus, overnight interest rates generally stayed close to the lower bound of the LAF rate corridor.
15. The large market borrowing by the Government put upward pressure on the yields on government securities during 2009-10. However, this was contained by active liquidity management by the Reserve Bank. Lower credit demand by the private sector also cushioned the yield. Equity markets generally remained firm during the year with intermittent corrections in line with the global pattern. Resource mobilisation through public issues increased sharply. Housing prices rebounded during 2009-10. According to the Reserve Bank’s survey, they surpassed their pre-crisis peak levels in Mumbai.
16. During 2009-10, the Central Government raised Rs.3,98,411 crore (net) through the market borrowing programme while the state governments mobilised Rs.1,14,883 crore (net). This large borrowing was managed in a non-disruptive manner through a combination of active liquidity management measures such as front-loading of the borrowing calendar, unwinding of securities under the market stabilisation scheme (MSS) and open market operation (OMO) purchases.
17. The Union Budget for 2010-11 has begun the process of fiscal consolidation by budgeting lower fiscal deficit (5.5 per cent of GDP in 2010-11 as compared with 6.7 per cent in 2009-10) and revenue deficit (4.0 per cent of GDP in 2010-11 as compared with 5.3 per cent in 2009-10). As a result, the net market borrowing requirement of the Central Government in 2010-11 is budgeted lower at Rs.3,45,010 crore as compared with that in the previous year.
18. Historically, fiscal deficits have been financed by a combination of market borrowings and other sources. However, in 2009-10 and 2010-11, reliance on market borrowings for financing the fiscal deficit increased in relative terms. The large market borrowing in 2009-10 was facilitated by the unwinding of MSS securities and OMO purchases, as a result of which fresh issuance of securities constituted 63.0 per cent of the total budgeted market borrowings. However in 2010-11, almost the entire budgeted borrowings will be funded by fresh issuance of securities. Therefore, notwithstanding the lower budgeted net borrowings, fresh issuance of securities in 2010-11 will be Rs.3,42,300 crore, higher than the corresponding figure of Rs.2,51,000 crore last year. The large government borrowing in 2009-10 was also facilitated by sluggish private credit demand and comfortable liquidity conditions. However, going forward, private credit demand is expected to pick up further. Meanwhile, inflationary pressures have also made it imperative for the Reserve Bank to absorb surplus liquidity from the system. Thus, managing the borrowings of the Government during 2010-11 will be a bigger challenge than it was last year.
19. The current account deficit during April-December 2009 was US$ 30 billion as compared with US$ 28 billion for the corresponding period of 2008. Net capital inflows at US$ 42 billion were also substantially higher than US$ 7 billion in the corresponding period last year. Consequently, on a balance of payments basis (i.e., excluding valuation effects), foreign exchange reserves increased by US$ 11 billion as against a decline of US$ 20 billion during the corresponding period a year ago. Foreign exchange reserves stood at US$ 279 billion as on March 31, 2010. The six-currency trade-based real effective exchange rate (REER) (1993-94=100) appreciated by 15.5 per cent during 2009-10 up to February as against 10.4 per cent depreciation in the corresponding period of the previous year.