Annual Policy Statement for the Year 2008-09
by Dr. Y. Venugopal Reddy, Governor,
Reserve Bank of India

This Statement consists of two parts:

Part I. Annual Statement on Monetary Policy for the Year 2008-09; and

Part II. Annual Statement on Developmental and Regulatory Policies for the Year 2008-09.

An analytical review of macroeconomic and monetary developments was issued a day in advance as a supplement to Part I of this Statement, providing the necessary information and technical analysis with the help of charts and tables.

2. The Annual Statement on Monetary Policy will be reviewed on a quarterly basis during 2008-09, whereas the Annual Statement on Developmental and Regulatory Policies will be reviewed along with the Mid-Term Review of Monetary Policy, in continuation of the changes in the institutional framework of policy formulation that were initiated in 2005-06. Accordingly, the dates for the First Quarter Review and the Mid-term Review are July 29, 2008 and October 24, 2008, respectively.

Part I. Annual Statement on Monetary Policy
for the Year 2008-09

3. The Annual Statement on Monetary Policy for the Year 2008-09 consists of three Sections:

I. Review of Macroeconomic and Monetary Developments during 2007-08;

II. Stance of Monetary Policy for 2008-09; and

III. Monetary Measures.

I. Review of Macroeconomic and Monetary
Developments during 2007-08

Domestic Developments

4. The growth of real gross domestic product (GDP) in 2007-08 was placed at 8.7 per cent by the Central Statistical Organisation (CSO) in its advance estimates released in February 2008. Economic activity in 2007-08 has evolved in consonance with policy expectations set out in April 2007, albeit with some moderation as compared with 9.6 per cent in 2006-07. In retrospect, the slackening of momentum in 2007-08 appears to have set in as anticipated and moved gradually over the four quarters. Real GDP growth was 9.3 per cent, 8.9 per cent, 8.4 per cent and 8.4 per cent, respectively, in the four quarters of 2007-08 as against 9.6 per cent, 10.1 per cent, 9.1 per cent and 9.7 per cent in the corresponding quarters of 2006-07.

5. Real GDP originating in agriculture and allied activities is estimated to have risen by 2.6 per cent in 2007-08, lower than 3.8 per cent in the previous year. According to the third advance estimates of agricultural production released by the Ministry of Agriculture in April 2008, total foodgrains production is expected to increase to an all-time high of 227.3 million tonnes in 2007-08 from 217.3 million tonnes in 2006-07. Kharif foodgrains production is expected to have risen by 8.6 per cent, whereas rabi foodgrains production is expected to increase by 0.5 per cent. Output is estimated to have risen in the case of rice (2.5 per cent), wheat (1.3 per cent), coarse cereals (17.0 per cent) and pulses (7.0 per cent). Among the commercial crops, production is estimated to have increased under cotton (2.5 per cent), oilseeds (16.1 per cent) and jute (2.3 per cent) whereas the production of sugarcane declined by 3.2 per cent.

6. Real GDP originating in industry rose by 8.6 per cent in 2007-08 as compared with 10.6 per cent in the previous year. The index of industrial production (IIP) recorded an increase of 8.7 per cent during April-February 2007-08 vis-à-vis 11.2 per cent a year ago. In manufacturing, which contributed 89 per cent of the increase in industrial production, the growth of output was lower at 9.1 per cent than 12.2 per cent a year ago. Growth in mining at 5.1 per cent was comparable with 5.0 per cent a year ago, while growth in electricity generation moderated to 6.6 per cent as compared with 7.2 per cent. Production of beverages, tobacco and related products, wood and wood products, leather and leather products, basic chemicals and products and basic metals and alloys recorded double-digit growth in 2007-08 (up to February 2008). The industry groups that registered deceleration of growth include textiles, paper and paper products, non-metallic mineral products and transport equipments and parts. On the other hand, the production of metal products and parts except machinery and equipments recorded a decline.

7. In terms of the use-based classification of industries, the production of capital goods continued to expand at a sustained pace, increasing by 17.5 per cent during April-February 2007-08, over and above the increase of 18.3 per cent a year ago. The basic, intermediate and consumer non-durable goods segments recorded lower growth of 7.4 per cent, 9.2 per cent and 8.9 per cent, respectively, as compared with 10.1 per cent, 11.7 per cent and 9.5 per cent a year ago. Production of consumer durables declined by 1.0 per cent as against an increase of 9.7 per cent a year ago. The output of the six key infrastructure industries (with a weight of 26.7 per cent in the IIP) also registered a lower growth of 5.6 per cent during April-February 2007-08 as against 8.7 per cent in the corresponding period of the previous year.

8. Corporate activity experienced some moderation in growth relative to the recent past but continued to remain healthy during 2007-08. During April-December 2007, growth in sales of surveyed non-financial private companies decelerated to 17.4 per cent from 29.1 per cent in the corresponding period of the preceding year. Net profits growth was also lower at 29.8 per cent from 46.6 per cent a year ago due to a combination of several factors including escalation in input costs and compensation to employees. Corporates' interest burden continues to be low with the interest payment to gross profits ratio estimated at 11.8 per cent, 12.8 per cent and 15.3 per cent in the first three quarters of 2007-08 as against 18.1 per cent and 13.4 per cent in 2005-06 and 2006-07, respectively, and an average of 43.7 per cent in 2000-05. The differential between sales and expenditure growth shrank to 20 basis points from 280 basis points in April-December 2006, reflecting pressure on profits at the operating level, somewhat mitigated by strong support from income from non-core activities which rose by 75.5 per cent in April-December 2007 as compared with 20.9 per cent a year ago. Early results for the fourth quarter of 2007-08 indicate that growth in sales and net profits are lower than in the corresponding quarter a year ago. There was also a larger increase in expenditure on both raw materials and compensation to employees for the selected companies. Consequently, the difference between sales growth and the overall expenditure growth narrowed, resulting in lower profitability both in gross and net terms.

9. The Reserve Bank's Industrial Outlook Survey conducted during February 2008 indicates a mixed picture in the business sentiment. With a pickup in demand conditions (including exports), the assessment for January-March 2007-08 shows an improvement over the expectation for the quarter in the previous round of the survey. The business expectations index for April-June 2008 at 123.2 has moved up from 118.6 recorded in the previous quarter, against the seasonal decline, but is still lower than its level at 127.5 in the corresponding quarter of the previous year. Production, order book positions and capacity utilisation growth are expected to pick up in relation to the previous quarter and increasing number of respondent firms expect employment levels to go up. Price pressures are seen as rising mainly on the back of higher raw material costs. About 27 per cent of respondent firms expect to pass on the price increase to customers in April-June 2008 as compared with 23 per cent in the corresponding quarter of the previous year. While imports and exports are expected to pick up in April-June 2008 as compared with the previous quarter, the growth in exports would be lower than in the corresponding quarter of 2007-08. With nearly one in every four respondents perceiving higher profit margins and more than 60 per cent expecting status quo, the optimism on profit margins for April-June 2008 has improved in relation to January-March 2008, although it is still lower than in April-June 2007.

10. Business confidence surveys conducted by other agencies convey a somewhat tempered though overall positive outlook. One survey's Business Optimism Index indicates a sharp decline in the first quarter of 2008-09 with respect to the previous quarter and a much sharper fall when compared to April-June 2007, attributable to less optimistic sentiment in the services and capital goods sectors. According to another survey, however, the overall economic conditions for the next six months are seen to be positive, with production closely following expectations of growth in domestic sales and a clear upturn in import growth. Seasonally adjusted purchasing managers' indices reflect lower business sentiment for January-March 2008 with some ebbing in relation to the previous quarter but still higher than a year ago. All the surveys indicate sustained though somewhat slower growth of manufacturing with firms trying to protect their profit margins through improvement in productivity and by passing on cost increases into selling prices. Investment sentiment remains positive on expectations of improvement in the financial position, order books and capacity utilisation.

11. Real GDP originating in the services sector rose by 10.6 per cent during 2007-08 as compared with 11.2 per cent a year ago. Activity in construction and financing, insurance, real estate and business services sector expanded by 9.6 per cent and 11.7 per cent, respectively, as compared with 12.0 per cent and 13.9 per cent in 2006-07. The growth of trade, hotels and restaurants, transport, storage and communication was 12.1 per cent in 2007-08, marginally higher than 11.8 per cent in 2006-07. Growth in community, social and personal services at 7.0 per cent was comparable to 6.9 per cent in the previous year.

12. Aggregate demand conditions in 2007-08 continued to be dominated by investment spending as in recent years. The growth of real gross fixed capital formation (GFCF) accelerated to 15.7 per cent from 15.1 per cent in the previous year. Real private final consumption expenditure (PFCE) increased by 6.8 per cent as compared with 7.1 per cent in 2006-07. In nominal terms, PFCE marginally declined to 55.5 per cent of GDP at current market prices during 2007-08 from 55.8 in 2006-07 and 57.4 per cent in 2005-06. On the other hand, GFCF increased to 34.6 per cent of GDP from 32.5 per cent in 2006-07 and 31.0 per cent in 2005-06.

13. The overall moderation in real sector activity was reflected in the evolution of monetary and banking developments in 2007-08. Non-food credit extended by the scheduled commercial banks (SCBs) increased by 22.3 per cent (Rs.4,19,425 crore) as compared with 28.5 per cent (Rs.4,18,282 crore) in the previous year. The incremental non-food credit-deposit ratio for the banking system declined to 72.3 per cent during 2007-08 from 83.2 per cent in 2006-07, 109.3 per cent in 2005-06 and 130.0 per cent in 2004-05. Food credit of SCBs declined by Rs.2,121 crore in 2007-08 as against an increase of Rs.5,830 crore in the previous year.

14. Provisional information on the sectoral deployment of bank credit available up to February 2008 indicates, as anticipated, a gradual deceleration over the year. On a year-on-year basis, credit to services sector recorded the highest growth (28.4 per cent), followed by industry (25.9 per cent) and agriculture sector (16.4 per cent). On the other hand, growth in personal loans decelerated to 13.2 per cent (30.6 per cent). Growth in housing and real estate loans decelerated to 12.0 per cent (25.8 per cent) and 26.7 per cent (79.0 per cent), respectively. Within the industrial sector, there was a sizeable credit pick-up in respect of infrastructure (42.1 per cent as against 28.2 per cent a year ago), food processing (32.0 per cent as against 27.6 per cent) and engineering (26.2 per cent as against 18.1 per cent). There was moderation in credit growth to basic metals and metal products (19.0 per cent as against 33.3 per cent), textiles (23.0 per cent as against 35.5 per cent), petroleum (23.3 per cent as against 64.4 per cent) and chemicals (13.9 per cent as against 19.2 per cent). Credit to industry constituted 45.2 per cent of the total expansion in non-food bank credit up to February 2008, followed by services (29.8 per cent), personal loans (15.8 per cent) and agriculture (9.2 per cent). The share of infrastructure in total credit to industry increased from 20.5 per cent to 23.1 per cent. On the contrary, the share of credit to metals, textiles, chemicals and petroleum declined from 12.4 per cent, 11.3 per cent, 8.3 per cent and 4.9 per cent, respectively, to 11.7 per cent, 11.1 per cent, 7.5 per cent and 4.8 per cent. Priority sector advances grew by 16.9 per cent with a moderation in their share in outstanding gross bank credit to 33.3 per cent in February 2008 from 34.7 per cent a year ago.

15. SCBs' investments in bonds/debentures/shares of public sector undertakings and the private corporate sector and commercial paper (CP) increased by 14.2 per cent (Rs.11,830 crore) during 2007-08 as compared with an increase of 5.1 per cent (Rs.4,081 crore) in the previous year. As a result, the total flow of funds from SCBs to the commercial sector, including non-SLR investments, increased by 21.9 per cent (Rs.4,31,256 crore) in 2007-08 as against 27.3 per cent (Rs.4,22,363 crore) in 2006-07. Banks' investment in instruments issued by mutual funds increased by Rs.6,818 crore in 2007-08 as compared with Rs.1,315 crore in 2006-07.

16. Commercial banks' investment in Government and other approved securities increased by 22.9 per cent (Rs.1,81,222 crore) during 2007-08 significantly higher than 10.3 per cent (Rs.74,062 crore) in 2006-07. Accordingly, their stock of statutory liquidity ratio (SLR) eligible securities marginally increased to 27.4 per cent of the banking system's net demand and time liabilities (NDTL) in March 2008 from 27.3 per cent in March 2007. Bank's holdings of SLR securities in excess of the prescribed ratio of 25 per cent amounted to Rs.1,02,422 crore although several banks are operating their SLR portfolios close to the prescribed level. Adjusted for collateral securities under the liquidity adjustment facility (LAF) and issuances under the market stabilisation scheme (MSS), banks' investment in SLR-eligible securities would amount to 23.7 per cent of NDTL.

17. Aggregate deposits of SCBs increased by 22.2 per cent (Rs.5,80,208 crore) during 2007-08 as compared with 23.8 per cent (Rs.5,02,885 crore) in the previous year. Demand deposit growth at 20.2 per cent was higher than 17.9 per cent in 2006-07 but time deposit growth moderated to 22.6 per cent from 25.1 per cent in the previous year. In addition to the mobilisation of deposits, the banking sector's lendable resources were augmented substantially by capital raised through public issues and innovative capital instruments during 2007-08.

18. Money supply (M3) increased by 20.7 per cent (Rs.6,86,096 crore) in 2007-08 as compared with 21.5 per cent (Rs.5,86,548 crore) in 2006-07. Bank credit to the commercial sector increased by 20.3 per cent (Rs.4,32,574 crore) in 2007-08 as compared with the increase of 25.8 per cent (Rs.4,37,074 crore) a year ago. Net bank credit to Government recorded an increase of Rs.67,363 crore, with increase in banks' investment of Rs.1,83,338 crore in Government securities offset by a decline of Rs.1,15,975 crore (net) in Reserve Bank's credit to Government. The large increase in net foreign exchange assets of the Reserve Bank was reflected in the increase of 38.7 per cent (Rs.3,53,118 crore) in the banking sector's net foreign exchange assets.

19. Reserve money increased by 30.9 per cent (Rs.2,19,326 crore) during 2007-08 as compared with 23.7 per cent (Rs.1,35,935 crore) in the previous year. While currency in circulation rose by 17.2 per cent (Rs.86,606 crore) in 2007-08 as compared with the increase of 17.1 per cent (Rs.73,523 crore) in the preceding year, bankers' deposits with the Reserve Bank increased substantially by 66.5 per cent (Rs.1,31,152 crore) — augmented by the increase of 150 basis points in cash reserve ratio (CRR) during the year — as compared with the increase of 45.6 per cent (Rs.61,784 crore) in 2006-07. Among the sources of reserve money, the Reserve Bank's foreign currency assets (adjusted for revaluation) increased by Rs.3,70,550 crore as compared with the increase of Rs.1,64,601 crore in the previous year. The Reserve Bank's net credit to the Central Government (adjusted for the Government's deposit balances including the MSS proceeds) declined by Rs.7,070 crore in 2007-08 as against an increase of Rs.30,888 crore in 2006-07. Reflecting the liquidity conditions, the Reserve Bank's credit to banks and the commercial sector declined by Rs.2,794 crore as compared with an increase of Rs.1,990 crore in the previous year. The ratio of net foreign exchange assets (NFEA) to currency increased from 171.8 per cent in March 2007 to 209.2 per cent in March 2008.

20. During the year, the financial markets experienced alternating shifts in liquidity conditions. Tightness in liquidity on account of year-end adjustments in March 2007 persisted up to April-May, necessitating net repo injections under the LAF. There was substantial drawdown in the Centre's cash balances during May-July 2007 and a dip in MSS outstanding in June-July 2007 due to redemptions. The total overhang of liquidity as reflected in the balances under the LAF, the MSS and surplus cash balances of the Central Government taken together declined from an average of Rs.97,412 crore in March 2007 to Rs.63,994 crore in July 2007. The resumption of net issuances under the MSS, accretions to Centre's cash balances and the increase in CRR by 100 basis points during August-November 2007 led to a reduction in the liquidity in the banking system and intermittent net liquidity injections of Rs.2,742 crore and Rs.10,804 crore on a daily average basis in November and December 2007, respectively. Auctions of dated securities under MSS were discontinued between November 2, 2007-January 16, 2008 to ease the stringency in liquidity. The liquidity overhang ruled steady in the range of Rs.2,13,847 crore-Rs.2,18,224 crore during October-December 2007.

21. During the fourth quarter of 2007-08, even though liquidity conditions were comfortable in January 2008 and MSS auctions were resumed in mid-January 2008, some tightness emerged during February 18-28, on account of increase in the Centre's cash balances. In view of the scheduled advance tax payments in mid-March 2008 and the subsequent bank holidays (March 20-22, 2008), the Reserve Bank conducted additional three-day repo/reverse repo auctions on March 14, 2008 (afternoon) and another seven-day repo auction on March 17, 2008 (afternoon) over and above the normal LAF arrangements for smooth liquidity management. Injection of liquidity through LAF repo and redemption of MSS around mid-February 2008 onwards, mitigated the liquidity tightness. During March 17-31, 2008 there were shortages of liquidity in the wake of advance tax payments. Net LAF injections rose to a peak of Rs.53,995 crore on March 31, 2008; however, in the additional LAF operations conducted on that day with a view to meeting the banking sector's year-end liquidity management requirements, there was absorption of liquidity under the LAF to the tune of Rs.3,645 crore. The build-up of cash balances of the Central Government to a peak of Rs.1,04,741 crore on March 27, 2008 also aggravated the liquidity shortage with banks. The overall liquidity overhang increased to the intra-year peak of Rs.2,73,694 crore on March 27, 2008 before declining to Rs.2,43,879 crore on April 25, 2008.

22. On a net basis, average daily LAF repo injections which stood at Rs.4,568 crore in the first quarter of 2007-08 changed to net absorption through LAF reverse repo of Rs.13,472 crore in the second quarter which declined sharply to Rs.7,820 crore in the third quarter and further to Rs.2,116 crore during the fourth quarter of 2007-08. During 2008-09 (up to April 25, 2008), the average daily net absorption under LAF reverse repo increased to Rs.28,271 crore. The average outstanding balances under MSS increased from Rs.64,863 crore at end-March 2007 to Rs.1,70,554 crore by end-March 2008 and further to Rs.1,74,465 crore on April 25, 2008 indicating net issuance of Rs.1,05,691 crore during 2007-08. Cash balances of the Central Government with the Reserve Bank increased from an average of Rs.55,890 crore in March 2007 to Rs.79,409 crore in March 2008 before declining to Rs.36,649 crore as on April 25, 2008.

23. On a year-on-year basis, inflation based on the wholesale price index (WPI) stood at 7.4 per cent at end-March 2008 as compared with 5.9 per cent a year ago. During 2007-08, headline inflation declined from 6.4 per cent at the beginning of the financial year to a low of 3.1 per cent in mid-October before firming up from mid-February 2008 onwards. On an annual average basis, inflation at 4.7 per cent during 2007-08 was lower than 5.4 per cent in the previous year. As on April 12, 2008 the headline inflation stood at 7.3 per cent as against 6.3 per cent a year ago.

24. At a disaggregated level, prices of primary articles (weight: 22.0 per cent in the WPI basket) registered a year-on-year increase of 8.9 per cent at end-March 2008 as compared with 10.7 per cent a year ago. The increase in prices of primary articles during 2007-08 was led by the rise in prices of food articles and non-food articles such as cotton and oilseeds. As on February 1, 2008 the stock of foodgrains with public agencies stood at 21.4 million tonnes as against the buffer stock norm of 20.0 million tonnes applicable for January-March, 2008. The build-up in food stocks on the back of the jump in foodgrains production during 2007-08 provides some comfort for supply management. Wheat procurement during the current rabi marketing season has also risen by 20.6 per cent on a year-on-year basis, strengthening food security strategies and conditions for stabilisation of domestic food prices going forward.

25. Inflation in terms of prices of manufactured products (weight: 63.8 per cent) was 7.1 per cent as compared with 6.1 per cent a year ago. Prices of edible oils, oil cakes, basic metals, alloys and metal products and basic heavy inorganic chemicals contributed to the rise in manufacturing prices in 2007-08. On the other hand, prices of textiles, leather and leather products and non-ferrous metals declined during the year.

26. The year-on-year increase in prices of the 'fuel, power, light and lubricants' group (weight: 14.2 per cent) was 6.7 per cent at end-March 2008 as compared )with 1.0 per cent a year ago. Excluding the fuel group, headline inflation was 7.6 per cent (7.4 per cent a year ago). The average price of the Indian basket of international crude increased by 27.6 per cent from US $ 62.4 per barrel during 2006-07 to US $ 79.7 per barrel in 2007-08. While there has been no revision in prices of kerosene and domestic LPG during 2007-08, domestic retail prices of petrol and diesel have been revised upwards only once during 2007-08 with effect from February 15, 2008 by 4.5 per cent for petrol and by 3.25 per cent for diesel (average of four metros). Among the freely priced petroleum products, however, prices of naptha, bitumen, furnace oil and aviation turbine fuel, recorded increases of 33.7 per cent, 36.4 per cent, 37.6 per cent and 38.7 per cent, respectively, over their levels a year ago.

27. Inflation, on a year-on-year basis, based on the consumer price index (CPI) for industrial workers (IW) stood at 5.5 per cent in February 2008 as compared with 7.6 per cent a year ago. The CPI for urban non-manual employees (UNME), agricultural labourers (AL) and rural labourers (RL) also declined to 6.0 per cent, 7.9 per cent and 7.6 per cent, respectively, in March 2008 as compared with 7.6 per cent, 9.5 per cent and 9.2 per cent a year ago. On an annual average basis, inflation based on CPI for IW was 6.1 per cent in February 2008 compared with 6.6 per cent a year ago and that for UNME, AL and RL were 5.9 per cent, 7.5 per cent and 7.2 per cent, respectively, in March 2008 as compared with 6.6 per cent, 7.8 per cent and 7.5 per cent a year ago.

28. The revised estimates (RE) of the Central Government's finances for 2007-08 indicate ongoing improvement in the fiscal position and lowering of the key deficit indicators relative to budget estimates (BE). The revenue deficit estimated at 1.4 per cent of GDP (Rs.63,488 crore) was lower than 1.5 per cent of GDP in the BE for 2007-08 and 1.9 per cent of GDP in 2006-07. The gross fiscal deficit (GFD) for 2007-08 constituted 3.1 per cent of GDP (Rs.1,43,653 crore) as against the budget estimates of 3.3 per cent and 3.5 per cent in 2006-07. The improvement in key fiscal indicators was largely enabled by the sustained buoyancy in tax revenue which, at Rs.4,31,773 crore (RE) was 6.9 per cent higher than the budget estimates and recorded a growth of 22.9 per cent over the previous year.

29. During 2007-08, the Central Government's net market borrowing through dated securities at Rs.1,10,671 crore was 101.0 per cent of the budgeted amount of Rs.1,09,579 crore and gross market borrowing of Rs.1,56,000 crore through dated securities was 100.35 per cent of the budgeted amount of Rs.1,55,455 crore. The Central Government also issued additional securities amounting to Rs.38,050 crore, outside the market borrowing programme and the MSS, to public sector oil companies for partial compensation of under-recoveries, to the State Bank of India and to various fertiliser companies. During 2006-07, the Central Government had issued such securities amounting to Rs.40,321 crore. The State Governments and the Union Territory of Pondicherry raised Rs.67,779 crore (gross) and Rs.56,224 crore (net) during 2007-08 under their market borrowing programme. The combined issuance (net) of Government securities under the market borrowing programme of the Centre and States was Rs.1,66,895 crore in 2007-08 as against Rs.1,21,190 crore in 2006-07, Rs.1,10,825 crore in 2005-06, Rs.80,012 crore in 2004-05 and Rs.1,35,192 crore in 2003-04.

30. Out of 35 issuances under the market borrowing programme of the Central Government, one new 10-year paper was issued and the remaining 34 issues were reissuances intended to impart liquidity. The actual issuance of dated securities under the Centre's market borrowing programme was generally as per the advance calendar except for one occasion when, in consultation with the Central Government, securities for Rs.5,000 crore were issued on June 12, 2007 over and above the scheduled issuances in the indicative calendar for the first half of 2007-08. The weighted average yield on primary issuance of the Central Government's dated securities increased by 23 basis points to 8.12 per cent in 2007-08 from 7.89 per cent in the previous year whereas the weighted average maturity of the dated securities issued during the year increased to 14.90 years from 14.72 years in the previous year. In the case of market borrowing by State Governments, the weighted average yields firmed up by 15 basis points to 8.25 per cent in 2007-08 from 8.10 per cent in 2006-07, whereas the average maturity of these issues has remained the same at 10.0 years.

31. Movements in interest rates in the domestic financial markets reflected the factors driving changes in liquidity with the banking system during 2007-08. The weighted average call market rates declined from 8.33 per cent in April 2007 to 0.73 per cent in July 2007 coincident with a ceiling of Rs.3,000 crore placed on daily reverse repo from March 5, 2007. The rates moved up in August following the removal of the ceiling but generally stayed within the informal LAF rate corridor up to December 2007. As liquidity conditions tightened, call money rates strayed, albeit marginally, above the repo rate during the last fortnight of February and in March 2008. The daily weighted average call rate during March 2008 was much lower at 7.37 per cent as compared with 14.10 per cent in March 2007. In April 2008, call rates declined further and the weighted average call rate stood at 5.93 per cent as on April 25, 2008. Interest rates in the CBLO and market repo segments moved in sympathy with call rates and declined from December 2007 peaks to 6.37 per cent and 6.72 per cent, respectively, in March 2008 and further to 4.93 per cent and 5.45 per cent in April 2008 (up to April 25, 2008). The daily average volume (one leg) in the call money market declined from Rs.14,845 crore in April 2007 to Rs.11,182 crore in March 2008 and further to Rs.9,374 crore in April 2008 (up to April 25, 2008). The corresponding volumes in the market repo (outside the LAF) were Rs.7,173 crore, Rs.14,800 crore and Rs.11,911 crore respectively, whereas in the CBLO segment, the volumes were Rs.18,086 crore, Rs.37,413 crore and Rs.31,297 crore, respectively.

32. Mobilisation of resources through issuance of commercial papers (CPs) was stepped up during 2007-08 as the weighted average discount rate on CP declined by 95 basis points from 11.33 per cent at end-March 2007 to 10.38 per cent in end-March 2008 and the outstanding amount of CPs increased from Rs.17,688 crore to Rs.32,592 crore during this period. The weighted average discount rate for certificates of deposit (CDs) also declined from 10.75 per cent at end-March 2007 to 10.00 per cent in end-March 2008, accompanied by a significant increase in outstanding amounts from Rs.93,272 crore to Rs.1,47,792 crore.

33. In the Government securities market, primary market yields of 91-day, 182-day and 364-day Treasury Bills softened over the course of 2007-08, declining by 63-84 basis points to reach 7.23 per cent, 7.36 per cent and 7.35 per cent, respectively, by end-March 2008. By April 25, 2008 the primary market yields of 91-day, 182-day and 364-day Treasury Bills stood at 7.44 per cent, 7.60 per cent and 7.69 per cent, respectively. In the secondary market, the yield on Government securities with 1-year residual maturity declined from 7.55 per cent at end-March 2007 to 7.49 per cent in March 2008 before increasing to 7.84 per cent as on April 25, 2008. The yield on Government securities with 10-year residual maturity declined marginally from 7.97 per cent in March 2007 to 7.93 per cent before rising to 8.23 per cent by April 25, 2008 while the yield on Government securities with 20-year residual maturity increased from 8.23 per cent at end-March 2007 to 8.31 per cent at end-March 2008 and further to 8.63 per cent as on April 25, 2008. Consequently, the yield spread between 10-year and 1-year Government securities increased marginally from 42 basis points at end-March 2007 to 44 basis points at end-March 2008 before declining to 39 basis points as on April 25, 2008. Similarly, the yield spread between 20-year and 1-year Government securities increased from 68 basis points at end-March 2007 to 82 basis points at end-March 2008 and subsequently declined marginally to 79 basis points as on April 25, 2008.

34. Rapid growth in turnover in the foreign exchange market was sustained by large surplus conditions in the spot market. The average daily turnover increased to US $ 57.30 billion at end-March 2008 from US $ 33.18 billion at end-March 2007. With increasing volumes of current and capital account transactions, the merchant turnover for the period increased to US $ 16.37 billion from US $ 8.66 billion, while the inter-bank turnover increased to US $ 40.88 billion from US $ 24.52 billion. There was a general softening in forward premia across all maturities over end-March 2007 but some hardening was witnessed after September 2007. The six-month forward premia eased from 4.40 per cent in March 2007 to 2.55 per cent by end-June 2007 and further to 0.78 per cent by end-September before it increased to 2.50 per cent at end-March 2008 and further to 2.67 per cent by April 25, 2008.

35. During March 2007-March 2008, pubic sector banks (PSBs) readjusted their deposit rates downwards by 25-50 basis points, while those offering lower deposit rates for similar maturity earlier increased their deposit rates by 50-100 basis points. Similarly, PSBs paying higher interest rates earlier on shorter term deposits of up to one year maturity also revised their deposit rates downwards by 25 basis points. In particular, the interest rates offered by the PSBs on deposits of above one year maturity moved from the range of 7.25-9.50 per cent in March 2007 to 8.00-9.25 per cent in March 2008, while deposit rates for shorter term deposits of up to one year maturity decreased from the range of 2.75-8.75 per cent to 2.75-8.50 per cent during the same period. On the other hand, private sector banks increased their interest rates for long term deposits of above one year maturity from a range of 6.75-9.75 per cent to 7.25-9.75 per cent during the same period. Foreign banks set deposit rates lower for maturities of less than one year while they have marginally raised their rates for deposits of longer maturities.

36. On the lending side, the benchmark prime lending rates (BPLRs) of PSBs increased by 75 basis points from a range of 12.25-12.75 per cent to 12.25-13.50 per cent during 2007-08. The private sector banks increased their BPLR from a range of 12.00-16.50 per cent to a range of 13.00-16.50 per cent, in the same period. The range of BPLRs for foreign banks, however, remained unchanged at 10.00-15.50 per cent during the same period. The median lending rates for term loans (at which maximum business is contracted) in respect of PSBs moved from a range of 9.13-12.50 per cent in March 2007 to 10.00-13.00 per cent by March 2008.

37. The Indian equity market witnessed large swings during 2007-08. The BSE Sensex (1978-79=100) increased by 19.7 per cent during the year from 13072 at end-March 2007 to 15644 at end-March 2008. The intra-year peak of 20873 was recorded on January 8, 2008 whereas the intra-year trough of 12445 was recorded on April 2, 2007. Corporates mobilised large resources through public issues during the year. Sound macroeconomic fundamentals, private corporate profitability, institutional buying support and global macroeconomic conditions were the major factors determining the movements in equity prices. As on April 25, 2008 the BSE Sensex stood at 17126.

Developments in the External Sector

38. The Reserve Bank's end-March 2008 release sets out the balance of payments data for April-December 2007. In US dollar terms, merchandise exports increased by 24.6 per cent during April-December 2007 from 23.9 per cent in April-December 2006. Provisional information on commodity-wise trade available from the Directorate General of Commercial Intelligence and Statistics (DGCI&S) shows that export growth in 2007-08 was driven by petroleum products, engineering goods and gems and jewellery. During the first nine months of 2007-08, merchandise import growth accelerated to 27.9 per cent from 27.7 per cent a year ago, mainly due to an increase of 29.9 per cent in non-oil imports from 22.7 per cent in April-December 2006. The growth in non-oil imports was mainly due to capital goods, pearls and precious stones, chemicals, and gold and silver. Oil imports increased by 24.0 per cent as against 39.4 per cent during April-December 2006 as the average price of the Indian basket of international crude recorded an annual increase of 15.9 per cent to US $ 74.7 per barrel in April-December 2007. On payments basis, the merchandise trade deficit increased to US $ 66.5 billion during April-December 2007 from US $ 50.3 billion in the corresponding period of 2006-07.

39. Net invisible earnings amounted to US $ 50.5 billion in April-December 2007 as against US $ 36.3 billion a year ago. The key contributors to invisibles were remittances from Indians working overseas, export of software services and travel earnings. Private transfers, comprising primarily remittances from overseas Indians, remained sizeable at US $ 28.8 billion as compared with US $ 20.2 billion a year ago. While the inward remittances for family maintenance increased by 39.0 per cent, local withdrawals from non-resident Indian (NRI) deposit accounts were higher by 49.0 per cent which may be attributed to higher returns domestically vis-à-vis NRI deposits. Software export proceeds amounted to US $ 27.5 billion as against US $ 21.8 billion in April-December 2006. Miscellaneous receipts, net of software exports, stood at US $ 18.1 billion in April-December 2007 as compared with US $ 17.6 billion a year ago, mainly on account of business services such as trade-related services, business and management consultancy, engineering and technical know-how. Invisible payments increased to US $ 49.7 billion during the first nine months of 2007-08 as compared with US $ 43.1 billion a year ago. The key components of invisible payments were travel payments, transportation, business and management consultancy, technical services, dividends, profit and interest payments. With invisible receipts rising faster than payments, the net invisible surplus increased from US $ 36.3 billion in April-December 2006 to US $ 50.5 billion in April-December 2007. Reflecting these developments in the merchandise and invisible accounts, the current account deficit (CAD) at US $ 16.0 billion was higher than US $ 14.0 billion in the corresponding period of the previous year.

40. Net capital inflows surged by 172 per cent to US $ 81.9 billion during April-December 2007 as compared with US $ 30.1 billion a year ago. While net foreign direct investment (FDI) increased by US $ 8.4 billion from US $ 7.6 billion in April-December 2006, portfolio investment recorded a substantial increase of US $ 33.0 billion from US $ 5.2 billion. Enabled by finer spreads and in response to rising financing requirements for domestic capacity expansion, net external commercial borrowings (ECBs) increased to US $ 16.3 billion as against an increase of US $ 9.8 billion in the previous year. During the first nine months of 2007-08, NRI deposits registered a net outflow of US $ 0.9 billion as against an increase of US $ 3.7 billion in April-December 2006, responding to the reduction in the ceiling on interest rate on NRI deposits in April 2007. Net short-term trade credit rose to US $ 10.8 billion as compared with US $ 5.7 billion a year ago. On the whole, debt flows (net) in the form of external assistance, ECBs, NRI deposits and short-term credit put together increased to US $ 27.5 billion in April-December 2007 from US $ 20.2 billion a year ago.

41. There was a large accretion of US $ 67.2 billion to foreign exchange reserves, excluding valuation changes, during April-December 2007 as against US $ 16.2 billion in April-December 2006. Valuation gains, reflecting the appreciation of major currencies against the US dollar, accounted for US $ 8.9 billion of the total accretion to the reserves during April-December 2007. Including these valuation effects, the foreign exchange reserves recorded an increase of US $ 76.1 billion and rose to reach a level of US $ 275.3 billion by end-December 2007. India's external debt increased by US $ 31.8 billion from end-March 2007 to US $ 201.4 billion at end-December 2007. The increase was mainly under ECBs (US $ 15.3 billion) and short-term credit (US $ 8.8 billion). Valuation changes due to the depreciation of the US dollar vis-à-vis major international currencies and the Indian rupee, accounted for US $ 6.0 billion of the increase in external debt during the period. In the total external debt stock, ECBs accounted for the highest share (28.3 per cent), followed by NRI deposits (21.4 per cent), multilateral debt (18.8 per cent) and bilateral debt (8.6 per cent). At end-2007, the ratio of short-term debt to total debt was 17.5 per cent. The share of US dollar-denominated debt in total debt was highest at 54.5 per cent, followed by 17.1 per cent in rupee-denominated debt and 11.2 per cent in Japanese yen-denominated debt.

42. Information available for subsequent months from the DGCI&S indicates that merchandise exports increased by 22.8 per cent in US dollar terms during April-February 2007-08 as compared with 23.2 per cent in the corresponding period of the previous year. On the other hand, imports showed an increase of 30.1 per cent as compared with 25.2 per cent. While the increase in oil imports was lower at 26.4 per cent as compared with 31.2 per cent, non-oil import recorded a higher growth of 31.8 per cent as compared with 22.6 per cent. During April-February 2007-08, the trade deficit widened to US $ 72.5 billion which was 46.8 per cent higher than the deficit of US $ 49.4 billion in the corresponding period of the previous year.

43. The sustained strength of capital flows during the year is noteworthy. Net portfolio flows on account of investments by FIIs surged to US $ 20.3 billion in 2007-08 from US $ 3.2 billion in the previous year. Net inflows in the form of FDI rose to US $ 25.5 billion in April-February 2007-08 from US $ 19.6 billion a year ago. Net inflows under ADRs/GDRs increased to US $ 8.7 billion from US $ 3.8 billion. On the other hand, net accretions to NRI deposits amounted to US $ 0.1 billion as against US $ 3.9 billion. During 2007-08, the foreign exchange reserves increased by US $ 110.5 billion to US $ 309.7 billion by end-March 2008 and stood at US $ 313.5 billion as on April 18, 2008.

44. The Indian foreign exchange market witnessed generally orderly conditions during 2007-08 with the exchange rate exhibiting two-way movements. The exchange rate of the rupee against the US dollar, which was Rs.43.59 at end-March 2007 appreciated by 5.6 per cent to Rs.41.29 at end-April 2007 and further to Rs.39.27 by January 8, 2008. In the subsequent period the exchange rate depreciated, easing to Rs.39.97 per US dollar by end-March 2008. The rupee-euro exchange rate depreciated from Rs.58.14 at end-March 2007 to Rs.63.09 by end-March 2008. Overall, during 2007-08, the rupee appreciated by 9.1 per cent against the US dollar and by 7.5 per cent against pound sterling but depreciated by 7.7 per cent against the Japanese yen, and by 7.8 per cent against the euro. As on April 25, 2008 the exchange rate of the rupee was Rs.40.18 per US dollar, Rs.62.90 per euro, Rs.79.25 per pound sterling and Rs.38.47 per 100 Japanese yen.

45. The exchange rate policy in recent years has been guided by the broad principles of careful monitoring and management of exchange rates with flexibility, without a fixed target or a pre-announced target or a band, coupled with the ability to intervene, if and when necessary. The overall approach to the management of India's foreign exchange reserves takes into account the changing composition of the balance of payments and endeavours to reflect the 'liquidity risks' associated with different types of flows and other requirements.

Developments in the Global Economy

46. Global economic activity decelerated somewhat in relation to earlier expectations, mainly on account of the slowdown in the US economy. During the first quarter of 2008, the unfolding of the subprime mortgage crisis coupled with growing concerns about a contraction of economic activity in the US in 2008 appears to be feeding into a deterioration in the outlook for global growth which has remained relatively resilient so far. There are some signs that the slowdown in the US may spill over to the euro area, China and Japan with potential implications for the emerging market economies (EMEs) through trade, financial markets and other linkages. According to the World Economic Outlook (WEO) of the International Monetary Fund (IMF) released in April 2008, the forecast for global real GDP growth, on a purchasing power parity basis, is expected to slow from 4.9 per cent in 2007 to 3.7 per cent in 2008 — as compared with the projection of 4.1 per cent published in January 2008 — and 3.8 per cent in 2009. World real GDP growth, on the basis of market exchange rates, is estimated to decelerate from 3.7 per cent in 2007 to 2.6 per cent in 2008 and 2009.

47. In the US, real GDP grew by 0.6 per cent in the fourth quarter of 2007 as compared with 2.1 per cent a year ago and 4.9 per cent in the previous quarter. In the first quarter of 2008, labour markets weakened with the unemployment rate rising to 5.1 per cent in March 2008. Household and consumption demand is likely to be affected with home prices having fallen by 10.7 per cent in the year ending January 2008, bank seizures having more than doubled in March 2008 over the level a year ago and the year-on-year monthly foreclosure continuing to increase in March 2008 for the 27th consecutive month. US real GDP growth is expected to slow further during 2008 as the housing market downturn deepens and the financial market turmoil spreads across the financial system with macroeconomic implications as apprehended by the IMF in its April 2008 Global Financial Stability Report. The index of leading indicators increased marginally in March after a continuous decline up to February 2008. However, consumer sentiment was at its lowest level in 26 years in April 2008. The US economy is expected to show some improvement in the second half of 2008, when tax rebates in the fiscal stimulus package could lift growth. The IMF's April 2008 update of its WEO expects the US economy to grow at a slower pace of 0.5 per cent in 2008 as against 2.2 per cent in 2007, but projects some recovery to 0.6 per cent in 2009.

48. Real GDP in the euro area grew by 2.3 per cent in the fourth quarter of 2007 on a year-on-year basis as compared with 3.3 per cent a year ago. Real activity appears to have strengthened in the first quarter of 2008. Unemployment fell in January-February 2008 to a record low of 7.1 per cent notwithstanding currency appreciation, surging oil prices and the US slowdown. Growth in European service industries has accelerated above projections with optimism on export prospects. However, European retail sales fell in March after rising for the first time in five months in February. Retailers continue to lack pricing power with consumer spending held down by inflation at its highest level in 14 years. The April 2008 update of the IMF's WEO has placed real GDP growth of the euro area at 1.4 per cent in 2008 and 1.2 per cent in 2009 as against 2.6 per cent in 2007.

49. The Japanese economy grew by 3.7 per cent in the fourth quarter of 2007 as compared with 2.2 per cent a year ago. In the first quarter of 2008, lead indicators point to some slackening of momentum while consumer and business sentiment has weakened. Japan's factory production fell in January-February 2008 as a deepening US slowdown weakened demand for cars and electronics. Exports and production are slowing and wages remain subdued. Consumer sentiment in Japan has been worsening with higher crude oil prices and the rising prices of daily necessities. The April 2008 WEO of the IMF has projected that Japan's economy, the world's second largest, will grow by 1.4 per cent in 2008 and by 1.5 per cent in 2009 as compared with the estimated growth of 2.1 per cent in 2007.

50. These unusual developments in global economy indicate heightened uncertainties and emerging challenges for the conduct of monetary policy, especially for EMEs. The IMF has forecast that the emerging and developing economies’ growth will slow to 6.7 per cent in 2008 from 7.9 per cent in 2007 and further to 6.6 per cent in 2009. Developing Asia will slow by 1.5 percentage points to a still-rapid 8.2 per cent. However, downside risks are emerging to the extent EMEs' growth has depended heavily on external demand and also due to the possibility of capital inflows drying up in the present risk-averse scenario. Rise in risk aversion has already dampened private bond issuance in several EMEs. Most importantly, inflation has raised its head in several EMEs and this might complicate monetary policy decision-making even further, particularly in view of the greater weight for food in consumer prices as well as inflation perceptions in EMEs.

51. The Chinese economy grew by 11.9 per cent in 2007 as compared with 11.1 per cent in 2006 in spite of measures to cool down the pace of growth, including reduction of export rebates and restrictions on processing exports. In the first quarter of 2008, however, growth has moderated to 10.6 per cent as compared with 11.7 per cent a year ago. Reflecting the slowdown in export growth, China's trade surplus fell year-on-year by 10.8 per cent in March 2008 to US $13.4 billion. The total foreign exchange reserves, however, increased to US $ 1.7 trillion in March 2008 as compared with US $ 1.2 trillion in March 2007. In 2008, the Chinese economy is expected to moderate to a growth of 9.3 per cent as tightening policies take effect. The CSI 300 Index, which tracks yuan-denominated A shares listed on China's two exchanges, has fallen by 28.8 per cent to 3803.1 on April 25, 2008 after increasing six-fold in the two years through 2007. The Chinese authorities are making efforts to resolve problems such as overheated growth in fixed asset investment, excessive supplies of money and credit and a huge trade surplus.

52. Among other major Asian economies, the Korean economy grew by 5.0 per cent in 2007, decelerating marginally from 5.1 per cent in 2006 despite higher exports to emerging markets such as China. Economic activity is expected to slow down further to 4.2 per cent in 2008 before accelerating to 4.4 per cent in 2009. In Thailand, economic activity is expected to grow by 5.3 per cent in 2008 and further to 5.6 per cent in 2009 as against 4.8 per cent in 2007, as stronger domestic demand growth and expansionary public expenditures offset slowing export growth.

53. Continuing strong demand and dwindling stocks are reflected in a tight supply-demand food situation globally, leading to the emergence of food price inflation as a key risk to global stability. The FAO's global food price index, which rose by 40 per cent in 2007 to the highest level on record, has continued to increase in the first quarter of 2008 as well, as world food stocks have fallen to their lowest levels in 25 years. Food import bills in the low-income food-deficit countries are likely to rise by 35 per cent for the second consecutive year in 2008. Shortages and high prices for all kinds of food have caused social tensions around the world in recent months in Haiti, Indonesia, Pakistan and several African countries. China has imposed price controls on cooking oil, grain, meat, milk and eggs. In Egypt, the Government has significantly raised food subsidies and signed a bilateral agreement with Kazakhstan for 1 million tonnes of wheat at a preferential price to be delivered during 2008. Indonesia has removed the 5 per cent duty on wheat import and suspended a 10 per cent duty on imported soybeans. In April 2008, the global food crisis appears to have intensified with Kazakhstan — one of the world's biggest wheat exporters — curbing exports, alongside restrictions in Russia, Ukraine and Argentina. These curbs are likely to trigger similar moves in other foodgrain exporting countries in the face of rising domestic prices worldwide.

54. In the global foodgrains market, prices of major crops such as corn, soyabeans and wheat have increased by 58.2 per cent, 86.3 per cent and 56.5 per cent, respectively, by April 25, 2008 from a year ago in response to surging demand. The increase in overall foodgrain prices has gained momentum from higher energy and fertiliser prices, low levels of inventories, shortfalls in certain crops mainly caused by weather-related factors such as the ongoing drought in Australia and strong increases in the demand for crops. Higher rice prices are also contributing to inflation in many developing countries as the price of rice, a staple in the diets of nearly half the world's population, has almost doubled on international markets in the last three months. Drawing down of costly stockpiles of rice in recent years has removed an effective price dampener in the face of adverse demand-supply imbalances. Rising prices and a growing fear of scarcity have prompted some of the world's largest rice producers — India, Vietnam, Egypt and Cambodia — at end-March 2008 to announce drastic limits on the amount of rice they export which have driven prices on the world market even higher. Philippines has started to track down rice hoarders. Rice prices in Thailand have trebled over their level in the beginning of 2008. With Indonesia joining other major rice exporters in banning exports, international near-month futures price of rice on Chicago Board of Trade (CBOT) has risen to a high of US $ 23.8 per hundredweight on April 25, 2008 _ up by 71 per cent since January 2008. On the same day, futures prices were quoted higher at US $ 24.18 for July 2008, but the quotes moderated for September 2008 to US $ 22.09 and for May 2009 to US $ 22.38.

55. Wheat prices remained generally firm and volatile since October 2007 on account of repeated downward revisions of production forecasts in a number of major exporting countries, most notably Australia. World wheat output is now estimated to have risen by only 1.6 per cent in 2007. Trade is expected to contract because of high and volatile prices, coupled with soaring freight rates. One month wheat futures at the CBOT rose from US $ 9.15 per bushel on January 2, 2008 to US $ 12.8 on February 27, 2008 before falling to US $ 8.01 on April 25, 2008. On the same day, futures prices for wheat were quoted higher for July 2008 at US $ 8.16, for December 2008 at US $ 8.49 and for May 2009 at US $ 8.68.

56. Strong demand for animal feed as well as for ethanol is the main driver in global coarse grain markets, but supply tightness in several exporting countries is also providing support to prices. The futures prices of corn on CBOT, which had moderated somewhat up to July 2007, started moving up thereafter and reached US $ 5.77 on April 25, 2008. On the same day, futures prices for corn were quoted higher for July 2008 at US $ 5.90, for September 2008 at US $ 6.00 and for May 2009 at US $ 6.25.

57. Metal prices have increased by 23.7 per cent during first three months of 2008 after declining by 8.1 per cent during 2007 following increases of 53.6 per cent in 2006 and 36.3 per cent in 2005. In the futures markets, aluminium, zinc and lead prices are showing a downward trend since October 2007. Copper prices have been buoyed up by the depreciating US dollar and high demand. Futures price of copper on the New York Mercantile Exchange (Nymex) increased to a record level of US $ 4.03 per pound on April 9, 2008. As on April 25, 2008 the May 2008 futures prices for copper which stood at US $ 3.96 per pound were quoted lower for July 2008 at US $ 3.91, at US $ 3.89 for September 2008 and at US $ 3.78 for May 2009. Spot gold rose to US $ 1000.10 an ounce on March 13, 2008 — the highest since January 1980 — as the dollar fell to a record low against the euro and on concerns about declining supply on mine shutdowns in South Africa, before declining to US $ 885.15 an ounce on April 25, 2008.

58. Prices of crude oil, which have rebounded since July 2007, increased by 83.2 per cent up to April 25, 2008 from their level a year ago and near-month futures prices have ruled at the record level of US $ 119.64 per barrel on April 25, 2008 — the highest since trading began on the Nymex in 1983. On the same day, oil futures ruled at a lower level of US $ 115.77 for September 2008 and US $ 114.06 for December 2008 and US $ 111.6 for May 2009. According to the Energy Information Administration (EIA), tight fundamentals, reflected by low available crude oil surplus production capacity, combined with supply concerns in several oil exporting countries, have continued to put upward pressure on world crude oil prices. The outlook over the next two years points to some easing of the oil market balance due to increased production outside of the Organization of the Petroleum Exporting Countries (OPEC) and planned additions to OPEC capacity. However, delays to capacity additions in both OPEC and non-OPEC nations could alter the outlook, as could OPEC production decisions. According to the EIA, the price of West Texas Intermediate (WTI) crude oil is expected to be at US $ 100.61 per barrel in 2008 and US $ 92.50 per barrel in 2009. Surplus production capacity is projected to decelerate from its current level of a little over 2 million barrels per day (bbl/d) to more than 1 million bbl/d by the end of 2009.

59. In the US, consumer prices increased from 2.8 per cent in March 2007 to 4.0 per cent in March 2008. In the euro area, inflation increased to 3.6 per cent in March 2008 — the highest level since the introduction of the euro — from 1.9 per cent a year ago. In Japan, inflation increased to a decade-high rate of 1.2 per cent in March 2008 from (-) 0.1 per cent a year ago on account of rising oil and food costs. In the UK, CPI inflation decelerated to 2.5 per cent in February-March 2008 from 2.8 per cent a year ago. At the retail level (in terms of retail prices index or RPI), inflation rose to 4.8 per cent in the UK in March 2007 — the highest since 1991 — but declined thereafter to 3.8 per cent in March 2008 with some fluctuations in between. Inflation pressures have also raised concerns in some of the EMEs such as China, Malaysia, Indonesia and Chile.

60. Core CPI inflation in the US increased to 2.4 per cent in March 2008 from 2.3 per cent in February 2008. In the UK, core CPI inflation has been declining in tandem with the headline rate and stood at 1.2 per cent in February-March, down from 1.3 per cent in January 2008. In the euro area, core CPI inflation increased to 2.0 per cent in March 2008 from 1.8 per cent in February 2008. Core inflation in Japan turned positive (0.1 per cent) in March 2008 as compared with -0.1 per cent in February 2008. The increase in producer prices has been sharper than in consumer prices, reflecting increased input costs. In the US, producer prices increased from 3.1 per cent in March 2007 to 6.9 per cent in March 2008. In the euro area, producer prices increased from 2.8 per cent in March 2007 to 5.3 per cent in March 2008. In the UK, producer prices increased to 6.2 per cent in March 2008 from 2.7 per cent in March 2007. Wholesale price inflation in Japan increased from 1.2 per cent in February 2007 to 3.4 per cent in February 2008. Overall, the persistence of high food and oil prices sustained at elevated levels and continued high prices of other commodities pose significant inflation risks for the global economy and challenges for monetary policy worldwide.

61. In the EMEs, the recent jump in headline inflation caused by higher energy and food prices are of concern since this requires a balanced response in controlling inflation while being alert to decelerating impulses from the slowdown in the developed countries and the possibilities of a prolonged global financial market turmoil. Even though higher headline inflation may be driven initially by rising food and energy prices, it could quickly lead to broader price and wage pressures in the EMEs which are witnessing rapid growth. In China, inflation accelerated to 8.7 per cent in February 2008 before easing to 8.3 per cent in March as compared with 3.3 per cent in March 2007 despite the central bank's repeated efforts to rein in inflation through monetary tightening policies. At end-March 2008, the Chinese State Council decided to increase budgetary subsidies for grain production and the government's minimum grain procurement prices to address the potential shortfall in grain production. Farmers' interest in grain production has been declining as raw material costs were rising faster than grain prices. Consumer price inflation in Korea accelerated to 3.9 per cent in March 2008 from 2.2 per cent in March 2007 which is causing concern. Inflation increased to 5.3 per cent in March 2008 in Thailand from 2.0 per cent in March 2007.

62. Concerns about a US slowdown and the uncertainty surrounding the financial health of some of the biggest US financial entities have imparted considerable volatility in the US equity markets since January 2008. On January 21, 2008 equity markets across the world experienced sharp declines with fall in Asian stocks as well. The volatility and bearishness in equity markets have continued in February-April 2008 on account of weak US economic data and substantial write-offs by financial institutions. The Dow Jones Industrial Average, Standard and Poor's (S&P) 500 and Nasdaq Composite exhibited considerable volatility and posted declines of 1.5 per cent, 6.5 per cent and 4.9 per cent, respectively, by April 25, 2008 over their levels a year ago. In the fixed income segment, Government bond yields in the major economies, which had firmed up in the first half of 2007, have softened thereafter since demand for government debt has increased as investors shifted their funds to the treasuries acknowledging the likelihood that the economy is already in a recession and seeking safety. The US 10-year bond yield increased from 4.70 per cent at end-December 2006 to 5.29 per cent on June 12, 2007 before falling to 3.87 per cent on April 25, 2008. The 10-year bond yield in the euro area increased from 3.95 per cent at end-December 2006 to 4.68 per cent on July 9, 2007 before falling to 4.18 per cent on April 25, 2008. The Japanese 10-year bond yield has increased from 1.68 per cent at end-December 2006 to 1.97 per cent on June 13, 2007 before falling to 1.61 per cent on April 25, 2008. These recent developments are indicative of evolving uncertainties in international financial markets with implications for EMEs.

63. On a trade-weighted basis, the US dollar has been depreciating since 2006 with intermittent fluctuations. After the cuts in the Fed funds rates since September 2007, the US dollar has weakened against other currencies. The pound sterling moved to the level of US $ 1.99 on April 25, 2008 — close to the 26-year high of US $ 2.11 reached on November 8, 2007 — amidst concerns relating to the US subprime mortgage market. The euro, which has also been strengthening against the US dollar since June 2007, rose to a peak of US $ 1.60 on April 22, 2008 before declining to US $ 1.56 on April 25, 2008. The Canadian dollar appreciated against the US dollar to a 33-year high to reach US $ 1.09 on November 6, 2007 before declining to US $ 1.01 on April 25, 2008. Turkey experienced a sharp appreciation in its currency vis-a-vis the US dollar to reach the level of 86.95 cents on January 10, 2008 before moving to 77.95 cents on April 25, 2008. The New Zealand dollar had appreciated to 81.10 cents to reach a 22-year peak against the US dollar on July 24, 2007 before declining to 78.07 cents on April 25, 2008.

64. Since the beginning of the turbulence in August 2007, central banks of advanced economies have responded with both conventional and unconventional measures to ease liquidity stress in financial markets and solvency issues among large financial institutions. There has, however, been several aspects that differentiate the approaches of the central banks. Some central banks, notably the ECB, the Reserve Bank of Australia and the Swiss National Bank have responded by providing liquidity to inter-bank markets, implicitly viewing the financial turmoil as essentially a problem of liquidity tightness. These central banks have provided liquidity through fine-tuning operations aimed at assuring orderly conditions in their respective money markets. On the other hand, some central banks like the US Fed, the Bank of England and the Bank of Canada have responded in a more diverse fashion, regarding the market stress as reflecting both liquidity seizure as well as broader threats to financial stability, coupled with dangers of the slowdown in economic activity becoming protracted. Accordingly, they have moved to inject liquidity into money markets through normal and special facilities. They have also relaxed the class of eligible securities for liquidity availment from the central bank. Furthermore, they have also cut policy rates substantially amid fears that the subprime crisis could turn into a major credit crunch with adverse implications for the real sector. The US Fed has also been involved in resolution of problems arising in non-bank entities like investment banks and insurance companies. The Bank of England has provided generalised and institution-specific emergency liquidity and facilities for swapping securities.

65. In the second phase of central bank intervention in December 2007 (the first phase being spread over August-September), major central banks such as the Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank and the Swiss National Bank (SNB) injected liquidity in a coordinated manner. Actions taken by the Federal Reserve included the establishment of a temporary Term Auction Facility (TAF) against a wide variety of collateral that can be used to secure loans at the discount window; the establishment of foreign exchange swap lines with the ECB and the SNB which will provide dollars in amounts of up to US $ 20 billion and US $ 6 billion to the ECB and the SNB, respectively, for use in their jurisdictions; a Term Securities Lending Facility announced on March 11, 2008; and a Primary Dealer Credit Facility (PDCF) on April 22, 2008. The Fed has also conducted nine auctions amounting to US $ 340 billion having 28-day maturity and an auction of US $ 20 billion having 35-day maturity.

66. Since December 2007, the ECB has conducted seven US dollar TAF auctions amounting to US $ 85 billion up to April 24, 2008 for 28 days maturity each. The Bank of Canada has conducted five 28-day auctions amounting to US $ 10 billion till April 17, 2008. The SNB has conducted four auctions amounting to US $ 20 billion for 28 days each up to April 22, 2008. The Bank of England increased liquidity injections from £2.85 billion to £11.35 billion for its operations in December 2007-January 2008 of which £10 billion was offered for 3-month maturity. It also announced that long term repo operations would be held against a wider range of high quality collateral. In April 2008, the Bank of England launched a scheme to allow banks to swap temporarily their high quality mortgage-backed and other securities for UK Treasury Bills. It has so far allotted amounts of £44.9 billion (three months), £2.95 billion (six months), £1.6 billion (nine months) and £ 0.8 billion (12 months) in four long-term repo auctions since December 2007.

67. Some central banks have cut policy rates since the third quarter of 2007 when the financial market turmoil surfaced. During September 18, 2007 to March 18, 2008 the US Federal Reserve cut its policy rate by 300 basis points to 2.25 per cent after seventeen increases to 5.25 per cent between June 2004 and June 2006. The Bank of England reduced its repo rate to 5.0 per cent by 25 basis points each in February and April 2008. The Bank of Canada reduced its rate to 3.0 per cent by 25 basis points reductions each in December 2007 and January 2008 and 50 basis points each in March and April 2008. Central banks of several countries, including the euro area, New Zealand, Japan, Korea, Malaysia, Thailand and Mexico have not changed their rates since the last quarter of 2007. Some central banks that have tightened their policy rates in recent months include the Reserve Bank of Australia (Cash Rate raised by 25 basis points in February-March 2008 to 7.25 per cent); the People's Bank of China (lending rate raised to 7.47 per cent in December 2007 from 7.29 per cent in September 2007); the Banco Central de Chile (benchmark lending rate raised to 6.25 per cent in January 2008 from 5.75 per cent in October 2007), and Banco Central do Brasil (overnight Selic rate raised by 50 basis points to 11.75 per cent in April 2008).

68. Large capital flows to EMEs have elicited various responses from central banks for managing and stabilising these flows including monetary tightening involving either hikes in policy rates or in reserve requirements or both. In China, the required reserve ratio was raised from 8 per cent in July 2006 to 16.0 per cent on April 25, 2008. After a gap of 17 years, the Bank of Korea raised reserve requirements from 5 per cent to 7 per cent for local currency deposits and short-term foreign currency deposits in November and December 2006, respectively. Meanwhile, in several EMEs including China and Korea, central bank bonds have continued to absorb liquidity from the banking system.

69. Measures directly aimed at managing capital flows are also in evidence in many EMEs. On December 18, 2006 Thailand imposed unremunerated reserve requirements (URR) of 30 per cent on most capital inflows, requiring them to be deposited with the central bank for one year. However, with effect from March 3, 2008 the Bank of Thailand has lifted the URR on short-term capital inflows and said it would introduce three supporting measures to temper the impact of the change. These measures involve (a) an increase in the foreign investment limit to US $30 billion to allocate to securities companies, mutual funds and individual investors, (b) an improvement in measures to prevent baht speculation and (c) a revision to the structure of non-residential baht accounts so as to help monitor fund flows of non-residents. In May 2007, Colombia introduced a package of measures, including a 40 per cent URR on external borrowing to be held for six months in the central bank. Additionally, a new ceiling on the foreign exchange position of banks, including gross positions in derivative markets, was stipulated to limit circumvention of the URR and banks' exposure to counterparty risk. The PBC raised the amount of foreign currencies that lenders must keep as reserves to 5 per cent from 4 per cent of their foreign-currency deposits from May 15, 2007. The Bank of Korea is investigating large volume trading of currency forward contracts by exporters and financial companies to limit gains in the won, which appreciated to a 10-year high in 2007. Chile and Brazil's central bank have bought up substantial amount of inflows from the spot market to add to reserves and also conducted sizeable operations in the forward markets.

70. Over the year gone by, global developments have brought forward several new realities that pose severe challenges to monetary policy globally. First, concerns relating to the US slowdown and its intensity have mounted in view of the potential spillover on to the global economy. Second, threats to the global economy are emanating from advanced economies in sharp contrast to earlier crises which stemmed from the emerging world. Third, there are indications that protectionist tendencies have increased around the world in anticipation of the growing possibilities of slower growth in advanced economies. In several key commodity-producing economies, policy measures are in place and are being intensified to restrict the availability of supplies to the international markets. Fourth, linkages between financial sector developments and the real sector have become more worrisome than before, with apprehensions that financial turmoil may spillover to the real sector with adverse implications for employment and growth. With financial institutions reporting tightening in lending standards, deterioration in asset quality and deceleration in consumer loan demand, there are signals that events in the financial markets are beginning to have a persisting impact on other dimensions of the real economy as well. Fifth, higher and more volatile prices of food, energy and other commodities have imparted a significant upside bias to inflation and inflation expectations across the world, complicating the conduct of monetary policy at a time of severe financial stress. In several countries, there are threats to food availability with consequent social tensions. Sixth, terms-of-trade losses due to soaring commodity prices and exchange rate appreciation are reducing the capacity of the euro area and Japan to contribute to a re-balancing of the world economy. Seventh, EMEs are exhibiting resilience so far in the face of the global financial turmoil reflecting relatively stronger macroeconomic framework and sustainable macroeconomic balances. Thus, there is so far some divergence in terms of growth performance between mature economies and EMEs but whether, how long and to what extent it will persist is uncertain. On the other hand, inflationary pressures appear to be common to mature economies and EMEs but the latter are under heavier pressure.

71. There are several issues emerging out of recent financial developments that are interacting with global macroeconomic changes and carry implications for the conduct of monetary policy globally. First, financial markets are currently at the heart of the turmoil and are regarded as sources of higher potential instability going forward. Despite sizeable central bank action over a wide spectrum, market interest rates and policy rates continue to be widely divergent. Second, there are renewed concerns about the gaps in the financial architecture and its limited capability for withstanding shocks or for preventing spillovers. Third, the effectiveness of financial regulations and supervision has come under scrutiny, especially in the context of appropriately assessing capital adequacy in large financial institutions, complex financial products and vehicles and risk management practices. In this context, it is important to note that even the Basel II and related processes are being reviewed in their granularities. Fourth, the role of credit rating agencies is being subjected to critical reassessment, particularly in view of their envisaged role under Basel II. There is active discussion on the need for credit rating agencies to clearly differentiate the ratings for structured products, improve their disclosure of rating methodologies, and assess the quality of information provided by originators, arrangers, and issuers of structured products. Fifth, current practices relating to transparency and disclosure are being subject to careful appraisal in view of their inadequacy in the context of structured financial products and special purpose vehicles. Sixth, the role of investment banks and their adequacy of capital needs to be reviewed, along with stipulation of separate yet complementary sets of best practices for hedge fund investors and asset managers to increase accountability for participants in this industry.

Overall Assessment

72. While aggregate supply capacities expanded and alleviated domestic macro-imbalances in 2007-08 to some extent, available indicators suggest that economic activity in India currently continues to be mainly demand-driven. The rate of gross fixed capital formation at current prices rose by 2.1 percentage points of GDP at current market prices in 2007-08, more than compensating for the decline of 0.3 percentage points in the rate of private final consumption expenditure and that of 0.2 percentage points in the rate of government final consumption expenditure. Looking ahead, the Union Budget for 2008-09 is likely to provide a stimulus to both private and government consumption in view of the proposals for effective reduction of the tax burden under personal income and excise as well as the revenue expenditure implications emanating from the recommendations of the Sixth Pay Commission. The dominance of investment demand in the economy is likely to persist in 2008-09 and beyond, supported as it were by the buoyancy in corporate saving in view of the sustained resilience of sales and profitability, and the ongoing improvement in public sector saving. Furthermore, patterns of domestic industrial output and imports remain skewed in favour of capital goods, indicative of ongoing expansion in capacity, both new and existing. Moreover, resources raised through public issues as well as investment intentions more than doubled in 2007-08, pointing to the corporate sector's positive assessment of evolving demand conditions and underlying plans for expanding production capacities. Finally, the sharp widening of the merchandise trade deficit reflects the spillover of domestic demand into the external sector with implications for the year ahead.

73. The pick-up in inflation during the fourth quarter of 2007-08 has, however, mainly emanated from supply-side pressures such as the one-off increase in domestic petrol and diesel prices to partially offset the global crude oil price increase over the year; continuous hardening of prices of petroleum products that are not administered, rising prices of wheat and oilseeds and the adjustment in steel prices in March 2008 due to the surge in international prices. In recognition of the unanticipated supply-sided origin of pressures in the recent months, partly due to global developments, the first response of public policy to the hardening of inflation has been in terms of reducing import duty on rice and edible oils, followed by a ban on exports of non-basmati rice and pulses, an increase in the minimum export price relating to basmati rice, reduction of customs duty on butter, ghee and maize, and administrative measures to enable imposition of stock limits on selected agricultural products. There are growing concerns that this upsurge in inflation in India has occurred at a time when global commodity prices have been volatile at historically elevated levels and central banks in mature and emerging economies alike have been articulating heightened inflation concerns. Consequently, there are concerns that demand pressures, which have been reasonably contained so far, are being coupled with supply-side factors which, if not temporary in view of global demand-supply imbalances, could impact domestic inflation significantly.

74. Monetary and financial conditions appear to have gone through underlying shifts in the fourth quarter of 2007-08. While the rate of money supply has dipped from mid-February 2008 in tandem with a moderation in the growth of time deposits, it remains high in relation to indicative projections. On the other hand, the moderation in non-food credit growth that was evident in the first half of 2007-08 appears to have extended into the fourth quarter of the year. The deceleration has been marked in respect of interest-sensitive sectors such as housing, personal loans and real estate as well as in some categories of services such as trade, professional and other services, shipping, transport operators, tourism, hotels and restaurants which had been recording significantly elevated growth rates in preceding years. These movements in banking aggregates have enabled a better balance between banks' sources and uses of funds than before, as reflected in the decline in the incremental non-food credit deposit ratio to below 75 per cent for the first time since August 2004.

75. During the fourth quarter of 2007-08, financial markets were impacted by unusual swings and high volatility in foreign exchange flows as well as in cash balances of the Government with the Reserve Bank with consequent shifts in liquidity conditions. These variations were smoothened by active liquidity management through a combination of instruments such as the MSS, the LAF and the CRR so that volatility in overnight interest rates was broadly contained within the informal LAF corridor. As a result, advance tax payments did not produce the usual spikes in money market rates. Generally orderly conditions were also observed in the Government securities market with some widening of yield spreads across maturities on concerns about rising inflation domestically, recent escalations in food, energy and metal prices internationally, and the atmosphere of heightened uncertainty. In the credit market, while deposit rates have been adjusted downwards, lending rates have edged up. In the foreign exchange market, two-way movements in spot rates have been in evidence in the fourth quarter of 2007-08 and in April 2008. On the other hand, asset prices, particularly equity prices, rose to record highs in January 2008 before declining dramatically in February-March 2008.

76. Finances of the Central Government have undergone further consolidation in 2007-08 in consonance with the path charted under