RBI Governor''s Mid-term Review of Annual Policy Statement for the year 2004-05

Dr Y Venugopal Reddy, Go
26 October 2004

Domestic Developments

GDP Growth in 2004-05 Taking into account the deficient monsoon in 13 out of 36 metrological subdivisions and its possible impact on kharif output, improved prospects for growth in industrial output and continued buoyancy in exports vis-à-vis the likely adverse impact of higher oil prices on GDP growth, it may be reasonable to place the overall GDP growth for the year 2004-05 in the range of 6.0-6.5 per cent as against the earlier expectation of 6.5-7.0 per cent assuming that the combined downward risk of high and uncertain oil price and sudden change in international liquidity environment remain manageable. Non-food Credit Governor observed a robust increase in non-food credit by 11.5 per cent (Rs. 92,443 crore) up to October 1, 2004 as compared with an increase of 6.0 per cent (Rs. 41,034 crore) in the corresponding period of the previous year. The total flow of resources to the commercial sector from banks and FIs increased substantially by Rs.1,08,510 crore as compared with Rs.66,863 crore in the corresponding period of the previous year. Detailed information on sectoral deployment of credit reveals that over two-thirds of the credit flows has been on account of retail, housing and other priority sector loans. Also, a discernible increase of industrial credit was observed in respect of petroleum, infrastructure, electricity, construction, metal & metal products, drug & pharmaceuticals, gems & jewellery and automobiles industries. Monetary Indicators Referring to monetary indicators, Governor said that money supply during the current financial year (up to October 1, 2004) increased by 5.4 per cent as compared with 7.8 per cent in the previous year. On an annual basis, the growth in M3 at 14.0 per cent was, however, higher than 11.9 per cent in the previous year. Aggregate deposit of commercial bank registered a lower growth mainly due to reduction on non-resident Indian (NRI) deposits with the banking system. The reserve money increased by 0.6 per cent in the current financial year up to October 15, 2004 as compared with an increase of 0.9 per cent in the corresponding period of the previous year. Inflation Rate Annual inflation, as measured by variations in the wholesale price index (WPI) on a point-to-point basis, rose from 4.6 per cent at end-March to 7.1 per cent by October 9, 2004. On an average basis, annual inflation based on WPI was 6.2 per cent as on October 9, 2004 as compared with 4.9 per cent a year ago. Governor explained that excluding four items viz., iron ore, iron and steel, mineral oils and coal mining which registered relatively high inflation rate, the WPI inflation rate works out to 4.2 per cent as on October 9, 2004, on a point-to-point basis, as against 3.8 per cent in the previous year. Governor pointed out that the impact of higher international oil prices so far has been partly cushioned by fiscal measures such as cuts in excise and customs duties. On current assessment, assuming that there would be no further major supply shock and liquidity conditions remain manageable, Governor felt that the point-to-point year-end inflation based on WPI for the year 2004-05 could be placed around 6.5 per cent instead of 5.0 per cent projected earlier. Governor, however, pointed out that the CPI inflation has been lower than the WPI inflation in the recent past reflecting difference in coverage and lower increase in prices of food items. He observed that a similar discrepancy has been observed between producer price indices and consumer price indices for most countries except for countries in the euro area. Government Borrowings The Central Government has completed net market borrowings of Rs.26,233 crore (29.0 per cent of the budgeted amount) and gross market borrowings of Rs.75,044 crore (49.8 per cent of the budgeted amount) up to October 21, 2004. The weighted average yield on government borrowings through dated securities at 5.76 per cent this year so far (up to October 21, 2004) has been lower than 5.90 per cent last year. The lower cost of government borrowings so far this year could be attributed to lower volume of first half borrowings than usual on account of carry forward of surplus cash balance of Rs.26,669 crore at end-March 2004 into this year and proportionately higher subscription emanated from market participants other than the traditional source of banks. Keeping in view larger than usual borrowing slated for the second half of the year, the market borrowing programme in the remainder of the year needs to be calibrated carefully in view of strong credit demand. It is, therefore, critical to ensure that there is no slippage in fiscal deficit. Governor expressed his concern over the persistence of large aggregate borrowing of the Central and state governments, while indicating the positive developments in terms of enactment of fiscal responsibility legislation by five states and the framing of the Fiscal Responsibility and Budget Management (FRBM) Rules by the Centre, effective July 5, 2004 for fiscal consolidation. Banks'' Investments Scheduled commercial banks'' excess investment in SLR securities at Rs.2,67,328 crore constituted 16.3 per cent of net demand and time liabilities (NDTL). However, during the current year, scheduled commercial banks'' investment in government and other approved securities at Rs.27,435 crore (up to October 1, 2004) was lower than Rs.76,705 crore in the corresponding period of the previous year partly on account of pick-up in credit demand. Even then, with effective SLR investment at 39.7 per cent, lower appetite for SLR securities against expected credit pick-up has implications for government borrowings in an environment of market determined interest rates. Market Stabilisation Scheme During 2004-05, liquidity absorption through MSS was Rs.54,146 crore up to October 21, 2004. With the issuance of MSS, the repo volumes tendered under liquidity adjustment facility declined from an average of Rs.70,523 crore in April to Rs.13,805 crore in October 2004 (up to October 21). The liquidity that remained sterilised declined from an average of about Rs.81,260 crore in April to Rs.67,321 crore in October (up to October 21). In addition to MSS and repo, surplus balances in the Central Government account with the Reserve Bank also helped in sterilising excess liquidity from time to time. Notwithstanding some decline in surplus liquidity during the year, the overhang of liquidity continues to remain substantial. Interest Rate Governor observed that financial markets have remained generally stable though interest rates have displayed some upward movement, particularly at the longer end. He indicated that commercial banks have announced their benchmark prime lending rates (BPLRs) as advised by the Indian Banks'' Association (IBA). He pointed out that representative (median) lending rates on demand and term loans (at which maximum business is contracted) of public sector banks was 10.50-12.75 per cent in June 2004. While emphasising the need for continuing to build up Investment Fluctuation Reserve (IFR), pending a review of existing guidelines on banks'' investment portfolio, Governor explained that RBI allowed banks to exceed the ceiling of 25 per cent of investments included under HTM category by shifting some of their investments in SLR securities from the HFT/AFS categories to HTM category at the lowest of the acquisition cost or prevailing market value or book value, subject to a maximum of 25 per cent SLR securities to be held in HTM. Governor indicated that banks were advised to prepare themselves to implement the capital charge for market risk as envisaged under Basel II norms in a phased manner by end-March 2006.

External Developments

Global Economic Prospects Governor indicated that though the global recovery is gaining strength, some risks have increased, primarily on account of persistence of uptrend in global oil prices, with a disproportionately larger burden on oil importing emerging markets like India given the increasing oil intensity and lower energy efficiency. Under these circumstances coupled with ongoing growth rebound, some central banks hiked their policy rates, while some other central banks reduced them. Overall, therefore, the choice of a specific interest rate stance by a country/region seems to have been largely guided by its own domestic economic considerations. Another major downside risk facing the global economy continues to emanate from global imbalances and the associated possibility of disruptive currency adjustments and persistent structural problems in the euro area and Japan. Forex Market Remains Stable The Indian forex market generally witnessed orderly conditions during the current financial year so far (April-October 2004). The exchange rate of the rupee, which was Rs.43.39 per US dollar at end-March 2004, depreciated by 5.2 per cent to Rs.45.77 per US dollar by October 21, 2004. It also depreciated by 7.9 per cent against Euro, by 4.3 per cent against Pound sterling and by 1.9 per cent against Japanese yen during the period. Reserve Increases Foreign exchange reserves increased by US $ 7.6 billion from US $ 113.0 billion at end-March 2004 to US $ 120.6 billion as on October 21, 2004. Governor indicated that the overall approach to the management of India''s foreign exchange reserves in recent years has reflected the changing composition of the balance of payments (BoP), and has endeavoured to reflect the ''liquidity risks'' associated with different types of flows and other requirements. Taking these factors into account, India''s foreign exchange reserves are at present comfortable and consistent with the rate of growth, the share of the external sector in the economy and the size of risk-adjusted capital flows. In view of the level of comfort provided by the international financial architecture, apart from considering reserves as an insurance against volatility in capital flows, there is need to provide cushions against shocks arising from uncertain monsoon conditions in the real sector, variations in global oil prices in the external sector and high levels of public debt in the fiscal arena. There is considerable merit in taking a national balance sheet approach to the external sector and to provide cushions through official reserves in response to increasing external liabilities on account of the private sector. Further, it is useful to recognise the comfort and the confidence provided to the investors by the level of reserves in the context of volatility in capital flows. Referring to the recent debate in the media on the need for exchange rate adjustment, Governor explained that in a scenario of uncertainty facing the authorities in determining temporary or permanent nature of inflows, it is prudent to presume that such flows are temporary till such time that they are firmly established as of a permanent nature. Balance of Payments India''s exports during April-September 2004 increased by 24.4 per cent in US dollar terms as compared with 8.1 per cent in the corresponding period of the previous year. Imports rose faster by 34.3 per cent as against an increase of 21.0 per cent in the corresponding period of last year. Oil imports increased by 57.8 per cent as compared with 6.4 per cent, while non-oil imports increased by 25.8 per cent as against 27.4 per cent. The overall trade deficit widened to US $ 12.7 billion from US $ 7.4 billion in the corresponding period of the previous year. The higher trade deficit this year, in substantial part, reflects the high oil imports bill in the wake of the hardening of international prices and also the growth in import demand emanating from a pick-up in economic activity as reflected in higher capital goods imports. Governor pointed out that the current account of the BoP had remained in surplus consecutively over the past three years. The first quarter of 2004-05 also posted a current account surplus of US $ 1.9 billion. The net accretion to foreign exchange reserves, excluding valuation effects, amounted to US $ 7.5 billion during April-June 2004. During the second quarter of 2004-05, however, there are indications that the continuing uptrend in imports may result in the current account being only marginally in surplus assuming continued robust growth of merchandise exports and invisible earnings. Net capital inflows have moderated from the level recorded in the first quarter. While it is difficult to anticipate the behaviour of capital flows in the wake of the global geopolitical uncertainties, the positive sentiment on India should augur well for continued buoyancy, but some moderation should not be ruled out in view of turning of the global interest rate cycle.

Overall Assessment Governor observed that a striking development during the year relates to growth of non-food credit in the first half, which is traditionally a slack season for credit off-take. A review of developments so far in the current year confirms that there has been a revival of investment activity. To the extent manufacturing industry is showing signs of robust growth, he felt that the credit needs will witness higher growth than that in the past. As a result of the current policy thrust, credit to agriculture is also picking up from its low base and could initiate greater credit penetration by displacing non-institutional lenders. The fast growing housing and consumer credit sectors also represent some degree of higher penetration, but the quality of lending needs to be ensured. Overall, the pick-up in investment activity and growth in non-food credit appear to be broad based and are not temporary phenomena. These favourable outcomes point to the need for enabling liquidity conditions and a continued thrust on credit delivery to the productive sectors of the economy. Governor pointed out that the initiation of accelerated growth in manufacturing industry amidst global competitive pressures is a positive development and needs to be supported by policy to ensure its momentum. Governor stated that although a supply shock emanated out of global developments, mainly on account of oil and a few other key commodities like iron & steel were anticipated, its magnitude and persistence were not. As the full impact of oil price increases is yet to be absorbed in domestic prices, the supply factors will continue to dominate the price situation, while demand management seems to invite closer attention than before, particularly for stabilising inflationary expectations in a credible manner. Governor indicated that various segments of financial markets have, by and large, exhibited stability. The government securities market showed some nervousness as well as bearish sentiments. This was attributed to several inter-related issues such as (a) the market was in need of correction from excessive optimism, (b) there was an unexpected surge in inflation, (c) the sharp increase in non-food credit has also put some pressure on expectations, and (d) the global environment has tended towards some hardening of interest rates in recent months. Despite RBI inviting attention to these issues in the annual policy Statement, some market participants appear to have been less than fully prepared as the events unfolded. In this context, he emphasized that while the Reserve Bank will continue to give some weight to consideration of stability, the markets should be prepared for the uncertainties. Governor indicated that the conduct of monetary policy, in the best of times, is complex since it has to be forward looking and based on current and sometimes outdated data relative to rapid changes. Additional complexities arise in the case of an emerging market, which is transiting from a closed to a progressively open economy. Currently, the combination of factors that complicate monetary management includes: globally transmitted supply shock; less than normal monsoon conditions; persistence of liquidity overhang; and long-awaited pick-up in non-food credit. The policy has been responding to the evolving circumstances based on analysis and some judgements. First, there was a widespread expectation of further progress in soft bias in interest rate regime in November 2003, when a view was taken that the interest rate cycle had reached the bottom. Second, a judgement had to be made on capital flows in the early part of the current calendar year as to what part of the capital inflows should be treated as temporary. In this regard, he pointed out the fact that international financial markets react asymmetrically to the same magnitude of growth in forex reserves (positively) and to the depletion in forex reserves (very negatively) cannot be lost sight of. Third, empirical evidence indicates that the perceptions of the financial markets in the context of changes in political executives in the Government cannot be ignored while monitoring developments. Fourth, when some central banks start moving from easy to more neutral policy and hike policy interest rates, there is an inevitable impact on Indian financial markets. In response to these developments, decisions have to be made on an ongoing basis, about the weight to be given to stability in financial markets relative to the possible costs of not altering the approaches. Fifth, when faced with a severe oil-shock, the first of its kind in the liberalised market-oriented environment in a semi-open economy, the governing thought in making judgements is the harmonisation of the communications and policy responses of RBI along with corresponding fiscal and corporate initiatives. Thus, the conduct of policy in the first half of the year was characterised by responses to developments on an ongoing and measured basis, giving appropriate weights, contextually, to global and domestic factors, to growth and price stability, to efficiency and financial stability and to over-riding concerns for the common person. Operationally, it is expected that the challenge for the rest of the year would broadly remain the same, viz., management of liquidity in tune with the draining of the overhang, progress of borrowing programme of the Government, the evolving domestic and global situation, especially oil prices and global interest rate environment, but with equal weight to considerations of maintaining growth momentum and stabilising inflationary expectations.