Reserve Bank of India's Third Quarter Review of Monetary Policy 2010-11 (Abridged)

The State of the Economy


The Global Economy

5. Global growth prospects have improved in recent weeks. The recovery in major advanced economies, which had weakened during Q2 of 2010, regained strength in Q3 of 2010. Real GDP growth in the US, which had moderated from 3.7 per cent in Q1 of 2010 to 1.7 per cent in Q2 of 2010, improved to 2.6 per cent in Q3. Corporate capital spending and retail sales in the US have improved. While uncertainty persists in the Euro area and Japan, the baseline outlook for both is improving. Growth in EMEs has remained strong, supported largely by domestic demand.

6. In advanced economies, the earlier fears of deflation have given way to early signs of inflation. In EMEs, inflation has accentuated significantly in the recent period. Rapidly rising food prices in several economies such as China, India, Indonesia, Brazil and Russia are a major contributory factor. According to the Food and Agriculture Organisation (FAO), international food prices rose by 25 per cent in December 2010 in comparison with the level at the end of 2009. The increase in global food prices has been led by prices of edible oils (55 per cent), cereals (39 per cent) and sugar (19 per cent). Significantly, the FAO expects food prices to further harden during 2011, intensifying global inflationary pressures.

7. These pressures are likely to be reinforced by trends in energy and commodity prices. The crude oil (Brent) price perked from US$ 85 per barrel on November 2, 2010 to US$ 97 per barrel on January 21, 2011. The price of crude (ICE Brent) in the futures market is ruling at US$ 98 per barrel for March 2011 delivery. Many other commodities have seen similar movements. As growth prospects in the US improve, the consequent increase in global demand for energy and commodities will exert further pressure on prices. Already, the 10-year benchmark US government securities yield increased from 2.4 per cent in early October 2010 to 3.4 per cent in mid-January 2011, indicating, among other things, rising inflationary expectations.

The Domestic Economy

8. Real GDP in India increased by 8.9 per cent during the first half of 2010-11, reflecting strong domestic demand, especially private consumption and investment, and improving external demand. Although on a cumulative basis, the IIP grew by 9.5 per cent during April-November 2010, it has been volatile in the current financial year with growth rates ranging between 2.7 per cent and 16.6 per cent. Overall, robust corporate sales, large indirect tax collections, advance tax payments and leading indicators of service sector activity suggest persistence of the growth momentum.

9. On the other hand, the latest quarterly Industrial Outlook Survey conducted by the Reserve Bank during October-December 2010 indicates a marginal moderation in overall business expectations during January-March 2011 from their high level in the previous quarter. The Reserve Bank’s order book, inventories and capacity utilisation survey for July-September 2010 showed a marginal improvement in capacity utilisation in Q2 of 2010-11, while the HSBC Purchasing Managers’ Index (PMI) showed some moderation in the pace of manufacturing sector expansion in December 2010.

10 . Headline inflation, based on year-on-year changes in the wholesale price index (WPI), moderated to a single digit in August 2010 and softened further to 7.5 per cent in November 2010, the lowest level attained during 2010. However, inflation reversed course to rise to 8.4 per cent in December 2010, driven primarily by food and fuel inflation.

11. Year-on-year primary food articles inflation spiked to 13.5 per cent in December from 9.4 per cent in November due to severe supply constraints in respect of some food items. In particular, vegetable prices increased by 22.9 per cent in December 2010 over the previous month’s level. Month-on-month price increases were very high for some vegetables such as brinjals (65 per cent), onions (35 per cent), garlic (26 per cent), cabbage (22 per cent), tomatoes (19 per cent) and potatoes (16 per cent).

12. Year-on-year fuel inflation, which had moderated from 14.4 per cent in May 2010 to 10.3 per cent in November 2010, rose again to 11.2 per cent in December 2010 due to a rise in non-administered domestic fuel prices, reflecting the sharp increase in international prices. In the first fortnight of January 2011, oil marketing companies further raised the prices of petroleum products (petrol and aviation turbine fuel) which will further add to fuel inflation. The year-on-year WPI non-food manufactured products (weight: 55 per cent) inflation, which moderated from 5.9 per cent in April 2010 to 5.1 per cent in September 2010, increased to 5.4 per cent in November, though it softened marginally to 5.3 per cent in December. Significantly, non-food manufactured products inflation continues to remain above its medium-term trend of 4.0 per cent. Moreover, in recent months, the underlying inflation momentum in this segment has been positive.

13. Between November and December 2010, as WPI inflation moved up from 7.5 per cent (year-on-year) to 8.4 per cent, the wholesale price index increased by 1.3 per cent. Of this increase in index, 82 per cent was contributed by primary articles and fuel groups and 18 per cent by the manufactured products group. At a disaggregated level, vegetables alone contributed as much as 40 per cent to the increase in the index in December, followed by mineral oil (13 per cent), condiment and spices (8 per cent) and minerals (7 per cent).

14. Money supply (M3) growth moderated during the year, reflecting slower deposit growth and faster currency expansion which reduced the money multiplier. Several banks raised their deposit rates after the Second Quarter Review of 2010-11 which contributed to a larger deposit mobilisation in December. Consequently, M3 growth increased to 16.5 per cent by end-December 2010, close to the indicative projection of 17 per cent for 2010-11.

15. However, year-on-year non­food credit growth has been above the Reserve Bank’s indicative projection of 20 per cent since early October 2010, rising to 24 per cent by end-December 2010. The wide gap between credit growth and deposit growth resulted in a sharp increase in the incremental non-food credit-deposit ratio to 102 per cent by end-December 2010, up from 58 per cent in the corresponding period of previous year.

16. Disaggregated data suggest that credit growth, which was earlier driven by the infrastructure sector, is becoming increasingly broad-based across sectors and industries, evidencing growth momentum and demand pressures. Credit flow to the services sector increased significantly for transport operators, tourism, hotel and restaurant and commercial real estate, besides retail housing and personal loans. As regards industry, apart from infrastructure, increase in credit was significant for metals, engineering, textiles, food processing and chemical and chemical products.

17. Rough estimates showed that the total flow of financial resources from banks and non-banks to the commercial sector during April-December 2010 was `9,01,000 crore, up from `6,36,000 crore during the corresponding period of last year. While bank credit to the commercial sector surged, the flow of funds from other sources was lower than last year’s level mainly on account of lower net inflows from foreign direct investment (FDI).

18 . As part of the calibrated exit from the crisis driven expansionary monetary stance, the Reserve Bank increased the repo rate by 150 basis points (bps) and the reverse repo rate by 200 bps during March–November 2010. In addition, the cash reserve ratio (CRR) was raised by 100 bps. In response to these monetary policy measures, scheduled commercial banks (SCBs) raised their deposit rates in the range of 25-250 bps during March 2010 -January 2011 across various maturities, indicating strong monetary policy transmission.

19. The Base Rate system replaced the Benchmark Prime Lending Rate system with effect from July 1, 2010. Several banks reviewed and increased their Base Rates by 25-100 bps between July 2010 and January 2011. Base Rates of 67 banks with a share of 98 per cent in the total bank credit were in the range of 7.5-9.0 per cent in December 2010.

20. Tight liquidity conditions persisted throughout the third quarter of 2010-11. The average daily net injection of liquidity through the liquidity adjustment facility (LAF) increased from around `62,000 crore in October to around `99,000 crore in November and further to around `1,20,000 crore in December, with the peak injection of around `1,71,000 crore on December 22, 2010. While the overall liquidity in the system has remained in deficit consistent with the policy stance, the extent of tightness after the Second Quarter Review of 2010-11 was outside the comfort zone of the Reserve Bank, i.e., (+)/(-) one per cent of net demand and time liabilities (NDTL) of banks. Above-normal government cash balances, which rose from an average of `73,000 crore in October to `1,53,000 crore by the second half of December 2010, contributed to the frictional component of liquidity deficit. However, the widening difference between credit and deposit growth rates coupled with high currency growth accentuated the structural liquidity deficit.

21. The Reserve Bank instituted a number of measures to mitigate the liquidity deficit. First, the statutory liquidity ratio (SLR) of SCBs was reduced from 25 per cent of their NDTL to 24 per cent with effect from December 18, 2010. Second, it conducted open market operation (OMO) purchase of government securities of the order of over `67,000 crore. Third, additional liquidity support to SCBs was provided under the LAF. This facility, which was initially available up to 2 per cent of their NDTL, was brought down to one per cent of NDTL after reduction in the SLR by one percentage point. Fourth, a second LAF window was introduced.

22. Government spending resulted in a reduction of its cash balances during January 2011 (up to January 21, 2011). As a result, the average daily net liquidity injection through the LAF declined from around `1,20,000 crore during December 2010 to around `90,000 crore in January 2011 (up to January 21, 2011).

23. Reflecting the improvement in the tight liquidity conditions, the average daily call rate moderated from 6.7 per cent during December 2010 to 6.5 per cent in January 2011 (up to January 21, 2011). At the longer end, 10-year government security (G-Sec) yield, which had generally remained above 8 per cent during most of October-November 2010 on account of inflationary pressures and persistent liquidity tightness, also softened in the second half of December 2010. However, the yield on 10-year G-sec moved up again to 8.2 per cent by January 21, 2011, reflecting both liquidity conditions and inflationary expectations.

24. Over 95 per cent of the Central Government’s budgeted borrowing programme (net) was completed by January 24, 2011. During the first eight months of 2010-11, the fiscal deficit of the Central Government was less than 50 per cent of the budget estimates. The one-off revenue generated from spectrum auctions, estimated to be around 1.5 per cent of GDP for the year, has been a major contributor to the current improvement on the revenue side.

25. During 2010-11 (up to December 2010), the real exchange rate of the rupee showed a mixed trend. It appreciated by 3.7 per cent on the basis of the trade based 6-currency real effective exchange rate (REER), reflecting both nominal appreciation of the rupee against the US dollar and the higher inflation differential with major advanced countries. However, against broader baskets of 36-currency and 30-currency REER, the rupee depreciated over its March 2010 levels by 0.6 per cent and 2.5 per cent, respectively.

26. On a balance of payments (BoP) basis, the trade deficit widened to US$ 35.4 billion in Q2 of 2010-11 from US$ 31.6 billion in Q1. Coupled with stagnation in invisibles receipts, this led to a widening of the current account deficit (CAD) from US$ 12.1 billion in Q1 of 2010-11 to US$ 15.8 billion in Q2 of 2010-11. In the first half of 2010-11, the CAD expanded to 3.7 per cent of GDP from 2.2 per cent in the corresponding period of last year. Subsequent trade data indicate faster growth in exports vis-a-vis imports which may help improve the CAD in Q3 of 2010-11. However, the sharp increase in global commodity prices, particularly oil, could have an adverse impact on our trade balance going forward. For the year as a whole, India’s CAD is expected to be close to 3.5 per cent of GDP.