Complete statement: RBI's Q3 2009-10 Monetary Policy review

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Here is the Policy Review statement, which should be read and understood together with the detailed review in Macroeconomic and Monetary Developments released on Thursday by the Reserve Bank. The statement is organised in four sections. Section I provides an overview of global and domestic macroeconomic developments; Section II sets out the outlook and projections for growth, inflation, money and credit aggregates. Section III explains the stance of monetary policy and Section IV specifies the monetary measures.

I. The State of the Economy

Global Economy

1. The global economy is showing increasing signs of stabilisation. The growth outlook in virtually all economies is being revised upwards steadily, with the Asian region experiencing a relatively stronger rebound. Global trade is gradually picking up, but other indicators of economic activity, particularly capital flows and asset and commodity prices are more buoyant. However, even as most of the forecasts on recovery are generally optimistic, significant risks remain. The recovery in many economies is driven largely by government spending, with the private sector yet to begin playing a significant part. There are signs that high levels of global liquidity are contributing to rising asset prices as well as rising commodity prices. Emerging market economies (EMEs) are generally recovering faster than advanced economies. But they are also likely to face increased inflationary pressures due to easy liquidity conditions resulting from large capital inflows.

2. While conditions in the beginning of 2010 are significantly better than they were at the beginning of 2009, a different set of policy challenges has emerged for both advanced economies and EMEs. In 2009, while advanced economies were focused on dealing with the financial crisis, especially reviving the credit market and restoring the health of the financial sector, EMEs were engaged in mitigating the adverse impact of the global financial crisis on their real economies. In 2010, the effort in advanced economies will be to further improve the financing conditions and strengthen the growth impulses, while the endeavour in the EMEs will be to strengthen the recovery process without compromising on price stability and to contain asset price inflation stemming from large capital inflows.

Domestic Economy

3. As stated in the Second Quarter Review of October 2009, India's macroeconomic context is different from that of advanced and other EMEs in at least four respects. One, India is facing rising inflationary pressures, albeit largely due to supply side factors. Two, households, firms and financial institutions in India continue to have strong balance sheets, although there is a need to encourage domestic consumption and investment demand. Three, since the Indian economy is supply-constrained, pick-up in demand could exacerbate inflationary pressures. Four, India is one of the few large EMEs with twin deficits - fiscal deficit and current account deficit.

4. Growth during Q2 of 2009-10, at 7.9%, reveals a degree of resilience that surprised many. Subsequent data releases, whether on industrial production, infrastructure or exports, confirm the assessment that the economy is steadily gaining momentum. Based on this better-than-expected performance, growth forecasts for 2009-10 have generally been revised upwards. As reassuring as this recovery is, it is still unbalanced. Public expenditure continues to play a dominant role and performance across sectors is uneven, suggesting that recovery is yet to become sufficiently broad-based.

5. For several months, rapidly rising food inflation has been a cause for concern. More recently, there are indications that the sustained increase in food prices is beginning to spill over into other commodities and services as well. The increases in the prices of manufactured goods have accelerated over the past two months. While food products, understandably, contribute significantly to this, pressures in other sectors are also visible. Further, prices of non-administered fuel items have increased significantly in line with rising international prices. With growth accelerating in the second half of 2009-10 and expected to gain momentum over the next year, capacity constraints could potentially reinforce supply-side inflationary pressures.

6. The inflation risk looms larger when viewed in the context of global price movements. As already indicated, global commodity prices are showing signs of firming up, driven both by the recovery in demand and the asset motive. Significantly, prices of important food items are also firming up. Going by the Food and Agriculture Organisation (FAO) data, the global rates of increase in the prices of sugar, cereals and edible oils are now appreciably higher than domestic rates. The opportunity to use imports as a way to contain domestic food prices is, therefore, quite limited.

7. Monetary aggregates during 2009-10 have so far moved broadly in line with their projections. However, non-food bank credit growth decelerated significantly from its peak of over 29% in October 2008 to a little over 10% in October 2009. Thereafter, it recovered to over 14% by mid-January 2010. This credit performance should be seen in the context of improved access of corporates to non-bank sources of funds this year. Rough calculations show that the total flow of financial resources from banks, domestic non-bank and external sources to the commercial sector during 2009-10 (up to January 15, 2010) at Rs 5,89,000 crore was only marginally lower than Rs 5,95,000 crore in the corresponding period of the previous year. These numbers suggest that non-bank sources of finance have, to a large extent, mitigated the impact of the slow down in bank credit growth.

8. Our previous Reviews have commented on the monetary transmission during the crisis period. While the changes in the Reserve Bank's policy rates were quickly transmitted to the money and government securities markets, transmission to the credit market was slower. Evidently, the transmission is still in progress. The effective average lending rate of scheduled commercial banks declined from 12.3% in March 2008 to 11.1% in March 2009. Although relevant information for the subsequent period is not available, the effective average lending rates may have declined further as banks' benchmark prime lending rates (BPLRs) softened by 25-100 basis points during this period.

9. Financial markets have remained orderly. Overnight money market rates remained below or close to the lower bound of the liquidity adjustment facility (LAF) corridor. Liquidity conditions remained comfortable with the Reserve Bank absorbing about Rs 1,09,000 crore on a daily average basis during the current financial year. Yields on government securities could potentially have increased sharply because of the abrupt increase in government borrowings. However, the upward pressure on yields was contained by lower commercial credit demand, open market operation (OMO) purchases and active liquidity management by the Reserve Bank. Equity markets are behaving in a manner consistent with global patterns. Real estate prices have firmed up as has been the trend in several other EMEs. Increasing optimism about the recovery and high levels of liquidity are driving up real estate prices although they are still some distance away from the pre-crisis peaks.

10. On the fiscal front, the stimulus by the government in the second half of 2008-09 has clearly contributed significantly to the recovery. It may be recalled that the crisis-driven stimulus by way of reduction in excise levies, interest rate subventions and additional capital expenditure came on top of structural measures already built into the budget such as the Sixth Pay Commission Award and farm debt waiver.

11. We will have to await the forthcoming budget in end-February 2010 for the Government's decision on phasing out the transitory components of the stimulus. As regards the structural components, even though they were one-off, some of their impact is expected to continue over the next couple of years, as state governments and public sector enterprises align their compensation structures with the recommendations of the Sixth Pay Commission.

12. Managing the government borrowing programme to finance the large fiscal deficit posed a major challenge for the Reserve Bank. In order to address this, the Reserve Bank front-loaded the government borrowing programme, unwound MSS securities and undertook OMO purchases.

13. On the external front, exports have begun responding to the revival in global demand. Right through the difficulties of 2008-09 and the early months of the current financial year, there was never any pressure on the current account. However, capital outflows in the third quarter of 2008-09 led to some stress on the balance of payments, but we rode this out on the strength of our forex reserves. The Reserve Bank, however, had to initiate some conventional and non-conventional measures to ease the pressure on forex and rupee liquidity. In the space of a year, the situation has clearly stabilised.

14. The current account deficit during April-September 2009 was USD 18.6 billion, up from USD 15.8 billion during April-September 2008. Over the first half of 2009-10, capital inflows resumed, but were not significantly in excess of the current account deficit. India's improving growth prospects, combined with persistently high levels of global liquidity, may result in a significant increase in net inflows over the coming months. Depending on how these are handled, there will be implications in terms of a combination of exchange rate appreciation, larger systemic liquidity and the fiscal costs of sterilisation.

Read page 2 for RBI's outlook and projection...