sahiloberoi9
New member
A Project Report
On
MACROECONOMIC AND MONETARY DEVELOPMENTS IN INDIA
Icfai university mumbai
Academic year
2007-2008
Submitted by
Vishal dilip thobhani (07BS4917)
Mba programme
(Semester – 2)
Project guide
Mr. MAQBOOL SHAIKH
INTRODUCTION
Economy of India is expected to be the third largest in the world as estimated by purchasing power parity (2007). When measured in USD exchange-rate terms, it is the twelfth largest in the world, with a GDP of US $1.09 trillion (2007).[1] India is the second fastest growing major economy in the world, with a GDP growth rate of 9.4% for the fiscal year 2006–2007. [However, India's huge population results in a per capita income of $4,182 at PPP and $964 at nominal (2007 estimate). The World Bank classifies India as a low-income economy.
India's economy is diverse and encompasses agriculture, handicrafts, textile, manufacturing, and a multitude of services. Although two-thirds of the Indian workforce still earns their livelihood directly or indirectly through agriculture, services are a growing sector and are playing an increasingly important role of India's economy. The advent of the digital age, and the large number of young and educated populace fluent in English, is gradually transforming India as an important 'back office' destination for global companies for the outsourcing of their customer services and technical support. India is a major exporter of highly-skilled workers in software and financial services, and software engineering. Other sectors like manufacturing, pharmaceuticals, biotechnology, nanotechnology, telecommunication, shipbuilding, aviation and tourism are showing strong potentials with higher growth rates.
India followed a socialist-inspired approach for most of its independent history, with strict government control over private sector participation, foreign trade, and foreign direct investment. However, since the early 1990s, India has gradually opened up its markets through economic reforms by reducing government controls on foreign trade and investment. The privatisation of publicly owned industries and the opening up of certain sectors to private and foreign interests has proceeded slowly amid political debate.
India faces a burgeoning population and the challenge of reducing economic and social inequality. Poverty remains a serious problem, although it has declined significantly since independence. Official surveys estimated that in the year 2004-2005, 27% of Indians were poor.
Since 1990 India has emerged as one of the wealthiest economies in the developing world; during this period, the economy has grown constantly, but with a few major setbacks. This has been accompanied by increases in life expectancy, literacy rates and food security.
While the credit rating of India was hit by its nuclear tests in 1998, it has been raised to investment level in 2007 by S&P and Moody's. In 2003, Goldman Sachs predicted that India's GDP in current prices will overtake France and Italy by 2020, Germany, UK and Russia by 2025 and Japan by 2035. By 2035, it was projected to be the third largest economy of the world, behind US and China.
General budget
The Finance minister of India presents the annual union budget in the Parliament on the last working day of February. The budget has to be passed by the Lok Sabha before it can come into effect on April 1, the start of India's fiscal year. The Union budget is preceded by an economic survey which outlines the broad direction of the budget and the economic performance of the country for the outgoing financial year. This economic survey involves all the various NGOs, women organizations, business people, old people associations etc.
India's union budget for 2005–06, had an estimated outlay of Rs.5, 14,344 crores ($118 billion). Earnings from taxes amount to Rs. 2, 73,466 crore ($63b). India's fiscal deficit amounts to 4.5% or 1, 39,231 crore ($32b). The fiscal deficit is expected to be 3.8% of GDP, by March 2007.
Currency system
The Rupee is the only legal tender accepted in India. The exchange rate as of October 13, 2007 is about 39.18 to a US dollar, 55.56 to a Euro, and 79.82 to a UK pound. The Indian rupee is accepted as legal tender in the neighboring Nepal and Bhutan, both of which peg their currency to that of the Indian rupee. The rupee is divided into 100 paisa. The highest-denomination banknote is the 1,000 rupee note; the lowest-denomination coin in circulation is the 25 paisa coin.
Exchange rates
Under the fixed exchange rate system, the value of the rupee was linked to the British pound sterling until 1946, and after independence, 30% of India's foreign trade was determined in pound sterling. In 1975, as per the floating exchange rate system, the value of the rupee was pegged to a basket of currencies and was tightly controlled by the Reserve Bank of India. Since 2005, its value has been appreciating against the US dollar, Euro and British Pound Sterling. Since liberalization reforms in early 1990s, the rupee is fully convertible on trade and current account.
Macroeconomic and Monetary Developments: First Quarter 2007-08
The highlights of macroeconomic and monetary developments during 2007-08sofarare:
The Real Economy
• The cumulative rainfall recorded during the 2007 monsoon (up to July 25) was 4 per cent above normal as compared with 14 per cent below normal a year ago. As on July 20, 2007, sowing was undertaken in almost 54 per cent of normal area under kharif crops. Total area sown was 1.7 per cent higher than that in the corresponding period of 2006.
• Industrial production remained robust during April-May 2007, recording a year-on-year expansion of 11.7 per cent. The manufacturing sector remained the key driver of industrial activity with growth of 12.7 per cent.
• The infrastructure sector recorded a higher growth of 8.1 per cent during April-May 2007 as compared with 7.2 per cent than a year ago mainly on account of improvement in electricity and petroleum refinery products.
• Growth rates in tourist arrivals, revenue earning freight traffic of the railways, new cell phone connections, export cargo handled by civil aviation, passengers handled by civil aviation, cement and steel moderated. On the other hand, cargo handled at major ports accelerated vis-à-vis the previous year.
Fiscal Situation
• Available information on Central Government finances for April-May 2007 indicates that all the key deficit indicators were lower than a year ago in absolute terms. As percentage of budget estimates, gross fiscal deficit was also lower than in April-May 2006. The improvement in Central Government finances during April-May 2007 was brought about by higher tax revenues, higher non-debt capital receipts and lower plan expenditure.
• Gross and net market borrowings (including dated securities and 364-day Treasury Bills) of the Centre during 2007-08 (up to July 26, 2007) amounted to Rs.85,628 crore and Rs.46,047 crore, respectively, accounting for 45.3 per cent and 42.0 per cent, respectively, of the estimated borrowings for the year. During the corresponding period of the previous year, the gross and net borrowings accounted for 39.5 per cent and 31.3 per cent, respectively, of the actual borrowings for 2006-07.
• During 2007-08 (up to July 26, 2007), the Centre took recourse to WMA for 72 days as compared with 33 days during the same period in 2006-07.
• During 2007-08 (up to July 26, 2007), fourteen States have raised market borrowings amounting to Rs. 8,542 crore (25.6 per cent of gross allocation for the year).
• The average utilization of WMA and overdraft by the States was Rs.694 crore during 2007-08 (up to July 20, 2007) as compared with Rs. 258 crore in the corresponding period of the previous year. The average investments by the States in Treasury Bills during April-June 2007 amounted to Rs.68, 800 crore as against Rs. 52,876 crore during the corresponding period of the previous year.
Monetary and Liquidity Conditions
• Growth in broad money (M3), year-on-year (y-o-y), was 21.6 per cent (Rs. 6, 09,610 crore) on July 6, 2007 as compared with 19.0 per cent (Rs. 4, 51,636 crore) a year ago.
• Aggregate deposits of banks, y-o-y, increased by 22.8 per cent (Rs. 5, 42,766 crore) on July 6, 2007 as compared with 19.6 per cent (Rs. 3, 90,409 crore) a year ago.
• Growth in bank credit moderated after the strong pace in the preceding three years. Non-food credit by scheduled commercial banks (SCBs) moderated to 24.4 per cent (Rs.3, 67,258 crore), y-o-y, as on July 6, 2007 from 32.8 per cent (Rs. 3, 70,899 crore) a year ago.
• Reserve money expanded by 29.1 per cent (21.7 per cent adjusted for the first round impact of the increase in the cash reserve ratio), y-o-y, as on July 20, 2007 as compared with 17.2 per cent a year ago.
• Liquidity conditions continued to be influenced by movements in capital flows and cash balances of the Governments. The Reserve Bank modulated market liquidity with the help of issuances of securities under the Market Stabilization Scheme (MSS), operations under Liquidity Adjustment Facility (LAF) and increase in the cash reserve ratio (CRR).
Price Situation
• Both headline and core inflation in major economies have remained firm during 2007-08 so far, reflecting the combined impact of high commodity prices and strong demand conditions. Several central banks further tightened monetary policy during March-June 2007.
• Global commodity prices firmed up further in the first quarter of 2007-08 led by crude oil, metals and edible oils. WTI crude oil prices increased to US $ 76 a barrel on July 19, 2007 from around US $ 60 a barrel in March 2007. The overall food price index compiled by the IMF increased by 10 per cent in June 2007 (y-o-y) on top of an increase of 12 per cent a year ago. Reflecting the sustained rise in food prices, the IMF’s food price index in June 2007 reached its highest level since 1981.
• In India, inflation based on the wholesale price index (WPI) initially rose to above 6.0 per cent in early April 2007 but eased to 4.4 per cent by July 14, 2007. Manufactured products inflation was 4.6 per cent on July 14, 2007 as compared with 3.9 per cent a year ago.
• Consumer price inflation also eased somewhat to 6.1-7.5 per cent by June 2007 from 7.6-9.2 per cent in March 2007, though it continued to remain high, mainly reflecting the impact of higher food prices.
• Pre-emptive monetary measures since mid-2004 accompanied by fiscal and supply-side measures helped in containing inflation.
Financial Markets
• Indian financial markets remained generally orderly for the most part of the first quarter of 2007-08. Capital flows and swings in cash balances of the Governments were the main drivers of liquidity conditions in the financial markets, imparting volatility to overnight interest rates.
• The call money rate softened during April-June 2007 and remained below the reverse repo rate on many occasions on the back of easier liquidity conditions. Interest rates in the collateralized segment of the overnight money market also softened and remained below the call rate during the quarter.
• In the foreign exchange market, the Indian rupee appreciated vis-à-vis all major currencies (US dollar, Euro, Pound sterling and Japanese yen) during the first quarter.
• Yields in the Government securities market, which hardened up to mid-June 2007 eased thereafter.
• Banks’ deposit and lending rates rose further during the first quarter; however, there was some softening in deposit rates in July 2007.
The External Economy
• The merchandise trade deficit, on a balance of payments basis, rose from US $ 51.8 billion (6.4 per cent of GDP) in 2005-06 to US $ 64.9 billion (7.1 per cent of GDP) in 2006-07. Net invisibles increased from 5.3 per cent of GDP during 2005-06 to 6.0 per cent of GDP during 2006-07 and continued to finance a large part of the merchandise trade deficit. The current account deficit, as a proportion to GDP, in 2006-07 was, thus, contained at the previous year’s level of 1.1 per cent. Net of remittances, the current account deficit was 4.0 per cent of GDP in 2006-07 (4.1 per cent in 2005-06 and 3.3 per cent in 2004-05).
• Net capital inflows were substantially higher than those in 2005-06 reflecting large flows under foreign direct investment (FDI) and external commercial borrowings. With capital flows (net) (US$ 46.2 billion) remaining well above the current account deficit (US$ 9.6 billion), the overall balance of payments recorded a surplus of US$ 36.6 billion during 2006-07, which was higher than US$ 15.1 billion recorded during 2005-06.
• During 2007-08 so far, merchandise exports and imports exhibited acceleration in growth.
• Capital flows have remained buoyant led by FII inflows. During 2007-08 (up to July 13, 2007), FIIs registered net inflows of US $ 8.4 billion as compared with outflows of US $ 2.0 billion in the corresponding period of 2006-07. FDI inflows were US $ 1.6 billion during April 2007 (US $ 0.7 billion a year ago). Non-resident deposits registered net outflows amounting to US $ 274 million during April 2007 as against net inflows of US $ 253 million during April 2006.
• India’s foreign exchange reserves were US $ 222.0 billion as on July 20, 2007, an increase of US $ 22.9 billion over end-March 2007 level.
• A comparison of major reserve holding countries over the period 2000-2006 shows that current account surplus accounted for 179 per cent and 138 per cent of accretion to reserves in Japan and Russia, respectively, and 56 per cent each in case of China and Korea. In contrast, in India, over the same period, accretion to foreign exchange reserves was almost entirely due to capital inflows. Total reserves increased by US $ 143.8 billion during 2000-2006; net capital inflows increased by US $ 143.9 billion over the same period.
FINANCIAL MARKETS
International Financial Markets
During the second quarter of 2007-08 (July-September), international financial markets turned volatile as uncertainties about the size and distribution of losses from the US sub-prime mortgage market made investors to adjust their positions. The fallout from strains in the US sub-prime mortgage market led to spikes in yields on structured credit vehicles and in other high risk credit markets, particularly in the US and the Euro area. Rising concerns about counterparty risks led to a drying up of liquidity in various segments of the financial market which forced major central banks to step in to inject liquidity to manage volatility. The losses, though concentrated in the US, dispersed globally to European and Asian investors holding asset-backed securities and collateralised debt obligations. Within Asia, exposure was reported to be concentrated in Japan, China, Taiwan Province of China, South Korea and Australia. Uncertainty over the location and scale of exposures induced a widespread ‘safe-haven’ demand for short maturity Government paper for collateral and investment purposes. As a result, long-term bond yields softened. Global equity markets recorded further gains, albeit with intermittent corrections. In the currency markets, the US dollar depreciated against major currencies. Central banks in the US and other affected economies have undertaken measures by injecting liquidity to stabilize inter-bank markets. Open market operations of increased size and maturity were undertaken by the Bank of England, the European Central Bank (ECB) and the US Federal Reserve System. Central bank actions have, to some extent, stabilized short-term inter-bank markets but appetite for asset-backed commercial paper (ABCP) may take some time to return. According to IMF’s assessment in October 20071, notwithstanding the recent volatility and the ‘extremely turbulent correction’, an underlying resilience in the advanced economies lay in the form of the strong balance sheets and capital positions of core financial institutions, the high profitability and generally low leverage of the corporate sector, healthy situation in labour markets and household net wealth. Emerging market economies (EMEs) have generally been less affected by turbulence in the advanced economies. The resilience of these economies reflected absence of innovative credit instruments and institutional structures prevalent in the advanced economies as well as strengthening of public balance sheets and policy frameworks, thereby reducing their external vulnerabilities. Nevertheless, financial market conditions continue to pose a major source of downside risk to the global outlook. Furthermore, although emerging markets have been less affected so far, some of them have become dependent on large external financing and may get adversely affected if a fuller re-pricing of risk and tightening of lending standards and a general increase in risk aversion were to take place in the wake of continued turbulent conditions.
In the foreign exchange market, the US dollar has depreciated against major currencies during 2007-08 so far (up to October 19, 2007), reflecting worries in the mortgage market, falling housing sales in the US and weakening consumer confidence. While the pound sterling strengthened against the US dollar and reached a 25-year high level during July 2007, Japanese yen appreciated against US dollar as a result of unwinding of Yen carry trade. Between end-March 2007 and October 19, 2007, the US dollar depreciated by 6.8 per cent against the euro, 4.4 per cent against the Pound sterling and 2.2 per cent against the yen. Amongst the Asian currencies, the US dollar depreciated by 2.9 per cent against Chinese Yuan, 2.7 per cent against the Malaysian Ringgit, 2.4 per cent against Thai Baht and 2.4 per cent against South Korean won
Domestic Financial Markets
Indian financial markets remained orderly for the most part of the second quarter of 2007-08. The call money rate, which had remained below the reverse repo rate during June-July 2007 on the back of the easing of liquidity conditions and prevalence of a ceiling on absorption through reverse repo operations under the liquidity adjustment facility (LAF), reverted to the corridor set by the reverse repo and repo rates in August-September 2007 after removal of the reverse repo ceiling. Interest rates in the collateralised segment of the overnight money market also increased in tandem and remained below the call rate during the quarter. In the foreign exchange market, the Indian rupee generally appreciated vis-à-vis the US dollar during the quarter. Yields in the Government securities market softened. Banks’ deposit and lending rates softened during the second quarter particularly at the upper end of the range of various maturities. The stock markets remained buoyant and the benchmark indices reached record highs (Table 38). The primary market segment of the capital market witnessed increased activity in the second quarter of 2007-08.
Money Market
Money market rates eased during the first quarter of 2007-08 from their elevated levels witnessed in the second half of March 2007 (Chart 28). This trend continued in July 2007 with call money rates remaining below one per cent level for most of days and averaging 0.73 per cent for the month. In view of the prevailing macroeconomic and overall monetary and liquidity conditions, the First Quarter Review of the Annual Statement on Monetary Policy for 2007-08 announced the withdrawal of the ceiling of Rs.3,000 crore on daily reverse repo under the LAF and the discontinuation of the Second LAF with effect from August 6, 2007. After the withdrawal of daily reverse repo ceiling, the weighted average rate in the call money market increased to 6.31 per cent during August 2007. Barring a few days in August 2007, call money rates have remained within the informal corridor set by reverse repo and repo rates. The call money rate was at 6.02 per cent on October 24, 2007.
Interest rates in the collateralised segment of the money market – market repo (outside the LAF) and collateralised borrowing and lending obligation (CBLO) – increased in line with call rates, but remained lower than the call money rate during July-September 2007 (Chart 29). During July-September 2007, interest rates averaged 4.48 per cent, 3.74 per cent and 3.98 per cent, respectively, in the call, CBLO and market repo segments (6.08 per cent, 5.91 per cent and 5.93 per cent, respectively, a year ago). The weighted average rate in all the three money market segments combined together was 3.97 per cent during July-September 2007 (5.97 per cent a year ago).
The average daily total volumes in the call, CBLO and market repo (outside the LAF) segments during July-September 2007 were 48.4 per cent higher than those in the same period of 2006. The collateralised market remained the predominant segment of the money market, accounting for about 80 per cent of the total volume during the second quarter of 2007-08 (Table 39). In both the CBLO and market repo segments, mutual funds have been the major lenders, while banks and primary dealers (PDs) have been the major borrowers.
Certificates of Deposit
The outstanding amount of certificates of deposit (CDs) increased from Rs.93,272 crore at end-March 2007 (4.8 per cent of aggregate deposits of issuing banks) to Rs. 1,13,892 crore (5.9 per cent of deposits) by September 14, 2007 (Table 39). Most of the CDs issued were of 12-month duration. As on September 14, 2007, the weighted average discount rate (WADR) declined to 8.64 per cent from 9.37 per cent at end-June 2007 (10.75 per cent as at end-March 2007) in tandem with the decline in other money market rates.
Commercial Paper
Issuances of commercial paper (CP) increased in the second quarter of 2007-08. Outstanding CP rose from Rs. 17,838 crore at end-March 2007 to Rs.33, 227 crore by September 15, 2007 (Table 39). The weighted average discount rate (WADR) on CP declined to 8.84 per cent as on September 15, 2007 from 8.93 per cent at end-June 2007 (11.33 per cent at end-March 2007) following easy liquidity conditions in short-term money market. The most preferred maturity of CP was for periods ranging from ‘61 to 90 days’ and ‘181 days and above’. Leasing and financing companies continued to be the major issuers of CP partly reflecting the policy decision to phase out the access of these companies to public deposits (Table 40).
Treasury Bills
The primary market yields on Treasury Bills (TBs) softened in July 2007, reflecting the trends in money market segments as well as fall in domestic inflation rate (Chart 30). TBs’ yields dipped on July 18, 2007, reflecting easy liquidity conditions and very low short term rates. The surplus liquidity in the wake of ceiling of Rs. 3,000 crore in LAF reverse repo resulted in extremely low
Short-term rates and aggressive bidding in auctions of TBs and hence the lower auction cut-off. TBs’ yields hardened during August-September 2007 in tandem with higher money market interest rates and removal of the ceiling on absorption through reverse repo. The yield spread between 364-day and 91-day TBs widened to 40 basis points in September 2007 from 26 basis points in June 2007 (17 basis points in March 2007)
Foreign Exchange Market
During the second quarter of 2007-08, the Indian rupee generally appreciated vis-à-vis the US dollar (Chart 31). Between end-March 2007 and October 24, 2007, the rupee moved in the range of Rs.39.31-43.15 per US dollar. The rupee, which had appreciated till end of May 2007, depreciated thereafter up to the last week of June 2007. The rupee, however, appreciated again from the first week of July 2007 and reached a level of Rs. 39.31 per US dollar on October 15, 2007 from its level of Rs. 43.60 per US dollar at end-March 2007. The rupee’s appreciation reflected, inter alia, large capital inflows and weakening of US dollar overseas against all the major currencies. The exchange rate of the rupee was Rs. 39.58 per US dollar as on October 24, 2007. At this level, the Indian rupee appreciated by 10.1 per cent vis-à-vis the US dollar over its level on March 31, 2007. Over the same period, the rupee appreciated by 5.6 per cent against the Pound sterling, 3.1 per cent against the Euro and 7.2 per cent against the Japanese yen.
The six-currency nominal effective exchange rate (NEER) and real effective exchange rate (REER) of the Indian rupee, on an average basis, appreciated by 6.3 per cent and 7.1 per cent, respectively, between March 2007 and September 2007. The six-currency NEER and REER appreciated further by 1.1 per cent and 1.3 per cent, respectively, between end-September 2007 and October 15, 2007. The 36-currency NEER and REER of the Indian rupee, on an average basis, appreciated by 6.8 per cent and 6.9 per cent, respectively, between March 2007 and July 2007.
Forward premia increased during the second quarter of 2007-08, after dipping in July 2007, in tandem with the domestic overnight interest rates (Chart 32). The forward premia, however, remained lower than their end-March 2007 and end- June 2007 levels. The one-month forward premia declined from 6.99 per cent in March 2007 to 1.75 per cent in September 2007, while the six-month forward premia declined from 3.80 per cent to 1.37 per cent over the same period. The average daily turnover in the foreign exchange market increased to US $ 43.8 billion during April-September 2007 from US $ 23.0 billion in the corresponding period of 2006. While the average inter-bank turnover increased to US $ 30.9 billion from US $ 16.6 billion, the average merchant turnover increased to US $ 13.0 billion from US $ 6.4 billion (Chart 33). The ratio of inter-bank to merchant turnover was 2.5 during April-September 2007 as compared with 2.6 a year ago.
Credit Market
Deposit rates of scheduled commercial banks (SCBs) softened somewhat, particularly at the upper end of the range for various maturities during the second quarter of 2007-08. Interest rates of public sector banks (PSBs) on deposits of maturity of one year to three years were placed in the range of 8.00- 9.00 per cent by mid-October 2007 as compared with 7.25-9.75 per cent in
June 2007 (7.25-9.50 per cent in March 2007), while those on deposits of maturity of above three years were placed in the range of 8.00-9.50 per cent by mid-October 2007 as compared with 7.75-9.75 per cent in June 2007 (7.50- 9.50 per cent in March 2007). Benchmark Prime Lending Rates (BPLRs) of private sector banks softened to the range of 13.00-16.50 per cent by mid-October 2007 from 13.00-17.25 per cent in June 2007. The range of BPLRs of PSBs and foreign banks, however, remained unchanged during this period (Table 43 and Chart 34).
The weighted average BPLR of public sector banks increased from 12.43 per cent in March 2007 to 13.07 per cent in June 2007 and remained unchanged in October 2007. The weighted average BPLR of private sector banks increased from 14.34 per cent in March 2007 to 15.12 per cent in June 2007, but marginally softened to 15.08 per cent in October 2007. The weighted average BPLR of foreign banks increased from 12.63 per cent in March 2007 to 13.83 per cent in June 2007 and further to 14.07 per cent in October 2007.
Government Securities Market
Yields in the Government securities market softened during the second quarter of 2007-08, partly reflecting global trends in yields, lower inflation and comfortable liquidity conditions (Chart 35). The 10-year yield moved in a range of 7.80-8.32 per cent during 2007-08 (up to October 24, 2007). As on October 24, 2007, the yield was 7.89 per cent, 8 basis points lower than that at end-
March 2007. The spread between 1-10 year yields was 52 basis points at end- September 2007 as compared with 65 basis points at end-June 2007 (42 basis points at end-March 2007). The spread between 10-year and 30-year yields was 49 basis points at end-September 2007 as compared with 31 basis points at end- June 2007 (37 basis points at end-March 2007). The turnover in the Government securities market almost doubled in July 2007 from its level in June 2007 on account of low funding cost at the shorter end, but reverted in August-September 2007 as overnight rates rose to the corridor set by the reverse repo and repo rates. The yield on 5-year AAA-rated corporate bonds softened during the second quarter of 2007-08 in tandem with lower Government securities yield. The credit spread between the yields on 5-year AAA-rated bonds and 5-year Government securities narrowed to 157 basis points at end-September 2007 from 186 basis points at end-June 2007 (142 basis points at end-March 2007).
Equity Market
Primary Market
Resources raised through public issues at Rs.31, 854 crore increased by 149.4 per cent during April-September 2007 over the corresponding period of 2006. The number of issues also increased from 50 to 60. Most of the resources raised were, however, during June-2007 (Rs.22, 688 crore out of Rs.31, 854 crore), due to two large issues. The average size of public issues increased from Rs.255 crore during April-September 2006 to Rs.531 crore during April-September 2007. All the public issues during April-September 2007 were in the form of equity except one issue. Out of 60 issues during April-September 2007, 46 issues were initial public offerings (IPO’s), constituting 62.3 per cent of total resource mobilisation. Mobilisation of resources through private placement increased by 60.2 per cent to Rs.49,874 crore during April-June 2007 as compared with an increase of 48.4 per cent during April-June 2006. Public sector entities accounted for 38.1 per cent of total mobilisation during April-June 2007, lower than the corresponding period of the previous year (50.8 per cent). Resource mobilisation through financial intermediaries (both from public sector and private sector) registered a growth of 16.4 per cent over the corresponding period of last year, accounting for 51.5 per cent of total mobilisation during April-June 2007. Resources raised by non-financial intermediaries registered a higher growth of 167.2 per cent (48.5 per cent of total resource mobilisation) during April-June 2007 over the corresponding period of last year.
During April-September 2007, resources raised through Euro issues – American Depository Receipts (ADRs) and Global Depository Receipts (GDRs) – by Indian corporates increased sharply by 42.5 per cent to Rs.11,284 crore (see During April-September 2007, net mobilisation of funds by mutual funds increased by 75.9 per cent to Rs.1,05,614 crore (Table 45). Inflows in private sector mutual funds increased by 107.0 per cent over the corresponding period of last year. Net inflows were witnessed in both income/debt-oriented schemes and growth/equity-oriented schemes.
Secondary Market
The domestic stock markets recorded further gains during the second quarter of 2007-08 amidst intermittent corrections. Liquidity support from foreign institutional investors (FIIs) on the back of strong GDP growth, robust corporate profitability, decline in domestic inflation rate and upward trend in major international equity markets provided support to the domestic stock Markets. However, slump in the US home sales and rising concerns over the US sub-prime mortgage and corporate lending markets, increase in global crude oil prices to record high levels, political uncertainty in the wake of the Indo-US nuclear deal and deceleration in India’s industrial production during the month of July 2007 depressed the markets intermittently. Between end-March 2007 and end-September 2007, the BSE Sensex moved in a range of 12455-17291. The BSE Sensex closed at a record high of 19059 on October 15, 2007, an increase of 45.8 per cent over end-March 2007. The S&P CNX Nifty also reached a record high of 5670 on October 15, 2007. However, key indices slipped from their record levels after the Securities and Exchange Board of India (SEBI) proposed to restrict investments through offshore derivative instruments/participatory notes on October 16, 2007 leading to large sales by FIIs. Subsequently, on allaying concerns of overseas investors by the SEBI and assuring them speeding up the process of registration as FIIs, the BSE Sensex recorded biggest ever single day gain of 879 points on October 23, 2007. The BSE Sensex closed at 18513 on October 24, 2007. According to the data released by the SEBI, FIIs have invested Rs.62,139 crore (US $ 15.1 billion) in the Indian stock markets during 2007-08 so far (up to October 19, 2007) as compared with net purchases of Rs.10,231 crore (US $ 2.2 billion) during the corresponding period of the previous year. Mutual funds have made net investments of Rs. 2,595 crore during 2007-08 so far (up to October 19, 2007) as compared with net investments of Rs.10,344 crore during the corresponding period of the last year.
The major gainers in the domestic stock markets during the current financial year so far (up to October 19, 2007) were metal followed by capital goods, oil and gas, public sector undertaking, banking, consumer durables, fast moving consumer goods, auto and healthcare sector stocks.
Reflecting the upward trend in stock prices, the price-earnings (P/E) ratios of the 30 scrips included in the BSE Sensex rose from 20.3 at end-March 2007 to 23.3 by end-September 2007. The market capitalization of the BSE increased by 46.7 per cent between end-March 2007 and end-September 2007. The volatility in the stock markets declined during April-September 2007. The combined turnover of BSE and NSE in the cash and derivatives segments during April September 2007 was higher by 43.2 per cent and 51.5 per cent, respectively, over the corresponding period of 2006.
THE EXTERNAL ECONOMY
India’s balance of payments position has remained comfortable during 2007-08 so far. Merchandise exports after registering robust growth in 2006-07, witnessed some moderation during April-August 2007. Cumulative imports during April-August 2007 posted a high growth rate; oil imports, however, witnessed a sharp deceleration from the strong growth recorded during the corresponding period of the previous year. Net invisibles surplus remained buoyant during the
first quarter of 2007-08, led by higher growth in private transfers. The surplus on the invisibles account contained the current account deficit at broadly the same level as in the first quarter of 2006-07. Net capital inflows were substantially higher than those in the corresponding period of 2006-07, reflecting large flows under portfolio investment and external commercial borrowings. Foreign exchange reserves increased further by US $ 62.0 billion during 2007-08 (up to October 19, 2007).
International Developments
The global economy sustained strong growth of above 5 per cent during the first half of 2007. Growth in the US economy, however, moderated during this period, as the housing correction continued to apply considerable drag. While private consumption growth slowed markedly in the US in the face of rising gasoline prices, net external demand provided a significant boost to growth – exports benefited from strong partner country growth combined with the weakening dollar, while imports weakened in line with slower household spending. Growth in the Euro area, Japan and OECD countries slowed in the second quarter after two quarters of high growth. The slowdown in the Japanese economy during the second quarter was largely driven by decline in public and residential investment and weaker consumption growth. The Chinese economy,
on the other hand, gained further momentum growing by 11.5 per cent during the first half of 2007. India and Russia also continued to grow at a rapid pace. These three countries alone have accounted for one half of global growth over the past year. China for the first time has become the largest contributor to the world growth both in terms of market as well PPP based exchange rates. According to the International Monetary Fund (IMF), India is projected to record 8.9 per cent growth in 2007. Developing Asia is projected to grow by 9.8 per cent in 2007 and
8.8 per cent in 2008. The current global expansion has been the strongest period of growth since the early 1970s and it is also remarkable in other dimensions. First, with the rapid growth of world trade, openness (exports plus imports as proportion to GDP) has risen by over 10 percentage points since 2001, while financial openness (capital inflows plus outflows as proportion to GDP) has also risen rapidly. Second, emerging market and developing countries now account for a high share of growth – over two-thirds compared to around half in the 1990s. Third, the growth process has been widespread across countries and regions rather than being driven by only a few dynamic countries. These countries/regions are doing well by their own past standards as reflected in the decline in the dispersion of growth rates relative to trend. Fourth, the volatility of growth has declined substantially. According to the projections released by the IMF in October 2007, growth in the world economy is likely to moderate to 5.2 per cent in 2007 and 4.8 per cent in 2008 from 5.4 per cent in 2006 (Table 49). The downside risks to the global outlook have increased considerably on account of tightening of credit conditions resulting from reduced risk appetite and less optimistic prospects for a turnaround in the US housing market. The cutback in residential construction is reported to have directly reduced the annual rate of US economic growth by about 0.75 per cent on an average over the past year and half. In case the current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy. However, at the present juncture, the broad assessment by the IMF is that sound fundamentals and the strong momentum of the emerging market economies will continue to support the solid growth. The extent of the impact on growth will depend on how quickly more normal market liquidity is restored and the extent of the retrenchment in credit market. According to the IMF, growth in world trade is expected to moderate to 6.6 per cent in volume terms in 2007 from 9.2 per cent in the preceding year.
Exports of other emerging market and developing countries are projected to grow by 9.2 per cent in 2007 (11.0 per cent a year ago), while those of advanced countries are expected to grow by 5.4 per cent (8.2 per cent a year ago). World exports (in US dollar terms) in the first six months of 2007 (January- June) recorded a growth of 13.3 per cent (13.5 per cent in the corresponding period a year ago) supported by export growth in industrial countries However, exports from developing countries showed a moderation in growth at 15.1 per cent during January-July 2007 from 18.7 per cent registered during the corresponding period a year ago. Amongst developing countries, exports from China maintained the high growth momentum at 28.6 per cent during January-July 2007.
Merchandise Trade
India’s merchandise exports after registering strong growth in 2006-07, witnessed some moderation in the first five months of 2007-08 (Chart 40). According to the Directorate General of Commercial Intelligence and Statistics (DGCI&S), merchandise exports during 2007-08 (April-August) registered a growth of 18.2 per cent as compared with 27.1 per cent in the corresponding period of the previous year. Imports, on the other hand, posted high growth during April- August 2007-08 (31.0 per cent as compared with 20.6 per cent a year ago). Non-oil imports, which registered a growth of 44.3 per cent (10.9 per cent a year ago), accounted for 93 per cent of the overall import growth during 2007-08 (April- August). Oil imports showed a sharp deceleration in growth at 6.0 per cent as against 44.5 per cent during 2006-07 (April-August). Commodity-wise data available for April-May 2007 show that the growth in exports emanated mainly from petroleum products, engineering goods and gems and jewellery, which together accounted for 69 per cent of the export growth (66 per cent in April-May 2006). Primary products showed a deceleration in April-May 2007, mainly due to a deceleration in exports of agriculture and allied products. Agricultural products exhibited moderation in growth on account of the decline in exports of raw cotton and sugar. Among the exports of manufactured goods, textiles and textile products exports showed a decline in April-May 2007; gems and jewellery exports witnessed a revival in April-May 2007 with a growth rate of 18.1 per cent as compared with a growth rate of only 3.9 per cent in April-May 2006.
Destination-wise, the US continued to be the major market for India’s exports during 2007-08, though its share declined from 15.4 per cent in April- May 2006 to 13.1 per cent in April-May 2007. The US was followed by the UAE (10.3 per cent), China (5.6 per cent), Singapore (5.1 per cent) and the UK (4.2 per cent). Among the major regions, exports to OPEC decelerated, while that to the European Union (EU) and Asia showed higher growth in April-May 2007 Commodity-wise data on imports available for April-May 2007 show that growth in non-oil imports was more diversified as compared with April- May 2006. Capital goods continued to be the major contributor to the growth in non-oil imports, but its relative share in growth declined in April-May 2007.
On the other hand, the contribution of gold and silver, iron and steel, pearls, precious and semi-precious stones increased. Capital goods accounted for 31.8 per cent of total non-oil imports in April-May 2007 followed by gold and silver (17.8 per cent), metalliferrous ores and metal scrap (6.9 per cent), pearls, precious and semi-precious stones (5.8 per cent) and iron and steel (5.6 per cent).
Source-wise, China was the major source of imports (oil plus non-oil imports) in April-May 2007, accounting for 10.4 per cent of total imports, followed by Switzerland (7.0 per cent), the UAE (6.0 per cent), Saudi Arabia (5.1 per cent), the US (4.8 per cent), Australia (4.8 per cent), Iran (4.6 per cent), Germany (3.9 per cent) and Singapore (3.2 per cent). Trade deficit during 2007-08 (April-August) widened to US $ 32.5 billion, an increase of US $ 12.6 billion from US $ 19.9 billion a year ago. The trade deficit on the oil account increased by US $ 0.7 billion in April-May 2007 to US $ 7.1 billion, while the non-oil trade deficit increased by US $ 4.8 billion to US $ 6.6 billion.
Capital Flows
Capital flows to India have remained buoyant during the financial year 2007-08 so far. Among the major components of capital flows, foreign investment recorded an inflow of US $ 20.7 billion during April-July 2007. Inflows under foreign direct investment (FDI) into India at US $ 6.6 billion during April-July 2007 (US $ 3.7 billion in April-July 2006) witnessed significant increase, reflecting the continuing pace of expansion of domestic activities, positive investment climate, and long-term view of India as the investment destination. FDI was channeled mainly into services sector (34.2 per cent), followed by construction industry (20.6 per cent). While Mauritius continued as the dominant sources of FDI to India, FDI from Singapore exceeded that from the US. Foreign institutional investors (FIIs) inflows (net) have aggregated US $ 21.2 billion during the current financial year so far (up to October 19, 2007), reflecting, inter alia, strong corporate performance and strong domestic equity markets. The number of FIIs registered with the SEBI increased from 997 by end-March 2007 to 1,113 by October 15, 2007. Capital inflows through American depository receipts (ADRs)/global depository receipts (GDRs) abroad amounted to US $ 2.3 billion during April-July 2007. During the first quarter of 2007-08 (April-June 2007), net inflows under external commercial borrowings (ECBs) continued to be buoyant at US $ 7.0 billion. Ongoing technological upgradation and modernisation combined with expansion of domestic industrial activities have led to increased investment demand by Indian companies, and some hardening of domestic interest rates, which is reflected in higher recourse to ECBs. Non-Resident Indian (NRI) deposits during April-July 2007 recorded a net outflow of US $ 148 million, which can be partly attributed to the impact of two downward revisions in ceiling interest rates during January 2007 and April 2007. While there were net inflows under Foreign Currency Non-Resident (Banks) [FCNR (B)] deposits, the higher magnitude of outflows under Non-Resident External Rupee Account [NR (E) RA] deposits resulted in overall net outflows. With net capital flows being substantially higher than the current account deficit, the overall balance of payments recorded a surplus of US $ 11.2 billion in the first quarter of 2007-08 (US $ 6.4 billion in the first quarter of 2006-07).
Foreign Exchange Reserves
India’s foreign exchange reserves were US $ 261.1 billion as on October 19, 2007, higher by US $ 62.0 billion over end-March 2007. The increase in reserves was mainly due to an increase in foreign currency assets from US $ 191.9 billion during end-March 2007 to US $ 253.3 billion as on October 19, 2007 India holds the fifth largest stock of reserves among the emerging market economies and sixth largest in the world. The overall approach to the management of India’s foreign exchange reserves in recent years reflects the changing composition of the balance of payments and the ‘liquidity risks’ associated with different types of flows and other requirements. Taking these factors into account, India’s foreign exchange reserves continued to be at a comfortable level and consistent with the rate of growth, the share of external sector in the economy and the size of risk-adjusted capital flows.
RBI further liberalises Forex Rules
On a review of the current macro economic situation and in consultation with the Government of India, it has been decided to accelerate the implementation of the third phase of the recommendations of the Committee on Fuller Capital Account Convertibility (CFCAC) with regard to the foreign exchange outflows.
Accordingly, the following measures are being implemented with immediate effect:
i) Investment in overseas Joint Ventures (JV) / Wholly Owned Subsidiaries (WOS) by Indian companies will now be permitted up to 400 per cent of the net worth of the Indian company under the Automatic Route. The enhanced limit will also be available to registered partnership firms.
ii) In order to provide greater opportunities to listed Indian companies for portfolio investment abroad, the existing limit of 35 per cent of the net worth for portfolio investments by listed companies is being increased to 50 per cent of the net worth. Further, the requirement of 10 per cent reciprocal share holding in the listed Indian companies by overseas companies for the purpose of portfolio investment outside India by Indian listed companies has been dispensed with.
iii) The existing limit for prepayment of External Commercial borrowings (ECBs) without the Reserve Bank approval is being increased from USD 400 million to USD 500 million, subject to compliance with the minimum average maturity period as applicable to the loan.
iv) The aggregate ceiling for overseas investments by mutual funds, registered with SEBI is being increased from USD 4 billion to USD 5 billion. In addition, the existing facility of investing up to USD 1 billion in overseas Exchange Traded Funds, as may be permitted by SEBI by a limited number of qualified Indian mutual funds would continue.
v) The existing limit under Liberalised Remittance Scheme (LRS) is being enhanced from USD 100,000 to USD 200,000 per financial year.
External Debt
India’s total external debt was placed at US $ 165.4 billion at end-June 2007, recording an increase of US $ 8.7 billion (5.6 per cent) over end-March 2007. The increase in external debt during the period was mainly on account of higher external commercial borrowings, followed by higher NRI deposits and short-term trade credit. Over 50 per cent of the external debt stock was denominated in US dollars followed by the Indian rupee (18.0 per cent), SDR (12.3 per cent) and Japanese yen (12.0 per cent). Debt sustainability indicators such as the ratio of short-term to total debt and short-term debt to reserves increased marginally between end-March 2007 and end June 2007. Foreign exchange reserves remained in excess of the stock of external debt.
International Investment Position
India’s net international liabilities declined by US $ 2.7 billion between end-March 2006 and end-March 2007, as the increase in international assets (US $ 60.8 billion) exceeded the increase in international liabilities (US $ 58.1 billion). The increase in international assets was mainly on account of reserve assets, which registered an increase of US $ 47.6 billion between end- March 2006 and end-March 2007, followed by direct investment abroad which increased by US $ 11 billion during the same period. International liabilities reflected increases in direct and portfolio investment and loans at end-March 2007 from their levels at end-March 2006. A major part of the liabilities like direct and portfolio investments reflects cumulative inflows, which are at historical prices.
Monetary Policy Developments in India: An Overview
I. A Review of Outcomes
Growth with Stability
The average growth rate of the Indian economy over a period of 25 years since 1980-81 has been impressive at about 6.0 per cent, which is a significant improvement over the previous three decades, when the annual growth rate was only 3.5 per cent. Over the last four years during 2003-07, the Indian economy has entered a high growth phase, averaging 8.6 per cent per annum. The acceleration of growth during this period has been accompanied by a moderation in volatility, especially in industry and services sectors.
An important characteristic of the high growth phase of over a quarter of century is resilience to shocks and considerable degree of stability. We did witness one serious balance of payments crisis triggered largely by the Gulf war in the early 1990s. Credible macroeconomic, structural and stabilization programme was undertaken in the wake of the crisis. The Indian economy in later years could successfully avoid any adverse contagion impact of shocks from the East Asian crisis, the Russian crisis during 1997-98, and sanction like situation in post-Pokhran scenario, and border conflict during May-June 1999. Seen in this context, this robust macroeconomic performance, in the face of recent oil as well as food price shocks, demonstrates the vibrancy and resilience of the Indian economy.
The Reserve Bank projects a real GDP growth at around 8.5 per cent during 2007-08, barring domestic and external shocks.
Poverty and Unemployment
The sustained economic growth since the early 1990s has also been associated with noticeable reduction in poverty. The proportion of people living below the poverty line (based on uniform recall period) declined from 36 per cent in 1993-94 to 27.8 per cent in 2004-05. There is also some evidence of pick-up in employment growth from 1.57 per cent per annum (1993-94 to 1999-2000) to 2.48 per cent (1999-2000 to 2004-05).
Consumption and Investment Demand
India's growth in recent years has been mainly driven by domestic consumption, contributing on an average to almost two-thirds of the overall demand, while investment and export demand are also accelerating. Almost one-half of the incremental growth in real GDP during 2006-07 was on account of final consumption demand, while around 42 per cent was on account of the rise in real gross fixed capital formation. The investment boom has come from the creation of fixed assets and this phenomenon has been most pronounced in the private corporate sector, although fixed investment in the public sector also picked up in this period. According to an estimate by the Prime Minister’s Economic Advisory Council, the investment rate (provisional) crossed 35 per cent in 2006-07 from 33.8 per cent in 2005-06.
A Reasonable Degree of Price Stability
High growth in the last four years has been accompanied by a moderation of inflation. The headline inflation rate, in terms of the wholesale price index, has declined from an average of 11.0 per cent during 1990-95 to 5.3 per cent during 1995-2000 and to 4.9 per cent during 2003-07. The trending down of inflation has been associated with a significant reduction in inflation volatility which is indicative of well-anchored inflation expectations, despite the shocks of varied nature. Although, inflation based on the wholesale price index (WPI) initially rose to above 6.0 per cent in early April 2007 it eased to 3.79 per cent by August 25, 2007. Pre-emptive monetary measures since mid-2004, accompanied by fiscal and supply-side measures, have helped in containing inflation in India.
The policy preference for the period ahead is strongly in favour of price stability and well-anchored inflation expectations with the endeavour being to contain inflation close to 5.0 per cent in 2007-08 and in the range of 4.0–4.5 per cent over the medium-term. Monetary policy in India would continue to be vigilant and pro-active in the context of any accentuation of global uncertainties that pose threats to growth and stability in the domestic economy.
Improved Fiscal Performance
Yet another positive outcome of developments in recent years is the marked improvement in the health of Government finances. The fiscal management in the country has significantly improved consistent with targeted reduction in fiscal deficit indicators after the adoption of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 by the Central Government. The finances of the State Governments have also exhibited significant improvement since 2003-04 guided by the Fiscal Responsibility Legislations (FRLs).
With gross fiscal deficit of the Central Government budgeted at 3.3 per cent of GDP in 2007-08, the FRBM target of 3.0 per cent by 2008-09 appears feasible. The revenue deficit is budgeted at 1.5 per cent of GDP for 2007-08; the FRBM path envisages elimination of revenue deficit in 2008-09.
External Sector
India’s linkages with the global economy are getting stronger, underpinned by the growing openness of the economy and the two way movement in financial flows. Merchandise exports have been growing at an average rate of around 25 per cent during the last four years, with a steady increase in global market share, reflecting the competitiveness of the Indian industry. Structural shifts in services exports, led by software and other business services, and remittances have imparted stability and strength to India’s balance of payments. The net invisible surplus has offset a significant part of the expanding trade deficit and helped to contain the current account deficit to an average of one per cent of GDP since the early 1990s. Gross current receipts (merchandise exports and invisible receipts) and gross current payments (merchandise imports and invisible payments) taken together, at present, constitute more than one half of GDP, highlighting the significant degree of integration of the Indian economy with the global economy.
Greater integration into the global economy has enabled the Indian corporates to access high-quality imports from abroad and also to expand their overseas assets, dynamically. The liberalised external payments regime is facilitating the process of acquisition of foreign companies by Indian corporates, both in the manufacturing and services sectors, with the objectives of reaping economies of scale and capturing offshore markets to better face the global competition. Notwithstanding higher outflows, there has been a significant increase in capital inflows (net) to almost five per cent of GDP in 2006-07 from an average of two per cent of GDP during 2000-01 to 2002-03. Capital inflows (net) have remained substantially above the current account deficit and have implications for the conduct of monetary policy and macroeconomic and financial stability.
With the significant strengthening of the current and capital accounts, the foreign exchange reserves have more than doubled from US$ 76 billion at the end of March 2003 to US $ 228.8 billion as on August 31, 2007.
Financial Stability
The Indian record on financial stability is noteworthy as the decade of the 1990s has been otherwise turbulent for the financial sector in many EMEs. The approach towards the financial sector in India has been to consistently upgrade it by adapting the international best practices through a consultative process. The Reserve Bank has endeavored to establish an enabling regulatory framework with prompt and effective supervision, and development of legal, technological and institutional infrastructure. The regulatory norms with respect to capital adequacy, income recognition, asset classification and provisioning have progressively moved towards convergence with the international best practices. The Basel – II capital adequacy framework is being implemented in a phased manner with effect from March 2008.
We have observed that the Indian banks’ balance sheets have strengthened considerably, financial markets have deepened and widened and, with the introduction of the real time gross settlements (RTGS) system, the payment system has also become robust. Currently, all scheduled commercial banks are compliant with the minimum capital adequacy ratio (CRAR) of 9 per cent. The overall CRAR for all scheduled commercial banks stood at 12.4 per cent at end-March 2006. The gross non-performing assets of scheduled commercial banks has declined from 8.8 per cent of advances at end March 2003 to 3.3 per cent at end March 2006, while the net non-performing assets have declined from 4.0 per cent to 1.2 per cent during the same period.
Financial Markets
Development of financial markets received a strong impetus from financial sector reforms since the early 1990s. The Reserve Bank has been engaged in developing, widening and deepening of money, government securities and foreign exchange markets combined with a robust payments and settlement system. A wide range of regulatory and institutional reforms were introduced in a planned manner over a period to improve the efficiency of these financial markets. These included development of market micro structure, removal of structural bottlenecks, introduction/ diversification of new players/instruments, free pricing of financial assets, relaxation of quantitative restrictions, better regulatory systems, introduction of new technology, improvement in trading infrastructure, clearing and settlement practices and greater transparency. Prudential norms were introduced early in the reform phase, followed by interest rate deregulation. These policies were supplemented by strengthening of institutions, encouraging good market practices, rationalised tax structures and enabling legislative and accounting framework.
II. A Review of Monetary Policy Challenges
The conduct of monetary policy has become more challenging in recent years for a variety of reasons. Many of the challenges the central banks are facing are almost similar which could be summarized as follows:
Challenges with Globalisation
First, globalisation has brought in its train considerable fuzziness in reading underlying macroeconomic and financial developments, obscuring signals from financial prices and clouding the monetary authority’s gauge of the performance of the real economy. The growing importance of assets and asset prices in a globally integrated economy complicates the conduct of monetary policy when it is focused on and equipped to address price stability issues.
Second, with the growing integration of financial markets domestically and internationally, there is greater activism in liquidity management with a special focus on the short-end of the market spectrum. There is also a greater sophistication in the conduct of monetary policy and central banks are consistently engaged in refining their technical and managerial skills to deal with the complexities of financial markets. As liquidity management acquires overriding importance, the evolving solvency conditions of financial intermediaries may, on occasions, get obscured in the short run. No doubt, with increasing globalization, there is greater coordination between central banks, fiscal authorities and regulatory bodies governing financial markets.
Third, there is considerable difficulty faced by monetary authorities across the world in detecting and measuring inflation, especially inflation expectations. Recent experience in regard to impact of increases in oil prices, and more recently elevated food prices shows that ignoring the structural or permanent elements of what is traditionally treated as shocks may slow down appropriate monetary policy response especially if the focus is on "core inflation". Accounting for house rents/prices in inflation measurement has also gained attention in some countries. The central banks are often concerned with the stability/variability of inflation rather than the level of prices. Inflation processes have become highly unclear and central banks are faced with the need to recognize the importance of inflation perceptions and inflation expectations, as distinct from inflation indicators. In this context, credible communication and creative engagement with the market and economic agents have emerged as a critical channel of monetary transmission.
Challenges for Emerging Market Economies
It is essential to recognize that the international financial markets have differing ways of judging macroeconomic developments in industrial and emerging market economies. Hence, the challenges and policy responses do differ.
First, the EMEs are facing the dilemma of grappling with the inherently volatile increasing capital flows relative to domestic absorptive capacity. Consequently, often the impossible trinity of fixed or managed exchange rates open capital accounts and discretion in monetary policy has to be managed in what could be termed as ‘fuzzy’ manner rather than satisfactorily resolved - a problem that gets exacerbated due to huge uncertainties in global financial markets and possible consequences in the real sector.
Second, in the emerging scenario of large and uncertain capital flows, the choice of the instruments for sterilization and other policy responses have been constrained by a number of factors such as the openness of the economy, the depth of the domestic bond market, the health of the financial sector, the health of the public finances, the country’s inflationary track record and the perception about the credibility and consistency in macroeconomic policies pursued by the country. Further deepening of financial markets may help in absorption of large capital inflows in the medium term, but it may not give immediate succour at the current stage of financial sector development in many EMEs, particularly when speed and magnitude of flows are very high. Some of the EMEs are also subject to adverse current account shocks in view of elevated commodity prices. Going forward, global uncertainties in financial markets are likely to dominate the concerns of all monetary authorities, but, for the EMEs, the consequences of such macro or financial disturbances could be more serious.
Third, the banking sector has been strengthened and non-banking intermediation expanded providing both stability and efficiency to the financial sector in many EMEs. Yet, sometimes, aligning the operations of large financial conglomerates and foreign institutions with local public policy priorities remains a challenge for domestic financial regulators in many EMEs. Further, reaping full benefits of competition in financial sector is somewhat limited in many EMEs. Large players in developed economies compete with each other intensely, while it is possible that a few of them dominate in each of the EME's financial markets. A few of the financial intermediaries could thus wield dominant position in the financial markets of these countries, increasing the concentration risk.
While it is extremely difficult to envision how the current disturbances in financial markets will resolve, the focus of many EMEs will be on considering various scenarios and being in readiness with appropriate policy strategies and contingency plans. Among the factors that are carefully monitored, currency markets, liquidity conditions, globally dominant financial intermediaries, impact on real sector through credit channel and asset prices are significant, but the list is certainly not exhaustive.
III. Monetary Policy Framework in India
Objectives
The basic objectives of monetary policy, namely price stability and ensuring credit flow to support growth, have remained unchanged in India, but the underlying operating framework for monetary policy has undergone a significant transformation during the past two decades. The relative emphasis placed on price stability and economic growth is modulated according to the circumstances prevailing at a particular point in time and is clearly spelt out, from time to time, in the policy statements of the Reserve Bank. Of late, considerations of macroeconomic and financial stability have assumed an added importance in view of increasing openness of the Indian economy.
Framework
In India, the broad money (M3) emerged as the nominal anchor from the mid-1980s based on the premise of a stable relationship between money, output and prices. In the late 1990s, in view of ongoing financial openness and increasing evidence of changes in underlying transmission mechanism with interest rates and exchange rates gaining in importance vis-à-vis quantity variables, it was felt that monetary policy exclusively based on the demand function for money could lack precision. The Reserve Bank, therefore, formally adopted a multiple indicator approach in April 1998 whereby interest rates or rates of return in different financial markets along with data on currency, credit, trade, capital flows, fiscal position, inflation, exchange rate, etc., are juxtaposed with the output data for drawing policy perspectives. Such a shift was gradual and a logical outcome of measures taken over the reform period since the early 1990s. The switchover to a multiple indicator approach provided necessary flexibility to respond to changes in domestic and international economic environment and financial market conditions more effectively. Now, liquidity management in the system is carried out through open market operations (OMO) in the form of outright purchases/sales of government securities and daily reverse repo and repo operations under a Liquidity Adjustment Facility (LAF) and repo and reverse repo rates have emerged as the main instruments for interest rate signaling in the Indian economy.
The armory of instruments to manage, in the context of large capital flows and sterilisation, has been strengthened with open market operations through Market Stabilisation Scheme (MSS), which was introduced in April 2004. Under the MSS, the Reserve Bank was allowed to issue government securities as part of liquidity sterilisation operations in the wake of large capital inflows and surplus liquidity conditions. While these issuances do not provide budgetary support, interest costs are borne by the fisc; as far as Government securities market is concerned, these securities are also traded in the secondary market, at par with the other government stock.
While the preferred instruments are indirect, and varied, there is no hesitation in taking recourse to direct instruments also, if circumstances so warrant. In fact, complex situations do warrant dynamics of different combination of direct and indirect instruments, in multiple forms, to suit the conditions affecting transmission mechanism.
There are occasions when the medium-term goals, say reduction in cash reserve ratios for banks, conflict with short-term compulsions of monetary management requiring actions in both directions. Such operations do warrant attention to appropriate articulation to ensure policy credibility. Drawing a distinction between medium term reform goals and flexibility in short-term management is considered something critical in the current Indian policy environment.
Similarly, while there is considerable merit in maintaining a broad distinction between monetary and prudential policies of the central bank, the Reserve Bank did not hesitate, as a complement to monetary tightening, to enhance the provisioning requirements and risk weights for select categories of banking assets, namely real estate, housing and capital market exposures. These measures were needed to specifically address issues of rapidly escalating asset prices and the possible impact on banks’ balance sheets in a bank dominated financial sector. This combination, and more important, readiness of the Reserve Bank to use all instruments, has a credible impact, without undue restraint on growth impulses.
Some of the important factors that shaped the changes in monetary policy framework and operating procedures in India during the 1990s were the delinking of budget deficit from its automatic monetization by the Reserve Bank, deregulation of interest rates, and development of the financial markets with reduced segmentation through better linkages and development of appropriate trading, payments and settlement systems along with technological infrastructure. With the enactment of the Fiscal Responsibility and Budget Management Act in 2003, the Reserve Bank has withdrawn from participating in the primary issues of Central Government securities with effect from April 2006. The recent legislative amendments enable a flexible use of the CRR for monetary management, without being constrained by a statutory floor or ceiling on the level of the CRR. The amendments also enable the lowering of the Statutory Liquidity Ratio (SLR) to the levels below the pre-amendment statutory minimum of 25 per cent of net demand and time liabilities of banks – which would further improve the scope for flexible liquidity management.
Institutional Mechanisms
Monetary policy formulation is carried out by the Reserve Bank in a consultative manner. The Monetary Policy Department holds monthly meetings with select major banks and financial institutions, which provide a consultative platform for issues concerning monetary, credit, regulatory and supervisory policies of the Bank. Decisions on day-to-day market operations, including management of liquidity, are taken by a Financial Markets Committee (FMC), which includes senior officials of the Bank responsible for monetary policy and related operations in money, government securities and foreign exchange markets. The Deputy Governor, Executive Director(s) and heads of four departments in charge of monetary policy and related market operations meet every morning as financial markets open for trading. They also meet more than once during a day, if such a need arises. In addition, a Technical Advisory Committee on Money, Foreign Exchange and Government Securities Markets comprising academics and financial market experts, including those from depositories and credit rating agencies, provides support to the consultative process. The Committee meets once a quarter and discusses proposals on instruments and institutional practices relating to financial markets. Besides FMC meetings, Monetary Policy Strategy Meetings take place regularly. The strategy meetings take a relatively medium-term view of the monetary policy and consider key projections and parameters that can affect the stance of the monetary policy. In pursuance of the objective of further strengthening the consultative process in monetary policy, a Technical Advisory Committee (TAC) on Monetary Policy has been set up with Governor as Chairman and Deputy Governor in charge of monetary policy as Vice Chairman, three Deputy Governors, two Members of the Committee of the Central Board and five specialists drawn from the areas of monetary economics, central banking, financial markets and public finance, as Members. The TAC meets ahead of the Annual Policy and the quarterly reviews of annual policy. The TAC reviews macroeconomic and monetary developments and advises on the stance of monetary policy.
IV. Some Issues in the Conduct of Monetary Policy in India
Let me now discuss some issues in the conduct of monetary policy in India, in the current context.
First, one of the major challenges relates to managing the transition of Indian economy to high growth trajectory accompanied by a low and stable inflation and well anchored inflation expectations. There is growing evidence that the upward shift in growth trajectory in India is of enduring nature as it is supported by high saving and investment rates, improved productivity and vast potential lying by way of demographic dividend. However, it is still important for monetary policy formulation to identify the cyclical and structural components of growth achieved in recent years, despite this task being rendered somewhat difficult in an economy that is undergoing a rapid and deep structural transformation.
Second, a situation in which the aggregate supply is evidently less elastic domestically imposes an additional burden on monetary policy. While open trade has expanded the supply potential of several economies, significant supply in-elasticities do persist domestically, particularly due to infrastructure constraints. Further, persisting impact of supply shocks on prices of commodities and services, to which headline inflation is sensitive, can therefore exert a lasting impact on inflation expectations. Faced with longer-term structural bottlenecks in supply with less than adequate assurance of timely, convincing and demonstrated resolution of these issues, monetary policy needs to respond appropriately.
Third, some categories of interest rates are yet to be fully liberalised in the system, thereby muting at least partly, the impact of monetary policy actions on the structure of interest rates.
Fourth, in the Indian context, it is recognized that monetary policy has to contend with large fiscal deficits and high levels of public debt by international standards. While the recent improvements in the fiscal position of States and significant consolidation in the finances of the Centre provided greater maneuverability, monetary policy needs to closely coordinate with cash and debt management of governments in a non-disruptive manner.
Fifth, the operation of monetary policy has to be oriented around the predominantly public sector ownership of most of the banking system which plays a critical role in the transmission of monetary policy to the extent other public policy considerations dominate their overall operations.
Finally, though India is essentially a bank-dominated economy, commercial credit penetration in the Indian economy is still relatively low. Concerns about credit to agriculture and small and medium enterprises usually relate to inadequacy, constraints on timely availability, high cost, neglect of small and marginal farmers, low credit-deposit ratios in several States and continued presence of informal credit markets with high interest rates. It is in this context that the Reserve Bank of India continues to address the need for ensuring financial inclusion of all segments of population, protecting interests of depositors and promoting a conducive credit culture. These considerations invite the attention of the Reserve Bank, even while monetary policy aims at financial stability by moderating excess volatility in financial markets.
V. Concluding Observations
In the current environment, monetary policy in India would continue to be vigilant and pro-active in the context of any accentuation of global uncertainties that pose threats to growth and stability in the domestic economy. The domestic outlook continues to be favorable and would dominate the dynamic setting of monetary policy in the period ahead. It is important to design monetary policy such that it promotes growth by contributing to the maintenance of financial and price stability. Accordingly, while the stance of monetary policy would continue to reinforce the emphasis on price stability and well-anchored inflation expectations and thereby sustain the growth momentum, contextually, financial stability assumes greater importance at the current juncture.
On
MACROECONOMIC AND MONETARY DEVELOPMENTS IN INDIA
Icfai university mumbai
Academic year
2007-2008
Submitted by
Vishal dilip thobhani (07BS4917)
Mba programme
(Semester – 2)
Project guide
Mr. MAQBOOL SHAIKH
INTRODUCTION
Economy of India is expected to be the third largest in the world as estimated by purchasing power parity (2007). When measured in USD exchange-rate terms, it is the twelfth largest in the world, with a GDP of US $1.09 trillion (2007).[1] India is the second fastest growing major economy in the world, with a GDP growth rate of 9.4% for the fiscal year 2006–2007. [However, India's huge population results in a per capita income of $4,182 at PPP and $964 at nominal (2007 estimate). The World Bank classifies India as a low-income economy.
India's economy is diverse and encompasses agriculture, handicrafts, textile, manufacturing, and a multitude of services. Although two-thirds of the Indian workforce still earns their livelihood directly or indirectly through agriculture, services are a growing sector and are playing an increasingly important role of India's economy. The advent of the digital age, and the large number of young and educated populace fluent in English, is gradually transforming India as an important 'back office' destination for global companies for the outsourcing of their customer services and technical support. India is a major exporter of highly-skilled workers in software and financial services, and software engineering. Other sectors like manufacturing, pharmaceuticals, biotechnology, nanotechnology, telecommunication, shipbuilding, aviation and tourism are showing strong potentials with higher growth rates.
India followed a socialist-inspired approach for most of its independent history, with strict government control over private sector participation, foreign trade, and foreign direct investment. However, since the early 1990s, India has gradually opened up its markets through economic reforms by reducing government controls on foreign trade and investment. The privatisation of publicly owned industries and the opening up of certain sectors to private and foreign interests has proceeded slowly amid political debate.
India faces a burgeoning population and the challenge of reducing economic and social inequality. Poverty remains a serious problem, although it has declined significantly since independence. Official surveys estimated that in the year 2004-2005, 27% of Indians were poor.
Since 1990 India has emerged as one of the wealthiest economies in the developing world; during this period, the economy has grown constantly, but with a few major setbacks. This has been accompanied by increases in life expectancy, literacy rates and food security.
While the credit rating of India was hit by its nuclear tests in 1998, it has been raised to investment level in 2007 by S&P and Moody's. In 2003, Goldman Sachs predicted that India's GDP in current prices will overtake France and Italy by 2020, Germany, UK and Russia by 2025 and Japan by 2035. By 2035, it was projected to be the third largest economy of the world, behind US and China.
General budget
The Finance minister of India presents the annual union budget in the Parliament on the last working day of February. The budget has to be passed by the Lok Sabha before it can come into effect on April 1, the start of India's fiscal year. The Union budget is preceded by an economic survey which outlines the broad direction of the budget and the economic performance of the country for the outgoing financial year. This economic survey involves all the various NGOs, women organizations, business people, old people associations etc.
India's union budget for 2005–06, had an estimated outlay of Rs.5, 14,344 crores ($118 billion). Earnings from taxes amount to Rs. 2, 73,466 crore ($63b). India's fiscal deficit amounts to 4.5% or 1, 39,231 crore ($32b). The fiscal deficit is expected to be 3.8% of GDP, by March 2007.
Currency system
The Rupee is the only legal tender accepted in India. The exchange rate as of October 13, 2007 is about 39.18 to a US dollar, 55.56 to a Euro, and 79.82 to a UK pound. The Indian rupee is accepted as legal tender in the neighboring Nepal and Bhutan, both of which peg their currency to that of the Indian rupee. The rupee is divided into 100 paisa. The highest-denomination banknote is the 1,000 rupee note; the lowest-denomination coin in circulation is the 25 paisa coin.
Exchange rates
Under the fixed exchange rate system, the value of the rupee was linked to the British pound sterling until 1946, and after independence, 30% of India's foreign trade was determined in pound sterling. In 1975, as per the floating exchange rate system, the value of the rupee was pegged to a basket of currencies and was tightly controlled by the Reserve Bank of India. Since 2005, its value has been appreciating against the US dollar, Euro and British Pound Sterling. Since liberalization reforms in early 1990s, the rupee is fully convertible on trade and current account.
Macroeconomic and Monetary Developments: First Quarter 2007-08
The highlights of macroeconomic and monetary developments during 2007-08sofarare:
The Real Economy
• The cumulative rainfall recorded during the 2007 monsoon (up to July 25) was 4 per cent above normal as compared with 14 per cent below normal a year ago. As on July 20, 2007, sowing was undertaken in almost 54 per cent of normal area under kharif crops. Total area sown was 1.7 per cent higher than that in the corresponding period of 2006.
• Industrial production remained robust during April-May 2007, recording a year-on-year expansion of 11.7 per cent. The manufacturing sector remained the key driver of industrial activity with growth of 12.7 per cent.
• The infrastructure sector recorded a higher growth of 8.1 per cent during April-May 2007 as compared with 7.2 per cent than a year ago mainly on account of improvement in electricity and petroleum refinery products.
• Growth rates in tourist arrivals, revenue earning freight traffic of the railways, new cell phone connections, export cargo handled by civil aviation, passengers handled by civil aviation, cement and steel moderated. On the other hand, cargo handled at major ports accelerated vis-à-vis the previous year.
Fiscal Situation
• Available information on Central Government finances for April-May 2007 indicates that all the key deficit indicators were lower than a year ago in absolute terms. As percentage of budget estimates, gross fiscal deficit was also lower than in April-May 2006. The improvement in Central Government finances during April-May 2007 was brought about by higher tax revenues, higher non-debt capital receipts and lower plan expenditure.
• Gross and net market borrowings (including dated securities and 364-day Treasury Bills) of the Centre during 2007-08 (up to July 26, 2007) amounted to Rs.85,628 crore and Rs.46,047 crore, respectively, accounting for 45.3 per cent and 42.0 per cent, respectively, of the estimated borrowings for the year. During the corresponding period of the previous year, the gross and net borrowings accounted for 39.5 per cent and 31.3 per cent, respectively, of the actual borrowings for 2006-07.
• During 2007-08 (up to July 26, 2007), the Centre took recourse to WMA for 72 days as compared with 33 days during the same period in 2006-07.
• During 2007-08 (up to July 26, 2007), fourteen States have raised market borrowings amounting to Rs. 8,542 crore (25.6 per cent of gross allocation for the year).
• The average utilization of WMA and overdraft by the States was Rs.694 crore during 2007-08 (up to July 20, 2007) as compared with Rs. 258 crore in the corresponding period of the previous year. The average investments by the States in Treasury Bills during April-June 2007 amounted to Rs.68, 800 crore as against Rs. 52,876 crore during the corresponding period of the previous year.
Monetary and Liquidity Conditions
• Growth in broad money (M3), year-on-year (y-o-y), was 21.6 per cent (Rs. 6, 09,610 crore) on July 6, 2007 as compared with 19.0 per cent (Rs. 4, 51,636 crore) a year ago.
• Aggregate deposits of banks, y-o-y, increased by 22.8 per cent (Rs. 5, 42,766 crore) on July 6, 2007 as compared with 19.6 per cent (Rs. 3, 90,409 crore) a year ago.
• Growth in bank credit moderated after the strong pace in the preceding three years. Non-food credit by scheduled commercial banks (SCBs) moderated to 24.4 per cent (Rs.3, 67,258 crore), y-o-y, as on July 6, 2007 from 32.8 per cent (Rs. 3, 70,899 crore) a year ago.
• Reserve money expanded by 29.1 per cent (21.7 per cent adjusted for the first round impact of the increase in the cash reserve ratio), y-o-y, as on July 20, 2007 as compared with 17.2 per cent a year ago.
• Liquidity conditions continued to be influenced by movements in capital flows and cash balances of the Governments. The Reserve Bank modulated market liquidity with the help of issuances of securities under the Market Stabilization Scheme (MSS), operations under Liquidity Adjustment Facility (LAF) and increase in the cash reserve ratio (CRR).
Price Situation
• Both headline and core inflation in major economies have remained firm during 2007-08 so far, reflecting the combined impact of high commodity prices and strong demand conditions. Several central banks further tightened monetary policy during March-June 2007.
• Global commodity prices firmed up further in the first quarter of 2007-08 led by crude oil, metals and edible oils. WTI crude oil prices increased to US $ 76 a barrel on July 19, 2007 from around US $ 60 a barrel in March 2007. The overall food price index compiled by the IMF increased by 10 per cent in June 2007 (y-o-y) on top of an increase of 12 per cent a year ago. Reflecting the sustained rise in food prices, the IMF’s food price index in June 2007 reached its highest level since 1981.
• In India, inflation based on the wholesale price index (WPI) initially rose to above 6.0 per cent in early April 2007 but eased to 4.4 per cent by July 14, 2007. Manufactured products inflation was 4.6 per cent on July 14, 2007 as compared with 3.9 per cent a year ago.
• Consumer price inflation also eased somewhat to 6.1-7.5 per cent by June 2007 from 7.6-9.2 per cent in March 2007, though it continued to remain high, mainly reflecting the impact of higher food prices.
• Pre-emptive monetary measures since mid-2004 accompanied by fiscal and supply-side measures helped in containing inflation.
Financial Markets
• Indian financial markets remained generally orderly for the most part of the first quarter of 2007-08. Capital flows and swings in cash balances of the Governments were the main drivers of liquidity conditions in the financial markets, imparting volatility to overnight interest rates.
• The call money rate softened during April-June 2007 and remained below the reverse repo rate on many occasions on the back of easier liquidity conditions. Interest rates in the collateralized segment of the overnight money market also softened and remained below the call rate during the quarter.
• In the foreign exchange market, the Indian rupee appreciated vis-à-vis all major currencies (US dollar, Euro, Pound sterling and Japanese yen) during the first quarter.
• Yields in the Government securities market, which hardened up to mid-June 2007 eased thereafter.
• Banks’ deposit and lending rates rose further during the first quarter; however, there was some softening in deposit rates in July 2007.
The External Economy
• The merchandise trade deficit, on a balance of payments basis, rose from US $ 51.8 billion (6.4 per cent of GDP) in 2005-06 to US $ 64.9 billion (7.1 per cent of GDP) in 2006-07. Net invisibles increased from 5.3 per cent of GDP during 2005-06 to 6.0 per cent of GDP during 2006-07 and continued to finance a large part of the merchandise trade deficit. The current account deficit, as a proportion to GDP, in 2006-07 was, thus, contained at the previous year’s level of 1.1 per cent. Net of remittances, the current account deficit was 4.0 per cent of GDP in 2006-07 (4.1 per cent in 2005-06 and 3.3 per cent in 2004-05).
• Net capital inflows were substantially higher than those in 2005-06 reflecting large flows under foreign direct investment (FDI) and external commercial borrowings. With capital flows (net) (US$ 46.2 billion) remaining well above the current account deficit (US$ 9.6 billion), the overall balance of payments recorded a surplus of US$ 36.6 billion during 2006-07, which was higher than US$ 15.1 billion recorded during 2005-06.
• During 2007-08 so far, merchandise exports and imports exhibited acceleration in growth.
• Capital flows have remained buoyant led by FII inflows. During 2007-08 (up to July 13, 2007), FIIs registered net inflows of US $ 8.4 billion as compared with outflows of US $ 2.0 billion in the corresponding period of 2006-07. FDI inflows were US $ 1.6 billion during April 2007 (US $ 0.7 billion a year ago). Non-resident deposits registered net outflows amounting to US $ 274 million during April 2007 as against net inflows of US $ 253 million during April 2006.
• India’s foreign exchange reserves were US $ 222.0 billion as on July 20, 2007, an increase of US $ 22.9 billion over end-March 2007 level.
• A comparison of major reserve holding countries over the period 2000-2006 shows that current account surplus accounted for 179 per cent and 138 per cent of accretion to reserves in Japan and Russia, respectively, and 56 per cent each in case of China and Korea. In contrast, in India, over the same period, accretion to foreign exchange reserves was almost entirely due to capital inflows. Total reserves increased by US $ 143.8 billion during 2000-2006; net capital inflows increased by US $ 143.9 billion over the same period.
FINANCIAL MARKETS
International Financial Markets
During the second quarter of 2007-08 (July-September), international financial markets turned volatile as uncertainties about the size and distribution of losses from the US sub-prime mortgage market made investors to adjust their positions. The fallout from strains in the US sub-prime mortgage market led to spikes in yields on structured credit vehicles and in other high risk credit markets, particularly in the US and the Euro area. Rising concerns about counterparty risks led to a drying up of liquidity in various segments of the financial market which forced major central banks to step in to inject liquidity to manage volatility. The losses, though concentrated in the US, dispersed globally to European and Asian investors holding asset-backed securities and collateralised debt obligations. Within Asia, exposure was reported to be concentrated in Japan, China, Taiwan Province of China, South Korea and Australia. Uncertainty over the location and scale of exposures induced a widespread ‘safe-haven’ demand for short maturity Government paper for collateral and investment purposes. As a result, long-term bond yields softened. Global equity markets recorded further gains, albeit with intermittent corrections. In the currency markets, the US dollar depreciated against major currencies. Central banks in the US and other affected economies have undertaken measures by injecting liquidity to stabilize inter-bank markets. Open market operations of increased size and maturity were undertaken by the Bank of England, the European Central Bank (ECB) and the US Federal Reserve System. Central bank actions have, to some extent, stabilized short-term inter-bank markets but appetite for asset-backed commercial paper (ABCP) may take some time to return. According to IMF’s assessment in October 20071, notwithstanding the recent volatility and the ‘extremely turbulent correction’, an underlying resilience in the advanced economies lay in the form of the strong balance sheets and capital positions of core financial institutions, the high profitability and generally low leverage of the corporate sector, healthy situation in labour markets and household net wealth. Emerging market economies (EMEs) have generally been less affected by turbulence in the advanced economies. The resilience of these economies reflected absence of innovative credit instruments and institutional structures prevalent in the advanced economies as well as strengthening of public balance sheets and policy frameworks, thereby reducing their external vulnerabilities. Nevertheless, financial market conditions continue to pose a major source of downside risk to the global outlook. Furthermore, although emerging markets have been less affected so far, some of them have become dependent on large external financing and may get adversely affected if a fuller re-pricing of risk and tightening of lending standards and a general increase in risk aversion were to take place in the wake of continued turbulent conditions.
In the foreign exchange market, the US dollar has depreciated against major currencies during 2007-08 so far (up to October 19, 2007), reflecting worries in the mortgage market, falling housing sales in the US and weakening consumer confidence. While the pound sterling strengthened against the US dollar and reached a 25-year high level during July 2007, Japanese yen appreciated against US dollar as a result of unwinding of Yen carry trade. Between end-March 2007 and October 19, 2007, the US dollar depreciated by 6.8 per cent against the euro, 4.4 per cent against the Pound sterling and 2.2 per cent against the yen. Amongst the Asian currencies, the US dollar depreciated by 2.9 per cent against Chinese Yuan, 2.7 per cent against the Malaysian Ringgit, 2.4 per cent against Thai Baht and 2.4 per cent against South Korean won
Domestic Financial Markets
Indian financial markets remained orderly for the most part of the second quarter of 2007-08. The call money rate, which had remained below the reverse repo rate during June-July 2007 on the back of the easing of liquidity conditions and prevalence of a ceiling on absorption through reverse repo operations under the liquidity adjustment facility (LAF), reverted to the corridor set by the reverse repo and repo rates in August-September 2007 after removal of the reverse repo ceiling. Interest rates in the collateralised segment of the overnight money market also increased in tandem and remained below the call rate during the quarter. In the foreign exchange market, the Indian rupee generally appreciated vis-à-vis the US dollar during the quarter. Yields in the Government securities market softened. Banks’ deposit and lending rates softened during the second quarter particularly at the upper end of the range of various maturities. The stock markets remained buoyant and the benchmark indices reached record highs (Table 38). The primary market segment of the capital market witnessed increased activity in the second quarter of 2007-08.
Money Market
Money market rates eased during the first quarter of 2007-08 from their elevated levels witnessed in the second half of March 2007 (Chart 28). This trend continued in July 2007 with call money rates remaining below one per cent level for most of days and averaging 0.73 per cent for the month. In view of the prevailing macroeconomic and overall monetary and liquidity conditions, the First Quarter Review of the Annual Statement on Monetary Policy for 2007-08 announced the withdrawal of the ceiling of Rs.3,000 crore on daily reverse repo under the LAF and the discontinuation of the Second LAF with effect from August 6, 2007. After the withdrawal of daily reverse repo ceiling, the weighted average rate in the call money market increased to 6.31 per cent during August 2007. Barring a few days in August 2007, call money rates have remained within the informal corridor set by reverse repo and repo rates. The call money rate was at 6.02 per cent on October 24, 2007.
Interest rates in the collateralised segment of the money market – market repo (outside the LAF) and collateralised borrowing and lending obligation (CBLO) – increased in line with call rates, but remained lower than the call money rate during July-September 2007 (Chart 29). During July-September 2007, interest rates averaged 4.48 per cent, 3.74 per cent and 3.98 per cent, respectively, in the call, CBLO and market repo segments (6.08 per cent, 5.91 per cent and 5.93 per cent, respectively, a year ago). The weighted average rate in all the three money market segments combined together was 3.97 per cent during July-September 2007 (5.97 per cent a year ago).
The average daily total volumes in the call, CBLO and market repo (outside the LAF) segments during July-September 2007 were 48.4 per cent higher than those in the same period of 2006. The collateralised market remained the predominant segment of the money market, accounting for about 80 per cent of the total volume during the second quarter of 2007-08 (Table 39). In both the CBLO and market repo segments, mutual funds have been the major lenders, while banks and primary dealers (PDs) have been the major borrowers.
Certificates of Deposit
The outstanding amount of certificates of deposit (CDs) increased from Rs.93,272 crore at end-March 2007 (4.8 per cent of aggregate deposits of issuing banks) to Rs. 1,13,892 crore (5.9 per cent of deposits) by September 14, 2007 (Table 39). Most of the CDs issued were of 12-month duration. As on September 14, 2007, the weighted average discount rate (WADR) declined to 8.64 per cent from 9.37 per cent at end-June 2007 (10.75 per cent as at end-March 2007) in tandem with the decline in other money market rates.
Commercial Paper
Issuances of commercial paper (CP) increased in the second quarter of 2007-08. Outstanding CP rose from Rs. 17,838 crore at end-March 2007 to Rs.33, 227 crore by September 15, 2007 (Table 39). The weighted average discount rate (WADR) on CP declined to 8.84 per cent as on September 15, 2007 from 8.93 per cent at end-June 2007 (11.33 per cent at end-March 2007) following easy liquidity conditions in short-term money market. The most preferred maturity of CP was for periods ranging from ‘61 to 90 days’ and ‘181 days and above’. Leasing and financing companies continued to be the major issuers of CP partly reflecting the policy decision to phase out the access of these companies to public deposits (Table 40).
Treasury Bills
The primary market yields on Treasury Bills (TBs) softened in July 2007, reflecting the trends in money market segments as well as fall in domestic inflation rate (Chart 30). TBs’ yields dipped on July 18, 2007, reflecting easy liquidity conditions and very low short term rates. The surplus liquidity in the wake of ceiling of Rs. 3,000 crore in LAF reverse repo resulted in extremely low
Short-term rates and aggressive bidding in auctions of TBs and hence the lower auction cut-off. TBs’ yields hardened during August-September 2007 in tandem with higher money market interest rates and removal of the ceiling on absorption through reverse repo. The yield spread between 364-day and 91-day TBs widened to 40 basis points in September 2007 from 26 basis points in June 2007 (17 basis points in March 2007)
Foreign Exchange Market
During the second quarter of 2007-08, the Indian rupee generally appreciated vis-à-vis the US dollar (Chart 31). Between end-March 2007 and October 24, 2007, the rupee moved in the range of Rs.39.31-43.15 per US dollar. The rupee, which had appreciated till end of May 2007, depreciated thereafter up to the last week of June 2007. The rupee, however, appreciated again from the first week of July 2007 and reached a level of Rs. 39.31 per US dollar on October 15, 2007 from its level of Rs. 43.60 per US dollar at end-March 2007. The rupee’s appreciation reflected, inter alia, large capital inflows and weakening of US dollar overseas against all the major currencies. The exchange rate of the rupee was Rs. 39.58 per US dollar as on October 24, 2007. At this level, the Indian rupee appreciated by 10.1 per cent vis-à-vis the US dollar over its level on March 31, 2007. Over the same period, the rupee appreciated by 5.6 per cent against the Pound sterling, 3.1 per cent against the Euro and 7.2 per cent against the Japanese yen.
The six-currency nominal effective exchange rate (NEER) and real effective exchange rate (REER) of the Indian rupee, on an average basis, appreciated by 6.3 per cent and 7.1 per cent, respectively, between March 2007 and September 2007. The six-currency NEER and REER appreciated further by 1.1 per cent and 1.3 per cent, respectively, between end-September 2007 and October 15, 2007. The 36-currency NEER and REER of the Indian rupee, on an average basis, appreciated by 6.8 per cent and 6.9 per cent, respectively, between March 2007 and July 2007.
Forward premia increased during the second quarter of 2007-08, after dipping in July 2007, in tandem with the domestic overnight interest rates (Chart 32). The forward premia, however, remained lower than their end-March 2007 and end- June 2007 levels. The one-month forward premia declined from 6.99 per cent in March 2007 to 1.75 per cent in September 2007, while the six-month forward premia declined from 3.80 per cent to 1.37 per cent over the same period. The average daily turnover in the foreign exchange market increased to US $ 43.8 billion during April-September 2007 from US $ 23.0 billion in the corresponding period of 2006. While the average inter-bank turnover increased to US $ 30.9 billion from US $ 16.6 billion, the average merchant turnover increased to US $ 13.0 billion from US $ 6.4 billion (Chart 33). The ratio of inter-bank to merchant turnover was 2.5 during April-September 2007 as compared with 2.6 a year ago.
Credit Market
Deposit rates of scheduled commercial banks (SCBs) softened somewhat, particularly at the upper end of the range for various maturities during the second quarter of 2007-08. Interest rates of public sector banks (PSBs) on deposits of maturity of one year to three years were placed in the range of 8.00- 9.00 per cent by mid-October 2007 as compared with 7.25-9.75 per cent in
June 2007 (7.25-9.50 per cent in March 2007), while those on deposits of maturity of above three years were placed in the range of 8.00-9.50 per cent by mid-October 2007 as compared with 7.75-9.75 per cent in June 2007 (7.50- 9.50 per cent in March 2007). Benchmark Prime Lending Rates (BPLRs) of private sector banks softened to the range of 13.00-16.50 per cent by mid-October 2007 from 13.00-17.25 per cent in June 2007. The range of BPLRs of PSBs and foreign banks, however, remained unchanged during this period (Table 43 and Chart 34).
The weighted average BPLR of public sector banks increased from 12.43 per cent in March 2007 to 13.07 per cent in June 2007 and remained unchanged in October 2007. The weighted average BPLR of private sector banks increased from 14.34 per cent in March 2007 to 15.12 per cent in June 2007, but marginally softened to 15.08 per cent in October 2007. The weighted average BPLR of foreign banks increased from 12.63 per cent in March 2007 to 13.83 per cent in June 2007 and further to 14.07 per cent in October 2007.
Government Securities Market
Yields in the Government securities market softened during the second quarter of 2007-08, partly reflecting global trends in yields, lower inflation and comfortable liquidity conditions (Chart 35). The 10-year yield moved in a range of 7.80-8.32 per cent during 2007-08 (up to October 24, 2007). As on October 24, 2007, the yield was 7.89 per cent, 8 basis points lower than that at end-
March 2007. The spread between 1-10 year yields was 52 basis points at end- September 2007 as compared with 65 basis points at end-June 2007 (42 basis points at end-March 2007). The spread between 10-year and 30-year yields was 49 basis points at end-September 2007 as compared with 31 basis points at end- June 2007 (37 basis points at end-March 2007). The turnover in the Government securities market almost doubled in July 2007 from its level in June 2007 on account of low funding cost at the shorter end, but reverted in August-September 2007 as overnight rates rose to the corridor set by the reverse repo and repo rates. The yield on 5-year AAA-rated corporate bonds softened during the second quarter of 2007-08 in tandem with lower Government securities yield. The credit spread between the yields on 5-year AAA-rated bonds and 5-year Government securities narrowed to 157 basis points at end-September 2007 from 186 basis points at end-June 2007 (142 basis points at end-March 2007).
Equity Market
Primary Market
Resources raised through public issues at Rs.31, 854 crore increased by 149.4 per cent during April-September 2007 over the corresponding period of 2006. The number of issues also increased from 50 to 60. Most of the resources raised were, however, during June-2007 (Rs.22, 688 crore out of Rs.31, 854 crore), due to two large issues. The average size of public issues increased from Rs.255 crore during April-September 2006 to Rs.531 crore during April-September 2007. All the public issues during April-September 2007 were in the form of equity except one issue. Out of 60 issues during April-September 2007, 46 issues were initial public offerings (IPO’s), constituting 62.3 per cent of total resource mobilisation. Mobilisation of resources through private placement increased by 60.2 per cent to Rs.49,874 crore during April-June 2007 as compared with an increase of 48.4 per cent during April-June 2006. Public sector entities accounted for 38.1 per cent of total mobilisation during April-June 2007, lower than the corresponding period of the previous year (50.8 per cent). Resource mobilisation through financial intermediaries (both from public sector and private sector) registered a growth of 16.4 per cent over the corresponding period of last year, accounting for 51.5 per cent of total mobilisation during April-June 2007. Resources raised by non-financial intermediaries registered a higher growth of 167.2 per cent (48.5 per cent of total resource mobilisation) during April-June 2007 over the corresponding period of last year.
During April-September 2007, resources raised through Euro issues – American Depository Receipts (ADRs) and Global Depository Receipts (GDRs) – by Indian corporates increased sharply by 42.5 per cent to Rs.11,284 crore (see During April-September 2007, net mobilisation of funds by mutual funds increased by 75.9 per cent to Rs.1,05,614 crore (Table 45). Inflows in private sector mutual funds increased by 107.0 per cent over the corresponding period of last year. Net inflows were witnessed in both income/debt-oriented schemes and growth/equity-oriented schemes.
Secondary Market
The domestic stock markets recorded further gains during the second quarter of 2007-08 amidst intermittent corrections. Liquidity support from foreign institutional investors (FIIs) on the back of strong GDP growth, robust corporate profitability, decline in domestic inflation rate and upward trend in major international equity markets provided support to the domestic stock Markets. However, slump in the US home sales and rising concerns over the US sub-prime mortgage and corporate lending markets, increase in global crude oil prices to record high levels, political uncertainty in the wake of the Indo-US nuclear deal and deceleration in India’s industrial production during the month of July 2007 depressed the markets intermittently. Between end-March 2007 and end-September 2007, the BSE Sensex moved in a range of 12455-17291. The BSE Sensex closed at a record high of 19059 on October 15, 2007, an increase of 45.8 per cent over end-March 2007. The S&P CNX Nifty also reached a record high of 5670 on October 15, 2007. However, key indices slipped from their record levels after the Securities and Exchange Board of India (SEBI) proposed to restrict investments through offshore derivative instruments/participatory notes on October 16, 2007 leading to large sales by FIIs. Subsequently, on allaying concerns of overseas investors by the SEBI and assuring them speeding up the process of registration as FIIs, the BSE Sensex recorded biggest ever single day gain of 879 points on October 23, 2007. The BSE Sensex closed at 18513 on October 24, 2007. According to the data released by the SEBI, FIIs have invested Rs.62,139 crore (US $ 15.1 billion) in the Indian stock markets during 2007-08 so far (up to October 19, 2007) as compared with net purchases of Rs.10,231 crore (US $ 2.2 billion) during the corresponding period of the previous year. Mutual funds have made net investments of Rs. 2,595 crore during 2007-08 so far (up to October 19, 2007) as compared with net investments of Rs.10,344 crore during the corresponding period of the last year.
The major gainers in the domestic stock markets during the current financial year so far (up to October 19, 2007) were metal followed by capital goods, oil and gas, public sector undertaking, banking, consumer durables, fast moving consumer goods, auto and healthcare sector stocks.
Reflecting the upward trend in stock prices, the price-earnings (P/E) ratios of the 30 scrips included in the BSE Sensex rose from 20.3 at end-March 2007 to 23.3 by end-September 2007. The market capitalization of the BSE increased by 46.7 per cent between end-March 2007 and end-September 2007. The volatility in the stock markets declined during April-September 2007. The combined turnover of BSE and NSE in the cash and derivatives segments during April September 2007 was higher by 43.2 per cent and 51.5 per cent, respectively, over the corresponding period of 2006.
THE EXTERNAL ECONOMY
India’s balance of payments position has remained comfortable during 2007-08 so far. Merchandise exports after registering robust growth in 2006-07, witnessed some moderation during April-August 2007. Cumulative imports during April-August 2007 posted a high growth rate; oil imports, however, witnessed a sharp deceleration from the strong growth recorded during the corresponding period of the previous year. Net invisibles surplus remained buoyant during the
first quarter of 2007-08, led by higher growth in private transfers. The surplus on the invisibles account contained the current account deficit at broadly the same level as in the first quarter of 2006-07. Net capital inflows were substantially higher than those in the corresponding period of 2006-07, reflecting large flows under portfolio investment and external commercial borrowings. Foreign exchange reserves increased further by US $ 62.0 billion during 2007-08 (up to October 19, 2007).
International Developments
The global economy sustained strong growth of above 5 per cent during the first half of 2007. Growth in the US economy, however, moderated during this period, as the housing correction continued to apply considerable drag. While private consumption growth slowed markedly in the US in the face of rising gasoline prices, net external demand provided a significant boost to growth – exports benefited from strong partner country growth combined with the weakening dollar, while imports weakened in line with slower household spending. Growth in the Euro area, Japan and OECD countries slowed in the second quarter after two quarters of high growth. The slowdown in the Japanese economy during the second quarter was largely driven by decline in public and residential investment and weaker consumption growth. The Chinese economy,
on the other hand, gained further momentum growing by 11.5 per cent during the first half of 2007. India and Russia also continued to grow at a rapid pace. These three countries alone have accounted for one half of global growth over the past year. China for the first time has become the largest contributor to the world growth both in terms of market as well PPP based exchange rates. According to the International Monetary Fund (IMF), India is projected to record 8.9 per cent growth in 2007. Developing Asia is projected to grow by 9.8 per cent in 2007 and
8.8 per cent in 2008. The current global expansion has been the strongest period of growth since the early 1970s and it is also remarkable in other dimensions. First, with the rapid growth of world trade, openness (exports plus imports as proportion to GDP) has risen by over 10 percentage points since 2001, while financial openness (capital inflows plus outflows as proportion to GDP) has also risen rapidly. Second, emerging market and developing countries now account for a high share of growth – over two-thirds compared to around half in the 1990s. Third, the growth process has been widespread across countries and regions rather than being driven by only a few dynamic countries. These countries/regions are doing well by their own past standards as reflected in the decline in the dispersion of growth rates relative to trend. Fourth, the volatility of growth has declined substantially. According to the projections released by the IMF in October 2007, growth in the world economy is likely to moderate to 5.2 per cent in 2007 and 4.8 per cent in 2008 from 5.4 per cent in 2006 (Table 49). The downside risks to the global outlook have increased considerably on account of tightening of credit conditions resulting from reduced risk appetite and less optimistic prospects for a turnaround in the US housing market. The cutback in residential construction is reported to have directly reduced the annual rate of US economic growth by about 0.75 per cent on an average over the past year and half. In case the current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy. However, at the present juncture, the broad assessment by the IMF is that sound fundamentals and the strong momentum of the emerging market economies will continue to support the solid growth. The extent of the impact on growth will depend on how quickly more normal market liquidity is restored and the extent of the retrenchment in credit market. According to the IMF, growth in world trade is expected to moderate to 6.6 per cent in volume terms in 2007 from 9.2 per cent in the preceding year.
Exports of other emerging market and developing countries are projected to grow by 9.2 per cent in 2007 (11.0 per cent a year ago), while those of advanced countries are expected to grow by 5.4 per cent (8.2 per cent a year ago). World exports (in US dollar terms) in the first six months of 2007 (January- June) recorded a growth of 13.3 per cent (13.5 per cent in the corresponding period a year ago) supported by export growth in industrial countries However, exports from developing countries showed a moderation in growth at 15.1 per cent during January-July 2007 from 18.7 per cent registered during the corresponding period a year ago. Amongst developing countries, exports from China maintained the high growth momentum at 28.6 per cent during January-July 2007.
Merchandise Trade
India’s merchandise exports after registering strong growth in 2006-07, witnessed some moderation in the first five months of 2007-08 (Chart 40). According to the Directorate General of Commercial Intelligence and Statistics (DGCI&S), merchandise exports during 2007-08 (April-August) registered a growth of 18.2 per cent as compared with 27.1 per cent in the corresponding period of the previous year. Imports, on the other hand, posted high growth during April- August 2007-08 (31.0 per cent as compared with 20.6 per cent a year ago). Non-oil imports, which registered a growth of 44.3 per cent (10.9 per cent a year ago), accounted for 93 per cent of the overall import growth during 2007-08 (April- August). Oil imports showed a sharp deceleration in growth at 6.0 per cent as against 44.5 per cent during 2006-07 (April-August). Commodity-wise data available for April-May 2007 show that the growth in exports emanated mainly from petroleum products, engineering goods and gems and jewellery, which together accounted for 69 per cent of the export growth (66 per cent in April-May 2006). Primary products showed a deceleration in April-May 2007, mainly due to a deceleration in exports of agriculture and allied products. Agricultural products exhibited moderation in growth on account of the decline in exports of raw cotton and sugar. Among the exports of manufactured goods, textiles and textile products exports showed a decline in April-May 2007; gems and jewellery exports witnessed a revival in April-May 2007 with a growth rate of 18.1 per cent as compared with a growth rate of only 3.9 per cent in April-May 2006.
Destination-wise, the US continued to be the major market for India’s exports during 2007-08, though its share declined from 15.4 per cent in April- May 2006 to 13.1 per cent in April-May 2007. The US was followed by the UAE (10.3 per cent), China (5.6 per cent), Singapore (5.1 per cent) and the UK (4.2 per cent). Among the major regions, exports to OPEC decelerated, while that to the European Union (EU) and Asia showed higher growth in April-May 2007 Commodity-wise data on imports available for April-May 2007 show that growth in non-oil imports was more diversified as compared with April- May 2006. Capital goods continued to be the major contributor to the growth in non-oil imports, but its relative share in growth declined in April-May 2007.
On the other hand, the contribution of gold and silver, iron and steel, pearls, precious and semi-precious stones increased. Capital goods accounted for 31.8 per cent of total non-oil imports in April-May 2007 followed by gold and silver (17.8 per cent), metalliferrous ores and metal scrap (6.9 per cent), pearls, precious and semi-precious stones (5.8 per cent) and iron and steel (5.6 per cent).
Source-wise, China was the major source of imports (oil plus non-oil imports) in April-May 2007, accounting for 10.4 per cent of total imports, followed by Switzerland (7.0 per cent), the UAE (6.0 per cent), Saudi Arabia (5.1 per cent), the US (4.8 per cent), Australia (4.8 per cent), Iran (4.6 per cent), Germany (3.9 per cent) and Singapore (3.2 per cent). Trade deficit during 2007-08 (April-August) widened to US $ 32.5 billion, an increase of US $ 12.6 billion from US $ 19.9 billion a year ago. The trade deficit on the oil account increased by US $ 0.7 billion in April-May 2007 to US $ 7.1 billion, while the non-oil trade deficit increased by US $ 4.8 billion to US $ 6.6 billion.
Capital Flows
Capital flows to India have remained buoyant during the financial year 2007-08 so far. Among the major components of capital flows, foreign investment recorded an inflow of US $ 20.7 billion during April-July 2007. Inflows under foreign direct investment (FDI) into India at US $ 6.6 billion during April-July 2007 (US $ 3.7 billion in April-July 2006) witnessed significant increase, reflecting the continuing pace of expansion of domestic activities, positive investment climate, and long-term view of India as the investment destination. FDI was channeled mainly into services sector (34.2 per cent), followed by construction industry (20.6 per cent). While Mauritius continued as the dominant sources of FDI to India, FDI from Singapore exceeded that from the US. Foreign institutional investors (FIIs) inflows (net) have aggregated US $ 21.2 billion during the current financial year so far (up to October 19, 2007), reflecting, inter alia, strong corporate performance and strong domestic equity markets. The number of FIIs registered with the SEBI increased from 997 by end-March 2007 to 1,113 by October 15, 2007. Capital inflows through American depository receipts (ADRs)/global depository receipts (GDRs) abroad amounted to US $ 2.3 billion during April-July 2007. During the first quarter of 2007-08 (April-June 2007), net inflows under external commercial borrowings (ECBs) continued to be buoyant at US $ 7.0 billion. Ongoing technological upgradation and modernisation combined with expansion of domestic industrial activities have led to increased investment demand by Indian companies, and some hardening of domestic interest rates, which is reflected in higher recourse to ECBs. Non-Resident Indian (NRI) deposits during April-July 2007 recorded a net outflow of US $ 148 million, which can be partly attributed to the impact of two downward revisions in ceiling interest rates during January 2007 and April 2007. While there were net inflows under Foreign Currency Non-Resident (Banks) [FCNR (B)] deposits, the higher magnitude of outflows under Non-Resident External Rupee Account [NR (E) RA] deposits resulted in overall net outflows. With net capital flows being substantially higher than the current account deficit, the overall balance of payments recorded a surplus of US $ 11.2 billion in the first quarter of 2007-08 (US $ 6.4 billion in the first quarter of 2006-07).
Foreign Exchange Reserves
India’s foreign exchange reserves were US $ 261.1 billion as on October 19, 2007, higher by US $ 62.0 billion over end-March 2007. The increase in reserves was mainly due to an increase in foreign currency assets from US $ 191.9 billion during end-March 2007 to US $ 253.3 billion as on October 19, 2007 India holds the fifth largest stock of reserves among the emerging market economies and sixth largest in the world. The overall approach to the management of India’s foreign exchange reserves in recent years reflects the changing composition of the balance of payments and the ‘liquidity risks’ associated with different types of flows and other requirements. Taking these factors into account, India’s foreign exchange reserves continued to be at a comfortable level and consistent with the rate of growth, the share of external sector in the economy and the size of risk-adjusted capital flows.
RBI further liberalises Forex Rules
On a review of the current macro economic situation and in consultation with the Government of India, it has been decided to accelerate the implementation of the third phase of the recommendations of the Committee on Fuller Capital Account Convertibility (CFCAC) with regard to the foreign exchange outflows.
Accordingly, the following measures are being implemented with immediate effect:
i) Investment in overseas Joint Ventures (JV) / Wholly Owned Subsidiaries (WOS) by Indian companies will now be permitted up to 400 per cent of the net worth of the Indian company under the Automatic Route. The enhanced limit will also be available to registered partnership firms.
ii) In order to provide greater opportunities to listed Indian companies for portfolio investment abroad, the existing limit of 35 per cent of the net worth for portfolio investments by listed companies is being increased to 50 per cent of the net worth. Further, the requirement of 10 per cent reciprocal share holding in the listed Indian companies by overseas companies for the purpose of portfolio investment outside India by Indian listed companies has been dispensed with.
iii) The existing limit for prepayment of External Commercial borrowings (ECBs) without the Reserve Bank approval is being increased from USD 400 million to USD 500 million, subject to compliance with the minimum average maturity period as applicable to the loan.
iv) The aggregate ceiling for overseas investments by mutual funds, registered with SEBI is being increased from USD 4 billion to USD 5 billion. In addition, the existing facility of investing up to USD 1 billion in overseas Exchange Traded Funds, as may be permitted by SEBI by a limited number of qualified Indian mutual funds would continue.
v) The existing limit under Liberalised Remittance Scheme (LRS) is being enhanced from USD 100,000 to USD 200,000 per financial year.
External Debt
India’s total external debt was placed at US $ 165.4 billion at end-June 2007, recording an increase of US $ 8.7 billion (5.6 per cent) over end-March 2007. The increase in external debt during the period was mainly on account of higher external commercial borrowings, followed by higher NRI deposits and short-term trade credit. Over 50 per cent of the external debt stock was denominated in US dollars followed by the Indian rupee (18.0 per cent), SDR (12.3 per cent) and Japanese yen (12.0 per cent). Debt sustainability indicators such as the ratio of short-term to total debt and short-term debt to reserves increased marginally between end-March 2007 and end June 2007. Foreign exchange reserves remained in excess of the stock of external debt.
International Investment Position
India’s net international liabilities declined by US $ 2.7 billion between end-March 2006 and end-March 2007, as the increase in international assets (US $ 60.8 billion) exceeded the increase in international liabilities (US $ 58.1 billion). The increase in international assets was mainly on account of reserve assets, which registered an increase of US $ 47.6 billion between end- March 2006 and end-March 2007, followed by direct investment abroad which increased by US $ 11 billion during the same period. International liabilities reflected increases in direct and portfolio investment and loans at end-March 2007 from their levels at end-March 2006. A major part of the liabilities like direct and portfolio investments reflects cumulative inflows, which are at historical prices.
Monetary Policy Developments in India: An Overview
I. A Review of Outcomes
Growth with Stability
The average growth rate of the Indian economy over a period of 25 years since 1980-81 has been impressive at about 6.0 per cent, which is a significant improvement over the previous three decades, when the annual growth rate was only 3.5 per cent. Over the last four years during 2003-07, the Indian economy has entered a high growth phase, averaging 8.6 per cent per annum. The acceleration of growth during this period has been accompanied by a moderation in volatility, especially in industry and services sectors.
An important characteristic of the high growth phase of over a quarter of century is resilience to shocks and considerable degree of stability. We did witness one serious balance of payments crisis triggered largely by the Gulf war in the early 1990s. Credible macroeconomic, structural and stabilization programme was undertaken in the wake of the crisis. The Indian economy in later years could successfully avoid any adverse contagion impact of shocks from the East Asian crisis, the Russian crisis during 1997-98, and sanction like situation in post-Pokhran scenario, and border conflict during May-June 1999. Seen in this context, this robust macroeconomic performance, in the face of recent oil as well as food price shocks, demonstrates the vibrancy and resilience of the Indian economy.
The Reserve Bank projects a real GDP growth at around 8.5 per cent during 2007-08, barring domestic and external shocks.
Poverty and Unemployment
The sustained economic growth since the early 1990s has also been associated with noticeable reduction in poverty. The proportion of people living below the poverty line (based on uniform recall period) declined from 36 per cent in 1993-94 to 27.8 per cent in 2004-05. There is also some evidence of pick-up in employment growth from 1.57 per cent per annum (1993-94 to 1999-2000) to 2.48 per cent (1999-2000 to 2004-05).
Consumption and Investment Demand
India's growth in recent years has been mainly driven by domestic consumption, contributing on an average to almost two-thirds of the overall demand, while investment and export demand are also accelerating. Almost one-half of the incremental growth in real GDP during 2006-07 was on account of final consumption demand, while around 42 per cent was on account of the rise in real gross fixed capital formation. The investment boom has come from the creation of fixed assets and this phenomenon has been most pronounced in the private corporate sector, although fixed investment in the public sector also picked up in this period. According to an estimate by the Prime Minister’s Economic Advisory Council, the investment rate (provisional) crossed 35 per cent in 2006-07 from 33.8 per cent in 2005-06.
A Reasonable Degree of Price Stability
High growth in the last four years has been accompanied by a moderation of inflation. The headline inflation rate, in terms of the wholesale price index, has declined from an average of 11.0 per cent during 1990-95 to 5.3 per cent during 1995-2000 and to 4.9 per cent during 2003-07. The trending down of inflation has been associated with a significant reduction in inflation volatility which is indicative of well-anchored inflation expectations, despite the shocks of varied nature. Although, inflation based on the wholesale price index (WPI) initially rose to above 6.0 per cent in early April 2007 it eased to 3.79 per cent by August 25, 2007. Pre-emptive monetary measures since mid-2004, accompanied by fiscal and supply-side measures, have helped in containing inflation in India.
The policy preference for the period ahead is strongly in favour of price stability and well-anchored inflation expectations with the endeavour being to contain inflation close to 5.0 per cent in 2007-08 and in the range of 4.0–4.5 per cent over the medium-term. Monetary policy in India would continue to be vigilant and pro-active in the context of any accentuation of global uncertainties that pose threats to growth and stability in the domestic economy.
Improved Fiscal Performance
Yet another positive outcome of developments in recent years is the marked improvement in the health of Government finances. The fiscal management in the country has significantly improved consistent with targeted reduction in fiscal deficit indicators after the adoption of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 by the Central Government. The finances of the State Governments have also exhibited significant improvement since 2003-04 guided by the Fiscal Responsibility Legislations (FRLs).
With gross fiscal deficit of the Central Government budgeted at 3.3 per cent of GDP in 2007-08, the FRBM target of 3.0 per cent by 2008-09 appears feasible. The revenue deficit is budgeted at 1.5 per cent of GDP for 2007-08; the FRBM path envisages elimination of revenue deficit in 2008-09.
External Sector
India’s linkages with the global economy are getting stronger, underpinned by the growing openness of the economy and the two way movement in financial flows. Merchandise exports have been growing at an average rate of around 25 per cent during the last four years, with a steady increase in global market share, reflecting the competitiveness of the Indian industry. Structural shifts in services exports, led by software and other business services, and remittances have imparted stability and strength to India’s balance of payments. The net invisible surplus has offset a significant part of the expanding trade deficit and helped to contain the current account deficit to an average of one per cent of GDP since the early 1990s. Gross current receipts (merchandise exports and invisible receipts) and gross current payments (merchandise imports and invisible payments) taken together, at present, constitute more than one half of GDP, highlighting the significant degree of integration of the Indian economy with the global economy.
Greater integration into the global economy has enabled the Indian corporates to access high-quality imports from abroad and also to expand their overseas assets, dynamically. The liberalised external payments regime is facilitating the process of acquisition of foreign companies by Indian corporates, both in the manufacturing and services sectors, with the objectives of reaping economies of scale and capturing offshore markets to better face the global competition. Notwithstanding higher outflows, there has been a significant increase in capital inflows (net) to almost five per cent of GDP in 2006-07 from an average of two per cent of GDP during 2000-01 to 2002-03. Capital inflows (net) have remained substantially above the current account deficit and have implications for the conduct of monetary policy and macroeconomic and financial stability.
With the significant strengthening of the current and capital accounts, the foreign exchange reserves have more than doubled from US$ 76 billion at the end of March 2003 to US $ 228.8 billion as on August 31, 2007.
Financial Stability
The Indian record on financial stability is noteworthy as the decade of the 1990s has been otherwise turbulent for the financial sector in many EMEs. The approach towards the financial sector in India has been to consistently upgrade it by adapting the international best practices through a consultative process. The Reserve Bank has endeavored to establish an enabling regulatory framework with prompt and effective supervision, and development of legal, technological and institutional infrastructure. The regulatory norms with respect to capital adequacy, income recognition, asset classification and provisioning have progressively moved towards convergence with the international best practices. The Basel – II capital adequacy framework is being implemented in a phased manner with effect from March 2008.
We have observed that the Indian banks’ balance sheets have strengthened considerably, financial markets have deepened and widened and, with the introduction of the real time gross settlements (RTGS) system, the payment system has also become robust. Currently, all scheduled commercial banks are compliant with the minimum capital adequacy ratio (CRAR) of 9 per cent. The overall CRAR for all scheduled commercial banks stood at 12.4 per cent at end-March 2006. The gross non-performing assets of scheduled commercial banks has declined from 8.8 per cent of advances at end March 2003 to 3.3 per cent at end March 2006, while the net non-performing assets have declined from 4.0 per cent to 1.2 per cent during the same period.
Financial Markets
Development of financial markets received a strong impetus from financial sector reforms since the early 1990s. The Reserve Bank has been engaged in developing, widening and deepening of money, government securities and foreign exchange markets combined with a robust payments and settlement system. A wide range of regulatory and institutional reforms were introduced in a planned manner over a period to improve the efficiency of these financial markets. These included development of market micro structure, removal of structural bottlenecks, introduction/ diversification of new players/instruments, free pricing of financial assets, relaxation of quantitative restrictions, better regulatory systems, introduction of new technology, improvement in trading infrastructure, clearing and settlement practices and greater transparency. Prudential norms were introduced early in the reform phase, followed by interest rate deregulation. These policies were supplemented by strengthening of institutions, encouraging good market practices, rationalised tax structures and enabling legislative and accounting framework.
II. A Review of Monetary Policy Challenges
The conduct of monetary policy has become more challenging in recent years for a variety of reasons. Many of the challenges the central banks are facing are almost similar which could be summarized as follows:
Challenges with Globalisation
First, globalisation has brought in its train considerable fuzziness in reading underlying macroeconomic and financial developments, obscuring signals from financial prices and clouding the monetary authority’s gauge of the performance of the real economy. The growing importance of assets and asset prices in a globally integrated economy complicates the conduct of monetary policy when it is focused on and equipped to address price stability issues.
Second, with the growing integration of financial markets domestically and internationally, there is greater activism in liquidity management with a special focus on the short-end of the market spectrum. There is also a greater sophistication in the conduct of monetary policy and central banks are consistently engaged in refining their technical and managerial skills to deal with the complexities of financial markets. As liquidity management acquires overriding importance, the evolving solvency conditions of financial intermediaries may, on occasions, get obscured in the short run. No doubt, with increasing globalization, there is greater coordination between central banks, fiscal authorities and regulatory bodies governing financial markets.
Third, there is considerable difficulty faced by monetary authorities across the world in detecting and measuring inflation, especially inflation expectations. Recent experience in regard to impact of increases in oil prices, and more recently elevated food prices shows that ignoring the structural or permanent elements of what is traditionally treated as shocks may slow down appropriate monetary policy response especially if the focus is on "core inflation". Accounting for house rents/prices in inflation measurement has also gained attention in some countries. The central banks are often concerned with the stability/variability of inflation rather than the level of prices. Inflation processes have become highly unclear and central banks are faced with the need to recognize the importance of inflation perceptions and inflation expectations, as distinct from inflation indicators. In this context, credible communication and creative engagement with the market and economic agents have emerged as a critical channel of monetary transmission.
Challenges for Emerging Market Economies
It is essential to recognize that the international financial markets have differing ways of judging macroeconomic developments in industrial and emerging market economies. Hence, the challenges and policy responses do differ.
First, the EMEs are facing the dilemma of grappling with the inherently volatile increasing capital flows relative to domestic absorptive capacity. Consequently, often the impossible trinity of fixed or managed exchange rates open capital accounts and discretion in monetary policy has to be managed in what could be termed as ‘fuzzy’ manner rather than satisfactorily resolved - a problem that gets exacerbated due to huge uncertainties in global financial markets and possible consequences in the real sector.
Second, in the emerging scenario of large and uncertain capital flows, the choice of the instruments for sterilization and other policy responses have been constrained by a number of factors such as the openness of the economy, the depth of the domestic bond market, the health of the financial sector, the health of the public finances, the country’s inflationary track record and the perception about the credibility and consistency in macroeconomic policies pursued by the country. Further deepening of financial markets may help in absorption of large capital inflows in the medium term, but it may not give immediate succour at the current stage of financial sector development in many EMEs, particularly when speed and magnitude of flows are very high. Some of the EMEs are also subject to adverse current account shocks in view of elevated commodity prices. Going forward, global uncertainties in financial markets are likely to dominate the concerns of all monetary authorities, but, for the EMEs, the consequences of such macro or financial disturbances could be more serious.
Third, the banking sector has been strengthened and non-banking intermediation expanded providing both stability and efficiency to the financial sector in many EMEs. Yet, sometimes, aligning the operations of large financial conglomerates and foreign institutions with local public policy priorities remains a challenge for domestic financial regulators in many EMEs. Further, reaping full benefits of competition in financial sector is somewhat limited in many EMEs. Large players in developed economies compete with each other intensely, while it is possible that a few of them dominate in each of the EME's financial markets. A few of the financial intermediaries could thus wield dominant position in the financial markets of these countries, increasing the concentration risk.
While it is extremely difficult to envision how the current disturbances in financial markets will resolve, the focus of many EMEs will be on considering various scenarios and being in readiness with appropriate policy strategies and contingency plans. Among the factors that are carefully monitored, currency markets, liquidity conditions, globally dominant financial intermediaries, impact on real sector through credit channel and asset prices are significant, but the list is certainly not exhaustive.
III. Monetary Policy Framework in India
Objectives
The basic objectives of monetary policy, namely price stability and ensuring credit flow to support growth, have remained unchanged in India, but the underlying operating framework for monetary policy has undergone a significant transformation during the past two decades. The relative emphasis placed on price stability and economic growth is modulated according to the circumstances prevailing at a particular point in time and is clearly spelt out, from time to time, in the policy statements of the Reserve Bank. Of late, considerations of macroeconomic and financial stability have assumed an added importance in view of increasing openness of the Indian economy.
Framework
In India, the broad money (M3) emerged as the nominal anchor from the mid-1980s based on the premise of a stable relationship between money, output and prices. In the late 1990s, in view of ongoing financial openness and increasing evidence of changes in underlying transmission mechanism with interest rates and exchange rates gaining in importance vis-à-vis quantity variables, it was felt that monetary policy exclusively based on the demand function for money could lack precision. The Reserve Bank, therefore, formally adopted a multiple indicator approach in April 1998 whereby interest rates or rates of return in different financial markets along with data on currency, credit, trade, capital flows, fiscal position, inflation, exchange rate, etc., are juxtaposed with the output data for drawing policy perspectives. Such a shift was gradual and a logical outcome of measures taken over the reform period since the early 1990s. The switchover to a multiple indicator approach provided necessary flexibility to respond to changes in domestic and international economic environment and financial market conditions more effectively. Now, liquidity management in the system is carried out through open market operations (OMO) in the form of outright purchases/sales of government securities and daily reverse repo and repo operations under a Liquidity Adjustment Facility (LAF) and repo and reverse repo rates have emerged as the main instruments for interest rate signaling in the Indian economy.
The armory of instruments to manage, in the context of large capital flows and sterilisation, has been strengthened with open market operations through Market Stabilisation Scheme (MSS), which was introduced in April 2004. Under the MSS, the Reserve Bank was allowed to issue government securities as part of liquidity sterilisation operations in the wake of large capital inflows and surplus liquidity conditions. While these issuances do not provide budgetary support, interest costs are borne by the fisc; as far as Government securities market is concerned, these securities are also traded in the secondary market, at par with the other government stock.
While the preferred instruments are indirect, and varied, there is no hesitation in taking recourse to direct instruments also, if circumstances so warrant. In fact, complex situations do warrant dynamics of different combination of direct and indirect instruments, in multiple forms, to suit the conditions affecting transmission mechanism.
There are occasions when the medium-term goals, say reduction in cash reserve ratios for banks, conflict with short-term compulsions of monetary management requiring actions in both directions. Such operations do warrant attention to appropriate articulation to ensure policy credibility. Drawing a distinction between medium term reform goals and flexibility in short-term management is considered something critical in the current Indian policy environment.
Similarly, while there is considerable merit in maintaining a broad distinction between monetary and prudential policies of the central bank, the Reserve Bank did not hesitate, as a complement to monetary tightening, to enhance the provisioning requirements and risk weights for select categories of banking assets, namely real estate, housing and capital market exposures. These measures were needed to specifically address issues of rapidly escalating asset prices and the possible impact on banks’ balance sheets in a bank dominated financial sector. This combination, and more important, readiness of the Reserve Bank to use all instruments, has a credible impact, without undue restraint on growth impulses.
Some of the important factors that shaped the changes in monetary policy framework and operating procedures in India during the 1990s were the delinking of budget deficit from its automatic monetization by the Reserve Bank, deregulation of interest rates, and development of the financial markets with reduced segmentation through better linkages and development of appropriate trading, payments and settlement systems along with technological infrastructure. With the enactment of the Fiscal Responsibility and Budget Management Act in 2003, the Reserve Bank has withdrawn from participating in the primary issues of Central Government securities with effect from April 2006. The recent legislative amendments enable a flexible use of the CRR for monetary management, without being constrained by a statutory floor or ceiling on the level of the CRR. The amendments also enable the lowering of the Statutory Liquidity Ratio (SLR) to the levels below the pre-amendment statutory minimum of 25 per cent of net demand and time liabilities of banks – which would further improve the scope for flexible liquidity management.
Institutional Mechanisms
Monetary policy formulation is carried out by the Reserve Bank in a consultative manner. The Monetary Policy Department holds monthly meetings with select major banks and financial institutions, which provide a consultative platform for issues concerning monetary, credit, regulatory and supervisory policies of the Bank. Decisions on day-to-day market operations, including management of liquidity, are taken by a Financial Markets Committee (FMC), which includes senior officials of the Bank responsible for monetary policy and related operations in money, government securities and foreign exchange markets. The Deputy Governor, Executive Director(s) and heads of four departments in charge of monetary policy and related market operations meet every morning as financial markets open for trading. They also meet more than once during a day, if such a need arises. In addition, a Technical Advisory Committee on Money, Foreign Exchange and Government Securities Markets comprising academics and financial market experts, including those from depositories and credit rating agencies, provides support to the consultative process. The Committee meets once a quarter and discusses proposals on instruments and institutional practices relating to financial markets. Besides FMC meetings, Monetary Policy Strategy Meetings take place regularly. The strategy meetings take a relatively medium-term view of the monetary policy and consider key projections and parameters that can affect the stance of the monetary policy. In pursuance of the objective of further strengthening the consultative process in monetary policy, a Technical Advisory Committee (TAC) on Monetary Policy has been set up with Governor as Chairman and Deputy Governor in charge of monetary policy as Vice Chairman, three Deputy Governors, two Members of the Committee of the Central Board and five specialists drawn from the areas of monetary economics, central banking, financial markets and public finance, as Members. The TAC meets ahead of the Annual Policy and the quarterly reviews of annual policy. The TAC reviews macroeconomic and monetary developments and advises on the stance of monetary policy.
IV. Some Issues in the Conduct of Monetary Policy in India
Let me now discuss some issues in the conduct of monetary policy in India, in the current context.
First, one of the major challenges relates to managing the transition of Indian economy to high growth trajectory accompanied by a low and stable inflation and well anchored inflation expectations. There is growing evidence that the upward shift in growth trajectory in India is of enduring nature as it is supported by high saving and investment rates, improved productivity and vast potential lying by way of demographic dividend. However, it is still important for monetary policy formulation to identify the cyclical and structural components of growth achieved in recent years, despite this task being rendered somewhat difficult in an economy that is undergoing a rapid and deep structural transformation.
Second, a situation in which the aggregate supply is evidently less elastic domestically imposes an additional burden on monetary policy. While open trade has expanded the supply potential of several economies, significant supply in-elasticities do persist domestically, particularly due to infrastructure constraints. Further, persisting impact of supply shocks on prices of commodities and services, to which headline inflation is sensitive, can therefore exert a lasting impact on inflation expectations. Faced with longer-term structural bottlenecks in supply with less than adequate assurance of timely, convincing and demonstrated resolution of these issues, monetary policy needs to respond appropriately.
Third, some categories of interest rates are yet to be fully liberalised in the system, thereby muting at least partly, the impact of monetary policy actions on the structure of interest rates.
Fourth, in the Indian context, it is recognized that monetary policy has to contend with large fiscal deficits and high levels of public debt by international standards. While the recent improvements in the fiscal position of States and significant consolidation in the finances of the Centre provided greater maneuverability, monetary policy needs to closely coordinate with cash and debt management of governments in a non-disruptive manner.
Fifth, the operation of monetary policy has to be oriented around the predominantly public sector ownership of most of the banking system which plays a critical role in the transmission of monetary policy to the extent other public policy considerations dominate their overall operations.
Finally, though India is essentially a bank-dominated economy, commercial credit penetration in the Indian economy is still relatively low. Concerns about credit to agriculture and small and medium enterprises usually relate to inadequacy, constraints on timely availability, high cost, neglect of small and marginal farmers, low credit-deposit ratios in several States and continued presence of informal credit markets with high interest rates. It is in this context that the Reserve Bank of India continues to address the need for ensuring financial inclusion of all segments of population, protecting interests of depositors and promoting a conducive credit culture. These considerations invite the attention of the Reserve Bank, even while monetary policy aims at financial stability by moderating excess volatility in financial markets.
V. Concluding Observations
In the current environment, monetary policy in India would continue to be vigilant and pro-active in the context of any accentuation of global uncertainties that pose threats to growth and stability in the domestic economy. The domestic outlook continues to be favorable and would dominate the dynamic setting of monetary policy in the period ahead. It is important to design monetary policy such that it promotes growth by contributing to the maintenance of financial and price stability. Accordingly, while the stance of monetary policy would continue to reinforce the emphasis on price stability and well-anchored inflation expectations and thereby sustain the growth momentum, contextually, financial stability assumes greater importance at the current juncture.
