Rakesh Mohan: First quarter review of monetary policy - underlying
macroeconomics
Valedictory address by Dr Rakesh Mohan, Deputy Governor, Reserve Bank of India, at the
Workshop for Top Executives of Banks on Macroeconomic Issues and their Relevance to the
Banking System organised by the State Bank of India, Mumbai, 3 August 2007.
Assistance of M.D. Patra and Indranil Bhattacharya in preparing the speech is gratefully acknowledged.
* * *
Shri Bhatt and distinguished participants,
I am deeply honoured to be invited to deliver the valedictory address at the High Powered
Macroeconomic Workshop organised by the State Bank of India. I am particularly gratified
that this Workshop has become a reality, since its genesis is in the extremely useful
discussions that we in the Reserve Bank of India had with the Indian Banks' Association as
part of pre-Annual Policy consultations held in April this year.
The success of any monetary policy formulation is dependent on successful communication
between the central bank and all market participants. The effectiveness of communication
would be greatly enhanced if there is deeper understanding among participants of all the
reasoning and the process that goes behind policy making. So we greatly value this initiative
that you have taken.
On July 31, we set out our first quarter review of the annual policy and you are all aware of
the response of financial markets and the banking and financial system to our
announcement. Today, I propose to move away from the minutiae of the policy review and
share with you my thoughts on the underlying macroeconomics and the unfolding of
expectations for the period ahead.
I propose to structure my address by beginning with an overview of domestic and global
macroeconomic developments that conditioned our assessment and response on July 31.
My approach will be to compare the current situation with that prevailing in April 2007 i.e., at
the time of the Annual Policy Statement, in order to highlight the changes that have taken
place within the Indian economy but more perceptibly, in the international environment.
Against this backdrop, I will try to set out the key elements of our assessment of underlying
developments, the complexities and the challenges. Finally, I will draw upon the rationale
emerging from this assessment to explain the stance of the first quarter review.
I. Overview of macroeconomic developments - then and now
You will all recall that the Annual Policy Statement of April 2007 was formulated at a time
when the Indian economy was seen to be facing the intensification of demand pressures
which, coupled with supply constraints, were showing up in inflation (as measured by the
Wholesale Price Index (WPI)), ruling above 6 per cent through the preceding quarter
(January-March, 2007). Consumer price inflation was even higher. There was also
expectation internationally at that time that the global economy was moderating after
unusually high growth in the last few years. However, some volatility had been observed in
international financial markets and there was some expectation of repricing of risks, and its
potential effects on financial markets. Overall, while prospects for growth continued to be
favourable, monetary authorities around the world were showing an inclination to be watchful
about risks to price and financial stability. By late July, while the evolution of macroeconomic
and financial developments was broadly on track, with some upward revisions about growth
prospects, there are some incipient shifts taking place in sentiment, liquidity and market
conditions, particularly in the presence of some volatility in financial markets. Policy
responses of central banks across the world have acquired a tone of increased caution.
(a) Domestic developments
In February 2007 i.e., prior to the Annual Policy Statement, the CSO had placed real GDP
growth at 9.2 per cent in 2006-07. By the time of the first quarter review, the CSO had
revised this estimate to 9.4 per cent, indicative of the improvement in aggregate supply
conditions, but also pointing to the firming up of demand pressures. In the first quarter of
2007-08, some supply conditions seem to have improved. The arrival of the rabi harvest, a
kharif
satisfactory south-west monsoon so far and a slow catch-up in sowing provides
grounds for optimism regarding agricultural performance this year. Activity in the industrial
and services sectors has continued apace, though there seems to have been some
moderation in specific sectors. In the disposition of aggregate demand, however, there
appear to be signs of some shifts underway. Although the demand for consumer
nondurables has picked up, the coincident high growth in capital goods and non-oil imports,
secondary effects on intermediate goods and stretched capacity utilisation together suggest
that investment demand could be intensifying. There seems to be a general optimism about
India's growth prospects in projections made by various agencies; some agencies have
taken the lead in initiating upward revisions (Table 1).
Within this overall picture of the real economy, headwinds to growth seem to be reshaping
the outlook. While corporate performance continues to be buoyant as assessed in April,
there is some deceleration in corporate sales and profitability growth on a year-on-year basis
as also increases in input and staff costs. There is some indication of a turn in business
sentiment with the optimism reflected in various surveys conducted at the time of the Annual
Policy Statement having been moderated by rising cost expectations, strained capacities and
the impact of recent exchange rate movements, particularly in IT, commercial vehicles, auto
parts and cement.
The key monetary and banking aggregates are exhibiting somewhat perging profiles. Money
supply is running well above the indicative path given in the Annual Policy Statement in April,
driven up by the expansion in reserve money and high growth in deposits. With banks having
launched aggressive mobilisation strategies, presumably in response to the high credit
demand of the last few years, there has been high growth in aggregate deposits in the
banking system. Consequent to the lagged and cumulative effects of monetary measures
taken since September 2004, there has been some slackening of non-food credit growth.
Banks SLR portfolios (at 28.7 per cent of NDTL on July 6) have increased. This will help
them to mitigate balance sheet risks and also allow for better liquidity management. The
deceleration in credit demand has been localised in the commercial real estate, housing and
retail segments. On the other hand, the pick up in bank credit to agriculture and industry is
favourable to sustaining the growth momentum (Table 2).
The combination of rising deposit growth and moderation of non-food credit growth is
contributing to the prevalence of excess liquidity conditions in the financial markets. With the
imposition of a ceiling of Rs.3,000 crore on daily LAF reverse repos since March 5, 2007, the
summary measure of the liquidity overhang, i.e., the sum of LAF, MSS and outstanding cash
balances of the government, did not fully capture the counterpart liquidity shifts in the market
during this period as the net position in the LAF presents only a partial picture. A large part of
the liquidity that would have otherwise been absorbed under the LAF is currently showing up
in excess CRR balances and in banks' investments in money market mutual funds. On the
other hand, the transfer of funds from the Government to the Reserve Bank on account of
the sale of the Reserve Bank's stake in the State Bank of India has had the indirect effect of
impounding market liquidity on a temporary basis. Thus, new factors have been impinging
the assessment of liquidity in recent weeks, which has been reflected in the behaviour of
overnight market rates and in the Reserve Bank's liquidity management operations (Table 3).
In the financial markets, the shifts in liquidity flows between the first quarter of 2007-08 and
the preceding quarter have imparted considerable volatility. Overnight rates have been close
to zero for a prolonged period of time (Chart 1). These have been caused by the cumulative
impact of the unwinding of government cash balances, excess capital flows, and high deposit
growth. In the Government securities market, there is reasonable stability but the yield curve
seems to be indicating that excess liquidity conditions in the short term segment was
beginning to effect longer term yields. The forex market is experiencing continuous upward
pressures on the spot exchange rate and forward premia have declined across maturities.
The most important change between April and now is in inflation conditions. It may be
recalled that in January 2007, the resolve of monetary policy was stated as returning inflation
to within the policy tolerance threshold on a priority basis. Against the backdrop of the spike
in WPI inflation in January and the persistence in the hardening of consumer prices, this
stance was reinforced in April. The combination of monetary, fiscal and supply management
measures appears to have had a salutary effect on inflation expectations and from end-May
there has been a distinct easing of inflation in terms of the headline. Yet, inflation pressures
appear to be ruling firmly. Excluding the decline in energy prices since February, WPI
inflation continues to be above 6 per cent. Excluding food and energy prices, inflation would
still be above the headline. Inflation in terms of consumer prices is still in the range of 5.7-7.8
per cent. Besides, global prices of key food grains such as wheat and rice, and of oilseeds
and livestock products are at historically elevated levels, igniting international concern on the
effect of these prices on overall inflation. With food having a higher weight in price indices in
developing countries, this development is of particular concern to countries such as ours.
International crude prices are high and volatile with expectations that they would remain at
these levels through 2007. These factors would have a definite bearing on the manner in
which the inflation outlook in India evolves over the months to come. Inflation concerns
remain with us and thus our vigil on inflation must continue. There are no grounds for
complacency on this account.
The balance of payments outlook remains strong and resilient between April and now. A
sharper than expected increase in non-oil imports has resulted in a widening of the
merchandise trade deficit in the early months of 2007-08. The key difference between
expectations and outlook relating to the external sector is the magnitude of capital inflows
received so far. In reflection, the foreign exchange reserves have gone up by nearly US $ 23
billion during April-July 20, which is already nearly half of the entire reserve accretion during
the year 2006-07. By current indications, managing capital flows and consequently, liquidity
will be the main challenge facing monetary policy in 2007-08.
(b) Global developments
The key change in the global outlook between April and July is the upward revision by the
IMF in global growth forecasts for 2007 and 2008 from 4.9 per cent to 5.2 per cent. This
upward revision is expected to be shared by all major mature economies, barring the US, as
well as the emerging market economies (EMEs), particularly China and India. In the EMEs
which are progressively increasing their contribution to global growth, the prospects are
strong but embedded with risks of overheating, volatile crude prices, leveraged international
financial markets and persisting global imbalances. In China, in particular, there have been
rising concerns, as stated by their highest authorities, that the growth process could have the
potential of becoming unstable and unsustainable. Inflation concerns have become renewed
on the back of the flare up of crude prices alongside elevated levels of food and metal prices
(Table 4).
Global financial markets, which faced major episodes of turbulence in May-June, 2006 and
again in February 2007, seem to be experiencing heightened volatility again in July due to
the fall in confidence related to the adverse developments in the US subprime mortgage
market transmitted to other segments through the highly leveraged activities of hedge funds
and private equity funds. Even as financial markets are repricing risks, there continues to be
a compression of risk spreads and an ever widening search for returns, interrupted by
sporadic flights to safety. While there seem to be signs of some abatement in the carry trade,
there are persisting uncertainties and EMEs, in particular, need to be on guard against the
manner in which carry trades unfold. Perhaps, the most volatile segments have been
currency and equity markets with increasing linkages and potential vulnerability to contagion
effects.
In response to these developments, several monetary authorities have continued to display a
readiness to tighten monetary policy further in reinforcement of their stance in April. Central
banks in EMEs have supported the withdrawal of monetary accommodation with successive
increases in cash reserve requirements and in the application of non-monetary measures. In
India and China, in particular, the use of cash reserve requirements has been more frequent
than in other EMEs (Table 5).
Thus, central banks across the world remain hawkish with respect to inflation and prepared
to act against any signs of instability developing. Where they have paused, as in the US,
they have done so on the back of sustained prior action. The outlook on inflation continues
to drive the response of central banks (Table 6).
One key issue that many of the key Emerging Market Economies (EMEs) are facing is the
issue of excess forex flows, both because of a current account surplus in most cases, and
additional capital flows. In this regard, the key difference between India and most of these
economies is the existence of a current account deficit, though modest, along with a
significant merchandise trade deficit which is now in excess of 7 per cent of GDP. Most of
these countries, along with us, have experienced significant real exchange rate appreciation
over the last year or two. So the practice of monetary management has encountered
significant complexity in a number of EMEs. We are not alone. We may note that we have so
far been managing this complexity relatively successfully within the context of high economic
growth, high credit growth, a reasonable degree of price stability and most importantly
maintenance of financial stability. The quality of bank balance sheets has been improving on
a continuous basis, and we are hopeful that they will reach international best practice soon. It
is interesting to observe that, just like us, many of these countries have been using the whole
range of monetary instruments, including direct sterilisation through issuance of government
or central bank bonds, increases in reserve requirements, and different means of capital
account management to manage the monetary impact of excess forex flows. The overall
problem of the capital flows, both from the point of view of the monetary management of
EMEs and reverse capital flows to industrialised countries, is now receiving worldwide
attention. The Committee of Global Financial System (CGFS) under the aegis of BIS has
also appointed a Working Group to look into these complex issues.
II. Macroeconomics of policy assessment
Domestic macroeconomic prospects are currently seen to be broadly favourable, with the
pace of growth being maintained and the inflation outlook softer. As already stated, however,
the attendant risks from global developments relating to food, commodity, and energy prices
remain and will have to be monitored carefully, and acted upon as necessary. In an overall
perspective, the main objective of policy as set out in April, is to manage the transition to
higher growth with price and financial stability. The key issues for the conduct of monetary
policy in the context of this objective are a continuing emphasis on price stability and well
anchored inflation expectations. This will involve managing liquidity in the presence of the
pressures from high deposit growth, shifts in government cash balances and continuing
capital flows. The flux in global financial markets is a clear and present danger to stability for
which policy makers and all stake holders have to be well prepared. Exchange rate
movements have become amplified by these developments. Going forward, it will be
necessary to reinforce the commitment to financial stability alongside the containment of
inflation so as to support growth. The Reserve Bank's Annual Policy statement had
announced the initiation of further development of financial markets, such as the work related
to currency futures, interest rate futures and credit default swaps. Our annual publication,
Report on Currency and Finance has, this year, paid particular attention to the overall
development of financial markets in some detail. The key element of our approach is the
maintenance of financial stability, along with the continuous development of markets.
Against this backdrop and a careful assessment of the balance of risks, the projection of real
GDP growth for 2007-08 has been retained around at 8.5 per cent as in the Annual Policy
Statement. A key assumption is that agriculture will post a return to trend growth and the
momentum will be maintained in industry and services. While the outlook for inflation remains
unchanged, the policy priority in the first quarter review is to hold headline inflation within 5
per cent in 2007-08 and within 4.0 - 4.5 per cent over the medium term. While money supply
and aggregate deposits are currently high, moderating the growth of these key aggregates
has assumed policy priority. Early indications suggest that the balance of payments position
is strong, that the current account deficit will be managed within sustainable limits but the
uncertainties and volatility associated with capital flows will test the evolving policy stance.
While the domestic outlook is positive and should remain so with appropriate corrections in
liquidity and financial market conditions to align them with the policy stance, it is the global
outlook which presents the greatest threats to growth with stability in India. The conduct of
monetary policy must ensure that the gains of strong macroeconomic performance are not
lost in the cross currents of global financial markets and the periodic episodes of volatility of
turbulence which have world wide ramifications. It is in this context that the Reserve Bank
has reinforced the emphasis on price stability and financial stability in the first quarter review
with a view to supporting growth by contributing stability. To sum up, therefore, inflation risks
and potential dangers of financial market turbulence dominate the macroeconomics of
current policy assessment.
III. The policy response
The operating framework of monetary management is rendered complex, particularly in a
developing economy such as ours which is undergoing significant financial deepening and
structural change. The relationship between real economy variables such as GDP growth
and monetary aggregates is subject to constant change. Similarly, the relationships between
different monetary aggregates themselves such as broad money (M3), narrow money (M1)
and reserve money (M0) is also subject to continuous change. It is for this reason that we
have to operate policy flexibly, leading to some impressions of lack of transparency. Our
overall job is to maintain price stability in the presence of the existing scenario of welcome
accelerated growth, along with the maintenance of financial stability of the system. It is our
firm judgement that low and stable inflation is essential to maintenance of the growth process
and we are determined to achieve this continuing goal. Similarly, in a low income country
such as ours, we also believe that the ability of market participants, ranging from far flung
subsistence farmers to the ultra sophisticated financial market players, such as you, is much
more varied than in a developed country. The costs of risks unfolding are asymmetric, so we
have to place a higher weight on the maintenance of financial stability than in a developed
country, as we pursue overall growth and associated financial market development.
The stance of monetary policy in the first quarter review assigns a higher priority for
managing appropriate liquidity in the financial markets while maintaining the intensive vigil on
price and financial stability. The Reserve Bank has articulated its approach to liquidity
management in the form of "appropriate use of CRR stipulations, open market operations
including MSS and LAF and all policy instruments at its disposal flexibly, as and when the
situation warrants".
In view of the surplus conditions in the financial markets, the ceiling on daily reverse repos
under the LAF has been removed. The objective is to absorb excess liquidity and align
overnight rates with the prevailing monetary policy stance so that policy signals are efficiently
and transparently passed through into the structure of interest rates, aggregate demand and
thereby, growth and stability. The restoration of the informal LAF corridor should help in
stabilising overnight rates and smoothing volatility. The key policy rates have been kept
unchanged. The cash reserve ratio has been raised by 50 basis points to 7 per cent in the
first quarter review with a view to impounding liquidity generated by excessive deposit growth
in the banking system. The CRR is expected to work in conjunction with the restoration of the
LAF corridor to ensure appropriate liquidity conditions in the economy. The policy stance will
be under careful and continuous review and the mix of instruments will be modulated by the
evolving situation. To reflect the Reserve Bank's point of view at the present time, the stance
of policy for the period ahead has been enunciated as:
•
To reinforce the emphasis on price stability and well-anchored inflation expectations
while ensuring a monetary and interest rate environment that supports export and
investment demand in the economy so as to enable continuation of the growth
momentum.
•
To re-emphasise credit quality and orderly conditions in financial markets for securing
macroeconomic and, in particular, financial stability while simultaneously pursuing
greater credit penetration and financial inclusion.
•
To respond swiftly with all possible measures as appropriate to the evolving global
and domestic situation impinging on inflation expectations, financial stability and the
growth momentum.
Once again, I congratulate Shri Bhatt and the State Bank of India for organising this
extremely useful and illuminating workshop.
Thank you.