MACROECONOMIC AND MONETARY DEVELOPMENTS IN 2009-10
Contents
Overview
I. Output
Agricultural Situation
Food Management
Industrial Performance
Services Sector
II. Aggregate Demand
Domestic Demand
External Demand
III. The External Economy
International Developments
Merchandise Trade
Balance of Payments
External Debt
International Investment Position
IV. Monetary Conditions
Reserve Money
Money Supply
V. Financial Markets
International Financial Markets
Domestic Financial Markets
Liquidity Conditions
Money Market
Government Securities Market
Credit Market
Foreign Exchange Market
Equity and Housing Markets
VI. Price Situation
Global Inflation
Global Commodity Prices
Inflation Conditions in India
VII. Macroeconomic Outlook
Business Expectation Surveys
Reserve Bank’s Industrial Outlook Survey
Survey of Professional Forecasters
Growth Projections of Different Agencies
Factors Influencing the Current Growth and Inflation Outlook
MACROECONOMIC AND MONETARY DEVELOPMENTS IN 2009-10
Overview
Global Economic Conditions
1. Recovery in the global economy picked up momentum in the fourth quarter of 2009. The speed of recovery, however, remains significantly divergent. The projections for global output for 2010 generally point to consolidating recovery, led by the Emerging Market Economies (EMEs). The WTO projects world trade to stage a strong recovery in 2010. The risks to the overall global macroeconomic environment have, however, increased because of large public debt in advanced economies, on the back of concerns relating to reduction in potential output, high unemployment rates, impaired financial systems and premature exit from the policy stimulus. Closer home, the improvement in global macroeconomic conditions is reflected in the turnaround in India’s exports and the return of capital flows. With stronger recovery in EMEs driven largely by domestic demand, improving exports and return of capital flows, EMEs face the risks of inflation and asset price build up.
Output
Concerns about domestic output growth are now subdued as the recovery is getting more broad-based. This is the result of a rebound in industrial output, better prospects for the Rabi crop and continuing resilience of the services sector. Survey data suggest increasing levels of capacity utilization in recent months. Subject to normal monsoons, output growth during 2010-11 is expected to gain further momentum.
Aggregate demand
Final consumption expenditure remained subdued during 2009-10, as growth in both private final consumption expenditure and government final consumption expenditure decelerated.
Investment demand, particularly gross fixed capital formation, however, showed a gradual recovery during the year. While the momentum in investment demand is expected to continue, pick-up in private consumption demand could drive the recovery in growth. The fiscal exit, as planned in the Union Budget for 2010-11, would contribute to improving the overall medium-term growth outlook, even as going forward, greater emphasis on quality of fiscal adjustment would be necessary.
External sector development
India’s external sector position improved alongside the recovery in the global economy. After declining for 12 consecutive months, exports recovered in October 2009. Similarly, imports recovered in November 2009 following a phase of decline. Despite a lower trade deficit, the current account deficit widened during April–December 2009, as compared with the corresponding period of the previous year. This is attributable to a fall in invisibles, particularly on account of business services. During 2009-10, foreign exchange reserves increased by US$ 27.1 billion, comprising mainly of increase in gold holdings (US$ 8.4 billion), SDRs (US$ 5.0 billion) and foreign currency assets (US$ 13.3 billion). The bulk of the increase in foreign currency assets was on account of valuation. Net capital inflows can be expected to increase further during the current year, reflecting the prospects of higher growth and larger interest rate differentials between India and the advanced economies. Like other EMEs, however, higher capital inflows could influence asset prices, domestic liquidity conditions and the exchange rate. This will have implications for monetary management.
Monetary and Credit Conditions
Reflecting the stronger recovery in economic activities, growth in broad money (M3) and flow of credit to the private sector exceeded the Reserve Bank’s indicative projections for 2009-10. While the increase in CRR effected by the Reserve Bank in its Third Quarter Policy Review of January
2010 led to some moderation in excess liquidity, overall liquidity conditions remain comfortable as reflected in the daily reverse repo operations. The banking system’s credit to the Government was the prime driver of monetary expansion during the year. The flow of resources to commercial sector distinctly improved from both bank as well as non-bank sources. Going forward, the demand for money may increase with acceleration in recovery and the elevated level of inflation.
Global Financial Markets
Global financial markets exhibited significant stabilization during 2009, despite the drag from the global financial crisis. However, volatility increased in the beginning of 2010 due to concerns about unsustainable fiscal positions, as reflected in sovereign risks. Episodes such as the
Dubai World debt standstill and the sovereign debt problems in Greece and East European countries pose a major risk to the stability of financial markets going forward.
Domestic Financial Markets
With market activity returning to the pre-global crisis level, volatility in the domestic financial markets was much lower during 2009-10 than in the year before, when the crisis erupted. Despite considerable stability and the commencement of exit, markets faced concerns emerging from large government borrowings and the increase in inflation. This affected yields in the government bond market. The transmission of lower policy rates to the credit markets improved, albeit, slowly. Asset prices increased at a relatively faster pace in the recent months. With the revival of capital inflows, nominal exchange rate appreciated. Given higher domestic inflation, the appreciation in real terms was even higher.
Inflation Situation
Headline WPI inflation firmed up significantly during the fourth quarter of 2009-10. The initial inflationary pressure was predominantly conditioned by rising food and fuel prices, reflecting the impact of a deficient monsoon on agricultural output and the increase in international crude prices. In the second half of the year, with persistent supply side pressures, inflation became increasingly generalised. This is evident from the acceleration of inflation in non-food manufactured products from -0.4 per cent in November 2009 to 4.7 per cent in March 2010.
Inflation, as measured by consumer price indices (CPIs) also remained high, though there was some moderation in February 2010. These inflationary conditions, coupled with the stronger momentum seen in the pace of economic recovery, created the compelling ground for altering the
Reserve Bank’s balance of policy focus to anchoring inflation expectations.
Growth Outlook
9. Output growth in 2010-11 is expected to be higher than in 2009-10, assuming a normal monsoon. Support for sustained momentum in growth can be expected from all three major components, viz., agriculture, industry and services. Nevertheless, apart from monsoon-related uncertainty, other downside risks to growth need to be recognised. First, private consumption demand needs to improve significantly to support the growth momentum. Second, global recovery, despite gaining strength, is expected to remain fragile, which has implications for exports. Third, the exit from fiscal stimulus and the growth-supportive monetary policy, unless calibrated carefully, could impact the growth process. Finally, the domestic saving rate has exhibited some decline, led by significant decline in public sector savings. This has adverse implications for the potential growth of the economy.
Inflation Outlook
Inflation can be expected to moderate over the next few months, from the peak levels seen in recent months. There are, however, upside risks to inflation. First, international commodity prices, particularly oil, have started to increase again. In several commodities, the import option for India to contain domestic inflation is limited, because of higher international prices. Second, the revival in private consumption demand and the bridging of the output gap will add to inflationary pressures. Finally, it is important to guard against the risk of hardening o finflation expectations conditioned by near double digit headline WPI inflation.
Overall Assessment
With the improving growth outlook, monetary and fiscal exit measures have started. While recovery in private demand needs to be stronger to reinforce the growth momentum, the already elevated headline inflation suggests that the weight of policy balance may have to shift to containing inflation, since high inflation itself will dampen recovery in growth. In the emerging
macroeconomic scenario, monetary policy management in 2010-11 will be dominated by the challenge of moderating inflation and anchoring inflation expectations, while remaining supportive of growth impulses.
Output
The Indian economy exhibited clear momentum in recovery, and despite the impact of a deficient monsoon on agricultural production, GDP growth for 2009-10 has been estimated at 7.2 per cent, up from 6.7 per cent recorded in 2008-09. The recovery also has been broad based, excluding “agriculture” and "community, social and personal services". The Index of Industrial Production (IIP) has shown double digit growth in recent months. Lead indicators for services activities point to overall improvement since the third quarter of 2009-10. Survey data suggest pick up in capacity utilisation levels in recent quarters, which however, remain below their previous peaks.
1.1 After experiencing a distinct moderation in growth to 6.7 per cent in 2008-09, the Indian economy recovered in 2009-10 with a growth of 7.2 per cent (as per Central Statistical Organisation (CSO) advance estimates). Five of the eight sectors/subsectors of the economy recorded higher growth rates in 2009-10 (Chart I.1).
I.2 The CSO recently revised the base year of national accounts statistics from 1999-2000 to 2004-05. Apart from revising the deflator, the new series (base : 2004-05) incorporates the available results of various surveys and studies undertaken by the CSO in collaboration with other Government agencies. The coverage of the new series has been expanded in terms of new
activities, besides incorporating a number of procedural changes in estimation. There are no major changes in the overall annual growth rates between the old and new series, with the exception of 2007-08. At the sectoral level, however, there are changes in the growth rates and shares in GDP.
I.3 The overall agricultural growth during 2009-10 was earlier expected to decline significantly as in the previous drought years. However, supported by good rbi prospects and a strong ‘allied sector’, decline in agricultural and allied activities GDP for the year is now expected to be much smaller at (-) 0.2 per cent as per the CSO’s advance estimates.
1.4 Quarterly growth trends during 2009-10 indicate moderation in Q3 after the strong recovery seen in Q2 (Table I.1 and Chart I.2). This moderation in growth resulted primarily from two factors: first, the adverse impact of deficient monsoon on agricultural output getting largely reflected in Q3 data. Second, the impact of high base in Q3 of 2008-09, when ‘community, social and personal services’ had exhibited higher growth reflecting disbursement of Sixth Pay Commission arrears. If the impact of these two factors is netted out, Q3 growth maintains the momentum seen in earlier quarters. The acceleration in industrial growth has been particularly strong since December 2009.
Agricultural Situation
I.5 The deficient South-West monsoon during 2009, with a short fall of 23 per cent in precipitation, resulted in drought in several states. The North-East monsoon performance during 2009 has been satisfactory, with the cumulative rainfall being 8 per cent above normal as
compared to 31 per cent below normal during the corresponding period of the previous year. The delayed withdrawal of the South West monsoon, above normal North East monsoon and focused
Government efforts towards improving rabi production are likely to have a positive effect on rabi output, thereby partially offsetting the losses in kharif output.
I.6 Encouraged by the record food grains production of 234.5 million tonnes during 2008-09, the Ministry of Agriculture had set a higher target of food grains production in 2009-10 (Table I.2). As per the Second Advance Estimates for 2009-10, total foodgrains production is estimated to decline by 7.5 per cent over the previous year. While kharif foodgrains and oilseeds production is expected to decline by 14.6 per cent, rabi production is expected to exhibit a marginal increase of 0.7 per cent. Crop-wise, a decline is expected for all crops except tur, gram, rapeseed and mustard, soyabean, cotton and jute.
Food Management
I.7 Notwithstanding the decline in production, procurement of foodgrains (rice and wheat) during 2009-10 (up to March 15, 2010) was higher than in the previous year. The total stock of food grains declined from the peak of 54.8 million tonnes as on June 1, 2009 to 45.8 million tonnes as on March 1, 2010 due to higher off-take. Even after the decline, both rice and wheat stocks have remained substantially higher than their respective buffer norms.
I.8 While off-take during the first half of 2009-10 was mainly through the targeted public distribution system (TPDS) and other welfare schemes, in the second half of the year, the Government allocated 3 million tonnes of wheat and 1 million tonne of rice for open market sale with a view to containing rising prices of food articles. Additional ad hoc allocations of 1.1 million tonnes of rice and 2.5 million tonnes of wheat were made under TPDS for the
period January-February 2010 to augment supply of these items.
Industrial Performance
I.9 Industrial output, which was affected by the cyclical slowdown and international commodity price shocks in 2007-08 and the global recession in 2008- 09, recovered substantially in 2009-10. The Index of Industrial Production (IIP) registered double digit growth during October 2009-February 2010 (Chart I.3 and Table I.4a). The industrial growth was driven by the manufacturing sector, with a weighted contribution of 88.8 per cent, higher than its weight of 79.4 per cent in
the IIP.
I.10 Thirteen out of seventeen industries in the IIP, accounting for 59.9 per cent of
the weight, recorded higher growth than in the previous year. The top five manufacturing industries with a combined weight of 36.1 per cent in the IIP contributed about 80.7 per cent of the growth during April-February 2009-10, as compared with 122.2 per cent contribution in the corresponding period in 2008-09 and 34 per cent in 2007-08. This suggests that though the recovery has become more broad-based as compared to the last year, there is scope for further improvement.
I.11 The use-based classification of industries shows that capital goods since September 2009 and intermediate goods since August 2009 have registered double digit growth, which will support the growth momentum in several downstream industries. Durables production, which had remained on the double-digit growth trajectory since the beginning of 2009-10, accelerated further between November 2009 and February 2010. The growth in basic goods remained relatively moderate during 2009-10, with intermittent spikes. Industry segments like ‘transport equipment and parts’, ‘machinery and equipment other than transport equipment’ and ‘metal products and parts, except machinery and equipment’ recorded growth. rates in the range of 36-59 per cent during December 2009-February 2010. The surge in growth of ‘transport, equipment and parts’ during the last few months is also corroborated by the robust performance seen in automobiles production. Overall
automobiles production grew by almost 24per cent during April-February 2009-10 and the share of exports in total production was about 13 per cent1. The consumer nondurables segment, remained subdued, notwithstanding some improvement in February 2010. The relative weakness in this segment could be attributed to output contraction in food products, beverages and tobacco products and jute and other vegetable fibre textiles (except cotton). Given its substantial weight in the overall consumer goods output, the weak performance of the consumer non-durable segment has dampened recovery in this subsector.
I.12 During the period April-January 2009-10, capacity utilisation in infrastructure sector showed a mixed trend, with finished steel and fertilizer sectors recording higher utilisation as compared with the corresponding period last year, while cement and refinery production of petroleum products witnessed lesser utlisation for the same period (Table I.5).
I.13 The Order Book, Inventory and Capacity Utilisation Survey of the Reserve Bank indicates that even though capacity utilisation has been witnessing an improvement since Q2 of 2009-10 it remains below the peak observed during the pre-global crisis period. Similar pattern is also observed from the Industrial Outlook Survey of the Reserve Bank (Chart I.5).
Infrastructure
I.14 The performance of core infrastructure after improving significantly during November 2009 to January 2010, decelerated in February 2010 (Charts I.6a). The slowdown in the growth of core infrastructure during February 2010 (4.5 per cent as compared to 9.4 per cent in January
2010) is led by cement and steel, which may be attributed partly to adjustment in inventories. The accelerated growth in power was led by the robust manufacturing sector performance, while the growth in the output of cement and steel until February 2010 has been on account of improved
construction activity. The output of crude and petroleum products remained generally subdued during the year so far. The petroleum products picked up somewhat since August 2009, while crude oil production has recovered since December 2009. Natural gas production, which is not represented in the core infrastructure index, increased sharply during 2009-10 on account of commencement of production from the D6 block in Krishna-Godavari (KG) basin and Rajasthan fields (Cairn). Natural gas production grew by about 40 per cent in April-January 2009-10 with high growth recorded particularly during the last few months (an average of 61 per cent during November 2009- January 2010).
Services Sector
I.15 The growth of services sector, after exhibiting significant recovery in the second quarter, decelerated to 6.6 per cent in Q3 of 2009-10 (Chart I.7). The decline in the growth of ‘community, social & personal services’ depressed the pace of growth during Q3 of 2009-10. Growth in the output of the sub-groups viz., ‘construction’ and ‘trade, hotel, transports & communication’, however, accelerated.
I.16 The lead indicators for services sector activity suggest an overall improvement, particularly since Q3 in relation to the performance in the first half of 2009-10. The services dependent on external demand such as tourist arrivals, cargo handled by seaports and airports, and passengers handled by international terminals recovered significantly during Q3 of 2009-10, reflecting the improving external environment. Services driven by
domestic demand also displayed robust performance in Q3 of 2009-10, particularly those having strong linkages with the manufacturing sector. Commercial vehicle production, a lead indicator for transport services, grew significantly during Q3 of 2009-10 (Table I.6).
I.17
To sum up, GDP growth in 2009-10 has been higher than in the previous year, despite the adverse impact of the deficient South West monsoon on agricultural output. Going forward, the short-term favourable impact of certain fiscal stimulus measures on growth will be absent, which has to be compensated by durable growth in private demand to sustain recovery. Industrial growth has already shown sustained acceleration, and better prospects for rabi crops would also add momentum to the overall recovery. The lead indicators of services activities point to firmer recovery in this sector.
II. AGGREGATE DEMAND
Growth in private consumption demand was subdued in 2009-10, while growth in
Government consumption expenditure decelerated. As a result, consumption demand,
accounting for about 70 per cent of aggregate demand, is estimated to have grown at
4.8 per cent in 2009-10. Investment demand, in terms of growth in gross fixed capital
formation, sustained the recovery seen over last few quarters, though remained below
the growth rates seen during the pre-global crisis period. Corporate sales growth
witnessed major rebound in the third quarter of 2009-10. The fiscal exit, as planned in
the Union Budget for 2010-11, would contribute to improving the overall medium-term
growth outlook, even though greater emphasis on quality of fiscal adjustment would be
necessary. Stronger pick-up in private consumption and investment demand could be
expected to drive and sustain the recovery in growth.
2.1
During the recovery phase, trends in private consumption and investment demand become critical, not only for providing information on the strength of the recovery but also for conditioning the timing and the pace of policy exit. Growth in private consumption demand moderated in 2009-10, while growth in Government consumption expenditure decelerated significantly (Chart II.1). Investment demand, in terms of growth in gross fixed capital formation, sustained the gradual recovery seen over the preceding four quarters. In comparison with the significant acceleration in the growth of capital formation during 2003-08, however, the recovery still looks subdued. Net exports during 2009-10 contributed positively to the demand side GDP, unlike in the preceding year.
2.2
Data on corporate performance points to a moderation in the inventory stock to sales ratio, even though that is largely on account of the strong rebound in sales growth in the third quarter of 2009-10, after a phase of significant deceleration over the preceding four quarters. Strong recovery in the growth of consumer durables as per the index of industrial production (IIP) in recent months, along with the pick up in corporate sales suggests stronger revival in consumption demand in relation to the subdued growth seen in the demand side GDP data. In this context, one has to recognise the excessive weight of demand emanating from agricultural growth in the overall demand side GDP data and the associated need for referring to other relevant indicators of
consumption demand for drawing policy relevant inferences. In view of the significant deceleration in the Government expenditure planned in the Union Budget for 2010-11, further pick-up in private demand will be important to sustain the recovery seen so far.
Domestic Demand
2.3
As per the new national accounts statistics series (base: 2004-05), the growth rates of GDP at factor cost for 2008-09 and 2009-10 have been higher than the growth rates of GDP at market prices reflecting the impact of fiscal stimulus measures on declines in net indirect taxes (i.e., indirect tax revenues net of subsidies). Private and Government consumption expenditures have been estimated to grow at a lower rate in 2009-10 over the previous year (Table II.1). Decline in agricultural production affected private consumption demand during 2009-10, which is also
reflected in the weakness in production of consumer non-durable goods in the recent period. The overall share of consumption expenditure in GDP at market prices (2004-05 prices) declined from 70.9 per cent in 2008-09 to 69.6 per cent in 2009-10. More importantly, the contribution of consumption expenditure (both private and Government) to overall GDP growth has been estimated to come down significantly from 111.8 per cent in 2008-09 to around 50 per cent in 2009-10, with declines estimated in both private and government consumption demand (Chart II.2). The contribution of gross fixed capital formation remains almost unchanged. The remaining part of the contribution to overall growth has been estimated to result from a sharp revival in the pattern of net exports (of goods and services). In absolute terms, while imports would exceed exports, the deceleration in the import growth in 2009-10 has been sharper than the deceleration in export growth. As a result, the share of net exports has been estimated to reverse from (-)36.2 per cent in 2008-09 to 20.7 per cent in 2009-10.
2.4
Compared to annual estimates, quarterly data show a stronger moderation in private final consumption expenditure (PFCE) growth in Q3 of 2009-10 over both the preceding quarter and the corresponding quarter of the previous year. This could be attributed to the adverse impact of a decline in agricultural output on both rural income and food prices, and hence on consumption demand. Government final consumption expenditure (GFCE) registered a sharp decline in Q3 of 2009-10 over the comparable quarter of the previous year due to the base effect of fiscal stimulus measures delivered then. Investment demand, however, picked up further during the quarter, alongside the industrial recovery; gross fixed capital formation rose by 8.9 per cent as compared to 0.8 per cent in the corresponding quarter of 2008-09.
Demand Management through Fiscal Policy
Central Government Finances: 2009-10 and 2010-11
2.5
During 2009-10, even though the expansionary fiscal stance continued in terms of further increase in the key deficit indicators of the Central Government, growth in total expenditure decelerated substantially, led by significant curtailment in the growth of revenue expenditure. A key reason for the enlargement in all the deficit indicators during 2009-10 (RE), despite the
moderation in the growth of expenditure was the much lower growth in tax receipts resulting from the cuts in indirect tax rates as well as the revenue impact of slowdown in the economy. Lower indirect taxes, by lowering the prices of manufactured products, however, would have helped in boosting demand indirectly.
2.6
The budgeted plans for 2010-11, recognising the significance of fiscal discipline for medium-term growth and inflation outlook, and also taking into account the clearer signs of recovery in
GDP growth, point to the beginning of exit of fiscal stimulus measures in a calibrated manner. This is reflected in envisaged reduction in the size of all the key deficit indicators (Table II.2). The total expenditure is slated to increase at a substantially lower rate than in the previous two years. Growth in capital expenditure, which was raised significantly in 2009-10 has further been revised upwards in 2010-11. This could be expected to aid medium-term growth prospects, despite overall moderation in the growth of Government expenditure.
2.7
On the revenue front also, the Budget for 2010-11 has announced partial rollback of the central excise duties on non-petroleum products and basic duties on petroleum products. The expected increase in prices of manufactured goods following this rollback in indirect taxes may entail some dampening effects on private sector aggregate demand. Along with the impact of decelerated Government expenditure, the support from fiscal policy related measures to aggregate demand, thus, could be much less than in the preceding two years. It needs to be recognised that large fiscal stimulus was a response to an exceptional circumstance, i.e., the risk of contagion from the global crisis weakening domestic growth. But by nature, these measures had to be temporary and rolled back over time to ensure sound fiscal position as a means to sustainable high growth in
the medium-term.
2.8
Moreover, the Budget announced certain direct tax measures, such as increase in income tax slabs, which would increase the private disposable income by about 0.4 per cent of GDP. This will have some positive impact on aggregate demand. The concessional customs duty, exemption of excise duty and service tax announced in the Budget on a number of items such as select agricultural goods and related sectors, environment friendly products, monorail projects for urban transport, domestic manufacture of mobile phones and medical equipments will also have some positive impact on the private sector aggregate demand, while providing incentive to expand output of these goods.
State Finances
2.9
The State Governments also recognised the need for enhanced public expenditure in view of the economic slowdown in the second half of 2008-09 (Chart II.3). The increase in revenue receipts by 9.1 per cent in 2009-10 (BE) was lower than the 18.3 per cent rise recorded in 2008- 09 (RE). The economic slowdown also affected the statutory transfer of tax revenues from the Centre to the States.
2.10
With a view to encouraging the State Governments to undertake additional capital investments and boost domestic aggregate demand, they were allowed to raise additional market borrowings to the extent of 0.5 per cent of the GSDP in 2008-09 and further 0.5 per cent in 2009-10. However, budget estimates for 2009-10 for capital expenditure do not seem to reflect these developments; capital expenditure as a ratio to GDP is budgeted to decline from 3.8 per cent in 2008-09 (RE) to 3.5 per cent in 2009-10 (BE). An additional factor that influenced State finances during 2009-10 but with positive implications for aggregate demand, is the implementation of the Sixth Central Pay Commission/State Pay Commissions recommendations.
Combined Fiscal Position
2.11
The fiscal stance during 2009-10 continued to be expansionary in order to boost aggregate demand and thereby contain the pace of economic slowdown. As a result, the combined fiscal deficit of the Central and State Governments during 2009-10 (BE) increased further to 9.7 per cent from 8.5 per cent in 2008-09 (RE) (Table II.3). Higher deficits, though, were not reflected in stronger expansion in public expenditure, since revenue receipts exhibited significant deceleration
(Table II.4). Unlike in 2008-09 (RE) when substantial emphasis was placed on boosting government consumption expenditure directly, during 2009-10 (BE), the total expenditure of the combined government decelerated sharply, particularly due to containment of revenue expenditure. Thus, the direct contribution of Government expenditure to the growthin aggregate demand weakened in relation to the previous year.
Corporate Performance
2.12 The moderation in private demand during the phase of economic slowdown was evident from the corporate sales data as well. In the third quarter of 2009-10, however, year-on-year sales growth of select non-financial non-government listed companies was the highest in last five
quarters. Seasonally adjusted sequential sales growth over the previous quarter also showed improvement. The rebound in sales growth points to improving private demand Reflecting the lower interest rate regime, interest expenses declined significantly in the third quarter of 2009-10, which also contributed to the improvement in profit after taxes. Gross and net profits rose by
60 per cent and 99.3 per cent, respectively, in Q3 of 2009-10, which was particularly aided by the low base effect of the same quarter of the previous year when profits had registered significant negative growth (Table II.5). Profit figures were further influenced by the last year’s cost reduction initiatives by the Government. While yearon- year growth in net profits was impacted
by low base effect, sequentially net profits rose moderately in Q3 over the previous quarter.
2.13
Reflecting the strong rebound in sales, the change in stocks to sales ratio declined in Q3 of 2009-10 (Chart II.4). The trend depicts the inventory cycle in relation to sales, and hence, a downward movement in the cycle may as much reflect an increase in sales as decrease in inventory stocks.
External Demand
2.14
Net exports (of goods and services) contributed positively (20.4 per cent) to GDP growth in 2009-10, as against a negative contribution of around 36.2 per cent in 2008- 09 (Chart II.2). This revival in the pattern in the first three quarters of 2009-10 was on account of sharper contraction in imports than in exports, even though in absolute terms, imports continued to exceed exports, thereby yielding negative net exports. Export growth continued to be negative in Q3 of 2009-10, but the rate of contraction had declined over the preceding quarters, indicating signs of recovery in external demand. Import growth continued to shrink at a higher rate than export growth, but the rate of decline, like in the case of exports, moderated in Q3 of 2009-10. The positive contribution of net exports could, however, reverse in the coming year as imports are likely to grow at a faster pace than exports given the prospects of Indian recovery remaining ahead of the global economy.
Merchandise trade deficit during April- February (2009-10) stood at US$ 95.7 billion, which was lower by 16.6 per cent than US$ 114.7 billion in April-February 2008-09, due to relatively sharper deceleration in imports than exports during the period. The merchandise trade data also
corroborate the reversal in contribution of net exports to growth in demand. A detailed discussion on the external demand conditions is set out in Chapter III.
2.15
An overall assessment of trends in aggregate demand and its different components, thus, suggests that while the support of expansionary Government expenditure to economic recovery has started to moderate significantly, private consumption demand needs to exhibit stronger momentum in growth. Investment demand has picked up and could be
expected to gain further acceleration. Major rebound in corporate sales growth and robust growth in consumer durables production in the recent period point to recovery in private demand. The Union Budget for 2010-11 indicates that the direct and indirect impact of fiscal policy measures in supporting aggregate demand in 2010-11 would be much less than in the preceding two years. The fiscal exit as planned in the Union Budget for 2010-11, however, would contribute to improving the medium-term growth outlook, and the
significantly stronger growth programmed for capital expenditure would also stimulate
growth. Alongside calibrated exit from the expansionary fiscal and accommodative monetary policy stances, stronger pick up in private consumption and investment
demand would be necessary to sustain the growth momentum.
III. THE EXTERNAL ECONOMY
India’s external sector witnessed further improvement with the recovery seen in the global economy as reflected in the turnaround in exports, buoyancy in capital inflows and further accretion to the country’s foreign exchange reserves. Exports recovered from 12 months of consecutive decline and posted an average growth of 20.5 per cent during November 2009-February 2010. Imports also turned around and exhibited an average growth of about 43.0 per cent during December 2009-February 2010, mirroring the impact of strong recovery in growth. India’s balance of payments position during April-December 2009 remained comfortable with a modest increase in current account deficit, despite a lower trade deficit, on account of decline in invisibles surplus. There has been a turnaround in capital inflows, mainly led by portfolio inflows, reflecting the buoyant growth prospects of the Indian economy.
India’s foreign exchange reserves during 2009-10 increased by US$ 27.1 billion to reach US$ 279.1 billion as at end-March 2010. As on April 9, 2010, foreign exchange reserves stood at US$ 280.0 billion.
III.1
Reflecting the improving global conditions, India’s merchandise exports have recovered since October 2009, after a phase of twelve consecutive months of decline. Imports have also shown a strong turnaround since December 2009, driven by the stronger recovery in growth. The balance of payments (BoP) position during April-December 2009 remained comfortable.
International Developments
III.2
The international economic situation improved further with most economies exhibiting acceleration in recovery during the fourth quarter of 2009 on the back of revival in world trade and industrial production. Since the decline in industrial production and exports had been sharper than in output during the global recession, recovery in industrial production
and exports has also been stronger than in output. Global recovery, however, now seems to be multi-paced, led by the EMEs and self-sustaining recovery is yet to take hold. III.3 Signs of recovery were particularly firm in the fourth quarter data of various economies (Chart III.1 a and b). Asia continues to spearhead the global recovery.
Going forward, both advanced and emerging market economies are expected to exhibit stronger recovery in 2010, though the speed would remain divergent across the countries
(Table III.1). Stronger economic frameworks and rapid policy responses have helped many emerging economies to mitigate the impact of the unprecedented external shocks.
III.4
After a period of decline in world trade over four consecutive quarters, growth in world trade has turned around. According to the latest monthly data from the IMF (International
Financial Statistics), world exports showed a positive growth of 19.1 per cent in January
2010. This was in line with the rise in world commodity prices. As per the WTO data, the world merchandise exports increased by 10.3 per cent (sequential quarter-onquarter) in the fourth quarter of 2009, though on a year-on-year basis, the increase was lower at 3.9 per cent.
III.5
The recovery in advanced economies was also evident in the growth of industrial production (month over month). With stronger recovery in EMEs and given the easy global liquidity conditions, capital inflows to EMEs have been projected to revive in 2010, though may remain much below the high level reached in the pre-global crisis period. The persisting high unemployment has brought to the fore the risk of jobless recovery, which would influence country strategies on exit. Post-stimulus high levels of public debt in advanced economies and thechallenges of recovering to pre-crisis levels would remain a permanent concern for the global economy in the post-crisis period.
III.6
On the way forward, there are significant risks to the global growth outlook. On the downside, a key risk emanates from differential growth and inflation conditions across countries leading to asymmetry in the timing of exit from crisis-time supportive policies, which may negatively impact global growth pattern and its rebalancing, besides influencing exchange rate and asset pricesin EMEs through shifts in the pattern of capital flows. The impaired financial systems/housing markets and rising unemployment in key advanced economies may hold back the recovery in household spending. Another key risk to global growth at the current juncture seems to be rising sovereign risk, presently confined to parts of Europe but likely to extend over time to other advanced economies. The other risk is the threat of rising inflation if large fiscal deficits are monetized. The still-low levels of capacity utilisation and well-anchored inflation expectations are expected to contain inflationary pressures. Growing concerns about worsening budgetary
positions and fiscal sustainability could ruffle financial markets and stifle the recovery by raising the cost of borrowing for households and companies.
III.7
The impact of the recovery in the global economy on India’s external sector was visible in the turnaround in exports and continuation of capital inflows. Despite concerns about protectionism as a response to the global crisis, the recovery in world trade projected for 2010 would improve the export prospects for India. Easy global liquidity conditions and higher growth prospects of India could add momentum to the revival in capital flows seen so far. The de-coupling of recovery across countries and the increasing divergence of
inflationary conditions were also reflected in India. This suggests that while global developments continue to impact India, there is greater evidence of asymmetry, both in terms of the pace of recovery and the headline inflation.
Merchandise Trade
Exports
III.8
Trade channel of the contagion from the global crisis had affected India’s export performance, which declined over twelve consecutive months. Since October 2009, export growth has turned around. Export growth averaged at 20.5 per cent during November 2009 to February 2010. The increase in exports has coincided with the uptrend in world commodity prices as well as the recovery in the global economy. Cumulatively, exports during 2009-10 (April-February) registered a decline of 11.4 per cent as against a growth of 18.2 per cent a year ago.
III.9
Commodity-wise exports data for the period 2009-10 (April-September) revealed that manufactured goods continued to maintain their largest share (69.4 per cent), followed by petroleum and primary products. Moreover, during the period, the share of manufactured goods increased along with decline in the shares of petroleum and primary products. During April-September 2009, the exports of all major commodity groups declined.
III.10
Destination-wise, developing countries and OECD countries were the major markets for India’s exports, accounting for 37.9 per cent and 36.6 per cent shares, respectively. Another major destination was OPEC with 23.3 per cent share. Country-wise, the UAE (with a share of 14.1 per cent) was the largest destinationfor India’s total exports followed by the US, China, Singapore, Hong Kong and the UK. Exports to all major export destinations declined during the period.
Imports
III.11
India’s imports, after declining since December 2008 for eleven months, exhibited reversal in trend in November 2009 with an increase of 2.6 per cent. The uptrend in imports continued through February 2010. Between December 2009 and February 2010, import growth averaged at 43.0 per cent. Cumulatively, during 2009-10 (April-February), imports recorded a decline of 13.5 per cent in contrast with a growth of 25.9 per cent a
year ago, which resulted from lower international crude oil prices during the period and slowdown in domestic economic activity. Reflecting the increase in oil prices and the higher volume of oil imports on account of the economic recovery, oil imports have increased during the recent period (Chart III.3).
III.12
The commodity-wise imports during April-September 2009 indicated slowdown in non-POL imports, which was mainly due to sharp decline inimports of capital goods, gold and silver, pearls, precious and semi-precious stones, chemicals, iron and steel. Imports of edible oil and pulses, however, witnessed considerable growth, reflecting domestic
supply constraints and higher prices (Table III.3).
III.13
Source-wise, during April- September 2009, developing countries had the highest share in India’s imports (33.6 per cent), followed by OECD (32.7 per cent) and OPEC (30.7 per cent). Country-wise, China continued to be the single largest source of imports with a share of 12.0 per cent in India’s total imports, followed by the US, the UAE, Saudi Arabia, Australia and Iran.
III.14
Merchandise trade deficit during 2009-10 (April-February) stood at US$ 95.7 billion, which was lower by 16.6 per cent than the level during 2008-09 (April- February), reflecting relatively larger decline in imports than exports (Table III.4).
Balance of Payments (BoP)
Current Account
III.15
The impact of global economic recovery was visible in different accounts of India’s balance of payments. The current account position during the third quarter of 2009-10 witnessed a turnaround in both exports and imports. India’s merchandise exports (on BoP basis) registered a robustgrowth in the third quarter of 2009-10 as compared with decline in the corresponding period of 2008-09. Imports (on BoP basis) increased moderately during the quarter as compared with a higher growth in the corresponding quarter of the previous year. Trade deficit was lower during the third quarter of 2009-10 as compared with the preceding quarter and the corresponding quarter a year ago. During April-December 2009 also, trade deficit remained lower (US $ 89.5 billion) as compared with the corresponding period of the preceding year (US$ 98.4 billion) led by decline in both
oil and non-oil imports.
Invisibles
III.16
The robust growth observed in invisibles receipts and payments in the past few years was reversed during 2009-10, reflecting the lagged impact of the recession in advanced economies. The decline was seen in both factor and non-factor components. Although software exports witnessed a turnaround, the decline in non-software exports mirroring the impact of global economic slowdown resulted in a decline in the overall services exports during the quarter. The decline in investment income receipts during the quarter was mainly on account of continued lower interest rates in advanced economies. Private transfer receipts, however, remained strong during the quarter. Invisibles payments registered a higher growth during the quarter as compared with the corresponding period
of 2008-09. Overall, the net invisibles (i.e. invisibles receipts minus invisibles payments) were lower during the quarter as compared with the corresponding period of the previous year.
III.17
During April-December 2009, invisibles receipts (except private transfer receipts) registered a decline, while invisibles payments witnessed a marginal increase over the corresponding period of the previous year. Net services exports of India declined by 36.9 per cent during April- December 2009 as against an increase of 30.9 per cent during the corresponding period of last year, mainly due to significant decline in services receipts coupled with increase in services payments. While the decline in services receipts was due to decline in almost all the components of services, the increase in services payments
was mainly driven by business and financial services. Consequently, net invisibles stood
lower during April-December 2009 as compared with the corresponding period of the previous year. At this level, the invisibles surplus financed 66.1 per cent of trade deficit during April-December 2009 as against 72.1per cent during April-December 2008. Despite lower trade deficit, the fall ininvisibles surplus led to marginally higher current account deficit during the third quarter of 2009-10 (Chart III.4). The current account deficit during April-December 2009 stood at US$ 30.3 billion, higher than US$ 27.5 billion during April-December 2008. During 2008-09, current account deficit as a per cent of GDP stood higher at 2.4 per cent as compared to 1.3 per cent a year ago.
Capital Account
III.18
Capital flows continued to remain buoyant during the third quarter of 2009-10, mainly led by large inflows under foreign direct investments, portfolio investments and short-term trade credits.
III.19
The latest available information on certain indicators of the capital account indicates that the revival in capital inflows, which started at the beginning of 2009-10 and gathered momentum in the second and third quarters, has remained buoyant even in the last quarter. Stronger recovery in 2009-10 ahead of the globaleconomy coupled with positive sentiments of global investors about India’s growth prospects are the factors that underlie the momentum of sustained capital inflows during the year. prospects are the factors that underlie the momentum of sustained capital inflows during the year.
III.20
Going forward, capital inflows to India during 2010-11 are expected to be stronger driven by both push and pull factors. While the push factors for surge in capital inflows include excess global liquidity accompanied by low interest rates leading to search for higher yield, the pull factors include the buoyant growth prospects, favourable interest rate
differential and relaxation of ECB norms for 3G spectrum. Higher expected capital inflows, however, may exert pressures on asset prices and exchange rate.
III.21
The appreciation of the rupee against the US dollar and increase in inflation differentials between India and its trading partners during the year led to appreciation of the real exchange rate.
Foreign Exchange Reserves
III.22
On balance of payments basis (i.e., excluding valuation effects), the foreign exchange reserves increased by US$ 11.3 billion during April-December 2009 as against a decline of US$ 20.4 billion during April-December 2008. The valuation gain, reflecting the depreciation of the US dollar against the major international currencies, accounted for US$ 20.2 billion during April-December 2009 as compared with a valuation loss of
US$ 33.4 billion during April-December 2008. Accordingly, valuation gain during April-December 2009 accounts for 64.1 per cent of the total gross increase in foreign exchange reserves.
III.23
During 2009-10, India’s foreign exchange reserves increased by US$ 27.1 billion to reach US$ 279.1 billion as at end-March 2010 (Table III.10 and Chart III.6). Foreign currency assets (FCAs) increased by US$ 13.3 billion during the year. Furthermore, the Reserve Bank purchased 200 metric tonnes of gold from the IMF on November 3, 2009 as part of the Reserve Bank’s foreign exchange reserve management operations. The foreign
exchange reserves, however, remained unaffected by this transaction as it merely
reflected substitution of foreign currency assets by gold. The IMF made additional
allocations of SDRs to India in two branches, viz., general allocation of SDR 3,082 million (equivalent to US$ 4.82 billion) on August 28, 2009 and a special allocation of SDR 214.6 million (equivalent to US$ 0.34 billion) on September 9, 2009. Foreign exchange reserves stood at US$ 280.0 billion as on April 9, 2010.
External Debt
III.24
India’s external debt stock at US$ 251.4 billion at end-December 2009 recorded an increase of US$ 26.8 billion over its level at end-March 2009, mainly on account of increase in long-term debt. Both long-term and short term debt increased at end-December 2009 from their levels at end-March 2009. Of the total increase in India’s
external debt at end-December 2009, the valuation effect on account of depreciation of US dollar against major international currencies accounted for 36.9 per cent.
III.25
The ratio of short-term to total debt declined at end-December 2009 from its level at end-March 2009. Similarly, the ratio of short-term debt to foreign exchange reserves moderated during the period. In terms of currency composition, the US dollar denominated debt accounted for the major portion of total external debt at end-
December 2009.
International Investment Position
III.26
India’s net international liabilities were placed at US$ 117.1 billion at end-
December 2009 as compared with US$ 96.0 billion at end-September 2009. The
international assets increased from US$ 378.9 billion at end-September 2009 to US$
385.9 billion at end-December 2009, mainly on account of increase in direct investment abroad, reserve assets, and other investment during the quarter. The increase in international liabilities from US$ 474.8 billion to US$ 503.0 billion during the same
period was on account of an increase in inward direct investment and portfolio equity investment.
III.27
India’s external sector, thus, improved alongside the recovery in global economy and further stabilisation in global financial conditions. This was reflected in the turnaround in exports and continued buoyancy in capital inflows. Despite higher net capital inflows during 2009-10, reflecting improved absorptive capacity of the economy, capital inflows
mostly financed the higher current account deficit. Reflecting easy global liquidity conditions and both interest rate and growth differentials in favour of India, capital inflows are expected to be strong, which may put pressure on asset prices and exchange rate. Global commodity price trends, particularly possible firming up of oil prices could exert pressures on the balance of payments through higher imports. For dealing with the external shocks transmitting through various accounts of the balance of payments, it is important to have adequate foreign exchange reserves
IV. MONETARY CONDITIONS
During the first half of 2009-10, growth in both broad money (M3) and non-food credit decelerated. This reversed course during the second half reflecting the pull of economic recovery. While non-food credit, which had been decelerating since October 2008 reached its inflexion point in November 2009, money growth turned around in March 2010. By the end of the financial year, growth in both M3 and non-food credit exceeded the Reserve Bank’s indicative projections of growth of 16.5 per cent and 16.0 per cent, respectively. During the year, there was a slowdown in the pace of deposit mobilization by the banking system, mainly due to the gradual decline in interest rates on time deposits in lagged response to the lower policy rates. With the increasing demand for credit from the banking system, deposit mobilisation has begun to gain strength, and deposit rates have also moved up in the recent period. Even after the absorption of Rs.36,000 crore through the 75 basis points hike in CRR effected in February 2010, liquidity conditions have remained comfortable, as evident from the reverse repo operations under the LAF in the recent weeks.
IV.1
During the crisis, maintenance of ample liquidity and lower policy rates were used by the Reserve Bank as the key channels to stimulate private demand and thereby contain the pace of slowdown in economic activity. The interest rate transmission through lower lending rates started becoming visible with a lag. When the private demand for credit remained depressed and decelerated till the middle of Q3 of 2009-10, the flow of resources from the non-banking sources to the commercial sector increased. The recent upturn in monetary and credit aggregates provides additional evidence that the recovery is taking hold.
IV.2
In 2009-10, growth in reserve money decelerated up to October and thereafter gradually rose back to the growth rate prevailing in September 2008, i.e., before the onset of the global financial crisis. In contrast, reserve money adjusted for the first round impact of CRR change, exhibited less volatility and followed a mildly decelerating trend for the year.
IV.3
Growth in broad money (M3) showed deceleration throughout the year, with a moderate turnaround seen in March 2010 (Chart IV.1 and Table IV.1). This was on account of deceleration in aggregate deposits on the components side of M3. On the sources side of M3, the deceleration was driven by the relatively weak demand for credit from the commercial sector during the first half of 2009-10, combined with moderation in banking system’s credit to the Government during the second half of 2009-10. After a phase of deceleration, there has been a revival in the flow of bank credit since November 2009, as a result of which the Reserve Bank’s indicative target of 16.0 per cent credit growth for the year was exceeded by mid-March 2010. The improved flow of credit from the banking sector in conjunction with higher availability of resources from the non-banking sources (both domestic as well as foreign) led to a significant increase in total flow of financial resources to the commercial sector, thereby financing the activities underpinning the economic recovery that is underway.
Reserve Money
IV.4
In 2008-09, the deceleration in the growth rate of reserve money was primarily on account of decline in bankers’ deposits with the Reserve Bank on the components side of reserve money (due to a net reduction in CRR by 250 basis points during the year) and decline in foreign currency assets (on account of capital outflows) on the sources side of reserve money. During 2009-10, the deceleration continued up to October. This was mainly due to decline in bankers’ deposits (since growth in banks’ aggregate deposits decelerated even as the CRR stayed unchanged at 5.0 per cent) on the components side of reserve money and decline in Reserve Bank’s credit to the Centre, reflecting increased reverse repo operations1 and increase in Centre’s surplus on the sources side of reserve money. As the outstanding reverse repo balances and open market operations declined October 2009 onwards, net Reserve Bank credit to the Centre became the important driver of acceleration in reserve money growth.
IV.5
For the entire financial year 2009-10, the decline in MSS balances by Rs.85,340 crore (through unwinding and de-sequestering of balances to the Government) was the largest source of increase in reserve money, accounting for more than 50 per cent of the Rs.1,67,281 crore increase in reserve money. The other major source was open market purchases. LAF operations and Centre’s surplus with the Reserve Bank played a significant role in quarter to quarter movements in net Reserve Bank credit to the Centre and hence in reserve money.
IV.6
The foreign currency assets of the Reserve Bank (adjusted for valuation) were the dominant source of variations in reserve money in the past five years. During 2009- 10, net accretion to foreign currency assets was the highest during the second quarter (Chart IV.2). In the last two quarters of 2009-10, however, the expansion in reserve money was not affected much by the moderate contraction and the subsequent expansion in foreign currency assets of the Reserve Bank. The significant movement in the net non-monetary liabilities of the Reserve Bank was mainly on account of the movement in the valuation of foreign exchange assets of the Reserve Bank.
IV.7
During the fourth quarter of 2009- 10, reserve money growth on the components side was led by the increase in bankers’ deposits with the Reserve Bank. This was on account of the increase in CRR by 75 basis points in February 2010. Currency in circulation also increased in line with the increased economic activity in the country (Table IV.2). On the sources side, net Reserve Bank credit to the Centre accounted for nearly the entire increase in reserve money (Chart IV.2). The increase in net Reserve Bank credit to the Centre was mainly due to the reduction in the Government’s cash surplus with the Reserve Bank. The other factor contributing to increase in net Reserve Bank credit to the Centre was decline in outstanding reverse repo balances2, which reflected the impact of the absorption of part of the excess liquidity in the system by the hike in the CRR as well as some tightening of the overall liquidity conditions resulting from the advance tax payments during the first fortnight of March 2010. There was also a reduction in MSS balances with the Reserve Bank due to unwinding (Rs.11,036 crore in the first week of January 2010) and de-sequestering (Rs.5,000 crore on March 11, 2010).
IV.8
Since bankers’ deposits with the Reserve Bank, a key determinant of reserve money on the components side, change in response to variations in CRR effected by the Reserve Bank as part of its monetary policy actions, it is often useful to analyse the behaviour of reserve money adjusted for the policy induced part of the change in base money. Adjusting the reserve money series for injection/absorption through CRR changes gives the adjusted reserve money series. The reserve money growth for the last few fortnights of 2009-10 exceeds the adjusted reserve money growth, reflecting the impact of the hike in CRR in February 2010 that led to absorption of about Rs.36,000 crore of surplus liquidity from the system.
Money Supply
IV.9
Broad money growth followed the growth pattern of its largest component – aggregate deposits. Since there was gradual deceleration in aggregate deposits, led primarily by time deposits, money growth decelerated during the year (Table IV.3). Due to the softening of interest rates, there was deceleration in the growth of time deposits through the year, with an erratic pattern in the closing fortnights of 2009-10 (Chart IV.4 a). Since April 2009, returns on small savings have remained higher than that of time deposits, leading to rising inflows since August 2009, after a period of 20 consecutive months of outflows. As the interest differentials over time deposits became more attractive, the rate of accretion into the small savings schemes increased in each successive month up to February 2010, i.e., the latest period for which data are available (Chart IV.4 b).
IV.10
On the sources side, the main driver of M3 has been the banking system’s credit to the Government, while credit to the commercial sector also showed revival in the last quarter of 2009-10. A quarter-wise analysis reveals that incremental credit extended by scheduled commercial banks (SCBs) in absolute terms in the fourth quarter of 2009-10 was the highest in last two years (Chart IV.5). After showing an absolute decline in the third quarter of 2009-10, SCBs’ credit to the Government increased during the fourth quarter, when the Government’s borrowing programme was completed.
IV.11
Reflecting the revival in flow of credit from the SCBs, the non-food credit growth was 16.9 per cent by end-March 2010 as against the Reserve Bank’s indicative trajectory of growth of 16 per cent (Chart IV.6 a). In the year up to October 2009, deceleration in non-food credit had continued and reached the low of 10.3 per cent. As the economic recovery is increasingly becoming more broad-based, with industrial output exhibiting particularly strong acceleration in recent months, there is a significant revival in credit demand since end-November 2009 and the incremental credit deposit ratio has also risen steadily in the second half of 2009-10.
IV.12
Due to the revival in credit demand for the banking system as a whole, the credit extended by private banks at end-March 2010 showed some improvement over last year. The loan portfolio of foreign banks, however, contracted.
IV.13
Reflecting the revival in credit demand from the private sector, SCBs’ investment in SLR securities increased at a lower rate of 18.5 per cent (y-o-y) as on March 26, 2010 as compared with 20.0 per cent a year ago. Commercial banks’ holdings of such securities at 28.8 per cent of their net demand and time liabilities (NDTL) were only marginally higher than 28.1 per cent at end-March 2009. Adjusted for LAF collateral securities on an outstanding basis, SCBs’ holding of SLR securities amounted to 28.4 per cent of NDTL as on March 26, 2010. SCBs reduced their overseas foreign currency borrowings as well as their holding of foreign currency assets during the year.
IV.14
Disaggregated data on Sectoral deployment of gross bank credit show improvement in credit growth (y-o-y) to all major sectors such as agriculture, industry, services and personal loans from November 2009 onwards. Industry absorbed 52.6 per cent of incremental non-food credit (yo- y) in February 2010 as compared with 55.8 per cent in the corresponding month of the previous year. This expansion was led by infrastructure and basic metals and metal products. The share of incremental non-food credit to services sector was 22.6 per cent in February 2010. Within services sector, credit growth (y-o-y) for transport operators, computer software, tourism, hotels and restaurants and trade accelerated in February 2010. Also, the share of incremental nonfood credit to micro and small enterprises (industry as well as services) increased to 16.4 per cent in February 2010 as compared with 12.4 per cent in February 2009. Credit to real estate decelerated sharply mainly on account of the definitional change to the concept of “lending to real estate sector” effected in September 2009. The agricultural sector absorbed 18.3 per cent of the incremental non-food bank credit in February 2010 (12.7 per cent last year). Share of personal loans in incremental nonfood credit increased markedly to 6.5 per cent by February 2010, from (-) 0.2 per cent in October 2009. Within personal loans, while education loan and housing loan continued to grow over 30 per cent and 8 per cent, respectively, the contraction in credit to some sub-sectors such as consumer durables and advances against shares, bonds, etc., moderated.
IV.15
In 2009-10, part of the impact of the deceleration in credit to the private sector was offset by higher availability of resources from non-banking sources, particularly in the first three quarters. While non-banking domestic sources such as issuance of commercial papers (CPs), private placements and initial public offerings (IPOs) have shown significant increase; financing from foreign sources in the form of FDI and issuance of American Depository Receipts (ADRs)/Global
Depository Receipts (GDRs) also improved.
IV.16
The emerging trends in monetary and credit aggregates in recent months, thus, corroborate the momentum seen in real activities. While elevated headline inflation and the recovery in growth could increase the demand for money, policy driven increase in CRR could contribute to containing the growth in broad money. Given the size of the Government’s borrowing programme for 2010-11, if the recovery in demand for credit from the private sector firms up further and capital flows also increase, then monetary expansion could be driven by all three main factors on the sources side, i.e., banking system’s credit to the Government, credit to the commercial sector and increase in net foreign assets.
V. FINANCIAL MARKETS
The global financial markets witnessed further stabilisation with firmer indications about the strength of the recovery but with concerns about fiscal conditions as reflected in sovereign risks. Domestic financial markets remained stable. While the persistent surplus liquidity conditions kept the money market interest rates low, the medium to long-term yield on government bonds increased, reflecting the concerns relating to the size of the borrowing programme and inflationary conditions as well expectations about the monetary exit. The credit market conditions improved with a turnaround in the demand for credit from the corporate sector as well as better transmission of policy rates to the deposit and lending rates, though with lags. Asset prices, in terms of stock prices as well as residential housing prices, exhibited significant rise. The upward pressure on the exchange rate continued, reflecting the revival in capital inflows.
V.1
Uncertainties about the path of future global recovery and risks arising from large sovereign debt continue to threaten the return to stability in the international financial markets. These developments in the global financial markets transmitted to the domestic financial markets by way of sporadic volatility in stock prices and the exchange rate. The domestic financial markets faced concerns emerging from the large fiscal deficit, despite the beginning of exit, and the inflationary expectations stemming from high headline inflation, which affected the government bond market. The transmission of lower policy rates to the credit markets improved through lower lending rates, though with lags. The flow of credit to support the recovery in growth improved in recent months, while availability of resources from non-banking sources also increased. Asset prices increased at a relatively faster pace in the recent period. With the turnaround in capital inflows, the exchange rate appreciated.
International Financial Markets
V.2
The global financial markets during 2009 exhibited significant stabilisation, despite the drag from the global financial crisis. Although financial markets were marked by intermittent volatility, mainly arising from the uncertainty regarding the shape of the global recovery, the risks in the global financial markets declined for most part of 2009, as stronger signs of global recovery became visible. The sovereign risk concerns, however, dominated the financial markets. Two major events i.e., the Dubai World debt standstill and the sovereign debt problem of the East
European countries, mainly Greece, posed another bout of risk to the financial system towards the end of 2009 and beginning of 2010, which led to greater volatility in the international markets.
V.3
In the aftermath of the global financial crisis, the high debt levels in the advanced economies – an outcome of bailouts and unprecedented fiscal stimulus – have created adverse market expectations about sustainability of such debt levels and exerted pressures on the government bond yield (Chart V.1a). With signals from the major central banks in the advanced economies that interest rates may remain low for some time, the bond yields have somewhat moderated towards the end of the year. The government bond yields in EMEs witnessed broadly a moderating trend, excluding India (Chart V.1b). Recent events, i.e., Greece’s sharp revisions of budget deficit from 3.7 per cent to 12.7 of GDP in 2009 and the Dubai World default, have renewed risk aversion in the sovereign bond markets (Chart V.1c and d). Besides Greece, the other Euro area countries such as Italy, Portugal, Ireland and Spain also seem to be under stress due to high public debt. While Ireland is already on fiscal adjustment, the contingent liabilities from the banking sector still loom large.
V.4
The US AAA-rated corporate bond spreads declined by about 100 basis points between January 2009 and March 2010 (Chart VI.1g). In the aftermath of the Dubai World debt default, however, the credit risk repricing for corporates was evident from the increase in global credit default swap (CDS) spreads for the corporate sector (Chart V.1e). In fact, activity in the CDS market in advanced economies increased significantly as investors reassessed their exposure to sovereign risks. The CDS spreads for the banking sector, which had shown sequential drop in 2009 due to improved bottom lines of the banks, witnessed pressure in Q1:2010 as the market concerns of sustainability of sovereign debt in many advanced countries and EMEs impacted on the risk perception towards the banking sector as they accumulated a large portfolio of government bonds in their balance sheet (Chart V.1f).
V.5
A significant reduction in investor risk appetite to both the advanced economies and the EMEs was reflected in large gains in equity prices in 2009, which have been sustained in 2010 so far. The US stocks recorded gains of about 42 to 56 percent between March 2009 and March 2010 (Chart V.1h). Although the gains in equity prices in both the advanced economies and EMEs were marginal in Q1: 2010 over Q4:2009, overall the advanced economies’ stock prices gained by 52 per cent between March 2009 and March 2010, while the EMEs recorded even higher gains of 78 per cent, reflecting the uneven pace of global recovery (Chart V.1i).
V.6
The gains in EME asset prices were aided by a number of factors such as robust economic recovery, reduced risks, low interest rates in the advanced economies and capital inflows in search for higher yield. The rising short-term capital flows to EMEs raised concerns about their adverse impact on the exchange rate and liquidity management, prompting some countries to impose variants of Tobin tax. Brazil imposed a 2 per cent tax on foreign capital (invested in domestic equity and bond markets) in October 2009 and a further 1.5 per cent tax on certain trades involving American Depository Receipts (ADRs). Taiwan also prevented flow of foreign funds into time deposits from mid- November 2009.
V.7
In the foreign exchange market, the depreciating trend of the US dollar was reversed during Q1 of 2010 (V.1j). The US dollar generally appreciated against major currencies like the euro and pound sterling during the quarter, buoyed by positive economic data from the US. However, despite the strength exhibited by the US dollar against major currencies during Q4 of 2009, it depreciated against the major currencies as also against the currencies of EMEs during the year as a whole.
V.8
The stronger signs of global recovery taking hold led to reduction in risks in the international markets, which also favourably impacted the domestic equity markets during the major part of 2009. Reduction in risk perception towards EMEs along with continuance of low policy rates in the advanced economies for the extended periods, led to revival in capital flows to India, which in turn contributed to significant gains by the equity markets and at the same time put appreciation pressures on the exchange rate. Nevertheless, since the last quarter of 2009, the global shocks from Dubai World standstill on debt payments and sovereign debt concerns spreading from Greece to other East European countries, have impacted the domestic markets in terms of higher volatility in stock prices and to some extent the exchange rate. Overall, the impact of such global shocks remained contained and transient; the various segments of the domestic market functioned in an orderly manner, with increasing volumes in activities.
Domestic Financial Markets
V.9
The domestic financial markets during 2009-10 were characterised by certain major trends, such as prevalence of comfortable liquidity conditions in money markets despite large government borrowing programme, MSS unwinding in alignment with the borrowing programme to contain pressure on yield, call rate remaining low and around the lower bound of the liquidity adjustment facility (LAF) corridor, rising pressure on medium to long-term government bond yield, appreciation of the rupee amid a two-way movement, and substantial gain in asset prices, in terms of both stock and housing prices.
Liquidity Conditions
V.10
The intra-year dynamics of liquidity conditions reflected the calibrated policy response to the evolving macroeconomic and financial market environment, interspersed with the impact of quarterly advance tax outflows. The surplus liquidity in the domestic markets, partly induced by unwinding of the MSS balances, prevailed during almost the entire financial year 2009-10. The key drivers of liquidity during the first half of 2009-10 were open market operations (OMO) to manage the Government borrowing programme coupled with MSS unwinding. The total liquidity released during 2009-10 through the unwinding of MSS and auctionbased OMO purchases amounted to Rs.1,42,827 crore. The surplus liquidity, however, declined somewhat in the second half of 2009-10 on account of relatively lower MSS redemptions, absence of OMO auctions, apart from the CRR hike in February 2010, which absorbed primary liquidity of around Rs.36,000 crore from the system. The surplus liquidity declined further on account of quarterly advance tax outflows from the banking system that more than offset the impact of de-sequestering of Rs.5,000 crore of MSS balances on March 11, 2010 (Table V.3). Thus, the overall surplus liquidity in the system declined during the last quarter of 2009-10.
V.11
Overall, changes in the centre’s balances were the key drivers of autonomous liquidity in 2009-10 along with the uptick in currency demand in the latter half of the year (Table V.4).
Money Market
V.12
The call rate continued to hover around the lower bound of the informal LAF corridor during the financial year 2009-10 as surplus liquidity persisted throughout the year (Chart V.2a). Interest rates in the collateralised segments generally moved in tandem with but remained below the call rate.
V.13
Transaction volumes in the collateralised borrowing and lending obligation (CBLO) and market repo segments continued to remain high during 2009-10 reflecting surplus liquidity and active market conditions throughout the year (Table V.5). Banks as a group continue to be the major borrowers in the collateralised segment whereas mutual funds (MFs) remain the single largest lender of funds in that segment. In fact, over 75 per cent of the lending in the collateralized segment is contributed by MFs, reflecting their high lending capacity. The collateralised segment continued to be the predominant segment of the money market, and its share in the total volume reached around 90 per cent during the year 2009-10.
V.14
During the year 2009-10, as observed in the Reporting Fridays’ statements, aggregate lending by MFs to banks (through CBLO, market repo and certificates of deposit) has generally exceeded banks’ aggregate investment in MFs. In general, banks have invested around Rs.1,00,000 crore in the liquid schemes of the MFs, while the MFs have lent around Rs.2,75,000 crore to banks through market repo, CBLO and certificates of deposit (CD); most of the increase in MFs investment in banks during 2009-10 has been in CD.
V.15
With persisting surplus liquidity conditions, the issuances of CD also remained substantially higher during 2009-10 than that in the previous year. The liquidity in the market ensured interest rates on CD to remain stable with some uptick in the last quarter. The commercial paper (CP) market also picked up as corporates increasingly took recourse to CPs as a means to financing their working capital requirements that led to a significant increase in the share of ‘manufacturing companies’ in the outstanding amount of CPs (Table V.6). Despite the sizeable increase in the issuances of CPs, the comfortable liquidity in the system led to a decline of about 340 basis points in the interest rates between March 2009 and mid-March 2010.
V.16
The Government mobilised large amount through issuances or rollover of treasury bills (TBs) in 2009-10. The yield on TBs that remained soft during the first half, reflecting the impact of low policy rate and ample liquidity, however, increased subsequently on account of expectations of
policy rate hike and rise in inflationary pressures.
Government Securities Market
V.17
In view of the increase in government’s borrowing requirements and the expected pick-up in credit during the second half, the market borrowing programme for 2009-10 was front loaded (Table V.8). In contrast to the low interest rates that prevailed in money markets, the yield on government bonds hardened after Q1 of 2009-10 reflecting the concerns of stimulus led large fiscal deficit and the rising inflationary expectations (Chart V.3a). The Market Stabilisation Scheme (MSS) buyback auctions and open market purchases were synchronised with the
Government’s normal market borrowings coupled with the de-sequestering of MSS balances. By appropriately releasing liquidity to the financial system, the Reserve Bank ensured a relatively smooth conduct of the Government’s market borrowing programme in 2009-10. The borrowing programme for State governments was also completed smoothly; however, the pressure on interest rates persisted(Table V.8). The Government will complete major part (about 63 per cent) of the gross market borrowing programme for 2010-11 in the first half of the year to ensure that there is no crowding out in the latter half of the year when the private credit demand is normally strong. Given the prevailing comfortable liquidity conditions, the frontloading of borrowings would ensure that the pressure on interest rates could be managed.
V.18
Notwithstanding easy liquidity conditions in the money market during 2009-10, the yield curve generally continued to shift upwards indicating market concerns of fiscal deficit and rising inflationary pressures (Chart V.3b). While the medium to long-term bond yields, in general, moved up during the year, reflecting inflation and fiscal deficit concerns, the short-term yield softened till Q3 of 2009-10, reflecting the surplus liquidity conditions, followed by a hardening trend in Q4 as the surplus liquidity reduced and there was a general shift in the interest rate environment. During the Q4 of 2009-10, the government securities market continued to trade with a hardening bias tracking the impact of the increase in CRR on liquidity conditions and the rising WPI inflation.
Credit Market
V.19
In tandem with the increase in the government bond yields, yield on 5-year AAA-rated corporate bonds, that had started hardening in Q2, continued the trend (Chart V.4). Nevertheless, the spreads on corporate bonds over the government bond yield declined to the pre-global crisis level, indicating that the pressure on corporate borrowings has moderated, which has significance during the recovery phase.
V.20
The monetary transmission, which was a concern when the policy rates were reduced by the Reserve Bank, has improved, although with some lags. In response to the ample market liquidity and the lower policy interest rate environment, the banks softened their deposit rates for various maturities between March and December 2009 (Table V.9). The deposit rates, however, moved up in February- March 2010 by 25-50 basis points, reflecting not only the competition for attracting deposits with the pickup in demand for credit but also a change in the interest rate environment resulting from higher policy rates and hardening yield on Government bonds. The transmission of lower cost of funds for banks was visible on the interest rates for private credit as the benchmark prime lending rates (BPLRs) declined. The sub-BPLR lending of banks (excluding export credit and small loans) decreased to 65.8 per cent in December 2009 from 66.9 per cent in March 2009. The introduction of the base rate is likely to impart greater transparency to fixation of lending rates by banks and may also improve the assessment of the monetary policy transmission.
V.21
The monetary policy transmission is reasonably efficient to the money and bond markets, though, slower to the credit market because of existing structural rigidities (Chart V.5a). The transmission of lower policy rates to lending rates in India looks comparable with trends in other EMEs (Chart V.5b). It is possible that the transmission to credit market may exhibit an asymmetric response in terms of speed when the interest rate cycle turns around.
Foreign Exchange Market
V.22
The Indian rupee generally exhibited strengthening trend against the US dollar on the back of capital inflows and positive growth outlook, although marked by intermittent depreciation pressures.
V.23
Reflecting the easing supply conditions in the market led by capital inflows, forward premia generally exhibited declining trend during 2009-10, with sporadic hardening on account of underlying demand conditions (Chart V.7).
V.24
A relatively subdued trade growth seems to have kept the activity in the merchant segment of the foreign exchange market at a relatively lower level, although it is slowly getting back to the pre-global crisis level. The ratio of inter-bank to merchant turnover, thus, increased marginally (Chart V.8a). The currency futures have also grown significantly in volume as the contracts are cash settled and unlike their OTC variants, do not require proof of an underlying that needs hedging.
Equity and Housing Markets
V.25
In the aftermath of the global financial crisis, the movements in asset prices and their implications for the financial stability and monetary policy have been explicitly recognised. During 2009-10, there was sharp growth in key asset prices in India; particularly the domestic equity market registered a phenomenal increase of 81 per cent in prices, outperforming many EMEs.
V.26
The slack in the growth of bank credit to the industry in 2009-10 was offset to a large extent by higher mobilisation of resources through IPOs, private placements and mobilisation by mutual funds. The activity in the primary segment of the domestic capital market displayed signs of revival in Q2 and Q3 of 2009-10. The resources raised through public issues increased considerably during 2009-10 (Table V.11). Mobilisation of resources through private placement (Rs.2,44,107 crore) also increased by 61.0 per cent during April-December 2009. The resource
mobilisation by mutual funds increased substantially with liquidity conditions remaining comfortable, deposit interest rates moderating and stock markets witnessing considerable gains.
V.27
Stock prices displayed a continuous upward momentum throughout the year, except for some occasional corrections during the last two quarters caused by Dubai World default and the Greek sovereign debt concerns. Following the optimism on account of measures announced in the Union Budget 2010-11 such as the roadmap for fiscal consolidation and PSU divestment, stock prices recorded further gains. As at end-March 2010, the Sensex and the Nifty both registered gains of 81 per cent and 74 per cent, respectively, over end-March 2009 (Chart V.9a). The gains in stock prices were associated with substantial increase in the activity in the derivative segment surpassing the preglobal crisis level (Chart V.9b). The gains in stock prices were also led by the FII investments, while at the same time mutual funds turned net sellers. FIIs made net purchases of US$ 23.7 billion in the Indian equity market during 2009-10 (net sales of US$ 10.4 billion in 2008-09), while the mutual funds’ net sales during 2009-10 amounted to Rs.10,512 crore (net purchases of Rs.6,985 crore in of 2008-09)
.
V.28
Another important segment of asset prices is the residential housing segment that has important implications for the behaviour of general prices and overall macroeconomic and financial stability. There has been a general upward pressure on housing prices in the recent period, which broadly co-terminates with the rise in stock prices, thus, indicating generalized asset price pressures (Chart V.11a and b).
V.29
The domestic financial markets during 2009-10, thus, exhibited reduced volatility with market activity returning to the pre-global crisis level. The evolution of interest rates in money and government bonds markets was different. While money market interest rates remained low, reflecting surplus liquidity conditions, there was persistent pressure on medium to long term bond yields. Nevertheless, stronger potential pressure on interest rate on account of the large size of the government borrowing programme was managed by the Reserve Bank through an array of liquidity management tools such as MSS unwinding, OMO purchases and shortening the maturity structure of new issues. Going forward, with the revival of credit demand from the private sector to normal levels, the borrowing programme for 2010-11, despite planned frontloading, could exert some crowding out pressures. A stronger recovery in India and the favourable interest rate differentials in the face of easy global liquidity conditions could lead to higher capital inflows, which may influence both exchange rate and asset prices. The strong rebound in asset prices needs to be monitored closely, given their implications for financial and macroeconomic stability
VI. PRICE SITUATION
The Wholesale Price Index (WPI) inflation, after remaining significantly subdued during the first half of the year, increased at a faster pace in the second half and reached 9.9 per cent by February 2010, and remained almost unchanged at the same high level in March 2010. The Wholesale Price Index, though, exhibited secular increases throughout the year, indicating sustained momentum in inflation. Decline in agricultural production caused by deficient South-West monsoon as well as increases in international price of crude oil largely conditioned the inflation path. Indications of generalisation of inflation became increasingly evident starting from November 2009. Inflation in non-food manufactured products increased from (-)0.4 per cent in November 2009 to 4.7 per cent in March 2010. Alongside increasing generalisation of the inflation process, demand side pressures from certain quarters also became visible. Consumer price inflation moderated in February 2010 although it still remains high in double digits. With recovery in growth gaining momentum, the Reserve Banks’ policy emphasis has shifted to anchoring inflation expectations.
VI.1
Inflationary conditions in India during 2009-10 were marked by two distinct phases. During the first half of2009-10, the year-on-year WPI inflation remained significantly low (negative during June-August 2009) on account of the high base of sharp increases in prices recorded a year ago. This period, however, was characterised by a significant build-up of inflationary momentum, largely on account of the partial pass-through of increases in international prices. During the second half of the year, increasing food prices, on account of unfavourable agricultural supply conditions caused by the deficient South-West monsoon coupled with the waning of base effect led to sharp increase in inflation and the headline WPI inflation reached 9.9 per cent (y-o-y) in February 2010. Increase in international oil prices, and the resultant upward revision in POL prices also contributed to the inflation process during the course of the year. The recent increases in manufactured non-food products inflation signal how an inflation process triggered by supply side pressures could get generalised over time. The primary factor behind the rising headline inflation, i.e., food price inflation, however, has started to moderate since December 2009, largely reflecting seasonal pattern, though it still remains elevated. Moreover, inflation as per Consumer Price Indices (CPIs), which have a higher relative weight for food articles, though declined marginally in February 2010, still remain high.
Global Inflation
VI.2
Most advanced economies witnessed very low or negative headline inflation during the first half of 2009-10. This was mainly on account of the contraction in demand associated with the recession as well the impact of sharp decline in international commodity prices. The emerging economies also experienced significant decline in inflation, mostly due to decline in commodity prices and lower demand pressures on account of moderation in growth. During the second half of 2009-10, inflation in major economies increased from sub zero/low levels, mainly reflecting the waning impact of the base (commodity prices had declined sharply during the second half of 2008-09 leading to decline in prices then in most countries). Some part of the recent increase in inflation across the globe could also be attributed to the rebound in commodity prices ahead of global recovery as well as gradual pick-up in demand as the economies work their way out of recession.
VI.3
Except Japan, most economies registered positive, though subdued CPI inflation by November 2009 (Chart VI.1). Year-on-year consumer price inflation in OECD countries, which was negative during the period June-September 2009, increased to 1.9 per cent in February 2010. Core inflation (excluding food and energy) in OECD countries, after declining since September 2008, has remained stable at around 1.5 per cent since June 2009, indicating the limited pressure on inflation from the demand side.
VI.4
During the first half of 2009-10, there were concerns over a possible deflationary spiral created by the negative inflation in the US, Japan and the Euro area. Those concerns abated with the recent increases in CPI inflation of major economies and stabilising core inflation. In the advanced economies, headline inflation is expected to pick up from 0.1 per cent in 2009 to 1.3 per cent in 2010, as rebound in energy prices could more than offset slowing labour costs. In emerging and developing economies, inflation is expected to increase from 5.2 per cent in 2009 to 6.2 per cent in 2010, as some of these economies may face growing upward pressures from limited economic slack and domestic liquidity effects of increased capital flows. In the emerging economies, inflationary pressures have remained subdued during 2009-10, albeit, with some firming up during the last quarter, except in India and Russia (Table VI.1).
VI.5
Monetary policy stance of most central banks in the advanced economies during 2009-10 was conditioned by concerns over the recession and the subsequent fragile recovery, and policy rates accordingly were left unchanged at near zero levels. During the second half of the year inflationary pressures started to emerge in some economies, particularly those that witnessed faster than expected recovery and gradual closing of the output gap, which led to exit from easy monetary policy. The Reserve Bank of Australia and Bank of Israel have increased their policy rates by 125 and 100 basis points, respectively, since September 2009 on the back of signs of economic recovery and improvement in indicators of confidence (Table VI.1). Peoples Bank of China also raised the reserve requirement ratio by 50 basis points each in January and February 2010.
Global Commodity Prices
VI.6
International commodity prices, which declined sharply during June- December 2008, gradually firmed up in 2009-10. Commodity price rebound ahead of global recovery has been driven by the expectations of recovery in growth and resultant tighter demand conditions in relation to supply (Table VI.2, Chart VI.2).
VI.7
Crude oil prices increased by about 70 per cent (year-on-year) in March 2010. According to the International Energy Agency (IEA) estimates, stronger global economic growth during 2010 may increase oil consumption by 1.7 million barrels per day. While this could suggest possible firming of crude oil prices, availability of ample surplus capacity may dampen any significant pressure on oil prices.
VI.8
The increase in metal prices was led by the improvement in global economic prospects as well as supply cutbacks in response to the prolonged decline in price. International food prices have been increasing gradually (except in July 2009). The FAO Food Price Index, a measure of the monthly change in international prices of a food basket composed of cereals, oilseeds, dairy, meat and sugar increased significantly up to January 2010. The major driver of this increase was sugar, the production of which was affected in the two major sugar producers, i.e., India and Brazil. The FAO Food Price Index, however, declined by 6.8 per cent during January- March 2010 as sugar and cereals price indices declined by 29 per cent and 7 per cent, respectively.
VI.9
The impact of increases in international commodity prices on domestic prices to an extent was modulated by the movements in exchange rate. As the exchange rate appreciated during the course of the year, the exchange rate pass-through effects helped in moderating the impact of
higher international commodity prices on domestic inflation.
Inflation Conditions in India
VI.10
The global trends in commodity prices and domestic demand-supply balance pointed towards less pressure on prices during 2009-10 at the time of the Annual Policy Statement (APS) of the Reserve Bank for the year 2009-10 (April 2009) and accordingly the APS projected WPI inflation at around 4.0 per cent by end- March 2010. The APS reduced the policy rates further by 25 basis points to support the revival of economic growth as economic growth had declined well below its potential level on account of the impact of the crisis along with significant moderation in price pressures (Table VI.3).
VI.11
The First Quarter Review (FQR) of Monetary Policy 2009-10 (July 2009) had highlighted that despite headline inflation turning negative, commensurate decline in inflationary expectations had not materialised. As the uncertain monsoon outlook increased the inflation risks, the FQR revised the end-March 2010 WPI inflation projection upward to 5.0 per cent. The Second Quarter Review (SQR) of Monetary Policy 2009-10 (October 2009) noted that the upside risk from deficient monsoon rainfall materialised and the baseline projection for WPI inflation at end- March 2010, therefore, was revised upwards to 6.5 per cent with an upside bias. The SQR noted that indications of consolidating recovery warranted a shift in policy stance from ‘managing the crisis’ to ‘managing the recovery’. The SQR also indicated the Reserve Bank’s commitment to a calibrated ‘exit’ from the expansionary monetary policy stance without hampering recovery process while anchoring inflation expectations and announced closure of some special liquidity support measures that had largely remained unutilised and restored the statutory liquidity ratio (SLR) of scheduled commercial banks to its pre-crisis level (25 per cent). It signalled the first phase of exit.
VI.12
The Third Quarter Review (TQR) of Monetary Policy 2009-10 (January 2010) raised the baseline projection for WPI inflation for March 2010 to 8.5 per cent on account of further strengthening of supply side pressures and emerging risks of such pressures spilling over on to a wider inflationary process. As part of the calibrated exit strategy, the CRR of scheduled banks was increased by 75 basis points from 5.0 per cent to 5.75 per cent of NDTL in two stages. Further, as WPI inflation increased and reached 9.9 per cent (y-o-y) in February 2010 amidst signs of generalisation of inflation, the Reserve Bank raised the repo and reverse repo rates under the LAF by 25 basis points each on March 19, 2010, balancing the needs of supporting recovery while anchoring inflation expectations.
Wholesale Price Inflation
VI.13
During the first half of 2009-10, the year-on-year WPI inflation remained moderate during April-May 2009 and subsequently turned negative during June- August 2009 on account of the strong base effect of the significant increase in administered prices of petroleum products in June 2008 (Chart VI.3a and b). The base effect of sharp increases in prices during the first half of 2008-09 waned during the second half as WPI had declined during the period September 2008-February 2009 (Chart VI.3a). The secular build up in price pressures, however, was visible throughout the year and WPI inflation increased significantly to 9.9 per cent by March 2010. The financial year build up of inflation exhibited secular uptrend during the year which was corroborated by the positive inflation momentum during all the months of 2009-10 (except June 2009) (Chart VI.3c and d).
VI.14
Though the WPI inflation remained moderate/negative during the first half of 2009-10, contrasting trends among the major sub-groups were visible during that period in terms of weighted contribution to the headline inflation. Since the rate of inflation in each month was different, the weighted contribution based analysis needs to be seen from the standpoint of making an assessment about the extent of variability resulting from different components of the WPI. Food inflation was significantly high during this period, which meant that food group (both primary food articles and manufactured food products) had a disproportionately larger contribution to inflation. On the other hand, fuel group exhibited large negative inflation, which pulled down the overall inflation low during the first half of the year (Chart VI.4 and Chart VI.5). In the second half of the year, inflation contribution came from all the major groups as positive contribution was visible from all the categories, indicating generalisation of inflation.
VI.15
In terms of contribution to overall inflation by the major groups, the contribution of the fuel group, which was significantly negative since January 2009, showed a reversal of trend in recent months (Chart VI.5). The contribution of non-food manufactured products group, which declined during the receding phase of inflation and turned negative during April- November 2009, has also started to increase in recent months. Food articles and products, as a group continue to drive the overall WPI inflation, though its contribution has declined since December 2009.
VI.16
The supply constraints on account of the shortfall in agricultural production and increasing international crude prices were the major drivers of inflation in India Up till November 2009. The emergence of inflationary pressures, thus, was led by increases in prices of a few commodities and inflation remained concentrated in a few commodities. Since then, the inflation has become increasingly generalised as more number of commodities have started to exhibit significant pick-up in inflation. This is manifested in the declining share of top ten contributors to inflation since
November 2009. The cumulative weight of the top ten contributors to inflation have also increased indicating that commodities with relatively higher weights have emerged as the drivers of inflation.
VI.17
When the inflation process tends to get generalised, the transmission from segmented pressures in certain items to the general inflation takes place with a lag, and during this period, containing inflation expectations becomes critical to enhance the effectiveness of monetary policy actions to reign in inflationary pressures. It can be expected that price pressure originating from inflation in fuel group may entail much greater risk to generalisation of inflation with more immediate impact as fuel enter as an intermediate input in most manufacturing products. Pressure from food price shocks on generalised inflation, on the other hand, may be gradual. This, to an extent, has been corroborated by the movements in manufactured non-food products inflation, which moved up significantly in recent months alongside increase in fuel inflation, while food inflation moderated in recent months (Chart VI.7).
VI.18
The y-o-y WPI inflation excluding food and fuel consistently remained below the headline inflation during 2009-10. The trend of non-food non-fuel inflation, however, was mostly in sync with the headline inflation. Inflation in essential commodities group increased sharply during 2009-10, largely driven by food items’ price increases. Essential commodity inflation shows signs of moderation since January 2010 in line with the moderation in food prices (Chart VI.8a).
VI.19
The increases in prices of food articles and food products have contributed 47 per cent of the build-up in WPI inflation during 2009-10. The upward revision of prices of petrol and diesel (effective July 2, 2009) and increase in prices of freely priced products under the fuel group in line with hardening of international crude oil prices further contributed to the increase in inflation during the year. Increases in administered prices of coal, reversal of excise and customs duty on petrol and diesel also partly contributed to the increase in inflation. Thus, the WPI inflation was
above the Reserve Bank’s projection of 8.5 per cent by March 2010.
VI.20
Amongst the major groups, primary articles inflation, y-o-y, remained in single digit up to October 2009 and increased significantly thereafter, mainly on account of food prices, which registered high double-digit increase (Chart VI.8b). Some softening of inflation in primary articles is visible in recent months reflecting the seasonal moderation in prices of food articles and the impact of arrival of fresh crops in the market.
VI.21
Year-on-year fuel group inflation, remained significantly negative during December 2008-November 2009 on account of the lower international crude oil prices compared to the very high levels in 2008. Fuel inflation turned positive in December 2009 reflecting the base effect of downward revision of administered prices in December 2008. The hikes in administered prices of petrol and diesel effective from July 2, 2009 and the reversal of customs and excise duty concessions given on petroleum products in the Union Budget for 2010-11, as part of the fiscal exit, led to increases in administered prices of petroleum products. Freely priced products under the minerals oil group followed the trends in international crude prices and gradually increased during the year (Chart VI.9). It is also to be noted that international oil prices remaining at current
levels would imply a significant gap in the administered prices of petroleum products in relation to the price of Indian basket crude oil (converted to rupees at respective monthly average exchange rates), which would significantly increase the under recoveries of oil marketing companies.
VI.22
Among the other major items in fuel group, coal prices were raised in January 2010 as global prices increased substantially (Chart VI.10). Increase in domestic coal prices, however, remain
significantly lower than international prices. Electricity prices inflation remained moderate during the year. Recent increases in oil and coal prices may, over time, spillover to electricity prices.
VI.23 Manufactured products inflation, y-o-y, declined during the first half of 2009-10 mainly reflecting the significant negative inflation in metals. Manufactured products inflation, however, increased from 0.1 per cent in August 2009 to 7.1 per cent in March 2010 mainly driven by the manufactured food products, led by sugar (Table VI.4). The non-food manufacturing inflation, which was negative up to November 2009, has changed course since then and increased significantly to 4.7 per cent in March 2010.
VI.24
Though the current inflation in food articles in India is quite significant, it needs to be noted that the international food prices have been much volatile in the recent past as compared to the domestic prices. Imports as an option to check price rise in India may not be fully effective as global inflation in food has already caught up with the high levels in India.
Consumer Price Inflation
VI.25
The divergence between WPI and CPI inflation increased during the first half of 2009-10 as WPI inflation declined and became negative while CPI inflation continued to increase. During the second half of the year, even though both CPI (up to January 2010) and WPI inflation
increased, the increase in WPI inflation was much faster than CPI inflation. This led to some narrowing down of the gap between and WPI and CPI inflation in recent months.
VI.26
Overall, while the inflation process continues to be dominated by supply factors, there is increasing evidence of generalization as well as pick-up in demand in certain areas, which could be expected to continue with added momentum, going forward. Strong revival in import growth, major turnaround in corporate sales, gradual increase in capacity utilisation and recent trends in demand for credit from the private sector point to the emerging demand side risks to inflation. Though food prices have started to show seasonal moderation, the level still remains high. Fuel group inflation has accelerated significantly, reflecting higher prices of freely priced fuel products, upward revision in coal prices, and reversal in excise and customs duties that led to corresponding increases in POL product prices, besides the impact of low base. Pressure on the inflation process to get generalised has, therefore, been persistent. Non-food manufacturing products inflation rose from (-)0.4 in November 2009 to 4.7 per cent in March 2010 suggesting more generalisation of the inflation process. Given inflation persistence, high generalised inflation, if not contained, could aggravate inflation expectations and impede the ongoing recovery.
VII. MACROECONOMIC OUTLOOK
Various forward looking surveys in the recent period generally point to an improvement
in business sentiments, besides the prospects of further acceleration in economic
activities in the forthcoming quarters. The Industrial Outlook Survey conducted by the
Reserve Bank shows improvement in the sentiments in the manufacturing sector, in
continuation of the trend seen in the previous survey. The professional forecasters’ survey
of the Reserve Bank suggests an overall (median) GDP growth of 8.2 per cent for 2010-
11. Stronger growth impulses now coexist with significant acceleration in headline
inflation in recent months. While the recovery in growth is expected to further firm up
in 2010-11 over the preceding year, headline inflation could be expected to moderate
over the next few months.
VII.1
After witnessing a slowdown during 2008-09, the economy has recovered in 2009-10, which is expected to firm up further and take hold in 2010-11. Continuing the optimism witnessed in the previous business confidence surveys, the bullish sentiments have grown stronger. The industrial outlook survey of the Reserve Bank indicates improved assessment of the January-March 2010 quarter. The professional forecasters’ survey conducted in March 2010 shows overall (median) growth rate for 2010-11 at 8.2 per cent, driven mainly by increased private consumption expenditure growth and relatively increased industrial activity in the first half and pick-up in services in the second half.
Business Expectation Surveys
VII.2
The forward looking surveys conducted by various agencies generally convey an optimistic picture about the economy. While almost all the surveys report strong Y-o-Y improvements, the picture about sequential Q-o-Q growth is somewhat mixed.
VII.3
Business Confidence Index (BCI) of the National Council of Applied Economic Research (NCAER) increased to 156.8 in April 2010, registering a gain of 2.0 per cent over its January 2010 level. This is the fourth successive quarter in which the BCI has registered an increase. Among the four components, ‘investment climate’ and ‘capacity utilisation’ were weaker as compared to the earlier quarter, but expectations about improvement in ‘overall business conditions’ and ‘financial position of firms’ in the next six months rose substantially, thus driving the increase in the BCI.
VII.4
The Business Confidence Survey of the FICCI for Q3:2009-10, which was released in February 2010, suggests that 83 per cent of the companies felt the overall current economic conditions to be “moderately to substantially better”. Going ahead, around 77 per cent of the companies feel that the economic conditions would improve further in the coming six months. The overall business confidence index contracted by 3.3 per cent over the previous quarter on account of anxiety over withdrawal of stimulus measures. The outlook for jobs, according to the survey, has somewhat improved, with 30 per cent firms stating that they would add to their employee strength in the coming six months.
VII.5
The Dun and Bradstreet Business Optimism Index (BOI) for Q2:2010 increased by 4.0 per cent to 142.8 over Q1:2010 on account of improvement in overall business sentiment. However, some cautiousness on account of high inflation and expected hardening of interest rates is visible from relatively lower optimism with regard to volume of sales, new orders, net profits and employee levels during Q2:2010 as compared to Q1:2010. On a Y-o-Y basis, the BOI for the Q2:2010 recorded a sharp increase of 52.2 per cent, corroborating the fact that the economy is firmly on a revival path. Improving domestic demand, surge in domestic stock markets, increase in advance tax collections, increased capital inflows and stabilising export demand seem to have supported the optimism in the business sentiments.
VII.6
The CII Business Confidence Index for October 2009-March 2010 increased by 7.4 points to 66.1 on top of the 2.4 point increase during the first half of 2009-10. Nevertheless, according to the survey, uncertain global economic outlook and slackening consumer demand continue to affect confidence levels.
VII.7
The seasonally adjusted HSBC Market Purchasing Managers’ Index (PMI) (manufacturing) which had recorded a twenty month high in February 2010 witnessed a marginal fall in March 2010 largely reflecting weaker expansion of both output and new orders. Notwithstanding this fall, the index which reached a level of 57.8 in March 2010, has remained in the above neutral territory (above 50 mark) in each of the past twelve months. It is noteworthy that the strong rise in domestic new orders had been driving the index in recent months. The survey also revealed a sharp rise in input prices, which in turn may be reflected in higher output prices, thus building up supply side pressures on inflation.
VII.8
The HSBC Market Services PMI complemented the trend in manufacturing PMI. The Services PMI declined to 58.1 in March 2010 from the seventeen month peak of 60.9 witnessed in February 2010. In the case of services as well, both input prices and prices charged in the services sector registered some increase.
Reserve Bank’s Industrial Outlook Survey
VII.9
The 49th round of Industrial Outlook Survey of the Reserve Bank conducted during January-March 2010 showed improvement in assessment for the same quarter (Table VII.2). The expectations for the quarter April-June 2010, however, exhibited marginal moderation as compared to January-March 2010 quarter, partly reflecting seasonality. The index, though, remained significantly higher as compared to the corresponding quarter last year. It is noteworthy that in line with the trend witnessed since Q2: 2009-10, both indices (i.e. assessment about the current quarter and expectations about the next quarter) remained in the growth terrain (i.e., above 100, which is the threshold that separates contraction from expansion).
VII.10
The survey reveals that for the assessment quarter, an optimistic view was expressed about the demand conditions. For the forthcoming quarter, however, deterioration in production capacity and capacity utilisation are anticipated by the respondents, reflecting an expected slowdown in demand. The respondents also expect the financial conditions to be adversely affected in the next quarter as reflected in an expected decline in working capital finance requirement and availability of finance. Notwithstanding this, the respondents expect their profit margins to increase as compared to the present quarter. Furthermore, as a sign of gradual return of the pricing power, the selling prices are expected to increase at a higher rate as compared to the previous quarter.
VII.11
The findings of various surveys on business conditions largely reflect similar pattern.
Survey of Professional Forecasters1
VII.12
The results of the eleventh round of ‘Survey of Professional Forecasters’ conducted by the Reserve Bank in March 2010 places overall (median) growth rate for 2010-11 at 8.2 per cent, driven mainly by increased private consumption expenditure growth, stronger industrial activity in first half and further pick-up in services in the second half. The sectoral growth rate forecast for 2010-11 suggests upward revision for agriculture and industry. The forecast for the agriculture sector growth was revised upwards to 4.0 per cent from 3.5 per cent. The forecast for industry was also revised upwards to 9.0 per cent from 8.1 per cent. For services, however, the forecasts remained constant at 9.0 per cent. The overall (median) growth rate for 2009-10 was revised upward to 7.2 per cent, as against 6.9 per cent reported in the earlier survey.
Growth Projections of Different Agencies
VII.13
The CSO advance estimates for GDP growth for 2009-10 at 7.2 per cent suggest that the economy has outperformed the earlier projections of most of the agencies, leading to subsequent upward revisions. Various agency estimates suggest that this uptrend in growth rate is expected to continue in the next financial year as well.
Factors Influencing the Current Growth and Inflation Outlook
VII.14
The economic recovery in 2009-10 so far has been driven by a turnaround in the industrial output and continuing resilience of the services sector. At this juncture, the strong outlook for growth points to significant improvement in the overall macroeconomic conditions while the substantial firming up of headline inflation in recent months has emerged as a key concern.
VII.15
The growth outlook for the Indian economy in the near term remains positive on account of the following factors:
(a) Expectations of satisfactory rabi output, which may offset, partially, the decline in kharif output.
(b) Expectations that the industrial sector would remain buoyant.
(c) Increase in corporate sales and profitability.
(d) Pick-up in order books and capacity utilisation as per different survey results;
(e) Turnaround in exports with improving global conditions.
(f) Pick-up in lead services indicators for transportation, telecommunication and construction, and
(g) Revival in credit demand from the private sector.
VII.16
Notwithstanding the overwhelming positive sentiments about stronger growth in the near term, certain downside risks remain:
(a) The revival in growth of agriculture during 2010-11 hinges on the assumption of normal monsoon, which entails the usual uncertainties.
(b) While investment demand is showing signs of picking up, it is still much below the rate of growth in the pre-global crisis period.
(c) The private consumption demand, which accounts for about 60 per cent of aggregate demand, needs to gain significant momentum.
(d) Decline in saving rate last year, led by sharp decline in public sector savings.
(e) Global economic recovery, though clearly visible, is still weak and thus has implications for sustaining the growth in Indian exports; and
(f) The rising inflation, which may push costs through demand for higher wages and increase in input costs.
VII.17
The headline inflation, which remained at 9.9 per cent in February-March 2010, has emerged as a major policy concern. In the recent weeks, while food inflation is showing signs of slowdown, inflation in fuel and manufactured products is causing more generalised inflationary pressures. Going forward, following factors may exert further upward pressures on inflation:
(a) On the supply side, international commodity prices, especially of crude oil and industrial inputs have been rising in the recent months, thus limiting the option of imports that could contain inflation in India;
(b) Return of pricing power of the corporates with stronger revival in demand;
(c) on demand side, revival in private consumption demand coupled with revival in growth of credit and money supply, and
(d) the gradual exit of the fiscal stimulus measures which has and would entail roll back of excise and customs duty reliefs as well as measures to align domestic prices with international oil prices.
VII.18
While the near-term factors corroborate the acceleration in inflation seen so far, certain factors could help in dampening the inflationary pressures, which include:
(a) Satisfactory rabi production and arrival of new crops in the market that could improve the supply conditions.
(b) A normal monsoon that may translate into improvement in agricultural production, and
(c) The impact of monetary policy actions already initiated by the Reserve Bank to anchor inflationary expectations.
VII.19
The conflicting pulls of supporting the recovery and anchoring inflationary expectations continue to pose a challenge for the conduct of monetary policy. While recovery in private demand needs to be stronger to make the growth process self sustaining, recent strong pick-up in headline inflation has emerged as a key policy concern, since high inflation itself may hamper the recovery in growth. The near-term outlook suggests that economic growth in 2010-11 will be higher than in 2009-10. Inflation, in turn, could be expected to moderate in next few months, from the peak levels seen in recent months, reflecting easing of supply pressures and the impact of necessary policy actions. In sum, there is an overall improvement in business sentiments and economic activity, but concerns relating to elevated levels of inflation remain in the near term. It is likely that the growth impulses could further strengthen during 2010-11, and therefore, anchoring inflationary expectations without hurting the growth process continue to be the focus of monetary policy.
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