Global Economic Conditions
1. The global economy recovered faster
than expected, led by robust growth in
Emerging Market Economies (EMEs).
Global output increased by over 5 per cent
in Q1 of 2010 but it has hit a soft patch
thereafter due to concerns stemming from
the sovereign debt situation in the euro
area. The IMF revised upwards its global
growth projections for 2010 to 4.6 per cent
from 4.2 per cent earlier. Recovery
continues to remain uneven across
countries in terms of both pace as well as
sustainability. Fiscal austerity measures
being adopted in many advanced
economies could potentially dampen the
growth impulses in these economies.
2. EMEs are expected to continue the
process of normalisation of monetary policy
in view of their stronger recovery, emerging
inflationary pressures, and risks of asset
price build-up. Advanced economies, on the
other hand, may further delay monetary
exit, due to the emergence of new risks to
recovery, as also their well anchored
inflation expectations. According to the
IMF, while headline inflation in advanced
economies could remain subdued at around
1.5 per cent or below, in emerging and
developing economies inflation will edge
up to more than 6 per cent in 2010.
3. The IMF assessment suggests that
because of the low risk appetite of global
investors in general after the euro area
developments, capital flows to EMEs may decline initially before recovering again
driven by their higher growth prospects and
lower public debt. Exchange rates of key
currencies have been highly volatile in
recent months. While the Chinese yuan
exhibited some appreciation, the euro has
depreciated significantly. World trade,
though recovering, is yet to revert to the
pre-crisis level. Divergent growth and
inflation conditions are likely to increase
the asymmetry in the stance of monetary
and fiscal policies across countries, which
in turn could feed into the equity, foreign
exchange and commodities markets to
accentuate volatility.
Indian Economy – Trends and the Outlook
Output
4. Economic recovery gained further
momentum, with robust growth in GDP
recorded in the last quarter of 2009-10.
Going by the progress of the monsoon so
far, the agricultural output is expected to
be better than last year. Industrial
production continues to exhibit strong
double digit growth in the current year, and
notwithstanding some moderation in May
2010, the downside risks to growth are low.
Lead indicators for services activities
suggest continuation of the momentum.
Thus, in 2010-11, GDP growth can be
expected to be higher than 8.0 per cent
projected in the April 2010 Monetary Policy
Statement.
Aggregate Demand
5. Private investment demand recovered
sharply, with gross fixed capital formation
accelerating significantly in the last quarter
of 2009-10. Production trends in capital
goods point to continuation of the strong
investment activities in the near-term.
Disaggregated information such as
production of consumer durables and nondurables,
auto sales and non-oil imports
suggest recovery in private consumption
demand going forward. Government
consumption demand would moderate
reflecting the fiscal consolidation
programmed in the budget. The recovery
in export demand that began in November
2009 may slow in the months ahead because
of developments in the euro area. Pick-up
in demand for credit from the private sector,
rapid growth in corporate sales, and
information on order books available from
forward looking surveys indicate
strengthening of domestic demand. Overall,
private consumption and investment
demand would be the two major drivers of
growth during 2010-11.
Fiscal Conditions
6. The fiscal consolidation plans
programmed in the Union Budget for
2010-11 will benefit from the larger than
expected mobilisation from 3G/ Broadband
Wireless Access (BWA) spectrum auctions,
which alone could reduce the fiscal deficit
by 1 percentage point of GDP. The partial
deregulation/upward revision to the prices
of petroleum products in June 2010 will
contain pressure on the fiscal situation from
under-recoveries of the public sector oil
companies. While the price adjustment in the
petroleum sector may add to headline inflation in the near-term, improved fiscal
situation would be congenial to both
inflation and growth outlook in the medium
run.
External Sector
7. With recovery in growth of exports and
the return of capital flows, the external sector
conditions improved during 2009-10. The
current account deficit, however, widened to
2.9 per cent of GDP in 2009-10, from 2.4
per cent in 2008-09, which contributed to
the recovery through higher absorption of
foreign capital. In 2010-11 so far, import
growth remains strong while capital inflows
have moderated led by the decline in
portfolio flows. During 2009-10, foreign
exchange reserves increased by US$ 13.4
billion (excluding valuation gains) and by
US$ 27.1 billion (including valuation gains).
As on July 16, 2010, the reserves stood at
US$ 281.9 billion.
Monetary and Liquidity Conditions
8. The surplus liquidity conditions that
prevailed all through 2009-10 started
moderating in early 2010-11 in response to
the calibrated normalisation of monetary
policy by the Reserve Bank. In June 2010,
however, there was a severe tightness in
liquidity conditions resulting from a sudden
and sharp increase in the government cash
balances arising out of significantly higher
mobilisation under 3G/BWA spectrum
auctions. While mitigating the liquidity
pressure, the Reserve Bank persevered with
calibrated monetary tightening keeping in
view the higher level of inflation. Between
April and July 2010, the repo and reverse
repo rates were raised cumulatively by 50
basis points and the CRR was raised by 25 basis points. Reflecting increased demand
for credit associated with recovery in growth,
non-food credit growth to the private sector
remained buoyant.
Financial Markets
9. In the first quarter of 2010-11, the
volatility in global markets emanating from
concerns about fiscal sustainability in the
euro area, spilled over to the Indian markets,
particularly the equity market. Reflecting the
tight liquidity conditions in June 2010,
interest rates at the short end of the term
structure edged up, while medium to longterm
yields moderated, in view of the
improved fiscal position after 3G/BWA
auction revenues. In the credit market, credit
spreads moderated while credit growth
accelerated, suggesting improved credit
conditions. The banking sector switched
over to a new “base rate” system of lending
effective July 1, 2010, which is expected to
enhance transparency in loan pricing,
promote competition in the credit market and
also improve the transmission of monetary
policy. The base rates set by major public
sector banks were in the narrow range of
7.25-8.0 per cent. In the housing market, the
pace of increase in house prices over
successive quarters moderated somewhat in
the fourth quarter of 2009-10.
Inflation
10. Headline WPI inflation has been in
double digits since February 2010 and
also become increasingly generalised in
every successive month. Non-food
manufacturing inflation accelerated from
near zero in November 2009 to 7.3 per cent
in June 2010, reflecting the impact of rising
input costs, recovering private demand and associated return of pricing power. In the
last few months, price increases also
reflected upward revisions in several
administered prices or delayed reporting
of data. Monetary policy may not be the
most effective instrument to deal with
supply side pressures on inflation. But
repeated supply shocks and administrative
price increases not only increase inflation
persistence but also aggravate inflation
expectations. For containing the inflation
persistence and anchoring inflation
expectations, anti-inflationary monetary
policy actions become a necessity,
notwithstanding the importance of supply
augmenting structural measures to ensure
a sustained low inflation regime.
Overall Assessment
11. The normalisation of monetary policy has
been conditioned by the growth-inflation
dynamics characterised by robust acceleration
in growth and increasing generalisation of
the double digit inflation. While external
conditions have turned more uncertain after
the sovereign debt related stress in the euro
area, the outlook in India points to further
consolidation in growth during the course of
the year, driven largely by pick-up in private
consumption and investment demand. For the
conduct of monetary policy, emerging demand
side pressures on inflation, increasing
generalisation of the inflation path and
persistence of high food price inflation need
to be assessed along with the expected
favourable impact of a better monsoon than
last year on food prices. With receding
concerns relating to the recovery and given
the emerging risks of generalised inflation,
monetary policy measures have to continue the
calibrated normalisation process. |