Global Economic Conditions
While the outlook for recovery in advanced
economies has improved, concerns persist
over the durability of the momentum
1. Global economic activity in the second half
of 2010 turned out to be stronger than earlier
expectations. However, the uneven pace of
growth across regions and uncertainty about
the durability of recovery in the advanced
economies persist. The positive sentiments
arising from the growth momentum in major
advanced economies was neutralised by the
persistence of high unemployment and
downside risks from weak housing markets and
unfinished deleveraging. The combination of
developments resulted in additional policy
stimulus. While in the US the second dose of
quantitative easing (QE2) was followed up with
extension of fiscal stimulus, other advanced
economies faced a difficult choice between
delaying fiscal exit to support growth on the
one hand and early exit to contain the sovereign
debt concerns on the other. The risk of sovereign
debt crisis spreading from the Euro-zone
periphery has resurfaced in recent months.
EMEs face the risk of inflation from
potential overheating and hardening of
commodity prices
2. Emerging Market Economies (EMEs),
which had recovered ahead of the advanced
economies, exhibited robust growth momentum
driven by domestic demand. Inflation and
overheating risks have, however, prompted
monetary tightening at varied pace. Commodity prices also firmed up, largely
reflecting easy liquidity conditions in advanced
economies, as well as growing demand
pressures in EMEs.
3. The asymmetry in monetary and liquidity
conditions between the advanced and the
emerging economies and the imbalance in their
growth outlook have led to larger capital inflows
to EMEs. The familiar policy challenges of asset
price inflation and upward pressure on exchange
rates have re-emerged. A number of EMEs
resorted to soft capital controls and exchange
market intervention to limit the adverse impact
of excess capital inflows on their economies.
Indian Economy : Developments and
Outlook
Output
Robust broad - based growth puts the
economy back on its earlier high growth
trajectory but sectoral imbalances pose
risks to inflation
4. The robust GDP growth in the first half of
2010-11 suggests that the economy has returned
to its earlier high growth path. Satisfactory
kharif production and higher rabi sowing point
to stronger contribution of the agriculture sector
to overall GDP growth in 2010-11. Industrial
production has exhibited near double digit growth
but the significant volatility adds uncertainty
to the outlook. Lead indicators of the services
sector show sustained buoyancy. In certain
sectors, particularly non-cereal food items,
however, the supply response to market signals
in the form of higher prices has been weak, thereby exerting upward pressures on inflation.
Core infrastructure sector has grown slower
than both the overall GDP and the industrial
sector, suggesting that it remains a constraint
to higher growth. Capacity utilisation levels
have generally remained steady, which
juxtaposed with high growth suggests that
capacity addition is keeping pace with growth
in demand.
Aggregate Demand
Private consumption expenditure and
gross capital formation emerge as the key
growth drivers
5. Growth in private consumption
expenditure, after remaining subdued over
several quarters, exhibited significant
acceleration in the first half of 2010-11. As per
trends in the growth of gross fixed capital
formation, the recovery in investment demand
that had started in the last quarter of the
previous year, has consolidated and remained
strong. Fiscal trends during the year to date
suggest that the fiscal deficit could remain
within the budgeted level, but high growth in
capital expenditure would add to the overall
growth momentum from private demand. Lead
indicators of private demand, such as corporate
sales, capital expenditure plans, non-oil imports
and credit demand point to sustained momentum
in growth. Weak demand conditions in advanced
economies have not affected the domestic
growth momentum much in 2010-11 so far, even
though global uncertainty remains a downside
risk to the growth process.
External Sector
Higher current account deficit remains
fully buffered by higher capital inflows, but
sustainability concerns could stem from
the composition of capital flows
6. As expected, the current account deficit
widened significantly in the second quarter of
the year. Even as exports expanded faster than
imports, the trade deficit widened. From the current account perspective, the cushion to a
widening trade deficit from net invisibles
declined. While higher net capital inflows did
not pose any immediate challenge, unlike in
many other EMEs, because of the widening
deficit in the current account, the shift in the
composition of capital flows, particularly the
sharp jump in portfolio inflows and significant
decline in net FDI inflows raises questions
about the sustainability of the external sector
in the medium-term.
Monetary and Liquidity Conditions
Large primary liquidity injected by the
Reserve Bank eased the liquidity pressures
without diluting its anti-inflationary focus
7. The liquidity conditions had started to
tighten by mid-2010 reflecting the normalisation
of monetary policy and large increase in
Government’s surplus balances with the Reserve
Bank due to revenues generated through 3G/
BWA spectrum auctions. While sustained deficit
liquidity conditions were consistent with the
anti-inflationary monetary policy stance of the
Reserve Bank during the year, the magnitude
of the deficit widened significantly in the
terminal months of 2010 to the point of posing
concerns for growth. The severe tightness in
liquidity was caused by both frictional factors
associated with unusually large surplus
balances of the Government and structural
factors as reflected in stronger credit growth
relative to deposit growth as well as higher
demand for currency. The Reserve Bank
introduced a number of measures with the aim
of limiting the scale of the deficit, including
reduction in SLR by 1 per cent of NDTL
accompanied by a roughly equivalent amount
of OMOs, which remained consistent with its
anti-inflationary policy stance. The magnitude
of liquidity deficit has moderated in recent
weeks.
8. The growth in non-food credit has
remained above the indicative trajectory of the
Reserve Bank since October 2010, reflecting growing credit demand associated with robust
economic growth. Flow of financing from nonbanking
sources lagged behind the incremental
flow of bank credit. Money supply (M3)
growth, however, was slightly below the
projected level on account of sluggish deposit
growth as well as some moderation in money
multiplier resulting from higher growth in
currency.
Financial Markets
Deficit liquidity conditions strengthened
the transmission of policy rate actions to
deposit and lending rates
9. The global financial markets continued
to reflect the uncertainty about sovereign debt
sustainability and the changing growth outlook
of advanced economies. Markets in EMEs,
including India, were influenced more by the
domestic growth outlook, normalisation of
monetary policy, corporate earnings prospects
and the portfolio capital inflows that entailed
a potential source of pressure on exchange rate
and asset prices. In India, reflecting the tight
liquidity conditions, interest rates in the money
market, particularly in CBLO, T-bill, CP and
CD segments hardened significantly.
Recognising the structural imbalance between
deposit growth and credit growth as well as
the underlying signals of the anti-inflationary
monetary policy stance, banks raised their
deposit rates to improve deposit mobilisation
while also raising the lending rates, which
could be expected to moderate the aggregate
demand, going forward. Asset prices generally
remained firm, notwithstanding some
correction in equity prices that partly reflected
expectations about monetary policy actions
associated with the abrupt reversal in the
inflation path. The pace of increase in housing
prices varied across cities. The Reserve Bank
has recently used macroprudential measures
to restrain the role of excessive leverage in
asset price build-up.
Inflation
Upside risks from structural demand supply
imbalance in certain sectors and firming
global commodity prices have increased
10. WPI inflation had witnessed modest
softening during August-November 2010 after
remaining in double digits for five consecutive
months. In December 2010, however, renewed
price pressures surfaced, driven by factors that
were largely unanticipated. Food inflation
exhibited a strong rebound, led by onion and
other vegetables, largely due to unseasonal
rains and supply chain frictions. The Reserve
Bank has already recognised the upside risks
to inflation from higher global commodity
prices, but this hardening happened sooner than
anticipated. The pace of moderation in WPI
inflation over a few months prior to December
2010 was also weak due to persistent elevated
levels of food and fuel inflation, which are
largely insensitive to anti-inflationary monetary
policy measures. The expected significant
softening of food inflation after a normal
monsoon did not materialise, reflecting the
impact of growing structural imbalances in
certain sectors, particularly non-cereal food
items. While the high growth in per capita
income and the shift in the composition of
demand have led to stronger growth in demand
for items such as vegetables, fruits, pulses, eggs
and meat, the supply response has generally
lagged behind. The impact of this imbalance
on food inflation has been magnified by
rigidities in the supply chain management.
11. Non-food manufactured inflation, which is
a broad indicator of generalised and demand
side price pressures, has remained stable in the
range of 5.1 to 5.9 per cent so far in the year.
Besides the expected better supply response in
non-food manufactured items to price signals
and the pressure of imports, normalisation of
the policy rate would have contributed to this
trend. High month-over-month (annualised)
inflation in recent months as also the rising price index of the non-food manufactured group,
however, suggest the combined impact of both
input costs and demand pressures. The factors
underlying the inflation process pose a major
challenge for monetary policy since the impact
of anti-inflationary monetary policy measures
on inflation expectations and core inflation
could be weakened considerably by structural
factors, particularly in an environment of
firming global commodity prices.
Growth and Inflation Outlook
Robust broad - based growth is expected to
coexist with elevated inflation in the nearterm
12. The return to the high growth path in
2010-11 materialised despite an uncertain
global environment. Though the overall global
outlook suggests some moderation in growth in
both advanced and emerging economies in
2011, downside risks to India’s growth
momentum have receded considerably. The
inflation outlook, which is being conditioned by
both demand side and supply side factors,
suggests slow paced moderation in inflation,
with the possibility of rigidity at above the
comfort level in the near-term. Recognising the
need to firmly anchor inflationary expectations
and contain inflation, the Reserve Bank has
raised policy rates six times since the beginning
of March 2010. As a result, along with the
impact of the shift in the LAF mode from reverse
repo to repo, the effective increase in policy rate
has been 300 basis points.
13. Going forward, the Reserve Bank’s
monetary policy measures would have to be
guided by not only the anti-inflationary thrust
that is necessary in an environment of persistent
high inflation, but also their expected
effectiveness in a condition of entrenched
supply side pressures on inflation. Oil prices moving permanently to a higher trading range
looks more probable now. Moreover, sectoral
imbalances in several non-cereal food items that
reflect weak supply side adjustments in response
to rising demand could persist in the near-term,
and higher policy rates may not ensure the
desirable degree of demand adjustment, even
with the usual transmission lags, given the
nature of the items in which the imbalances are
growing. Aggregate demand side pressures on
inflation, however, would have to be contained
in a forward looking manner. Recent trends in
sales growth and earnings of corporates point
to their improving pricing power. MGNREGS,
in turn, has the potential to raise the wage
bargaining power even in the unorganised
sector, particularly in the agriculture and
construction sectors, besides raising rural
demand at a faster pace relative to production
of cereals and non-cereal food items. The
demand side risks are also visible in the growing
size of the current account deficit, and high
inflation differential is a potential factor for
eroding export competitiveness.
14. Thus, given the fact that elevated inflation
and current account deficit are the two major
macroeconomic concerns at the current
juncture, demand management measures need
to acquire centre stage in the near-term, with
structural measures in the medium-run
addressing sectoral imbalances and export
competitiveness. The anti-inflationary focus of
monetary policy would have to continue,
recognising though the limits of monetary
policy in dealing with structural pressures on
inflation, and the need for forward looking
response to demand side pressures. Since a
lower inflation regime is essential for
sustainable high growth, containing inflation
becomes the dominant policy objective in the
current environment. |