Annual Report

3.1 Monetary policy during 1999-2000 attempted to ensure that all legitimate requirements for bank credit were met while guarding against any emergence of inflationary pressures. During the year as a whole, broad money (M₃) grew by 13.9 per cent, which was substantially below the long-run average of a little over 17.0 per cent. Scheduled commercial banks' non-food credit off-take picked up to record 16.5 per cent in support of industrial recovery. At the same time, long-term interest rates eased significantly.

3.2 Increased by 13.9 per cent M₃ (Rs.1,36,182 crore) during 1999-2000 as compared with the growth of 19.4 per cent in 1998-99 (Table 3.1). Net of Resurgent India growth rate worked out Bonds (RIBs), the M₃ to 14.1 per cent during 1999-2000 as compared with 17.3 per cent during 1998-99.

3.3 Monetary aggregates as at end-March are compiled on the basis of data pertaining to the Reserve Bank as on March 31 (i.e., the last working day of the fiscal year) and scheduled commercial banks as on the last reporting Friday of the year. However, in 1999-2000, with the lag between the last reporting Friday of March (i.e., March 24, 2000) and March 31, widening to one full week, the year-end balance sheet adjustments, such as interest rate applications and credit disbursals, were large. For instance, scheduled commercial bank deposits increased by Rs.28,623 crore between March 24-31, 2000 as compared with Rs.11,526 crore between March 26-31, 1999. The year-end bulge in deposits usually results in a degree of overestimation of monetary growth, given the fact that a large part of such deposits, especially demand deposits are, in general, drained out of the banking system in April and May (Table 3.2). The exclusion of such outliers from monetary statistics would provide a more accurate picture of monetary growth. The aberrations that such point estimates could bring about could be somewhat obviated by growth averaging the monthly year-on-year M₃ rates in line with the recommendations of the Working Group on Money Supply (1998). The (net of RIBs) monthly average year-on-year M₃ growth rate worked out to 16.6 per cent during 1999-2000 as compared with 18.2 per cent during 1998-99.

3.4 The year-on-year growth rateM₃ jumped in August 1998 due to inflows on account of RIBs and correspondingly dipped in August 1999 (Chart III.1). If RIBs are not directly reckoned in broad money in line with the residency criterion recommended by the Working Group, the month-end year-on-year growth rate would turn out to be broadly M₃ stable throughout 1999-2000. Monetary growth was mainly driven by the accretion to primary liquidity during the first half of the year and multiplier resulting from the increase in the M₃ the reduction in cash reserve requirements during the second half of the year. The increase in reserve money during 1999-2000 essentially emanated from a steady accretion to the Reserve Bank's net foreign assets (NFA) for the larger part of the year. Although the Reserve Bank's NFA declined during June-October 1999, the resultant contractionary effect was largely offset by an increase in the Reserve Bank's domestic credit, especially to banks and primary dealers. The growth in net bank credit to the government sector, which had been a major factor in intra-year fluctuations in M₃ growth in the recent past, remained subdued in 1999-2000, reflecting the Reserve Bank's liquidity management operations. The expectations of a spurt in transactions demand on account of the Year 2000 transition did not, however, materialise.

3.5 Currency with the public expanded by 11.7 per cent (Rs.19,761 crore) in 1999-2000 as against 16.1 per cent in 1998-99. However, on monthly average basis, currency grew at a much higher rate of 16.3 per cent during 1999-2000 than that of 11.7 per cent during 1998-99. Aggregate deposits decelerated to 14.5 per cent (Rs.1,17,108 crore) during 1999-2000 from 20.2 per cent (17.6 per cent, net of RIBs) during 1998-99, because of a subdued growth in scheduled commercial banks' deposits at 13.9 per cent. During 1999-2000, interest rates on bank deposits of various maturities were revised downwards while the return on other financial assets such as equities remained strong. This was partly reflected in the relatively sluggish accretion to bank fixed deposits.

3.6 The income velocity of money is expected to decline with increased monetisation of the economy, especially with the spread of bank branches but increase with the implementation of financial sector reforms with consequential financial innovations. The income velocity has declined, since 1970-71, from an average of 3.5 in the 1970s to 2.4 in the 1980s and 2.1 in the 1990s. The demand for money which should have declined with financial innovations, has, in fact, gone up in the 1990s on the basis of evidence provided by the downward movement in the income velocity of money. This may be essentially on compilation includes banks' non-resident foreign currency repatriable fixed deposit liabilities such as FCNR(B) deposits (since May 1993) and RIBs (since August 1998), which essentially relate to non-resident portfolio considerations rather than domestic money demand. Secondly, the saving motive for holding money in the form of bank fixed deposits is still very strong despite the emergence of alternate instruments of saving, partly because of public confidence in the Indian banking system and partly because of absence of awareness about how the other financial markets operate. Thirdly, as all financial transactions between the non-bank financial intermediaries and the non-financial commercial sector are routed through the organised clearing and settlement operations in which banks are the participants, the role of banks as providers of financial services is best reflected in the growing number of bank accounts and the predominant share of bank deposits in total financial assets.

3.7 Monetary policy for 1999-2000 had to be framed in the context of uncertainties. The outlook on growth and inflation at the beginning of 1999-2000 was less than clear. However, the actual outcome in respect of real GDP growth and inflation turned out to be relatively favourable. While the foreign exchange market remained relatively stable during the year, the Reserve Bank had to occasionally undertake money market and foreign exchange market operations to contain speculative pressures. The course of monetary management, however, had to contend with buoyant commercial credit demand, the rise in the fiscal deficit and the inflationary implications arising out of the uncertainties surrounding the performance of agriculture. To face the multiple challenges, the Reserve Bank had to use an array of instruments to influence both the quantity and rate variables. While it is recognised that the rate channel would have to ultimately gain prominence in the conduct of monetary policy, in the absence of adequate integration of financial markets, quantity variables such as monetary and credit aggregates would continue to play an important role in the transition. In this context, the movements in broad money need to be seen along with those in output and prices (Chart III.2).

3.8 In the Indian context, both output and price stability should be recognised as vital objectives that should be pursued in both the short term and the medium term. In the absence of complete financial integration and in view of the on-going financial sector reforms, it would be difficult to have a specified single anchor for monetary policy. However, several central banks, especially in industrialised countries, have adopted inflation targeting, by doing away with the intermediate targeting framework, because of the uncertainties in the links between intermediate and final targets and because financial markets are generally well knit (Box III.1). Although price stability is an important economic policy objective by itself, there are several difficulties in adopting such a single goal of monetary policy in India. Given the need to manage the Government borrowing programme, the Reserve Bank would have to balance, often times, its internal debt management function with the monetary

3.9 In most cases of central banking in industrialised countries, the inflation mandate is pursued by adjusting interest rates in order to maintain the economy at a consistent (usually potential) level. Certain central banks have favoured the adoption of some monetary policy rules, including the Taylor rule, in order to provide a basis for expectation formation under normal circumstances (Box III.2). In India, the development of such a rule would require considerable deepening and integration of financial markets and emergence of a strong relation between the interest rate, output and inflation.

3.10 Of late, there has been a growing interest in the impact of the volatility of asset prices on the conduct of monetary policy. There is an ongoing debate as to whether asset prices should be factored into the commodity price indices to be targeted or merely considered as an information variable (Box III.3). There is not much evidence to show that movements in asset, particularly stock, prices have a significant impact on monetary conditions in India. This is because exposure of the Indian banking system to the capital market (lending against shares, for instance) is, at present, limited.

3.11 Net domestic credit (NDC), including commercial banks' investments in commercial paper (CP), public and private sector bonds/ debentures/preference shares and equity shares (termed as non-SLR investments) recorded a lower increase of 16.1 per cent during 1999-2000 as compared with 16.9 per cent during 1998-99 (Table 3.3 and Appendix Table III.1). The ratio of scheduled commercial banks' incremental non-food credit (including incremental non-SLR investments) in incremental NDC increased to 47.1 per cent from 41.8 per cent during 1998-99. This development was in line with the policy objective of ensuring availability of sufficient credit in order to facilitate economic recovery. In the event, the share of the Government sector in incremental NDC declined to 36.7 per cent during 1999-2000 from 41.6 per cent during 1998-99 (Chart III.3).

3.12 Net bank credit to Government increased by a lower order of 14.2 per cent (Rs.55,077 crore) during 1999-2000 as compared with 17.0 per cent during the previous year. While scheduled commercial banks' investments in Government securities shot up by 24.7 per cent during 1999-2000, the net Reserve Bank credit to the Government recorded a decline of 2.8 per cent, brought about by a reduction in net Reserve Bank credit to the Centre by 3.8 per cent. For the first time since 1977-78, the Central Government account with the Reserve Bank showed a surplus, the surplus being Rs.5,587 crore in 1999-2000, as against a deficit of Rs.11,800 crore in 1998-99. The ratio of scheduled commercial banks' incremental investments in Government securities in the incremental net bank credit to the Government soared to 100.3 per cent during 1999-2000 from 64.7 per cent during 1998-99.

3.13 Bank credit to commercial sector accelerated to 16.6 per cent (Rs.82,548 crore) during 1999-2000 from 14.5 per cent during 1998-99. Scheduled commercial banks' total flow of non-food resources to the commercial sector grew at 17.6 per cent in 1999-2000 as compared with 16.4 per cent during 1998-99. The resource flow from bank and non-bank sources - including capital issues, GDRs/ ADRs/FCCBs, CPs (other than those subscribed by banks) and borrowings from as well as bills rediscounted with financial institutions - to the commercial sector increased by Rs.1,51,787 crore in 1999-2000 as against Rs.1,27,952 crore in the previous year (Table 3.3).

3.14 The share of the banking system in the total resource flow to the commercial sector, at 54.7 per cent during 1999-2000 was comparable to that of 54.8 per cent during 1998-99. The increase in the share of the banking system in resource mobilisation by the commercial sector in the past four years suggests that bank finance continues to remain important in the Indian economy.

3.15 Reserve money increased at a slower rate of 8.1 per cent (Rs.20,969 crore) during 1999-2000 as compared with 14.6 per cent during 1998-99, primarily reflecting the reduction in reserve requirements, on the one hand, and the impact of the increasing market orientation of monetary policy operations on the Reserve Bank balance sheet, on the other. Adjusting bank reserves for the first round release of lendable resources, the increase in the monetary base would work out to about 13.0 per cent.

3.16 The increase in reserve money is conventionally decomposed into domestic and external sources of monetisation (Table 3.4). It may be pointed out that a correct picture of the contribution of the domestic and external sources to primary liquidity would require adjustment mainly of Reserve Bank's revaluation of and income from foreign currency asset (FCA) accounts, which are essentially the Reserve Bank's claims on itself and hence reserve money-neutral. In the event, the Reserve Bank's adjusted net foreign assets increased by Rs.21,890 crore during 1999-2000, accounting for as much as 104.4 per cent of incremental reserve money. The ratio of the accretion to the Reserve Bank's adjusted NFA to currency drawals worked out to 104.7 per cent during 1999-2000. The Reserve Bank's adjusted net domestic assets (NDA) declined by Rs.921 crore as the Reserve Bank's incremental credit to commercial banks (Rs.3,256 crore) and primary dealers (PDs) (Rs.3,206 crore) were largely offset by the Centre's monetised surplus (Rs.5,587 crore) (Table 3.5).

3.17 The intra-year switches between the domestic and external sources of reserve money could be viewed in terms of four distinct phases, viz., the first, April-May 1999, the second, June-October 1999, the third, November 1999-February 2000, and the fourth, March 2000 (Chart III.4 and Table 3.6).

3.18 The first phase, i.e., April-May 1999, saw relatively easy monetary conditions. The stage was set by a turnaround in capital inflows in March 1999, resulting in an accretion of Rs.8,008 crore (net of revaluation) to the Reserve Bank's NFA. With the return of orderly conditions in the foreign exchange market, the Reserve Bank announced the reduction in cash reserve requirements by 50 basis points to 10.5 per cent, effective March 13, 1999, releasing lendable resources of about Rs.3,100 crore to the banking system. The Reserve Bank also signaled its preference for a lower interest rate regime by reducing the Bank Rate by one percentage point to 8.0 per cent and the fixed repo rate by two percentage points to 6.0 per cent, effective March 2, 1999.

3.20 The situation changed in the second phase, i.e., June-October 1999, as capital flows dried up in the wake of domestic uncertainties, border tensions and bulk crude oil imports. The foreign exchange market witnessed some degree of volatility during end-May-June 1999 and August 1999. Orderly conditions were restored in the foreign exchange market with the Reserve Bank reiterating its policy to meet temporary demand-supply mismatches in the foreign exchange market, backed by foreign exchange operations. During this period, the Reserve Bank's FCA declined by Rs.2,242 crore (adjusted for revaluation). The Reserve Bank expanded its net domestic assets by Rs.7,269 crore (adjusted for revaluation) largely through credit to scheduled commercial banks (Rs.2,382 crore) and primary dealers (Rs.1,649 crore). As a result, reserve money increased by Rs.4,376 crore. The increase in the net Reserve Bank credit to the Centre was limited to Rs.2,040 crore with the Reserve Bank's fresh subscription to fresh dated securities (Rs.11,000 crore) more than swamped by net open market sales (Rs.11,683 crore).

3.21 The third phase, i.e., November 1999-February 2000, saw the revival of capital inflows which enabled the Reserve Bank to build up its reserves through net purchases from authorised dealers (Rs.8,365 crore). The Reserve Bank mopped up the resultant liquidity by net open market sales amounting to Rs.8,088 crore. This, in turn, reduced net Reserve Bank credit to the Centre by Rs.10,972 crore. Consequently, the incremental primary liquidity was limited to a mere Rs.320 crore.

3.22 The Reserve Bank augmented the lendable resources with banks by about Rs.10,000 crore through a one percentage point reduction in CRR (as well as phasing of incremental CRR on FCNR(B) deposits, etc.) during the fortnights ending November 19 and December 3, 1999. This allowed scheduled commercial banks and PDs to reduce their recourse to the Reserve Bank (Rs.9,791 crore during these two fortnights) and thereby facilitate the easing of call rates below the Bank (and refinance) rate. The Reserve Bank announced that scheduled commercial banks' cash in hand would be eligible for CRR compliance between December 1, 1999 and January 31, 2000 to mitigate any possible difficulties that may arise out of the Year 2000 transition in order to ensure that liquidity conditions would not be under any stress. This was reflected on the sources side by repos (Rs.4,752 crore at face value) during the week ended December 3, 1999. The average inter-bank call rates eased during December 1999 and January 2000. Money market conditions firmed up with the usual seasonal credit demand picking up in February 2000, especially with the year-on-year scheduled commercial banks' non-food credit growth rate accelerating to 18.4 per cent as on February 25, 2000, on the one hand and the withdrawal of the Y2K facility on the other. This, in turn, resulted in scheduled commercial banks and PDs drawing liquidity support of Rs.6,427 crore from the Reserve Bank. Consequently, the call rates averaged 10.6 per cent during February 2000 exceeding, in the process, the Bank Rate.

3.23 The fourth phase, i.e., March 2000, saw a sharp increase in reserve money by Rs.14,150 crore driven by both domestic and external sources. The Reserve Bank's FCA recorded an accretion of Rs.10,926 crore (adjusted for revaluation) as a result of continued capital inflows. The Reserve Bank's net domestic assets also increased by Rs.3,104 crore (adjusted for revaluation). The usual seasonal credit demand put pressure on money market conditions, which was partly mitigated by the Reserve Bank's incremental credit to scheduled commercial banks and PDs amounting to Rs.4,034 crore. The net Reserve Bank credit to the Centre declined by Rs.4,501 crore.

3.24 Unlike in the 1980s, when the reserve money was largely determined by the automatic monetisation of the Centre's fiscal deficit, capital inflows influenced the course of reserve money in the 1990s. The increasing market orientation of monetary policy in order to manage liquidity and ensure orderly conditions has also imparted a degree of volatility to the monetary base. The year-on-year month-end reserve money growth rate has, therefore, recorded a high degree of volatility, with the co-efficient of variation working out to 39.8 per cent during the 1990s as compared with 30.1 per cent during the 1980s.

3.25 Broad money (M₃) recorded a strong growth of 4.7 per cent (Rs.52,061 crore) during the first quarter of 2000-01 as compared with 3.4 per cent during 1999-2000 (up to July 2, 1999) (Appendix Table III.1). The first quarter of 2000-01 which ended on the reporting Friday, June 30, 2000, comprised seven reporting Fridays while the comparable quarter of 1999-2000 which ended on the reporting Friday, June 18, 1999 contained only six reporting Fridays. It would, therefore, be appropriate to compare the June 30, 2000 monetary data with that as on July 2, 1999, which is the seventh reporting Friday of 1999-2000. The year-on-year growth rate M₃ decelerated to 15.2 per cent as on June 30, 2000 from 16.3 per cent (net of RIBs) as on July 2, 1999.

3.26 The sharp increase in the M₃ growth rate during the first quarter of 2000-01 may partly be explained by the impact of end-March 2000 bulge in deposits, which largely took place in the first reporting fortnight of fiscal 2000-01 (ending April 7, 2000), as there was a gap of a whole week between the last reporting Friday (March 24) of 1999-2000 and the balance sheet date (March 31). Reflective of this, aggregate deposits increased by 4.5 per cent (Rs.41,749 crore) during 2000-01 (up to June 30, 2000) as compared with 2.3 per cent in the corresponding period of 1999-2000. Currency with the public, however, decelerated to 4.7 per cent (Rs.8,922 crore) during 2000-01 (up to June 30, 2000) from 8.0 per cent during 1999-2000 (up to July 2, 1999), partly reflecting the slackening of cash demand on account of subdued agricultural activity since the latter half of 1999-2000. On the sources side, net bank credit to Government increased by 6.5 per cent (Rs.28,912 crore) during the first quarter of 2000-01 as compared with the increase of 7.3 per cent during 1999-2000 (up to July 2, 1999). Bank credit to commercial sector accelerated to 3.5 per cent (Rs.20,068 crore) during 2000-01 (up to June 30) from 0.5 per cent during 1999-2000 (up to July 2, 1999) driven by a sharp increase in scheduled commercial banks' non-food credit (2.9 per cent).

3.27 Reserve money declined by 2.1 per cent (Rs.5,896 crore) during 2000-01 (up to June 30, 2000) in contrast to the increase of 0.7 per cent during 1999-2000 (up to July 2, 1999), partly reflecting CRR reductions. The net Reserve Bank credit to the Centre recorded a higher increase of Rs.14,412 crore during the first quarter of 2000-01 as compared with that of Rs.11,279 crore during 1999-2000 (up to July 2, 1999). The Reserve Bank's credit to commercial banks and primary dealers declined by Rs.3,936 crore. The Reserve Bank's net foreign currency assets declined by Rs.4,683 crore (adjusted for revaluation) in sharp contrast to the increase of Rs.4,986 crore (adjusted for revaluation) over the same period essentially reflecting net foreign currency sales to authorised dealers.

3.28 A summary measure of primary liquidity may not be sufficient to capture the multi-dimensional aspects of the Reserve Bank's liquidity management in the context of financial sector reforms and its impact on the short-term interest rate. The management of primary liquidity could be more meaningfully analysed by classifying the Reserve Bank's balance sheet flows according to its autonomous and discretionary components¹ (Box III.4). The offsetting movements of discretionary liquidity (DL) vis-a-vis autonomous liquidity (AL) during 1999-2000 bound the movements in the call rate within a narrow range (Chart III.5).

3.29 The overall liquidity and interest rate conditions in the economy exhibited a marked improvement in 1999-2000. There was a substantial decline in the yield on government dated securities in the primary as well as the secondary markets. The movements in short-term interest rates during the year were influenced by the day-to-day liquidity position determined by the combined effects of autonomous and discretionary liquidity. The Reserve Bank cut the fixed repo rate (in two steps of 2 percentage points in March 1999 and one percentage point in April 2000) to 5 per cent and the Bank Rate (in two steps of one percentage point each in March 1999 and in April 2000) to 7 per cent and enhanced liquidity via CRR cuts from 11 per cent in early March 1999 to 8 per cent in April 2000. The Reserve Bank also reduced the savings deposit rate by 0.5 percentage point to 4.0 per cent in April 2000, which led to a substantial reduction in the cost of funds of the banking system. Interest rates on bank deposits and loans, which exhibited relative stickiness during the greater part of 1999-2000, declined significantly during April 2000 following the liquidity enhancing measures announced by the Reserve Bank on April 1, 2000 (Table 3.8).

3.30 Responding to monetary policy signals and liquidity enhancing measures, long-term interest rates in all segments of the financial market, viz., the government securities market, credit markets and the private bond market, softened during 1999-2000. Deposit rates as well as prime lending rates (PLRs) of public sector banks declined during 1999-2000. Following the one percentage point reduction in the administered interest rates on Public Provident Fund (PPF) and National Saving Certificates (NSC) in January 2000 and General Provident Fund (GPF) in March 2000 and the announcement of monetary policy measures in April 2000, there has been a general reduction in the deposit rates of most public sector banks across all maturities by 50 to 200 basis points. The post-tax return on small saving instruments even after the recent reduction in nominal interest rates, remains considerably higher than that on bank deposits, although the lower effective return on the latter is partly compensated by the liquidity premium and lower transaction costs associated with bank deposits.

The autonomous liquidity (AL) component of a stylised central bank balance sheet may be defined as the liquidity generated by regular central banking functions, other than short-term domestic liquidity management, that accrues to the banking system (Table 3.7). This is typically taken to be the sum of the central banks' credit to the Government and the non-bank domestic sector, its net foreign assets and net other assets minus currency in circulation. Discretionary liquidity (DL) comprises the liquidity generated by policy action by the central bank in order to modulate domestic liquidity conditions. This would consist of central bank credit to banks, which would club all channels for influencing liquidity in the form of discretionary and stand-by facilities. On an ex post basis, the net liquidity (NL) generated by AL and DL would work out to be the change in bank reserves. On an ex ante basis, central banks could modulate NL through changes in DL by estimating the gap between the AL flow and the demand for bank reserves.

3.31 While banks have been given the freedom to offer variable interest rates on longer-term deposits, few have actually shifted over to a variable rate structure. This could be partly due to the strong preference of depositors for fixed rate deposits, mostly to insure against the downside interest rate risk. As a result, as at end-March 1999, about 73 per cent of deposits were of a longer-term nature with a maturity of 364 days and above. The ratio rises to 80 per cent in the case of large public sector banks. Consequently, the effective rate of interest on the outstanding deposits of maturities of 364 days and above is as high as 11 per cent as against the rate of 8.0-9.5 per cent on fresh deposits. The relatively high concentration of deposits at a longer maturity and high non-interest operating expenses of public sector banks at 2.5-3.0 per cent of total assets provide the basic reasons as to why lending rates remain relatively rigid. Further, banks have shifted to floating rate loans for working capital, with fixed interest rates applicable only for project finances. When the average interest rate on deposits are weakly sensitive to changing interest rate conditions, the concentration of banks' portfolios towards floating rate loans exerts pressure on the operating margin. This acts as an important constraint for banks' ability to reduce lending rates sufficiently.

3.32 In April 1999, the banks were given freedom to operate different PLRs for different maturities. About 41 scheduled commercial banks, predominantly foreign banks and private sector banks, have so far reported the introduction of tenor linked PLRs. In order to accord more freedom to banks to determine their interest rates, they were allowed to prescribe separate Prime Term Lending Rates (PTLR) on term loans of three years and above since March 1999. While nominal interest rates softened considerably since March 1999, several structural and other factors have constrained downward flexibility in the interest rate structure. The decline in nominal interest rates has generally lagged behind the decline in the rate of inflation. Along with reduction in PLR by major public sector banks by up to 50 basis points, banks also revised their PTLR downwards by 0.90-1.0 percentage points between end-March 1999 and end-March 2000. The inflation rate, however, (on the basis of average of weeks) declined by 2.6 percentage points. This has raised the ex-post real interest rate in 1999-2000, although on the ex-ante basis, that is taking into account expected inflation rather than actual inflation, real interest rates may not seem to have risen sharply (Box III.5).

3.33 While interest rates declined at the longer end reflecting generally manageable liquidity conditions, the undertone at the shorter end of the market, viz., in the call money market and in the primary market for Treasury Bills remained somewhat firm (Table 3.9) (for details, refer to Section V).

3.34 Aggregate deposits of scheduled commercial banks decelerated to 13.9 per cent (Rs.99,319 crore) in 1999-2000 from 19.3 per cent (16.3 per cent, excluding RIBs) in 1998-99 (Table 3.10 and Appendix Table III.3). The fortnightly average year-on-year increase in bank deposits was also lower at 17.0 per cent during 1999-2000 than 19.5 per cent in 1998-99 (Chart III.6). As indicated earlier, deposit expansion during 1999-2000, measured on March 31 basis increased, but at Rs.1,16,416 crore was nonetheless lower than the projected estimate of Rs.1,18,500 crore in the April 1999 monetary and credit policy statement. Besides this factor, time deposit growth was impacted by the savers' favourable expectation of returns from mutual funds, particularly as a result of tax concessions extended to these funds in the Union Budget 1999-2000 and the reduction in the interest rates on bank deposits.

3.35 Time deposits grew by 15.0 per cent (Rs.89,376 crore) for the year as against 20.3 per cent in 1998-99; it was a reflection of the large net inflows to mutual funds amounting to Rs.21,971 crore as against Rs.3,611 crore in the preceding year. It also reflects to an extent the lack of speedy action on the part of the banks to compete for funds through interest rate adjustments. On a year-on-year basis, resources mobilised/total lendable resources of nine all-India financial institutions, Life Insurance Corporation, General Insurance Corporation and Unit Trust of India increased by 8.8 per cent (Rs.18,602 crore) to Rs.2,29,349 crore as at end-March 2000. The growing preference for market related financial instruments, both by savers and investors, and the recent deceleration in bank deposit growth while indicating the rising importance of non-bank sources of funds in the economy has implications for the future direction of intermediation (Box III.6). In this context, the issue of conversion of specialised financial institutions into either banks or non-banks assumes importance.

3.36 Bank credit recovered with the revival in industrial activity during 1999-2000 growing by 18.2 per cent (Rs.67,121 crore) in 1999-2000 as compared with 13.8 per cent in 1998-99. The increase in bank credit during 1999-2000 was also markedly higher than the average of 15.6 per cent during the 1990s (up to 1998-99). The expansion in food credit by Rs.8,875 crore during 1999-2000 was more than double of Rs.4,331 crore during 1998-99. The conventional non-food bank credit showed a higher order of expansion of 16.5 per cent (Rs.58,246 crore) in 1999-2000 as compared with an increase of 13.0 per cent in the previous year. On an average basis too, the year-on-year month-end non-food credit growth rate was higher at 15.4 per cent than 14.4 per cent during 1998-99 (Chart III.7).

3.37 The increase of 3.5 percentage points in non-food credit growth over 1998-99 largely reflected the increased demand for funds as industrial activity picked up. The share of incremental credit in incremental deposits increased sharply to 67.6 per cent in 1999-2000 as against an average of about 40 per cent during 1996-97 to 1998-99.

3.38 Scheduled commercial banks' non-SLR investments expanded by Rs.12,441 crore in 1999-2000 as compared with Rs.15,921 crore in 1998-99 (Table 3.3). Consequently, banks' non-SLR investments decelerated to 25.7 per cent during 1999-2000 from 49.0 per cent during 1998-99. Nonetheless, the total flow of funds from scheduled commercial banks to the commercial sector (i.e., non-food credit and non-SLR investments) grew by 17.7 per cent (Rs.70,687 crore) as compared with 16.4 per cent during 1998-99. The order of growth in resource availability was more or less consistent with the projected increase of about 18 per cent set in the April 1999 monetary and credit policy statement.

3.39 An analysis of the trends in non-food gross bank credit of select scheduled commercial banks suggests that the pick-up in non-food credit spanned almost all the sectors with the exception of agriculture and small-scale industries (Appendix Table III.4). Credit to the priority sector recorded an increase of Rs.17,236 crore during 1999-2000 as compared with an increase of Rs.15,104 crore in the previous year. It reflected, inter alia, the widening of the scope of the priority sector to include (i) direct housing loans up to Rs.10 lakh in urban and metropolitan areas, (ii) subscription to bonds issued by the National Housing Bank (NHB) and Housing and Urban Development Corporation (HUDCO) exclusively for financing of housing irrespective of the loan size per dwelling unit, (iii) micro credit extended by banks to individual borrowers whether directly or through any intermediary, (iv) credit to NBFCs for on-lending to small road and water transport operators and to units in tiny industries and (v) investment in venture capital. While credit extended to small-scale industries (included under priority sector) declined to Rs.3,330 crore from Rs.4,975 crore during 1998-99, that to medium and large industries increased sharply to Rs.16,783 crore from Rs.12,986 crore during 1998-99. Loans to other sectors recorded a rise of Rs.13,383 crore as compared with the increase of Rs.8,560 crore during 1998-99. Sectors such as housing, consumer durables, NBFCs, loans to individuals against shares/debentures/bonds, real estate, tourism related credit and non-priority sector personal loans exhibited a higher order of increase during 1999-2000, reflecting the banking sector's recent thrust towards financing the services sector and consumer loans.

3.40 Reflecting industrial recovery and increased demand for funds from the banking sector, the gross bank credit to the industrial sector increased by Rs.20,113 crore during 1999-2000 as compared with Rs.17,961 crore in the previous year (Appendix Table III.5). The industry-wise distribution of gross bank credit reveals that out of 26 industries, only two industries exhibited a negative growth in credit as against seven in 1998-99. Credit to engineering and petroleum industries exhibited a sharp turnaround during 1999-2000 while credit to chemicals, dyes, paints, etc., food processing, cement, automobiles, construction, computer software and export related industries such as gems and jewellery, exhibited a substantial rise during 1999-2000 as compared with 1998-99. On the other hand, credit to electricity, iron and steel, vegetable oils (including vanaspati) and infrastructure and other industries was lower while that to mining, tobacco and tobacco products and telecommunications declined in 1999-2000.

3.41 Notwithstanding the pick-up in credit growth, banks sharply increased their investments in government securities by 24.7 per cent (Rs.55,239 crore) in 1999-2000 as against 19.4 per cent in 1998-99. The share of banks' incremental investments in government paper to incremental deposits jumped to 55.6 per cent in 1999-2000 from 31.4 per cent in 1998-99 and the share of lending to government in the overall deployment of resources by scheduled commercial banks was substantially higher at 42.9 per cent than 35.1 per cent in 1998-99. Currently, the banking system holds government and other approved securities of around 34.5 per cent of its net demand and time liabilities as against the requirement of 25 per cent. The excess SLR holdings by banks amounted to about Rs.85,000 crore as at end-March 2000. Banks' preference for government securities, despite a reduction in the stipulated SLR to the statutory minimum of 25 per cent was prompted by the higher capital adequacy requirement of 9 per cent and the prospect of reaping capital gains in the context of a decline in the market yields of government securities. This could, however, have implications for the interest rate spread of the banking system given the relative rigidity in the cost structure of funds mobilised by banks.

3.42 The liquidity enhancing monetary policy measures and a sharp increase in non-deposit resources enabled banks to finance incremental credit disbursals and investments. The Reserve Bank augmented liquidity of the banking system by about Rs.13,000 crore during 1999-2000. This was manifested in the reduction in the balances with the Reserve Bank by Rs.6,129 crore as against an increase by Rs.5,850 crore in 1998-99 (Table 3.10). Secondly, banks' 'other' demand and time liabilities increased by 30.6 per cent (Rs.18,369 crore) as against an increase of 28.7 per cent in 1998-99. Thirdly, banks' 'other' non-bank borrowings (primarily borrowings from the money market) increased by Rs.1,594 crore as against a decline of Rs.139 crore in 1998-99.

3.43 During 1999-2000, the outstanding aggregate export credit of scheduled commercial banks increased from Rs.36,827 crore as on March 26, 1999 to Rs.40,460 crore as on March 24, 2000 and further to Rs.41,958 crore as on June 2, 2000 (Appendix Table III.6). However, as a percentage of net bank credit, it declined from 10.1 per cent as on March 26, 1999 to 9.3 per cent as on March 24, 2000 and increased to 9.5 per cent as on June 2, 2000. The export credit refinance limits of banks increased from Rs.7,269 crore (23.5 per cent of outstanding export credit eligible for refinance of Rs.30,945 crore) as on March 26, 1999 to Rs.10,579 crore (30.6 per cent of outstanding export credit eligible for refinance) as on March 24, 2000 and further to Rs.11,506 crore (32.0 per cent) of outstanding export credit (for working out refinance limit) as on June 2, 2000. With call rates hovering over the Bank Rate (also export credit refinance rate) of 8 per cent during the greater part of 1999-2000, utilisation of export credit refinance was quite substantial, except in December 1999 and January 2000. The daily average utilisation of export credit refinance by banks on a fortnightly basis ranged between Rs.4,106 crore (47.9 per cent of limits) and Rs.9,152 crore (92.0 per cent of limits) during 1999-2000. As on June 2, 2000, the daily average utilisation of export credit refinance was Rs.9,189 crore (79.9 per cent of limits).

3.44 Utilisation of CLF/ACLF continued to be low despite occasional spurts in call money rates in August and October 1999. During April - October 8, 1999, daily average utilisation of CLF ranged between Rs.5 crore (0.3 per cent of limit) and Rs.476 crore (36.2 per cent of limit) whereas the daily average utilisation of ACLF ranged between Rs.6 crore (0.5 per cent of limit) and Rs.110 crore (8.4 per cent of limit). The removal of stipulation of the cooling period, effective October 6, 1999, imparted some impetus to utilisation of CLF/ACLF. The daily average utilisation of CLF and ACLF during the fortnight ended March 24, 2000 was Rs.629 crore (47.8 per cent of limit) and Rs.40 crore (3.1 per cent of limit), respectively. Further, the average utilisation of CLF and ACLF during the fortnight ended June 2, 2000 was Rs.488 crore (37.2 per cent of limit) and Rs.2 crore (0.2 per cent of limit), respectively. With the introduction of the Liquidity Adjustment Facility (LAF), with effect from June 5, 2000, ACLF was replaced by variable rate repo auctions with same day settlement (Box I.1).

3.45 The aggregate outstanding priority sector advances of public sector banks increased from Rs.1,07,200 crore (43.5 per cent of net bank credit) as on the last reporting Friday of March 1999 to Rs.1,27,807 crore (43.6 per cent of net bank credit) as on the last reporting Friday of March 2000 and was 3.6 percentage points higher than the stipulated target of 40 per cent. The advances to the agricultural sector by public sector banks at 15.8 per cent on that date was 2.2 percentage points lower than the sub-target of 18 per cent of net bank credit. Advances to the weaker sections amounted to 7.2 per cent as against the stipulated target of 10 per cent of net bank credit. Private sector banks increased their priority sector credit from Rs.14,295 crore in March 1999 to Rs.14,747 crore in September 1999 and adhered to the priority sector target of 40 per cent as at end-September 1999. However, they faced a substantial shortfall in extending credit to agriculture (8.7 per cent of net bank credit as against the stipulated 18 per cent). The outstanding advances by foreign banks to the priority sector increased from Rs.8,270 crore (37.1 per cent of net bank credit) to Rs.9,699 crore (34.5 per cent). As against the sub-targets of 10 and 12 per cent for SSI and exports, respectively, credit extended by foreign banks to these sectors amounted to 10.2 and 22.5 per cent of net bank credit. While 66 per cent of priority sector advances of foreign banks were directed towards export credit, the bulk of the public sector banks' priority sector advances was accounted for by agriculture (36.1 per cent) and small-scale industries (35.8 per cent).

3.46 Aggregate deposits of scheduled commercial banks increased by 4.6 per cent (Rs. 37,081 crore) during the first quarter of 2000-01 as against the rise of 2.1 per cent during the comparative period of 1999-2000 (up to July 2, 1999). Bank credit increased by 4.4 per cent (Rs.19,303 crore) with food credit and non-food credit rising by Rs. 7,491 crore and Rs. 11,812 crore, respectively. The pickup in non-food credit in the first quarter of this year, in contrast to a decline of 1.0 per cent during 1999-2000 (up to July 2, 1999), indicated continuity in the industrial recovery and the effect of the sharp increase in the fortnight ended April 7, 2000. Scheduled commercial banks' investments in government securities decelerated to 6.5 per cent from 9.8 per cent in 1999-2000 (up to July 2, 1999). The acceleration in non-food credit off-take and high, albeit, lower growth in investments in government securities were facilitated by the reduction in CRR announced in April 2000.

3.47 According to the new series of Wholesale Price Index (WPI) (Box III.7), introduced with effect from April 1, 2000, the annual rate of inflation measured on a point-to-point basis, during 1999-2000, remained consistently below the rates of inflation in 1998-99 for 48 weeks moving in the range of 1.9 per cent to 5.3 per cent in 1999-2000 as compared with the range of 4.2 per cent to 7.3 per cent in 1998-99. The rate of inflation picked up above 5 per cent in the first three weeks of March 2000, before closing the year at 6.5 per cent as against 5.3 per cent in 1998-99² (Chart III.8). The significant spurt in inflation in the last month of 1999-2000 was accounted for by the revision of prices of electricity (15.1 per cent) and urea N content (14.0 per cent) in the third week of February 2000 and prices of kerosene (100.9 per cent), liquified petroleum gas (30.2 per cent) and aviation turbine fuel (18.2 per cent) on March 22, 2000. Excluding the price increases of the above administered items, the inflation rate works out to 2.6 per cent for 1999-2000. Notwithstanding the year-end spurt, the low order of inflation during the major part of 1999-2000 led to the decline of the average rate of inflation (on a weekly basis) to the low of 3.3 per cent in 1999-2000 as against 5.9 per cent in 1998-99 and the average of 9.0 per cent during 1990-91 to 1997-98 (Tables 3.12 and 3.13 and Appendix Table III.7).

The comparative picture of the weighting diagrams of the previous, the existing and the revised series are presented in Table 3.11.

3.48 The inflation rates at the retail level, as measured by the annual variations in the Consumer Price Index for Industrial Workers (CPI-IW), on a point-to-point basis, by and large, moved in tandem with the WPI inflation. The CPI recorded an inflation rate of 4.8 per cent in 1999-2000 as against 8.9 per cent in 1998-99 with the month to month annual rate of inflation ranging between zero per cent in November 1999 and 8.4 per cent in March 1999. The steep deceleration in consumer inflation was reflected in the average (monthly) inflation rate for the year, which moved down to 3.4 per cent in 1999-2000 from 13.1 per cent in 1998-99.

3.49 An analysis of WPI at the disaggregated level indicates that, on an average basis, fuel, power, light and lubricants recorded the highest price increase of 9.0 per cent (3.2 per cent in 1998-99) reflecting the revision of diesel prices, in October 1999, the hike in the price of electricity in the third week of February 2000 and the substantial increase in the prices of kerosene, liquified petroleum gas and aviation turbine fuel in the last week of March 2000. Within the fuel group, the inflation rates of mineral oils and electricity accelerated to 11.8 per cent and 7.5 per cent, respectively, in 1999-2000 from 3.1 per cent and 3.4 per cent in 1998-99. The primary articles group witnessed a moderate order of increase in prices of 1.1 per cent in 1999-2000 as compared with 12.0 per cent in 1998-99. Within the primary articles group, cereals recorded double digit rate of inflation of 17.8 per cent in 1999-2000 as compared with 9.0 per cent in 1998-99. On the other hand, prices of fruits and vegetables, raw cotton and oilseeds declined by 16.9 per cent, 11.7 per cent and 10.2 per cent, respectively, in 1999-2000 in contrast to increases of 29.8 per cent, 7.4 per cent and 15.8 per cent in 1998-99.

3.50 Manufactured products, both on an average as well as on a point-to-point bases, showed the lowest order of increase in inflation since 1982-83. The average inflation in the case of manufactured products decelerated to 2.7 per cent in 1999-2000 from 4.4 per cent in 1998-99. On a point-to-point basis, the inflation rate of manufactured products fell to 2.4 per cent in 1999-2000 from 4.9 per cent during the previous year. The deceleration in the inflation rate, on an average basis, in the case of manufactured products was primarily contributed by the decline in the prices of edible oils, cotton textiles and cement to 12.3 per cent, 0.3 per cent and 1.9 per cent, respectively, in 1999-2000 as against the increases of 22.8 per cent, 1.7 per cent and 1.5 per cent in 1998-99. Besides, sugar, khandsari and gur, iron and steel and machinery and machine tools also exhibited very low inflation rates of 1.6 per cent, 1.3 per cent and 0.1 per cent, respectively, in 1999-2000 as compared with the increases of 14.2 per cent, 2.3 per cent and 0.6 per cent in 1998-99 (Appendix Table III.7).

3.51 The average increase in the administered prices was 8.9 per cent in 1999-2000 as compared with 3.0 per cent in 1998-99 (Table 3.14). This was primarily led by a sharp increase in the prices of mineral oils, electricity and urea N content. Excluding the administered items, the annual average inflation rate fell to 2.1 per cent as against the actual of 3.3 per cent. Chart III.9 shows V shaped price trends in administered commodities between 1997-98 and 1999-2000. Administered prices of fuel and electricity were revised to a high level in 1997-98 and fell in 1998-99, before returning in 1999-2000 to the average levels witnessed during 1994-95 to 1996-97.

3.52 An analysis of the weighted contribution of major commodity groups to the WPI indicates that the fuel group contributed 41.4 per cent of the overall inflation rate in 1999-2000 as compared with a low share of 8.3 per cent in 1998-99. The share of primary articles in the overall WPI inflation receded to 8.1 per cent in 1999-2000 from 46.6 per cent in 1998-99 while that of manufactured products rose from 45.2 per cent to 49.9 per cent over the same period (Table 3.15 and Appendix Table III.8).

3.53 The rate of inflation in terms of the point-to-point variation in the Consumer Price Index for Industrial Workers (CPI-IW) recorded an increase of 4.8 per cent in 1999-2000 as compared with an increase of 8.9 per cent in 1998-99. On an average basis, CPI-IW showed an inflation rate of 3.4 per cent in 1999-2000, much lower than that of 13.1 per cent in 1998-99. The overall deceleration in CPI-IW reflects the subdued movement in the price of food products emanating from the bumper foodgrains production, better management of the Public Distribution System and improved supply position of essential items like edible oils and sugar through imports, which quelled the inflationary expectations in respect of primary articles. As a result, the annualised monthly inflation rates measured by CPI-IW and WPI showed a larger degree of convergence in 1999-2000 than in the preceding year (Appendix Table III.9 and Chart III.10). The differential moved in the range of (-) 2.8 per cent to 4.6 per cent in 1999-2000 as compared with the range of 3.2 per cent to 12.4 per cent in 1998-99. Within the consumer inflation, prices of pulses and products, oils and fats, condiments and spices and vegetables and fruits recorded sharp drops, in line with the comparable counterparts in the wholesale prices. However, the consumer inflation of meat, fish and eggs and fruits and vegetables remained above the wholesale prices of these groups (Chart III.11).

3.54 The frequency distribution of the consumer price inflation based on centre-wise data available for 70 cities across India showed that the price deceleration was common to all centres. Out of 70 centres, 3 centres reported negative inflation, 50 registered under 5.0 per cent inflation and the remaining recorded inflation within the range of 5.0 per cent to 9.9 per cent. The rate of inflation never exceeded the double digit level in any of the centres as against 58 centres, which had reported double digit inflation, in 1998-99.

3.55 The recent trends in the inflation rates have brought to focus a number of aspects of management of prices in India. First, the inflation rate in the past two years (1998-99 and 1999-2000) has moved in a cyclical fashion, reflecting the larger role of agricultural supply cycles on the price situation. Secondly, the delayed revision of administered prices has added a certain degree of uncertainty to the inflation situation. Both these factors have blurred the role of demand side factors in the inflation process. Thirdly, the steady decline in manufacturing sector inflation, a result mainly brought about by internal restructuring and technological upgradation in industry, indicates, inter alia, the growing importance of a competitive industrial sector in sustaining improvement in the price situation. Fourthly, the Indian inflation rate has remained lower than the average inflation rate for developing economies in the 1990s. However, the substantial decline in the inflation rate of the developing economies during the second half of the 1990s has narrowed the differential with the rate obtained in India³ (Chart III.12).

3.56 The year-on-year rate of inflation, as measured by WPI, during the first quarter of 2000-01, increased due to the one time hike in the prices of electricity and urea N content and fuel items effected in February and March 2000, respectively, and also the rise in the prices of primary articles. The rate of inflation was high at 6.8 per cent as on April 1, 2000 and remained above 6.0 per cent till end-June 2000. Among the major groups of WPI, the fuel group exhibited the maximum increase of 26.8 per cent as at end-June 2000 as compared with an increase of 3.0 per cent a year ago and the primary articles group increased to 4.4 per cent from a marginal increase of 0.1 per cent as at end-June 1999. The inflation rate of manufactured products further dipped to a low order of 1.8 per cent as compared with 2.9 per cent a year ago. Within the primary articles group, milk, eggs, fish and meat, fibres and fruits and vegetables contributed to a higher order of increase. In the case of the fuel group, the price increase of major components like mineral oils and electricity was high at 41.8 per cent and 15.1 per cent, respectively, as at end-June 2000 as compared with increases of 1.8 per cent and 5.3 per cent a year ago. In the case of the manufactured products group, mainly edible oils, cement and chemicals and chemical products brought down the overall inflation rate of the group (Appendix Table III.7). The weighted contribution of the fuel group to the overall price rise as at end-June 2000 was maximum at 65.7 per cent as compared with 20.7 per cent as at end-June 1999. The shares of primary articles and manufactured products were 17.1 per cent and 17.2 per cent, respectively, as at end-June 2000 as compared with 1.4 per cent and 78.1 per cent a year ago. The CPI-IW, on a point-to-point basis, showed an increase of 5.2 per cent as at end-June 2000 as compared with 5.3 per cent as at end-June 1999.

3.57 The concept of core inflation has gained importance in the monetary policy framework of several countries in recent years. Core inflation provides a measure of long-term inflation movements in the economy when various types of supply shocks or administered price changes produce fluctuations in the price index. Thus, the core inflation essentially captures the underlying cost and demand conditions which affect inflation when output is at its normal level.

3.58 Core inflation is estimated in several ways. Of them, the two frequently used approaches, viz., the exclusion principle, through which relatively volatile commodity prices are excluded from the inflation rate and the limited influence estimators like the trimmed mean method⁴, through which only a certain part of the skewness in actual commodity prices is removed, are employed to derive the core inflation for India. The inflation targeting countries have been monitoring the core inflation rate by excluding certain commodities from the headline price index.

3.59 The empirical work regarding the estimates of core inflation is of recent origin in India, with few estimates available. It needs to be recognised that estimates of core rate of inflation are sensitive to factors such as the commodity basket and the weight structure. The measure of core inflation for the Indian economy could be worked out by an index constructed after excluding the commodities which are significantly influenced by supply shocks and administered prices from the WPI. By these criteria, the commodities excluded constitute about 38 per cent of the total weight of the WPI. The core inflation measured by the exclusion criteria is estimated to have declined to 2.6 per cent during 1999-2000 from 4.5 per cent in 1998-99. However, given the large number of commodities that were to be excluded from the WPI following the criteria of sensitivity to supply shocks and administered price controls, the core inflation measured on this basis may not reflect a true measure of inflation.

3.60 An alternative estimate is provided by the weighted trimmed mean method, which considers all commodities but removes only the fixed percentage of skewness of inflation from the WPI basket⁵. Chart III.13 provides the annual trends in the actual inflation, as measured by the WPI, and the two alternative core measures of inflation for the Indian economy during 1995-96 to 1999-2000. The core inflation measured by the weighted trimmed mean method (20 per cent trimmed mean) also showed a substantial decline in underlying inflation during the past two years. It declined to 4.0 per cent in 1999-2000 from 4.9 per cent in 1998-99.

3.61 Chart III.14 gives the trends in the annual average M₃ growth, actual inflation and core inflation as measured by the weighted trimmed mean method. The core inflation indicates a closer co-movement with M₃ growth than that of the actual inflation, particularly in the years of significant supply shocks. Both core and actual inflation diverged significantly growth in the years immediately from the M₃ following the second half of the 1990s. It must, however, be emphasised that these are very preliminary results and further work, therefore, is needed both on the methodology and on the utility of the concept for purposes of formulation of monetary policy.