1. With improved stability in the foreign
exchange market, the marginal standing
facility (MSF) rate, which had become the
effective anchor for money market rates, was
reduced by 75 bps in the Mid-Quarter Review
on September 20 and further by 50 bps on
October 7 to 9.0 per cent. The Reserve Bank
further introduced 7-day and 14-day variable
rate term repos to provide additional liquidity
up to 0.25 per cent of net demand and time
liabilities (NDTL) of banks.
2. Given the tight liquidity conditions in
line with the policy intent, the MSF rate had
served as the effective policy rate in the short-run.
So the effective cost of funds in the money
market was reduced by lowering the MSF
rate. However, keeping in view the concerns
emanating from high and persistent consumer
price index (CPI) inflation and some rise in the
wholesale price index (WPI) inflation, as also
the impact of low real interest rates on saving
behaviour, the Reserve Bank hiked the repo rate
by 25 bps on September 20. This signalled that the
policy rate needed to respond to inflation risks
so as to secure macroeconomic stability, even
as the process of normalisation of monetary
policy with a rollback of exceptional measures
proceeds.
3. The Reserve Bank has been adopting
a judicious mix of policy under a difficult
macroeconomic scenario of high inflation,
low growth and financial fragilities. Unlike
countries which could go for quantitative easing to support growth on the back of
deflation or very low inflation, India has faced
markedly higher inflation even when compared
to its emerging market peers in recent years.
This makes it important to keep liquidity under
check and the policy rate at a reasonable level
to anchor inflation expectations, with a view
to ensuring stable macro-financial conditions
and positive real returns to savers. As the
exceptional measures are rolled back with the
improvement in exchange market conditions, it
is important to keep this balance in view.
Global Economic Conditions
Sluggish global growth continues to be a
drag on the domestic economy
4. Global growth continues to be sluggish,
as reflected in the downward revisions in
projections by various international agencies.
Notwithstanding a distinct improvement in
growth in the advanced economies, as also
some key emerging market and developing
economies (EMDEs), new risks to global
recovery have arisen from fiscal discord in the
US and uncertainties arising from expectations
related to withdrawal from unconventional
monetary easing by advanced economies.
5. The global inflation remains benign
with slack in labour markets, expected stable
commodity prices on the back of improved
capacities and receding geo-political risks.
6. Global financial markets got a
breather with the Fed decision to maintain the pace of its bond purchases and its signal
that the withdrawal of QE may take longer.
However, financial markets could be disrupted
again when the extraordinary monetary
accommodation in the advanced economies is
withdrawn.
Indian Economy: Developments and Outlook
Output
Moderate recovery expected during H2 on
the back of a rebound in agriculture and an
improvement in exports
7. The slowdown facing the Indian
economy extended into 2013-14 with growth
in Q1 falling to a 17-quarter low. The
growth slowdown was broad-based reflecting
moderation in the services and agriculture
sectors, and contraction in the industrial
sector. Modest improvement in growth is
likely in H2 of 2013-14 on the back of a good
monsoon and some improvements in industrial
growth. A fuller recovery is likely to start taking
shape towards the end of the fiscal year when
current steps to clear the logjams constraining
economic activity seep through the various
inter-sectoral linkages in the economy.
Aggregate Demand
Demand management requires balancing
fiscal consolidation with investment support
8. The aggregate demand of the economy
remained weak during Q1 of 2013-14 despite
government final consumption expenditure
increasing sharply. Private consumption
decelerated, while fixed investment contracted.
There was a sharp fall in fresh investment
proposals from the private corporate sector.
Weak demand conditions were also reflected
in decelerating corporate sales. However,
a good monsoon this year and consequent
encouraging crop prospects are expected to
shore up rural demand. The recent uptick in
exports, if sustained, could provide added momentum. Revival of investment demand
will take some more time. Meanwhile, further
measures are needed to avert fiscal slippage
by reduction in revenue spending, especially
poorly targeted subsidies. At the same time,
public investments need to be boosted to
crowd-in private investment with a view to
supporting a revival in the economy.
External sector
External sector risks lowered as CAD likely
to moderate since Q2
9. The current account deficit (CAD)
which widened again in Q1 of 2013-14, is
likely to moderate in Q2, broadly in line with
the narrower trade deficit. The trade balance
has responded to the policy measures taken,
especially as gold imports declined and
exports picked up. While external risks have
lowered somewhat, it is important to build on
the recent CAD improvement through further
structural adjustments. Focus will also be
needed to encourage stable long-term capital
inflows and to exercise caution with regard to
private external debt that has been rising in
recent years.
Monetary and Liquidity Conditions
Growth-inflation dynamics to shape monetary
policy as normalisation of exceptional
liquidity measures make headway
10. Since mid-July 2013, exceptional
measures were put in place by the Reserve
Bank to maintain liquidity conditions such that
volatility in the forex market is contained. The
policy rate was effectively recalibrated to the
MSF rate, leading to the hardening of money
market rates. However, to facilitate adequate
credit to productive sectors, significant
primary liquidity injection was provided via
LAF, MSF, OMOs and standing facilities.
Notable pick-up in credit off-take since
mid-July has occurred as corporates have substituted costlier money market sources by
bank credit. As such, monetary and liquidity
conditions are evolving broadly in sync with
the policy. Further monetary policy actions
would have to be recalibrated keeping in mind
the growth-inflation dynamics, going forward.
Financial Markets
Near-term uncertainties remain a lingering
concern
11. Forward guidance by the Fed in
September 2013 appears to have calmed near-term
market uncertainties to a significant
extent. Equity markets have rallied, currencies
have appreciated and bond yields appear to
have stabilised after a spell of volatility. The
Indian financial markets also reacted positively
to these developments. With a hesitant global
recovery still unfolding, the challenge would
be to put the domestic economy back on track
quickly before a new world of less abundant
liquidity becomes a reality.
Price Situation
Risks to inflation in H2 of 2013-14 broadly
in balance, but persistence in CPI inflation
remains a concern
12. The trajectory of softening WPI
inflation reversed in Q2 of 2013-14 mainly
due to an increase in food and fuel inflation.
Vegetable prices increased sharply,
impacting food inflation, while exchange rate depreciation and rise in crude oil prices
led to a rebound in fuel inflation. However,
manufactured non-food inflation remained
subdued. While food inflation pressures could
recede somewhat on the back of a normal
south-west monsoon, upside risks exist. These
stem largely from second-round effects of high
food and fuel inflation. This, to an extent, is
already reflected in the stubborn non-food and
non-fuel component of CPI inflation. Risks also
arise from high wage growth and rising costs
of transport, education and health services.
Besides, structural elements and the ratchet
effect may check the fall in food inflation
arising from good harvest.
Macroeconomic Outlook
Macro risks and inflationary pressures to
underpin policy actions
13. A modest improvement in growth is
anticipated in H2 of 2013-14. Both WPI and
CPI inflation may stay range-bound around
the current levels that remain above comfort
levels. Various surveys, including those by the
Reserve Bank show that business confidence
remains weak, while inflation expectations
have risen again. In this milieu, monetary and
fiscal policies will have to be crafted so as to
allow structural policy measures and ground-level
actions to shape a sustainable recovery
by next year. The monetary policy will need to
aim at anchoring inflation expectations, while
appropriately addressing growth risks.
|